UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C.
20549


Form 10-K





(Mark
      One) ý      ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
 For
      the fiscal year ended December 31, 2008OR o     TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
 For
      the transition period
      from                                to


Commission
file number: 001-33204


OBAGI
MEDICAL PRODUCTS, INC.


(Exact
name of registrant as specified in its charter)





Delaware
            
            22-3904668(State
      or other jurisdiction of
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      No.)3760
      Kilroy Airport Way, Suite 500, Long Beach, CA 90806(Address
      of principal executive offices)


(562) 628-1007


(Registrant's
telephone number, including area code)


Not
applicable


(Former
name, former address and former fiscal year, if changed since last report)


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





Title
      of class
            
            Name
      of each exchange on which registeredCommon
      Stock, par value $0.001 per share
            
            Nasdaq
      Global Market


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


Not applicable


Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act. Yes o No ý


Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Exchange Act. Yes o No ý


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


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


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





Large
      accelerated filer  o
            Accelerated
      filer  ýNon-accelerated
      filer  o
              (Do
      not check if a smaller reporting company)
            Smaller
      reporting company  o




Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes o
No


ý


As of February 11, 2009, there
were 22,044,872 shares of the Registrant's common stock
outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




Part III incorporates information
by reference from the definitive proxy statement for the Annual Meeting of
Stockholders to be held on June 11, 2009.





OBAGI MEDICAL
PRODUCTS, INC.


ANNUAL
REPORT ON FORM 10-K


TABLE
OF CONTENTS





PAGEPART
      IItem 1.
                  Business
                  1Item 1A.
                  Risk Factors
                  22Item 1B.
                  Unresolved SEC Staff Comments
                  35Item 2.
                  Properties
                  35Item 3.
                  Legal Proceedings
                  36Item 4.
                  Submission of Matters to a Vote of Security
      Holders
                  36PART
      IIItem 5.
                  Market for Registrant's Common Equity,
      Related Stockholder Matters and Issuer Purchases of Equity
      Securities
                  37Item 6.
                  Selected Financial
Data
                  39Item 7.
                  Management's Discussion and Analysis of
      Financial Condition and Results of Operations
                  39Item 7A.
                  Quantitative and Qualitative
      Disclosures About Market Risk
                  53Item 8.
                  Financial Statements and
      Supplementary Data
                  53Item 9.
                  Changes in and Disagreements with
      Accountants on Accounting and Financial Disclosure
                  54Item 9A.
                  Controls and
Procedures
                  54Item 9B.
                  Other Information
                  54PART
      IIIItem 10.
                  Directors, Executive Officers and
      Corporate Governance
                  55Item 11.
                  Executive Compensation
                  55Item 12.
                  Security Ownership of Certain Beneficial Owners
      and Management and Related Stockholder Matters
                  55Item 13.
                  Certain Relationships and Related
      Transactions, and Director Independence
                  55Item 14.
                  Principal Accountant Fees and
      Services
                  55PART
      IVItem 15.
                  Exhibits and Financial Statement
      Schedules
                  56










Forward-looking
Statements





We have made forward-looking statements
in this Annual Report on Form 10-K, including the sections entitled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations and Business," that are based on our management's beliefs and
assumptions and on information currently available to our management.
Forward-looking statements include the information concerning our possible or
assumed future results of operations, business strategies, financing plans,
competitive position, industry environment, potential growth opportunities, the
effects of future regulation and the effects of competition. Forward-looking
statements include all statements that are not historical facts and can be
identified by the use of forward-looking terminology such as the words
"believe," "expect," "anticipate," "intend," "plan," "estimate" or similar
expressions.





Forward-looking statements involve
risks, uncertainties and assumptions. Actual results may differ materially from
those expressed in the forward-looking statements. We do not have any intention
to update forward-looking statements after this Annual Report of Form 10-K
is filed. You should understand that many important factors, in addition to
those discussed elsewhere in this Annual Report on Form 10-K, could cause
our results to differ materially from those expressed in the forward-looking
statements.








PART I





ITEM
1:    BUSINESS





Corporate
Information





Dr. Zein Obagi founded WorldWide
Product Distribution, Inc. (“Worldwide”) in 1988. OMP Acquisition
Corporation was formed as a California corporation in October 1997 to purchase
substantially all of the assets and to assume the accounts payable and related
operating liabilities of WorldWide and subsequently changed its name to Obagi
Medical Products, Inc. in December 1997. OMP, Inc. (“OMP”) was
incorporated in Delaware in November 2000 and, in January 2001, Obagi Medical
Products, Inc. was merged into OMP, with OMP as the surviving corporation.
In December 2004, the stockholders of OMP exchanged their shares of OMP for an
equal number of shares in a newly formed holding company incorporated in
Delaware, Obagi Medical Products, Inc., which became the parent holding
company for all existing operations of OMP.





Our principal executive offices are
located at 3760 Kilroy Airport Way, Suite 500, Long Beach, California 90806 and
our telephone number is (562) 628-1007. Our website address is
http://www.obagi.com. Copies of our most recent Annual Report on Form 10-K,
our Quarterly Reports on Form 10-Q and our other reports filed with the
Securities and Exchange Commission ("SEC"), can be obtained, free of charge as
soon as reasonably practicable after such material is electronically filed with,
or furnished to the SEC, through the SEC's website by clicking the SEC Filings
link from the Investor Relations page on our website at www.obagi.com or
directly from the SEC's website at www.sec.gov. Our website and the information
contained therein or connected thereto are not intended to be incorporated into
this Annual Report on Form 10-K.





Overview





We are a specialty pharmaceutical
company focused on the aesthetic and therapeutic skin health markets. We develop
and commercialize, topical skin health systems, some of which contain
prescription-based products, that enable physicians to treat a range of skin
conditions, including pre-mature aging, photo-damage, hyperpigmentation
(irregular or patchy discoloration of the skin), acne, rosacea, and soft tissue
deficits, such as fine lines and wrinkles. Our products are designed to improve
the underlying health of patients' skin, and our clinical studies have
demonstrated that the use of our systems result in skinthat looks and acts younger and
healthier. We focus our research and development activities on improving the
efficacy of established prescription and over-the-counter ("OTC"), therapeutic
agents by enhancing the penetration of these agents across the skin barrier
using proprietary technologies known as Penetrating Therapeutics. Through our
own domestic sales force and foreign distribution partners, we market and sell
predominantly through the physician-dispensed skin channel directly to plastic
surgeons, dermatologists and other physicians who are focused on aesthetic and
therapeutic skin care. We believe we are the market leader in the growing
medical care provider skin care channel, according to an independent 2008 study
by Kline & Co., an independent market research firm. Our net sales
have grown from approximately $35.6 million in 2001 to $104.6 million
for the year ended December 31, 2008.





We currently market and sell a range of systems and related products for the
enhancement of skin health. Our leading product line is our Obagi Nu-Derm
System. This system was launched in 1988, and since that time, we have made
substantial enhancements to the system through the application of our
Penetrating Therapeutics technology. We believe that our Obagi® Nu-Derm® System is the
only clinically proven, prescription-based topical skin health system on the
market that has been shown to enhance the skin's overall health by correcting
photo- damage using drugs that, by definition, work at the cellular level,
resulting in a reduction of the visible signs of aging.


1


In 2004, we launched the Obagi-C
RxTM ("C-Rx")
System, which we believe is the only prescription-based system that reduces the
early effects of sun damage and evens skin tones through the use of Vitamin C
serum combined with 4% hydroquinone. We are the sole licensee of certain Avon
patents relating to this technology. In 2005, we launched Professional-C, a
series of high potency antioxidant Vitamin C serums that help to counteract the
effects of ultraviolet radiation and other environmental influences.
Professional-C represents an improved product line with more effective skin
barrier penetration replacing our Vitamin C serum offerings marketed under the
Cffectives®
and Obagi-C brands that we introduced in 2000.





In July 2006, we launched Obagi
Condition & Enhance ("Condition & Enhance") targeted for use with
surgical and non-surgical cosmetic procedures, such as Botox (Botox is a
registered trademark of Allergan, Inc.), injectable fillers, chemical
peels, micro-dermabrasion and laser resurfacing treatments. This system provides
adjunctive therapy both before and after these procedures, and is designed to
enhance aesthetic outcomes and improve overall patient
satisfaction.





In October 2006, we introduced the
first product in the Obagi ELASTIdermTM ("ELASTIderm") product line, ELASTIderm
Eye Cream, a twice daily treatment for skin laxity around the eye. In February
2007, we launched a second product in the ELASTIderm line, ELASTIderm Eye Gel,
for patients who prefer gels. In February 2008, we launched ELASTIdermTM
Décolletage, a system to treat skin conditions resulting from sun damage and
improve the elasticity and skin tone for the neck and chest
area.  ELASTIderm products are formulated with a patent pending
bi-mineral complex, which is clinically shown to help the body's own natural
ability to increase epidermal thickness, augment hypodermal fat and increase
elastin levels.





In February 2007, we launched Obagi
CLENZIderm M.D.TM ("CLENZIderm") for normal to oily skin, a system of products
for acne treatment, featuring the only solubilized formulation of Benzoyl
Peroxide ("BPO"). Our clinical studies have shown that CLENZIderm M.D.
penetrates more readily into the hair follicle than current BPO creams or gels
due to the solubilized particle size being 1/10,000 of other brands. We believe
that our acne system is a more effective treatment for acne because a greater
amount of the active ingredient, BPO, will penetrate the hair follicle to more
rapidly kill Propionibacterium acne (“P. acne”) bacteria. In July 2007, we
launched CLENZIderm M.D. for normal to dry skin.





In August
2008, we entered the pharmacy Rx channel for the first time by launching
SoluCLENZ Rx GelTM , a
solubilized benzoyl peroxide gel for the treatment of acne, which is available
only by prescription.  We have demonstrated that SoluCLENZ Rx Gel is a
novel treatment alternative that provides clinically significant lesion
reductions that are comparable to the leading prescription BPO/antibiotic
combination products, without the use of a topical antibiotic.





In January 2009, we launched the Obagi RosaclearTM System. It is the first and
only complete prescription-based system developed specifically for treating the
signs and symptoms of rosacea. The all-in-one system is designed to effectively
reduce redness and flushing, along with treating papules and pustules, to help
rosacea patients achieve a clearer, calmer and more balanced-looking
complexion.





In
addition, we offer tretinoin, a generic equivalent to Retin-A, which has been
among the most widely used acne treatments for approximately 25 years. We
currently distribute a Food and Drug Administration ("FDA"), approved generic
equivalent in the physician-dispensed skin care channel under an exclusive
license agreement with Triax Pharmaceuticals, LLC ("Triax"). We also sell
the Obagi Blue Peel which has been cited by Kline & Co. as one of
the most well known brands for use in physician-strength facial peel procedures.
While the Obagi Blue Peel products are not dispensed fordaily home use in a system and are
therefore not a significant source of our revenue, they are used to aid the
physician in skin peeling activities.





We are engaged in an active development
program using our Penetrating Therapeutics technology to enhance the efficacy of
established FDA-approved and OTC active ingredients. Positive findings from
completed pilot studies of these new systems may not be duplicated in the larger
studies that we are currently completing, or the incidence of side effects in
these larger studies may force us to reformulate our products. We will continue
to seek additional market opportunities where we believe we can improve the
effectiveness of existing products through the application of our Penetrating
Therapeutics technology to address conditions such as skin elasticity, dark
circles, dermatitis, psoriasis, hair loss and hair removal.





We also advance our development
objectives through product and license agreements with third parties. These
agreements may include patent and technology licenses, product licenses and new
product collaboration agreements. For example, we have developed and are
continuing to develop products for the skin which are covered by claims
contained in patent applications which we license from JR Chem LLC ("JR").
Our initial focus was centered on products applied around the eyes, and we will
continue to focus on products applied on the neck and on the back of the hands,
where the break down in skin elasticity is most visible in aging skin. The first
products to result from our collaboration with JR are the products in our
ELASTIderm, CLENZIderm and SoluCLENZ product lines.





In the United States, we sell our
systems and related products directly to physicians through our internal and
contracted sales force, which as of December 31, 2008 consisted of 157
sales, marketing and education specialists, including 120 direct sales
representatives and managers. Physicians dispense our products in-office,
directly to their patients, a distribution method commonly referred to as the
"physician-dispensed" channel. We believe that the physician-dispensed
distribution model ultimately results in higher patient satisfaction because it
is better suited to the provision of system-based skin care than traditional
drug distribution channels. Our physician customer base consists primarily of
plastic surgeons and dermatologists, but also includes an increasing number of
physicians from other practice areas,
such as internal medicine and obstetrics and gynecology ("OBGYN"), who are
adding skin care to their practices.


2




As of December 31, 2008, we sold
our products to more than 5,700 accounts in the United States, which we believe
represented over 8,900 individual practicing physicians. Based on a 2008 study
by Kline & Co., we are the leading skin health company in the
physician-dispensing channel, with an estimated 29.6% market share and more than
three times the market share of the next largest competitor. Outside the United
States, we utilize distribution partners for the sale of our systems and related
products. As of December 31, 2008, we have 19 distribution partners and two
licensing partners who sell our products through their own dedicated sales
forces in approximately 42 countries.





We also compete in the Japanese retail
skin care markets through a strategic licensing agreement with Rohto
Pharmaceutical Co., Ltd. ("Rohto"). Rohto is a Japanese pharmaceutical
manufacturer and distributor. Under various agreements, Rohto is licensed to
manufacture and sell a series of OTC products under the Obagi brand name,
including Obagi-C (a Vitamin C based topical serum in various concentrations)
and products containing our bi-mineral complex in the Japanese drug store
channel.  We receive an annual license fee from Rohto for products that
they manufacture and distribute under the Obagi name and will receive annual
development fees and a royalty based upon Rohto's product sales in Japan. We
recently expanded our relationship with Rohto to provide for collaboration on
the development of new products and to pursue higher-end distribution channels
to sell products in Japan.  We have other licensing arrangements in
Japan to market and sell OTC product systems under the Obagi brand, both for
in-office use in facial procedures, as well as for sale as a take-home product
kit in the spa channel. Our net licensing revenue from skin health systems and
products in Japan was approximately $4.8 million for the year ended
December 31, 2008.





Background





Skin
Damage and Disorders





The skin is the largest organ in the
body, consisting primarily of two layers: the epidermis, a thin outer layer; and
the dermis, a relatively thick inner layer. The epidermis is comprised of
specialized cells such as keratinocytes and melanocytes. Keratinocytes are
formed in the epidermis and travel to the skin's surface and are exfoliated, or
shed off, as they die in a maturation cycle which normally takes approximately
six weeks. Buildup of excess keratinocytes can result in rough, thick or dry
skin. Melanocytes produce melanin, the pigment that determines skin color and
protects the body from ultraviolet radiation. The dermis is comprised largely of
connective tissue fibers made of collagen and elastin. Collagen is a tough,
fibrous protein that helps give skin its strength and resiliency. Elastin is a
tissue that helps maintain healthy skin tension and gives skin its shape, but
does not readily regenerate post-puberty and degrades over time. As the elastin
degrades, skin tone and elasticity become diminished, resulting in loose,
sagging skin.





The health and appearance of a person's
skin is impacted by a variety of intrinsic and extrinsic factors, including
pre-mature aging, photo-damage, hormones, stress, pollutants, diets and skin
diseases. These factors cause newly created cells to be damaged which leads to
an increase in the skin cell maturation cycle. The result is that skin cells are
disorganized and pigment cell activity is increased. The damaged epidermal cells
cause a wide variety of conditions such as mottled pigmentation (varied pigment
density across the skin), melasma (skin discoloration often caused by hormonal
changes such as those from pregnancy), age spots, fine lines and dry thickened
sallow skin. In the dermis of extrinsic or intrinsic aged skin, the amount of
new collagen and elastin produced decreases, resulting in fibers that do not
support the structure and the dermis becoming thinner. As a result deep lines,
wrinkles and sagging skin make the appearance of skin significantly worse. Skin
health is also impacted by diseases such as acne, rosacea, dermatitis, and
psoriasis. Imbalanced production of skin oils such as sebum encourages
accelerated growth of microbes in the skin such as P. acne. The skin can also
become host to viral or fungal infections.





While these conditions and diseases are
not life-threatening, they are readily apparent, sometimes disfiguring, usually
chronic, and can be debilitating in terms of a person's self image and
confidence. As a result, people are
often highly motivated to seek treatment programs to restore the look and feel
of their skin.





The
Skin Care Market





The independent research firm,
Kalorama Information, estimates that from 2005 to 2010, over 70 million
people in the United States alone will receive cosmetic facial procedures for
which they will pay over $60 billion. We believe this reflects a growing
desire and acceptance among the aging population to seek aesthetic facial
products and procedures from their physicians. A key driver of this trend is the
aging of the "baby boomer" segment of the U.S. population. In addition, life
expectancy in the United States has extended in recent years, leading to a
further increase in the average age of the country's population. Because
healthcare needs, including the treatment of skin disorders, tend to increase
with age, we expect the demand for dermatologic products to continue to increase
over time. In particular, women tend to demonstrate a higher motivation than men
to improve their personal appearances. The number of women between the ages of
35 and 65, the primary users of our products, was estimated by the U.S. Census
Bureau to have grown 30% between 1990 and 2006. With this segment's strong
desire to reduce the signs of pre-mature aging, we expect the aging female
population to continue to increase the market opportunity for skin care
products.


3


Consumer demand for physician-dispensed
skin care products and procedures has been steadily growing. We believe this
growth is due to consumers realizing that many non-prescription consumer
cosmetic products are unable to fully meet their needs. Consumers have
increasingly turned to their physicians for products and simple in-office
procedures that can provide better results than consumer cosmetics. For example,
physician-directed cosmetic products and commonly performed cosmetic procedures
such as Botox injections, injectable fillers, laser hair removal and
microdermabrasion (a cosmetic procedure that removes the outermost layer of the
skin to promote skin rejuvenation), have experienced substantial growth as
consumers learn that they can achieve positive cosmetic results with minimally
invasive techniques. According to the American Society of Aesthetic Plastic
Surgery (“ASAPS”), the number of surgical and non-surgical cosmetic procedures
reached 11.7 million in 2007, with 9.6 million attributable to non-surgical
procedures.  Three of the leading non-surgical procedures included
Botox, soft tissue fillers, and facial rejuvenation such as lasers, which
accounted for 58% of all non-surgical procedures in 2007.





Beyond anti-aging and aesthetic
treatments, there is significant market demand for effective treatments of skin
diseases such as acne, rosacea, psoriasis, and eczema (dermatitis). While a
number of therapies and treatments exist for such diseases, most treatments
consist of either topical applications with efficacy that is limited by their
inability to cross the skin barrier effectively, or systemic (oral) applications
that carry significant potential side effects.





According to
Kline & Co., in 2008, there were approximately 46,100 physicians
practicing dermatology and plastic surgery in the United States, of which there
were more than 11,600 dispensed skin care products directly to their patients.
Based on our experience with physicians who have opened accounts with us, we
believe a growing number of general practice, family practice, internal
medicine, and OBGYN physicians are continuing to dedicate resources in their
practices to skin care. We believe that these physicians are responding to the
rapid increase in consumer demand for non-invasive skin care treatments.
Furthermore, many of these physicians are dispensing prescription and
non-prescription skin care products directly to their patients.





Outside the United States, the
physician-dispensed skin care market varies by country due to cultural
differences and regulatory variations. Cultural desires for skin with lighter
and more evenpigmentation have
created large and growing aesthetic skin care demand across the Pacific Rim
countries, particularly Japan, China and Korea. European and certain South
American countries such as Brazil also present large skin care markets due to
the complementary growth in cosmetic procedures and willingness on the part of
their consumers to spend discretionary income on aesthetic enhancements. We
believe that the growth in major international markets will also be driven by
cultural desires to lessen the appearance of skin darkening caused by exposure
to sun, aging populations and a heightened awareness and acceptance of
physician-dispensed products and procedures. Additionally, while physician
dispensing is common in most countries, certain countries prohibit or limit the
types of products that can by dispensed from the physician office, requiring
physicians to either partner with a retail pharmacy or drug store, or to simply
forgo dispensing.





Limitations
of Traditional Products and Procedures





Most of the cosmetic skin care products
and procedures available today are designed to mask the effects of aging and
skin disorders, rather than treat the underlying health of the skin. As a result
of using these cosmetic skin care products, consumers may see temporary skin
surface improvements, but underlying skin restoration often does not occur. We
believe that the limitations of traditional products and procedures result
primarily from the following causes:





§
            The
      outer layer of human skin is a highly effective protective barrier against
      the entry of foreign particles into the body. The active agents in many
      competing topical products and procedures lack the ability to effectively
      penetrate the skin barrier, reducing their ability to improve the health
      of the skin at the stratum corneum, epidermis and dermis level. The most
      commonly used skin care products are cosmetics by definition under the
      U.S. Food, Drug and Cosmetic Act ("FDCA"), consisting largely of surface
      covers and moisturizers, which only add water to the cells on the surface
      of the skin, providing superficial and temporary improvement in the
      appearance of the skin. Moisturizers are not capable of causing the skin
      to generate healthy new cells to replace older, damaged ones that make up
      the epidermis.





§
            Most
      traditional approaches to skin care are not comprehensive programs
      designed to integrate complementary products. As a result, individual
      products, even those that are widely used by consumers (such as facial
      soaps or sunscreens) are not generally designed to work together, and
      therefore may cause unintended side effects or reduced effectiveness when
      used in combination. Furthermore, the range of skin types in any given
      patient population is highly varied and different skin types respond
      differently to treatment, yet few products are capable of treating the
      specific needs of the individual patient's overall skin
      health.





The
Obagi Medical Products Approach to Skin Aging





We believe the effects of aging and
skin disorders are best addressed not at the surface of the skin but at a deeper
level, where the skin's natural regeneration processes occur. Our Obagi Nu-Derm,
Obagi Condition & Enhance and Obagi-C Rx Systems improve the overall health
of the skin by improving cellular processes such as collagen and elastin
production, keratinocyte clearing, and melanocyte regulation, using drugs that,
by definition, work at the cellular level. With improved underlying skin health,
we believe a patient's skin shows fewer signs of aging, is less susceptible to
disease, and is better able to combat exposure to the elements. We have
developed skin care systems that we believe address
the limitations of traditional skin care products and procedures, including the
following:


4





§
            Our
      Obagi Nu-Derm, Obagi Condition & Enhance and Obagi-C Rx Systems are
      drug-based systems designed to penetrate below the skin's surface to
      correct damage in all layers of the skin (the stratum corneum, the
      epidermis and the dermis) and accelerate cellular turnover. We have
      demonstrated in clinical studies that by enhancing the penetration of the
      intended active ingredient (tretinoin), more of this drug gets to the
      targeted tissue, improving patient outcomes. The increased penetration of
      asystem of active ingredients
      triggers a therapeutic cascade that (i) pushes fresher cells to the
      surface faster, resulting in smoother skin, reduced wrinkles and increased
      tolerance, (ii) corrects current hyperpigmentation (including
      freckles and age spots) and prevents the appearance of new
      hyperpigmentation, (iii) promotes more uniform cells at the deepest
      layer for better skin structure and balanced, even skin tone,
      (iv) helps stimulate collagen and elastin for firmer, more resilient
      skin, and (v) helps increase natural hydration and circulation for
      supple, healthy-looking skin.





§
            To
      achieve improved skin health, our Penetrating Therapeutics technology
      integrates proprietary formulations of existing prescription and
      non-prescription skin care products into treatment programs specially
      designed and physician-tailored to address the unique needs of each
      patient's skin. The individual products within our systems are formulated
      to work synergistically using our proprietary Penetrating Therapeutics
      technology in formulations that enhance the stability and efficacy of what
      are often otherwise unstable molecules. When this system of products is
      applied within a physician directed protocol tailored to the patient's
      skin health needs, overall penetration of the active ingredient to the
      appropriate layer of skin is achieved, resulting in greater efficacy and
      improved patient outcomes.





Our
Business Strategy





Our objective is to become the leading
specialty pharmaceutical company dedicated to developing and commercializing
systems that enable physicians to improve skin health at the cellular level. Key
elements of our strategy include:





§
            Leveraging
      the strength of our physician-dispensed marketing and distribution channel
      to increase market share and introduce new Obagi products. We
      believe that our market-leading position in the physician-dispensed skin
      care channel presents us with the opportunity to increase the market share
      of our existing products and to launch a range of new Obagi Systems and
      products. We have built long-term relationships with skin health
      professionals based on the success of our products during the
      20 years since the first Obagi Systems and products were launched. We
      will continue our sales and marketing efforts aimed at helping physicians
      understand how our systems' products can meet growing patient demand for
      effective skin care treatments, thereby generating additional sources of
      revenue for physician practices. Furthermore, we believe that our systems'
      product offerings and our experienced sales force uniquely position us to
      benefit from growth in the number of physicians who dispense skin care
      products directly to their patients. According to
      Kline & Co., in 2008 only about 25% (11,600) of the
      approximately 46,100 physicians practicing plastic surgery and dermatology
      in the United States dispense professional skin care products. According
      to the results of a study we sponsored by Wirthlin Worldwide Company, an
      additional 40% of non-dispensing surveyed plastic surgeons and
      dermatologists indicated that they are considering dispensing skin care
      products. Based on our experience with physicians who have opened accounts
      with us, we believe a growing number of general practice, family practice,
      internal medicine and OBGYN physicians are also dedicating resources in
      their practices to skin care. We believe that these physicians are
      responding to the rapid increase in consumer demand for non-invasive skin
      care treatments. Furthermore, many of these physicians are already
      dispensing prescription and non-prescription skin care products directly
      to their patients.





