**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

# ** **

# **FORM 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 
| **For the  fiscal year ended July 3, 2004** |   | **Commission  file number 000-14742** |
|--------------------------------------------------|--------|---------------------------------------|

 

**CANDELA CORPORATION**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                     |   | **04-2477008**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **530 Boston  Post Road, Wayland, Massachusetts**                |   | **01778**                             |
| (Address of principal  executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephone number,including area code **508-358-7400**

 

Securities registered pursuantto Section 12(b) of the Act: **None**

Securities registered pursuantto section 12(g) of the Act:

 

Common Stock, $.01 par value pershare

 (Title of Class)

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during theproceeding 12 months (or for such shorter period than the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  ý  No   o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form

10-K or any amendment to thisForm 10-K.  o

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule12b-2 of the ExchangeAct) Yes   ý  No   o

 

The aggregate market value ofthe registrant’s voting and non-voting stock, held by non-affiliates of theregistrant as of September 9, 2004, based upon the closing price of suchstock on the NASDAQ Stock Market on that date, was $245,763,149. As ofSeptember 9, 2004, 22,485,192 shares of the registrant’s common stock,$.01 par value, were issued and outstanding.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

 

Portions of the registrant’s definitiveproxy statement for the registrant’s 2004 annual meeting of stockholders, whichis expected to be filed pursuant to Regulation 14A within 120 days of theregistrant’s fiscal year ended July 3, 2004, are incorporated by referenceinto Part III of this Annual Report on Form 10-K.

 

 

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**CANDELA CORPORATION**

**2004 FORM 10-K ANNUAL REPORT**

 

**TABLE OF CONTENTS**

 
|       | PART I                                                                                          |   |
|------------|-------------------------------------------------------------------------------------------------|--------|
|       |                                                                                            |   |
| ITEM 1.    | BUSINESS                                                                                        | 2      |
| ITEM  2.   | PROPERTIES                                                                                      | 15     |
| ITEM  3.   | LEGAL  PROCEEDINGS                                                                              | 16     |
| ITEM 4.    | SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                            | 16     |
|       |                                                                                            |   |
|       | PART II                                                                                         |   |
|       |                                                                                            |   |
| ITEM 5.    | MARKET FOR THE REGISTRANT’S COMMON EQUITY  AND RELATED SHAREHOLDERS’ MATTERS          | 17     |
| ITEM 6.    | SELECTED FINANCIAL DATA                                                                         | 17     |
| ITEM 7.    | MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS     | 19     |
| ITEM 7A.   | QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISK                                     | 29     |
| ITEM 8.    | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                     | 29     |
| ITEM 9.    | CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE           | 30     |
| ITEM 9A.   | CONTROLS AND PROCEDURES                                                                         | 30     |
| ITEM  9B.  | OTHER  INFORMATION                                                                              | 30     |
|       |                                                                                            |   |
|       | PART  III                                                                                       |   |
|       |                                                                                            |   |
| ITEM 10.   | DIRECTORS AND EXECUTIVE OFFICERS OF THE  REGISTRANT                                             | 31     |
| ITEM 11.   | EXECUTIVE COMPENSATION                                                                          | 31     |
| ITEM 12.   | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS | 31     |
| ITEM 13.   | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS                                                 | 31     |
| ITEM 14.   | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                          | 31     |
|       |                                                                                            |   |
|       | PART IV                                                                                         |   |
|       |                                                                                            |   |
| ITEM 15.   | EXHIBITS, FINANCIAL STATEMENT SCHEDULES,  AND REPORTS ON FORM 8-K                               | 32     |
|       |                                                                                            |   |
| SIGNATURES | 34                                                                                              |

 

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### **Part I**

 

**Item 1. Business.**

 

Candela Corporation is a pioneer in thedevelopment and commercialization of advanced aesthetic laser systems thatallow physicians and personal care practitioners to treat a wide variety ofcosmetic and medical conditions including:

 

•                  vascular lesion treatment of rosacea, facialspider veins, leg veins, scars, stretch marks, warts, port wine stains andhemangiomas

 

•                  hair removal

 

•                  removal of benign pigmented lesions such asage spots, freckles and tattoos

 

•                  skin rejuvenation and wrinkles

 

•                  acne and acne scars

 

•                  psoriasis

 

•                  other skin treatments

 

Since our founding 34 years ago, we havecontinuously developed and enhanced applications of laser technology.  In the mid-1980’s we began developing lasertechnology for medical applications, and since that time have shippedapproximately 7,000 lasers to over 60 countries.  Since the early 1990’s we have focused our organizationalresources on developing laser technology for use solely in the aesthetic andcosmetic laser industry.  Ourintroduction of new dermatology/plastic surgery laser systems during themid-1990’s allowed us to expand rapidly in this area.  Candela’s current product line offers comprehensive andtechnologically sophisticated aesthetic and medical laser systems used bydermatologists, plastic surgeons and various other medical and personal carepractitioners. Candela’s product line includes the following innovativeproducts:

 

•                  GentleLASE® family of lasers forthe treatment of unwanted hair and the treatment of vascular lesions, pigmentedlesions and wrinkles.

 

•                  Vbeam® for the treatment ofvascular lesions and wrinkles.

 

•                  ALEXLAZRTM for treating pigmented lesions andtattoos.

 

•                  SmoothbeamTM diode laser, for non-ablativedermal remodeling of wrinkles and the treatment of acne and acne scars.

 

•                  C-beamTM pulsed dye laser for treatment ofpsoriasis and surgical scars.

 

The discretionary income ofaging baby boomers continues to rise which creates new opportunities forCandela.  This market segment places apremium on good health and personal appearance, and has demonstrated awillingness to pay for health and cosmetic products and services.  The growing popularity of laser treatmentsamong the general population is also spurring demand for Candela’sproducts.  Last year, Americans spent anestimated $8.3 billion on cosmetic procedures. Increasingly, lasers are proving an attractive alternative foreliminating unwanted hair.  The laserhair removal market has experienced significant growth over the last severalyears.

 

The Company is dedicated todeveloping safe and effective products. Our aesthetic laser systems are furtherdistinguished by being among the fastest, smallest and most affordable in theirrespective markets.  We believe that wehave increasingly captured significant market share because of these productattributes and we are committed to continual innovation to meet the needs ofour markets.

 

The Company was incorporated in Massachusettson October 22, 1970.  The Companysubsequently reincorporated in Delaware on July 1, 1985.

 

2

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**Industry Overview**

 

Medical lasers use the uniquecharacteristics of laser light to achieve precise and efficacious therapeuticeffects, often in a non-invasive manner. The precise color, concentration, and controllability of different typesof laser light provide for the delivery of a wide range of specializedtreatments.  First introduced in the1960’s, the use of lasers for medical applications grew rapidly in the 1990’sas technical advances made medical lasers more effective and reliable.  Medical lasers today are used for numeroustypes of procedures falling into four broad categories: ophthalmic surgery,aesthetic and cosmetic procedures, general surgery, and dental procedures.  Candela competes solely within the growingmarket for lasers performing aesthetic and cosmetic procedures including:

 

•                  removal of unwanted hair from the face,legs, back, and other body areas

 

•                  treatment of rosacea, facial veins and legveins, red birthmarks, scars, stretch marks, and warts

 

•                  facial rejuvenation and reduction in theappearance of fine lines and wrinkles

 

•                  removal of pigmented lesions such as agespots, freckles and tattoos

 

•                  treatment of acne and acne scars

 

•                  treatment of psoriasis

 

•                  treatment of Nevus of Ota and melasma

 

Lasers produce intense bursts ofhighly focused light to treat skin tissues. A laser’s wavelength (color), energy level, spot size and pulse width(exposure time) are optimized for the specific treatment.  Hair removal and the treatment of variousleg vein malformations require the deepest laser penetration for successful treatmentwhile scars and red birthmarks (port wine stains and hemangiomas) require lesslaser penetration.  Pigmented lesionssuch as sun spots, liver spots and tattoos are typically surface conditionsthat require the least amount of penetration. Different conditions may require the use of different types of lasers,and an active aesthetic and cosmetic practice addressing a broad range of laserprocedures will need multiple lasers.

 

In the pioneering years of thecosmetic and aesthetic laser industry from the late 1980’s to the mid 1990’s,the market for laser procedures was focused on vascular conditions such as portwine stains and hemangiomas and the development of treatments for pigmentedlesions, such as tattoos.  Equipmentavailable in this period tended to be expensive, slow, and bulky. In addition,laser applications addressed the needs of relatively small patient populations,served by a narrow group of specialists.

 

The aesthetic and cosmetic laserindustry is now in an era of broader-based growth.  The major factors converging to drive this growth are:

 

•                  the economics of practitioners in adifficult medical reimbursement environment

 

•                  the rising discretionary income of agingbaby boomers

 

•                  the development of technology that allowsfor new, effective and economical procedures for conditions with large patientpopulations

 

Aesthetic and cosmetic laservendors, who are able to deliver lasers that are efficacious, cost effective,reliable, and easy to use, will be well positioned to take advantage of suchbroader-based industry growth.

 

Managed care and reimbursementrestrictions in the U.S. and similar constraints outside the U.S., such associalized medicine, are motivating practitioners to emphasize aesthetic andcosmetic procedures that are delivered on a private, fee-for-servicebasis.  While cosmetic procedures wereonce the domain of plastic surgeons and dermatologists, reimbursementreductions coupled with the reliable revenue stream from private-pay procedureshave piqued the interest of other specialties, including general practitioners,family care, obstetricians and gynecologists, and general and vascularsurgeons.

 

3

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Key technical developmentsrequired for the broader cosmetic laser markets relate to ease-of-use, speed,lower costs, safety, and effective elimination of undesirable sideeffects.  These factors are critical forbroader segments of practitioners who wish to build aesthetic and cosmetic laserpractices.  These factors are also importantfor minimizing the disruption of a patient’s normal routine and for buildingdemand for procedures addressing very large patient populations.

 

**Business Strategy**

 

Candela continues to believethat a convergence of price, performance and technology is occurring in theaesthetic and cosmetic laser industry, driving market expansion.  We believe we have the necessaryinfrastructure in place to capitalize on this expansion.  Candela’s objective is to continue as theleading provider of aesthetic and cosmetic lasers by using its proprietarytechnology and expertise in light and tissue interaction, as well as bydeveloping market-oriented products that utilize related technologies.  Our business strategy is focused on thefollowing goals:

 

•                  increase penetration of our traditionalcustomer base

 

•                  expand beyond our traditional customer base

 

•                  reduce product costs

 

•                  expand our direct domestic distributionchannels

 

•                  expand our international distributionchannels

 

•                  continue investing in research and developmentto develop new applications that are efficacious, cost-effective, reliable andeasy to use

 

***IncreasePenetration of Our Traditional Customer Base.  ***Ourtraditional customer base consists of dermatologists and plastic and cosmeticsurgeons.  We believe that theaffordability of our products will enable us to penetrate further into thedermatologist, plastic and cosmetic surgeon markets. We believe thataffordability has been a major obstacle preventing the remaining practitionersfrom purchasing a laser.  As competitionfor patients among practitioners increases, those practitioners with aestheticand cosmetic lasers will be able to differentiate themselves.

 

***Expandbeyond our traditional customer base.***  Asreimbursement rates dropped over the past several years, many primary carephysicians (family and general practice, OB/GYN) have begun to seek newservices to offer to their patients. Cosmetic laser procedures represent an ideal new service that isappealing to their patients, and adds a new “cash-pay” revenue stream to theirpractice.  Cosmetic laser procedures aresafe, easy to perform.  As more primarycare physicians realize that these procedures are safe and easy to perform,awareness of cosmetic laser procedures will continue to grow.

 

***ReduceProduct Costs.  ***We apply bottom-up engineering, focusing oneach component to improve the performance of each device while reducing itssize, complexity, and cost.  We believeour approach leads to lasers with fewer parts and greater manufacturing efficiency,resulting in lower production costs, which enables us to offer more reliableproducts at more affordable prices.

 

***ExpandOur Direct Domestic Distribution Channels.  ***NorthAmerica presently represents almost 50% of our sales and is the largest single geographicmarket for our products.  We continue toupgrade our U.S. direct sales force to better address the needs of ourtraditional core markets.

 

***ExpandOur International Distribution Channels.  ***Outsideof the U.S., we continue to strengthen our long-standing positions in Europeand Japan and are seeking to expand our markets in Asia and Latin and SouthAmerica.  We currently have direct salesoffices in Madrid, Frankfurt, Paris, Bangkok, Osaka, Nagoya and Tokyo. Over thepast year we increased the number and improved the quality of our internationalindependent distributor channel.  Wecurrently utilize 52 independent distributors in 64 countries.

 

4

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***ContinueInvesting in R&D.  ***We believe that investment in research anddevelopment is necessary to remain a leader in the aesthetic and cosmetic lasermarket.  Our research and developmentapproach is to develop high quality, reliable, and affordable products that continueto address existing markets and allow us to enter and expand into largermarkets, such as acne therapy.  Ourresearch and development staff works closely with our marketing and operationsgroups to ensure our goals are met.  Ourstrategy has been to drive technology that is market applicable and addressesunmet needs in the marketplace.  To thatend, Candela will continue to apply technologies to reduce the size andcomplexity of its technology and products, increase the speed and ease withwhich therapeutic applications can be delivered, improve its ability to buildand deliver lasers at affordable prices, and address expanding therapeuticapplications and markets.  Candela hasnumerous research and development arrangements with leading hospitals andmedical laboratories in the U.S. and throughout the world.

 

 

**The Market for Aesthetic and Cosmetic Lasers**

 

Our traditional customer basefor aesthetic and cosmetic lasers consists of dermatologists and plastic andcosmetic surgeons.  In addition, otherpractitioner groups are emerging as potential customers, including generalpractitioners, obstetricians, gynecologists, and general and vascularsurgeons.  In the U.S., according to theAmerican Medical Association and various professional societies, there areapproximately 10,000 dermatologists, 8,000 plastic and cosmetic surgeons and11,000 ear, nose and throat specialists. Practitioners in other specialties that are beginning to buy aestheticand cosmetic lasers include 70,000 general practitioners, 35,000 obstetriciansand gynecologists, and 28,000 general and vascular surgeons.  In addition, the aesthetic and cosmeticlaser market includes non-medical practitioners, notably electrologists, ofwhich there are an estimated 6,000 in the U.S.

 

The end markets for cosmeticlaser procedures encompass broad and growing patient groups, including aging“baby boomers” as well as younger age groups. According to the U.S. Census Bureau, at the end of 1998 the number of“baby boomers” in the 35 to 54 age range was approximately 80 million,representing more than 29% of the total U.S. population.  This large population group has exhibited astrong demand for aesthetic and cosmetic procedures.  We believe that as the cost of treatments decreases and thepopularity of laser cosmetic procedures such as hair removal increases, thetarget market for these procedures will expand beyond the baby boomers toinclude a broad range of women and men aged 17 to 65. Demographic factorssimilar to the U.S. underlie the growth of the aesthetic and cosmetic lasermarket outside of the U.S. as well.

 

***HairRemoval.  ***We believe that the great majority of the108 million women over the age of 16 in the U.S. employ one or more techniquesfor temporary hair removal from various parts of the body.  Also, a growing number of men are removinghair by means other than their daily shaving routine.  A number of techniques are used to pull hair from the follicleincluding waxing, depilatories, and tweezing. In the waxing process, a lotion, generally beeswax-based, is spread onthe area to be treated and is then rapidly peeled off, pulling out theentrapped hairs.  Depilatories employrotating spring coils or slotted rubber rolls to trap and pull out thehairs.  Tweezing involves removingindividual hairs with a pair of tweezers. Pulling hair from the follicle produces temporary results, but is oftenpainful and may cause skin irritation. Depilatory creams, which contain chemicals to dissolve hair, frequentlyleave a temporary unpleasant odor and may also cause skin irritation.  Shaving is the most widely used method ofhair removal, especially for legs and underarms, but produces the shortest-termresults.  Hair bleaches do not removehair, but instead lighten the color of hair so that it is less visible.  A principal drawback of all of these methodsis that they require frequent treatment.

 

Before the advent of laser hairremoval, electrolysis was the only method available for the long-term removalof body hair.  Electrolysis is a processin which an electrologist inserts a needle directly into a hair follicle andactivates an electric current in the needle, which disables the hairfollicle.  The tiny blood vessels ineach hair follicle are heated and coagulated, presumably cutting off the bloodsupply to the hair matrix, or are destroyed by chemical action depending uponthe modality used.  The success rate forelectrolysis is variable depending upon the skill of the electrologist andalways requires a series of treatments. Electrolysis is time-consuming, expensive and sometimes painful.  There is also some risk of skin blemishesand a rising concern relating to needle infection.  Because electrolysis requires that each hair follicle be treatedseparately and can only treat visible hair follicles, the treatment of an areaas small as an upper lip may require numerous visits at an aggregate cost of upto $1,000.  The American ElectrologyAssociation estimates that approximately one million people per year undergoelectrology procedures.  Although webelieve the large majority of all electrolysis treatments are for facial hair,the neck, breasts and bikini line are also treated.  Because hair follicles are disabled one at a time, electrolysisis rarely used to remove hair from large areas such as the back, chest,abdomen, and legs.   We believe lasersenable the practitioner to address a potentially larger market thanelectrolysis by treating a larger area of the body more quickly and with betterresults.

 

5

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We believe the market forlaser-based hair removal is growing as the customer compares laser treatmentsto other hair removal methods that are currently available.  The benefits of laser treatment include:

 

•                  significant longer term cosmetic improvement

 

•                  treatment of larger areas in each treatmentsession

 

•                  less discomfort during and immediately afterprocedures

 

•                  reduced procedure time and number oftreatments

 

•                  reduced risk of scarring and infection

 

•                  non-invasive procedures

 

•                  no risk of cross-contamination

 

***VascularLesions.  ***Benign vascular lesions are abnormal,generally enlarged and sometimes proliferating blood vessels that appear on thesurface of the skin as splotches, dots, bulges, and spider shapes in a varietyof colors ranging from red to purple. Different types of benign vascular lesions include the following:

 

•                  rosacea, which is the dilation ofcapillaries in the cheeks, nose, forehead and chin

 

•                  telangiectasias, more commonly referred toas spider veins, appearing on the face and other parts of the body

 

•                  varicose veins, which are large veinsgreater than 1mm in diameter and often bulge above the skin surface

 

•                  leg telangiectasias, which are smallerspider veins up to 1mm in diameter appearing as single strands

 

•                  port wine stains, which are vascularbirthmarks characterized by a red or purple discoloration of the skin

 

•                  hemangiomas, which are protuberances thatconsist of dilated vessels, which often appear on newborns within one month ofbirth

 

•                  stretch marks and scars

 

Varicose leg veins typicallyresult when damaged valves cause blood to stagnate rather than be pumped backto the heart, causing the vein walls to stretch and bulge.  Varicose veins affect a significant portionof the U.S. adult population and increase in prevalence with age.  To date, treatment for varicose veins hasbeen predominantly performed on women. Other benign vascular lesions include port wine stains, hemangiomas, andfacial and truncal telangiectasias or spider veins.  It is estimated that in 1997 there were approximately 661,000procedures performed in the U.S. to remove vascular lesions and the number ofprocedures increased to an estimated 2.6 million in 2003 and worldwideprocedures grew to an estimated 5 million in 2003.

 

***PigmentedLesions/Tattoos: ***Benign pigmented lesions can be both epidermal,on the outer layer of skin, and dermal, on the innermost layer of skin, naturalor man-made (tattoos), and can constitute a significant cosmetic problem tothose who have them. Laser treatment of pigmented lesions is primarilyperformed in international markets, especially in Asia.

 

***SkinRejuvenation: ***Skin rejuvenation is one of the fastestgrowing segments of the aesthetic laser market. A significant percentage of thepopulation suffers from fine lines and wrinkles or older looking skin as a resultof the normal aging process. This is the primary group of candidates fornon-ablative laser treatment. While the market for skin rejuvenation isgreatest in the U.S., significant opportunities abound in international marketswhere there is an aging demographic, such as Japan, or a high prevalence ofphotodamaged skin, such as Australia and Latin/South America.

 

***Acne:*** Patients have expressed dissatisfaction with existing therapies for acneand acne scarring. These therapies include the following: dermabrasion,ablation, excision, chemical peeling and injections of filler materials.According to a direct survey of patients, these therapies have minimalefficacy, require long recovery periods and, in most cases, do not meet patientexpectations.

 

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The majority of acne scarpatients that seek treatment decide not to undertake a procedure. A moreeffective alternative for acne treatment is laser therapy. The Smoothbeam laseremploys a combination of laser light at 1450 nm and cryogen spray to heat thedermis, sebaceous glands, and associated structures within the dermis—withoutdamaging the epidermis. The thermal injury alters the structure of thesebaceous glands, the root cause of acne lesions, resulting in more effectiveand longer-lasting acne clearance. In the treatment of acne scars, the laserinitiates deposition of new collagen to raise depressions in the skin, reducingthe appearance of acne scars. Over a series of treatments, new collagen canfill in and soften the appearance of acne scars.

 

***Psoriasis:***  TheNational Psoriasis Foundation estimates that psoriasis afflicts more than 7million Americans and that between 150,000 and 260,000 new cases are diagnosedeach year.  Candela received FDAclearance in 2001 to market a pulsed dye laser for the treatment ofpsoriasis.  This laser specificallytreats recalcitrant psoriatic plaque safely and effectively and began shippingduring fiscal year 2002.

 

**Candela’s Products**

 

We research, develop,manufacture, market, sell and service lasers used to perform proceduresaddressing patients’ aesthetic, medical and cosmetic concerns.  We offer a comprehensive range of productsbased on proprietary technologies.  Ourproducts focus on the major aesthetic and cosmetic laser applicationsincluding:

 

•                  hair removal

 

•                  non-invasive treatment of facial and legveins and other benign vascular lesions

 

•                  treatment of rosacea

 

•                  removal of benign pigmented lesions such asage spots and tattoos

 

•                  treatment of scars and stretch marks

 

•                  wrinkle reduction

 

•                  treatment of acne and acne scars

 

•                  treatment of psoriasis

 

•                  other skin treatments

 

Laser technology forms the basisfor most of our products.  Our patentedtechnology uses thermal energy generated by an intense pulsed laser lightsource to selectively eliminate unwanted skin blemishes without damaging thesurrounding healthy tissue, and to remove facial or other unwanted hairthroughout the body.  Candela’sobjective is to remain as the leading provider of aesthetic and cosmetic lasersby continually striving to develop smaller, faster, and less expensive devices.Candela has been a pioneer in the laser industry.  From the start, our mission has been to lead the way in thedevelopment of innovative laser products. Significant innovations include:

 

**Dynamic Cooling Device**. The Dynamic Cooling Device (“DCD”) selectively cools only the top layerof the skin, while leaving the targeted underlying hair follicle, vein or otherstructure at normal temperature.  As aresult, higher levels of laser energy can be delivered during treatment, whileminimizing thermal injury, pain, and the inconvenience associated withanesthetics. The design of the hand-held DCD enables the practitioner toclearly see the area being treated, and the combined efficiency of the lasersand DCD reduces the risks of over treatment. The DCD delivers just the rightamount of cooling quickly and consistently. Currently, DCD is available as anoption on several Candela laser systems.

 

**GentleLASE Family**. The GentleLASE is a high-energy,long-pulse solid-state laser that generates laser light in the near infraredwavelength range.  It is used for bothhair removal and the treatment of large (1mm or larger) leg veins.  The technology incorporated in theGentleLASE uses intense pulsed light energy directed through an Alexandriterod, which achieves selective heating while keeping the temperature of the skinbelow its damage threshold.  The longerAlexandrite laser wavelength enables the GentleLASE to penetrate skin surfacesdeeper than traditional Ruby lasers, and the large spot size (18mm) is theindustry’s largest. The basic GentleLASE was recently re-introduced with newadvanced features including a smaller, more transportable size.

 

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Hair removal typically requiresthree to five treatments to achieve efficacious results due to the growth cycleof hair follicles.  A typical treatmentcan range from approximately $200 for an upper lip and chin procedure to asmuch as $1,000 per treatment for the back or chest.

 

The other systems of theGentleLASE family are the GentleLASE Limited EditionTM, our most affordable hairremoval laser, and the GentleYAGTM, a high energy long pulse Nd:YAG laser,designed for the removal of unwanted hair and leg veins for darker and tannedskin. The GentleLASE and GentleYAG lasers are currently cleared to treatunwanted hair on all skin types, vascular and pigmented lesions, and wrinkles.