§
            Continuing
      to develop and market new indications for Obagi Systems. We believe
      a significant opportunity exists to use current Obagi Systems as
      non-invasive adjunctive therapies to improve certain current skin care
      procedures, resulting in overall better patient outcomes and satisfaction.
      Many cosmetic procedures are limited in their ability to provide healthier
      skin and an overall enhanced aesthetic outcome. For example, Botox
      injections and injectable fillers for reducing wrinkles have no effect on
      the skin's color, hyperpigmentation, age spots, acne or the overall health
      of the skin. We conducted a
      clinical study to evaluate the adjunctive use of our systems before and
      after these types of procedures, and based on outcomes for over 2,600
      patients, we launched the Obagi Condition & Enhance Systems, which had
      an initial focus on use in conjunction with Botox injections and now is
      also marketed for use before and after other cosmetic procedures such as
      IPL Laser procedures.  Based on the results of the initial
      clinical use trial, we have conducted further research specifically with
      Obagi Condition & Enhance plus Botox and Obagi Condition & Enhance
      plus IPL.  This data was published at the March 2009
      American Academy of Dermatology meeting.  We plan to
      continue to build clinical support for the benefits of our systems in
      conditioning the skin and enhancing the outcomes of the most commonly
      performed cosmetic procedures, such as chemical peels, dermabrasion and
      laser resurfacing.





§
            Creating
      additional clinically proven Obagi Systems that increase the efficacy of
      commonly prescribed dermatological agents in addressing new areas of skin
      disease. We focus our research and development efforts on
      increasing the ability of FDA-allowed skin agents to penetrate the skin
      barrier, thereby increasing the effectiveness of such agents within the
      Generally Recognized As Safe, ("GRAS"), OTC or Drug Efficacy Study
      Indication ("DESI"), classification as defined by the FDA. This approach
      accelerates the commercialization timeline and avoids the lengthy clinical
      development processes


5


§
            typically
      required to obtain new drug approvals. We intend to further differentiate
      our products and systems by supporting them with randomized controlled and
      comparative clinical studies conducted by leading experts in the markets
      in which we are developing products. Supporting this strategy we initiated
      an aggregate of 18 clinical studies in 2005 and 2006 in the areas of acne
      and elasticity, eight clinical studies in 2007, and twelve clinical
      studies in 2008 in the areas of acne and aesthetics. We are also launching
      additional clinical studies in 2009 for other therapeutic indications of
      new and existing products.





§
            Establishing
      new strategic collaborations and relationships. We intend to
      continue accessing new and complementary products through in-licensing,
      strategic collaborations and strategic acquisitions. We also intend to
      explore new product distribution partnerships in high growth channels such
      as the spa and salon channel, in which manufacturers' sales of skin care
      products are estimated at over $536 million in 2008, according to
      Kline & Co. We plan to target new products and channels,
      which will expand the Obagi brand and Obagi System concept but will not
      compete directly with the physician-dispensed skin care channel or
      products. We believe that skin health professionals will be receptive to
      new products we introduce under the Obagi brand name, and that the brand
      credibility that exists among skin health professionals will allow for
      more rapid trial and acceptance. This belief is supported by a 2003 study
      we sponsored by Wirthlin Worldwide Company of 1,000 medical professionals
      (primarily consisting of plastic surgeons, dermatologists, and medical
      skin care professionals), which found that the Obagi brand had the highest
      total awareness, at 97%, among leading physician-dispensed
      brands.





§
            Continuing
      to expand intellectual property protection. Our intellectual
      property protection is based on a combination of issued patents, patent
      applications, licensed patents, licensed product methods and technologies
      and trade secrets. As of December 31, 2008, we were the sole licensee
      of eighteen patents, and have filed ninety U.S. and
      international provisional and non-provisional patent applications
      since the beginning of 2004, some of which have been issued. We will
      continue to pursue additional invention and method patents as we find new
      applications and improvements to our existing intellectual property. We
      also pursue an aggressive trademark registration policy as a means to
      increase brand recognition and product differentiation in the
      market.





Our
Obagi Systems and Related Products





We currently market and sell our
systems and related products to physicians for the treatment of age-related skin
disorders, incorporating a range of individual prescription and non-prescription
therapeutic agents, as well as cosmetic ingredients. The individual components
of each system have been formulated to complement one another, enhancing the
effectiveness of the system as a whole and allowing the physician to tailor the
treatment program to the specific needs of the patient. The designof our systems is proprietary to us,
and we are the sole licensee of both provisional and issued U.S. patents and
have patent applications pending for the composition of certain of the
products.




System
      and related products
                Segment/product
      category
                Description
                Applications
                Launch
      dateObagi
      Nu-Derm System
                Physician
      Dispensed/ Nu-Derm
                Comprehensive
      system of six products including prescription and OTC
drugs
                Fine
      lines, wrinkles, acne, photo -damage, hyperpigmentation, melasma, laxity,
      skin sallowness
                1988Obagi
      Condition & Enhance Systems
                Physician
      Dispensed/ Nu-Derm
                Line
      extension of Nu-Derm designed for use before and after surgical and
      non-surgical cosmetic procedures
                Enhances
      patient outcomes and patient satisfaction
                2006Obagi-C
      Rx System
                Physician
      Dispensed/ Vitamin C
                Highly
      stable Vitamin C serum with 4% hydroquinone system;
      prescription-based
                Fine
      lines, wrinkles, hyperpigmentation, skin sallowness
                2004Professional-C
      and Cffectives
                Physician
      Dispensed/ Vitamin C
                Highly
      stable Vitamin C serums; non-prescription
                Antioxidant
      protection, fine lines, wrinkles, hyperpigmentation
                2005ELASTIderm
      Eye and Decolletage
                Physician
      Dispensed/ Skin Laxity
                System
      of skin health products built around a novel formulation of a mineral
      complex; non-prescription
                Increase
      elasticity and skin tone of eyes, face, neckline and chest
                2006/2008CLENZIderm
      M.D. Systems
                Physician
      Dispensed/ Therapeutic
                Systems
      for acne treatment built around a novel formulation of BPO
                Acne
                2007SoluCLENZ
      Rx Gel
                Pharmacy
      Rx
                Acne
      treatment built around a novel formulation of BPO
                Acne
                2008Obagi
      Rosaclear System
                Physician
      Dispensed/ Therapeutic
                System
      for rosacea treatment which reduces redness and flushing, along with
      treating papules and pustules
                Rosacea
                2009Tretinoin
                Physician
      Dispensed/ Other
                Generic
      equivalent of Retin-A available in the United States through an exclusive
      license
                Acne
                2002Obagi
      Blue Peel System
                Physician
      Dispensed/ Other
                Topical
      system to aid in the application of TCA (trichloroacetic acid) chemical
      peels
                Fine
      lines, wrinkles, hyperpigmentation
                1988


Obagi Nu-Derm System





Our Obagi Nu-Derm System consists of a
combination of six prescription and OTC drugs and adjunctive cosmetic skin care
products to treat visible skin conditions such as photo-damage and
hyperpigmentation resulting from extrinsic damage and intrinsic changes to the
skin. The Obagi Nu-Derm cosmetic skin care products include cleansers and
exfoliating creams. Three of these products contain the drug hydroquinone in a
4% prescription concentration, which acts as a bleaching agent that is designed
to correct skin pigmentation problems by normalizing the production of new
melanin in the epidermis. Physicians may also prescribe the drug tretinoin as a
complement to the system, in various concentrations, depending on the
physician's judgment of patient need. We believe that the use of these
prescription drugs, the ability of the drugs to penetrate the skin's surface and
the order of application distinguishes our Obagi Nu-Derm System from other
commonly prescribed regimens. While we have designed our Obagi Nu-Derm System to
include products that patients can use in a systematic treatment regimen, we
also make the component products available for individual sale. We believe that
physicians who dispense the Obagi Nu-Derm System generally encourage their
patients to use the component products together in a systematic treatment
regimen. However, we also believe that some patients elect to use the products
that make up the system individually. Products that are used individually at
times include the sun screen products and Obagi Nu-Derm Clear, which physicians
may dispense on occasion to address localized pigmentation problems. Side
effects from use of the products may include redness, mild to moderate
irritation and/or excessive flaking or sloughing of the outer layers of the
treated skin. Side effects generally resolve after the first 10 days of
use, or in cases with certain sensitive individuals, in a few days upon
discontinuance of use.


6




In 2003, we sponsored a 301-subject,
six-month, randomized, controlled, two-center, clinical use study that was
independently designed and conducted by Thomas J. Stephens & Associates
to compare the efficacy, side effects and tolerability of our Obagi Nu-Derm
System with other commonly prescribed regimens of tretinoin, hydroquinone and
OTC moisturizer. One of our minority stockholders assisted in the preparation of
the study. Improvements in perioral (around the mouth) and periocular (around
the eyes) fine wrinkles, facial mottled hyperpigmentation, clarity, sallowness,
laxity (the appearance of loose, sagging and/or excess skin), and tactile
roughness were measured. After 24 weeks of treatment, the mean changes
observed with our Obagi Nu-Derm System were consistently larger than, and
statistically superior to, the changes produced with the other treatment
regimens. Of particular note were the changes in the perioral fine wrinkles,
mottled pigmentation and laxity. While treatment with all regimens was generally
well tolerated, there was a higher level of both objective and subjective
irritation with the Obagi Nu-Derm System that largely resolved by the end of the
study.





The Obagi Nu-Derm System, including the
Obagi Condition & Enhance System (described below), accounted for
approximately 61% and 56% of our consolidated net sales for the years ended
December 31, 2007 and 2008, respectively. We sell our Obagi Nu-Derm System
primarily at a single-price. Although volume of sales for each individual
product within the system varies, we believe the majority of our sales of each
component product is due to the fact that they are sold as part of the
system.





Obagi
Condition & Enhance – Surgical and Non-surgical Cosmetic
Procedures




In
July 2006, we launched Obagi Condition & Enhance targeted for use with
surgical and non-surgical cosmetic procedures, such as Botox (Botox is a
registered trademark of Allergan, Inc.), injectable fillers, chemical
peels, micro-dermabrasion and laser resurfacing treatments. This system provides
adjunctive therapy both before and after these procedures, and is designed to
enhance aesthetic outcomes and improve overall patient
satisfaction.


Like our
Obagi Nu-Derm System, Obagi Condition & Enhance consists of a combination of
six prescription and OTC drugs and adjunctive cosmetic skin care products to
treat visible skin conditions such as photo-damage and hyperpigmentation
resulting from extrinsic damage and intrinsic changes to the skin. The Obagi
Condition & Enhance cosmetic skin care products include cleansers and
exfoliating creams. Three of these products contain the drug hydroquinone in a
4% prescription concentration, which acts as a bleaching agent that is designed
to correct skin pigmentation problems by normalizing the production of new
melanin in the epidermis. While we have designed Obagi Condition & Enhance
to include products that patients can use in a systematic treatment regimen, we
also make the component products available for individual sale. We believe that
physicians who dispense Obagi Condition & Enhance generally encourage their
patients to use the component products together in a systematic treatment
regimen. Side effects from use of the products may include redness, mild to
moderate irritation and/or excessive flaking or sloughing of the outer layers of
the treated skin. Side effects generally resolve after the first 10 days of
use, or in cases with certain sensitive individuals, in a few days upon
discontinuance of use.




Obagi-C
Rx System





The Obagi-C Rx System consists of a
combination of four prescription and OTC drugs and adjunctive cosmetic skin care
products to treat skin conditions resulting from sun damage and the oxidative
damage of free radicals. The central ingredients in the system are 4%
hydroquinone, a prescription drug, and Vitamin C. This combination distinguishes
Obagi-C Rx from other Vitamin C based products available in the physician
office. Two Obagi-C Rx System products contain this concentration of
hydroquinone, which is designed to correct skin pigmentation problems by
normalizing the production of new melanin in the epidermis. The Obagi-C Rx
System includes cosmetic skin care cleansers and exfoliating lotions. When
combined in a system, we believe hydroquinone, Vitamin C and a sunscreen provide
correction of, and protection against, premature skin aging. As with the ObagiNu-Derm System, the products that make
up the Obagi-C Rx System are generally used together in a coordinated regimen by
the majority of patients. Side effects from use of these products may include
redness and/or mild to moderate irritation of the treated skin. Side effects
generally resolve after the first 10 days of use, or in cases with certain
sensitive individuals, in a few days upon discontinuance of use. We sponsored an
in vitro study at the University of California, Irvine in September 2003 to
evaluate the percutaneous absorption and bioavailability of our patented 10%
Vitamin C and 4% hydroquinone combination product compared with the leading
Vitamin C competitor, SkinCeuticals 20 Vitamin C. Our product demonstrated, with
statistical significance, more Vitamin C in all layers of the skin than
SkinCeuticals 20 Vitamin C serum.





Obagi
Professional-C





The Obagi Professional-C products are a
complete line of proprietary, non-prescription products, which consist of
Vitamin C serums used to reduce the appearance of damage to the skin caused by
ultraviolet radiation and other environmental influences. Vitamin C (L-ascorbic
acid) acts as a potent antioxidant. The Obagi Professional-C line consists of a
5% serum for the area around the eyes and 10%, 15% and 20% serums for the face,
neck and chest. Professional-C represents an expanded line that replaced our 5%
and 10% Vitamin C serum offerings marketed under the Cffectives brand
domestically, and Obagi-C brand internationally, as introduced in 2000.
Obagi Professional-C products are sold individually and are used on their own,
or in combination with other Obagi system products. These products are
classified as cosmetics and side effects are not generally associated with their
use, however certain sensitive individuals may experience mild irritation of the
skin where product is applied. In addition, the product has been shown in
studies we sponsored at the University of California, Irvine in September 2003
and July 2005 to penetrate all levels of skin better than SkinCeuticals 20
Vitamin C serum.


7





Obagi
ELASTIderm





Our ELASTIderm product line consists of
products for the treatment of skin laxity featuring novel mineral complexes
which may help the body's own natural ability to increase epidermal thickness,
augment hypodermal fat and increase elastin levels by supplying increased local
concentrations of natural mineral actives to the relevant tissue, thereby
improving the elasticity and skin tone around the eyes. We believe this is the
first clinically proven skin health system to aid in the regeneration of
elastin, which we believe is a new and novel topical application for anti-aging.
A nine-week treatment, randomized, double-blind clinical study was conducted
with 33 subjects to determine the safety and efficacy of our novel under eye
elastin regeneration product. The primary endpoints were appearance in under eye
skin elasticity, fine line wrinkles and moisturization. A visible improvement in
the appearance of fine lines and wrinkles was observed throughout the study,
based on photographic evidence. In addition, coarse wrinkles decreased at all
time points and reached statistical significance at nine weeks. Statistically
significant increases in elasticity were observed at all time points during the
study and as early as two weeks following treatment. We believe that a more
rapid improvement in elasticity is essential to earning customer compliance and
repurchase. Based on clinically significant improvements in measured collagen
and elastin in skin treated over the eight week period, we launched an eye cream
product under the Obagi ELASTIderm brand name in mid-October 2006. In February
2007, we launched an eye gel which is the second product under the Obagi
ELASTIderm brand. In February 2008, we launched ELASTIdermTM Décolletage, a
system to treat skin conditions resulting from sun damage and improve the
elasticity and skin tone for the neck and chest area.





CLENZIderm
M.D.—Acne





We have developed a system of products
for acne treatment featuring a novel formulation of BPO which our clinical
studies show to penetrate more readily into the skin follicle than current
creams or gels because it is in solution form. We believe that our
solution-based acne system will be a more effective treatment for acne because a
greater amount of the active ingredient, BPO, will penetrate thehair follicle to act on P. acne
bacteria. We conducted several clinical studies that demonstrated that our novel
BPO alone achieved greater intrafollicular and skin surface bactericidal
activity (or kill) against P. acnes than both a prescription generic BPO
formulation and a prescription BPO/antibiotic combination product. We believe
these studies show the efficacy of our novel BPO formulations in reducing P.
acnes and clearing visible acne lesions on the skin. Additionally, in
mid-November 2006, we conducted under the CLENZIderm M.D. brand name, a
controlled experience trial with select dermatologists who currently prescribe
the existing Obagi systems. Based on the results of that trial, we began a full
commercial launch of the CLENZIderm M.D. for normal to oily skin in February
2007 and for normal to dry skin in July 2007.





SoluCLENZ
Rx Gel—Acne





As our
CLENZIderm M.D. system is dispensed by physicians, we decided to enter the
pharmacy Rx channel by launching the BPO gel, SoluCLENZ Rx Gel in August
2008.  This product contains our novel BPO formulation and is
available only by prescription.  We have demonstrated that SoluCLENZ
Rx Gel is a novel treatment alternative that provides clinically significant
lesion reductions that are comparable to the leading prescription BPO/antibiotic
combination products, without the use of a topical antibiotic.





Obagi
Rosaclear - Rosacea





Our
Rosaclear System is the first and only complete prescription-based system
developed specifically for treating the signs and symptoms of rosacea. The
all-in-one system is designed to effectively reduce redness and flushing, along
with treating papules and pustules, to help rosacea patients achieve a clearer,
calmer and more balanced-looking complexion. In 2008 we conducted several
clinical studies with our Rosaclear System. The system consists of a Gentle
Cleanser and a Hydrating Complex Corrector.  A chemical-free,
non-comedogenic Skin Balancing Sun Protection SPF 30 sunscreen was developed in
conjunction with the System.





Tretinoin





Tretinoin creams and related adjunctive
acne care products are used for the topical treatment of acne in the United
States. Tretinoin, the active ingredient in the prescription acne drug Retin-A,
is a Vitamin A derivative and has been the primary prescription acne therapy for
approximately 25 years. Topical tretinoin normalizes the growth rate of
skin cells, disrupting the onset of acne. We offer FDA-approved formulations of
tretinoin through an exclusive license in the physician-dispensed skin care
channel. Our Tretinoin cream line is available in concentrations of 0.1%, 0.05%
and 0.025%. These products are sold individually and are used by doctors as a
single therapy, in combination with Obagi Nu-Derm and Condition &
Enhance or in combination with other acne therapies including but not
limited to salicylic acid and clindamycin. Side effects include excessively red,
edematous, blistered, or crusted skin for certain sensitive individuals. If
these effects occur, the medication should either be discontinued until the
integrity of the skin is restored, or the medication
should be adjusted to a level the patient can tolerate. To date, adverse effects
generally have been reversed upon discontinuation of
therapy.


8





Obagi
Blue Peel





Obagi Blue Peel is a topical system to
aid in the application of trichloroacetic acid ("TCA"), chemical peels used to
smooth the surface of skin, improve skin tone and color, diminish wrinkles and
shrink pore sizes. Chemical peels are an in-office procedure performed either by
a physician or a member of a physician's staff, depending on the skin depth of
the peel. During the procedure, acidic solutions are combined in our delivery
system and applied to the face to remove the thin surface layers of aged and
damaged skin. After removal, the body will naturally replace the removed skin
layers with new, healthy skin cells. The Obagi Blue Peel provides for an even
application and slows the penetration of the solution into the skin, allowing
physicians to more accurately monitor the peel. This produces a more uniform and
consistent application, which reduces the risk of complications. We believe that
the Obagi Blue Peel is especially effective as a complementary treatment to our
Obagi Nu-Derm System. The Obagi Blue Peel products have no known side effects in
and of themselves. Patients receiving blue peel products as part of an acid peel
procedure can expect to experience side effects that are associated with such
procedures.





Expanded
Applications for Existing Products that have Launched or are under
Development





We believe that many of our products
have applications in areas beyond their current uses. For example, in July 2006,
we launched our Obagi Condition & Enhance System, for use before and after
both surgical and non-surgical cosmetic procedures.




Nu-Derm





Market opportunity.
    According to the ASAPS, the number of surgical and
non-surgical cosmetic procedures reached 11.7 million in 2007, with 9.6 million
attributable to non-surgical procedures.  Three of the leading
non-surgical procedures included Botox, soft tissue fillers, and facial
rejuvenation such as lasers, which accounted for 58% of all non-surgical
procedures in 2007.





Our Obagi Nu-Derm System restores skin to a healthier state and helps regulate
skin cell functions and improve circulation. This improves the skin's ability to
constantly renew itself, repair damage, and act as an effective barrier. It also
restores the skin to an active and tolerant state so that it responds better to
the trauma of surgical procedures, and is less likely to exhibit an undesirable
post-procedure response. Clinicians who use our products have reported decreased
recovery periods and reduction in post-inflammatory hyperpigmentation. Another
potential advantage of pre-treating patients undergoing laser resurfacing with
our Obagi Nu-Derm System is that priming collagen might enhance the response to
laser resurfacing, thereby improving cosmetic results. Further, our Obagi
Nu-Derm System, when used as adjunctive therapy following Botox injections, has
the possibility of enhanced aesthetic outcomes and improved overall patient
satisfaction as suggested to us by several dermatologists and plastic surgeons
and supported by our physician use study.





Product
      line
                  
                  Description
                  
                  Applications
                  
                  Launch
      dateObagi
      Condition & Enhance for Botox
                  
                  Line
      extension of Nu-Derm System designed for use after facial
      injections
                  
                  Enhances
      patient outcomes and satisfaction for Botox and other injectable
      procedures
                  
                  2006Obagi
      Condition & Enhance for Non-Surgical Cosmetic
    Procedures
                  
                  Line
      extension of Nu-Derm System designed for use with non-surgical cosmetic
      procedures such as Botox, fillers and lasers
                  
                  Enhances
      patient outcomes and patient satisfaction
                  
                  2007Obagi
      Condition & Enhance for Surgical Cosmetic Procedures
                  
                  Line
      extension of Nu-Derm System designed for use before and after surgical
      cosmetic procedures
                  
                  Enhances
      patient outcomes and patient satisfaction
                  
                  2007




9




Obagi Condition & Enhance for
Botox




Market opportunity.
    According to ASAPS, there were approximately
2.8 million Botox injections performed in 2007. Botox is a non-surgical,
physician administered cosmetic treatment that can temporarily reduce moderate
to severe frown lines between eye brows (glabellar lines associated with
corrugator and/or procerus muscle activity) for up to four months. In order to
maintain the results, a patient needs to be injected every three to four months.
We are currently conducting a 16-week multi-center, randomized, single-blind,
post-market study comparing the aesthetic outcome of the application of Botox
alone to the application of Botox with our post treatment Obagi Condition &
Enhance System. The primary endpoints will be additive improvements in
periorbital and periocular fine wrinkles, facial mottled hyperpigmentation, skin
clarity, sallowness, laxity, tactile roughness and overall patient satisfaction.
This study will be completed in
2009.





Obagi
Condition & Enhance for Laser





Market opportunity.
    We also evaluated and sponsored studies to evaluate the
use of Obagi Condition & Enhance products in aiding skin healing in
non-ablative and ablative laser procedures, which are procedures using lasers
that work primarily by removing the top layer of the skin, while the subsequent
layer is heated. These initiatives were based on anecdotal evidence, supplied by
physicians who are experienced with our Obagi Nu-Derm System, that indicated the
possibility of improved recovery and healing time when our Obagi Condition &
Enhance is used with ablative laser procedures. We decided to conduct a more
formal study with IPL. We recently completed the final phase of a multi center,
randomized, single blind, post marketing clinical trial looking at our
Condition & Enhance System in conjunction with IPL laser versus the IPL
plus a placebo system. The trial was initiated in 2008 with two leading
aesthetic investigators.  The highly favorable results of this trial
will be presented at the American Academy of Dermatology annual meeting in March
of 2009.  We continue to evaluate additional applications of Obagi
Condition & Enhance for use both before and after other cosmetic
procedures.





New Products and Product
Lines





ELASTIderm—Anti-Aging





Market opportunity.
    Elastin is a protein found in the dermis which allows
the skin to resume its normal shape after stretching. As skin ages, it loses its
elasticity and begins to sag, particularly around the eyes, on the neck and on
the hands. According to Kline & Co., in 2008, the eye, hand and
neck professional skin care market in the medical channel as well as the spa and
salon channel was estimated at over $135 million per year, comprised of
products that are primarily designed to improve skin appearance through added
moisturization, or building collagen in the skin. We conducted a soft-launch of
an eye cream product under the Obagi ELASTIderm brand name in mid-October 2006,
limited to our aesthetic sales force and targeted for existing accounts. In
February 2007, we announced the formal launch of an ELASTIderm Eye Therapy,
including both the eye cream and a new eye gel product. In January 2008, we
announced the launch of ELASTIderm Décolletage System, a system designed to
treat mottled hyperpigmentation, including age spots and freckles, while
reducing the appearance of fine lines and wrinkles on the chest and neck area.
In February 2008, we launched ELASTIdermTM Décolletage, a system to treat skin
conditions resulting from sun damage and improve the elasticity and skin tone
for the neck and chest area.





We are also evaluating the use of
future ELASTIderm products on other areas of the body which may help the body's
own natural ability to increase epidermal thickness, augment hypodermal fat and
increase elastin levels by supplying increased local concentrations of natural
mineral actives to the relevant tissue, thereby improving the elasticity and
skin tone. These areas may include the hands, full face, arms and other areas of
the body. However, there can be no assurance that additional products will be
successfully developed in the future. The level of commercial acceptance of the
recently introduced products cannot yet be determined.