 

**Vbeam**. The Vbeam delivers the safety and efficacyof the clinically proven pulsed dye laser (PDL) while minimizing theproblematic side effects of postoperative bruising, commonly referred to aspurpura.  It features Candela’s patentedDynamic Cooling Device to protect the epidermis.  The system comes in a choice of four colors, an industry first,and is priced very competitively. The Vbeam provides treatment of facial spiderveins, port wine stains, leg telangiectasias, hemangiomas, poikiloderma,rosacea, scars, warts, stretch marks, vulvodynia, and other vascularabnormalities in adults, children and infants. The Vbeam’s user-adjustable laser pulse duration (0.45-40msec) featuresCandela’s ultra-long pulse duration, the longest offered in a dye laser.  Most treatments of vascular lesions costbetween $300 and $800, depending on the length and the type of procedure.  The combination of Vbeam and GentleLASEoffers the capability to treat a majority of leg veins in patients.  A predecessor product to Vbeam, the SPTL-1b,is currently marketed in Japan, pending Ministry of Health approval of theVbeam. The Vbeam was initially cleared by the FDA for marketing in the U.S. inJanuary 2000, and has since received additional clearance for thetreatment of wrinkles.

 

**ALEXLAZR**. The ALEXLAZR is a short-pulse solid-statelaser, which emits near-infrared light for the non-invasive removal of tattoopigments and pigmented lesions such as freckles and Nevus of Ota, a bluishcolored, non-vascular, pigmented lesion, generally found among persons of Asiandescent.  The ALEXLAZR was cleared bythe FDA for marketing for these uses in the U.S. in 1994.  The ALEXLAZR has a fiber optic deliverysystem that produces an even beam distribution without hot spots. Itswavelength maximizes beam penetration, providing positive results with deeperpigments and is effective in the removal of most tattoo pigments.

 

**Smoothbeam**. Introduced in March 2001, the Smoothbeam diode laser heats collagenin the upper dermis, stimulating new collagen deposition for the improvement ofwrinkles and acne scars. The system is small, easily portable and available infour unique colors to ideally complement the practice environment. Candela hasreceived FDA clearance for the marketing of the Smoothbeam for the treatment ofwrinkles, acne, and acne scars. The Smoothbeam laser employs laser light at1450 nm to heat the dermis, sebaceous glands, and associated structures withinthe dermis in combination with cryogen spray to cool and protect the epidermis.The thermal injury alters the structure of the sebaceous glands, the root causeof acne lesions, resulting in more effective and longer-lasting acne clearance.

 

**C-beam**. Introduced in February 2002, theC-beam is a pulsed dye laser used for the treatment of psoriasis, wrinkles andsurgical scars.  The system has a verylow risk profile; moreover, it is small in size, affordable, and offerseffective results from just a few treatment sessions.

 

# **Sales and Distribution**

 

We market and sell our products in more than64 countries worldwide. Separate regional executives in North America, Latinand South America, Japan, Asia, Europe and the Middle East manage ourmarketing, selling and service activities through a combination of directpersonnel and a network of independent distributors.

 

The mix of direct sales and distributor salesvaries by region. Generally, our distributors enter into a 2-3 year exclusiveagreement during which they typically agree not to sell our competitors’products.  Our sales strategy is tochoose the most productive and practicable distribution channel within each ofour geographic markets.

 

We sell products in the U.S. primarilythrough our direct sales force to our traditional customer base ofdermatologists and plastic and cosmetic surgeons. Outside the U.S. we sell ourproducts in Western Europe, Japan, Latin and South America, the Middle East, andthe Pacific Rim through direct sales offices and distributionrelationships.  We have a total of 75employees in our direct sales offices in Madrid, Frankfurt, Bangkok, Paris,Tokyo, Nagoya and Osaka.  We haveestablished distribution relationships throughout Europe, Japan, Africa, Latinand South America, and the Middle East. Outside the U.S. we currently utilize 52 distributors in 64countries.  Refer to Note 9 of our ConsolidatedFinancial Statements for additional financial information about segments andgeographical areas.

 

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The following chart shows data relating toCandela’s international activities during each of the last three fiscal yearsby geographic region.  Revenue generatedfrom regions other than the U.S. includes sales from Candela’s German, Spanish,French, and Japanese subsidiaries, as well as sales shipped directly tointernational locations from the U.S.

 
| **Revenues:**                            |   | **July 3,  2004** |    | **June 28,  2003** |   | **June 29,  2002** |   |
|------------------------------------------|--------|------------------------|---------|-------------------------|--------|-------------------------|--------|
| **(000)**                                |   |                   |    |                    |   |                    |   |
|                                     |   |                   |    |                    |   |                    |   |
| United States and Canada                 |   | $                      | 49,915  |                    | $      | 37,755                  |   | $ | 25,942 |   |
| Japan and the Far East                   |   | 26,666                 |    | 23,483                  |   | 20,157                  |   |
| Europe                                   |   | 26,525                 |    | 16,685                  |   | 11,693                  |   |
| United States shipments to other regions |   | 1,332                  |    | 728                     |   | 896                     |   |
|                                     |   |                   |    |                    |   |                    |   |
| Total Revenue                            |   | $                      | 104,438 |                    | $      | 78,651                  |   | $ | 58,688 |   |

 

#### **Service and Support**

 

We believe that quick and effective deliveryof service is important to our customers. We strive to respond to service calls within 24 hours and to completethe call within 48 hours to minimize practitioner disruption.  Our principal service center and parts depotis located at our Wayland, Massachusetts headquarters.  Parts depots are also located at our salesoffices in Japan, Thailand, Spain, Germany and France.  Independent distributors also maintain partsdepots.

 

We also believe a highly trained andqualified service staff is key to product reliability. Distributors andsubsidiaries have the primary responsibility of servicing systems within theirterritories. Their service personnel are required to attend formal training tobecome certified. In addition, we have service and technical support staff ineach of our markets worldwide.

 

Product maintenance and repair following thewarranty period provides an additional recurring source of revenue.  Customers may elect to purchase a servicecontract or purchase service on a time-and-materials basis.  Our service contracts vary by the type ofsystems and the level of services desired by the customer and typically lastfor a 12 to 24-month period after the initial warranty period expires.  Initial warranties on most laser productscover parts and service for twelve months. One of our products, the Vbeam lasersystem, comes with a standard 3-year warranty that includes maintenance and aspecified level of consumables.

 

Candela emphasizes education and support ofits customers.  Our recommendedpreventive maintenance, coupled with continuing technical education for servicerepresentatives, helps to ensure product reliability.  After a sale, a Candela-qualified service engineer installs thesystem at the customer site by performing validation tests to ensure the systemis operating properly. Before or after installation, a nurse clinician isavailable to provide the practitioner with training and clinical support.

 

**Manufacturing**

 

We design, assemble, and test our brandedproducts at our Wayland, Massachusetts facility.  Ensuring adequate and flexible production capacity, continuouscost reduction, and superior product quality are top priorities of ourmanufacturing organization.  We achieveour goals by:

 

•                  working closely with the research anddevelopment organization, including significant early involvement in productdesign,

 

•                  continually improving our just-in-timemanufacturing and inventory processes, and

 

•                  effectively managing a limited number of themost qualified suppliers.

 

9

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Our facility has ISO 9001 certification andhas established and is maintaining a quality system that meets the requirementsof EN 46001, ISO 13485 and CAN/CSA-ISO 13485. ISO 9001 certification providesguidelines for the quality of company systems associated with the design,development, production, servicing and distribution of medical lasers andaccessories. EN 46001 and ISO 13485 standards are European quality requirementsand CAN/CSA-ISO 13485 is a Canadian quality requirement, all specificallyrelating to the design of medical devices.

 

Our products are manufactured with standardcomponents and subassemblies supplied by subcontractors to our specifications.  We purchase certain components andsubassemblies from a limited number of suppliers.

 

If our suppliers are unable to meet ourrequirements on a timely basis, our production could be interrupted until weobtain an alternative source of supply. To date, we have not experienced significant delays in obtaining dyes,optical and electro-optical components, electronic components, and rawmaterials for our products.

 

**Research and Development**

 

We believe that our advanced research andengineering activities are crucial to maintaining and enhancing our business,and we are currently conducting research on a number of applications.  We believe that our in-house research anddevelopment staff has demonstrated its ability to develop innovative newproducts that meet evolving market needs. Our core competencies include:

 

•                  applied laser physics and technology

 

•                  new imaging methods

 

•                  tissue optics

 

•                  photochemistry

 

•                  laser-tissue interaction

 

•                  clinical research

 

•                  engineering and design of medical laser devices

 

As we discover new technologies orapplications with commercial potential, we assemble a team to develop the newproduct or application in cooperation with leading physicians and medical andresearch institutions.  In the U.S. inparticular, we must receive FDA clearance before marketing new products orapplications.

 

Our research and development team works withour operations group to design our products for ease of manufacturing andassembly and with our marketing group to respond to market opportunities.  We believe this interaction betweenfunctional groups facilitates the introduction of new products with the rightbalance of features, performance, quality, and cost.  To date our research and development effort has relied primarilyon internal development building on our core technologies rather than throughacquisition.

 

In addition, Candela conducts joint researchwith physicians affiliated with various medical and research institutions.  One example of technology developed throughjoint research is our DCD that was developed in conjunction with the BeckmanLaser Institute at the University of California, Irvine.  We anticipate continuing joint research andlicensing arrangements with medical research institutions.

 

Our expenditures on research and developmentare set forth in Item 7.

 

# **Customers**

 

We currently sell our products primarily tophysicians.  The majority of ourcustomers choose to finance their purchases through independent leasingcompanies. Our sales are not dependent on any single customer or distributor,and Candela continues to expand its distribution channel in the U.S. through adirect sales force. Our customers are located in more than 64 countries.  We continue to target the estimated 6,000electrologists in the U.S. as potential customers for GentleLASE for hairremoval, positioning GentleLASE as an adjunct to traditional electrolysismethods.

 

10

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**Competition**

 

Competition in the aesthetic and cosmeticlaser industry is intense and technological developments are expected tocontinue at a rapid pace.  Althoughthere are several manufacturers of aesthetic and cosmetic lasers, we believeCandela is one of only a few companies that offer a broad range of productsable to address multiple applications. Unlike Candela, few of our competitors focus exclusively on the cosmeticand aesthetic laser market.  We competeon the basis of proprietary technology, product features, performance, service,price, and reputation.  Some of ourcompetitors have greater financial, marketing, and technical resources than wedo; moreover, some competitors have developed, and others may attempt todevelop, products with applications similar to ours.

 

We believe that many factors will affect ourcompetitive position in the future, including our ability to:

 

•                  develop and manufacture new products thatmeet the needs of our markets

 

•                  respond to competitive developments andtechnological changes

 

•                  manufacture our products at lower cost

 

•                  retain a highly qualified research andengineering staff

 

•                  provide sales and service to a worldwidecustomer base

 

•                  improve product reliability

 

**Proprietary Rights**

 

We have several U.S. and foreign patents andhave four U.S.and one foreign patent applications pending to protect our rightsin certain technical aspects of our hair removal, benign vascular lesion,pigmented lesion, and other laser systems. The expiration dates for our issued U.S. patents range fromDecember 8, 2006 to December 6, 2019.

 

In addition to our portfolio of patentsissued and pending, we license patented technology from third parties.  We use DCD under a license agreement topatent rights owned by the Regents of the University of California (“Regents”).  In August 2000 we entered into anagreement to amend the license agreement whereby in exchange for an exclusivityfee of approximately $1.7 million, which was prepaid in full, Candela obtainedexclusive license rights to the DCD (subject to certain limited license rightsof Cool Touch, Inc (“Cool Touch”)) in the following fields of use:  procedures that involve skin resurfacing andrejuvenation, vascular skin lesions, and laser hair removal.  Cool Touch obtained a license to the DCD ona co-exclusive basis with Candela, in certain narrower fields of use.  Cool Touch is restricted in its ability toassign its license rights to certain existing competitors of Candela.  Candela is entitled to one-half of allroyalty income payable to the Regents from Cool Touch.  Under the amended agreement, Candela nolonger is required by the Regents to negotiate sublicenses to thirdparties.  However, Candela is entitledto one-half of all royalties due from any other entity that licenses the DCDtechnology from the Regents in other fields of use.

 

We rely primarily on a combination of patent,copyright, and trademark laws to establish and protect our proprietaryrights.  We also rely on trade secretlaws, confidentiality procedures, and licensing arrangements to establish andprotect our technology rights. In addition, we seek to protect our proprietaryrights by using confidentiality agreements with employees, consultants,advisors, and others.  We cannot becertain that these agreements will adequately protect our proprietary rights inthe event of any unauthorized use or disclosure, that our employees,consultants, advisors, or others will maintain the confidentiality of suchproprietary information, or that our competitors will not otherwise learn aboutor independently develop such proprietary information.

 

Despite our efforts to protect ourintellectual property, unauthorized third parties may attempt to copy aspectsof our products, to violate our patents, or to obtain and use our proprietaryinformation.  In addition, the laws ofsome foreign countries do not protect our intellectual property to the sameextent as do the laws of the U.S.  Theloss of any material trademark, trade name, trade secret, or copyright couldhurt our business, results of operations, and financial condition.

 

11

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We believe that our products do not infringethe rights of third parties.  However,we cannot be certain that third parties will not assert infringement claimsagainst us in the future or that any such assertion will not result in costlylitigation or require us to obtain a license to third party intellectualproperty.  In addition, we cannot becertain that such licenses will be available on reasonable terms or at all,which could hurt our business, results of operations, and financial condition.

 

**Government Regulation**

 

***FDA’sPremarket Clearance and Approval (“PMA”) Requirements.  ***Unless an exemption applies, each medicaldevice that we wish to market in the U.S. must receive either “510(k)clearance” or PMA in advance from the U.S. Food and Drug Administrationpursuant to the Federal Food, Drug, and Cosmetic Act.  The FDA’s 510(k) clearance process usually takes from four totwelve months, but it can last longer. The process of obtaining PMA approval is much more costly, lengthy, anduncertain and generally takes from one to three years or even longer.  We cannot be sure that 510(k) clearance orPMA approval will ever be obtained for any product we propose to market.

 

The FDA decides whether a device must undergoeither the 510(k) clearance or PMA approval process based upon statutorycriteria.  These criteria include thelevel of risk that the agency perceives is associated with the device and adetermination whether the product is a type of device that is similar todevices that are already legally marketed. Devices deemed to pose relatively less risk are placed in either class Ior II, which requires the manufacturer to submit a pre-market notificationrequesting 510(k) clearance, unless an exemption applies.  The pre-market notification must demonstratethat the proposed device is “substantially equivalent” in intended use and insafety and effectiveness to a legally marketed “predicate device” that iseither in class I, class II, or is a “pre-amendment” class III device (i.e.,one that was in commercial distribution before May 28, 1976) for which the FDAhas not yet decided to require PMA approval.

 

After a device receives 510(k) clearance, anymodification that could significantly affect its safety or effectiveness, orthat would constitute a major change in its intended use, requires a new 510(k)clearance.  The FDA requires eachmanufacturer to make this determination in the first instance, but the FDA canreview any such decision. If the FDA disagrees with a manufacturer’s decision notto seek a new 510(k) clearance, the agency may retroactively require themanufacturer to submit a pre-market notification requiring 510(k)clearance.  The FDA also can require themanufacturer to cease marketing and/or recall the modified device until 510(k)clearance is obtained.  We have modifiedsome of our 510(k) cleared devices, but have determined that, in our view, new510(k) clearances are not required.  Wecannot be certain that the FDA would agree with any of our decisions not toseek 510(k) clearance.  If the FDArequires us to seek 510(k) clearance for any modification, we also may berequired to cease marketing and/or recall the modified device until we obtain anew 510(k) clearance.

 

Devices deemed by the FDA to pose thegreatest risk such as life-sustaining, life-supporting, or implantable devices,or deemed not substantially equivalent to a legally marketed predicate device,are placed in class III.  Such devicesare required to undergo the PMA approval process in which the manufacturer mustprove the safety and effectiveness of the device to the FDA’ssatisfaction.  A PMA application mustprovide extensive pre-clinical and clinical trial data and also informationabout the device and its components regarding, among other things, manufacturing,labeling, and promotion. After approval of a PMA, a new PMA or PMA supplementis required in the event of a modification to the device, its labeling, or itsmanufacturing process.

 

A clinical trial may be required in supportof a 510(k) submission or PMA application. Such trials generally require anInvestigational Device Exemption (“IDE”) application approved in advance by theFDA for a limited number of patients, unless the product is deemed anonsignificant risk device eligible for more abbreviated IDE requirements.  The IDE application must be supported byappropriate data, such as animal and laboratory testing results.  Clinical trials may begin once the IDEapplication is approved by the FDA and the appropriate institutional reviewboards are at the clinical trial sites.

 

To date, the FDA has deemed our products tobe class II devices eligible for the 510(k) clearance process.  We believe that most of our products indevelopment will receive similar treatment. However, we cannot be certain that the FDA will not deem one or more ofour future products to be a class III device and impose the more burdensome PMAapproval process.

 

12

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***Pervasiveand Continuing FDA Regulation. ***A host of regulatory requirements apply tomarketed devices such as our laser products, including labeling regulations,the Quality System Regulation (which requires manufacturers to follow elaboratedesign, testing, control, documentation, and other quality assuranceprocedures), the Medical Device Reporting regulation (which requires thatmanufacturers report to the FDA certain types of adverse events involving theirproducts), and the FDA’s general prohibition against promoting products forunapproved or “off label” uses.  Class IIdevices such as ours also can have special controls such as performancestandards, post-market surveillance, patient registries, and FDA guidelinesthat do not apply to class I devices. Unanticipated changes in existingregulatory requirements or adoption of new requirements could hurt ourbusiness, financial condition, and results of operations.

 

We are subject to inspection and marketsurveillance by the FDA for compliance with regulatory requirements.  If the FDA finds that we have failed tocomply with applicable requirements, the agency can institute a wide variety ofenforcement actions.  The FDA sometimesissues a public warning letter, but also may pursue more drastic remedies, suchas refusing our requests for 510(k) clearance or PMA approval of new products,withdrawing product approvals already granted to us, requiring us to recallproducts, or asking a court to require us to pay civil penalties or criminalfines, adhere to operating restrictions, or close down our operations.  Ultimately, criminal prosecution isavailable to the FDA as punishment for egregious offenses.  Any FDA enforcement action against us couldhurt our business, financial condition, and results of operation.

 

***OtherU.S. Regulation. ***We also must comply with numerous federal, state,and local laws relating to such matters as safe working conditions,manufacturing practices, environmental protection, fire hazard control, andhazardous substance disposal.  We cannotbe sure that we will not be required to incur significant costs to comply withsuch laws and regulations in the future or that such laws or regulations willnot hurt our business, financial condition, and results of operations.

 

***ForeignRegulation. ***International sales are subject to foreigngovernment regulation, the requirements of which vary substantially fromcountry to country.  The time requiredto obtain approval by a foreign country may be longer or shorter than thatrequired for FDA approval, and the requirements may differ.  Companies are now required to obtain the CEMark prior to sale of certain medical devices within the European Union(“EU”).  During this process, thesponsor must demonstrate compliance with ISO manufacturing and qualityrequirements.

 

Candela and its products may also be subjectto other federal, state, local, or foreign regulations relating to health andsafety, environmental matters, quality assurance, and the like.  Candela’s compliance with laws that regulatethe discharge of materials into the environment or otherwise relate to the protectionof the environment does not have a material effect on its ongoingoperations.  Candela has not made anymaterial expenditures for environmental control facilities.

 

**Product Liability and Warranties**

 

Our products are generally covered by aone-year warranty, with an option to purchase extended warranty contracts atthe time of product sale or service contracts after the time of sale, exceptfor our Vbeam product which is covered by a standard three-year warranty.  We set aside a reserve based on anticipatedstandard warranty claims.  We believesuch reserves to be adequate, but in the event of a major product problem orrecall, such reserves may be inadequate to cover all costs, and such an eventcould have a material adverse effect on our business, financial condition, andresults of operations.

 

Our business involves the inherent risk ofproduct liability claims.  We maintainappropriate product liability insurance with respect to our products with acoverage limit of $13 million in the aggregate.  We cannot be certain that with respect to our current or futureproducts, such insurance coverage will continue to be available on termsacceptable to us or that such coverage will be adequate for liabilities thatmay actually be incurred.

 

**The Skin Care Centers**

 

In 1996, we began an effort to own andoperate skin care centers offering cosmetic laser treatments utilizing ourequipment along with other cosmetic services traditionally offered by high-endspas.  We pursued this strategy bypurchasing an operating spa in Boston in 1996. In March 1997, we opened a new facility in Scottsdale, Arizona,with no pre-existing customer base.   Wesubsequently decided to reduce our focus on our skin care center efforts.  We closed our Scottsdale facility in 1997.We have subleased the Scottsdale facility as of the third quarter of fiscal2002. The remaining spa in Boston was closed in September of 2003.

 

13

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**Applied Optronics**

 

On January 8, 2003, the Company acquiredsubstantially all of the assets of Applied Optronics, the diode division ofSchwartz Electro-Optics, Inc. Applied Optronics was a leading manufacturer ofhigh-powered, pulsed and CW lasers, and was a component supplier to the OEMmarket that serves a variety of industries including the military, medical,industrial, research and robotics fields. Applied Optronics was the leadsupplier of the diodes for the Company’s Smoothbeam diode laser system. TheApplied Optronics operation, located in South Plainfield, New Jersey, generatesrevenue from diode sales to third-party customers.

 

**Employees**

 

As of July 3, 2004, we employed 290people in the following areas of our organization:

 

•                  29 in research, development, and engineering

 

•                  58 in manufacturing and quality assurance

 

•                  38 in service positions

 

•                  49 in sales and marketing

 

•                  41 in finance and administrative positionsand all others

 

•                  75 in our international sales and servicesubsidiaries

 

###### **Recent AccountingPronouncements**

 

In January 2003, the FASB issued FASB InterpretationNo. 46 (“FIN 46”) “Consolidation of Variable Interest Entities.” Thisinterpretation of Accounting Research Bulletin No. 51, “Consolidated FinancialStatements,” addresses consolidation by business enterprises of variableinterest entities. Under current practice, two enterprises generally have beenincluded in consolidated financial statements because one enterprise controlsthe other through voting interests. This interpretation defines the concept of“variable interests” and requires existing unconsolidated variable interestentities to be consolidated by their primary beneficiaries if the entities donot effectively disperse the risks among the parties involved. Thisinterpretation applied immediately to variable interest entities created afterJanuary 31, 2003, and to variable interest entities in which an enterpriseobtains an interest after that date. It applied in the first fiscal year orinterim period beginning after June 15, 2003, to variable interestentities in which an enterprise holds a variable interest that it acquiredbefore February 1, 2003. If it is reasonably possible that an enterprisewill consolidate or disclose information about a variable interest entity whenthis interpretation becomes effective, the enterprise shall discloseinformation about those entities in all financial statements issued afterJanuary 31, 2003. The interpretation may be applied prospectively with acumulative-effect adjustment as of the date on which it is first applied or byrestating previously issued financial statements for one or more years with acumulative-effect adjustment as of the beginning of the first year restated. Wehave completed our assessment of this interpretation and determined that we arenot party to any variable interest entities as of July 3, 2004.

 

In April 2003, the FASB issued Statement ofFinancial Accounting Standards No. 149 (“SFAS 149”), “Amendment of Statement133 on Derivative Instruments and Hedging Activities.” This Statement amendsand clarifies financial accounting and reporting for derivative instruments,including certain derivative instruments embedded in other contracts(collectively referred to as derivatives) and for hedging activities underStatement of Financial Accounting Standards No. 133 (SFAS 133), “Accounting forDerivative Instruments and Hedging Activities.” The statement was effective forcontracts entered into or modified after June 30, 2003. The adoption ofthis standard did not have a material impact on our financial position orresults of operations.

 

In May 2003, the FASB issued Statement of FinancialAccounting Standards No. 150 (“SFAS 150”), “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.” ThisStatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. It requires that an issuer classify a financial instrument that iswithin its scope as a liability (or an asset in some circumstances). Thisstandard was effective at the beginning of the first interim period beginningafter June 15, 2003, except for mandatorily redeemable financialinstruments of nonpublic entities that are subject to the provisions of thisStatement for the first fiscal period beginning after December 15, 2003.The adoption of this standard did not have a material impact on our financialposition or results of operations.

 

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**Available Information**

 

Access to our Annual Report on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K and amendments to thesereports filed with or furnished to the Securities and Exchange Commission maybe obtained through the Investor Relations section of our website atwww.candelalaser.com/ir_corp.asp as soon as reasonably practical after weelectronically file or furnish these reports. We do not charge for access toand viewing of these reports. Information on our Investor Relations page and onour website is not part of this Annual Report on Form 10-K or any of our othersecurities filings unless specifically incorporated herein by reference. Inaddition, our filings with the Securities and Exchange Commission may beaccessed through the Securities and Exchange Commission’s Electronic Data Gathering,Analysis and Retrieval system at www.sec.gov. All statements made in any of oursecurities filings, including all forward-looking statements or information,are made as of the date of the document in which the statement is included, andwe do not assume or undertake any obligation to update any of those statementsor documents unless we are required to do so by law.

 

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

 

We lease a facility totaling approximately35,000 square feet for our operations in Wayland, Massachusetts, which islocated approximately 20 miles west of Boston. The lease on this facility was amended in April 2003 to extend theexpiration date to March 2008. We also lease a 12,000 square foot facilityin South Plainfield, New Jersey for our diode operation. This lease ends onOctober 31, 2008. Candela’s management believes that its currentfacilities are suitable and adequate for our near-term needs.

 

Candela’s subsidiaries currentlylease the following facilities:

 

•                  Candela Skin Care Center of Scottsdale, Inc.,7,555 square feet located in Scottsdale, AZ. The lease on this facility is for a period of ten years, expiring onJune 30, 2006, with a provision for two five-year extensions. OnNovember 1, 2001, the Scottsdale facility was subleased, although subleasepayments did not begin until April 2002. As part of the sub-leaseagreement, Candela will pay one month of rent in each of fiscal years 2003,2004 and 2005. Future rent payments have been accounted for in ourrestructuring reserve.

 

•                  Candela Skin Care Center of Boston, Inc.,20,728 square feet located in Boston, MA. The lease on this facility is for a period of 15 years, and commenced onJune 1, 1994.  Future rent paymentshave been accounted for in our restructuring reserve.

 

•                  Candela KK. – Tokyo office. The lease on400, and 72 square meters of space, expires on May 23, 2005, andSeptember 16, 2006, respectively.

 

•                  Candela KK – Osaka office. The lease on this97 square meter facility is for a period of 2 years, expiring on Jan 31, 2005.

 

•                  Candela KK – Nagoya office. The lease onthis 49 square meter facility is for a period of 1 year, expiring onNovember 14, 2004.

 

•                  Candela KK – Fukuoka office. The lease onthis 56 square meter facility is for a period of 2 years, expiring onSeptember 30, 2005.

 

•                  Candela Iberica, S.A..  The lease on this 367 square meter facilitylocated in Madrid, Spain is for a period of three years and expires onDecember 31, 2006.

 

•                  Candela Deutschland GmbH.  The lease on this 380 square meter facilityin Neu Isenberg, Germany is for a period of 5 years and expires onOctober 31, 2006.

 

•                  Candela France SARL.  The lease on this 108 square meter facilityin Gometz le Chatel, France is for a period of 9 years, expiring on May 1,2011.

 

•                  Bangkok, Thailand.  The Manager of Pacific Rim operations resides and operates out ofa leased residence in Bangkok, Thailand. The total leased area is approximately4,800 square feet and the lease is renewed each year.

 

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**Item 3.  Legal Proceedings.**

 

The Company has an Amended and RestatedLicense Agreement (the “License”) with The Regents of the University ofCalifornia (“The Regents”) pursuant to which the Company licenses certainpatent rights to its dynamic cooling device (“DCD”) from The Regents.  The Company sells its DCD as a componentpart of its Smoothbeam (®) laser system and as an accessory to its other lasersystems.  In April of 2004, TheRegents issued a notice of default under the License, asserting, among otherthings, that the Company is in breach of the License for the alleged failure tomake required royalty payments and to make required disclosures.  The Regents’ April notice asserted thatthe total underpaid royalties, interest and other charges for the period fromAugust of 2000 through September 2003 are $1,128,000.  The Regents issued a subsequent notice ofdefault, dated June 30, 2004, relating to the quarterly periods endedDecember 27, 2003 and March 27, 2004, for which The Regents assertedthat the Company underpaid royalties amounting to $1,350,000.  The Company and The Regents differ in theirrespective interpretations of which products sold by Candela give rise to aroyalty-bearing obligation to The Regents. The Company believes it has made all payments it was required to make.

 

Under the License, disputes are to be settledby binding arbitration through a mutually acceptable single arbitrator.  On June 14, 2004, the Company filed aDemand for Arbitration to adjudicate the differing interpretations of theLicense Agreement held by the Company and The Regents.  On July 8, 2004, The Regents filedtheir response and counterclaim for breach of contract and declaratory relief. Candela deposited approximately $1.0 million inJune of 2004, and an additional $1.0 million in August of 2004, intoan escrow fund to be paid in whole or in part to the Company or The Regents asdetermined by the arbitrator.  As aresult of the establishment of the escrow fund, The Regents will not terminate or purport to terminate theLicense Agreement based on any alleged breach by Candela related to any matternow before the arbitrator.  A finaldecision of the arbitrator in this matter is presently expected to be deliveredduring the second quarter of fiscal 2005.

 

From time to time, we are a party to variouslegal proceedings incidental to our business. Except for the pending arbitration proceedings with The Regents, webelieve that none of the legal proceedings that are presently pending, ifadversely decided to the Company, will have a material adverse effect upon ourfinancial position, results of operations, or liquidity.

 

 

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

 

No matter was submitted to a vote of oursecurity holders during the fourth quarter of the fiscal year covered by thisreport.

 

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##### **PART II**

 

**Item 5**.  **Market for the Registrant’s Common Stock and RelatedStockholder Matters****.**

 

Candela’s common stock trades on The NASDAQNational Market under the symbol “CLZR.”

 

At September 9, 2004, therewere approximately 313 holders of record of our common stock and the closingsale price of our common stock was $10.93.

 

The following table sets forth quarterly highand low closing sales prices of the common stock for the indicated fiscalperiods. These prices have been adjusted from historic levels to reflect theeffect of the Company’s two-for-one stock split implemented in the thirdquarter of 2004:

 
|            |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
| **Fiscal 2004** |   |     |   |    |   |
| First Quarter   |   | $        | 8.585  |    | $      | 5.745 |   |
| Second Quarter  |   | 10.975   |   | 6.335   |   |
| Third Quarter   |   | 14.200   |   | 9.035   |   |
| Fourth Quarter  |   | 17.130   |   | 8.840   |   |
|            |   |     |   |    |   |
| **Fiscal 2003** |   |     |   |    |   |
| First Quarter   |   | $        | 2.875  |    | $      | 1.815 |   |
| Second Quarter  |   | 3.475    |   | 1.950   |   |
| Third Quarter   |   | 4.940    |   | 3.005   |   |
| Fourth Quarter  |   | 6.400    |   | 4.000   |   |

 

**Dividend Policy**

 

We have never paid a cashdividend and have no present intention to pay cash dividends in the foreseeablefuture.  The Board of Directorscurrently intends to retain any future earnings for use in our business.

 

**Securities Authorized for Issuance UnderEquity Compensation Plans**

 

See Part III, Item 12 for informationregarding securities authorized for issuance under equity compensation plans.

 

 

**Item 6. Selected ConsolidatedFinancial Data.**

 

The table set forth below contains certainconsolidated financial data for each of the last five fiscal years ofCandela.  This data should be read inconjunction with the detailed information, financial statements and relatednotes, as well as Management’s Discussion and Analysis of Financial Conditionand Results of Operations included elsewhere herein.

 

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|                                                                                                                                                              |   | **For the Year Ended** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|
| **(in thousands, except per share data)**                                                                                                                         |   | **July 3,  2004** |       | **June 28,  2003** |   | **June 29,  2002** |   | **June 30,  2001** |   | **July 1,  2000** |   |
|                                                                                                                                                              |   |                   |       | **(Restated)** |   | **(Restated)** |   | **(Restated)** |   | **(Restated)** |   |
| **Consolidated  Statement of Operations Data:**                                                                                                                   |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Revenue:**                                                                                                                                                      |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Lasers and other products                                                                                                                                         |   | **$**                  | **87,965** | ** ** | **$** | **68,072** | ** ** | **$** | **45,957** | ** ** | **$** | **48,375** | ** ** | **$** | **60,340** | ** ** |
| Product related service                                                                                                                                           |   | **16,473**             | ** ** | **10,579** | ** ** | **12,731** | ** ** | **12,498** | ** ** | **11,320** | ** ** |
| Total revenue                                                                                                                                                     |   | **104,438**            | ** ** | **78,651** | ** ** | **58,688** | ** ** | **60,873** | ** ** | **71,660** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Cost of sales:**                                                                                                                                                |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Lasers and other products                                                                                                                                         |   | **36,413**             | ** ** | **30,641** | ** ** | **20,396** | ** ** | **21,208** | ** ** | **22,703** | ** ** |
| Product related service                                                                                                                                           |   | **14,860**             | ** ** | **7,992** | ** ** | **11,205** | ** ** | **7,676** | ** ** | **6,802** | ** ** |
| Total cost of sales                                                                                                                                               |   | **51,273**             | ** ** | **38,633** | ** ** | **31,601** | ** ** | **28,884** | ** ** | **29,505** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Gross profit:**                                                                                                                                                 |   | **53,165**             | ** ** | **40,018** | ** ** | **27,087** | ** ** | **31,989** | ** ** | **42,155** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Operating expenses:**                                                                                                                                           |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Research and development                                                                                                                                          |   | **5,302**              | ** ** | **4,545** | ** ** | **4,644** | ** ** | **5,575** | ** ** | **4,822** | ** ** |
| Selling, general and administrative                                                                                                                               |   | **33,978**             | ** ** | **24,519** | ** ** | **24,832** | ** ** | **21,064** | ** ** | **19,686** | ** ** |
| Total operating expenses                                                                                                                                          |   | **39,280**             | ** ** | **29,064** | ** ** | **29,476** | ** ** | **26,639** | ** ** | **24,508** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Income (loss) from operations:**                                                                                                                                |   | **13,885**             | ** ** | **10,954** | ** ** | **(2,389** | **)** | **5,350** | ** ** | **17,647** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Other income (expense):**                                                                                                                                       |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Interest income                                                                                                                                                   |   | **308**                | ** ** | **651** | ** ** | **546** | ** ** | **1,652** | ** ** | **1424** | ** ** |
| Interest expense                                                                                                                                                  |   | **(19**                | **)**      | **(218** | **)** | **(476** | **)** | **(438** | **)** | **(471** | **)** |
| Other income (expense), net                                                                                                                                       |   | **924**                | ** ** | **(44** | **)** | **487** | ** ** | **31** | ** ** | **242** | ** ** |
| Total other income (expense)                                                                                                                                      |   | **1,213**              | ** ** | **389** | ** ** | **557** | ** ** | **1,245** | ** ** | **1,195** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Income (loss) from continuing operations  before income tax:**                                                                                                  |   | **15,098**             | ** ** | **11,343** | ** ** | **(1,832** | **)** | **6,595** | ** ** | **18,842** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Provision for (benefit from) income taxes**                                                                                                                     |   | **4,586**              | ** ** | **3,516** | ** ** | **(421** | **)** | **2,387** | ** ** | **3,767** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Income (loss) from continuing operations**                                                                                                                      |   | **10,512**             | ** ** | **7,827** | ** ** | **(1,411** | **)** | **4,208** | ** ** | **15,075** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Discontinued operations:**                                                                                                                                      |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Loss from discontinued  skin care center operations of $473, $1468, $964, $2635 and $639 less income  tax benefit of $175, $455, $221, $953 and $128 respectively |   | **(298**               | **)**      | **(1,013** | **)** | **(743** | **)** | **(1,682** | **)** | **(511** | **)** |
| Loss on closure of skin care center of  $3,348 less income tax benefit of $1,253                                                                                  |   | **(2,095**             | **)**      |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Net income (loss)**                                                                                                                                             |   | **$**                  | **8,119**  | ** ** | **$** | **6,814** | ** ** | **$** | **(2,154** | **)** | **$** | **2,526** | ** ** | **$** | **14,564** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Net income (loss) per share of common stock**                                                                                                                   |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Basic:**                                                                                                                                                        |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Income from continuing operations                                                                                                                                 |   | **.48**                | ** ** | **.39** | ** ** | **(.07** | **)** | **.19** | ** ** | **.69** | ** ** |
| Loss from discontinued operations                                                                                                                                 |   | **(.11**               | **)**      | **(.05** | **)** | **(.04** | **)** | **(.07** | **)** | **(.02** | **)** |
| **Net income (loss)**                                                                                                                                             |   | **.37**                | ** ** | **.34** | ** ** | **(.11** | **)** | **.12** | ** ** | **.67** | ** ** |
| **Diluted:**                                                                                                                                                      |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Income from continuing operations                                                                                                                                 |   | **.46**                | ** ** | **.38** | ** ** | **(.07** | **)** | **.18** | ** ** | **.62** | ** ** |
| Loss from discontinued operations                                                                                                                                 |   | **(.10**               | **)**      | **(.05** | **)** | **(.04** | **)** | **(.07** | **)** | **(.02** | **)** |
| **Net income (loss)**                                                                                                                                             |   | **.36**                | ** ** | **.33** | ** ** | **(.11** | **)** | **.11** | ** ** | **.60** | ** ** |
|                                                                                                                                                              |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Basic weighted average shares outstanding**                                                                                                                     |   | **21,902**             | ** ** | **20,083** | ** ** | **20,106** | ** ** | **21,856** | ** ** | **21,864** | ** ** |
| **Diluted weighted average shares outstanding**                                                                                                                   |   | **22,712**             | ** ** | **20,645** | ** ** | **20,106** | ** ** | **23,042** | ** ** | **24,380** | ** ** |

 

18

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|                                                 |   | **For the  Year Ended** |       |
|------------------------------------------------------|--------|-------------------------|------------|
|                                                 |   | **July 3,  2004**  |       | **June 28,  2003** |   | **June 29,  2002** |   | **June 30,  2001** |   | **July 1,  2000** |   |
|                                                 |   |                    |       | **(Restated)** |   | **(Restated)** |   | **(Restated)** |   | **(Restated)** |   |
| **Consolidated  Balance Sheet Data:**                |   |                    |       |   |   |   |   |   |   |   |   |
| **Cash and cash  equivalents**                       |   | **$**                   | **37,139** | ** ** | **$** | **31,813** | ** ** | **$** | **19,657** | ** ** | **$** | **32,127** | ** ** | **$** | **34,764** |   |
| **Working capital**                                  |   | **61,387**              | ** ** | **47,307** | ** ** | **35,642** | ** ** | **61,836** | ** ** | **45,980** |   |
| **Total assets**                                     |   | **100,479**             | ** ** | **80,501** | ** ** | **67,130** | ** ** | **72,718** | ** ** | **71,151** |   |
| **Long-term debt**                                   |   | **—**              | ** ** | **—** | ** ** | **2,115** | ** ** | **2,815** | ** ** | **3,034** |   |
| **Total stockholders’  equity**                 |   | **66,769**              | ** ** | **53,348** | ** ** | **40,853** | ** ** | **46,975** | ** ** | **48,562** |   |
| **Total liabilities  and stockholders’ equity** |   | **100,479**             | ** ** | **80,501** | ** ** | **67,130** | ** ** | **72,718** | ** ** | **71,151** |   |
|                                                      |        |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7**.  **Management’s Discussion and Analysis of FinancialCondition and Results of Operations****.**

 

*All statements, trend analysis and otherinformation contained in the following discussion relative to markets for ourproducts and trends in revenue, gross margins and anticipated expense levels,as well as other statements including words such as “anticipate”, “believe”,“plan”, “estimate”, “expect”, and “intend” and other similar expressions,constitute forward-looking statements. These forward-looking statements are subject to business and economicrisks and uncertainties, and our actual results of operations may differmaterially from those contained in the forward-looking statements.  Factors that could cause or contribute tosuch differences include, but are not limited to, those discussed in“Cautionary Statements” as well as other risks and uncertainties referenced inthis Annual Report on Form 10-K.*

 

 

**Overview**

 

We research, develop, manufacture, market,sell and service lasers used to perform aesthetic and cosmetic procedures.  We sell our lasers principally to medicalpractitioners.  Candela markets itsproducts directly and through a network of distributors to end users.  Our traditional customer base includesplastic and cosmetic surgeons and dermatologists.  More recently, we have expanded our sales to a broader group ofpractitioners consisting of general practitioners and certain specialistsincluding obstetricians, gynecologists, and general and vascular surgeons.  We derive our revenue from the sale oflasers and other products, and the provision of product related services.

 

We sell products in the U.S. through ourdirect sales force to our traditional customer base of dermatologists andcosmetic surgeons.  Outside the U.S. wesell our products in Western Europe, Japan, Latin and South America, the MiddleEast, and the Pacific Rim through seven direct sales offices and more than 50independent distributors.

 

We typically assemble products in ourWayland, Massachusetts, facility in the quarter in which they are shipped, andbacklog has not been significant.  Weexperience some seasonal reduction of our product sales in the quarter endingin September due to the summer holiday schedule of physicians andtheir patients.

 

All product shipments include a standard12-month parts and service warranty except for Vbeam products that include astandard 3-year warranty. The anticipated cost associated with the warrantycoverage is accrued at the time of shipment as a cost of sales charged toproduct related service costs.  Anycosts associated with product installation are also recognized as costs ofproduct related service.  Both suchanticipated and actual costs have no associated revenue and therefore reducethe gross profit from product related service revenue.

 

Product related service revenue consists ofrevenue from maintenance and repair services and the sale of spare parts andconsumables.  We derive revenue fromextended service contracts, which are typically for a 12 or 24-month period,and the revenue is initially deferred and recognized over the life of the servicecontract. In addition, we provide on-site service worldwide on atime-and-materials basis directly or through our distributors.

 

International revenue, consisting of salesfrom our subsidiaries in Germany, France, Spain, and Japan, and sales shippeddirectly to international locations from the U.S., during the fiscal yearsended July 3, 2004, June 28, 2003, and June 29, 2002 represented52%, 53% and 55% of total sales, respectively.

 

19

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Our fiscal year consists of the 52 or 53-weekperiod ending on the Saturday closest to June 30 of each year.  The years ended July 3, 2004,June 28, 2003 and June 29, 2002 contained 53, 52 and 52 weeks,respectively.

 

**DiscontinuedOperations**

 

In June 1996, we began aneffort to own and operate skin care centers offering cosmetic laser treatmentsutilizing our equipment, along with providing other cosmetic servicestraditionally offered by high-end spas. We pursued this strategy by purchasing an existing spa in Boston in 1996and by opening a new skin care center in Scottsdale, Arizona inMarch 1997.  We subsequentlydecided to reduce our focus on our skin care center efforts and to renew ourcommitment to our core aesthetic and cosmetic laser business.  During fiscal 1998, we closed the Scottsdalefacility. During the quarters ended December 27, 1997 and June 30,2001, the Company recorded combined restructuring charges of $3,721,000 relatedto this closure and was subsequently able to reverse a substantial portion ofthis charge due to the Company’s ability to secured a sublease for theScottsdale facility. Per the sublease agreement, the sublessee will pay allcosts associated with the facility through the end of the lease term endingJune 2006.  The sublessee commencedmaking payments to the landlord on behalf of the Company on April 1, 2002.

 

In September 2003 weinitiated a plan to close our only remaining skin care center. The closure wasaccounted for as a discontinued operation in accordance with APB 30 “*Reportingthe Results of Operations—Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions*” and SFAS 146 “*Accounting for Costs Associated with Exit or DisposalActivities*”. As a result, in the fiscal quarter endedSeptember 27, 2003 we recorded a $2,095,000 charge for the accrual of$3,000,000 of future occupancy costs and $348,000 of severance obligations andother related costs of closure, net of anticipated tax benefits of $1,253,000.In addition, all prior period financial statements have been restated toreflect skin care centers operations as discontinued.

 

**Critical AccountingPolicies**

 

The discussion and analysis of our financialcondition and results of operations are based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to revenue recognition, bad debts,inventories, warranty obligations, and income taxes. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying value of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions. We believe the followingcritical accounting policies and the related judgments and estimates affect thepreparation of our consolidated financial statements.

 

**Revenue Recognition**.  Our policy is to recognize revenue upon shipment of our products to ourcustomers and the fulfillment of all contractual terms and conditions, pursuantto the guidance provided by Staff Accounting Bulletin (SAB) No. 104 “*RevenueRecognition in Financial Statements*”, issued by the Securities andExchange Commission.  Judgments arerequired in evaluating the credit worthiness of our customers. Credit is notextended to customers and revenue is not recognized until collectibility isreasonably assured.

 

**Allowance for Doubtful Accounts**.  Our policy is to maintain allowances for estimated losses resulting fromthe inability of our customers to make required payments. Credit limits areestablished through a process of reviewing the financial history and stabilityof each customer. Where appropriate, we obtain credit rating reports andfinancial statements of customers when determining or modifying their creditlimits. We regularly evaluate the collectibility of our trade receivablebalances based on a combination of factors. When a customer’s account balancebecomes past due, we initiate dialogue with the customer to determine thecause. If it is determined that the customer will be unable to meet itsfinancial obligation to us, such as in the case of a bankruptcy filing,deterioration in the customer’s operating results or financial position orother material events impacting their business, we record a specific allowanceto reduce the related receivable to the amount we expect to recover given allinformation presently available.

 

20

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As of July 3, 2004, our accounts receivable balance of $34.3million is reported net of allowances for doubtful accounts of $1.5 million. Webelieve our reported allowances at July 3, 2004, are adequate. If thefinancial conditions of those customers were to deteriorate, however, resultingin their inability to make payments, we may need to record additionalallowances that would result in additional selling, general and administrativeexpenses being recorded for the period in which such determination was made.

 

**InventoryReserves**.   Asa designer and manufacturer of high technology equipment, we are exposed to anumber of economic and industry factors that could result in portions of ourinventory becoming either obsolete or in excess of anticipated usage. Thesefactors include, but are not limited to, technological changes in our markets,our ability to meet changing customer requirements, competitive pressures inproducts and prices, and the availability of key components from our suppliers.Our policy is to establish inventory reserves when conditions exist thatsuggest that our inventory may be in excess of anticipated demand or is obsoletebased upon our assumptions about future demand for our products and marketconditions. We regularly evaluate the ability to realize the value of ourinventory based on a combination of factors including the following: historicalusage rates, forecasted sales or usage, product end of life dates, estimatedcurrent and future market values and new product introductions. Purchasingrequirements and alternative usage avenues are explored within these processesto mitigate inventory exposure. When recorded, our reserves are intended toreduce the carrying value of our inventory to its net realizable value. As ofJuly 3, 2004, our inventory of $13.6 million is stated net of inventoryreserves of $1.4 million. If actual demand for our products deteriorates, ormarket conditions are less favorable than those that we project, additionalinventory reserves may be required.

 

**Product Warranties**. Our products are sold with warrantyprovisions that require us to remedy deficiencies in quality or performance ofour products over a specified period of time at no cost to our customers. Ourpolicy is to establish warranty reserves at levels that represent our estimateof the costs that will be incurred to fulfill those warranty requirements atthe time that revenue is recognized. We believe that our recorded liability atJuly 3, 2004, is adequate to cover our future cost of materials, labor andoverhead for the servicing of our products sold through that date. If actualproduct failures or material or service delivery costs differ from ourestimates, our warranty liability would need to be revised accordingly.

 

**Contingencies**.   We are subject to proceedings, lawsuits andother claims.  We assess the likelihoodof any adverse judgments or outcomes to these matters as well as potentialranges of probable losses. A determination of the amount of reserves required,if any, for these contingencies is made after careful analysis of eachindividual issue. The required reserves may change in the future due to newdevelopments in each matter or changes in approach such as a change insettlement strategy in dealing with these matters. We record charges for thecosts we anticipate incurring in connection with litigation and claims againstus when we can reasonably estimate these costs.

 

As disclosed in Legal Proceedings, theCompany has moved to arbitrate the varying contract interpretations held byitself on the one hand and The Regents of the University of California (“TheRegents”) on the other hand.  While afinal decision of the arbitrator is pending, the Company established an escrowfund into which it deposited approximately $1.0 million in the fourth quarterof fiscal 2004, and an additional $1.0 million in the first quarter of fiscal2005, to resolve claims under the Amended and Restated License Agreement (the“License”) between the Company and The Regents.  Amounts paid into the escrow fund will be paid in whole or inpart to the Company or The Regents as determined by the arbitrator.  If the arbitrator were to find in TheRegents’ favor on all matters, the Company would need to pay an additionalamount in excess of the total amount in the escrow fund which could amount tothe payment of $0.5 million or moreand the Company would also face increased royalty expense infuture periods since a royalty would be due on products that the Companycurrently believes are not subject to royalty payments.  The $1.0 million deposited in the escrowfund in the fourth quarter of fiscal 2004 has been included in Other Assets on theaccompanying 2004 balance sheet, and no expense has or will be recorded withrespect to the escrow fund or any additional contingent liabilities while thematter is being arbitrated.

 

**Restructuring**.   We record restructuring charges incurred inconnection with consolidation or relocation of operations, exited businesslines, or shutdowns of specific sites. These restructuring charges, whichreflect our commitment to a termination or exit plan that will begin withintwelve months, are based on estimates of the expected costs associated withsite closure, legal matters, contract terminations, or other costs directlyrelated to the restructuring. If the actual cost incurred exceeds the estimatedcost, an additional charge to earnings will result. If the actual cost is lessthan the estimated cost, a credit to earnings will be recognized.