Clinical development.
    An eight-week, split-face, randomized, double-blind,
controlled clinical study was conducted in 21 subjects to evaluate the cellular
and molecular effects of our ELASTIderm product which contains a novel
bi-mineral complex known as "copper zinc malonate."   In this
study, subjects with advanced facial photodamage applied ELASTIderm once or
twice daily to the left and right periorbital areas for 8
weeks.  Punch biopsies were obtained at baseline and 6 weeks following
treatment with ELASTIderm.  Histological analyses
of  ELASTIderm’s effect on the periorbital elastic fiber network,
which is responsible for the skins elasticity, were performed by Jouni Uitto,
M.D., Ph.D., at the Department of Dermatology and Cutaneous Biology at Jefferson
Medical College.  The results of this study, published in Experimental Dermatology,
September 2008, suggest that elastin biosynthesis in photodamaged skin is
enhanced with twice daily application of the bi-mineral complex.  Data
published in the manuscript supports findings in earlier studies that
demonstrated correlations with increases in elastic fibers and collagen with
improvements in photographic evidence, following treatment with
ELASTIderm.





In 2007, we initiated a 24-week
single-centered, investigator-blinded, randomized study in 42 female subjects
with at least moderate photodamage and moderate hyperpigmentation or coarse
wrinkling in the décolletage (chest and neck) area, to evaluate the efficacy and
tolerability of the ELASTIderm Décolletage System (Wrinkle Reducing Lotion and
Skin Lightening Complex) in conjunction with a topical retinoid.  Key
efficacy variables evaluated were changes in letigines, mottled
hyperpigmentation, fine and coarse wrinkling, tactile roughness, crepiness and
laxity. Visual improvements were reported by study subjects and the investigator
as early as 2 weeks following treatment.  Statistically significant
improvements in the overall appearance of the décolletage, including mottled
hyperpigmentation, fines lines and wrinkles and skin texture were achieved all
time points during the study, from week 4 thorough week 24.


10


CLENZIderm M.D. and SoluCLENZ Rx
Gel—Acne





Market opportunity.
    Acne is an inflammatory disease of the skin that results
from a blockage of follicles or pores, as a consequence of accumulating dead
skin cells and sebum, together which create a perfect medium for bacteria. The
bacterium, P. acne, is a gram positive anaerobic bacterium that colonizes the
sebaceous follicles and is implicated in the pathogenesis of acne. The
prescription topical anti-acne market primarily includes BPO as a single active
ingredient, or monotherapy product, BPO combination products (with antibiotics),
topical retinoids, such as Retin-A, and topical antibiotics. The 2007 Kalorama
Report projects that the global market for prescription acne and rosacea drugs,
including BPO, retinoids, and antibiotics, will increase 3% from
$1.6 billion to $1.7 billion over the five years from 2006 to
2010.





Current formulations of BPO are
emulsions, comprised of large, highly insoluble particles which do not pass
easily into the skin follicle to treat the underlying causes of acne. As a
result, the efficacy of existing formulations of currently marketed BPO products
is limited. We have developed proprietary technologies that we believe will
increase the ability of BPO to penetrate the epidermis and compromised sebaceous
follicle.




We have
developed the CLENZIderm systems and SoluCLENZ for acne treatment
featuring a novel formulation of BPO which our clinical studies show to
penetrate more readily into the skin follicle than current creams or gels
because it is in solution form. We believe that our solution-based acne system
will be a more effective treatment for acne because a greater amount of the
active ingredient, BPO, will penetrate the hair follicle to act on P. acne
bacteria.





Clinical development.
    In 2008, we obtained final data on several clinical
studies conducted with our CLENZIderm M.D. System (Normal to Oily) and SoluCLENZ
(Solubilized 5% BPO monotherapy) versus the leading prescription BPO/clindamycin
combination product.





A 4-week
multi-centered, randomized investigator-blinded study of SoluCLENZ versus a
leading prescription BPO/antibiotic product was extended to 12
weeks.  The primary endpoints for this study were the reduction in
non-inflammatory and inflammatory lesions and tolerability with SoluCLENZ
monotherapy versus the combination product. The study showed that when compared
to twice-daily treatment with a leading prescription BPO/clindamycin combination
product, twice-daily monotherapy with Obagi's SoluCLENZ resulted in a greater
and more rapid reduction in the number of non-inflammatory lesions throughout
the study.  Statistically significant decreases in non-inflammatory
lesions were observed at weeks 1 through 4 following treatment and at week
12.  Non-inflammatory reductions at week 4 were 45% vs 33% (p< .05) and 57% vs
46% at week 12 (p< .05). Reductions
in inflammatory lesions were clinically significant at all time points. A
similar efficacy profile was demonstrated in a sub-set analysis of pediatric
subjects, ages 12 to 17.





A 10-week, 140-patient, multi-centered,
randomized investigator-blinded study of the CLENZIderm M.D. System for
(Normal-to-Oily) versus a leading prescription BPO/clindamycin product was
conducted for 12 weeks.  The primary endpoints for this study were the
reduction in non-inflammatory and inflammatory lesions and tolerability with
CLENZIderm M.D. System for (Normal-to-Oily) versus the combination product. The
study showed that when compared to twice-daily treatment with a leading
prescription BPO/clindamycin combination product, twice-daily treatment with the
CLENZIderm M.D. System resulted in early onset of efficacy. For non-inflammatory
lesions, reductions at weeks 2 and 4 were 27% vs 13% and 39% and 25%,
respectively.  In a sub-set analysis of pediatric subjects ages 12 to
17, a statistically significant reduction in non-inflammatory lesions was
observed at weeks 2 (23% vs. 11% ; p< 0.05) and 4 (32%
vs. 12%; p<
0.01).  Reductions in inflammatory lesions were clinically significant
at all time points.





CLENZIderm
M.D. System (Normal to Oily) and SoluCLENZ have consistently demonstrated
clinically significant reductions in both non-inflammatory and non-inflammatory
lesions when compared to the leading prescription BPO/clindamycin combinations
product.  The SoluCLENZ product produced a statistically significant
decrease in non-inflammatory lesions at virtually all time points evaluated
through week 12. Obagi's CLENZIderm M.D. System (Normal to Oily) and SoluCLENZ
were well tolerated by patients. Mean levels of irritation commonly to BPO were
mild or moderate, and in a majority cases were less than mild; any irritation
reported during clinical studies occurred during the early weeks of treatment
and resolved over time. Patients consistently reported high levels of overall
satisfaction with the products.




Obagi
RosaclearTM—Rosacea





Market opportunity.
   According to a 2008 American Academy of Dermatology and the
National Rosacea Society study, rosacea is a very common skin condition,
affecting more than 14 million Americans.  Products prescribed in the
treatment of rosacea represent a $254 million market, despite the lack of a
topical treatment proven to effectively treat the symptoms of the disease,
primarily redness and flushing.





Clinical development.
    In 2008 we conducted several clinical studies with our
Rosaclear System. This prescription-based system provides Rosacea patients with
a complete therapeutic skin care system designed specifically to treat the signs
and symptoms of their disease.  The system consists of a Gentle
Cleanser, Metronidazole Topical Gel 0.75% to treat inflammatory papules and
pustules associated with Rosacea and a Hydrating Complex Corrector designed to
protect and moisturizer irritated skin as well as minimize redness and
flushing.  A chemical-free, non-comedogenic Skin Balancing Sun
Protection SPF 30 sunscreen was developed in conjunction with the
System.  This sunscreen was designed to provide broad-spectrum UVA/UVB
protection and is tinted to help reduce the appearance of facial redness and
irritation.


11





We
completed a 4 week single-center, controlled initial proof of concept study with
the Rosaclear System. In this study 90% of patients experienced at least a 1
grade reduction in the severity of their Rosacea by the second week of
treatment.  There are plans to initiate a larger, multicenter,
confirmatory study in 2009.





Areas of Future Growth





We believe that our Penetrating
Therapeutics technology may be applicable in other skin health areas. We are
currently screening therapeutic candidates in related areas such as dark
circles, dermatitis/seborrhea, hair growth and topical hair removal. According
to Kalorama, in 2008 these therapeutic areas represented topical markets ranging
from $766 million to over $2.4 billion in size.





Our product development strategy is to
enhance the efficacy of established, widely prescribed, FDA-approved dermatology
products (both prescription and OTC) by developing mechanisms that significantly
enhance the penetration of these agents across the skin's protective barrier
into the deeper layers of the skin, where therapeutic benefits are realized. We
describe this enabling technology as Penetrating Therapeutics, in which the
individual chemical characteristics of both active and inactive agents are
addressed and then combined in a systematic manner based on their
pharmacokinetic properties.





We seek to demonstrate through clinical
studies the improved efficacy of various topical agents when used as part of our
systems. We are conducting and plan to initiate numerous clinical studies to
demonstrate the advantages of our products in both blinded, randomized
controlled studies and direct comparative studies that will provide both
clinically and statistically significant results. We will work with leading
researchers and clinicians in their respective fields of applications and
markets. We intend to use these results in marketing our products.





Sales
and Marketing





Domestic.
    We believe we are the market leader in the
physician-dispensed skin care channel with a 29.6% share and over three times
the market share of the next largest competitor, according to a 2008 study by
Kline & Co. As of December 31, 2008, we had more than 5,700
active accounts in the United States. Each account has at least one licensed
physician on-site and we estimate that there are approximately 8,900 physicians
in total practicing under these active accounts. This includes physicians
on-site at a small but rapidly growing number of medical spas.





The U.S. market accounted for 85% and
84% of our net sales for the years ended December 31, 2007 and 2008. In the
United States, we focus our sales and marketing efforts primarily toward plastic
surgeons, dermatologists and other physicians with an aesthetic skin care focus
using our direct sales force. As of December 31, 2008, we had 157 sales,
marketing and education specialists, including 120 dedicated sales
representatives and managers, of which 20 representatives were contracted to
support the launch of SoluCLENZ. We believe that we have sufficient sales
representation to enable us to effectively target the plastic surgeons,
dermatologists and aesthetic skin care physicians who dispense skin care
products in the United States.   In addition to effective
systems, we also offer turn-key practice building programs and patient events
that help the physicians grow their practices. These resources help each
physician practice improve their recurring patient visits and revenue
streams.





Our marketing efforts have a dual
focus. First, we market directly to physicians in an attempt to both create
treatment awareness and encourage the use of our products by both new and
existing physician clients. To support this effort, we use medical journal
advertising, sales aids, video, CD and slide demonstrations,
physician-to-physician speaker presentations, trade shows, reminder items,
educational and training support, internet resources, and telemarketing. Second,
we attempt to create and then build upon the relationships with our physician
customers by marketing our products to their patients through their medical
practices. In addition, we provide patienteducation booklets and videos, funding
for cooperative advertising, training and direct assistance in patient seminars
and other programs, continuous product education and public relations programs
for patient referrals.





In
addition, our research and development staff is designing and directing clinical
studies to support the application of our existing product lines for new markets
and to enhance our current marketing efforts. We have conducted numerous studies
with the leading academic institutions and key experts in dermatology and
aesthetic medicine and will continue to expand our collaborations with leading
dermatologists and institutions to coordinate additional clinical studies for
new product applications and formulations. We believe evidence from our clinical
studies will validate the performance of our existing products and provide a
platform for the development of new products and product
applications.





International.
    International markets accounted for 15% and 16% of our
net sales for the years ended December 31, 2007 and 2008, respectively. We
address international markets through 19 international distribution and two
licensing partners that have sales and marketing activities in approximately 42
countries outside of the United States, and three trademark and know-how license
agreements for the drug store and aesthetic spa channel of Japan. We target
distribution partners who are capable and willing to mirror our sales and
distribution model in the United States and who have an established business and
reputation in the physician channel.


12


Much like
our business model in the United States, these distributors address their
territories through direct sales representatives selling to physicians, or
through alternative distribution channels, depending on regulatory requirements
and industry practices. The sale of skin health and restoration products through
physician offices is not as widely established internationally as it is in the
United States. For example, some of our more successful international
distribution partners include our partners in Southeast Asia, the Middle East,
the Philippines and North America (excluding the United States). In these
territories, our partners utilize Obagi-branded medical centers to employ
trained physicians for patient sales, as well as a training center to provide
product and sales training to regional physicians and their staff. Separately,
some of our distribution partners, such as our partners for Mexico and Canada,
leverage their existing complimentary product offerings to gain rapid account
penetration for Obagi Systems in their territories. International sales are
diversified, and our largest individual medical channel distribution partner
purchased approximately $2.4 million from us during the year ended
December 31, 2008.





We intend to continue expanding our
international presence by entering into strategic relationships in key locations
such as Asia, Europe and South America. We believe that there is potential for
significant sales growth of our products in international markets due to
cultural emphasis on overall skin health and appearance and the continued
development and acceptance of surgical and non-surgical cosmetic procedures
throughout many countries of the world.





Licensing.
    Where the physician-dispensed skin care channel is
underdeveloped we will look for alternative models to build a presence and brand
awareness for our products. For example, in Japan we have pursued three separate
distribution channels for our brand and product concepts. In 2002, we launched
our first formal long-term relationship in Japan by entering into a trademark
and know-how license agreement with Rohto to market and sell our Obagi-developed
products in Japan. Rohto is a Japanese pharmaceutical manufacturer and
distributor. Under our current agreement, Rohto is licensed to manufacture and
sell a series of OTC products under the Obagi brand name, including Obagi-C (a
vitamin C based topical serum in various concentrations) and ELASTIderm (our
bi-mineral Collagen and Elastin enhancing line of products), in the Japanese
drug store channel for which it pays us a license fee. Rohto's Obagi branded
products achieved retail annual sales of approximately $74 million in 2008
through approximately 6,300 high-end drug stores. We are currently evaluating
expansion of that relationship into the higher end department store
channel.  In addition, we recently entered into a License Distribuion
Agreement with Rohto for sales of products using our bi-mineral complex
technology, for which we will receive royalty payments on net sales.  We
have additional licensing arrangements in Japan as well to market and sell OTC
product systems under the Obagi brand in the aesthetic spa channel, both for
in-office use in facial procedures, as well as for sale as a take-home product
kit. Separately, in early 2004, we entered into a distribution agreement with
Koken Ltd., granting Koken exclusive rights to distribute certain
prescription based Obagi Systems in the physician-dispensed channel. Our
strategic partners in Japanhave
engaged in aggressive direct to consumer advertising, which we believe has
raised consumer demand in Japan which creates greater brand awareness in the
physician channel to the benefit of our core prescription lines. During the year
ended December 31, 2008, these separate distribution channels in Japan
generated approximately $4.8 million in net sales through the payment of
license fees for us.





We will continue to look for credible
partners to address new geographies, and to evaluate alternative channel
opportunities in other countries to drive brand awareness and accelerate overall
market penetration.





Manufacturing





We believe our manufacturing
processes provide us with a competitive advantage, which we have
developed through years of experience formulating skin care products. We
maintain manufacturing scalability and flexibility by maintaining manufacturing
with five qualified contract manufacturers. For all of our proprietary product
concepts, we also own the related manufacturing processes, methods and
formulations. In the fourth quarter of 2005, we invested in our own
manufacturing facility in order to develop the ability to manage and protect the
manufacturing process with respect to certain of our new product pipeline
concepts. Currently, we plan to use this facility solely for the purpose of
smaller scale product manufacturing in connection with new product technologies
and smaller market introduction quantities. We currently perform part of the
manufacturing process for the CLENZIderm M.D. system and SoluCLENZ Rx Gel in
this facility. This facility will allow us to protect intellectual property
related to our products in the initial stages unless and until we believe we can
transfer such know-how to third-party manufacturers with full protection of
related intellectual property.





We use only FDA compliant manufacturers
who specialize in the manufacture of prescription and OTC pharmaceutical and/or
cosmetic products. These parties manufacture products pursuant to our
specifications. All of these manufacturers are required by law and by our
manufacturing standards to comply with current Good Manufacturing Practice
("cGMP"). We pre-qualify and continually monitor our manufacturers for quality
and compliance. We also require documentation of compliance and quality from
those manufacturers that we act as representative for in connection with the
promotion and sale of their products. For most of our key products, we have two
or more qualified manufacturers. Certain products, including some of our sun
protection products, are supplied by a single source. We have one supplier for
our Healthy Skin Protection and Sun Block sunscreen products. That supply
arrangement can be terminated at any time, and there is no guarantee that we
could replace the aesthetic qualities or exact formulation of those sun screen
products.





In addition, since physicians can
and in many cases do write a prescription for tretinoin to be filled by a
pharmacy in conjunction with our Obagi Nu-Derm System, we also purchase
tretinoin directly from Triax in order to provide physicians the option of
dispensing tretinoin directly from the office along with the Obagi products.
These products are currently purchased under a five year product supply
agreement, entered into in December 2005, which also provides Obagi with the
right to develop Obagi branded product offerings.  Our Rosaclear System
contains prescription metronidazole, the generic equivalent of Metrogel, which
we purchase from a third party branded with our name.


13




Intellectual
Property





Our success depends in part on our
ability to obtain and maintain proprietary protection for our product
candidates, technology and know-how, to operate without infringing the
proprietary rights of others and to prevent others from infringing our
proprietary rights. Our policy is to seek to protect our proprietary position
by, among other methods, filing United States and foreign patent applications
related to our proprietary technology, inventions and improvements that are
important to the development of our business. We also rely on trade secrets,
know-how, continuing technological innovation and in-licensing opportunities to
develop and maintain our proprietary position.





We have pursued an aggressive trademark
registration policy as a means to achieve brand recognition and product
differentiation in the market. We own various U.S. and foreign trademark
registrations and applications and common law marks. In connection with
developing new products and product applications, we have filed over 40 U.S.
provisional and non-provisional patent applications since 2004.





We have also licensed certain patent
applications owned by JR covering our ELASTIderm system, CLENZIderm system and
SoluCLENZ Rx Gel. We have relied on services provided by JR in the development
of new products to address acne and skin elasticity products, under a five-year
contract that expires in 2010. We also have licensed the rights to four patents
owned by Avon Products, Inc. ("Avon"), one of which expired in 2008 while
the remaining three expire between 2013 and 2018, covering methods and
formulations for stabilizing Vitamin C in a serum for facial skin benefits,
which is in our Obagi-C Rx C-Clarifying serum, Professional-C 5% serum,
Professional-C 10% serum, Professional-C 15% serum and Professional-C 20% serum.
We entered into the license with Avon in June 2003, for an initial three-year
term, and the license is renewed year to year thereafter, at our option, through
the life of the last patent to expire.





We have acquired rights to market,
distribute, sell and, in some cases, make products pursuant to license
agreements with third parties. Such agreements contain provisions which require
us to meet requirements under these agreements, such as quantity purchase,
payment or royalty obligations, in order to maintain the rights granted under
the agreements.





Certain
Material Agreements





Triax





Under a product supply agreement with
Triax, entered into on December 8, 2005, we have exclusive rights to sell
certain tretinoin products in 0.1%, 0.05% and 0.025% concentrations in the
physician-dispensed skin care channel in the United States (including all
territories of the United States). If we do not purchase a minimum number of
units of products each year in any combination of concentrations, we will lose
our exclusive selling rights in the United States. During the years ended
December 31, 2008 and 2007, we met the minimum purchase requirements. Under
the terms of the agreement, we are required to pay Triax a fixed price for the
products, subject to volume discounts we may receive if we purchase a certain
number of products and those products are sold to our customers within a
specified period of time. These volume discounts are based on calendar year
performance and applied to cumulative quarterly purchases. The initial term of
our agreement is five years, with an automatic renewal for a successive five
year term unless written notice is provided by either party at least
120 days before the end of the current term. Each party has the right to
terminate the agreement upon  prior written notice in the case of
material breach and failure to take action to cure such a breach within a
specified period. Each party also has the option to terminate the agreement by
written notice if the other party ceases to carry on its business or becomes the
subject of anyproceeding under
state or federal law for the relief of debtors or otherwise becomes insolvent,
bankrupt or makes an assignment for the benefit of creditors, or upon the
appointment of a receiver for the other party or the reorganization of the other
party for the benefit of creditors.





Jose
Ramirez and JR





Pursuant to a consultant services and
confidentiality agreement with Jose Ramirez and JR ("JR Agreement"), we have
hired JR to perform research and development activities including product
formulation, product development and regulatory work, as detailed in various
statements of work. Under the terms of the agreement, JR must assign or license
to us all rights, title and interests to any and all inventions made during JR's
engagement with us or during the one year period thereafter if such inventions
involve or are related to our actual or anticipated research or development, or
incorporate or are based on any of our confidential information or ideas. We
agreed to pay JR a minimum annual fee per year for five years plus reasonable
and customary expenses incurred at our request in connection with the provision
of such services, commencing on January 1, 2005, for this product
formulation, product development and regulatory work. We also agreed to pay a
tiered royalty for successful commercialization of products developed or
identified by JR based on annual net sales, with a maximum royalty paid per
product, subject to an annual cap.  We have negotiated a separate
royalty arrangement for sales of our bi-mineral complex with
Rohto.  Pursuant to our arrangement with Rohto, in December 2008, we
amended the JR Agreement to modify the royalty rates paid to JR based on Rohto's
sales of products containing the bi-mineral technology.  We have a right of
first refusal for the exclusive license of any and all of JR's inventions
related to skin healthcare that are developed or reduced to practice by JR
during the term of the agreement, but not
in connection with certain service activities documented in the agreement or
certain various statements of work, that are not assignable to us under the
terms of the agreement. We would pay a royalty fee for any such exclusive
licenses.


14




The initial term of the agreement is
five years, which began in January 2005, and may be extended for up to two,
one-year renewable terms with the mutual written agreement of each party within
a certain number of days prior to the expiration of the then-current term.
We have the right to terminate the agreement at any time in our sole discretion
with written notice by exercising an option to buy-out JR's remaining service
obligation for the then-current term. In our sole discretion, we may pay for the
buy-out option with our stock or a combination of stock and cash at a fair
market valuation. We have the right to terminate the agreement, without
triggering the buy-out option, upon written notice for any violation by JR of
this agreement, unless JR is able to cure such violation within such 30 day
period. We also have the right to immediately terminate the agreement, without
triggering the buy-out option, if JR is convicted of a felony or other crime
involving material harm to our standing or reputation, for JR's nonfeasance or
willful misconduct, for conduct that brings us into public disgrace or
disrepute, or for continuous inattentiveness to JR's duties after written notice
of the same. If we exercise our right to terminate the agreement, all of our
obligations to JR, except for royalty obligations, shall cease
immediately.





To date, pursuant to this agreement, we
have several patents pending or issued that cover novel methods and
formulations for the treatment of acne, which we are using as the basis for our
new acne system marketed under the CLENZIderm M.D. brand, including the first
product launched in February 2007 and SoluCLENZ launched in August 2008. We have
also licensed three pending patent applications dealing with composition of
matter, wound healing and method of anti-aging treatment, which we are using as
the basis for our new ELASTIderm products and System.





Avon





Under a license agreement with Avon,
dated June 26, 2003, we have an exclusive worldwide license to manufacture
and sell skin care products containing an ascorbic acid component directly to
physiciansand medical spas. Under
the terms of the agreement, we also have a non-exclusive license to manufacture
and sell such products directly to drug stores outside of the United States. We
paid Avon a non-refundable license issue fee.  Additionally, we pay a
non-refundable annual renewal fee. The original term of the agreement expired in
2006 and we have continued to annually renew the agreement each year since that
time.  Our annual option to renew the agreement survives until the
last of the licensed patents expires on September 10, 2018. Each party, at
its option, may terminate the agreement upon prior written notice in the case of
default in the performance of any obligation under the agreement by the other
party and failure to take action to cure such a default within a specified
period. If we become bankrupt or insolvent, or file a petition for
bankruptcy, or if our business is placed in the hands of a receiver, assignee or
trustee from which we cannot extract ourselves within 120 days, or if we
are liquidated or substantially all of our assets or shares are sold, exchanged
or transferred, or in the event of a merger or consolidation to which we are a
party and to which Avon reasonably objects, the agreement shall immediately
terminate without notice.





Rohto





On
September 13, 2002, we entered into a strategic licensing agreement with Rohto
Pharmaceutical Co., Ltd. ("Rohto"). Rohto is a Japanese pharmaceutical
manufacturer and distributor. Under the agreement, Rohto is licensed to
manufacture and sell a series of over-the-counter (“OTC”) products under the
Obagi brand name, including Obagi-C (a Vitamin C based topical serum in various
concentrations), in the Japanese drug store channel and the Company receives a
royalty based upon sales of Obagi branded products in Japan by Rohto. The
Company also has other licensing arrangements in Japan to market and sell OTC
product systems under the Obagi brand, both for in-office use in facial
procedures, as well as for sale as a take-home product kit in the spa
channel.





On
December 4, 2008, the Company entered into an amendment (the “Amendment”) to the
original agreement with Rohto.  The Amendment extends the term of
agreement to December 4, 2017 and amends the Territory (as defined) to
areas outside Japan, subject to separate written agreement(s) to be
developed.  The Channel (as defined) has been expanded to include
department stores, including mail-order and internet activities to support such
expansion, provided that the parties complete a joint development
plan.  The parties have also agreed to work together to up-brand the
Obagi products sold in the various channels and work cooperatively on messaging,
branding and product imaging.  Under the Amendment, the Company has
also agreed to provide an exclusive royalty bearing license to sell and/or
manufacture certain products developed by the Company, Rohto or jointly
developed by the Company and Rohto.





On
December 4, 2008, OMP and Rohto entered into a License and Supply Agreement (the
"Bi-mineral Agreement") whereby the Company granted Rohto an exclusive right to
manufacture, market and sell the Company’s bi-mineral Collagen and Elastin
enhancing products in all channels (other than the aesthetic and spa channels)
in Japan.  Rohto also has the right to develop improvements to such
products or new products related to the products.  The initial term of
the Bi-mineral Agreement is for five years, through December 4, 2013, with an
optional five year extension and calls for certain annual sales volume and
expense commitments on behalf of Rohto.   If such commitments are
not met, the Company shall have the right to terminate the Agreement or render
it non-exclusive.


15


As
consideration for the exclusive license, Rohto shall pay a development
fee  to the Company in equal installments over a five-year period as
well as quarterly royalty fees based on product sales.  If this
Agreement should be terminated by either party before all five installments of
the development fee have been paid or even in the event of early termination,
then any unpaid installments will become due and payable to the Company ten days
before the effective termination date.  The royalty rate is scaled
over the term of the Agreement.





Cellogique





On
November 10, 2005, we entered into a new Distribution Agreement with
Cellogique Corporation (“Cellogique”) effective January 1, 2006. The agreement
granted Cellogique the exclusive right to promote, market, sell, distribute and
sub-distribute certain specified products to customers within the Middle East.
The agreement includes discounts off of the distributors' base price based on
volume purchases, and certain advertising and promotional activities. Such
discounts may at times be a significant percentage off the distributors' base
price listing. The agreement is for a term of 12 years.





Ventiv





In July 2008, we entered into a service
agreement with Ventiv Commercial Services, LLC (“Ventiv”).  Pursuant
to the agreement, Ventiv is to provide us with 20 field sales representatives
who are to market, sell and distribute SoluCLENZ product, including samples and
literature.  Ventiv is to provide all administrative support and
oversight of the 20 field sales representatives.  We agreed to pay an
up front base fee and escalating fixed monthly fees over the two year period of
the contract.  The agreement may be renewed for additional one year
periods upon written agreement of both parties to be executed at least 90 days
prior to the end of the term.  If the agreement is terminated, we may
be liable for the entire amounts remaining under the agreement, unless
termination for specified reasons, in which case we may be liable for only up to
two months of fixed fees.  In addition, we may be liable for any
remaining payment obligations for early termination of equipment leased by
Ventiv and provided to the 20 field sales representatives, subject to Ventiv’s
obligation to mitigate such fixed fees by redeploying such equipment into the
field under other contractual arrangements.   In October 2008, we
entered into an amendment to the agreement with Ventiv whereby they prepare
certain managed care and third party payer reimbursement analysis for
us.    This agreement ends on April 1, 2009 unless we choose
to extend it.  If we choose to terminate this agreement early, we are
obligated to pay Ventiv one-month’s worth of service fees.





Competition





The market for skin health and
restoration is highly competitive with many established manufacturers, suppliers
and distributors engaged in all phases of the business. We believe that we face
strong competition. Competitive factors in our market include:





§
            product
      efficacy and uniqueness;





§
            brand
      awareness and recognition;





§
            product
      quality, reliability of performance and convenience of
  use;





§
            cost-effectiveness;





§
            breadth
      of product offerings;





§
            sales
      and marketing capabilities and methods of
  distribution;





§
            resources
      devoted to product education and technical support;
  and





§
            speed
      of introducing new competitive products and existing product
      upgrades.





We face and will continue to face
intense competition. A number of our competitors have greater research and
development and marketing capabilities and greater financial resources than we
do. These competitors may have developed, or could in the future develop, new
technologies that compete with our products or render our products obsolete. We
are also likely to encounter increased competition as we enter new markets and
as we attempt to further penetrate existing markets. Some of our competitors
have in the past and may in the future compete by lowering prices on their
products. We may respond by lowering our prices, exiting the market or competing
by investing in the development of new, improved products.





We believe our direct competitors in
the physician-dispensed skin care channel include BioMedic from La-Roche Posay,
TNS from SkinMedica, Inc., Kinerase from Valeant Pharmaceuticals
International, various products from SkinCeuticals, a division of
L'Oreal S.A., M.D. Forté and Clinique Medical and PREVAGE from
Allergan, Inc., Vitamin C and various products from IS Clinical, and Neova
from PhotoMedex, Inc.


16





We believe our indirect competitors
which generally sell skin care products directly to consumers consist of large
cosmetic companies, including but not limited to The Estee Lauder
Companies Inc., Helene Curtis Industries, Inc., L'Oreal S.A.,
Matrix Essentials, Inc., a division of L'Oreal, Procter & Gamble
Company, Neutrogena, a division of Johnson & Johnson, Revlon, Inc.
and Unilever N.V.





Our acne products compete with Triaz
from Medicis Pharmaceutical Corporation, Benzaclin from Dermik
Laboratories, Inc., Brevoxyl and Duac from Stiefel Laboratories Inc.,
and Benzac from GaldermaLaboratories, L.P. Our acne products also indirectly compete with OTC
anti-acne products.





Our elasticity products have
demonstrated clinical evidence of aiding the restoration of elasticity and
mature elastin in aged skin. We currently know of no other products which have
clinical evidence to support this claim. However, there are several products
which claim to enhance elastin.





Our products also compete with current
and future medical devices, such as lasers, which are or will be positioned for
a variety of skin enhancements such as facial rejuvenation, dermal thickening,
acne and other uses. However, we believe, when used as a pre/post treatment, our
Obagi Systems are complementary to many of these procedures.





Government
Regulation





Federal, state and local governmental
authorities in the United States and other countries regulate, among other
things, the testing, production, distribution, advertising promotion and sale of
prescription and OTC drugs and cosmetics. In the United States, the FDA, acting
under the Food Drug and Cosmetic Act (“FDCA”), and other federal
statutes (including the Public Health Service Act, Administrative Procedure Act,
Federal Trade Commission Act, Fair Packaging and Labeling Act, Lanham Act and
Homeland Security Act) and agencies implementing regulations, regulate
our products primarily on the basis of their intended use, as determined by
the labeling claims or other representations made for the product.





FDA
regulation of cosmetics





The FDCA defines cosmetics as products
and their components intended to be rubbed, poured, sprinkled, or sprayed on,
introduced into, or otherwise applied to the human body or any part thereof for
cleansing, beautifying, promoting attractiveness, or altering the appearance.
Cosmetic products are not subject to FDA pre-market approval authority, although
the FDA can take enforcement action under the Code of Federal Regulations
(“CFR”) for marketed cosmetic products that are adulterated or misbranded,
including violations of product safety requirements, use and quantity of
ingredients, labeling and promotion and methods of manufacture. Additionally,
the FDA monitors compliance of cosmetic products through random inspections of
cosmetic company websites, importers, manufacturers and distributors. The
labeling of cosmetic products is subject to the requirements of the FDCA, the
Fair Packaging and Labeling Act and other FDA regulations.





We believe that many of our products in
the Obagi Nu-Derm, Obagi Condition & Enhance, Obagi-C Rx, Obagi
Professional-C, ELASTIderm (including the Décolletage System), CLENZIderm M.D.,
Obagi Rosaclear System and other product lines, as labeled and intended for use,
fall within the FDA definition of cosmetics and therefore do not require
pre-market review and approval. Cosmetics may be sold both over the counter and
through a physician's office, subject to state laws governing the commercial
practices of physicians.





FDA
regulation of drug products





The FDCA defines drugs as products
intended to cure, mitigate, treat or prevent a disease or to affect the
structure or any function of the human body. Drug products are subject to more
comprehensive safety and effectiveness requirements of the FDCA and its
implementing regulations. In general, products falling within the FDCA's
definition of "new drugs" require pre-marketing clearance by the FDA. Products
falling within the FDCA's definition of "drugs" that are not "new drugs" and
that are generally recognized as "safe and effective" for the indication for
which they are being marketed generally do not require pre-market review and
approval from the FDA. Such drug products are commonly commercialized under the
FDA Compliance Policy Guide entitled "Marketed New Drugs Without Approved New
Drug Applications or Abbreviated New Drug Applications" and are subject to
compliance with FDA regulations concerning manufacture, labeling, distribution,
and recordkeeping for drug products.





FDA regulation of "new drug"
products





The steps required before a "new drug"
may be marketed in the United States include (i) pre-clinical laboratory
and animal testing, (ii) submission to the FDA of an Investigational New
Drug ("IND"), application which must become effective before clinical trials may
commence, (iii) adequate and well-controlled clinical trials to establish
the


17


safety
and efficacy of the drug, (iv) submission to the FDA of a New Drug
Application ("NDA"), and (v) FDA approval of the NDA prior to any
commercial sale or shipment of the drug. An Abbreviated New Drug Application
("ANDA"), is required to be submitted and approved when the drug product
intended for commercialization is bioequivalent to an already approved NDA
product; an ANDA application does not need to repeat the clinical trials that
were required for approval of the NDA, or reference listed drug. In addition to
obtaining FDA approval for each product, each domestic drug-manufacturing
establishment must be registered with the FDA. Drug product manufacturing
establishments located in California also must be licensed by the State of
California in compliance with separate regulatory requirements.





Pre-clinical testing is generally
conducted on laboratory animals to evaluate the potential safety and the
efficacy of a drug. The results of these studies are submitted to the FDA as a
part of an IND, which must be approved before clinical trials in humans can
begin. Typically, clinical evaluation involves a time consuming and costly
three-phase process. In Phase I, clinical trials are conducted with a small
number of subjects to determine the early safety profile, the pattern of drug
distribution and metabolism. In Phase II, clinical trials are conducted
with groups of patients afflicted with a specific disease to determine
preliminary efficacy, optimal dosages and expanded evidence of safety. In
Phase III, large-scale, multi-center, comparative trials are conducted with
patients afflicted with a target disease to provide sufficient data to
demonstrate the efficacy and safety required by the FDA. The FDA closely
monitors the progress of each of the three phases of clinical trials and may, at
its discretion, re-evaluate, alter, suspend or terminate the testing based upon
the data that have been accumulated to that point and its assessment of the
risk/benefit ratio to the patient.





We in
license two ANDA products; tretinoin and metronidazole prescription drug product
offerings which are licensed from and/or supplied by Triax and a third
party, respectively, each of which holds FDA approval of ANDAs for those
products.





FDA
Drug Efficacy Study Implementation





The DESI
was a program begun by FDA in 1962 after the requirement that all drugs be
efficacious as well as safe.  The DESI program was intended to
classify all pre-1962 drugs that were already on the market as either effective,
ineffective, or needing further study.   The DESI evaluated over
3000 separate products and over 16,000 therapeutic claims. By 1984, final action
had been completed on 3,443 products; of these, 2,225 were found to be
effective, 1,051 were found not effective, and 167 were pending.  One
of the early effects of the DESI study was the development of the
ANDA.





We market
a number of sunscreen products that are regulated by the FDA as OTC drug
products subject to an FDA final monograph but not requiring FDA pre-market
review or approval. We also market a number of products containing 4%
hydroquinone that we believe are not "new drug" products and that are generally
recognized as safe and effective for the indications for which they are being
marketed. We also market a number of products containing 4% hydroquinone that
are currently not subject to FDA pre-market approval. In August 2006, the FDA
issued a proposed rule that stated that OTC skin bleaching products containing
hydroquinone and currently marketed outside the physician channel at 2%
concentrations or less, were not generally recognized as safe and effective,
were misbranded, and are new drugs within the meaning of the FDCA. The FDA
proposed that because of the carcinogenic and ochronosis potential of
hydroquinone, its use in skin bleaching drug products should be restricted to
prescription use only, and users of such products should be closely monitored
under medical supervision. The FDA also withdrew a tentative proposed monograph
that concluded that hydroquinone products were generally recognized as safe and
effective and stated its intent to require New Drug Application approval for
continued marketing of prescription hydroquinone products at the time of
publication of the final rule. It is our understanding that the FDA is no longer
evaluating this proposal and is not intending to take any action with respect to
the regulation of products containing 4% hydroquinone at the present
time.  Finally, our tretinoin and metronidazole prescription drug
product offerings are licensed from and/or supplied by Triax and a third party,
respectively, each of which holds FDA approval of ANDAs for those
products.





The
OTC Monograph System





While FDA approval is generally
required before a new drug product may be marketed in the U.S., many OTC drugs
are exempt from the FDA's pre-marketing approval requirements. In 1972, the FDA
instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness
of OTC drug ingredients in the market. Through this process, the FDA issues
monographs for therapeutic product categories that set forth the specific active
ingredients, dosages, strengths, indications for use, warningsand labeling statements for OTC drug
ingredients that the FDA will consider generally recognized as safe and
effective for OTC use and therefore not subject to pre-market
approval.





OTC drug ingredients are classified by
the FDA in one of three categories: Category I ingredients which are deemed
generally recognized as "safe and effective and not misbranded" for OTC use;
Category II ingredients which are deemed "not generally recognized as safe
and effective or would result in misbranding" for OTC use; and Category III
ingredients which are those for which "available data is insufficient" to
classify them in Category I or II. Based upon the results of ongoing
studies, the FDA may reclassify all Category III ingredients as
Category I or Category II ingredients.





For most categories of OTC drugs not
yet subject to a final monograph, the FDA usually permits such drugs to continue
to be marketed until a final monograph becomes effective, unless the drug will
pose a potential health hazard to consumers. The FDA's policy also generally
applies to prescription drugs containing the same active


18


ingredients
as a marketed OTC product for the same or similar uses as the OTC
product.





Drugs subject to final monographs, as
well as drugs that are subject only to proposed monographs, are subject to
various FDA regulations concerning, for example, manufacturing in accordance
with cGMPs, general and specific labeling requirements and prohibitions against
promotion for conditions other than those stated in the labeling. Drug
manufacturing facilities are subject to FDA inspection, and failure to comply
with applicable regulatory requirements may lead to administrative or judicially
imposed penalties. State agencies also may require registration, licensure and
inspection of manufacturing or distribution facilities and may require reporting
of promotional activities.





We market a number of OTC products
under the following monographs: Sunscreen, Acne, Skin Bleaching, Skin
Protectant, External Analgesic and Topical Antibiotic.  Our
monographed products are regulated by the FDA as OTC drugs are subject to an FDA
final monograph but do not requiring FDA pre-market review or
approval.





FDA
Enforcement Discretion for Marketed Unapproved Drug Products





The Obagi Nu-Derm Clear, Blender and
Sunfader products and the Obagi-C Rx C-Clarifying Serum, C-Night Therapy and
Décolletage Skin Lightening Complex, products contain the active ingredient
hydroquinone at a 4% concentration and are marketed as prescription drugs under
the FDA Compliance Policy Guide ("CPG"), entitled Marketed New Drugs Without
Approved New Drug Applications or Abbreviated New Drug Applications. These
hydroquinone products must be administered under the supervision of a physician
but are not subject to prior FDA approval when formulated and labeled in
accordance with guidelines for prescriber information under direction of a
physician. 4% Hydroquinone is known as a DESI II drug, as its active ingredient
was marketed prior to FDA's 1962 institution of drug effectiveness requirements.
To date, the FDA has not required NDA approval for the continued marketing of
hydroquinone. In its August 2006 proposed rule, regarding OTC hydroquinone, the
FDA indicated its intent to require NDA approval for prescription 4%
hydroquinone products. See "Risks Related to Regulatory Matters," and "FDA
Regulation of Drug Products." It is our understanding that the FDA is no longer
evaluating this proposal and is not intending to take any action with respect to
the regulation of products containing 4% hydroquinone at the present
time.  However, if the FDA does change the status of 4% hydroquinone
to require an NDA, and if the FDA does not allow us to continue to market our
products while we attempt to comply with such new requirement as imposed, or if
the FDA does not approve an NDA filed by us or a third party for 4% hydroquinone
drug product, then we will no longer be able to rely on the CPG to market our
Obagi Nu-Derm, Obagi-C Rx and Décolletage Systems containing hydroquinone. FDA
approval of a 4% hydroquinone drug product under an NDA filed by another party
may adversely affect our ability to continue to market our products under the
CPG.





FDA
Regulation of Drug Manufacturing





We and the third-party manufacturers on
which we rely for the manufacture of our products are subject to requirements
under 21CFR parts 210 and 211 that drugs be manufactured, packaged and labeled
in conformity with cGMPs. To comply with cGMPs, manufacturers must continue to
spend time, money and effort to meetrequirements relating to personnel, facilities, equipment, production and
process, labeling and packaging, quality control, recordkeeping and other
requirements. The FDA, state agencies and foreign Ministries of Health
periodically inspect drug manufacturing facilities to evaluate compliance with
cGMPs.




19





FDA
Regulation of Our Products and Product Candidates





The following table summarizes the
current status of the active ingredients in, FDA pre-marketing approval (if any)
required for, FDA regulatory category of, and launch date for our material
products and product candidates:




Product
                    Main
      Functioning or Active Ingredients(1)
                    FDA
      Pre-Marketing Approval Required
                    Product
      Status(2)
                    Date
      LaunchedObagi
      Nu-Derm Gentle Cleanser(3)
                    Mild
      Cleansers
                    No
                    Cosmetic
                    1988Obagi
      Nu-Derm Foaming Gel(3)
                    Mild
      Cleansers
                    No
                    Cosmetic
                    1988Obagi
      Nu-Derm Toner(3)
                    Hamamelis
      Virginiana (Witch Hazel) Distillate
                    No
                    Cosmetic
                    1988Obagi
      Nu-Derm Clear(3)
                    Hydroquinone
      4%
                    No
                    DESI
      II
                    1988Obagi
      Nu-Derm Exfoderm(3)
                    Phytic
      Acid
                    No
                    Cosmetic
                    1988Obagi
      Nu-Derm Exfoderm Forte(3)
                    Glycolic
      Acid, Lactic Acid
                    No
                    Cosmetic
                    1988Obagi
      Nu-Derm Blender(3)
                    Hydroquinone
      4%
                    No
                    DESI
      II
                    1988Obagi
      Nu-Derm Sun Block SPF 32(3)
                    Zinc
      Oxide 18.5%
                    No
                    OTC
                    2004Obagi
      Nu-Derm HSP SPF 35(3)
                    Octyl
      Methoxycinnamate 7.5%, Zinc Oxide 9.0%;
                    No
                    OTC
                    2002Obagi
      Nu-Derm Sunfader
                    Hydroquinone
      4% Octyl Methoxycinnamate 7.5%, Oxybenzone 5.5%
                    No
                    DESI
      II/OTC
                    1984Obagi
      Nu-Derm Eye Cream
                    Mild
      Moisturizers
                    No
                    Cosmetic
                    1984Obagi
      Nu-Derm Tolereen
                    Hydrocortisone
      0.5%
                    No
                    OTC
                    1988Obagi-C
      Rx C-Cleansing Gel
                    Mild
      Cleansers
                    No
                    Cosmetic
                    2004Obagi-C
      Rx C-Exfoliating Day Lotion
                    Glycolic
      Acid
                    No
                    Cosmetic
                    2004Obagi-C
      Rx C-Clarifying Serum
                    Hydroquinone
      4%
                    No
                    DESI
      II
                    2004Obagi-C
      Rx C-Therapy Night Cream
                    Hydroquinone
      4%
                    No
                    DESI
      II
                    2004Obagi-C
      Rx C-Sunguard SPF 30
                    Octyl
      Methoxycinnamate 7.5%, Zinc Oxide 9.0%
                    No
                    OTC
                    2004Obagi
      Professional-C Serum
                    L
      Ascorbic Acid (Vitamin C) 5% to 20% concentrations
                    No
                    Cosmetic
                    2005Obagi
      Nu-Derm Tretinoin(4)
                    Tretinoin
      0.025% to 0.1%
                    Yes
                    ANDA
                    2006Obagi
      CLENZIderm M.D. Daily Care Foaming Cleanser
                    Salicylic
      Acid 2%
                    No
                    OTC
                    Feb-07Obagi
      CLENZIderm M.D. Pore Therapy
                    Salicylic
      Acid 2%
                    No
                    OTC
                    Feb-07Obagi
      CLENZIderm M.D. Serum Gel
                    Benzoyl
      Peroxide 5%
                    No
                    OTC
                    Feb-07Obagi
      ELASTIderm Eye Cream
                    Mineral
      complexes
                    No
                    Cosmetic
                    2006Obagi
      ELASTIderm Eye Gel
                    Mineral
      complexes
                    No
                    Cosmetic
                    Feb-07Obagi
      CLENZIderm M.D. Therapeutic Lotion
                    Benzoyl
      Peroxide 5%
                    No
                    OTC
                    Jul-07Obagi
      CLENZIderm M.D. Therapeutic
                    Glyceryn
      20% Dimethieme 1%
                    No
                    OTC
                    Jul-07Obagi
      CLENZIderm M.D. Daily Care Cream Cleanser
                    Mild
      Cleansers
                    No
                    Cosmetic
                    Jul-07Obagi
      Decolletage Chest and Neck Akin Lightening Complex
                    Hydroquinone
      4%
                    No
                    DESI
      II
                    Jan-08Obagi
      Decolletage Chest and Neck Wrinkle Reducing Lotion
                    Mineral
      complexes
                    No
                    Cosmetic
                    Jan-08SoluCLENZ
      Rx Gel
                    Benzoyl
      Peroxide 5%
                    No
                    OTC
                    Aug-08Obagi
      Rosaclear Metronidazole(5)
                    Metronidazole
      Topical Gel USP, 0.75%
                    Yes
                    ANDA
                    Jan-09Obagi
      Rosaclear Hydrating Complexion Corrector
                    Titanium
      Dioxide
                    No
                    Cosmetic
                    Jan-09Obagi
      Rosaclear Gentle Cleanser
                    Mild
      Cleansers
                    No
                    Cosmetic
                    Jan-09Obagi
      Rosaclear Skin Balancing Sun Protection SPF 30
                    Zinc
      Oxide 15.5%, Titanium Dioxide 2.0%
                    No
                    OTC
                    Jan-09





(1)  By
definition, products classified as cosmetics do not have active ingredients. For
cosmetics, the main functioning ingredient is listed.





(2)  Product Status
Definitions:





OTC, or
Over-the-Counter, products are defined as products that are considered drugs by
the FDA, but that do not require physician prescription or
oversight.





DESI II
products are defined as products that are considered drugs that require
physician prescription, but are not subject to FDA pre-marketing approval as
they are generally recognized as safe and effective for their intended uses and
are commercialized under an FDA Compliance Policy Guide for marketed unapproved
drugs, which includes Drug Efficacy Study Indication, or DESI drugs. ANDA
products are defined as drugs that have received FDA approval under an
abbreviated new drug application; our only ANDA product requires physician
prescription.


20




Cosmetic
products are defined as products which are not considered drugs by the FDA, are
not allowed to make drug claims, and do not require FDA pre-marketing approval
or physician prescription or oversight.





(3)  These
products are also included in our Obagi Condition & Enhance System, which
was launched in 2006.





(4)  Obagi
Nu-Derm branded Tretinoin is manufactured by Triax under its ANDAs, and was
launched under the Obagi brand in 2006, however, we have been selling tretinoin
supplied by Triax under the Spear brand since 2003.





(5) Obagi
Rosaclear branded Metronidazole is manufactured by a third party under
its ANDA and was launched under the Obagi brand in 2008.





Federal
Regulation of Advertising and Promotion





The FDA regulates the advertisement of
prescription drug products. The U.S. Federal Trade Commission ("FTC"), Fair
Packaging and Labeling Act, and state authorities regulate the advertising of
OTC drugs and cosmetics, as well as exercise general authority to prevent unfair
or deceptive trade practices.





In addition to FDA restrictions on
marketing of prescription products, several other types of state and federal
laws have been applied to restrict certain marketing practices in the
pharmaceutical industry in recent years. These laws include anti-kickback
statutes and false claims statutes. The federal healthcare program anti-kickback
statute prohibits, among other things, knowingly and willfully offering, paying,
soliciting or receiving remuneration to induce or in return for purchasing,
leasing, ordering or arranging for the purchase, lease or order of any
healthcare item or service reimbursable under Medicare, Medicaid or other
federally financed healthcare programs. This statute has been interpreted to
apply to arrangements between pharmaceutical manufacturers on the one hand and
prescribers, purchasers and formulary managers on the other. Violations of the
anti-kickback statute are punishable by imprisonment, criminal fines, civil
monetary penalties and exclusion from participation in federal healthcare
programs. Although there are a number of statutory exemptions and regulatory
safe harbors protecting certain common activities from prosecution or other
regulatory sanctions, the exemptions and safe harbors are drawn narrowly, and
practices that involve remuneration intended to induce prescribing, purchases or
recommendations may be subject to scrutiny if they do not qualify for an
exemption or safe harbor.





Federal false claims laws prohibit any
person from knowingly presenting, or causing to be presented, a false claim for
payment to the federal government, or knowingly making, or causing to be made, a
false statement to have a false claim paid. Recently, several pharmaceutical and
other healthcare companies have been prosecuted under these laws for allegedly
inflating drug prices they report to pricing services, which in turn are used by
the government to set Medicare and Medicaid reimbursement rates, and for
allegedly providing free product to customers with the expectation that the
customers would bill federal programs for the product. In addition, certain
marketing practices, including off-label promotion, may also violate false
claims laws. The majority of states also have statutes or regulations similar to
the federal anti-kickback law and false claims laws, which apply to items and
services, reimbursed under Medicaid and other state programs, or, in several
states, apply regardless of the payer.