 

21

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**Taxes**.  In accordance with SFAS No. 109, “*Accountingfor Income Taxes*,” we recognize deferred income taxes based on theexpected future tax consequences of differences between the financial statementbasis and the tax basis of assets and liabilities, calculated using enacted taxrates for the year in which the differences are expected to be reflected in thetax return. Realization is dependent on the generation of sufficient taxableincome in future years.  Managementcontinually evaluates the need for a valuation allowance for deferred taxassets based on the probability of realization determined by expectations forfuture taxable income and other factors. Although realization is not assured,based on available evidence, management believes it is more likely than notthat the full amount of the net deferred tax asset will be realized.  However, the amount realizable could bereduced if estimates of future taxable income are reduced.

 

**Results of Operations**

 

The following tables set forth selectedfinancial data for the periods indicated, expressed as a percentage of totalrevenue.

 
|                                                              |   | **For the  Year Ended** |   |
|-------------------------------------------------------------------|--------|-------------------------|--------|
|                                                              |   | **July 3,  2004**  |   | **June 28,  2003** |   | **June 29,  2002** |   |
|                                                              |   |                    |   | **(Restated)** |   | **(Restated)** |   |
| **Consolidated  Statement of Operations Data:**                   |   |                    |   |   |   |   |   |
| **Revenue Mix:**                                                  |   |                    |   |   |   |   |   |
| Lasers and other products                                         |   | 84.2                    | %      | 86.6 | % | 78.3 | % |
| Product related service                                           |   | 15.8                    | %      | 13.4 | % | 21.7 | % |
| Total revenue                                                     |   | 100.0                   | %      | 100.0 | % | 100.0 | % |
|                                                              |   |                    |   |   |   |   |   |
| **Operating Ratios:**                                             |   |                    |   |   |   |   |   |
| **Gross profit:**                                                 |   |                    |   |   |   |   |   |
| Lasers and other products                                         |   | 49.4                    | %      | 47.6 | % | 43.6 | % |
| Product related service                                           |   | 1.5                     | %      | 3.3 | % | 2.6 | % |
| Total gross profit                                                |   | 50.9                    | %      | 50.9 | % | 46.2 | % |
|                                                              |   |                    |   |   |   |   |   |
| **Operating expenses:**                                           |   |                    |   |   |   |   |   |
| Research and development                                          |   | 5.1                     | %      | 5.8 | % | 7.9 | % |
| Selling, general & administrative                             |   | 32.5                    | %      | 31.2 | % | 42.3 | % |
| Total operating expenses                                          |   | 37.6                    | %      | 37.0 | % | 50.2 | % |
|                                                              |   |                    |   |   |   |   |   |
| Income (loss) from continuing operations                          |   | 13.3                    | %      | 13.9 | % | -4.1 | % |
|                                                              |   |                    |   |   |   |   |   |
| Total other income (expense)                                      |   | 1.2                     | %      | 0.5 | % | 1.0 | % |
| **Income (loss) from  continuing operations before income taxes** |   | 14.5                    | %      | 14.4 | % | -3.1 | % |
|                                                              |   |                    |   |   |   |   |   |
| Provision for (benefit from) income taxes                         |   | 4.4                     | %      | 4.4 | % | -0.6 | % |
| **Net income (loss)  from continuing operations**                 |   | 10.1                    | %      | 10.0 | % | -3.7 | % |

 

**Fiscal Year Ended July 3, 2004 Compared to Fiscal Year EndedJune 28, 2003**

 

***Revenue.  ***Total revenue increased $25.7 million, or33% to $104.4 million in fiscal 2004 from $78.7 million in fiscal 2003.Increases in unit sales and the growth in popularity of our YAG and GentleLasesystems accounted for the increase. We sold approximately 440 additional lasersystems during fiscal 2004 as compared to 2003 with an average selling priceroughly equivalent to that of the prior year. International revenue, consistingof sales from our subsidiaries in Germany, Spain, France and Japan, and salesshipped directly to international locations from the U.S., increased $14.6million over the prior year and accounted for 52% of total revenue for fiscal2004 in comparison to 51% for fiscal 2003. Of the $14.6 million increaseapproximately $3.0 million was related to favorable currency fluctuations.  Product-related service revenue increased56% to $16.5 million in fiscal 2004 from $10.6 million in fiscal 2003. Thisincrease was consistent with the increase in systems sold over the past fewyears and the need for general maintenance and parts on these systems.

 

22

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***GrossProfit.  ***Gross profit increased $13.2 million to$53.2 million or 51% of revenue in fiscal 2004 from $40.0 million or 51% ofrevenue in fiscal 2003 as a direct result of the increase in sales. Grossprofit on lasers and other products increased $14.1 million or 38% to $51.6million or 49% of revenue in fiscal 2004 from $37.4 million or 48% of revenuein fiscal 2003.  Gross profit on productrelated services in fiscal 2004 decreased $1.0 million to $1.6 million or 2% ofrevenue compared to $2.6 million or 3% of revenue for fiscal 2003. The decreasein gross profit on product related services is due primarily to an increase inproducts under warranty associated with Vbeam and GentleLase product sales anda corresponding decrease in the number of systems on service contracts.

 

***Researchand Development Expense.  ***Research and development spending increasedslightly for fiscal 2004 over fiscal 2003 due to more active projects ongoing.This increase accounted for approximately $0.8 million in additional expense,but as a percentage of total revenue this category decreased almost a full percentagepoint from the prior year.

 

***Selling,General and Administrative Expense.  ***Selling, general and administrative expenseincreased to $33.9 million or 33% of revenue during fiscal 2004 compared to$24.5 million or 31% during fiscal 2003. The increase in selling, general andadministrative expenses is due primarily to the payment of additional bonus andcommission amounts due to overachievement of planned targets by our sales forcecoupled with the implementation of Sarbanes Oxley control and reporting requirements.

 

***OtherIncome/Expense.  ***For the fiscal year ended July 3, 2004,total other income increased $0.8 million to $1.2 million, from $0.4 millionfor the fiscal year ended June 28, 2003. Interest income decreased $0.3 million from the prior year to $0.3million primarily as a result of the absence during the current period ofinterest payments of $0.4 million received from the PSS settlement in the prioryear, partially offset by higher cash balances invested throughout the fiscalyear. Interest expense was negligible for 2004 due to the retirement of ourlong-term debt in fiscal 2003 leading to a comparative gain of $0.2 millionover the prior year. Other income increased $1.0 million in fiscal 2004 ascompared to fiscal 2003 due primarily to an insurance reimbursement ofapproximately $0.5 million for stolen merchandise at our German subsidiary,period gains on subsidiary transactions of approximately $0.2 million, and thetiming of an investment distribution.

 

***IncomeTaxes.***The provision for income taxes results from a combination of activities of boththe domestic and foreign subsidiaries of the Company.  The Companyrecorded a 30% effective tax rate for the year ended July 3, 2004 comparedto a 31% effective tax rate for the year ended June 28, 2003. Theprovision for income taxes for the year ended July 3, 2004, includes a taxprovision calculated for taxable income generated in Japan and Spain at ratesin excess of the U.S. statutory tax rate.

 

**Fiscal Year Ended June 28, 2003 Compared to Fiscal Year EndedJune 29, 2002**

 

***Revenue.  ***Total revenue increased 34% to $78.7 millionin fiscal 2003 from $58.7 million in fiscal 2002. International revenue,consisting of sales from our subsidiaries in Germany, Spain, France and Japan,and sales shipped directly to international locations from the U.S., was 52% oftotal revenue for fiscal 2003 in comparison to 56% for fiscal 2002.  Laser and product revenue increased 48% to$68.1 million in fiscal 2003 from $46.0 million in fiscal 2002.  Increases in unit sales and the averageselling price of the GentleLASE, Smoothbeam and Vbeam products were responsiblefor the increase in laser and other product revenue from fiscal 2002 to2003.  Product-related service revenuedecreased 17% to $10.6 million in fiscal 2003 from $12.7 million in fiscal 2002due primarily to an increase in the number of lasers covered by extendedwarranties and a corresponding decrease in the number of lasers covered byservice contracts.

 

***GrossProfit.  ***Gross profit increased to $40.0 million or51% of revenue in fiscal 2003 from $27.1 million or 46% of revenue in fiscal2002 mainly as a result of the increase in sales of lasers and other products.Gross profit on lasers and other products increased 46% to $37.4 million or 48%of revenue in fiscal 2003 from $25.6 million or 44% of revenue in fiscal2002.  Gross profit on product relatedservices in fiscal 2003 increased to $2.6 million or 3.3% of revenue comparedto $1.5 million or 2.6% of revenue for fiscal 2002. The increase in grossprofit on product related services is due primarily to a decrease in warrantycosts associated with the Vbeam products. The decrease in Vbeam warranty costswas largely due to the one-time replacement of a component of the system duringfiscal 2002 that did not reoccur in fiscal 2003.

 

***Researchand Development Expense.  ***Research and development spending for fiscal2003 decreased 2% to $4.5 million from $4.6 million for fiscal 2002.

 

23

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***Selling,General and Administrative Expense.  ***Selling, general and administrative expensedecreased 1% from $24.8 million in fiscal 2002 to $24.5 million in fiscal2003.  The decrease in selling, generaland administrative expenses is due primarily to the reimbursement of legal expenserelating to the PSS dispute that was settled favorably in fiscal 2003. Selling,general and administrative expenses were 42% of revenue in fiscal 2002 comparedto 31% for fiscal 2003.

 

***OtherIncome/Expense.  ***For the fiscal year ended June 28,2003, total other income declined to $0.4 million from $0.6 million for thefiscal year ended June 29, 2002. Interest income increased from $0.5 million in fiscal 2002 to $0.6million in fiscal 2003 due to interest payments of $0.4 million received fromthe PSS settlement offset by generally lower levels of cash invested at lowerinterest rates throughout the fiscal year. Interest expense decreased from $0.5million in fiscal 2002 to $0.2 million in fiscal 2003 due primarily to theearly retirement of our long-term debt in fiscal 2003. Other income (expense)decreased from $0.5 million income in fiscal 2002 to a $0.04 million expense infiscal 2003 primarily as a result of charges resulting from the earlyretirement of our long-term debt.

 

***IncomeTaxes.***The provision for income taxes results from a combination of activities of boththe domestic and foreign subsidiaries of the Company.  The Companyrecorded a 31% effective tax rate for the year ended June 28, 2003compared to a 23% effective tax rate for the year ended June 29,2002. The benefit from income taxes for the year ended June 29, 2002,includes a tax benefit for taxable losses in the U.S. offset by a tax provisioncalculated for taxable income generated in Japan and Spain at rates in excessof the U.S. statutory tax rate.

 

**Liquidity and Capital Resources**

 

Cash provided by operating activities amounted to $1.1 million forfiscal 2004 as compared to $11.7 million for fiscal 2003. This decrease in cashprovided by operating activities primarily reflects the timing of receivablescollections and cash outlay for inventory during a strong sales cycle. Salesduring the last 70 days of the quarter exceeded those of the same period in theprior year by approximately $6.6 million. We expect the collection of receivablesto have a positive impact on cash during the first quarter of fiscal 2005. Cashused by investing activities remained relatively flat for the fiscal 2004, asthe Company continued its conservative policy towards capital outlays forproperty, plant and equipment.  Cashprovided by financing activities amounted to $4.7 million for the year endedJuly 3, 2004 in comparison to cash used of $1.2 million for the prioryear.  The increase reflects theproceeds from the issuance of common stock by the Company, primarily toemployees under the existing stock option plan, and the absence of prior-yearpayments used to extinguish long-term debt.

 

Off-Balance Sheet Arrangements

 

The Company did not have any off-balancesheet arrangements that have or are reasonably likely to have a current orfuture effect on the Company's financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

The Company did not have any off-balancesheet arrangements that have, or are reasonably likely to have a current orfuture effect on the Company’s financial condition, revenues or expenses,results of operations, liquidity, capital expenditures or capital resources.

 

Outstanding contractual obligations of theCompany are reflected in the following table:

 
| **(in thousands)**                  |   | **Total** |   | **Less than  1 year** |   | **1-3 years** |   | **4-5 years** |   | **After  5 years** |   |
|-------------------------------------|--------|-----------|--------|-----------------------|--------|---------------|--------|---------------|--------|--------------------|--------|
| **(restated)**                      |   |      |   |                  |   |          |   |          |   |               |   |
|                                |   |      |   |                  |   |          |   |          |   |               |   |
| Operating  leases                   |   | $         | 2,374  |                  | $      | 809           |   | $             | 1,020  |               | $      | 450 |   | $ | 95 |   |
| Total  contractual cash obligations |   | $         | 2,374  |                  | $      | 809           |   | $             | 1,020  |               | $      | 450 |   | $ | 95 |   |

 

We maintain a renewable $10,000,000 revolvingcredit agreement with a major bank with interest at the bank’s base rate orLIBOR plus 2.25%.  Any borrowingsoutstanding under the line of credit are due on demand or according to apayment schedule established at the time funds are borrowed.  The line of credit is unsecured.  The agreement contains restrictive covenantslimiting the establishment of new liens, and the purchase of margin stock.  No amounts were outstanding under the lineof credit as of July 3, 2004.

 

As discussed in Note 11 to the financialstatements, on September 24, 2003, we closed our only remaining skin carecenter in Boston, Massachusetts. As a result, in the fiscal quarter endedSeptember 27, 2003 we recorded a $2,095,000 charge for the accrual of$3,000,000 of future occupancy costs and $348,000 of severance obligations andother related costs of closure, net of anticipated tax benefits of $1,253,000.

 

24

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We believe that cash balances will besufficient to meet anticipated cash requirements.  However, we cannot be sure that we will not require additionalcapital beyond the amounts currently forecasted by us, nor that any such requiredadditional capital will be available on reasonable terms, if at all, as itbecomes required.

 

###### **Cautionary Statements**

 

This Annual Report on Form 10-K containsforward-looking statements including, without limitation, statements concerningthe future of the industry, product development, business strategy (includingthe possibility of future acquisitions), anticipated operational and capitalexpenditure levels, continued acceptance and growth of our products, anddependence on significant customers and suppliers.  This Annual Report on Form 10-K contains forward-lookingstatements that we have made based on our current expectations, estimates andprojections about our industry, operations, and prospects, not historicalfacts.  We have made these forward-lookingstatements pursuant to the provisions of the Private Securities LitigationReform Act of 1995.  These statementscan be identified by the use of forward-looking terminology such as “may,”“will,” “believe,” “expect,” “anticipate,” “estimate,” “continue” or othersimilar words.  These statements discussfuture expectations, and may contain projections of results of operations or offinancial condition or state other forward-looking information.  When considering forward-looking statements,you should keep in mind the cautionary statements in this Annual Report on Form10-K.  The cautionary statements notedbelow and other factors noted throughout this Annual Report on Form 10-K couldcause our actual results to differ significantly from those contained in anyforward-looking statement.  We may notupdate or publicly release the results of these forward-looking statements toreflect events or circumstances after the date hereof.

 

**Because we derive more than half of ourrevenue from international sales, including approximately 26% of our revenuefrom Japan and the Asia-Pacific marketplace in fiscal 2004, we are susceptibleto currency fluctuations, negative economic changes taking place in Japan andthe Asia-Pacific marketplace, and other risks associated with conductingbusiness overseas.**

 

We sell more than half of our products andservices outside the U.S. and Canada. International sales, consisting of salesfrom our subsidiaries in Germany, Spain, France and Japan, and sales shippeddirectly to international locations from the U.S., accounted for 52% of ourrevenue for fiscal year 2004, and we expect that they will continue to besignificant. As a result, a major part of our revenues and operating resultscould be adversely affected by risks associated with international sales.  In particular, significant fluctuations inthe exchange rates between the U.S. dollar and foreign currencies could causeus to lower our prices and thus reduce our profitability, or could causeprospective customers to push out orders to later dates because of theincreased relative cost of our products in the aftermath of a currencydevaluation or currency fluctuation. Other risks associated with international sales that we currently faceor have faced in the past include:

 

•                  longer payment cycles common in foreignmarkets

 

•                  failure to obtain or significant delays inobtaining necessary import or foreign regulatory approvals for our products

 

•                  difficulties in staffing and managing ourforeign operations.

 

**The failure to obtain Alexandrite rods forthe GentleLASE from our sole supplier would impair our ability to manufactureand sell GentleLASE.**

 

We use Alexandrite rods to manufacture theGentleLASE, which accounts for a significant portion of our totalrevenues.  We depend exclusively onNorthrup Grumman to supply these rods, for which no alternative suppliermeeting our quality standards exists. We cannot be certain that Northrup Grumman will be able to meet ourfuture requirements at current prices or at all.  To date, we have been able to obtain adequate supplies ofAlexandrite rods in a timely manner, but any extended interruption in oursupplies could hurt our results.

 

25

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**Disappointing quarterly revenue or operatingresults could cause the price of our common stock to fall.**

 

Our quarterly revenue and operating resultsare difficult to predict and may swing sharply from quarter to quarter.  Historically, our first fiscal quarter hastypically had the least amount of revenue in any quarter of our fiscalyear.  The results of the first quarterare directly impacted by the seasonality of the purchasing cycle.

 

If our quarterly revenue or operating resultsfall below the expectations of investors or public market analysts, the priceof our common stock could fall substantially. Our quarterly revenue is difficult to forecast for many reasons, some ofwhich are outside of our control, including the following:

 

MarketSupply and Demand 

 

•                  potential increases in the level and intensityof price competition between our competitors and us

 

•                  potential decrease in demand for ourproducts

 

•                  possible delays in market acceptance of ournew products.

 

Customer Behavior 

 

•                  changes in or extensions of our customers’budgeting and purchasing cycles

 

•                  changes in the timing of product sales inanticipation of new product introductions or enhancements by us or ourcompetitors.

 

CompanyOperations 

 

•                  absence of significant product backlogs

 

•                  our effectiveness in our manufacturingprocess

 

•                  unsatisfactory performance of ourdistribution channels, service providers, or customer support organizations

 

•                  timing of any acquisitions and relatedcosts.

 

**An adverse result in the arbitrationproceeding pending against The Regents of the University of California wouldresult in additional expenditures and would negatively impact our operatingresults.**

 

The Company has moved to arbitrate thevarying contract interpretations held by itself on the one hand and The Regentsof the University of California (“The Regents”) on the other hand.  While a final decision of the arbitrator ispending, the Company established an escrow fund into which it depositedapproximately $1.0 million in the fourth quarter of fiscal 2004, and anadditional $1.0 million in the first quarter of fiscal 2005, toresolve claims under the Amended and Restated License Agreement (the “License”)between the Company and The Regents. Amounts paid into the escrow fund will be paid in whole or in part tothe Company or The Regents as determined by the arbitrator.  If the arbitrator were to find in TheRegents’ favor on all matters, the Company would need to pay an additionalamount in excess of the total amount in the escrow fund which could amount tothe payment of $500,000 or more and the Company would also face increasedroyalty expense in future periods since a royalty would be due on products thatthe Company currently believes are not subject to royalty payments.  The $1.0 million deposited in theescrow fund in the fourth quarter of fiscal 2004 has been included in OtherAssets on the accompanying 2004 balance sheet, and no expense has or will berecorded with respect to the escrow fund or any additional contingentliabilities while the matter is being arbitrated.

 

26

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**Our failure to respond to rapid changes intechnology and intense competition in the laser industry could make our lasersobsolete.**

 

The aesthetic and cosmetic laser equipmentindustry is subject to rapid and substantial technological development andproduct innovations.  To be successful,we must be responsive to new developments in laser technology and newapplications of existing technology. Our financial condition and operating results could be hurt if ourproducts fail to compete favorably in response to such technologicaldevelopments, or we are not agile in responding to competitors’ new productintroductions or product price reductions. In addition, we compete against numerous companies offering productssimilar to ours, some of which have greater financial, marketing, and technicalresources than we do.  We cannot be surethat we will be able to compete successfully with these companies and ourfailure to do so could hurt our business, financial condition, and results ofoperations.

 

**Like other companies in our industry, we aresubject to a regulatory review process and our failure to receive necessarygovernment clearances or approvals could affect our ability to sell ourproducts and remain competitive.**

 

The types of medical devices that we seek tomarket in the U.S. generally must receive either “510(k) clearance” or “PMAapproval” in advance from the U.S. Food and Drug Administration (FDA) pursuantto the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process usually takes from four to twelvemonths, but it can last longer. The process of obtaining PMA approval is muchmore costly and uncertain and generally takes from one to three years or evenlonger.  To date, the FDA has deemed ourproducts eligible for the 510(k) clearance process.  We believe that most of our products in development will receivesimilar treatment.  However, we cannotbe sure that the FDA will not impose the more burdensome PMA approval processupon one or more of our future products, nor can we be sure that 510(k)clearance or PMA approval will ever be obtained for any product we propose tomarket.

 

Many foreign countries in which we market ormay market our products have regulatory bodies and restrictions similar tothose of the FDA.  Particularly, forexample, we are awaiting Ministry of Health approval in Japan for the sale ofthe Vbeam.  We cannot be certain that wewill be able to obtain (or continue to obtain) any such government approvals orsuccessfully comply with any such foreign regulations in a timely andcost-effective manner, if at all, and our failure to do so could adverselyaffect our ability to sell our products.

 

**We have modified some of our products withoutFDA clearance.  The FDA couldretroactively decide the modifications were improper and require us to ceasemarketing and/or recall the modified products**.

 

Any modification to one of our 510(k) cleareddevices that could significantly affect its safety or effectiveness, or thatwould constitute a major change in its intended use, requires a new 510(k)clearance.  The FDA requires everymanufacturer to make this determination in the first instance, but the FDA canreview any such decision.  We havemodified some of our marketed devices, but we believe that new 510(k)clearances are not required.  We cannotbe certain that the FDA would agree with any of our decisions not to seek510(k) clearance.  If the FDA requiresus to seek 510(k) clearance for any modification, we also may be required tocease marketing and/or recall the modified device until we obtain a new 510(k)clearance.

 

**Achieving complete compliance with FDAregulations is difficult, and if we fail to comply, we could be subject to FDAenforcement action.**

 

We are subject to inspection and marketsurveillance by the FDA to determine compliance with regulatoryrequirements.  The FDA’s regulatoryscheme is complex, especially the Quality System Regulation (“QSR”), whichrequires manufacturers to follow elaborate design, testing, control,documentation, and other quality assurance procedures.  This complexity makes complete compliancedifficult to achieve.  Also, thedetermination as to whether a QSR violation has occurred is oftensubjective.  If the FDA finds that wehave failed to comply with the QSR or other applicable requirements, the agencycan institute a wide variety of enforcement actions, including a public warningletter or other stronger remedies, such as:

 

•                  fines, injunctions, and civil penaltiesagainst us

 

•                  recall or seizure of our products

 

•                  operating restrictions, partial suspension,or total shutdown of our production

 

27

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•                  refusing our requests for 510(k) clearanceor PMA approval of new products

 

•                  withdrawing product approvals already granted

 

•                  criminal prosecution

 

**Claims by others that our products infringetheir patents or other intellectual property rights could prevent us frommanufacturing and selling some of our products or require us to incursubstantial costs from litigation or development of non-infringing technology.**

 

Our industry has been characterized byfrequent litigation regarding patent and other intellectual propertyrights.  Patent applications aremaintained in secrecy in the U.S. until such patents are issued and are maintainedin secrecy for a period of time outside the U.S.  Accordingly, we can conduct only limited searches to determinewhether our technology infringes any patents or patent applications of others.  Any claims of patent infringement would betime-consuming and could:

 

•                  result in costly litigation

 

•                  divert our technical and managementpersonnel

 

•                  cause product shipment delays

 

•                  require us to develop non-infringingtechnology

 

•                  require us to enter into royalty orlicensing agreements.

 

Although patent and intellectual propertydisputes in the laser industry have often been settled through licensing orsimilar arrangements, costs associated with such arrangements may besubstantial and often require the payment of ongoing royalties, which couldhurt our gross margins.  In addition, wecannot be sure that the necessary licenses would be available to us onsatisfactory terms, or that we could redesign our products or processes toavoid infringement, if necessary. Accordingly, an adverse determination in a judicial or administrativeproceeding, or the failure to obtain necessary licenses, could prevent us frommanufacturing and selling some of our products, which could hurt our business,results of operations, and financial condition.  On the other hand, we may have to start costly and time consuminglitigation in order to enforce our patents, to protect trade secrets, andknow-how owned by us or to determine the enforceability, scope, and validity ofthe proprietary rights of others.

 

**We could incur substantial costs as a resultof product liability claims.**

 

There are various risks of physical injury tothe patient when using our lasers for aesthetic and cosmetic treatments.  Injuries often result in product liabilityor other claims being brought against the practitioner utilizing the device andus.  The costs and management time wewould have to spend in defending or settling any such claims, or the payment ofany award in connection with such claims, could hurt our business, results ofoperations, and financial condition. Although we maintain product liability insurance, we cannot be certainthat our policy will provide sufficient coverage for any claim or claims thatmay arise, or that we will be able to maintain such insurance coverage onfavorable economic terms.