Also, as part of the sales and
marketing process, pharmaceutical companies frequently provide samples of
approved drugs to physicians. This practice is overseen by the FDA, state and
other governmental authorities under the Prescription Drug Marketing Act and
regulations that include requirements concerning record keeping and control
procedures.





Certain states, including California, have also recently begun regulating the
promotion of prescription drug products and require compliance with annual
certification and disclosure requirements regarding our policies for drug
promotion and the amount of money we spend per prescribing physician on drug
promotion. Compliance with changing federal and state laws and regulations on
prescription product promotion requires a great deal of time and
effort.





Other
Government Regulation





We and our suppliers or third-party
manufacturers may also be subject to regulations under other federal, state, and
local laws, including the Occupational Safety and Health Act, the Environmental
Protection Act, the Clean Air Act and import, export and customs regulations as
well as the laws and regulations of other countries.





Employees





As of December 31, 2008, we had
218 employees, of whom all except three, were located in the United States. Our
employees include 157 in sales and marketing, 32 in product development,
manufacturing and distribution and 29 in administrative functions. Our sales and
marketing employees include a 20 person contracted sales force hired to support
the launch of SoluCLENZ.  Our employees are all non-unionized, and we
believe our relations with our employees are good.


21


ITEM
1A:    RISK FACTORS





An investment in our common stock
involves a high degree of risk. You should consider carefully the following
risks and other information contained in this Annual Report on Form 10-K
before you decide whether to buy our common stock. If any of the events
contemplated by the following discussion of risks should occur, our business,
results of operations and financial condition could suffer significantly. As a
result, the market price of our common stock could decline, and you may lose all
or part of the money you paid to buy our common stock.





Risks
Related to Our Business





Our
sales and profitability may suffer if the current economic downturn in any of
our major markets inhibits people from spending their disposable income on
aesthetic and skin health products.





Virtually
all of our products are purchased based on consumer choice due to the fact that
all of our products are considered cosmetic in nature. As a result, they
are typically paid directly by the patient out of disposable income and are not
subject to reimbursement by third-party payors such as health insurance
organizations. Adverse changes in the economy or the development of economic
uncertainties could accordingly have a significant negative effect on consumer
spending for these products.  If consumers reassess their spending
choices, the demand for these products could decline
significantly.  If demand declines significantly in our major markets,
such as North America, the Pacific Rim and the Middle East, it would have a
material adverse effect on our sales and profitability and could lead to a
decline in our stock price.





Furthermore,
if we are unable to successfully sell our products against competitive products
or if consumer preferences in the marketplace shift to less costly alternative
treatments, we may experience a decline in demand for our products, which could
also have a material adverse effect on our sales and profitability.





Recent
economic trends could adversely affect our financial performance and stock
price.





As widely
reported, the global financial markets have been experiencing extreme disruption
in recent months, including severely diminished liquidity and credit
availability.  Concurrently, economic weakness has begun to accelerate
globally.  We believe these conditions have not materially impacted
our financial position as of December 31, 2008 or liquidity for the year ended
December 31, 2008.  However, we could be negatively impacted if either
of these conditions exists for a sustained period of time, or if there is
further deterioration in financial markets and major global
economies.  The economic downturn has also resulted in increased
downward pressure on stock prices generally, including our own which are
unrelated to financial performance.





The
credit crisis could negatively impact our cash flow and that of our customers
and suppliers.




We have
maintained a positive operating cash flow in each year since 2001, and we
believe that the net cash provided by operating activities, existing cash and
equivalents and amounts available under our Revolving Credit Agreement (the
“Facility”) entered into in November 2008 with Comerica Bank, will provide us
with sufficient resources to meet our expected working capital requirements and
other cash needs for the foreseeable future.  However, the current
uncertainty in the global economic conditions resulting from the recent
disruption in credit markets pose a risk to the overall economy that could
impact demand for our products, reduce sales, create pressure for us to lower
our prices, delay product launches or discontinue the sales of certain of our
products.   This could force us to use cash on hand and draw down
on our Facility.  Doing so would impact our ability to in-license new
technologies, develop future products or expand our pipeline of products, all of
which would have an adverse effect on our ability to grow our business and
remain competitive in our marketplace.





Furthermore,
the economic downturn and current tightening of credit in financial markets may
result in continued declines in consumption and consumer spending in our
markets.  These conditions may adversely affect the cash flow
positions and ability of our suppliers and third party contract manufacturers to
obtain financing for significant purchases and operations.  This could
result in the inability of us to obtain product from our manufacturers on a
timely basis and may result in a decrease in, or cancellation of, orders for our
products.   In addition, the economic downturn may also
affect levels of our customers’ cash flow, impacting their ability to
sell our products into the consumer marketplace and our competitors' cash flow
and credit availability, making it difficult or impossible for us to out-license
technologies or products.  We are unable to predict the likely
duration and severity of the current disruption in the global financial markets
or its impact on our ability to manufacture and sell our products.





Since
certain third party payors do not currently reimburse patients for SoluCLENZ,
sales for the product have suffered to date and have affected the success of the
launch of that product.




Our
commercial success of SoluCLENZ depends in part on physicians’ willingness
to prescribe the product based on the availability to patients of reimbursement
from third-party payors, such as Medicare, Medicaid and private insurance
companies.  These third-party payors frequently challenge the pricing
of new drugs where they believe generic equivalents are available or that are
not included on one of the three standard formulary lists.  Currently,
one of the three major reimbursement compendiums does not permit reimbursement
of SoluCLENZ and our sales have suffered as a result.  To the extent
that certain patients continue to be unable to obtain reimbursement for
SoluCLENZ based on
the availability of a generic equivalent, future sales will continue to be
impacted, and we may discontinue selling SoluCLENZ into the pharmacy Rx channel,
which would result in possible discontinuation costs of approximately $0.5
million to $1.5 million in expenses related to the write-down of inventory and
early termination of contracts.


22





Our
revenues and financial results depend significantly on sales of our Obagi
Nu-Derm System. If we are unable to manufacture or sell our Obagi Nu-Derm System
in sufficient quantities and in a timely manner, or maintain physician and/or
patient acceptance of our Obagi Nu-Derm System, our business will be materially
and adversely impacted.





To date, substantially all of our
revenues have resulted from sales of our principal product line, our Obagi
Nu-Derm System and related products. Our Obagi Nu-Derm System and related
products accounted for approximately 56%, 61% and 69% of our net sales for the
year ended December 31, 2008, 2007 and 2006, respectively. Although we have
introduced new products such as Obagi-C Rx, ELASTIderm, CLENZIderm, SoluCLENZ
and Rosaclear and we intend to introduce additional products, we still expect
sales of our Obagi Nu-Derm System and related products to account for a
significant majority of our sales for the foreseeable future. Because our
business is highly dependent on our Obagi Nu-Derm System and related products,
factors adversely affecting the pricing of, or demand for, these products could
have a material and adverse effect on our business. Our Obagi Nu-Derm Systems
also experience seasonality. We believe this is due to variability in patient
compliance that relates to several factors such as a tendency to travel and/or
engage in other disruptive activities during the summer months. Additionally,
our commercial success depends in large part on our ability to sustain market
acceptance of our Obagi Nu-Derm System. If existing users of our products
determine that our products do not satisfy their requirements, or if our
competitors develop a product that is perceived by patients or physicians to
better satisfy their respective requirements, sales of our Obagi Nu-Derm System
and related products may decline, and our total net sales may correspondingly
decline. We cannot assure you that we will be able to continue to manufacture
these products in commercial quantities atacceptable costs. Our inability to do
so would adversely affect our operating results and cause our business to
suffer.





We
face intense competition, in some cases from companies that have significantly
greater resources than we do, which could limit our ability to generate
sales.





The market for aesthetic and
therapeutic skin health products is highly competitive and we expect the
intensity of competition to increase in the future. We also expect to encounter
increased competition as we enter new markets and as we attempt to penetrate
existing markets with new products. We may not be able to compete effectively in
these markets, we may face significant pricing pressure from our competitors and
we may lose market share to our competitors. Our principal competitors are
large, well-established companies in the fields of pharmaceuticals, medical
devices, cosmetics and health care. Our direct competitors include La-Roche
Posay, SkinMedica, Inc., Valeant Pharmaceuticals International,
SkinCeuticals, a division of L'Oreal S.A., Allergan, Inc., IS
Clinical, and PhotoMedex, Inc.





We believe our indirect competitors, who generally sell skin care products
directly to consumers, consist of large cosmetic companies, including but not
limited to, The Estee Lauder Companies Inc., Helene Curtis
Industries, Inc., L'Oreal S.A., Matrix Essentials, Inc., a
division of L'Oreal S.A, Procter & Gamble Company, Neutrogena, a
division of Johnson & Johnson, Revlon, Inc. and Unilever N.V.
We also face competition from medical device companies offering products used to
enhance the skin's appearance to physicians, such as Candela Corp., CoolTouch
Corporation, Cynosure, Inc., Lumenis Ltd., Reliant
Technologies, Inc., Syneron Medical Ltd. and
Thermage, Inc.





We
may not be able to successfully expand the use of our current product lines or
develop new products.





We are working to improve, extend and
reformulate many of our existing products. Continued market acceptance of our
products will depend on our ability to successfully develop additional
applications of our existing products. The development of additional
applications will require significant commitments of personnel and financial
resources and we cannot assure you that they will be successful. If the
attempted extensions of our product lines are not commercially successful, our
business will be adversely affected.





We are also developing new product
lines by applying our Penetrating Therapeutics technology to new agents. We also
have acquired rights to technologies described in certain patent applications
relating to additional methods and formulations. New products, in various stages
of development, include other applications for our acne and skin elasticity
products and other new systems. These development activities, as well as
clinical studies, which must be completed before these products can be marketed
and sold, will require significant commitments of personnel and financial
resources. We cannot assure you that we will be able to develop new products or
technologies in a timely manner, or at all. Delays in the development or testing
processes will cause a corresponding delay in revenue generation from those
products. Regardless of whether such new products or technologies are ever
released to the market, the expense of such processes, which may be
considerable, will have already been incurred and we may not be able to recover
such expenses.





We reevaluate our development efforts
regularly to assess whether our efforts to develop a particular new product or
technology
are progressing at a rate that justifies our continued expenditures. On the
basis of these reevaluations, we have abandoned in the past, and may abandon in
the future, our efforts on a particular product or technology. New products that
we develop may not be successfully commercialized. If we fail to take a product
or technology from the development stage to market on a timely basis, we may
incur significant expenses without a near-term financial return or any financial
return.


23





Our
failure to successfully in-license or acquire additional products and
technologies would impair our ability to grow.





We intend to in-license, acquire,
develop and market new products and technologies. Because we have limited
internal research capabilities, our business model depends in part on our
ability to license patents, products and/or technologies from third parties. The
success of this strategy also depends upon our ability and the ability of our
third-party formulators to formulate products under such licenses, as well as
our ability to manufacture, market and sell such licensed products.





We may not be able to successfully
identify any new products to in-license, acquire or internally develop.
Moreover, negotiating and implementing an economically viable acquisition is a
lengthy and complex process. Other companies, including those with substantially
greater financial, marketing and sales resources, may compete with us for the
acquisition of products. We may not be able to acquire or in-license the rights
to such products on terms that we find acceptable, or at all. As a result, our
ability to grow our business or increase our profits could be adversely
impacted.





Our
marketed products and our products under development could be rendered obsolete
by technological or medical advances.





Our marketed products and our products
under development may be rendered obsolete or uneconomical by the development of
medical advances to treat the conditions that our products are designed to
address. The treatment of skin conditions and the enhancement of the appearance
of skin, which is what all of our products target, are the subjects of active
research and development by many potential competitors, including major
pharmaceutical companies, such as Johnson & Johnson and Galderma,
specialized biotechnology firms, such as Allergan and Medicis, universities and
other research institutions. Competitive advances may also include the potential
development of new laser or radio frequency therapies being developed by
manufacturers such as Candela, Syneron and Thermage, aimed at treating
hyperpigmentation and photo-damaged skin. While we intend to expand our
technological capabilities to remain competitive, research and development by
others may render our technology or products obsolete or noncompetitive or
result in treatments superior to any therapy we develop, as our competitors may
develop and patent products which are better than ours, which could harm our
competitive position.





If
we lose key personnel or are unable to attract and retain other qualified
personnel, we may be unable to execute our business plan and our business would
be materially adversely affected.





As of December 31, 2008, we had
218 employees, which include a 20 person contracted sales force hired in
anticipation of the launch of SoluCLENZ. Our success depends on our continued
ability to attract, retain and motivate highly qualified management, business
development, sales and marketing, product development and other personnel. In
the future we may not be able to recruit and retain qualified personnel,
particularly for senior sales and marketing and research and product development
positions due to intense competition for personnel among businesses like ours,
and the failure to do so could have a significant negative impact on our future
product sales and business results. In addition, the majority of options granted
to employees have an option price greater than our current market
price.  This may hinder our ability to retain qualified personnel. Our
success depends in large part on the efforts and abilities of Steven Carlson,
our Chief Executive Officer, Preston Romm, our Chief Financial Officer, and
David Goldstein, our Executive Vice President of Sales, as well as other members
of our senior management team and our scientific and technical personnel,
including our third party formulators at JR. We may not be able to retain the
services of our officers. In addition, we do not have "key person" insurance
policies on any of our executive officers that would compensate us for the loss
of their services. If we lose the services of one or more of these individuals,
finding a replacement could be difficult, may take an extended period of time
and could significantly impede the achievement of our business objectives. This
may have a material adverse effect on our results of operations and financial
condition.





To
sustain our continued growth, we will need to increase the size of our
organization, and we may encounter difficulties managing our growth, which could
adversely affect our results of operations.





If we are able to successfully develop
additional products and extend the use of our current products, we may
experience growth in the number of our employees and the scope of our
operations. To the extent that we acquire and launch additional products, the
resulting growth and expansion of our sales force will place a significant
demand on our financial, managerial and operational resources. Since many of the
new products or systems we are working on may involve new technologies or
entering new markets, we may not be able to accurately forecast the number of
employees required and the timing of their hire or the associated cost. The
extent of any expansion we may experience will be driven largely by the success
of our new products and systems. As a result, management's ability to project
the size of any such expansion and its cost to the company is limited by the
following uncertainties: (i) we will not have previously sold any of the
new products and technologies and the ultimate success of these new products and
technologies is unknown; (ii) we will be entering new markets; and
(iii) the costs associated with any expansion will be partially driven by
factors that may not be fully in our control (e.g., timing of hire, market
salary rates). As of December 31, 2008, due to the uncertainties in the
economic markets, our current business plan does not anticipate that we hire
a


24


substantial
number of new employees in 2009.  However, since we are unable to ascertain
the length or severity of this market downturn, we could be in a position to
hire significant numbers of new employees on a relatively short time frame to
support the launch of new product lines or increases in sales by physicians once
the global markets begin to stabilize.  Due to the uncertainty
surrounding the timing of new product lines or the stabilization of the global
markets, our costs to hire significant numbers of new employees could be higher
than anticipated.  Our success will also depend on the ability of our
executive officers and senior management team to continue to implement and
improve our operational, information management and financial control systems,
particularly in light of our status as a public company subject to the reporting
requirements of the Securities Exchange Act of 1934, or the Exchange Act, and to
expand, train and manage our employee base. Our inability to manage growth
effectively could cause our operating costs to grow even faster than we are
currently anticipating and adversely affect our results of
operations.





Because
we have limited research and development capabilities, we will be dependent on
third parties to perform research and development for us.





We have limited internal research and
development capabilities and currently outsource all of our product research and
development to third-party research labs. In particular, we have licensed
technologies that may issue as patents under certain patent applications filed
by JR, and have relied heavily on services provided by JR in the development of
new products to address acne and skin elasticity. We have received sufficient
support from our third-party research labs to drive our current new product
development, and we expect to continue to rely on third parties to research and
develop new products.





There are a limited number of
third-party research and development companies that specialize or have the
expertise required to achieve our product development objectives. As a result,
it may be difficult for us to engage research and development labs and personnel
for our anticipated future needs. If we are unable to arrange for third-party
research and development of our products, or to do so on commercially reasonable
terms, we may not be able to develop new products or expand the application of
our existing products.





Reliance on third-party research and
development labs entails risks to which we would not be subject if we performed
the research and development ourselves. These risks include reliance on the
third party for maintaining the confidentiality of the proprietary information
relating to the product being developed and for maintaining quality assurance,
the possibility of breach of the research and development agreement by the third
party, and the possibility of termination or non-renewal of the agreement by the
third party.





Dependence upon third parties for the
research and development of our future products may limit our ability to
commercialize and deliver products on a timely and competitive
basis.





Because
we currently have limited commercial manufacturing capabilities, we will
continue to be dependent on third parties to manufacture products for us for
some time.





We have limited commercial
manufacturing experience and currently outsource all of our non-BPO product
manufacturing to third-party contract manufacturers. Although we have received
sufficient material from our manufacturers to meet our current needs, we do not
have long-term contracts with most of these third parties. Triax and our
supplier of metronidazole are our sole suppliers and manufacturers of tretinoin
and metronidazole, respectively, pursuant to contracts that have initial
termination dates in 2010 and 2015, respectively. The termination of those
agreements or any loss of services under those agreements would be difficult for
us to replace. We expect to continue to rely on third parties to produce
materials required for clinical trials and for the commercial production of our
products.





There are a limited number of
third-party manufacturers that operate under the FDA's current cGMP, regulations
and that have the necessary expertise and capacity to manufacture our products.
As a result, it may be difficult for us to locate manufacturers for our
anticipated future needs. If we are unable to arrange for third-party
manufacturing of our products, or to do so on commercially reasonable terms, we
may not be able to complete development of, market and sell our new
products.





Reliance on third-party manufacturers
entails risks to which we would not be subject if we manufactured products
ourselves, including reliance on the third party for regulatory compliance and
quality assurance, the possibility of breach of the manufacturing agreement by
the third party, and the possibility of termination or non-renewal of the
agreement by the third party.





We have developed a manufacturing
facility dedicated to the production of our CLENZIderm M.D. Serum Gel and
SoluCLENZ Rx. We may expand the capabilities of that manufacturing site and may
in the future elect to manufacture certain new products developed or certain
existing products without the assistance of third parties. However, in order to
make that election, we will need to invest substantial additional funds and
recruit qualified personnel in order to operate our development manufacturing
facility on a commercial basis. There can be no assurance that we will
successfully manufacture our own products, and if we are not able to make or
obtain adequate supplies of our products, it will be more difficult for us to
maintain and grow sales of CLENZIderm M.D. or SoluCLENZ Rx, or launch other new
products and compete effectively.


25





Dependence upon third parties for the
manufacture of our products may reduce our profit margins, or the sale of our
products, and may limit our ability to develop and deliver products on a timely
and competitive basis.





Our products may cause undesirable side
effects that could limit their use, require their removal from the market or
prevent further development.





The most common side effects associated
with our therapeutic products are temporary redness, stinging, burning
sensation, skin peeling, flaking, acne flare-ups and photo-sensitivity normally
experienced within approximately the first ten weeks of use. While these side
effects generally are not severe, they may limit the use of our products,
particularly if physicians or patients perceive that the risks or discomfort
outweigh the benefits or if they perceive that the side effects of competitive
products are less significant.





Undesirable side effects caused by our
products could interrupt, delay or halt our development programs, including
clinical trials, and could result in adverse regulatory action by the FDA or
other regulatory authorities. More severe side effects associated with our
products may be observed in the future. Even if we are able to complete the
development of a new product and obtain any required regulatory approval,
undesirable side effects could prevent us from achieving or maintaining market
acceptance of the product or could substantially increase the costs and expenses
of commercializing the product. Negative publicity concerning our products,
whether accurate or inaccurate, could also reduce market or regulatory
acceptance of our products, which could result in decreased product demand,
removal from the market or an increased number of product liability claims,
whether or not such claims have merit.





The
FDA has issued a proposed rule which cites evidence that an active ingredient
contained in some of our Obagi Nu-Derm and Obagi-C Rx Systems may have negative
side effects.





In August 2006, the FDA issued a
proposed rule which cites some evidence that hydroquinone may be a carcinogen,
if orally administered, and may be related to a skin condition called
ochronosis, which results in the darkening and thickening of the skin, and the
appearance of small bumps and grayish-brown spots. Hydroquinone is an active
ingredient contained in our Obagi Clear, Obagi Blender and Obagi Sunfader
products, which are part of our Obagi Nu-Derm and Condition & Enhance
System, and in our Obagi-C Rx C-Clarifying Serum and Obagi-C Rx C-Night Therapy
products, which are part of our Obagi-C Rx System. The FDA also concluded that
it could not rule out the potential carcinogenic risk from topically applied
hydroquinone. After further review of the evidence cited in the notice, or
information provided in the public comments on the proposed rule, or if
additional evidence of cancer or ochronosis, or other side effects associated
with any of our products were to be reported to or observed by the FDA or other
regulatory authorities, we could be required to suspend the marketing of our
products that contain hydroquinone, conduct additional safety tests and
potentially cease the sale of affected products, which would harm our business.
In addition, patients who experience side effects from our products may bring
product liability claims against us.





All of our products which contain
hydroquinone are prescription-based. The FDA was considering regulating all
hydroquinone products, including prescription-based hydroquinone products, as
new drugs, and may conclude that the continued use of prescription-based
hydroquinone products will require the submission and approval of an NDA. It is
our understanding that the FDA is no longer evaluating this proposal and is not
intending to take any action with respect to regulation of products containing
4% hydroquinone at the present time.  If the FDA changes this position
and we are required to submit an NDA for our prescription-based hydroquinone
products, we believe that the FDA may allow us to continue to market these
products while we are preparing, submitting and waiting for approval of such
NDA. However, there can be no assurance that we will be able to continue to
market our products during the NDA process, and we may be required to suspend
marketing of our prescription-based hydroquinone products until such time as an
NDA is approved. In addition, there can be no assurance that any NDA we submit
for our prescription-based hydroquinone products will be approved. If we are
required to suspend or cease marketing of our prescription-based hydroquinone
products, it would adversely affect our business.





Product
liability lawsuits could divert our resources, result in substantial liabilities
and reduce the commercial potential of our products.





Our business exposes us to the risk of
product liability claims that are inherent to the development, clinical testing
and marketing of aesthetic and skin health products. These lawsuits may divert
our management from pursuing our business strategy and may be costly to defend.
In addition, if we are held liable in any of these lawsuits, we may incur
substantial liabilities and may be forced to limit or forgo further
commercialization of those products. Although we maintain general liability and
product liability insurance in an amount that we believe is reasonably adequate
to insulate us from potential claims, this insurance may not fully cover
potential liabilities. In addition, our inability to obtain or maintain
sufficient insurance coverage at an acceptable cost or to otherwise protect
against potential product liability claims could prevent or inhibit the
commercial production and sale of our products, which could adversely affect our
business.




26


We
are subject to risks associated with doing business
internationally.


Our international sales currently
depend upon the marketing efforts of and sales by certain distributors and
licensees, particularly Rohto, a licensee of certain of our trademarks and
products for the retail drug store channel in Japan, from whom we receive
royalties that accounted for approximately 5% and 4% of our net sales and
approximately 5% and 5% of our gross margin for the years ended
December 31, 2008 and 2007, respectively. Because incremental costs
associated with this agreement are minimal, a material decline in licensing
revenues from or termination of this agreement would have a material adverse
effect on our net income. While no other international distribution or license
partner accounted for more than 5% of our net sales for both of the years ended
December 31, 2008 and 2007, our business is subject to certain risks
inherent in international business, many of which are beyond our control. These
risks include:





§
            adverse
      changes in tariff and trade protection
measures;





§
            unexpected
      changes in foreign regulatory
requirements;





§
            potentially
      negative consequences from changes in tax
laws;





§
            the
      potential business failure of one or more of our distribution
      partners;





§
            changing
      economic conditions in countries where our products are sold or
      manufactured;





§
            exchange
      rate risks;





§
            potential
      political unrest and hostilities;





§
            differing
      degrees of protection for intellectual property;
  and





§
            difficulties
      in coordinating foreign
distribution.





Any of these factors could adversely
affect our business, financial condition and results of operations. We cannot
assure you that we can successfully manage these risks or avoid their
effects.





Potential
business combinations could require significant management attention and prove
difficult to integrate with our business, which could distract our management,
disrupt our business, dilute stockholder value and adversely affect our
operating results.





If we become aware of potential
business combination candidates that are complementary to our business, we may
decide to combine with such businesses or acquire their assets in the future.
Business combinations generally involve a number of additional difficulties and
risks to our business, including:





§
            failure
      to integrate management information systems, personnel, research and
      development and marketing, operations, sales and support;





§
            disruption
      of our ongoing business and diversion of management's attention from other
      business matters;





§
            potential
      loss of the acquired company's
customers;





§
            failure
      to develop further the acquired company's technology
      successfully;





§
            unanticipated
      costs and liabilities; and





§
            other
      accounting consequences.





In addition, we may not realize
benefits from any business combination we may undertake in the future. If we
fail to successfully integrate such businesses, or the technologies associated
with such business combinations into our company, the revenue and operating
results of the combined company could be adversely affected. Any integration
process would require significant time and resources, and we may not be able to
manage the process successfully. If our customers are uncertain about our
ability to operate on a combined basis, they could delay or cancel orders for
our products. We may not successfully evaluate or utilize the acquired
technology or accurately forecast the financial impact of a combination,
including accounting charges or volatility in the stock price of the combined
entity. If we fail to successfully integrate other companies with which we may
combine in the future, our business could be adversely
affected.


27


Risks
Related to Regulatory Matters





Our
ability to commercially distribute our products and our business may be
significantly harmed if the regulatory environment governing our products
changes, if the FDA takes enforcement action against us or our competitors
marketing similar products, or if a third party obtains FDA approval of an NDA
for 4% hydroquinone for the same uses for which we market our hydroquinone
products.





The FDA and comparable agencies of
other countries regulate our products. In the United States, FDA regulations
govern, among other things, the activities that we perform, including product
development, product testing, product labeling, product storage, manufacturing,
advertising, promotion, product sales, reporting of certain product adverse
events and failures, and distribution. Individual state regulations may also
govern drug product manufacturing, distribution, advertising and
promotion.





In addition, the Obagi Nu-Derm, Obagi
Condition & Enhance and Obagi-C Rx Systems contain products that include 4%
hydroquinone as an active ingredient and are marketed in the United States
without an FDA-approved marketing application. We believe that these products
are not currently subject to FDA pre-market approval. In August 2006, the FDA
issued a proposed rule that, if adopted in its current form, would establish
that OTC skin bleaching drug products, such as hydroquinone, are not generally
recognized as safe and effective and are misbranded, and could seek to require
NDAs for new products using skin bleaching drug products, including prescription
skin bleaching drug products. The FDA had indicated that upon adoption of the
final rule it intended to consider all skin bleaching drug products, whether
currently marketed on a prescription or OTC basis, to be new drugs requiring an
approved NDA for continued marketing. It is our understanding that the FDA is no
longer evaluating this proposal and is not intending to take any action with
respect to regulation of products containing 4% hydroquinone at the present
time.    However, should the DFDA reverse this position,
such new rule may require us to withdraw the Obagi Nu-Derm, Obagi Condition
& Enhance and Obagi-C Rx Systems until required clinical trials are
performed and new drug approvals are obtained, in effect foreclosing us from
selling the Obagi Nu-Derm, Obagi Condition & Enhance and Obagi-C Rx Systems.
If we are required to seek new drug approval for these products, our attention
and resources will be dedicated to the process of obtaining new drug approval,
which may be time-consuming and expensive. In addition, we may not successfully
obtain such approval or may be delayed in obtaining such approval if one of our
competitors obtains approval and nonpatent exclusivity for the same uses for
which we seek approval. Other manufacturers of 4% prescription hydroquinone
include SkinMedica, Inc., Taro Pharmaceuticals Inc. and Stiefel
Laboratories, Inc. If we are unable to obtain such approval, we would be
prohibited from selling the Obagi Nu-Derm, Obagi Condition & Enhance and
Obagi-C Rx Systems, which would have a material adverse impact on our
business.





Finally, as discussed above, the August
2006 proposed rule cites some evidence that hydroquinone may be a carcinogen and
may be related to ochronosis. If new studies are published that corroborate such
evidence, or if based on further review of the current evidence, the FDA
determines that such potential health risks warrant a ban on the sale of 4%
hydroquinone, such determinations would have a material adverse effect on our
sale of the Obagi Nu-Derm, Obagi Condition & Enhance and Obagi-C Rx Systems.
The FDA's proposed rulemaking itself, and the concerns expressed therein
relating to the use of hydroquinone, could have an adverse impact on the sales
of our Obagi Nu-Derm, Obagi Condition & Enhance and Obagi-C Rx Systems.
Certain of our competitors are attempting to use the FDA's proposed rulemaking
in order to convince physicians and patients not to use our products containing
hydroquinone. To date, these marketing efforts by our competitors have not had a
negative impact on our sales levels. However, we cannot provide assurance that
such marketing efforts will not have a negative impact on our sales levels in
the future.





FDA and the FTC, regulations limit the
type of marketing claims we can make about our products. If the FDA determines
that any of our marketing claims are false or misleading, or suggest a clinical
benefit that is not supported in the studies we have done, we may be required to
cease making the challenged marketing claims, issue corrective communications,
pay fines, or stop selling products until the incorrect claims have been
corrected. FDA or FTC enforcement actions regarding promotional claims,
including warning letters, would also divert management attention and create
public relations issues for our customers and opportunities for our
competitors.





We are also subject to review, periodic
inspection and marketing surveillance by the FDA and comparable state agencies
to determine our compliance with regulatory requirements. Our manufacturing
processes, any clinical trials that we perform, our distribution and our
promotional activities are subject to ongoing regulatory obligations. In
addition, state agencies also may require registration, licensure and inspection
of manufacturing or distribution facilities and may require reporting of
promotional activities. If the FDA or any state or comparable agency finds that
we have failed to comply with these requirements or later discovers previously
unknown problems with our products, including unanticipated adverse events of
unanticipated severity or frequency, or our manufacturer or manufacturing
processes, it can institute a wide variety of enforcement actions, ranging from
a public warning letter to more severe sanctions, including





§
            fines,
      injunctions and civil penalties;





§
            recall
      or seizure of our products;





§
            restrictions
      on our products manufacturing processes, or distribution systems,
      including operating restrictions,
partial


28


§
            suspension
      or total shutdown of production;





§
            denial
      of requests for approvals of product
candidates;





§
            withdrawal
      of approvals already granted;





§
            disgorgement
      of profits; and





§
            criminal
      prosecution.





Any of these enforcement actions could
affect our ability to commercially distribute our products in the United States
and may also harm our ability to conduct the clinical trials necessary to
support the marketing, clearance or approval of these products and could
materially and adversely affect our business.





New
regulations could prohibit physicians from dispensing our products
directly.





In our primary market, the United
States, we market our products and systems directly to physicians to dispense in
their offices. Most of the products and systems we sell are dispensed by
physicians directly to their patients in their offices, although some patients
choose to have prescriptionsfor our
products filled by pharmacies instead of the treating physician. In the event
state regulations change to limit or prohibit the ability of physicians to
dispense our products directly to patients in their offices or change to limit
or prevent our ability to distribute products, patients may be required to
purchase our products in pharmacies, as opposed to directly from their
physicians. If patients are unable to purchase our products directly from
physicians, it could result in patients purchasing less of our product than they
otherwise would, which would harm our business.





Failure
to obtain regulatory approvals in foreign jurisdictions would prevent us from
marketing our products internationally.





We market our products outside of the
United States. In order to market our products in many non-U.S. jurisdictions we
must obtain separate regulatory approvals and comply with numerous and varying
regulatory requirements. In others, we do not have to obtain prior regulatory
approval but do have to comply with other regulatory restrictions on the
manufacture, marketing and sale of our products. We may be unable to file for
regulatory approvals and may not receive necessary approvals to commercialize
our products in any market. The approval procedure varies among countries and
can involve additional testing and data review. The time required to obtain
approval in non-U.S. jurisdictions may differ from that required to obtain FDA
approval. The foreign regulatory approval process may include all of the risks
associated with obtaining FDA approval. We may not obtain foreign regulatory
approvals on a timely basis, if at all. If we get approval by the FDA, that does
not ensure approval by regulatory agencies in other countries, and approval by
one foreign regulatory authority does not ensure approval by regulatory agencies
in other foreign countries or by the FDA. The failure to obtain these approvals
could harm our business.





If
we or any of our third-party manufacturers do not operate in accordance with
current Good Manufacturing Practices, we could be subject to FDA enforcement
actions, including the seizure of our products and the halt of our
production.





Third-party manufacturers that we
currently rely on or will rely on in the future must continuously adhere to the
cGMPs set forth in the FDA's regulations and guidance documents. In complying
with cGMPs, we and our third-party manufacturers must expend significant time,
money and effort in development, testing, production, record keeping and quality
control to assure that our products meet applicable specifications and other
regulatory requirements. The failure to comply with these specifications and
other requirements could result in an FDA enforcement action, including the
seizure of products and shutting down of production. Our third-party
manufacturers may also be subject to comparable or more stringent regulations of
foreign regulatory authorities. If our third-party manufacturers or we are
unable to comply with cGMPs and applicable foreign regulatory requirements, our
ability to develop, produce and sell our products could be
impaired.





Risks
Related to Intellectual Property





If
we are unable to protect our proprietary rights, we may not be able to compete
effectively.





Our success depends significantly on
our ability to protect our proprietary rights to the technologies used in our
products. We rely primarily on maintaining the confidentiality of our trade
secrets and the protection of trade secret laws, as well as a combination of
patent, copyright, and trademark (including common law trademark) laws, and
nondisclosure, confidentiality and other contractual restrictions, to protect
our proprietary technology. However, these legal means afford only limited
protection and may not adequately protect our rights or permit us to gain or
keep any competitive advantage. For example, our trade secrets may be
misappropriated by current or former employees, contractors, or parties with
whom we partner, or may be inadvertently disclosed or obtained by breach of a
confidentiality agreement. We have recently applied for several patents both in
the United Statesand abroad. These
patent applications may not issue as patents at all, or the applications may not
issue as a patent in a form that will be




29





advantageous
to us or may issue and be subsequently successfully challenged by others and
invalidated or rendered unenforceable. Both the patent application process and
the process of managing patent disputes can be time-consuming and expensive.
Competitors may be able to design around our patents or develop products that
provide outcomes comparable to ours even without misappropriating our trade
secrets. Although we have taken steps to protect our intellectual property and
proprietary technology, including entering into confidentiality agreements and
intellectual property assignment agreements with our employees, consultants and
advisors, such agreements may not be enforceable or may not provide meaningful
protection for our trade secrets or other proprietary information in the event
of unauthorized use or disclosure or other breaches of the agreements. Further,
the parties with whom we enter into confidentiality and intellectual property
assignment agreements could dispute the ownership of intellectual property
developed under these agreements. In addition, the laws of some foreign
countries may not protect our intellectual property rights to the same extent as
the laws of the United States.





If
we are involved in intellectual property claims and litigation, the proceedings
may divert our resources and subject us to significant liability for damages,
substantial litigation expense and the loss of our proprietary
rights.





In order to protect or enforce our
intellectual property rights, we may initiate litigation. In addition, others
may initiate litigation related to intellectual property against us. Companies
against whom we might initiate litigation or who might initiate litigation
against us may be better able to sustain the costs of litigation because they
have substantially greater resources. We may become subject to interference
proceedings conducted in patent and trademark offices to determine the priority
of inventions. There are numerous issued and pending patents in the skin care
product field. The validity and breadth of such patents may involve complex
legal and factual questions for which important legal principles may remain
unresolved. If third parties file oppositions to our patent applications in
foreign countries, we may also have to participate in opposition proceedings in
foreign tribunals to defend the patentability of our filed foreign patent
applications. We also have worked with consultants in developing our
intellectual property portfolio. To the extent any of these consultants are
involved in litigation involving intellectual property related to us, we may
also become a party to such actions or otherwise be adversely affected by virtue
of our relationships with the consultants. For example, we recently learned that
JR, a consultant who helped us develop CLENZIderm, SoluCLENZ and our bi-mineral
complex contained in our ELASTIderm products and has granted us a license under
certain patent applications that cover CLENZIderm, SoluCLENZ and our bi-mineral
complex contained in our ELASTIderm products, is involved in a lawsuit in which
the plaintiff claims that the owner of JR misappropriated the plaintiff's trade
secrets. Based upon our review of certain documents filed in connection with
this lawsuit, it appears that the plaintiff may believe that JR may have
utilized the plaintiff's trade secrets in developing CLENZIderm, SoluCLENZ and
our bi-mineral complex contained in our ELASTIderm products and filing the
patent applications that cover CLENZIderm, SoluCLENZ and our bi-mineral complex
contained in our ELASTIderm products. To date, no claims have been asserted
against us by the plaintiff, but if the plaintiff is successful in pursuing its
claims against JR, it could result in a material adverse effect on our
CLENZIderm, SoluCLENZ and our bi-mineral complex contained in our ELASTIderm
products’ sales.





Litigation
may be necessary for us to assert or defend against infringement claims, enforce
our issued and licensed patents, protect our trade secrets or know-how or
determine the enforceability, scope and validity of the proprietary rights of
others. Our involvement in intellectual property claims and litigation
could:





§
            divert
      existing management, scientific and financial
  resources;





§
            subject
      us to significant liabilities;





§
            result
      in a ruling that allows our competitors to market competitive products
      without obtaining a license from us;





§
            require
      us to enter into royalty or licensing agreements, which may not be
      available on terms acceptable to us, if at all;
  or





§
            force
      us to discontinue selling or modify our products, or to develop new
      products.





If any of these events occur, our
business will be materially and adversely affected.





We
and our manufacturers and suppliers license certain technologies and patents
from third parties. If these licenses are breached, terminated or disputed, our
ability to commercialize products dependent on these technologies and patents
may be compromised.





We have licensed eighteen patents,
including patents related to our Vitamin C serums, from Avon. We entered into
the license in June 2003, for an initial three-year term, and the license is
renewed year to year thereafter, at our option through the life of the last
patent to expire (which will be in 2018). These licensed patents contain claims
that cover our Obagi-C Rx C-Clarifying serum, Professional-C 5% serum,
Professional-C 10% serum, Professional-C 15% serum and Professional-C 20% serum.
If one or more of our licenses with Avon or licenses we have with other parties
terminate, if we violate the terms of our licenses or otherwise lose our rights
to these patents, we may be unable to continue developing and selling our
products that are covered by claims in the patents we license. Our licensors or
others may dispute the scope of our rights under any of these licenses. The
licensors under these licenses may breach the terms of their respective
agreements or fail to prevent infringement of the licensed patents by third
parties. Loss of any of


30


these
licenses for any reason could materially and adversely affect our financial
condition and operating results.





Further, we purchase products from
manufacturers and suppliers who have licensed patent rights to use and sell
these products from third-party licensors, and if any dispute arises as to these
licensed rights, the third-party licensors may bring legal actions against us,
our respective licensees, suppliers, customers or collaborators, and claim
damages and seek to enjoin the manufacturing and marketing of such
products.





In addition, if we determine that our
products do not incorporate the patented technology that we have licensed from
third parties, or that one or more of the patents that we have licensed are not
valid, we may dispute our obligation to pay royalties to our licensors. Any
dispute with a licensor could be complex, expensive and time-consuming and an
outcome adverse to us could materially and adversely affect our business and
impair our ability to commercialize our patent-licensed products.





Risks
Related to Our Capital Requirements and Finances





If
we fail to generate sufficient cash flow from our operations, we will be unable
to continue to develop and commercialize new products.





We expect capital outlays and operating
expenditures to increase over the next several years as we expand our
infrastructure, and our commercialization, clinical trials, research and
development and manufacturing activities. We believe that our net cash provided
by operating activities and existing cash and cash equivalents will be
sufficient to fund our operations for the foreseeable future. However, our
present and future funding requirements will depend on many factors, including,
among other things:





§
            the
      level of research and development investment required to maintain and
      improve our competitive position;





§
            the
      success of our product sales and related
  collections;





§
            our
      need or decision to acquire or license complementary businesses, products
      or technologies or acquire complementary
  businesses;





§
            costs
      relating to the expansion of the sales force, management and operational
      support;





§
            competing
      technological and market developments;
and





§
            costs
      relating to changes in regulatory policies or laws that affect our
      operations.





As a result of these factors, we may
need to raise additional funds, and we cannot be certain that such funds will be
available to us on acceptable terms when needed, if at all. In addition, if we
raise additional funds through collaboration, licensing or other similar
arrangements, it may be necessary to relinquish potentially valuable rights to
our future products or proprietary technologies, or grant licenses on terms that
are not favorable to us. If we cannot raise funds on acceptable terms, we may
not be able to expand our operations, develop new products, take advantage of
future opportunities or respond to competitive pressures or unanticipated
customer requirements.





Our
quarterly operating results are variable, which may cause our stock price to
decline.





Our quarterly results of operations
have varied in the past and are likely to vary significantly in the future due
to a number of factors, many of which are outside of our control,
including:





§
            demand
      for and market acceptance of our
products;





§
            the
      development of new competitive products by
  others;





§
            changes
      in regulatory classifications of our
products;





§
            changes
      in physician or patient acceptance of the use of physician-dispensed
      products;





§
            changes
      in treatment practices of physicians who currently prescribe our
      products;





§
            reduced
      demand for our products during the summer months due to variability of
      patient compliance resulting from travel and other disruptive activities,
      particularly during July and
August;


31




§
            delays
      between our expenditures to acquire new product lines or businesses and
      the generation of revenues from those acquired products or
      businesses;





§
            the
      timing, release and competitiveness of our
  products;





§
            increases
      in the cost of raw materials used to manufacture our
    products;





§
            the
      mix of products that we sell during any time
  period;





§
            increased
      price competition; and





§
            adverse
      changes in the level of economic activity in the United States and other
      major regions in which we do
business.





Due to the factors summarized above, we
do not believe that period-to-period comparisons of our results of operations
are necessarily meaningful and should not necessarily be relied upon to predict
future results of operations. It is also possible that in future periods, our
results of operations will not meet the expectations of investors or analysts,
or any published reports or analyses regarding our company. In that event, the
price of our common stock could decline, perhaps substantially. For example, due
to the reduced demand for our products during the summer months discussed above,
our results of operations for the third quarter have historically been lower
than our results of operations for the second quarter. We do not expect this
will change in the future.





Changes
in, or interpretations of, accounting rules and regulations, could result in
unfavorable accounting charges or require us to change our
policies.





Changes to, or interpretations of,
accounting methods or policies in the future may require us to reclassify,
restate or otherwise change or revise our financial statements, including those
contained inthis Annual Report on
Form 10-K. For example, the Financial Accounting Standards Board (“FASB”)
has adopted an accounting pronouncement requiring the recording of expense for
the fair value of stock options granted. Beginning January 1, 2006, we have
adopted Statement of Financial Accounting Standards ("SFAS") 123R (“SFAS No.
123R”) , Share-Based
Payment, which required us to change our accounting policy to record
compensation expense for the fair value of stock options granted, and as a
result, our operating expenses have increased. We rely on stock options to
motivate current employees and attract new employees. As a result of the
requirement to expense stock options, we may choose to reduce our reliance on
stock options as a recruitment or motivation tool. If we reduce our use of stock
options, it may be more difficult for us to attract and retain qualified
employees. However, if we do not reduce our reliance on stock options, our
operating expenses may continue to increase.





On January 1, 2008, we adopted FASB Interpretation No. (“FIN”)48 (“FIN 48”), Accounting for Uncertainty in Income
Taxes – an Interpretation of Financial Accounting Standards Board Statement
No. 109. We provide for uncertain tax positions when such tax
positions do not meet the recognition thresholds or measurement standards
prescribed byFIN48. Changes to uncertain tax
positions, including related interest and penalties, impact our effective tax
rate. When particular tax matters arise, a number of years may elapse before
such matters are audited and finally resolved. Favorable resolution of such
matters could be recognized as a reduction to our effective tax rate in the year
of resolution. Unfavorable resolution of any tax matter could increase the
effective tax rate. Any resolution of a tax issue may require the use of cash in
the year of resolution.





Impairment
of our significant intangible assets may reduce our profitability.





The costs of our goodwill, acquired
product rights, distribution rights, and trademark are recorded as intangible
assets and all, except for goodwill, are amortized over the period that we
expect to benefit from the assets. As of December 31, 2008, acquired net
intangible assets and goodwill comprised approximately 14% of our total assets.
We evaluate periodically the recoverability and the amortization period of our
intangible assets. Some factors we consider important in assessing whether or
not impairment exists include performance relative to expected historical or
projected future operating results, significant changes in the manner of our use
of the assets or the strategy for our overall business, and significant negative
industry or economic trends. These factors, assumptions, and changes in them
could result in an impairment of our long-lived assets. Any impairment of our
intangible assets may reduce our profitability and have a material adverse
effect on our results of operations and financial condition.





Fluctuations
in demand for our products could create inventory maintenance uncertainties and
could adversely affect our business.





As a result of customer buying
patterns, a substantial portion of our revenues has been recognized in the last
month of each quarter and the last month of the year. We schedule our inventory
purchases to meet anticipated customer demand. As a result, relatively small
delays in the receipt of manufactured products by us could result in revenues
being deferred or lost. Our operating expenses are based upon anticipated sales
levels, and a high percentage of our operating expenses are relatively fixed in
the short term.  Consequently, variations in the timing of sales, or
reductions in sales due to the current global financial market crisis, could
cause significant fluctuations in operating


32


results
from period to period and may result in unanticipated periodic earnings
shortfalls or losses.





If we overestimate demand, we may be
required to write off inventories and increase our reserves for product returns.
If we underestimate demand, we may not have sufficient inventory of products to
ship to our customers. Our products have expiration dates that range from 24 to
36 months from the date of manufacture. We establish reserves for
potentially excess, dated or otherwise impaired inventories. We may not be able
to accurately estimate the reserve requirement that will be needed in the
future. Although our estimates are reviewed quarterly for reasonableness, our
product return, rebate or chargeback activity could differ significantly from
our estimates. Judgment is required in estimating these reserves and we rely on
data from third parties, including, but not limited to, distributor forecasts
and independent market research reports. The actual amounts could be different
from our estimates, and differences are accounted for in the period in which
they become known. If we determine that the actual amounts exceed our reserve
amounts, we will record a charge to earnings to approximate the difference. A
material reduction in earnings resulting from a charge could have a material
adverse effect on our net income, results of operations and financial
condition.





The
agreements governing our credit facility impose restrictions on our business
that may limit our business opportunities and hinder our ability to execute our
business strategy.





Our current credit facility contains,
and other agreements we may enter into in the future may contain, covenants
imposing restrictions on our business and require us to maintain certain
financial covenants. These restrictions and covenants may affect our ability to
operate our business and may limit our ability to take advantage of potential
business opportunities as they arise. These covenants place restrictions on our
ability to, among other things, incur additional debt, create liens, make
investments, enter into transactions with affiliates, sell assets, guarantee
debt, declare or pay dividends, redeem common stock or make other distributions
to stockholders, and consolidate or merge. As of December 31, 2008, we were not
in compliance with the non-financial covenant, requiring us to report monthly, a
listing of our intellectual property.  Subsequent to year end, we
obtained a waiver with respect to this covenant.





Although we currently believe we
will be in compliance with all of our non-financial and financial covenants as
of March 31, 2009, our ability to comply with these covenants may be affected by
events beyond our control, including prevailing economic, financial, and
industry conditions. An event of default under our credit facility would permit
our lenders to declare all amounts borrowed from them to be due and payable,
together with accrued and unpaid interest. If we were unable to repay any debt
owed, the lender could proceed against the collateral securing that
debt.





We
are subject to the requirements of Section 404 of the Sarbanes-Oxley Act.
If we are unable to comply with Section 404 in a timely manner it may
affect the reliability of our internal control over financial
reporting.





As of December 31, 2008, we are
subject to the requirements of Section 404 of the Sarbanes-Oxley Act and
the Securities and Exchange Commission rules and regulations require an annual
management report on our internal control over financial reporting, including,
among other matters, management's assessment of the effectiveness of our
internal control over financial reporting, and an attestation report by our
independent registered public accounting firm addressing the effectiveness of
our internal control over financial reporting. Although our independent
registered public accounting firm did not identify material weaknesses in our
internal controls in connection with their audit of our financial statements as
of and for the year ended December 31, 2008, we cannot assure you that we
will maintain an effective system of internal controls in the future. If we are
not able to adequately comply with the requirements of Section 404 we may
be subject to sanctions or investigation by regulatory authorities, including
the SEC or the Nasdaq National Market. Moreover, if we are unable to assert that
our internal control over financial reporting is effective in any future period
(or if our independent registered public accounting firm is unable to express an
opinion on the effectiveness of our internal controls), we could lose investor
confidence in the accuracy and completeness of our financial reports, which may
have an a material adverse effect on our Company.





We
incur costs as a result of being a public company.





As a public company, we incur
significant legal, accounting and other expenses that we did not incur as a
private company. We incur costs associated with our public company reporting
requirements. We also are incurring costs associated with corporate governance
requirements, including requirements under the Sarbanes-Oxley Act of 2002. We
expect these rules and regulations to continue to increase our legal and
financial compliance costs and to make some activities more time-consuming and
costly. While we have taken steps to improve our financial accounting
organization and processes to date, we may still need to make additional
changes, including adding staff in the areas of internal control andinternal audit. We may also need to
adopt and implement additional policies and procedures to further strengthen our
financial reporting capability. However, the process of designing and
implementing an effective financial reporting system is a continuous effort that
will require us to anticipate and react to changes in our business and the
economic and regulatory environments. All of this will also require us to expend
significant resources. We also expect these rules and regulations may make it
more difficult and more expensive for us to obtain director and officer
liability insurance, and we may be required to accept reduced policy limits and
coverage or incur substantially higher costs to obtain the same or similar
coverage.




Our
Board of Directors can issue preferred stock without stockholder approval of the
terms of such stock.


33


Our amended and restated certificate of
incorporation authorizes our Board of Directors, without stockholder approval,
to issue up to 10,000,000 shares of preferred stock in one or more series and to
fix the rights, preferences, privileges, and restrictions granted to or imposed
upon the preferred stock, including voting rights, dividend rights, conversion
rights, terms of redemption, liquidation preference, sinking fund terms,
subscription rights, and the number of shares constituting any series or the
designation of a series. Our Board of Directors can issue preferred stock with
voting and conversion rights that could adversely affect the voting power of the
holders of common stock, without stockholder approval. As of December 31,
2008, no shares of preferred stock were outstanding and we have no present plan
to issue any shares of preferred stock.