 

**We may be unable to attract and retainmanagement and other personnel we need to succeed.**

 

The loss of any of our senior management orother key research, development, sales, and marketing personnel, particularlyif lost to competitors, could hurt our future operating results.  Our future success will depend in large partupon our ability to attract, retain, and motivate highly skilledemployees.  We cannot be certain that wewill attract, retain, and motivate sufficient numbers of such personnel.

 

28

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**Our failure to manage future acquisitions andjoint ventures effectively may divert management attention from our corebusiness and cause us to incur additional debt, liabilities or costs.**

 

We may acquire businesses, products, andtechnologies that complement or expand our business.  We may also consider joint ventures and other collaborativeprojects.  We may not be able to:

 

•                  identify appropriate acquisition or jointventure candidates

 

•                  successfully negotiate, finance, orintegrate any businesses, products, or technologies that we acquire

 

•                  successfully manage any joint ventures orcollaborations.

 

Furthermore, the integration of anyacquisition or joint venture may divert management time and resources.  If we fail to manage these acquisitions orjoint ventures effectively, we may incur debts or other liabilities or coststhat could harm our operating results or financial condition.  While we from time to time evaluatepotential acquisitions of businesses, products, and technologies, considerjoint ventures and other collaborative projects, and anticipate continuing tomake these evaluations, we have no present understandings, commitments, oragreements with respect to any acquisitions or joint ventures.

 

**Item 7A.****               ****Quantitative and Qualitative Disclosures About Market Risk****.**

 

Revenue from outside the US, consisting ofsales from our subsidiaries in Germany, Spain, France and Japan and salesshipped directly from the US to international locations, constituted 52% of ourtotal revenue for fiscal 2004.

 

Our international subsidiaries transactbusiness in both local and foreign currencies and therefore we are exposed toforeign currency exchange risk resulting from fluctuations in foreigncurrencies.  This risk could adverselyimpact our results and financial condition. From time to time, we may enter into foreign currency exchange andoption contracts to reduce our exposure to foreign currency exchange risk and variabilityin operating results due to fluctuation in exchange rates underlying the valueof current transactions and anticipated transactions denominated in foreigncurrencies.  These contracts obligate usto exchange predetermined amounts of specified foreign currencies at specifiedexchange rates on specified dates. These contracts are denominated in the same currency in which theunderlying transactions are denominated and bear a contract value and maturitydate that approximate the value and expected settlement date, respectively, ofthe underlying transactions. We do not engage in foreign currency speculation.

 

On July 3, 2004 the Euro closed at 0.812Euro to 1.00 U.S Dollar compared to 0.875 Euro to 1.00 U.S. Dollar onJune 28, 2003. The Japanese Yen closed at 108.38 Yen to 1.00 U.S. Dollaron July 3, 2004 compared to 119.61 Yen to 1.00 U.S. Dollar onJune 28, 2003. Net gains resulting from foreign currency translationsamounted to $338,509 for fiscal 2004.

 

At July 3, 2004 and June 28, 2003,a hypothetical 10% positive change in foreign exchange rates would result intranslation gains of $18,000 and $135,000 respectively that would be recordedin the equity section of our balance sheet.

 

At July 3, 2004 and June 28, 2003,a hypothetical 10% adverse change in foreign exchange rates would result in anet transaction loss of $6,000 and a net transaction gain of $73,000,respectively that would be recorded in current earnings.

 

**Item 8**.                         **Financial Statements and Supplementary Data****.**

 

Financial statements and supplementary dataare included herein and are indexed under Item 15 (a) (1)-(2).

 

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

 

On December 4, 2003, the Audit Committeeof the Board of Directors of the Company (the “Audit Committee”) dismissedErnst &Young LLP (“E&Y”) as the Company’s independent publicaccountants.  The audit reports ofE&Y on the consolidated financial statements of the Company for the fiscalyears ended June 28, 2003 and June 29, 2002 did not contain anyadverse opinion or disclaimer of opinion, nor were the reports qualified ormodified as to uncertainty, audit scope or accounting principles.  On December 4, 2003, the Audit Committeeengaged BDO Seidman, LLP (“BDO”) to serve as the Company’s independent publicaccountants for the Company’s fiscal year ending July 3, 2004.  During the Company’s fiscal years endedJuly 3, 2004 and June 28, 2003, there have been no disagreements withE&Y on any matter of accounting principles or practices, financialstatement disclosure or auditing scope or procedure, which disagreements, ifnot resolved to the satisfaction of E&Y, would have caused it to makereference to the subject matter of the disagreements in connection with itsreports.

 

During the Company’s fiscal years endedJuly 3, 2004 and June 28, 2003, there were no reportable events (asdefined in Item 304 (a)(1)(v) of Regulation S-K), except that in connectionwith its audit for the year ended June 28, 2003 E&Y advised theCompany of two reportable conditions which constituted material weaknesses ininternal controls necessary for the Company to develop reliable financialstatements.  E&Y advised the Companythat in its opinion the material weaknesses were (i) a failure in the Company’simplementation of a new accounting software system and (ii) a lack of standardoperational controls to detect errors in account balances once the newaccounting software system was implemented. However, E&Y has advised the Audit Committee and management thatthese conditions were considered in determining the nature, timing, and extentof the procedures performed in E&Y’s audit of the Company’s consolidatedfinancial statements for the year ended June 28, 2003, and that theseconditions did not affect E&Y’s report dated August 18, 2003 (exceptfor Note 14 as to which the date is September 24, 2003) on those financialstatements.

 

The Audit Committee and management discussedthe reportable conditions with E&Y. Management believes that it has implemented additional controlssufficient to prevent the data entry problems it encountered during theimplementation of its new accounting software system from occurring in thefuture.  In connection with its auditfor the year ended July 3, 2004, BDO did not advise the Company of anycontinuing or new reportable conditions. The Company has also reevaluated its other internal controls, andmanagement believes it has taken the necessary steps so that adequate controlprocedures are in place and will be followed. Management also believes that the Company’s financial statements andrelated disclosures, as filed to date, present fairly, in all materialrespects, the Company’s financial condition and results of operations for therespective periods.  Management alsobelieves that the material weaknesses specified by E&Y did not adverselyaffect the Company’s ability to report, in a timely manner, materialinformation required to be included in the Company’s periodic filings with theSecurities and Exchange Commission.  TheCompany authorized E&Y to respond fully to the inquiries of BDO concerningthe material weaknesses and any other accounting or other matters.

 

The Company provided a copy of the abovedisclosures to E&Y and requested that E&Y furnish the Company with aletter addressed to the Securities and Exchange Commission stating whether itagreed with the above statements and, if not, stating the respects in which itdoes not agree.  A copy of such letter,dated December 9, 2003, is filed as Exhibit 16.1 to the Company’s CurrentReport on Form 8-K dated December 4, 2003.

 

During the Company’s fiscal years ended June 28, 2003 andJune 29, 2002 and until BDO’s engagement on December 4, 2003, theCompany did not consult BDO with respect to the application of accounting principlesto a specified transaction, either completed or proposed, or the type of theaudit opinion that might be rendered on the Company’s consolidated financialstatements, or any other matters or reportable events listed in Items 304(a)(1)(iv) and (v) of Regulation S-K.

 

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

 

(a) Evaluation of disclosure controls andprocedures.  An evaluation of theeffectiveness of the design and operation of our “disclosure controls andprocedures” (as defined in the Securities Exchange Act of 1934 Rule 13a-15(e))was performed under the supervision and with the participation of members ofour management, including our Chief Executive Officer and our Chief FinancialOfficer, as of July 3, 2004 (the “Evaluation Date”).  Based on that evaluation, members of our management, includingour Chief Executive Officer and our Chief Financial Officer, have concludedthat, as of the Evaluation Date, our disclosure controls and procedures wereeffective in enabling us to record, process, summarize and report theinformation required to be included in this annual report within the requiredtime period.

 

(b) Changes to Internal Control overFinancial Reporting.  There were nochanges in our internal control over financial reporting during the fourthfiscal quarter ended July 3, 2004 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Item 9B.****               ****Other Information**

 

None.

 

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**PartIII**

 

Anything herein to thecontrary notwithstanding, in no event are the sections entitled “StockPerformance Graph”, “Compensation Committee Report on Executive Compensation”and “Audit Committee Report” to be incorporated by reference herein from theCompany’s definitive proxy statement for the Company’s 2004 annual meeting ofstockholders.

 

**Item10:****                ****Directors and Executive Officers Of The Registrant**

 

Certain informationconcerning the directors and executive officers of the Company is incorporatedby reference herein from the information contained in the section entitled“Occupations of Directors and Executive Officers” in our definitive proxystatement (the “Definitive Proxy Statement”) for the 2004 annual meeting ofstockholders to be filed with the Securities and Exchange Commission within 120days after the end of Candela’sfiscal year ended July 3, 2004.

 

The information concerningcompliance with Section 16(a) of the Exchange Act required under this itemis incorporated herein by reference from the information contained in thesection entitled “Section 16(a) Beneficial Ownership ReportingCompliance” in the Definitive Proxy Statement.

 

**Item11:****                ****Executive Compensation**

 

Certain informationconcerning executive compensation is incorporated herein by reference from theinformation contained in the section entitled “Compensation and OtherInformation Concerning Directors and Officers” in the Definitive ProxyStatement.

 

**Item12:****                ****Security Ownership Of Certain Beneficial Ownersand Management and Related Stockholder Matters**

 

Certain informationconcerning security ownership of certain beneficial owners and management isincorporated herein by reference from the information contained in thesection entitled “Security Ownership of Certain Beneficial Owners andManagement” in the Definitive Proxy Statement.

 

**Item13:****                ****Certain Relationships and Related Transactions**

 

Certain informationconcerning certain relationships and related transactions is incorporatedherein by reference from the information contained in the section entitled“Certain Relationships and Related Transactions” in the Definitive ProxyStatement.

 

**Item14:****                ****Principal Accountant Fees and Services**

 

Certain informationconcerning principal accountant fees and services is incorporated hereinby reference from the information contained in the section entitled“Principal Accountant Fees and Services” in the Definitive Proxy Statement.

 

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**Part IV**

 

**Item 15.  Exhibits,Financial Statement Schedules, and Reports on Form 8-K.**

 
| (a)  The following items are  filed as part of this report: |                                                                                                                                    |   |   |
|------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                             |                                                                                                                                    |   |   |   |   |
| (1)  Consolidated Financial  Statements:                    |                                                                                                                                    |
|                                                             |                                                                                                                                    |   |   |   |   |
|                                                             | Report  of Registered Independent Public Accounting Firm                                                                                |   |   |   |
|                                                             | Report of Registered  Independent Public Accounting Firm                                                                                |   |   |   |
|                                                             | Consolidated  Balance Sheets – July 3, 2004 and June 28, 2003                                                            |   |   |   |
|                                                             | Consolidated  Statements of Operations Years ended July 3, 2004, June 28, 2003,  and June 29, 2002                       |   |
|                                                             | Consolidated Statements of  Stockholders’ Equity – Years Ended July 3, 2004, June 28, 2003, and  June 29, 2002 |   |
|                                                             | Consolidated  Statements of Cash Flows - Years Ended July 3, 2004, June 28, 2003,  and June 29, 2002                     |   |
|                                                             | Notes to  Consolidated Financial Statements                                                                                             |   |   |   |
|                                                             |                                                                                                                                    |   |   |   |   |
| (2)  Consolidated Financial  Statement Schedules:           |                                                                                                                                    |   |   |
|                                                             |                                                                                                                                    |   |   |
|                                                             | Schedule II -  Valuation and Qualifying Accounts                                                                                   |   |   |   |
|                                                                  |                                                                                                                                         |        |        |  |  |  |  |

 
|                                                                                                                                                                                                               | The reports of the registrant’s independent auditor with respect to  the above-listed financial statements and financial statement  schedule appears on page F-1 and F-2 of this report.                                  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                               |
|                                                                                                                                                                                                               | All other financial statements and schedules not listed have been  omitted since the required information is included in the consolidated  financial statements or the notes thereto, or is not applicable, material, or  required. |
|                                                                                                                                                                                                               |                                                                                                                                                                                                                                |   |   |   |
| (3)  Exhibits:  Except as otherwise noted, the following  documents are incorporated by reference from the Company’s Registration  Statement on Form S-1 (File Number 333-78339) or filed herewith: |

 
|   | 3.1      | Certificate of Incorporation, as amended                                          |
|--------|----------|-----------------------------------------------------------------------------------|
|   |     |                                                                              |
|   | 3.2      | <FN9>                                                                       | By-laws of the Company, as amended and restated |
|   | 10.1     | <FN1>                                                                       | 1985 Incentive Stock Option Plan |
|   | 10.2     | <FN2>                                                                       | 1987 Stock Option Plan |
|   | 10.2.1   | <FN2>                                                                       | 1989 Stock Plan |
|   | 10.2.2   | <FN3>                                                                       | 1990 Employee Stock Purchase Plan |
|   | 10.2.3   | <FN3>                                                                       | 1990 Non-Employee Director Stock Option Plan |
|   | 10.2.4   | <FN7>                                                                       | 1993 Non-Employee Director Stock Option Plan |
|   | 10.2.5   | <FN13>                                                                      | 1998 Amended and Restated Stock Plan |
|   | 10.3     | <FN7>                                                                       | Lease for premises at 526 Boston Post Road, Wayland, Massachusetts. |
|   | 10.4     | <FN7>                                                                       | Lease for premises at 530 Boston Post Road, Wayland, Massachusetts. |
|   | 10.5     | <FN7>                                                                       | Patent License Agreement between the Company and Patlex Corporation  effective as of July 1, 1988. |
|   | 10.6     | <FN4>                                                                       | License Agreement among the Company, Technomed International, Inc. and  Technomed International S.A. dated as of December 20, 1990. |
|   | 10.7     | <FN5>                                                                       | License Agreement between the Company and Pillco Limited Partnership  effective as of October 1, 1991. |
|   | 10.8     | <FN8>                                                                       | Distribution Agreement between the Company and Cryogenic Technology  Limited, dated October 15, 1993. |
|   | 10.9     | <FN10>                                                                      | Asset Purchase Agreement between the Company and Derma-Laser, Limited  and Derma-Lase, Inc. dated June 23, 1994. |
|   | 10.10    | <FN13>                                                                      | Letter Agreement between the Company and Fleet Bank dated  February 13, 1997. |
|   | 10.10.1  | <FN13>                                                                      | Amendment to Letter Agreement between the Company and Fleet Bank dated  December 15, 1998. |
|   | 10.12*   | <FN14>                                                                      | Amended and Restated License Agreement between the Company and The  Regents of the University of California for Dynamic Skin Cooling Method and  Apparatus effective as of August 11, 2000. |
|   | 10.12.1* | <FN15>                                                                      | Settlement Agreement dated August 11, 2000 by and among the  Company, the Regents of the University of California, and Cool Touch, Inc. |
|   | 10.13    | <FN12>                                                                      | Note and Warrant Purchase Agreement, dated as of October 15, 1998  by and among the Company, Massachusetts Capital Resource Company, William D.  Witter and Michael D.Witter. |
|   | 10.13.1  | <FN12>                                                                      | Form of Note delivered to the Company in the aggregate principal  amount of $3,700,000 to Massachusetts Capital Resource Company, William D.  Witter and Michael D. Witter. |
|   | 10.13.2  | <FN12>                                                                      | Form of Common Stock Purchase Warrant to purchase an aggregate of  370,000 shares of the Company’s Common Stock delivered to Massachusetts Capital  Resource Company, William D. Witter and Michael D. Witter. |
|   | 21.1     | Subsidiaries of the Company                                                       |
|   | 23.1     | Consent of BDO Seidman, LLP (Independent Registered Public Accounting  Firm)      |
|   | 23.2     | Consent of Ernst & Young LLP (Independent Registered Public  Accounting Firm) |
|   | 31.1     | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                 |

 

32

----

 
|   | 31.2 | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer |
|--------|------|-------------------------------------------------------------------|
|   | 32.1 | Section 1350 Certification of Chief Executive Officer        |
|   | 32.2 | Section 1350 Certification of Chief Financial Officer        |

 

----

*   Confidential treatment as to certainportions has been requested pursuant to Rule 24b-2.

 
| <FN1>  |   | Previously filed as an exhibit to Registration Statement No. 33-54448B  and incorporated herein by reference.                                                                                                                 |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| <FN2>  |   | Previously filed as an exhibit to the Company’s Amended and Restated  Annual Report on Form 10-K for the fiscal year ended June 30, 1988  (Commission file number 000-14742), and incorporated herein by reference. |
| <FN3>  |   | Previously filed as an exhibit to the Company’s Annual Report on Form  10-K for the fiscal year ended June 30, 1990 (Commission file number  000-14742), and incorporated herein by reference.                      |
| <FN4>  |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  December 29, 1990 (Commission file number 000-14742), and incorporated  herein by reference.                                                          |
| <FN5>  |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  September 28, 1991 (Commission file number 000-14742), and incorporated  herein by reference.                                                         |
| <FN6>  |   | Previously filed as an exhibit to Form 8-K, dated September 8,  1992 (Commission file number 000-14742), and incorporated herein by  reference.                                                                          |
| <FN7>  |   | Previously filed as an exhibit to the Company’s Annual Report on Form  10-K for the fiscal year ended July 3, 1993 (Commission file number  000-14742), and incorporated herein by reference.                       |
| <FN8>  |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  January 1, 1994 (Commission file number 000-14742), and incorporated  herein by reference.                                                            |
| <FN9>  |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  April 2, 1994 (Commission file number 000-14742), and incorporated  herein by reference.                                                              |
| <FN10> |   | Previously filed as an exhibit to the Company’s Annual Report on Form  10-K for the fiscal year ended July 2, 1994 (Commission file number  000-14742), and incorporated herein by reference.                       |
| <FN11> |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  March 27, 1999 (Commission file number 000-14742), and incorporated  herein for reference.                                                            |
| <FN12> |   | Previously filed as an exhibit to the Company’s Amended and Restated  Annual Report on Form 10-K for the fiscal year ended June 27, 1998  (Commission file number 000-14742), and incorporated herein by reference. |
| <FN13> |   | Previously filed as Appendix A to the Company’s Schedule 14A,  filed December 28, 2002, and incorporated herein by reference.                                                                                  |
| <FN14> |   | Previously filed as an exhibit to Form 10-Q for the quarter ended  March 31, 2001 (Commission file number 000-14742), and incorporated  herein by reference.                                                             |
| <FN15> |   | Previously filed as an exhibit to Form 10-K for the fiscal year ended  July 1, 2000 (Commission file number 000-14742), and incorporated by  reference.                                                                  |

 

(b)         Reports on Form 8-K.  OnMay 4, 2004, the Company filed a current report on Form 8-K (includingitem 12) reporting our earnings for the third fiscal quarter endedMarch 27, 2004.

 

(c)          The Company hereby files, as part of this Form 10-K, the exhibits listedin Item 15(a)(3) above, other than exhibits 32.1 and 32.2, which the Companyhereby furnishes.

 

(d)         The Company hereby files, as part of this Form 10-K, the consolidatedfinancial Statement schedules listed in Item 15(a)(2) above.

 

33

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized, on September 14, 2004.

 

 
|   | CANDELA CORPORATION |
|--------|---------------------|
|   |                |
|   | By:                 | /s/ Gerard E. Puorro |   |
|   |                | Gerard E. Puorro, President, |
|   |                | Chief Executive Officer and Director |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title** | ** **                                            | **Date** |
|------------------------|------------|-----------|-------------------------------------------------------|----------|
|                   |       |      |                                                  |     |
| /s/ Gerard E. Puorro   |       |      | President, Chief Executive  Officer, and Director     |     | September 14, 2004 |
| Gerard E. Puorro       |       |      |                                                  |
|                   |       |      | (Principal Executive  Officer)                        |     |   |
|                   |       |      |                                                  |     |
| /s/ F. Paul Broyer     |       |      | Senior Vice President of  Finance and Administration, |     | September 14, 2004 |
| F. Paul Broyer         |       |      |                                                  |
|                   |       |      | Chief Financial Officer                               |     |   |
|                   |       |      |                                                  |     |
| /s/ Kenneth D. Roberts |       |      | Chairman of the Board of  Directors                   |     | September 14, 2004 |
| Kenneth D. Roberts     |       |      |                                                  |
|                   |       |      |                                                  |     |   |
|                   |       |      |                                                  |     |
| /s/ Nancy Nager        |       |      | Director                                              |     | September 14, 2004 |
| Nancy Nager            |       |      |                                                  |     |
|                   |       |      |                                                  |     |
| /s/ Douglas W. Scott   |       |      | Director                                              |     | September 14, 2004 |
| Douglas W. Scott       |       |      |                                                  |     |
|                   |       |      |                                                  |     |
| /s/ Ben Bailey, III    |       |      | Director                                              |     | September 14, 2004 |
| Ben Bailey, III        |       |      |                                                  |     |
|                   |       |      |                                                  |     |
| /s/ George Abe         |       |      | Director                                              |     | September 14, 2004 |
| George Abe             |       |      |                                                  |     |
|                   |       |      |                                                  |     |
| /s/ Eric Bernstein     |       |      | Director                                              |     | September 14, 2004 |
| Eric Bernstein         |       |      |                                                  |     |
|                        |            |           |                                                       |          |  |  |  |  |  |  |

 

34

----

 

# **Report of IndependentRegistered Public Accounting Firm**

# ** **

Boardof Directors and Stockholders

CandelaCorporation

Wayland,MA

 

Wehave audited the accompanying consolidated balance sheet of Candela Corporationand subsidiaries as of July 3, 2004 and the related consolidatedstatements of operations and comprehensive income (loss), stockholders’ equity,and cash flows for the year then ended July 3, 2004.  Our audit also included the financialstatement schedule listed in the index at item 15(a).  These financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements and schedule based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance as to whether the financial statements andschedule are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements andschedule.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentationand schedule.  We believe that our auditprovides a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofCandela Corporation and subsidiaries at July 3, 2004 and the consolidatedresults of their operations and their cash flows for the year then endedJuly 3, 2004, in conformity with accounting principles generally acceptedin the United States.  Also, in ouropinion, the schedule presents fairly, in all material respects, theinformation set forth therein.

 

/s/ BDO SEIDMAN, LLP

----

Boston,Massachusetts

August 24,2004

 

F-1

----

 

**Reportof Independent Registered Public Accounting Firm**

 

The Board of Directorsand Stockholders

CandelaCorporation

 

Wehave audited the accompanying consolidated balance sheet of Candela Corporationand subsidiaries as of June 28, 2003 and the related consolidatedstatements of operations and comprehensive income (loss), stockholders’ equity,and cash flows for each of the two years in the period ended June 28,2003.  Our audits also included thefinancial statement schedule listed in the Index at         Item 15(a) for the twoyears in the period ended June 28, 2003. These financial statements and schedule are the responsibility of theCompany’s management.  Our responsibilityis to express an opinion on these financial statements and schedule basedon our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance as to whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofCandela Corporation and subsidiaries at June 28, 2003 and the consolidatedresults of their operations and their cash flows for each of the two years inthe period ended June 28, 2003, in conformity with U.S. generally acceptedaccounting principles.  Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

 

 
| /s/ ERNST & YOUNG LLP |   |
|---------------------------|--------|

 

 

Boston,Massachusetts

September 2,2004

 

F-2

----

 

**CANDELA CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

**July 3, 2004 and June 28, 2003**

 
| **(in  thousands, except share information)**                                                                                        | ** ** | **2004**    | ** **  | **2003**       | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|----------------|------------|
| ** **                                                                                                                           | ** ** | ** **  | ** **  | **(Restated)** | ** ** |
| **Assets:**                                                                                                                          | ** ** | ** **  | ** **  | ** **     | ** ** |
| Current assets:                                                                                                                      |       |        |        |           |       |
| Cash and cash equivalents                                                                                                            | ** ** | **$**       | **37,139**  | ** **     | **$**      | **31,813** | ** ** |
|                                                                                                                                 | ** ** | ** **  | ** **  | ** **     | ** ** | ** ** | ** ** |
| Restricted cash (note 6)                                                                                                             | ** ** | **257**     | ** **  | **57**         | ** ** |
| Accounts receivable (net of allowance for doubtful  accounts of $1,492 in  2004  and $970 in 2003)                              | ** ** | **34,302**  | ** **  | **26,572**     | ** ** |
| Notes receivable                                                                                                                     | ** ** | **1,151**   | ** **  | **1,086**      | ** ** |
| Inventories, net                                                                                                                     | ** ** | **13,571**  | ** **  | **10,834**     | ** ** |
| Other current assets                                                                                                                 | ** ** | **2,184**   | ** **  | **658**        | ** ** |
| Total current assets                                                                                                                 | ** ** | **88,604**  | ** **  | **71,020**     | ** ** |
| ** **                                                                                                                           | ** ** | ** **  | ** **  | ** **     | ** ** |
| Property and equipment, net                                                                                                          | ** ** | **3,406**   | ** **  | **3,327**      | ** ** |
| Deferred tax assets                                                                                                                  | ** ** | **5,914**   | ** **  | **4,760**      | ** ** |
| Prepaid licenses                                                                                                                     | ** ** | **1,054**   | ** **  | **1,228**      | ** ** |
| Other assets                                                                                                                         | ** ** | **1,501**   | ** **  | **166**        | ** ** |
| Total assets                                                                                                                         | ** ** | **$**       | **100,479** | ** **     | **$**      | **80,501** | ** ** |
| ** **                                                                                                                           | ** ** | ** **  | ** **  | ** **     | ** ** |
| **Liabilities and Stockholders’  Equity**                                                                                       | ** ** | ** **  | ** **  | ** **     | ** ** |
| Current liabilities:                                                                                                                 | ** ** | ** **  | ** **  | ** **     | ** ** |
| Accounts payable                                                                                                                     | ** ** | **$**       | **6,973**   | ** **     | **$**      | **5,271** | ** ** |
| Accrued payroll and related expenses                                                                                                 | ** ** | **5,428**   | ** **  | **4,656**      | ** ** |
| Accrued warranty costs                                                                                                               | ** ** | **4,946**   | ** **  | **3,628**      | ** ** |
| Income taxes payable                                                                                                                 | ** ** | **1,844**   | ** **  | **3,528**      | ** ** |
| Other accrued liabilities                                                                                                            | ** ** | **3,586**   | ** **  | **2,755**      | ** ** |
| Deferred income (current portion)                                                                                                    | ** ** | **3,421**   | ** **  | **2,779**      | ** ** |
| Current liabilities of discontinued operations                                                                                       | ** ** | **1,019**   | ** **  | **1,095**      | ** ** |
| Total current liabilities                                                                                                            | ** ** | **27,217**  | ** **  | **23,712**     | ** ** |
| Other long-term liabilities                                                                                                          | ** ** | **3,945**   | ** **  | **3,393**      | ** ** |
| Long-term liabilities of discontinued operations                                                                                     | ** ** | **2,548**   | ** **  | **48**         | ** ** |
| Total liabilities                                                                                                                    | ** ** | **33,710**  | ** **  | **27,153**     | ** ** |
| ** **                                                                                                                           | ** ** | ** **  | ** **  | ** **     | ** ** |
| Stockholders’ equity:                                                                                                           | ** ** | ** **  | ** **  | ** **     | ** ** |
| Common stock, $.01 par value: 60,000,000 shares  authorized, 24,567,062 and 23,527,894 shares issued in 2004 and 2003,  respectively | ** ** | **246**     | ** **  | **235**        | ** ** |
| Treasury stock, 2,250,000 shares in 2004 and 2003,  at cost                                                                          | ** ** | **(12,997** | **)**       | **(12,997**    | **)**      |
| Additional paid-in capital                                                                                                           | ** ** | **53,069**  | ** **  | **48,373**     | ** ** |
| Accumulated earnings                                                                                                                 | ** ** | **26,023**  | ** **  | **17,904**     | ** ** |
| Accumulated other comprehensive income (loss)                                                                                        | ** ** | **428**     | ** **  | **(167**       | **)**      |
| Total stockholders’ equity                                                                                                      | ** ** | **66,769**  | ** **  | **53,348**     | ** ** |
| Total liabilities and stockholders’ equity                                                                                      | ** ** | **$**       | **100,479** | ** **     | **$**      | **80,501** | ** ** |

 

***The accompanying notes are an integral part of the financialstatements.***

 

F-3

----

 

**CANDELACORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS****AND COMPREHENSIVE INCOME (LOSS)**

**For the years ended July 3, 2004, June 28, 2003 andJune 29, 2002**

 
| **(in thousands, except per share  data)**                                                                                                                | ** ** | **2004**    | ** ** | **2003**       | ** ** | **2002**       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|----------------|------------|
| ** **                                                                                                                                                |       |        |       | **(Restated)** |       | **(Restated)** |       |
| **Revenue:**                                                                                                                                              |       |        |       | ** **     |       | ** **     |       |
| Lasers  and other products                                                                                                                                |       | **$**       | **87,965** | ** **     | **$**      | **68,072**     | ** ** | **$** | **45,957** | ** ** |
| Product  related service                                                                                                                                  |       | **16,473**  | ** ** | **10,579**     | ** ** | **12,731**     | ** ** |
| Total  revenue                                                                                                                                            |       | **104,438** | ** ** | **78,651**     | ** ** | **58,688**     | ** ** |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Cost of sales:**                                                                                                                                        |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| Lasers  and other products                                                                                                                                |       | **36,413**  | ** ** | **30,641**     | ** ** | **20,396**     | ** ** |
| Product  related service                                                                                                                                  |       | **14,860**  | ** ** | **7,992**      | ** ** | **11,205**     | ** ** |
| Total  cost of sales                                                                                                                                      |       | **51,273**  | ** ** | **38,633**     | ** ** | **31,601**     | ** ** |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Gross profit**                                                                                                                                          |       | **53,165**  | ** ** | **40,018**     | ** ** | **27,087**     | ** ** |
| **Operating expenses:**                                                                                                                                   |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| Research  and development                                                                                                                                 |       | **5,302**   | ** ** | **4,545**      | ** ** | **4,644**      | ** ** |
| Selling,  general and administrative                                                                                                                      |       | **33,978**  | ** ** | **24,519**     | ** ** | **24,832**     | ** ** |
| Total  operating expenses                                                                                                                                 |       | **39,280**  | ** ** | **29,064**     | ** ** | **29,476**     | ** ** |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Income (loss) from operations**                                                                                                                         |       | **13,885**  | ** ** | **10,954**     | ** ** | **(2,389**     | **)**      |
| **Other income (expense):**                                                                                                                               |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| Interest  income                                                                                                                                          |       | **308**     | ** ** | **651**        | ** ** | **546**        | ** ** |
| Interest  expense                                                                                                                                         |       | **(19**     | **)**      | **(218**       | **)**      | **(476**       | **)**      |
| Other  income expense, net                                                                                                                                |       | **924**     | ** ** | **(44**        | **)**      | **487**        | ** ** |
| Total  other income (expense)                                                                                                                             |       | **1,213**   | ** ** | **389**        | ** ** | **557**        | ** ** |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Income (loss) from continuing operations before income tax**                                                                                            |       | **15,098**  | ** ** | **11,343**     | ** ** | **(1,832**     | **)**      |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| Provision  for (benefit from) income taxes                                                                                                                |       | **4,586**   | ** ** | **3,516**      | ** ** | **(421**       | **)**      |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Income (loss) from continuing operations**                                                                                                              |       | **10,512**  | ** ** | **7,827**      | ** ** | **(1,411**     | **)**      |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Discontinued operations:**                                                                                                                              |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Loss from discontinued skin care  center operations of $473, $1,468, and ****$964 less income tax  benefit of $175, $455, and $221, respectively** |       | **(298**    | **)**      | **(1,013**     | **)**      | **(743**       | **)**      |
| **Loss on closure of skin care center of $3,348 less income  tax benefit of $1,253**                                                                      |       | **(2,095**  | **)**      | ** **     | ** ** | ** **     | ** ** |
| **Net income (loss)**                                                                                                                                     |       | **$**       | **8,119**  | ** **     | **$**      | **6,814**      | ** ** | **$** | **(2,154** | **)** |
|                                                                                                                                                      |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Net income (loss) per share of common stock**                                                                                                           |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Basic:**                                                                                                                                                |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Income (loss) from continuing operations**                                                                                                              |       | **$**       | **.48**    | ** **     | **$**      | **.39**        | ** ** | **$** | **(.07** | **)** |
| **Loss from discontinued operations**                                                                                                                     |       | **(.11**    | **)**      | **(.05**       | **)**      | **(.04**       | **)**      |
| **Net income (loss)**                                                                                                                                     |       | **$**       | **.37**    | ** **     | **$**      | **.34**        | ** ** | **$** | **(.11** | **)** |
| **Diluted:**                                                                                                                                              |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Income (loss) from continuing operations**                                                                                                              |       | **$**       | **.46**    | ** **     | **$**      | **.38**        | ** ** | **$** | **(.07** | **)** |
| **Loss from discontinued operations**                                                                                                                     |       | **(.10**    | **)**      | **(.05**       | **)**      | **(.04**       | **)**      |
| **Net income (loss)**                                                                                                                                     |       | **$**       | **.36**    | ** **     | **$**      | **.33**        | ** ** | **$** | **(.11** | **)** |
| ** **                                                                                                                                                |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Basic weighted average shares outstanding**                                                                                                             |       | **21,902**  | ** ** | **20,083**     | ** ** | **20,106**     | ** ** |
| **Diluted weighted average shares outstanding**                                                                                                           |       | **22,712**  | ** ** | **20,645**     | ** ** | **20,106**     | ** ** |
| **Net income (loss)**                                                                                                                                     |       | **$**       | **8,119**  | ** **     | **$**      | **6,814**      | ** ** | **$** | **(2,154** | **)** |
| **Other comprehensive income (loss) net of tax:**                                                                                                         |       | ** **  | ** ** | ** **     | ** ** | ** **     | ** ** |
| **Foreign currency translation adjustment**                                                                                                               |       | **595**     | ** ** | **(732**       | **)**      | **661**        | ** ** |
| **Total comprehensive income (loss)**                                                                                                                     |       | **$**       | **8,714**  | ** **     | **$**      | **6,082**      | ** ** | **$** | **(1,493** | **)** |

 

***The accompanying notes are an integral part of the financialstatements.***

 

F-4

----

 

**CANDELA CORPORATION ANDSUBSIDIARIES CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

**For the years ended July 3,2004, June 28, 2003 and June 29, 2002**

 
| **(in  thousands)**                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** **  | **Treasury Stock** | ** ** | **Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** **   | ** ** | ** **        |
|-----------------------------------------|------------|------------------|------------|-------------------------|-------------|--------------------|------------|-----------------|------------|---------------------------------------|--------------|------------|-------------------|
| ** **                              | **Shares** | ** **       | **Amount** | ** **              | **Capital** | ** **         | **Shares** | ** **      | **Amount** | ** **                            | **Earnings** | ** ** | **Income (Loss)** | ** ** | **Total** | ** ** |
| **(Restated)**                          | ** ** | ** **       | ** ** | ** **              | ** **  | ** **         | ** ** | ** **      | ** ** | ** **                            | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** |
| **Balance June 30, 2001**          | ** ** | **21,318**       | ** ** | **$**                   | **213**     | ** **         | **$**      | **43,380**      | ** ** | **(1,000**                            | **)**        | **$**      | **(7,782**        | **)** | **$** | **13,244** | ** ** | **$** | **(2,081** | **)** | **$** | **46,974** | ** ** |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Sale  of common stock under stock plans |       | 200              |       | 2                       |        | 393                |       |            |       |                                  |         |       |              |   |   | 395 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Treasury  stock purchases               |       |             |       |                    |        |               |       | (1,250          | )          | (5,215                                | )       |       |              |   |   | (5,215 | )  |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Net  loss                               |       |             |       |                    |        |               |       |            |       |                                  |         | (2,154     | )                 |   |   | (2,154 | ) |
| Currency  translation adjustment        |       |             |       |                    |        |               |       |            |       |                                  |         |       |              | 853 |   | 853 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| **Balance June 29, 2002**          | ** ** | **21,518**       | ** ** | **215**                 | ** **  | **43,773**         | ** ** | **(2,250**      | **)**      | **(12,997**                           | **)**        | **11,090** | ** **        | **(1,228** | **)** | **40,853** | ** ** |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Sale  of common stock under stock plans |       | 1,140            |       | 11                      |        | 3,452              |       |            |       |                                  |         |       |              |   |   | 3,463 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Exercise  of stock warrants             |       | 870              |       | 9                       |        | 1,148              |       |            |       |                                  |         |       |              |   |   | 1,157 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Net  income                             |       |             |       |                    |        |               |       |            |       |                                  |         | 6,814      |              |   |   | 6,814 |   |
| Currency  translation adjustment        |       |             |       |                    |        |               |       |            |       |                                  |         |       |              | 1,061 |   | 1,061 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| **Balance June 28, 2003**          | ** ** | **23,528**       | ** ** | **235**                 | ** **  | **48,373**         | ** ** | **(2,250**      | **)**      | **(12,997**                           | **)**        | **17,904** | ** **        | **(167** | **)** | **53,348** | ** ** |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Sale  of common stock under stock plans |       | 979              |       | 9                       |        | 4,618              |       |            |       |                                  |         |       |              |   |   | 4,627 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Exercise  of stock warrants             |       | 60               |       | 1                       |        | 79                 |       |            |       |                                  |         |       |              |   |   | 80 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| Net  income                             |       |             |       |                    |        |               |       |            |       |                                  |         | 8,119      |              |   |   | 8,119 |   |
| Currency  translation adjustment        |       |             |       |                    |        |               |       |            |       |                                  |         |       |              | 595 |   | 595 |   |
|                                    |       |             |       |                    |        |               |       |            |       |                                  |         |       |              |   |   |   |   |
| **Balance July 3, 2004**           | ** ** | **24,567**       | ** ** | **$**                   | **246**     | ** **         | **$**      | **53,069**      | ** ** | **(2,250**                            | **)**        | **$**      | **(12,997**       | **)** | **$** | **26,023** | ** ** | **$** | **428** | ** ** | **$** | **66,769** | ** ** |

 

***The accompanying notes are an integral part of thefinancial statements.***

 

F-5

----

 

**CANDELA CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**For the years ended July 3, 2004, June 28, 2003 andJune 29, 2002**

**(in thousands)**

 
| ** **                                                                                            | ** ** | **2004**   | ** ** | **2003**       | ** ** | **2002**       | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|
| ** **                                                                                            | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Cash  flows from operating activities:                                                                |       |       |       |           |       |           |       |
| Net  income (loss)                                                                                    |       | **$**      | **8,119**  | ** **     | **$**      | **6,814**      | ** ** | **$** | **(2,154** | **)** |
| Adjustments  to reconcile net income (loss) to net cash provided by (used for) operating  activities: |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Provision  for the disposal of discontinued operations                                                |       | **2,095**  | ** ** | **—**     | ** ** | **—**     | ** ** |
| Loss  from discontinued operations                                                                    |       | **298**    | ** ** | **1,013**      | ** ** | **743**        | ** ** |
| Depreciation                                                                                          |       | **668**    | ** ** | **582**        | ** ** | **355**        | ** ** |
| Accretion  of imputed interest on stock warrants                                                      |       | **—** | ** ** | **475**        | ** ** | **102**        | ** ** |
| Provision  for bad debts                                                                              |       | **520**    | ** ** | **(13**        | **)**      | **116**        | ** ** |
| Provision  for deferred taxes                                                                         |       | **955**    | ** ** | **(682**       | **)**      | **(115**       | **)**      |
| Tax  benefit from exercised stock options                                                             |       | **(1,223** | **)**      | **(505**       | **)**      | **(6**         | **)**      |
| Effect  of exchange rate changes on foreign currency denominated assets and  liabilities              |       | **26**     | ** ** | **36**         | ** ** | **(305**       | **)**      |
| Changes  in assets and liabilities:                                                                   |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Restricted  cash                                                                                      |       | **(200**   | **)**      | **(57**        | **)**      | **—**     | ** ** |
| Accounts  receivable                                                                                  |       | **(7,663** | **)**      | **(2,417**     | **)**      | **(3,525**     | **)**      |
| Notes  receivable                                                                                     |       | **62**     | ** ** | **179**        | ** ** | **(54**        | **)**      |
| Inventories                                                                                           |       | **(2,134** | **)**      | **1,761**      | ** ** | **(1,661**     | **)**      |
| Other  current assets                                                                                 |       | **(2,550** | **)**      | **225**        | ** ** | **175**        | ** ** |
| Other  assets                                                                                         |       | **(236**   | **)**      | **157**        | ** ** | **305**        | ** ** |
| Accounts  payable                                                                                     |       | **(91**    | **)**      | **(1,409**     | **)**      | **(3,069**     | **)**      |
| Accrued  payroll and related expenses                                                                 |       | **707**    | ** ** | **1,622**      | ** ** | **1,139**      | ** ** |
| Deferred  income                                                                                      |       | **548**    | ** ** | **574**        | ** ** | **24**         | ** ** |
| Accrued  warranty costs                                                                               |       | **1,776**  | ** ** | **(921**       | **)**      | **830**        | ** ** |
| Income  tax payable                                                                                   |       | **(1,312** | **)**      | **4,168**      | ** ** | **(784**       | **)**      |
| Other  accrued liabilities                                                                            |       | **767**    | ** ** | **53**         | ** ** | **813**        | ** ** |
| Net  cash provided by (used in) operating activities                                                  |       | **1,132**  | ** ** | **11,655**     | ** ** | **(7,071**     | **)**      |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Cash  flows from investing activities:                                                                |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Purchase  of property, plant and equipment                                                            |       | **(685**   | **)**      | **(1,227**     | **)**      | **(1,058**     | **)**      |
| Net  cash used in investing activities                                                                |       | **(685**   | **)**      | **(1,227**     | **)**      | **(1,058**     | **)**      |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Cash  flows from financing activities:                                                                |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Proceeds  from issuance of common stock                                                               |       | **4,707**  | ** ** | **4,620**      | ** ** | **394**        | ** ** |
| Repurchases  of treasury stock                                                                        |       | **—** | ** ** | **—**     | ** ** | **(5,215**     | **)**      |
| Principal  payments of long-term debt                                                                 |       | **—** | ** ** | **(3,330**     | **)**      | **(370**       | **)**      |
| Net  borrowings (repayments) on line of credit                                                        |       | **—** | ** ** | **(1,114**     | **)**      | **50**         | ** ** |
| Net  cash provided by (used in) financing activities                                                  |       | **4,707**  | ** ** | **176**        | ** ** | **(5,141**     | **)**      |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Effect  of exchange rate changes on cash and cash equivalents                                         |       | **172**    | ** ** | **1,552**      | ** ** | **890**        | ** ** |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Net  increase (decrease) on cash and cash equivalents                                                 |       | **5,326**  | ** ** | **12,156**     | ** ** | **(12,380**    | **)**      |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Cash  and cash equivalents, beginning of year                                                         |       | **31,813** | ** ** | **19,657**     | ** ** | **32,037**     | ** ** |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Cash  and cash equivalents, end of year                                                               |       | **$**      | **37,139** | ** **     | **$**      | **31,813**     | ** ** | **$** | **19,657** | ** ** |
|                                                                                                  |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Cash  paid during the year for:                                                                       |       | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| Interest                                                                                              |       | **$**      | **15**     | ** **     | **$**      | **235**        | ** ** | **$** | **347** | ** ** |
| Income  Taxes                                                                                         |       | **$**      | **3,265**  | ** **     | **$**      | **751**        | ** ** | **$** | **(68** | **)** |

 

***The accompanying notes are an integral part of the financialstatements.***

 

F-6

----

 

**Notes to Consolidated Financial Statements**

 

**1.  Summary of Significant Accounting Policies**

 

***Description of Business and Basis of Presentation***

 

CandelaCorporation is a pioneer in the development and commercialization of advancedaesthetic laser systems that allow physicians and personal care practitionersto treat a wide variety of cosmetic and medical conditions. The consolidatedfinancial statements include the accounts of Candela Corporation and itswholly-owned subsidiaries.  Allintercompany accounts and transactions have been eliminated in consolidation.The notes to our consolidated financial statements pertain to continuingoperations except where otherwise noted.

 

Allprior period financial statements have been restated to reflect skin carecenters operations as discontinued (See note 11).

 

All share and per-share information included in the accompanyingconsolidated financial statements for all periods presented have been restatedto retroactively reflect the effect of a two-for-one stock split which occurredon February 16, 2004.

 

TheCompany’s fiscal year ends on the Saturday nearest June 30.  The year ended July 3, 2004 contains 53weeks. The years ended June 28, 2003 and June 29, 2002 each contain52 weeks.

 

***Use of Estimates***

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  It is the belief of the Company’s managementthat all necessary adjustments have been made for an accurate presentation ofresults.  Actual results could differfrom those estimates and impact future results of operations and cash flows.

 

Inthe ordinary course of accounting for the items discussed above, we makechanges in estimates as appropriate, and as we become aware of circumstancessurrounding those estimates. Such changes and refinements in estimationmethodologies are reflected in reported results of operations in the period inwhich the changes are made and, if material, their effects are disclosed in theNotes to the Consolidated Financial Statements.

 

***Cash and Cash Equivalents***

 

TheCompany classifies investments purchased with a maturity, at the date ofacquisition, of three months or less as cash equivalents.  These are valued at cash plus accruedinterest, which approximates market value. At July 3, 2004, and June 28, 2003, substantially all cashequivalents were invested in overnight Repurchase Agreements with a major bank.

 

***Accounts Receivable and Notes Receivable***

 

TheCompany’s trade accounts receivables and notes receivables are primarily fromsales to end users, leasing companies, and distributors servicing the medicaldevice market, and reflect a broad domestic and international customerbase.  The Company does not requirecollateral and has not historically experienced significant credit lossesrelated to receivables from individual customers or groups of customers in anyparticular industry or geographic area. Our policy is to maintain allowances for estimated losses resulting fromthe inability of our customers to make required payments. Credit limits areestablished through a process of reviewing the financial history and stabilityof each customer. Where appropriate, we obtain credit rating reports andfinancial statements of customers when determining or modifying their creditlimits. We regularly evaluate the collectibility of our trade receivablebalances based on a combination of factors. When a customer’s account balancebecomes past due, we initiate dialogue with the customer to determine thecause. If it is determined that the customer will be unable to meet its financialobligation to us, such as in the case of a bankruptcy filing, deterioration inthe customer’s operating results or financial position or other material eventsimpacting their business, we record a specific allowance to reduce the relatedreceivable to the amount we expect to recover given all information presentlyavailable.

 

***Inventories***

 

Inventoriesare stated at the lower of cost (first-in, first-out method) or market, using astandard costing system.

 

F-7

----

 

***Property and Equipment***

 

Purchasedproperty and equipment is recorded at cost. Property and equipment purchased under capital lease arrangements isrecorded at the lesser of cost or the present value of the minimum leasepayments required during the lease period. Laser systems used for testing are capitalized at cost.  Repairs and maintenance costs are expensed asincurred. Depreciation is provided using the straight-line method overthe estimated useful lives as follows:

 
| ** **                                            | ** ** | **Number of Years** |
|-------------------------------------------------------|------------|---------------------|
|                                                  |       |                |
| Leasehold improvements and assets under capital lease |       | 2 to 13             |
| Office furniture, computer and other equipment        |       | 3 to 10             |

 

***Income Taxes***

 

The Company accounts for income taxes using anasset and liability approach that requires the recognition of deferred taxassets and liabilities for the expected future tax consequences of events thathave been recognized in the financial statements or tax returns. In estimatingfuture tax consequences, all expected future events are considered other thanenactments of changes in tax laws or rates. Valuation allowances areestablished as necessary to reduce deferred tax assets in the event thatrealization of the assets is considered unlikely.

 

***Research and Development Costs***

 

Researchand development costs are expensed as incurred

 

***Impairment of Long-Lived Assets***

 

We review therecoverability of our long-lived assets, including building improvements,equipment and other intangible assets, when events or changes in circumstancesoccur that indicate that the carrying value of the asset may not berecoverable. The assessment of possible impairment is based on our ability torecover the carrying value of the asset from the expected future pre-tax cashflows (undiscounted and without interest charges) of the related operations. Ifthese cash flows are less than the carrying value of such asset, an impairmentloss is recognized for the difference between estimated fair value and carryingvalue. Our primary measure of fair value is based on discounted cash flows. Themeasurement of impairment requires management to make estimates of these cashflows related to long-lived assets, as well as other fair value determinations.

 

***Advertising Costs***

 

Advertisingcosts are expensed as incurred and are included as a component of selling,general and administrative expenses in the accompanying Statements ofOperations.  Advertising costs were $766,$798 and $594 for the years ended July 3, 2004, June 28, 2003 andJune 29, 2002, respectively.

 

***Foreign Currency Translation***

 

Theactivity of the Company’s foreign subsidiaries is translated into U.S. dollarsin accordance with SFAS No. 52, “*Foreign CurrencyTranslation*”.  Assets andliabilities are translated into U.S. dollars at current exchange rates, whileincome and expense items are translated at average rates of exchange prevailingduring the year.  Exchange gains andlosses arising from translation of the Japanese, Spanish, German, and Frenchsubsidiary balance sheets are accumulated as a separate component ofstockholders’ equity.  Net exchange gains(losses) resulting from foreign currency transactions amounted to $339, $(56)and $661 for fiscal 2004, 2003 and 2002, respectively, and are included inother income (expense).