Risks
Related to Owning our Stock





We
expect that the price of our common stock will fluctuate
substantially.





The market price for our common stock
will be affected by a number of factors, including:





§
            downturns
      in the global financial markets that are beyond our
    control;





§
            changes
      in earnings estimates, investors' perceptions, recommendations by
      securities analysts or our failure to achieve analysts' earnings
      estimates;





§
            quarterly
      variations in our or our competitors' results of
    operations;





§
            the
      announcement of new products or service enhancements by us or our
      competitors;





§
            announcements
      related to litigation;





§
            developments
      in our industry; and





§
            general
      market conditions and other factors unrelated to our operating performance
      or the operating performance of our
competitors.





The
interests of our controlling stockholder may conflict with the interests of our
other stockholders.





As of December 31, 2008,
Stonington Capital Appreciation 1994 Fund LP (“Stonington”) beneficially
owned approximately 21.4% of the outstanding shares of our voting capital stock,
without giving effect to the exercise of outstanding options. As a result,
Stonington has significant influence over the outcome of matters requiring
stockholder approval, including:





§
            the
      election and removal of our directors;
and





§
            the
      approval of mergers, consolidations or the sale of all or substantially
      all of our assets.





Currently, John A. Bartholdson and Albert J. Fitzgibbons III, both of whom serve
on our Board of Directors, are employees of Stonington and serve on the board of
directors of Stonington's general partner. This concentration of stock ownership
could limit the ability of our other stockholders to influence corporate matters
and could have the effect of delaying, deferring or preventing (or promoting) a
change incontrol of the company, or
impeding (or promoting) a merger or consolidation, takeover or other business
combination or a sale of all or substantially all of our assets. In addition,
the significant concentration of stock ownership may adversely affect the
trading price of our common stock due to investors' perception that conflicts of
interest may exist or arise.





Future
sales of our common stock, or the perception in the public markets that these
sales may occur, could depress our stock price.





Sales of substantial amounts of our
common stock in the public market, or the perception in the public markets that
these sales may occur, could cause the market price of our common stock to
decline. This could also impair our ability to raise additional capital through
the sale of our equity securities. As of December 31, 2008, we had
22,044,872 shares of our common stock outstanding. In addition, we had
outstanding options to purchase a total of 1,592,474 shares under our 2000 Stock
Option/Stock Issuance Plan and 2005 Stock Incentive Plan of which 744,064 were
vested. In February 2007, we filed a Form S-8 registration statement to
register all the shares of common stock issuable under our equity incentive
plans, including the 2005 Stock Incentive Plan.





Each of Stonington, the holder of
approximately 4,722,285 shares of our common stock as of December 31, 2008
and the Zein and Samar Obagi Family Trust, the holder of approximately 2,138,767
shares of our common stock as of December 31, 2008, has rights to demand
the registration of their shares or include their shares in registration statements
that we may file on our behalf or on behalf of other
stockholders.


34





The partnership through which
Stonington holds its shares terminated in March 2007. Although Stonington may
return the investment in us through a distribution of shares to the fund's
investors, Stonington has also exited its investments in publicly traded
companies through a combination of sales under Rule 144 and registered
secondary offerings,. By exercising its registration rights and selling a large
number of shares, Stonington could cause the price of our common stock to
decline, which could impede our ability to make acquisitions through the
issuance of additional shares of our common stock. Furthermore, if we
file a registration statement to offer additional shares of our common
stock and have to include shares held by Stonington or other holders of
registration rights, it could impair our ability to raise needed capital by
depressing the price at which we could sell our common stock.





Provisions
in our charter documents and Delaware law could discourage a takeover you may
consider favorable or could cause current management to become entrenched and
difficult to replace.





Provisions in our certificate of
incorporation and our bylaws, as well as Delaware law could make it more
difficult for other companies to acquire us, even if doing so would benefit our
stockholders. Our certificate of incorporation and bylaws contain the following
provisions, among others, which may inhibit an acquisition of our company by a
third party:





§
            advance
      notification procedures for matters to be brought before stockholder
      meetings;





§
            a
      limitation on who may call stockholder
meetings;





§
            a
      prohibition on stockholder action by written consent;
  and





§
            the
      ability of our Board of Directors to issue up to 10 million shares of
      preferred stock without a stockholder
vote.





We are also subject to provisions of
Delaware law that prohibit us from engaging in any business combination with any
"interested stockholder," meaning generally that a stockholder who beneficially
owns more than 15% of our stock cannot acquire us for a period of three years
from the date this person became an interested stockholder unless various
conditions are met, such as approval of thetransaction by our Board of Directors.
Any of these restrictions could have the effect of delaying or preventing a
change in control.





We
do not intend to pay cash dividends on our common stock in the foreseeable
future.





We currently anticipate that we will
retain all future earnings, if any, to finance the growth and development of our
business and do not anticipate paying cash dividends on our common stock in the
foreseeable future. Any payment of cash dividends will depend upon our financial
condition, capital requirements, earnings and other factors deemed relevant by
our Board of Directors.





ITEM
1B:    UNRESOLVED SEC STAFF COMMENTS





None.





ITEM
2:    PROPERTIES





As of December 31, 2008, we leased
the following facilities:





Function
                
                Location
                
                Square
      feet
                
                Lease
      expirationHeadquarters
                
                Long
      Beach, CA
                
                30,884
                
                October
      2018Distribution
      Center
                
                Carson,
      CA
                
                26,959
                
                October
      2013Manufacturing
                
                Milford,
      CT
                
                5,600
                
                November
      2013Marketing &
      Training Center
                
                Beverly
      Hills, CA
                
                2,100
                
                July
      2011





On
August 6, 2008, we entered into a lease amendment with Kilroy
Realty, L.P. (“Kilroy”) for the lease of office space located in Long
Beach, California. The new facility consists of 30,884 rentable square feet and
the term of the lease is for ten years with an option to extend the lease term
for five years.   We took possession of the facility on
July 1, 2008, and the lease term commenced in October 2008 when we took
occupancy and relocated our corporate headquarters to the new
facility.  We believe our facilities are adequate for their intended
use and are sufficient for our current level of operations.




35


Our physician dispensed, pharmacy Rx
and licensing activities are initiated and coordinated from our Long Beach





Our physician dispensed distribution
center is strategically located for quick, convenient and reliable distribution
with access to all major carriers in Southern California.





ITEM 3:    LEGAL
PROCEEDINGS





From time to time, we are involved in
litigation and other legal matters in the normal course of business. Management
does not believe that the outcome of any of these matters will have a material
adverse effect on our consolidated financial position, results of operations or
cash flows.





ITEM 4:    SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS





None.


36


PART
II





ITEM 5:    MARKET FOR
REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES





Market
Information





Our common stock is quoted on the
Nasdaq Global Market under the symbol "OMPI" and has been quoted since our
initial public offering on December 13, 2006. The initial public offering
price of our common stock on December 14, 2006 was $11.00 per share. The
following table sets forth for the fiscal periods indicated the high and low
sale prices for our common stock as reported by the Nasdaq:





High
                
                
                LowFiscal
      2007First
      Quarter
                
                $
                15.82
                
                
                $
                8.80Second
      Quarter
                
                $
                19.42
                
                
                $
                12.48Third
      Quarter
                
                $
                19.75
                
                
                $
                15.15Fourth
      Quarter
                
                $
                24.96
                
                
                $
                16.67Fiscal
      2008First
      Quarter
                
                $
                19.05
                
                
                $
                8.68Second
      Quarter
                
                $
                9.75
                
                
                $
                6.86Third
      Quarter
                
                $
                10.61
                
                
                $
                8.00Fourth
      Quarter
                
                $
                9.68
                
                
                $
                5.58





Holders





The approximate number of stockholders
of record of our common stock was 3,512 as of February 4, 2009. Because
many of the shares of our common stock are held by brokers and other
institutions on behalf of stockholders, we are unable to estimate the total
number of beneficial owners represented by these shareholders of
record.





Dividends





We currently intend to retain all
available funds and any future earnings for use in the operation of our business
and do not anticipate paying any cash dividends in the foreseeable future. Any
future determination to declare cash dividends will be made at the discretion of
our board of directors, subject to compliance with certain covenants under our
line of credit facility, which limit our ability to declare or pay dividends,
and will depend on our financial condition, results of operations, capital
requirements, general business conditions, and other factors that our board of
directors may deem relevant.





Securities
Authorized for Issuance Under Equity Compensation Plans





The following table sets forth
information regarding outstanding options and rights and shares reserved for
future issuance under our equity compensation plans as of December 31,
2008:





Plan
      Category
                                                  
                                                  Number
      of securities to be issued upon exercise of outstanding options, warrants
      and rights
                                                  
                                                  
                                                  Weighted-average
      exercise price of outstanding options, warrants and rights
                                                  
                                                  
                                                  Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in
      column (a))(1)(a)
                                                  
                                                  
                                                  (b)
                                                  
                                                  
                                                  (c)Equity
      compensation plans approved by security holders
                                                  
                                                  
                                                  1,592,474
                                                  
                                                  
                                                  $
                                                  11.22
                                                  
                                                  
                                                  
                                                  1,210,560Equity
      compensation plans not approved by security holders
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  —
                                                  
                                                  
                                                  
                                                  —Total
                                                  
                                                  
                                                  1,592,474
                                                  
                                                  
                                                  $
                                                  11.22
                                                  
                                                  
                                                  
                                                  1,210,560





37





(1)  The
2005 Plan provides that the number of shares authorized for issuance will be
cumulatively increased on January 1, 2007 and on each January 1
thereafter for nine years by the lesser of 500,000 shares, 3% of our outstanding
common stock as of the preceding December 31 or the number of shares
determined by our board of directors or compensation committee.





Issuer
Purchases of Equity Securities





On August
5, 2008, the board of directors authorized the repurchase of up to $10 million
of our outstanding common shares over a period of two years.  The
purchases are to be made in the open market or in privately negotiated
transactions from time to time as permitted by securities laws and other legal
requirements.  The timing manner, price and amount of any repurchases
are determined by a three person committee, consisting of members of our board
and management, at its discretion and will be subject to economic and market
conditions, stock price, applicable legal requirements and other factors that
may be discontinued at any time.





The
following table provides information regarding repurchases of our common stock
made by or on behalf of us, or any “affiliated purchasers” as defined in SEC
rules, of our equity securities registered pursuant to Section 12 of the
Exchange Act, for each month during the fourth quarter of fiscal year 2008, in
the format required by SEC rules:





Total
      Number of Shares Purchased
                                                                      
                                                                      
                                                                      Average
      Price Paid per Share
                                                                      
                                                                      
                                                                      Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      Programs
                                                                      
                                                                      
                                                                      Maximum
      Dollar Amount of Shares (in thousands) That May Yet Be Purchased Under the
      Plans or ProgramsOctober
      1, 2008 - October 31, 2008
                                                                      
                                                                      
                                                                      —
                                                                      
                                                                      
                                                                      $
                                                                      —
                                                                      
                                                                      
                                                                      
                                                                      —
                                                                      
                                                                      
                                                                      $
                                                                      10,000November
      1, 2008 - November 30, 2008
                                                                      
                                                                      
                                                                      263,400
                                                                      
                                                                      
                                                                      
                                                                      6.00
                                                                      
                                                                      
                                                                      
                                                                      263,400
                                                                      
                                                                      
                                                                      
                                                                      8,419December
      1, 2008 - December 31, 2008
                                                                      
                                                                      
                                                                      363,967
                                                                      
                                                                      
                                                                      
                                                                      6.64
                                                                      
                                                                      
                                                                      
                                                                      363,967
                                                                      
                                                                      
                                                                      
                                                                      6,003Total
                                                                      
                                                                      
                                                                      627,367
                                                                      
                                                                      
                                                                      $
                                                                      6.37
                                                                      
                                                                      
                                                                      
                                                                      627,367
                                                                      
                                                                      
                                                                      $
                                                                      6,003





Performance
Graph





The following information is not deemed
to be "soliciting material" or to be "filed" with the SEC or subject to the
liabilities of Section 18 of the Exchange Act, and the report shall not be
deemed to be incorporated by reference into any prior or subsequent filing by
the Company under the Securities Act or the Exchange Act.





The Performance Graph below represents
a comparison of the total return of our common stock, the NASDAQ Market Index
and the SIC—Pharmaceutical Preparations for the period between December 14,
2006, and December 31, 2008. The graph assumes $100 was invested on
December 14, 2006, and dividends, if any, are reinvested for the fiscal
year ended December 31, 2008.





COMPARISON OF CUMULATIVE TOTAL
RETURN


AMOUNG
OBAGI MEDICAL PRODUCTS, INC.,


NASDAQ
MARKET INDEX AND SIC CODE INDEX







38


ITEM 6:    SELECTED FINANCIAL
DATA





The selected consolidated financial
data set forth below are derived from our consolidated financial statements. The
consolidated statements of income data for the years ended December 31,
2006, 2007, and 2008, and consolidated balance sheet data as of
December 31, 2007 and 2008, are derived from our audited consolidated
financial statements for such years and as of such dates, which are included
elsewhere in this Annual Report on Form 10-K. The consolidated statements
of income data for the years ended December 31, 2004 and 2005, and
consolidated balance sheet data as of December 31, 2004, 2005 and 2006 are
derived from our audited consolidated financial statements for such years and as
of such dates, which are not included in this Annual Report on
Form 10-K.





The information in the following table should be read together with
"Management's discussion and analysis of financial condition and results of
operations" and our consolidated financial statements and the related notes
included elsewhere in this Annual Report on Form 10-K.





Year
      Ended December 31,2004
                                  
                                  
                                  2005
                                  
                                  
                                  2006
                                  
                                  
                                  2007
                                  
                                  
                                  2008Consolidated
      statements of income data:Net
      sales
                                  
                                  $
                                  56,256
                                  
                                  
                                  $
                                  64,941
                                  
                                  
                                  $
                                  77,996
                                  
                                  
                                  $
                                  102,648
                                  
                                  
                                  $
                                  104,593Income
      from operations
                                  
                                  
                                  21,395
                                  
                                  
                                  
                                  21,084
                                  
                                  
                                  
                                  17,747
                                  
                                  
                                  
                                  27,702
                                  
                                  
                                  
                                  19,998Income
      from operations attributable to common shares(1)Basic
                                  
                                  $
                                  1.34
                                  
                                  
                                  $
                                  1.20
                                  
                                  
                                  $
                                  0.99
                                  
                                  
                                  $
                                  1.26
                                  
                                  
                                  $
                                  0.88Diluted
                                  
                                  $
                                  1.24
                                  
                                  
                                  $
                                  1.19
                                  
                                  
                                  $
                                  0.98
                                  
                                  
                                  $
                                  1.25
                                  
                                  
                                  $
                                  0.88December
      31,2004
                                  
                                  
                                  2005
                                  
                                  
                                  2006
                                  
                                  
                                  2007
                                  
                                  
                                  2008Consolidated
      balance sheet data:Total
      assets
                                  
                                  $
                                  48,704
                                  
                                  
                                  $
                                  45,947
                                  
                                  
                                  $
                                  52,961
                                  
                                  
                                  $
                                  59,763
                                  
                                  
                                  $
                                  72,259Long-term
      debt less current portion
                                  
                                  
                                  30
                                  
                                  
                                  
                                  63,195
                                  
                                  
                                  
                                  23,052
                                  
                                  
                                  
                                  42
                                  
                                  
                                  
                                  18Redeemable
      preferred stock
                                  
                                  
                                  22,511
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —Cash
      dividends declared and paid
                                  
                                  
                                  —
                                  
                                  
                                  
                                  63,088
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —Per
      share (1)
                                  
                                  
                                  —
                                  
                                  
                                  $
                                  3.60
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —
                                  
                                  
                                  
                                  —




(1)  On
November 27, 2006, the Board of Directors of the Company approved an
amended and restated Certificate of Incorporation and amended and restated
Bylaws in preparation for the initial public offering. This amended and restated
Certificate of Incorporation was approved by the stockholders on
November 28, 2006, and was filed by the Secretary of State of the State of
Delaware prior to the effectiveness of the Company's Registration Statement on
Form S-1. All share and per share amounts included in our financial
statements have been adjusted to reflect this 1-for-1.2 reverse stock split for
all periods presented.





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





You should read the following
discussion and analysis of our financial condition and results of operations
together with our financial statements and related notes appearing elsewhere in
this Annual Report on Form 10-K. Some of the information contained in this
discussion and analysis or set forth elsewhere in this Annual Report on
Form 10-K, including information with respect to our plans and strategy for
our business and related financing, includes forward-looking statements that
involve risks and uncertainties. You should review the "Risk Factors" section of
this Annual Report on Form 10-K for a discussion of important factors that
could cause our actual results to differ materially from the results described
in or implied by the forward-looking statements contained in the following
discussion and analysis.





Overview





We are a specialty pharmaceutical
company focused on the aesthetic and therapeutic skin health markets. We develop
and commercialize prescription-based, topical skin health systems that enable
physicians to treat a range of skin conditions, including pre-mature aging,
photo-damage, skin laxity, hyperpigmentation, acne and soft tissue deficits,
such as fine lines and wrinkles.





Current products.
    Our primary product line is the Obagi Nu-Derm System,
which we believe is the only clinically proven, prescription-based, topical skin
health system on the market that has been shown to enhance the skin's overall
health by correcting photo-damage at the cellular level, resulting in a
reduction of the visible signs of aging.


39


The
primary active ingredients in this system are 4% hydroquinone and over the
counter, or OTC, skin care agents. In April 2004, we introduced the Obagi-C Rx
System consisting of a combination of prescription and OTC drugs and adjunctive
cosmetic skin care products to treat skin conditions resulting from sun damage
and the oxidative damage of free radicals. The central ingredients in this
system are 4% hydroquinone and Vitamin C. In October 2005, we launched the Obagi
Professional-C products, a complete line of proprietary, non-prescription
products, which consists of Vitamin C serums used to reduce the appearance of
damage to the skin caused by ultraviolet radiation and other environmental
influences. In July 2006, we launched our Obagi Condition & Enhance System,
for use in conjunction with commonly performed cosmetic procedures including
Botox® injections. In October 2006, we launched our first product in the
ELASTIdermTM product line, an eye cream for improving the elasticity and skin
tone around the eyes. We introduced the CLENZIderm M.D.TM system and a second
product in the ELASTIdermTM product line to address acne and skin elasticity
around the eye, respectively, based on positive interim clinical results, in
February 2007. In July 2007, we launched our second system in the CLENZIderm
M.D. line, CLENZIderm M.D. System II, which is specifically formulated for
normal to dry skin. In August 2007, we launched two new Nu-Derm Condition &
Enhance Systems.  One is designed specifically for use with
non-surgical procedures while the other has been developed for use with surgical
procedures.  In February 2008, we launched ELASTIdermTM Décolletage, a
system to treat skin conditions resulting from sun damage and improve the
elasticity and skin tone for the neck and chest area. We also market tretinoin,
used for the topical treatment of acne in the U.S., and Obagi Blue Peel
products, used to aid the physician in the application of skin peeling actives.
In August 2008, we entered the pharmacy Rx channel with our first product,
SoluCLENZ TM, a
solubilized benzoyl peroxide gel for the treatment of acne, which is available
only by prescription.  In January 2009, we launched Obagi Rosaclear, a
system to treat the symptoms of rosacea.





Future products.
    We focus our research and new product development
activities on improving the efficacy of established prescription and OTC
therapeutic agents by enhancing the penetration of these agents across the skin
barrier using our proprietary technologies collectively known as Penetrating
Therapeutics. There can be no assurance that we will be able to introduce any
additional systems using these technologies.





U.S. distribution.
    We market all of our products through our direct sales
force in the United States primarily to plastic surgeons, dermatologists and
other physicians who are focused on aesthetic skin care.





Aesthetic skin care.
    As of December 31, 2008, we sold our products to
more than 5,700 physician-dispensing accounts in the United States, with no
single customer accounting for more than 5% of our net sales. Our current
products, other than SoluCLENZ, are not eligible for reimbursement. We generated
U.S. net sales of $87.5 million and $87.0 million during the years
ended December 31, 2008 and 2007, respectively.





Retail Pharmacy Rx Channel.
  We market SoluCLENZ through our dermatology sales force and an
outside third party contract sales organization in the U.S. primarily to
dermatologists.  We sell SoluCLENZ to pharmaceutical wholesalers who
then distribute directly to the pharmacy to fill patient
prescriptions.





International distribution.
    We market our products internationally through 19
international distribution and two licensing partners that have sales and
marketing activities in 42 countries outside of the United States. Much like our
business model in the United States, these distributors sell our products
through direct sales representatives to physicians, or through alternative
distribution channels depending on regulatory requirements and industry
practices. We generated international net sales of $12.3 million and
$11.0 million during the years ended December 31, 2008 and 2007,
respectively.





Licensing.
    We market our products in the Japanese retail markets
through a trademark and know-how license agreement with Rohto. Under our
agreement, Rohto is licensed to manufacture and sell a series of OTC products
under the Obagi brand name in the Japanese drug store channel, and we receive a
royalty based upon sales of Obagi branded products in Japan by Rohto. Rohto's
Obagi branded products are sold through approximately 6,300 high-end drug
stores. We have other licensing arrangements in Japan to market and sell OTC
product systems under the Obagi brand, both for in-office use in facial
procedures, as well as for sale as a take-home product kit in the spa channel.
We receive royalties based upon these arrangements. We generated licensing
revenue of $4.8 million and $4.7 million during the years ended
December 31, 2008 and 2007, respectively.





Sales growth.     Our total net sales have grown from
$102.6 million for the year ended December 31, 2007 to
$104.6 million for the year ended December 31, 2008. Our sales growth
has been driven primarily by new ELASTIderm sales coupled with the launch
of the third product in the product line in January 2008.  Our sales
growth has been driven primarily by:





§
            Our professional marketing
      efforts to physicians.   Our professional sales force
      targets physicians who are providing aesthetic treatments and educates
      them on how to best provide our products to their patients. Our
      professional sales force also provides education to physicians,
      aestheticians, other staff and patients about the benefits of promoting
      skin health. We have increased our sales force from 96 employees as of
      January 1, 2006 to 141 employees as of December 31, 2008, which
      includes a 20 person contracted sales force hired to support the launch of
      SoluCLENZ. We will continue to invest in expanding our sales force as
      warranted by the success of new product offerings and continued core
      product growth. We currently do not have plans to hire a substantial
      number of employees in 2009.


40





§
            Strong
      growth in the aesthetic skin care market.   Additionally, the
      independent research firm, Kalorama Information, estimates that from 2005
      to 2010, over 70 million people in the United States will receive
      cosmetic facial procedures for which they will pay over $60 billion.
      We believe this reflects a growing desire and acceptance among the aging
      population to seek aesthetic facial products and procedures from their
      physicians. With our leading position in the physician-dispensed channel,
      the clinically proven aesthetic benefits of our products and the potential
      of our systems to enhance or complement many other facial procedures, we
      believe we are well positioned to meet this growing patient
      demand.




§
            Conducting clinical studies on
      our products.   We have completed 50 clinical studies
      since 2003 to demonstrate the efficacy of our products. We believe that
      these clinical studies provide our products added scientific credibility
      in the physician-dispensed market. We plan to initiate approximately 12
      additional clinical studies by December 31,
  2009.


§
            International.
        We have formal distribution agreements with 19 distribution
      and two licensing partners covering over 50 countries and a trademark and
      product know-how license agreement in the OTC market of Japan. Currently,
      those distributors have sales activities in approximately 42 countries,
      with growth in 2006 and 2008 coming primarily from the Middle East, Far
      East, Europe, and Americas.





Results of operations.
    We commenced operations in 1997, and as of
December 31, 2008, we had accumulated earnings of $6.6 million. We
reported net income of $12.6 million and $15.2 million for the years
ended December 31, 2008 and December 31, 2007,
respectively.





Seasonality.
    Sales of our products have historically been higher
between September and March. We believe this is due to increased product use and
patient compliance during these months. We believe this increased usage and
compliance relates to several factors such as higher patient tendencies toward
daily compliance inversely proportionate to their tendency to travel and/or
engage in other disruptive activities during summer months. Patient travel and
other disruptive activities that affect compliance are at their peak during July
and August. The effects of seasonality in the past have been offset by the
launch of new products. This trend was very pronounced during 2007 when we
launched four new product offerings and rebranded two systems.





Economy.
    Many treatments in which our products are used are
considered cosmetic in nature, are typically paid for by the patient out of
disposable income and are generally not subject to reimbursement by third-party
payors such as health insurance organizations. As a result, we believe that our
current and future sales growth may to some extent be influenced by the economic
conditions within the geographic markets in which we sell our products. During
the year ended December 31, 2008, we saw the unprecedented economic conditions
within the U.S. have a negative impact on our revenue growth performance. We
believe that the economic downturn has reduced disposable income, which we
believe has led to reduced patient visits to physician offices for aesthetic
procedures and patients’ using less product per application to extend the time
needed for obtaining refills of product from their physicians. The U.S. economic
slow down effect was seen in all of our product categories, as growth was slower
than expected, but was more pronounced within the Nu-Derm product
line.  At this time, it is extremely difficult to measure the
severity, length, geographic and financial impact of the economic downturn and
its longer term impact on our product sales, but we will continue to monitor it
closely.  We do believe that some of the negative impact may be
partially offset due to the following: (i) the continued growth in our market
share; (ii) the aesthetic nature of our products; (iii) the lower price point of
our products compared to other aesthetic products in our market; (iv) the desire
to maintain a healthy and youthful appearance; and (v) the demographics of the
patients who use our products.