 

F-8

----

 

***Derivative Instruments and Hedging Activity***

 

Candela enters into financial instruments to reduce its exposure tofluctuations in foreign exchange rates by creating offsetting positions throughthe use of foreign currency forward contracts. The Company recognizes all derivative instruments as eitherassets or liabilities in the statements of financial position and measuresthose instruments at fair value. Changes to the fair value of derivativecontracts that do not qualify for hedge accounting are reported in earnings inthe period of the change. For derivatives that qualify for hedge accounting,changes in the fair value of the derivatives are either recorded inshareholders’ equity as a component of other comprehensive income or arerecognized currently in earnings, along with an offsetting adjustment againstthe basis of the item being hedged. Cumulative gains and losses on derivativesthat have hedged our foreign operations and that have been recorded in othercomprehensive income as of July 3, 2004 and June 28, 2003 did notamount to a significant gain or loss.

 

TheCompany’s foreign currency forward contracts may involve elements of credit andmarket risk in excess of the amounts recognized in the financial statements.The Company monitors its positions and the credit quality of counter-parties,consisting primarily of major financial institutions, and does not anticipatenonperformance by any counter-party. The Company does not use derivativefinancial instruments for trading or speculative purposes, nor is the Company aparty to leveraged derivatives.

 

***Revenue Recognition***

 

*Productsales* – The Companyrecognizes revenue upon shipment of product to customers and the fulfillment ofall contractual terms and conditions, pursuant to the guidance provided by SABNo. 104, *Revenue Recognition in FinancialStatements*. Credit is not extended to customers and revenue is notrecognized until collectibility is reasonably assured.

 

*Service* - Revenue from the sale of servicecontracts is deferred and recognized on a straight-line basis over the contractperiod.  Revenue from serviceadministered by Candela that is not covered by a service contract is recognizedas the services are provided.

 

*Multiple-elementarrangements* – In certain instances, the Company may sellproducts together with extended warranties or maintenance contracts.  The revenue recognized per element isdetermined by allocating the total sales price to each element, based on therelative fair values.

 

***Product Warranty Costs***

 

Thelength of the Company’s warranty on end user sales of medical devices isgenerally one year on parts and labor except on the Vbeam system, which carriesa standard three-year warranty.  Anextended warranty is also available for purchase on all systems.  Distributor sales generally include a parts warrantyonly.  Estimated future costs for initialproduct warranties are provided for at the time of sale.

 

***Comprehensive Income (Loss)***

 

Comprehensiveincome (loss) is comprised of two components, net income (loss) and othercomprehensive income (loss). Other comprehensive income (loss) consists oftranslation adjustments, which represent the effect of translating assets andliabilities of the Company’s foreign subsidiaries.  Translation adjustments are shown net of taxof $167, $329 and $197 for fiscal years 2004, 2003 and 2002, respectively.

 

***Earnings (Loss) Per Share***

 

The following tableprovides share information used in the calculation of the Company’s basic anddiluted earnings per share:

 

F-9

----

 
| ** **                                                                        | ** ** | **For the years ended:** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|
| **(in thousands, except per share data)**                                         | ** ** | **July 3,  2004**   | ** ** | **June 28,  2003** | ** ** | **June 29,  2002** | ** ** |
| ** **                                                                        | ** ** | ** **               | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **Basic shares used in the calculation of earnings per share**                    | ** ** | **21,902**               | ** ** | **20,083** | ** ** | **20,106** | ** ** |
| ** **                                                                        | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Effect of dilutive securities:**                                                | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Stock options**                                                                 | ** ** | **810**                  | ** ** | **297** | ** ** | **—** | ** ** |
| **Stock warrants**                                                                | ** ** | **—**               | ** ** | **265** | ** ** | **—** | ** ** |
| ** **                                                                        | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Diluted shares used in the calculation of earnings per  share**                 | ** ** | **22,712**               | ** ** | **20,645** | ** ** | **20,106** | ** ** |
| ** **                                                                        | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per share effect of dilutive securities on income from  continuing operations** | ** ** | **$**                    | **.02**    | ** ** | **$** | **.01** | ** ** | **—** | ** ** |
| ** **                                                                        | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per share effect of dilutive securities on net income**                         | ** ** | **$**                    | **.01**    | ** ** | **$** | **.01** | ** ** | **—** | ** ** |

 

Duringthe years ended July 3, 2004, June 28, 2003 and June 29, 2002,options and warrants to purchase 497, 615 and 815 shares of common stock,respectively, were not included in the computation of diluted earnings (loss)per share because they would have had an anti-dilutive effect.

 

***Dividends***

 

The Company currently intends to retain futureearnings for use in its business and, therefore, does not expect to paydividends in the foreseeable future.

 

***Accounting for Stock-Based Compensation***

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedStatement No. 148, “Accounting for Stock-Based Compensation, Transition andDisclosure” (“FAS 148”). FAS 148 provides alternative methods of transition fora voluntary change to the recognition of the cost of the options in thestatement of operations. FAS 148 also requires that disclosures of the proforma effect of using the fair value method of accounting for stock-basedemployee compensation be displayed more prominently and in a tabular format.Additionally, FAS 148 requires disclosure of the pro forma effect in interimfinancial statements. The transition and annual disclosure requirements of FAS148 were effective for fiscal years ended after December 15, 2002. Theinterim disclosure requirements of FAS 148 are effective for interim periodsbeginning after December 15, 2002. The adoption of the provisions of FAS148 did not have an impact on the Company’s consolidated financial statements;however, the Company has modified its disclosures as provided for in the newstandard.

 

TheCompany follows the provisions of FASB Statement No. 123, “Accounting forStock-Based Compensation” (“FAS 123”). The provisions of FAS 123 allowcompanies to either expense the estimated fair value of stock options or tocontinue to follow the intrinsic value method set forth in AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (“APB 25”), but disclose the pro forma effects on net income(loss) had the fair value of the options been expensed. Candela haselected to continue to apply APB 25 in accounting for its stock optionincentive plans.

 

Inaccordance with APB 25 and related interpretations, compensation expense forstock options is recognized in income based on the excess, if any, of thequoted market price of the stock at the grant date of the award or othermeasurement date over the amount an employee must pay to acquire the stock.Generally, the exercise price for stock options granted to employees equals orexceeds the fair market value of Candela common stock at the date of grant,thereby resulting in no recognition of compensation expense by Candela. For awardsthat generate compensation expense as defined under APB 25, the Companycalculates the amount of compensation expense and recognizes the expense overthe vesting period of the award.

 

Hadcompensation cost for Candela’s stock option plans been determined based on thefair value method set forth in FAS 123, Candela’s net income (loss) andbasic and diluted net income (loss) per common share would have beenchanged to the pro forma amounts indicated below:

 

F-10

----

 

 
| ** **                                                                                                                               | ** ** | **For the year ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| **(in thousands, except per  share data)**                                                                                               | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** | **June 29,  2002** | ** ** |
|                                                                                                                                     |       |                   |       | **(Restated)** |   | **(Restated)** |   |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net Income (loss), as reported**                                                                                                       | ** ** | **$**                  | **8,119**  | ** ** | **$** | **6,814** | ** ** | **$** | **(2,154** | **)** |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Add: Stock-based employee compensation expense included in  reported net income, net of related tax effects**                          | ** ** | **—**             | ** ** | **—** | ** ** | **—** | ** ** |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Deduct: Total stock-based employee compensation expense  determined under fair value based method for all awards, net of tax effects** | ** ** | **(780**               | **)**      | **(833** | **)** | **(1,196** | **)** |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Pro forma net income (loss)**                                                                                                          | ** ** | **$**                  | **7,339**  | ** ** | **$** | **5,981** | ** ** | **$** | **(3,350** | **)** |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Earnings (loss) per share**                                                                                                            | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic - as reported**                                                                                                                  | ** ** | **$**                  | **0.37**   | ** ** | **$** | **0.34** | ** ** | **$** | **(0.11** | **)** |
| **Basic - pro forma**                                                                                                                    | ** ** | **$**                  | **0.34**   | ** ** | **$** | **0.30** | ** ** | **$** | **(0.17** | **)** |
| ** **                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Diluted - as reported**                                                                                                                | ** ** | **$**                  | **0.36**   | ** ** | **$** | **0.33** | ** ** | **$** | **(0.11** | **)** |
| **Diluted - pro forma**                                                                                                                  | ** ** | **$**                  | **0.32**   | ** ** | **$** | **0.29** | ** ** | **$** | **(0.17** | **)** |

 

Incomputing this pro-forma amount, the Company has used the Black-Scholes pricingmodel using the following assumptions for options granted in fiscal years 2004,2003, and 2002: 

 
| ** **                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| risk-free  interest rate                     |       | 1.25     | %          | 4.25     | %          | 5.19     | %          |
| estimated  volatility                        |       | 80       | %          | 76       | %          | 78       | %          |
| expected  life for stock options (yrs)       |       | 2.92     |       | 2.99     |       | 3.65     |       |
| expected  life for stock purchase plan (yrs) |       | 0.5      |       | 0.5      |       | 0.5      |       |
| expected  dividends                          |       | none     |       | none     |       | none     |       |

 

***Recent Accounting Pronouncements***

 

In May 2003, the FASBissued Statement of Financial Accounting Standards No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*(“Statement No.150”). This statement establishes standards for how an issuer classifies andmeasures in its statement of financial position certain financial instrumentswith characteristics of both liabilities and equity. It requires that an issuerclassify mandatorily redeemable financial instruments and other financialinstruments that embody an obligation of the issuer as liabilities. Atinception, these liabilities shall initially be measured at fair value.Mandatorily redeemable financial instruments and certain forward contracts inwhich both the amount to be paid and the settlement date are fixed shall besubsequently measured at the present value of the amount to be paid atsettlement, accruing interest cost using the rate implicit at inception. Other financialinstruments shall be subsequently measured at fair value. Additionally,mandatorily redeemable financial instruments and certain forward contractsshall, on a prospective basis, reflect any amounts paid or to be paid toholders of these instruments in excess of the initial measurement amount asinterest cost. For financial instruments created before the issuance date ofStatement No. 150 and still existing at the beginning of the interim period ofadoption, any changes between carrying value and fair value or othermeasurement attribute provided for by this statement, upon adoption of thisstatement, shall be reflected as a cumulative effect of a change in accountingprinciple. This statement is effective for interim periods beginning after June 15,2003. On November 7, 2003, the FASB deferred the aforementionedmeasurement provisions of Statement No. 150 for securities issued beforeNovember 5, 2003. The adoption of Statement No. 150 did not have amaterial effect on the Company’s financial position or results of operations.

 

F-11

----

 

 In April 2003, the FASB issuedStatement of Financial Accounting Standards No. 149, *Amendment of Statement 133 on Derivative Instruments and HedgingActivities*(“Statement No. 149”). This statement amends financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under Statement of Financial AccountingStandards No. 133, *“Accounting forDerivative Instruments and Hedging Activities”* (“Statement No. 133”)as a result of certain decisions made by the Derivatives Implementation Group.In addition, this statement also clarifies the definition of a derivative. Thisstatement is effective, on a prospective basis, for contracts entered into ormodified after June 30, 2003, and for hedging relationships designatedafter June 30, 2003, except for those implementation issues previously clearedby the FASB prior to June 30, 2003. The provisions related to previouslycleared implementation issues shall continue to be applied in accordance withtheir respective effective dates. The adoption of Statement No. 149 did nothave a material effect on the Company’s financial position or results ofoperations.

 

In January 2003, theFASB issued Interpretation No. 46, *Consolidationof Variable Interest Entities – an interpretation of ARB No. 51*,which was subsequently revised by the December 2003 issuance of InterpretationNo. 46, (collectively referred to as “FIN 46 or the “Interpretation”). FIN 46provides guidance regarding the application of Accounting Research Bulletin No.51, *Consolidated Financial Statements*,specifically as it relates to the identification of entities for which controlis achieved through a means other than voting rights (“variable interestentities”) and the determination of which party is responsible forconsolidating the variable interest entities (the “primary beneficiary”). Inaddition to mandating that the primary beneficiary consolidate the variableinterest entity, FIN 46 also requires disclosures by companies that hold asignificant variable interest, even if they are not the primary beneficiary.Certain financial statement disclosures were applicable immediately for thoseentities for which it was reasonably possible that the enterprise would, uponadoption of FIN 46, consolidate or be required to disclose information aboutany variable interest entities. Additionally, an enterprise with an interest inan entity to which FIN 46 had not been applied as of December 24, 2003, isrequired to apply this Interpretation no later than the end of the firstreporting period that ends after March 15, 2004. Application of FIN 46 forspecial purpose entities was required no later than as of the end of the firstreporting period that ends after December 15, 2003. The Company performeda review of potential variable interest entities and concluded that as ofJuly 3, 2004, Candela was not the primary beneficiary of any materialvariable interest entities; and, therefore would not be required to consolidatethose entities as a result of implementing FIN 46.

 

***Uncertainties***

 

TheCompany is subject to risks common to companies in the aesthetic laser industry,including (i) the Company’s ability to successfully complete preclinical andclinical development and obtain timely regulatory approval and adequate patentand other proprietary rights protection of its products and services, (ii) thecontent and timing of decisions made by the Food & Drug Administration andother agencies regarding the procedures for which the Company’s products may beapproved, (iii) the ability of the Company to manufacture adequate supplies ofits products for development and commercialization activities, (iv) theaccuracy of the Company’s estimates of the size and characteristics of marketsto be addressed by the Company’s products and services, (v) market acceptanceof the Company’s products and services, (vi) the Company’s ability to obtainreimbursement for its products from third-party payers, where appropriate, and(vii) the accuracy of the Company’s information concerning the products andresources of competitors and potential competitors.

 

TheCompany depends on a single vendor for Alexandrite rods used to manufacture theGentleLASE.  This product accounts for asignificant portion of total revenues.

 

**2.Inventories**

 

Inventoriesconsist of the following:

 
| **(in  thousands)**     | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** |
|-------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **              | ** ** | ** **             | ** ** | **(Restated)**          | ** ** |
|                    |       |                   |       |                    |       |   |   |
| Raw  materials          |       | $                      | 4,833      |                    | $          | 4,216 |   |
| Work  in process        |       | 556                    |       | 469                     |       |
| Finished  goods         |       | 8,182                  |       | 6,149                   |       |
| Total  inventories, net |       | $                      | 13,571     |                    | $          | 10,834 |   |

 

F-12

----

 

**3.Property and Equipment**

 

Propertyand equipment consist of the following:

 
| **(in  thousands)**                     | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** |
|-----------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | ** **             | ** ** | **(Restated)**          | ** ** |
| Leasehold improvements                  |       | $                      | 740        |                    | $          | 699 |   |
| Office furniture                        |       | 479                    |       | 454                     |       |
| Computers, software and other equipment |       | 8,172                  |       | 7,518                   |       |
|                                    |       | 9,391                  |       | 8,671                   |       |
| Less accumulated depreciation           |       | 5,985                  |       | 5,344                   |       |
| Property and equipment, net             |       | $                      | 3,406      |                    | $          | 3,327 |   |

 

**4.Guarantees**

 

TheCompany’s products generally carry a standard one-year warranty, except forVbeam products that typically carry a three-year warranty. The Company setsaside a reserve based on anticipated warranty claims at the time productrevenue is recognized. In anticipation of actual warranty claims, the Companyamortizes the reserve ratably over the life of the warranty thereby offsettingactual warranty claims incurred. Actual warranty claims incurred and charged toproduct costs of sales during an interim period may be more or less than theamount of amortized warranty reserve allocated against them. Factors thataffect the Company’s product warranty liability include the number of installedunits, the anticipated cost of warranty repairs and historical and anticipatedrates of warranty claims.

 

Thefollowing table reflects changes in the Company’s accrued warranty accountduring the fiscal year ended July 3, 2004:

 

# ** **

| **(in thousands)**                             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------|------------|
| **Beginning balance on June 28, 2003**    | ** ** | **$**      | **6,666**  | ** ** |
| **Plus accruals related to new sales**         | ** ** | **7,458**  | ** ** |
| **Less amortization of prior period accruals** | ** ** | **5,867**  | ** ** |
| **Ending balance on July 3, 2004**        | ** ** | **$**      | **8,257**  | ** ** |

 

TheCompany also offers extended service contracts that may be purchased after astandard warranty has expired. Service contracts may be purchased for periodsfrom one to five years. The Company recognizes service contract revenue ratablyover the life of the contract. Actual service contract expenses incurred andcharged to service costs of sales during an interim period may be more or lessthan the amount of amortized service contract revenue recognized in thatperiod.

 

Thefollowing table reflects changes in the Company’s deferred service contractrevenue account during the fiscal year ended July 3, 2004:

 
| **(in  thousands)**                                                                                       | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **Beginning balance on June 28, 2003**                                                               | ** ** | **$**      | **3,086**  | ** ** |
| **Plus deferral of new service contract sales****         ** | ** ** | **5,154**  | ** ** |
| **Less  recognition of deferred revenue**                                                                 | ** ** | **4,185**  | ** ** |
| **Ending balance on July 3, 2004**                                                                   | ** ** | **$**      | **4,055**  | ** ** |

 

**5.Deferred Income**

 

Deferredincome consists solely of service contract revenue:

 
| **(in  thousands)**                      | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** |
|------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **Service contract revenue**             | ** ** | **$**                  | **4,055**  | ** **              | **$**      | **3,086** | ** ** |
| **Less current portion**                 | ** ** | **3,421**              | ** ** | **2,779**               | ** ** |
| **Long term portion of deferred income** | ** ** | **$**                  | **634**    | ** **              | **$**      | **307** | ** ** |

 

F-13

----

 

**6.  Debt, Lease and Other Obligations**

 

***Line of Credit***

 

TheCompany has a renewable $10,000,000 revolving credit agreement with a majorbank with interest at the bank’s base rate or LIBOR plus 2.25 percent.  Any borrowings outstanding under the line ofcredit are due on demand or according to a payment schedule established atthe time funds are borrowed.  The line ofcredit is unsecured.  The agreementcontains restrictive covenants limiting the establishment of new liens, and thepurchase of margin stock.  No amountswere outstanding under the line of credit as of July 3, 2004 andJune 28, 2003.

 

***Subordinated Notes***

 

In1998, the Company issued eight-year, 9.75% subordinated term notes to threeinvestors in the aggregate amount of $3.7 million, secured by the assets of theCompany.  The notes were due inOctober 2006, and required quarterly interest payments.  The Company was required to make mandatoryquarterly principal payments of $0.2 million, along with any unpaid interest,beginning on January 31, 2002.

 

Thenotes permitted early repayment with a decreasing early redemption premiumamount through October 31, 2004. The Company repaid the entire debt onNovember 8, 2002.  As a result ofthe early repayment, the Company incurred a one-time charge of $0.7 millionduring the fiscal year ended June 28, 2003. This charge represents theunamortized balance of the fair value of common stock warrants issued inconjunction with the original debt issuance ($0.4 million) and the earlyredemption premium. The cash paid was calculated as follows:

 
| Outstanding  principal balance                                                |   | $       | 2,960,000 |   |
|-------------------------------------------------------------------------------|--------|---------|-----------|--------|
| Early  redemption premium                                                     |   | 236,800 |      |
| Interest  for the period October 1, 2002  to  November 8, 2002 |   | 30,463  |      |
| Total                                                                         |   | $       | 3,227,263 |   |

 

Inconjunction with the repayment of the notes on November 8, 2002, two ofthe warrant holders exercised warrants to acquire 435,000 shares of commonstock for $1,2 million.

 

***Restricted Cash***

 

Afinancing company used by Candela’s customers has limited recourse with Candelaon a small number of product leases. As such, Candela has placed approximately$0.3 and $0.1 million in restricted funds at this institution as collateral asof July 3, 2004 and June 28, 2003, respectively. This restricted cashrepresents Candela’s entire exposure under these agreements.

 

***Operating Lease Commitments***

 

TheCompany leases several facilities and automobiles under non-cancelable leasearrangements.  The facility leases may beadjusted for increases in maintenance and insurance costs above specifiedlevels.  In addition, certain facilityleases contain escalation provisions based on certain specified criteria, andone lease calls for the payment of additional rent based on a percentage ofgross revenues above a base gross sales level for that particular location.These operating leases expire in various years through 2011. These leases maybe renewed for periods ranging from one to five years.

 

Our outstandingcontractual obligations consist of the aforementioned leases and are reflected in thefollowing table as of July 3, 2004:

 

| **(in  thousands)**           | ** ** | ** ** | ** ** |
|-------------------------------|------------|------------|------------|
| 2005                          |       | $          | 809        |   |
| 2006                          |       | 545        |       |
| 2007                          |       | 475        |       |
| 2008                          |       | 384        |       |
| 2009                          |       | 66         |       |
| Thereafter                    |       | 95         |       |
|                          |       |       |       |
| Total minimum  lease payments |       | $          | 2,374      |   |

 

F-14

----

 

Totalrent expense was approximately $884, $1,100 and $1,043 in fiscal 2004, 2003 and2002, respectively.

 

***Royalty***

 

InAugust 2000, the Company entered into an agreement to amend the licenseagreement with The Regents of the University of California whereby in exchangefor an exclusivity fee of approximately $1.7 million, which was prepaid infull, Candela obtained exclusive license rights to the DCD (subject to certainlimited license rights of Cool Touch, Inc. (“Cool Touch”)) in the followingfields of use:  procedures that involveskin resurfacing and rejuvenation, vascular skin lesions, and laser hairremoval.  Cool Touch, a subsidiary of NewStar Technology, Inc. obtained a license to the DCD on a co-exclusive basiswith Candela, in certain narrower fields of use.  Cool Touch is restricted in its ability toassign its license rights to certain existing competitors of Candela.  Candela is entitled to one-half of allroyalty income payable to the Regents from Cool Touch.  Under the amended agreement, Candela nolonger is required by the Regents to negotiate sublicenses to thirdparties.  However, Candela is entitled toone-half of all royalties due from any other entity that licenses the DCDtechnology from the Regents in other fields of use.  The Company recognized royalty expense of$2.6 million and $3.4 million for fiscal 2004 and fiscal 2003, respectivelybased on the license agreement with the Regents. In fiscal 2003, the Companyrecognized royalty income of approximately $0.3 million which related toroyalties earned since the August 11, 2000 settlement agreement with theRegents of the University of California and New Star Technology, Inc. Noroyalty income was recognized in fiscal 2004.

 

**7.  Stockholders’ Equity**

 

**StockPlans**

 

### **1990 Candela Corporation Employee Stock PurchasePlan**

 

The1990 Employee Stock Purchase Plan (the “Purchase Plan”) provides for the saleof up to 1,500,000 shares of common stock to eligible employees.  The shares are issued at the lesser of 85% ofthe average market price on the first or last day of semi-annual periods.  Substantially all full-time employees areeligible to participate in the Purchase Plan. At July 3, 2004 there were 755,286 shares available for sale.

 

Thefollowing is a summary of shares issued under the Purchase Plan:

 
| ** ** | ** ** | **Shares** | ** ** | **Range of  Price per share** | ** ** |
|------------|------------|------------|------------|-------------------------------|------------|
| 2002       |       | 63,988     |       | $1.75                         |       |
| 2003       |       | 49,724     |       | $2.35-$2.65                   |       |
| 2004       |       | 37,956     |       | $5.00-$8.00                   |       |

 

**1985,1987, 1989 and 1998 Candela Corporation Stock Option Plans**

 

The1985, 1987, 1989 and 1998 Stock Option Plans (the “Stock Option Plans”) providefor the granting of incentive stock options to employees for the purchase ofcommon stock at an exercise price not less than the fair market value of thestock on the date of grant.  The StockOption Plans also provide for the granting of non-qualified stock options.

 

TheBoard of Directors has terminated the granting of options under the 1985, 1987and 1989 Stock Option Plans.  Optionsgranted under the 1998 Stock Option Plan become exercisable on the date of grantor in installments, as specified by a Committee established by the Board ofDirectors, and expire ten years from the date of the grant.  The maximum number of shares for whichoptions may be granted under the 1998 Stock Option Plan was increased from2,500,000 to 3,300,000 in fiscal 2003, and from 3,300,000 to 5,300,000 infiscal 2004.

 

F-15

----

 

**1990and 1993 Candela Corporation Non-Employee Director Stock Option Plans**

 

The1990 and 1993 Non-Employee Director Stock Option Plans (the “Non-EmployeeDirector Plans,” collectively with the Stock Option Plans, the “Plans”) providefor the issuance of options for the purchase of up to 180,000 and 240,000shares of common stock, respectively. Under the Non-Employee Director Plans, each director who is neither anemployee nor an officer receives a one-time grant of an option to purchase20,000 shares of common stock at an exercise price equal to the fair marketvalue of the common stock on the date of grant. Under the 1990 and 1993 Non-Employee Director Plans, options becomeexercisable in equal amounts over a period of four and two years,respectively.  Shares under theNon-Employee Director Plans expire four and ten years, respectively, after thedate of grant and are nontransferable.

 

Thefollowing is a summary of stock option activity under the Plans:

 
| ** **                                        | ** ** | **Number of  Shares** | ** ** | **Option Price** | ** ** | **Weighted Avg.  Exercise Price  per Share** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|------------------|------------|----------------------------------------------|------------|
|                                              |       |                  |       |             |       |                                         |       |   |   |   |   |
| Balance  at June 30, 2001                    |       | 2,230,798             |       |             |       |                                         |       |   |   |   |   |
|                                              |       |                  |       |             |       |                                         |       |   |   |   |   |
| Granted                                           |       | 563,134               |       | $                | 1.75       |                                         | -          |   | $ | 3.31 |   | $ | 2.85 |   |
| Exercised                                         |       | (167,120              | )          | $                |  1.07 |                                         | -          |   | $ | 1.57 |   | $ | 1.13 |   |
| Canceled                                          |       | (309,588              | )          | $                | 0.92       |                                         | -          |   | $ | 6.02 |   | $ | 2.97 |   |
| Balance  at June 29, 2002                    |       | 2,317,224             |       |             |       |                                         |       |   |   | $ | 3.21 |   |
|                                              |       |                  |       |             |       |                                         |       |   |   |   |   |
| Granted                                           |       | 972,032               |       | $                | 2.75       |                                         | -          |   | $ | 4.67 |   | $ | 3.60 |   |
| Exercised                                         |       | (1,082,064            | )          | $                | 1.04       |                                         | -          |   | $ | 4.63 |   | $ | 2.61 |   |
| Canceled                                          |       | (149,270              | )          | $                | 1.07       |                                         | -          |   | $ | 4.63 |   | $ | 3.11 |   |
| Balance  at June 28, 2003                    |       | 2,057,922             |       |             |       |                                         |       |   |   | $ | 3.71 |   |
|                                              |       |                  |       |             |       |                                         |       |   |   |   |   |
| Granted                                           |       | 1,038,560             |       | $                | 5.59       |                                         | -          |   | $ | 11.98 |   | $ | 9.82 |   |
| Exercised                                         |       | (928,730              | )          | $                | 1.06       |                                         | -          |   | $ | 6.02 |   | $ | 3.44 |   |
| Canceled                                          |       | (58,410               | )          | $                | 2.75       |                                         | -          |   | $ | 11.96 |   | $ | 9.23 |   |
| Balance  at July 3, 2004                     |       | 2,109,342             |       |             |       |                                         |       |   |   | $ | 6.58 |   |
|                                              |       |                  |       |             |       |                                         |       |   |   |   |   |
| Options  available for grant at July 3, 2004 |       | 1,625,924             |       |             |       |                                         |       |   |   |   |   |

 

Thefollowing table summarizes information about stock options outstanding underthe Plans as of July 3, 2004:

 
| **OPTIONS OUTSTANDING**        | ** ** | **OPTIONS EXERCISABLE** | ** ** |
|--------------------------------|------------|-------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life (yrs)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                           |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| $                              | 1.08       |                    | -          |   | $ | 3.67 |   | 547,032 |   | 6.42 |   | $ | 2.79 |   | 394,532 |   | $ | 2.70 |   |
| $                              | 4.07       |                    | -          |   | $ | 5.59 |   | 573,706 |   | 8.62 |   | $ | 4.83 |   | 281,206 |   | $ | 5.04 |   |
| $                              | 6.02       |                    | -          |   | $ | 9.90 |   | 458,604 |   | 7.87 |   | $ | 7.55 |   | 196,874 |   | $ | 6.02 |   |
| $                              | 11.47      |                    | -          |   | $ | 11.98 |   | 530,000 |   | 9.58 |   | $ | 11.94 |   | — |   | $ | — |   |
|                           |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| $                              | 1.08       |                    | -          |   | $ | 11.98 |   | **2,109,342** |   | 8.14 |   | $ | 6.58 |   | **872,612** |   | $ | 4.11 |   |

 

### **Reserved Shares**

### ** **

TheCompany has reserved 3,315,568 shares of common stock for issuance under itsPurchase, Stock Option, and Non-Employee Director Plans.

 

F-16

----

 

**8.  Income Taxes**

 

Thecomponents of income (loss) before income taxes and the related provision for(benefit from) income taxes consist of the following (in thousands):

 
| ** **                                                     | ** ** | **For Years Ended**    | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                     | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** | **June 29,  2002** | ** ** |
| Income  (loss) from continuing operations before income taxes: |       |                   |       |   |   |   |   |
| Domestic                                                       |       | $                      | 12,880     |   | $ | 9,701 |   | $ | (3,065 | ) |
| Foreign                                                        |       | 2,218                  |       | 1,642 |   | 1,233 |   |
|                                                           |       | $                      | 15,098     |   | $ | 11,343 |   | $ | (1,832 | ) |
|                                                           |       |                   |       |   |   |   |   |
| Loss  from discontinued operations before income taxes:        |       |                   |       |   |   |   |   |
| Domestic                                                       |       | $                      | (3,821     | ) | $ | (1,468 | ) | $ | (964 | ) |
|                                                           |       |                   |       |   |   |   |   |
| Provision  for (benefit from) income taxes:                    |       |                   |       |   |   |   |   |
| Current  provision:                                            |       |                   |       |   |   |   |   |
| Federal                                                        |       | $                      | 2,911      |   | $ | 1,841 |   | $ | (1,391 | ) |
| State                                                          |       | 238                    |       | 99 |   | — |   |
| Foreign                                                        |       | 552                    |       | 439 |   | 864 |   |
| Total  current provision for (benefit from) income taxes       |       | 3,701                  |       | 2,379 |   | (527 | ) |
| Deferred  provision (benefit)                                  |       |                   |       |   |   |   |   |
| Federal                                                        |       | (543                   | )          | 682 |   | (115 | ) |
| Total  provision for (benefit from) income taxes               |       | $                      | 3,158      |   | $ | 3,061 |   | $ | (642 | ) |

 

Thecomponents of the Company’s deferred tax assets consist of the following (inthousands):

 
| ** **                                  | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| Warranty  reserve                           |       | $                      | 1,931      |                    | $          | 2,464 |   |
| Inventory  valuation reserves               |       | 509                    |       | 745                     |       |
| Restructuring  reserve                      |       | 1,193                  |       | 131                     |       |
| Deferred  Revenue                           |       | 1,593                  |       | 479                     |       |
| Federal  and state tax credit carryforwards |       | 321                    |       | 321                     |       |
| Bad  debt reserve                           |       | 479                    |       | 191                     |       |
| Pre-opening  expense                        |       | —                 |       | 257                     |       |
| Other                                       |       | (112                   | )          | 172                     |       |
| Deferred  tax assets                        |       | $                      | 5,914      |                    | $          | 4,760 |   |

 

Areconciliation from the federal statutory tax rate to the effective tax rate isas follows:

 
| ** **                                     | ** ** | **July 3,  2004** | ** ** | **June 28,  2003** | ** ** | **June 29,  2002** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-------------------------|------------|-------------------------|------------|
| Statutory  rate                                |       | 35                     | %          | 34                      | %          | 34                      | %          |
| State  income taxes                            |       | 1                      | %          | 1                       | %          | —                  |       |
| Difference  between foreign and US tax rates   |       | (3                     | )%         | (1                      | )%         | (16                     | )%         |
| Benefit  from foreign sales credits            |       | (3                     | )%         | (2                      | )%         | 4                       | %          |
| Increase  (utilization) of deferred tax assets |       | —                 |       | —                  |       | —                  |       |
| Other                                          |       | —                 |       | (1                      | )%         | 1                       | %          |
| Effective  tax rate                            |       | 30                     | %          | 31                      | %          | 23                      | %          |

 

F-17

----

 

As of July 3, 2004, the Company has no valuation allowance againstthe deferred tax asset. In accounting for the deferred tax asset, the Companyhas relied on historical data to determine the necessity of providing avaluation allowance for this asset. Under the requirements of SFAS No. 109, “*Accountingfor Income Taxes*”, Candela believed it is more likely than not thatthe deferred tax asset would be fully utilized against future incometaxes.  At July 3, 2004, the Companyhad available research and development tax credits of approximately $321,000for state income tax purposes that will begin expiring in fiscal year 2006.

 

**9.Segment, Geographic and Major Customer Information**

 

The Company operatesprincipally in one industry segment: the design, manufacture, sale, and serviceof medical devices and related equipment. The results in this segment have beenpresented in the Consolidated Statements of Operations for the appropriateperiods. Candela Corporation has no single customer that represents asignificant portion of revenue during the periods presented.

 

***Geographic data***

 

Geographicinformation for fiscal 2004, 2003 and 2002 is as follows (in thousands):

 

 
| ** **                                       | ** ** | **2004**   | ** ** | **2003**       | ** ** | **2002**       | ** ** |
|--------------------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **Revenue:**                                     | ** ** | ** ** | ** ** | ** **     | ** ** | ** **     | ** ** |
| United  States                                   |       | $          | 69,626     |           | $          | 50,663         |       | $ | 36,656 |   |
| Intercompany                                     |       | 17,705     |       | 15,865         |       | 14,362         |       |
|                                             |       | 87,331     |       | 66,528         |       | 51,018         |       |
| Japan                                            |       | 16,947     |       | 16,630         |       | 15,178         |       |
| Spain                                            |       | 10,780     |       | 6,636          |       | 5,040          |       |
| Germany                                          |       | 3,550      |       | 2,824          |       | 988            |       |
| France                                           |       | 3,535      |       | 1,898          |       | 826            |       |
|                                             |       | 122,143    |       | 94,516         |       | 73,050         |       |
| Elimination                                      |       | (17,705    | )          | (15,865        | )          | (14,362        | )          |
| Consolidated  total                              |       | $          | 104,438    |           | $          | 78,651         |       | $ | 58,688 |   |
|                                             |       |       |       |           |       |           |       |
| Income  (loss) from operations:                  |       |       |       |           |       |           |       |
| United  States                                   |       | $          | 11,158     |           | $          | 9,828          |       | $ | (2,488 | ) |
| Europe                                           |       | 663        |       | 995            |       | (692           | )          |
| Japan                                            |       | 763        |       | 556            |       | 1,329          |       |
| Elimination                                      |       | 1,301      |       | (425           | )          | (538           | )          |
| Consolidated  total                              |       | $          | 13,885     |           | $          | 10,954         |       | $ | (2,389 | ) |
|                                             |       |       |       |           |       |           |       |
| Geographic  identification of long-lived assets: |       |       |       |           |       |           |       |
| United  States                                   |       | $          | 3,223      |           | $          | 3,196          |       | $ | 2,604 |   |
| Europe                                           |       | 183        |       | 131            |       | 99             |       |
| Consolidated  total                              |       | $          | 3,406      |           | $          | 3,327          |       | $ | 2,703 |   |

 

UnitedStates revenue includes export sales to unaffiliated companies locatedprincipally in Europe and in the Asia-Pacific region, which approximated $19.7,$12.9 and $10.7 million in fiscal 2004, 2003 and 2002, respectively.

 

**10.Employee Benefit Plans**

 

TheCompany offers a savings plan which allows eligible U.S. employees to maketax-deferred contributions, a portion of which are matched by the Company.  Company contributions vest ratably with threeyears of employment and amounted to $224, $167 and $184 thousand in fiscal2004, 2003 and 2002, respectively.

 

F-18

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**11.Discontinued Operations**

 

OnSeptember 27, 2003 management initiated a plan to close its only remainingskin care center. The closure is accounted for as a discontinued operation inaccordance with Statement of Financial Accounting Standards (“SFAS”) 144 “*Accounting for the Impairment or Disposal of Long-Lived Assets*”and SFAS 146 “*Accounting for Costs Associated with Exit orDisposal Activities*”. As a result, in the fiscal quarter endedSeptember 27, 2003, the Company recorded a $2,095 charge for the accrualof $3,000 of future occupancy costs, primarily relating to future leasepayments for the Boston facility, and $348 of severance obligations and otherrelated costs of closure, net of anticipated tax benefits of $1,253.Approximately 45 positions have been eliminated as a result of thisrestructuring plan, and 44 employees have been terminated as of July 3,2004. In addition, all prior period financial statements have been restated toreflect skin care centers operations as discontinued.

 

Duringthe quarters ended December 27, 1997 and June 30, 2001, the Companyrecorded combined restructuring charges of $3,721,000 resulting frommanagement’s decision to close the skin care center located in Scottsdale,Arizona. During the three month-period ended December 29, 2001, theCompany secured a sublease for the Scottsdale facility. Per the subleaseagreement, the sublessee will pay all costs associated with the facilitythrough the end of the lease term ending June 2006. As an incentive to thesublessee, the Company agreed to pay eight months of rent during the life ofthe sublease.  The sublessee commencedmaking payments to the landlord on behalf of the Company on April 1, 2002.

 

Asa result of the sublease, the Company revised the estimate of future costsassociated with the Scottsdale facility and, in the quarter endedMarch 30, 2002, reversed $693,000 of the restructuring reserve whichrepresents primarily the amount of future contractual sublease payments as wellas revisions to the net realizable value of certain leasehold improvements.

 

Thefollowing table reflects the restructuring charges incurred during fiscal years2002, 2003 and 2004:

 
| **(in  thousands)**                                                 | ** ** | **Payroll &  Severance** | ** ** | **Leasehold Improvements  and Fixed  Assets** | ** ** | **Facility  Costs** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------|------------|---------------------|------------|-----------|------------|
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| **Balance at June 30, 2001**                                   | ** ** | **$**                        | **178**    | ** **                                    | **$**      | **841**             | ** ** | **$**     | **670**    | ** ** | **$** | **1,689** | ** ** |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| Reduction  of reserve due to cash payments                          |       | (60                          | )          | —                                        |       | (185                | )          | (245      | )          |
| Non-cash  amortization                                              |       | —                       |       | (192                                          | )          | —              |       | (192      | )          |
| Establishment  of reserve due to closure of the Scottsdale facility |       | (6                           | )          | (239                                          | )          | (448                | )          | (693      | )          |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| **Balance at June 29, 2002**                                   | ** ** | **112**                      | ** ** | **410**                                       | ** ** | **37**              | ** ** | **559**   | ** ** |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| Reduction  of reserve due to cash payments                          |       | (62                          | )          | —                                        |       | (12                 | )          | (74       | )          |
| Non-cash  amortization                                              |       | —                       |       | (106                                          | )          | —              |       | (106      | )          |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| **Balance at June 28, 2003**                                   | ** ** | **50**                       | ** ** | **304**                                       | ** ** | **25**              | ** ** | **379**   | ** ** |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| Reduction  of reserve due to cash payments                          |       | (171                         | )          | (152                                          | )          | (301                | )          | (624      | )          |
| Non-cash  amortization                                              |       | (18                          | )          | (79                                           | )          | —              |       | (97       | )          |
| Additions  to reserve due to closure of the Boston facility         |       | 139                          |       | 124                                           |       | 3,085               |       | 3,348     |       |
|                                                                |       |                         |       |                                          |       |                |       |      |       |
| **Balance at July 3, 2004**                                    | ** ** | **$**                        | **0**      | ** **                                    | **$**      | **197**             | ** ** | **$**     | **2,809**  | ** ** | **$** | **3,006** | ** ** |

 

F-19

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AtJuly 3, 2004, the discontinued segment had a net liability ofapproximately $3.6 million consisting primarily of the aforementioned reserveof $3.0 million and deferred gift certificate revenue of $.8 million partiallyoffset by fixed assets of approximately $.2 million.  Revenues for discontinued operations were$0.4 million, $2.1 million and $2.9 million for the fiscal years 2004, 2003and 2002, respectively.

 

**12.Legal Proceedings**

 

TheCompany has an Amended and Restated License Agreement (the “License”) with TheRegents of the University of California (“The Regents”) pursuant to which theCompany licenses certain patent rights to its dynamic cooling device (“DCD”)from The Regents.  The Company sells itsDCD as a component part of its Smoothbeam (®) laser system and as an accessoryto its other laser systems.  InApril of 2004, The Regents issued a notice of default under the License,asserting, among other things, that the Company is in breach of the License forthe alleged failure to make required royalty payments and to make requireddisclosures.  The Regents’April notice asserted that the total underpaid royalties, interest andother charges for the period from August of 2000 throughSeptember 2003 are $1,128,000.  TheRegents issued a subsequent notice of default, dated June 30, 2004,relating to the quarterly periods ended December 27, 2003 andMarch 27, 2004, for which The Regents asserted that the Company underpaidroyalties amounting to $1,350,000.  TheCompany and The Regents differ in their respective interpretations of whichproducts sold by Candela give rise to a royalty-bearing obligation to TheRegents.  The Company believes it hasmade all payments it was required to make.

 

Underthe License, disputes are to be settled by binding arbitration through amutually acceptable single arbitrator. On June 14, 2004, the Company filed a Demand for Arbitration toadjudicate the differing interpretations of the License Agreement held by theCompany and The Regents.  On July 8,2004, The Regents filed their response and counterclaim for breach of contractand declaratory relief.  Candeladeposited approximately $1.0 million in June, and an additional $1.0 million inAugust of 2004, into an escrow fund to be paid in whole or in part to theCompany or The Regents as determined by the arbitrator.  As a result of the establishment of theescrow fund, The Regents will not terminate or purport to terminate the LicenseAgreement based on any alleged breach by Candela related to any matter nowbefore the arbitrator. The $1.0 million deposited in the escrow fund in thefourth quarter of fiscal 2004 has been included in Other Assets on the 2004balance sheet, and no expense has, or will be recorded with respect to theescrow fund or any associated contingent liability while the matter is beingarbitrated. A final decision of the arbitrator in this matter is presentlyexpected to be delivered during the second quarter of fiscal 2005.

 

**13. Asset Acquisition**

 

OnJanuary 8, 2003, the Company acquired substantially all of the assets ofApplied Optronics, the diode division of Schwartz Electro-Optics, Inc., forapproximately $1,200,000 in cash. Applied Optronics was a leading manufacturerof high-powered, pulsed and CW lasers, and was a component supplier to the OEMmarket that serves a variety of industries including the military, medical,industrial, research and robotics fields. Applied Optronics was the leadsupplier of the diodes for the Company’s Smoothbeam diode laser system. Inaccordance with SFAS No. 141 “Business *Combinations*,”the Company records acquisitions under the purchase method of accounting.Accordingly, the purchase price is allocated to the tangible assets andliabilities and intangible assets acquired, based on their estimated fairvalues.

 

Theasset acquisition consisted primarily of fixed assets, including production andoffice equipment, and inventory located at the division’s facility in NewJersey. The acquisition increased the Company’s net Property and Equipment byapproximately $800,000 and Inventory by approximately $400,000. For the periodfrom January 8, 2003 to June 28, 2003, the Applied Optronicsoperation generated approximately $1,196,000 in revenue from diode sales tothird-party customers. During fiscal 2004, the Applied Optronics operationgenerated approximately $466,000 in sales to third-party customers.

 

F-20

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**14. Quarterly Results ofOperations (unaudited)**

 
| ** **                                          | ** ** | **Quarter** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|
| **2003**                                            | ** ** | **First**   | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| **(Restated)**                                      | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                            |       | $           | 13,244     |   | $ | 18,028 |   | $ | 21,440 |   | $ | 25,939 |   |
| Gross  profit                                       |       | 6,644       |       | 8,965 |   | 10,997 |   | 13,412 |   |
| Net  income from continuing operations              |       | 960         |       | 806 |   | 2,836 |   | 3,225 |   |
| Loss  from discontinued Skin Care Center operations |       | (226        | )          | (336 | ) | (216 | ) | (235 | ) |
| Net  income                                         |       | 734         |       | 470 |   | 2,620 |   | 2,990 |   |
| Earnings  (loss) per common share                   |       |        |       |   |   |   |   |   |   |
| Basic:                                              |       |        |       |   |   |   |   |   |   |
| Income  from continuing operations                  |       | $           | 0.05       |   | $ | 0.04 |   | $ | 0.14 |   | $ | 0.16 |   |
| Loss  from discontinued operations                  |       | $           | (0.01      | ) | $ | (0.02 | ) | $ | (0.01 | ) | $ | (0.01 | ) |
| Net  income                                         |       | $           | 0.04       |   | $ | 0.02 |   | $ | 0.13 |   | $ | 0.15 |   |
| Diluted:                                            |       |        |       |   |   |   |   |   |   |
| Income  from continuing operations                  |       | $           | 0.05       |   | $ | 0.04 |   | $ | 0.14 |   | $ | 0.15 |   |
| Loss  from discontinued operations                  |       | $           | (0.01      | ) | $ | (0.02 | ) | $ | (0.01 | ) | $ | (0.01 | ) |
| Net  income                                         |       | $           | 0.04       |   | $ | 0.02 |   | $ | 0.13 |   | $ | 0.14 |   |

 
| ** **                                          | ** ** | **Quarter** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|
| **2004**                                            | ** ** | **First**   | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
|                                                |       |        |       |   |   |   |   |   |   |
| Revenues                                            |       | $           | 18,686     |   | $ | 23,898 |   | $ | 27,650 |   | $ | 34,204 |   |
| Gross  profit                                       |       | 9,312       |       | 12,247 |   | 13,978 |   | 17,628 |   |
| Net  income from continuing operations              |       | 1,790       |       | 2,441 |   | 1,960 |   | 4,321 |   |
| Loss  from discontinued Skin Care Center operations |       | (298        | )          | — |   | — |   | — |   |
| Loss  on closure of Skin Care Center                |       | (2,095      | )          | — |   | — |   | — |   |
| Net  income (loss)                                  |       | (603        | )          | 2,441 |   | 1,960 |   | 4,321 |   |
| Earnings  (loss) per common share                   |       |        |       |   |   |   |   |   |   |
| Basic:                                              |       |        |       |   |   |   |   |   |   |
| Income  from continuing operations                  |       | $           | 0.08       |   | $ | 0.11 |   | $ | 0.09 |   | $ | 0.20 |   |
| Loss  from discontinued operations                  |       | $           | (0.11      | ) | — |   | — |   | — |   |
| Net  income (loss)                                  |       | $           | (0.03      | ) | $ | 0.11 |   | $ | 0.09 |   | $ | 0.20 |   |
| Diluted:                                            |       |        |       |   |   |   |   |   |   |
| Income  from continuing operations                  |       | $           | 0.07       |   | $ | 0.11 |   | $ | 0.09 |   | $ | 0.19 |   |
| Loss  from discontinued operations                  |       | $           | (0.10      | ) | — |   | — |   | — |   |
| Net  income (loss)                                  |       | $           | (0.03      | ) | $ | 0.11 |   | $ | 0.09 |   | $ | 0.19 |   |

 

F-21

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**SCHEDULE II**

 

**CANDELA CORPORATION**

**VALUATION AND QUALIFYING ACCOUNTS**

**For the years ended July 3, 2004, June 28, 2003 andJune 29, 2002**

 

 
| **Description**                                                    | ** ** | **COLUMN A  Balance at  Beginning  of Period** | ** ** | **COLUMN B  Additions  Charged to  Income** | ** ** | **COLUMN C  Deductions  from  Reserves** | ** ** | **COLUMN D  Balance at  End of  Period** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
|                                                               |       |                                           |       |                                        |       |                                     |       |                                     |       |
| Reserves  deducted from assets to which they apply (in thousands): |       |                                           |       |                                        |       |                                     |       |                                     |       |
|                                                               |       |                                           |       |                                        |       |                                     |       |                                     |       |
| Allowance  for doubtful accounts:                                  |       |                                           |       |                                        |       |                                     |       |                                     |       |
|                                                               |       |                                           |       |                                        |       |                                     |       |                                     |       |
| Year  ended July 3, 2004                                      |       | $                                              | 970        |                                        | $          | 852                                      |       | $                                        | 330        |   | $ | 1,492 |   |
|                                                               |       |                                           |       |                                        |       |                                     |       |                                     |       |
| Year  ended June 28, 2003 (Restated)                          |       | $                                              | 981        |                                        | $          | 620                                      |       | $                                        | 631        |   | $ | 970 |   |
|                                                               |       |                                           |       |                                        |       |                                     |       |                                     |       |
| Year  ended June 29, 2002 (Restated)                          |       | $                                              | 901        |                                        | $          | 449                                      |       | $                                        | 369        |   | $ | 981 |   |

 

F-22

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**EXHIBIT INDEX**

 

21.1                           Subsidiaries of the Company

23.1                           Consent of BDO Seidman, LLP, IndependentRegistered Public Accounting Firm

23.2                           Consent of Ernst & Young LLP,Independent Registered Public Accounting Firm

33.1                           Certification pursuant to Section 302of the Sarbanes-Oxley Act of 2002

33.2                           Certification pursuant to Section 302of the Sarbanes-Oxley Act of 2002

32.1                           Certification pursuant to 18 U.S.C.Section 1350

32.2                           Certification pursuant to 18 U.S.C.Section 1350

 

II-1

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