Launch of
SoluCLENZ.We launched SoluCLENZ in August
2008.  Since the launch, we have been monitoring the weekly scripts
filled by pharmacies.  Currently, one of the three major reimbursement
compendiums does not permit reimbursement of SoluCLENZ and our sales have
suffered as a result.  To the extent that certain patients continue to
be unable to obtain reimbursement for SoluCLENZ based on the availability
of a generic equivalent, future sales will continue to be impacted, and we
may discontinue selling SoluCLENZ into the pharmacy Rx
channel.  However, while we are disappointed with the results, in the
fourth quarter of 2008, we continued to take steps to make SoluCLENZ a
commercially viable product.  We are currently exploring alternatives
to marketing this novel product such as potential partnering in both or either
the pharmacy Rx channel and the OTC channel.  As such, we believe that
the inventory on hand and consigned inventory of $0.4 million and $0.1 million,
respectively, as of December 31, 2008 related to our SoluCLENZ product is
recoverable.  In the event we aren’t successful in establishing a
partnership in either the pharmacy Rx or OTC channels, we may incur
approximately $0.5 million to $1.5 million in expenses related to the write-down
of inventory and early termination of contracts.





Future growth.
    We believe that our future growth will be driven by
increased direct sales coverage, penetration into non-core markets such as other
medical specialties, ongoing marketing efforts to create increased awareness of
the Obagi brand and the benefits of skin health and new product offerings. We
plan to continue to invest resources on the commercialization of new
applications of our current products, the continuing development of our pipeline
of products and the in-licensing or acquisition of new product opportunities.
However, due to the uncertainties in the economic markets, our current business
plan does not anticipate that we invest significant resources in these strategic
initiatives.  We believe that our on-going profitability is primarily
dependent upon the continued success of our current product
offerings.  Since we are unable to ascertain the length and severity
of this downturn, we could be in a position to decide to invest in such
initiatives in a relatively short time frame once the global markets begin to
stabilize.


41


Critical
Accounting Policies and Use of Estimates




Our discussion and analysis of our
financial condition and results of operations is based upon our financial
statements which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of financial statements
requires management to make estimates and judgments that affect the reported
amounts of assets and liabilities, sales and expenses, and disclosures of
contingent assets and liabilities at the date of the financial statements. On a
periodic basis, we evaluate our estimates, including those related to revenue
recognition, sales return reserve, accounts receivable, inventory and goodwill
and other intangible assets. We use authoritative pronouncements, historical
experience and other assumptions as the basis for making estimates. By their
nature, these estimates are subject to an inherent degree of uncertainty. As a
result, we cannot assure you that actual results will not differ significantly
from estimated results. Our significant accounting policies are further
described in Note 2 to our audited consolidated financial statements
included elsewhere in this Annual Report on Form 10-K.





We believe the following critical
accounting policies affect our more significant judgments and estimates used in
the preparation of our financial statements.





Revenue recognition.
    We recognize revenues for our physician dispensed
segment in accordance with Securities and Exchange Commission ("SEC") Staff
Accounting Bulletin ("SAB") No. 104 ("SAB No. 104"), Revenue Recognition in Financial
Statements, which provides guidance on the recognition, presentation and
disclosure of revenue in financial statements filed with the SEC. SAB
No. 104 outlines the basic criteria that must be met to recognize revenue
and provides guidance for disclosure related to revenue recognition policies. We
recognize revenue when (i) persuasive evidence of an arrangement exists,
(ii) shipment of products has occurred or services have been rendered,
(iii) the sales price charged is fixed or determinable and
(iv) collection is reasonably assured. Our shipment terms are FOB shipping
point as outlined in our sales agreements.





Our domestic sales agreements do not
provide for rights of return or price protection. However, we may approve
returns on a case-by-case basis at our discretion. Certain international
distribution agreements do provide for rights of return and price protection.
Generally, such return rights are for a period of not more than 90 days
after the products have been shipped to the distributors. In accordance with
SFAS No. 48, Revenue
Recognition When Right of Return Exists, we continuously monitor and
track product returns and record a provision for the estimated future amount of
such future returns, based on historical experience and any notification we
receive of pending returns. We do not grant any warranty provisions on our
products. We provide for discounts and allowances based on historical experience
at the time revenue is recognized as a reduction to revenue. To date such
provisions have approximated management's estimates. Other than our provision
for future returns, the only estimates that we have to make regarding revenue
recognition pertain to the collectability of the resulting receivable, both of
which are discussed below.





We grant price protection rights to
certain international distributors. Such price protection rights require us to
pay the distributor if there is a reduction in the list price of our products.
Price protection payments would be required for the distributor's inventory
on-hand or in-transit on the date of the price reduction, for a period not to
exceed 90 days prior to the date of the price reduction. We havenot recorded a liability in connection
with such price protection rights as we have never reduced the list prices of
our products.





In September 2002, we entered into a
licensing agreement, as amended in November 2008, with Rohto (see Note 8 to
our financial statements), a large Japan-based company that specializes in the
distribution and marketing of OTC medical oriented products in the drug store
and retail channels. In January 2006, we entered into a licensing agreement with
Tokyo Beauty Center (see Note 8), a diversified Japanese consumer products
and services company, which also owns and operates a large chain of aesthetic
spas in Japan. Royalty revenue is recognized as earned and is based upon a
predetermined rate within the respective licensing agreement.





As noted earlier, during the year ended
December 31, 2008, we entered the pharmacy Rx channel for the first time by
launching SoluCLENZ Rx GelTM, a
solubilized benzoyl peroxide gel for the treatment of acne, which is available
only by prescription. We sell SoluCLENZ to pharmaceutical wholesalers, who have
the right to return purchased product prior to the units being dispensed through
patient prescriptions. Revenue for this product is recognized in accordance with
SAB No. 104 and SFAS No. 48. Among its criteria for revenue
recognition from sale transactions where a buyer has a right of return, SFAS
No. 48 requires the amount of future returns to be reasonably
estimated.




During
the launch period only, we sold product to wholesalers with a guaranteed sale
provision, allowing the wholesalers to return the product within 120 days of
shipment. Product shipments during the launch period were $1,569 for the year
ended December 31, 2008. As substantially all of the risks and rewards of
ownership did not transfer upon shipment, we are treating the sale of product
during the launch period and after the launch period under a consignment
model.  Under this consignment model, we did not recognize revenue
upon the shipment of product with the guaranteed sale provision and accounted
for inventory held by the wholesalers as consignment inventory.  Due
to our limited experience in the pharmacy Rx channel, we are currently unable to
reasonably estimate customer returns and, therefore, will only recognize revenue
related to SoluCLENZ units once the units have been dispensed through patient
prescriptions because units dispensed to patients are not subject to return. We
obtain actual prescription units dispensed based on distribution channel data
provided by external, independent sources. As of December 31, 2008, amounts
included as deferred revenue in accrued liabilities totaled $398.  Gross
product revenue and net product revenue (gross product revenue, net of cash
discounts, rebates and patient coupons) for prescription units dispensed was
$248 and $162, respectively, for the
year ended December 31, 2008. Inventory on consignment represents the cost of
SoluCLENZ units shipped to wholesalers that has not yet been dispensed to
patients.




42




We will
continue to recognize revenue upon prescription units dispensed until we can
reasonably estimate product returns based on our product returns experience. At
that time, we will record a one-time increase in net revenue related to the
recognition of revenue previously deferred.  In order to develop a
methodology, and provide a basis, for estimating future product returns on sales
to our wholesalers at the time of shipment, we have begun tracking the SoluCLENZ
product return history, taking into consideration product expiration dating at
time of shipment and inventory levels in the distribution channel. Revenue will
also be reduced for estimates of allowances for cash discounts, rebates and
patient coupons based on historical experience, and current contract prices and
terms with wholesalers. If actual, or expected wholesaler returns and revenue
allowances differ from previous estimates, adjustments of these estimates would
be recognized in the period such facts become known.





Sales returns and allowances.
    When we sell our products, we reduce the amount of
revenue recognized from such sales by an estimate of future product returns and
other sales allowances. Sales allowances include cash discounts, rebates and
sales incentives relating to products sold in the current period. Factors that
are considered in our estimates regarding sales returns include the historical
rate of returns as a percent of gross sales less licensing fees, historical
aging of returns and the current market conditions. We maintain a return policy
that allows our customers to return product within a specified period after
shipment of the product has occurred. Factors that are considered in our
estimates regarding sales allowances include quality of product and recent
promotional activity. If actual future experience for product returns and other
sales allowances exceed the estimates we made at the time of sale, our financial
position, results of operations and cash flow would be negatively impacted. To
date, such provisions have approximated management's estimates.





Accounts receivable.
    We perform periodic credit evaluations of our customers
and adjust credit limits based upon payment history and the customer's current
creditworthiness, as determined by our review of current credit information. We
monitor collections and payments from our customers and maintain an allowance
for doubtful accounts based upon our historical write-offs as a percentage of
sales less licensing fees, adjusted specifically for accounts that are past due,
non-performing, in bankruptcy or otherwise identified as at risk for potential
credit loss.  Receivables are charged to the allowance for doubtful
accounts when an account is deemed to be uncollectible, taking into
consideration the financial condition of the customer and the value of any
collateral. Recoveries of receivables previously charged off as uncollectible
are credited to the allowance. If the financial condition of our customers
deteriorates, resulting in an impairment of their ability to make payments and
this exceeds our estimates as of the balance sheet date, we would need to charge
additional receivables to our allowances, and our financial position, results of
operation and cash flow would be negatively impacted. Our credit losses have
historically been within our expectations and the allowance
established.





Inventory.
    We state our inventories at the lower of cost or market,
computed at actual cost on a first-in, first-out basis and market being
determined as the lower of replacement cost or net realizable value. Inventory
reserves are established when conditions indicate that the selling price could
be less than cost due to physical deterioration, usage, obsolescence, reductions
in estimated future demand and reductions in selling prices. Inventory reserves
are measured as the difference between the cost of inventory and estimated
market value. Inventory reserves are charged to cost of sales and establish a
lower cost basis for the inventory. We balance the need to maintain strategic
inventory levels with the risk of obsolescence due to changing technology, new
product offerings and customer demand levels. Unfavorable changes in market
conditions may result in a need for additional inventory reserves that could
adversely impact our gross margins. Conversely, favorable changes in demand
could result in higher gross margins. To date, actual reserve requirements
approximated management's estimates.





Goodwill and other intangible
assets.     Effective January 1, 2002, we
adopted SFAS No. 142 ("SFAS No. 142"), Goodwill and Other Intangible
Assets, which requires, among other things, the use of a nonamortization
approach for purchased goodwill and certain intangibles. Under a nonamortization
approach, goodwill and intangibles having an indefinite life are not amortized,
but instead will be reviewed for impairment at least annually or if an event
occurs or circumstances indicate the carrying amount may be impaired. Events or
circumstances which could indicate an impairment include a significant change in
the business climate, economic and industry trends, legal factors, negativeoperating performance indicators,
significant competition, changes in our strategy or disposition of a reporting
unit or a portion thereof. Goodwill impairment testing is performed at the
reporting unit level.





SFAS
No. 142 requires that goodwill be tested for impairment using a two-step
process. The first step of the goodwill impairment test, used to identify
potential impairment, compares the fair value of a reporting unit with its
carrying amount, including goodwill. If the fair value of a reporting unit
exceeds its carrying amount, goodwill of the reporting unit is not considered to
be impaired and the second step of the impairment test is unnecessary. If the
carrying amount of a reporting unit exceeds its fair value, the second step of
the goodwill impairment test must be performed to measure the amount of
impairment loss, if any. The second step of the goodwill impairment test
compares the implied fair value of reporting unit goodwill with the carrying
amount of that goodwill. The implied fair value of goodwill is determined in the
same manner as the amount of goodwill recognized in a business combination. If
the carrying amount of the reporting unit goodwill exceeds the implied fair
value of that goodwill, an impairment loss is recognized in an amount equal to
that excess.





Application
of the goodwill impairment test requires judgment, including the identification
of reporting units, assignment of assets
and liabilities to such reporting units, assignment of goodwill to such
reporting units, and determination of the fair value of each reporting unit. The
fair value of each reporting unit is estimated using a discounted cash flow
methodology. This requires significant judgments including estimation of future
cash flows, which is dependent on internal forecasts, estimation of the
long-term rate of growth for our business, the useful life over which cash flows
will occur, and determination of our weighted average cost of capital. Changes
in these estimates and assumptions could materially affect the determination of
fair value and/or goodwill impairment for each reporting
unit.


43





We have
selected September 30 as the date on which we will perform our annual
goodwill impairment test. We attribute the entire balance of our goodwill of
$4.6 million to our largest operating segment, which is also a reporting unit,
the Physician Dispensed segment.  Our determination of fair value of
our goodwill considered the current and future economic, market, and competitive
conditions, and other relevant factors.  We evaluated the fair value
of our goodwill using two approaches.  For the first method, we
derived valuation multiples from historical earnings data of guideline companies
within our industry that compete in the Physician Dispensed market, and then
evaluated and adjusted the multiples based on our strengths and weaknesses
relative to the guideline companies.  The derived multiples are then
applied to our operating data to arrive at an indication of fair
value.  Cash-free invested capital multiples, representing a
marketable, minority interest, were calculated for the guideline companies as of
September 30, 2008.  Revenue and earnings multiples were based on a
valuation of the guideline companies’ profit margins, historical growth
patterns, and a review of our own market factors, primarily related to our
Physician Dispensed business.  The second method, the discounted cash
flow method, focused on the expected cash flows of our Physician Dispensed
business.  We evaluated earnings projections through 2013, trending
the growth down to 3% in the terminal year.  The discount rate for our
Physician Dispensed segment was determined by utilizing a weighted average cost
of capital analysis, which analyzed long-term government bonds, the Moody’s
Seasoned AAA bond rate, the cost of equity of similar companies relative to our
Physician Dispensed business, as well as our capital structure.  Both
methods were weighted 50%.  The analyses concluded that the fair value
of our Physician Dispensed segment significantly exceeded the carrying amount of
our goodwill.  There were no impairment triggers subsequent to
September 30, 2008.  As such, based on our analyses, no impairment
charges were recognized for the years ended December 31, 2008, 2007, and
2006.





Other
intangible assets consist of trademarks, distribution rights, covenants
not-to-compete, patents, customer lists, and proprietary formulations. Other
intangible assets are amortized over the expected period of benefit using the
straight-line method over the following lives: trademarks (20 years);
distribution rights (ten years); covenants not-to-compete (seven years); and
other intangible assets (three to 17 years). In accordance with
SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, long — lived assets (including
intangible assets that are amortized) are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable, such as a significant sustained change in the business
climate, during the interim periods. If an indicator of impairment exists for
any grouping of assets, an estimate of undiscounted future cash flows is
compared to the asset group’s carrying value. If an asset is determined to be
impaired, the loss is measured by the excess of the carrying amount of the asset
over its fair value as determined by an estimate of discounted
future cash flows. There were no indicators of impairment noted during 2008,
therefore no tests were performed for long-lived assets. Any unfavorable changes
in market conditions or our product lines may result in the impairment of
goodwill or an intangible asset, which could adversely impact our net
income.





Leases.
    We account for leases under the provisions of SFAS
No. 13, Accounting for
Leases, and subsequent amendments, which require that our leases be
evaluated and classified as either operating leases or capital leases for
financial reporting purposes. Minimum base rents for our operating leases, which
generally have scheduled rent increases over the term of the lease, are recorded
on a straight-line basis over the lease term. The initial lease term includes
the period from when we are given access and control over the lease property,
whether or not rent payments are due under the terms of the lease.





For
leases with renewal periods at our option, we generally consider the lease term
to consist of the initial lease term, as exercise of the renewal options as
determined at lease inception are not considered to be reasonably assured of
exercise. However, if failure to exercise a renewal option imposes an economic
penalty of sufficient magnitude to us, then the renewal, at inception, is
reasonably assured and will be included in the determination of the appropriate
lease term.





In
certain instances, we disburse cash for leasehold improvements, furnishings,
fixtures and equipment to renovate leased premises. If costs are paid directly
by the landlord or reimbursed to us by the landlord, we record a deferred rent
liability and amortize the deferred rent liability over the leaseterm as a reduction to rent expense.
In other instances, we may expend cash for landlord additions that we make to
leased premises that are reimbursed to us by the landlord. Based on the
specifics of the leased space and the lease agreement, during the renovation
period, amounts paid will be recorded as prepaid rent and any landlord
reimbursement will be recorded as an offset to prepaid rent.





Stock-based compensation.
    We account for stock-based compensation in accordance
with the provisions of SFAS No. 123R ("SFAS No. 123R"), Share-Based Payment. In
connection with our January 2006 adoption of SFAS No. 123R, we adopted the
modified prospective transition method in the first quarter of fiscal 2006, and
as a result, did not retroactively adjust results from prior periods. Under this
transition method, stock-based compensation is recognized for: (i) expense
related to the remaining unvested portion of all stock option awards granted
during the one year period preceding our initial public offering, based on the
grant date fair value estimated in accordance with the original provisions of
SFAS No. 123; and (ii) expense related to all stock option awards
granted on or subsequent to January 1, 2006, based on the grant date fair
value estimated in accordance with the provisions of SFAS No. 123R. In
accordance with SAB No. 107, Share-Based Payment,("SAB
No. 107"), the remaining unvested options we issued prior to the one year
period preceding our initial public offering, with the exception of the October
2005 grants, are not included in the SFAS No. 123R option pool as they were
valued using the minimum value method.


44




As a
result, unless subsequently modified, repurchased or cancelled, such unvested
options will not be included in stock-based compensation. Determining the
appropriate fair-value model and calculating the fair value of stock-based
awards at the date of grant using any valuation model requires judgment. We use
the Black-Scholes option-pricing model, which requires the input of highly
subjective assumptions. These assumptions include estimating the length of time
employees will retain their stock options before exercising them ("expected
term"), the estimated volatility of our common stock price over the expected
term and the number of options that will ultimately not complete their vesting
requirements ("forfeitures"). We estimated our options' expected terms in
accordance with SAB No. 107 and SAB No. 110, using our best estimate
of the period of time from the grant date that we expect the options to remain
outstanding. If we determine another method to estimate expected volatility or
expected term was more reasonable than our current methods, or if another method
for calculating these input assumptions is prescribed by authoritative guidance,
the fair value calculated for stock-based awards could change significantly.
Higher volatility and expected terms result in a proportional increase to
stock-based compensation determined at the date of grant. The expected dividend
rate and expected risk-free rate of return are not as significant to the
calculation of fair value.





The
impact of SFAS No. 123R on our Consolidated Statement of Income for the
year ended December 31, 2007 on income before income taxes and net income
was $1.6 million and $0.9 million and had a $0.04 and a $0.04 impact on basic
and dilutive earnings per share, respectively. For the year ended
December 31, 2008, the impact on income before income taxes and net income
was $2.0 million and $1.3 million, respectively, and had a $0.06 and a $0.06
impact on basic and diluted earnings per share, respectively. In addition, prior
to the adoption of SFAS No. 123R, we presented the tax benefit resulting
from the exercise of stock options as operating cash inflows in our Consolidated
Statements of Cash Flows. Upon the adoption of SFAS No. 123R, the excess
tax benefits for those options are classified as financing cash
inflows.





Prior to
our common stock being actively traded, our board of directors, the members of
which we believe have extensive business, finance and investment experience,
were required to estimate the fair value of our common stock at the time of each
option grant for purposes of determining stock-based compensation expense for
the periods presented herein. In response to that requirement, our board of
directors appointed members of the compensation committee to analyze our stock
value and recommend common stock valuation estimates. For economic reasons, we
initially chose to value our options using a model that employed a market based
approach based principally upon applying appropriate valuation multiples to the
EBITDA and revenue and not to obtain a contemporaneous valuation by an
independent third party. As a privately held company, we believed that the
members ofour compensation
committee had the requisite experience and expertise to determine the fair value
of the options. If a valuation model using different input variables and
assumptions had been used, our common stock valuation may have been
different.





If we had made different assumptions and estimates, the amount of our recognized
and to be recognized stock-based compensation expense, net income and net income
per share amounts could have been materially different. We believe that we have
used reasonable methodologies, approaches and assumptions consistent with the
American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company
Equity Securities Issued as Compensation, to determine the fair market
value of our common stock.





Uncertainty in Income Taxes.
    Effective January 1, 2007, we began to measure and
record tax contingency accruals in accordance with FIN 48 ("FIN 48"),
Accounting for Uncertainty in
Income Taxes—an Interpretation of FASB Statement No. 109 . The
expanded disclosure requirements of FIN 48 are presented in Note 6 to
the Consolidated Financial Statements in Part I, Item I. FIN 48
prescribes a threshold for the financial statement recognition and measurement
of a tax position taken or expected to be taken in a tax return. Only tax
positions meeting the more-likely-than-not recognition threshold at the
effective date may be recognized or continue to be recognized upon adoption of
this interpretation. FIN 48 also provides guidance on accounting for
derecognition, interest and penalties, and classification and disclosure of
matters related to uncertainty in income taxes. Prior to January 1, 2007,
we recorded accruals for tax contingencies and related interest when it was
probable that a liability had been incurred and the amount of the contingency
could be reasonably estimated based on specific events such as an audit or
inquiry by a taxing authority. As a result of the implementation of FIN 48,
we recognized approximately a $0.1 million increase in the liability for
unrecognized tax benefits, which was accounted for as an increase to the
January 1, 2007 accumulated deficit balance.  As of December 31,
2008, the liability for unrecognized tax benefits was $0.2 million.




45




Results
of Operations





The
year ended December 31, 2008 compared the year ended December 31,
2007





Net sales.
    The following table compares net sales by product line
and certain selected products for the year ended December 31, 2008 and
2007:


Year
      Ended December 31,2008
                                              
                                              
                                              2007
                                              
                                              
                                              Change(in
      thousands)Net
      sales by product category:Physician
      dispensedNu-Derm
                                              
                                              $
                                              58,378
                                              
                                              
                                              $
                                              62,184
                                              
                                              
                                              
                                              -6
                                              %Vitamin C
                                              
                                              
                                              12,380
                                              
                                              
                                              
                                              11,438
                                              
                                              
                                              
                                              8
                                              %Elasticity
                                              
                                              
                                              11,643
                                              
                                              
                                              
                                              8,356
                                              
                                              
                                              
                                              39
                                              %Therapeutic
                                              
                                              
                                              6,098
                                              
                                              
                                              
                                              5,753
                                              
                                              
                                              
                                              6
                                              %Other
                                              
                                              
                                              11,115
                                              
                                              
                                              
                                              10,261
                                              
                                              
                                              
                                              8
                                              %Total
                                              
                                              
                                              99,614
                                              
                                              
                                              
                                              97,992
                                              
                                              
                                              
                                              2
                                              %Pharmacy Rx
                                              
                                              
                                              162
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Licensing
      fees
                                              
                                              
                                              4,817
                                              
                                              
                                              
                                              4,656
                                              
                                              
                                              
                                              3
                                              %Total
      net sales
                                              
                                              $
                                              104,593
                                              
                                              
                                              $
                                              102,648
                                              
                                              
                                              
                                              2
                                              %United
      States
                                              
                                              
                                              84
                                              %
                                              
                                              
                                              85
                                              %International
                                              
                                              
                                              16
                                              %
                                              
                                              
                                              15
                                              %








Net sales increased by
$2.0 million, or 2%, to $104.6 million during the year ended
December 31, 2008, as compared to $102.6 million during the year ended
December 31, 2007. Overall, the economic conditions within the U.S. had a
slightly negative impact on our revenue growth performance during the year ended
December 31, 2008. We believe that the economic downturn has reduced disposable
income which we believe has led to reduced patient visits to physician offices
for aesthetic products and procedures, and fewer such procedures being performed
and products being purchased. The U.S. economic slow down effect was seen in all
of our product categories, as growth was lower than expected, but was more
pronounced within the Nu-Derm product line. During the year ended
December 31, 2008, we experienced Nu-Derm sales decline of
$3.8 million. We saw sales growth of $0.9 million and
$0.9 million in the Vitamin C and Other categories,
respectively.  The growth in the Vitamin C category was primarily due
to strong sales performance by the Professional-C product line. The Other
product category growth was driven by a sales focused system approach. The
system approach is designed to educate physicians on the benefits of prescribing
the complete Nu-Derm system as opposed to partial systems. We had a total of
$3.3 million increase in Elasticity sales driven by the launch of our
ELASTIdermTM Décolletage product in January 2008, our new system that focuses on
restoring the elasticity of the neck and chest area. We had a total of $0.3
million increase in Therapeutic sales due to the sales performance of
CLENZIderm, the primary product in our Therapeutic product category, which was
launched in February 2007, with a second system launched in July 2007.Pharmacy Rx, our new operating
segment, includes the sale of prescription and over-the-counter dermatological
products that are dispensed through pharmacies.  The primary product
sold in this channel, SoluCLENZ Rx Gel, which was launched in August 2008,
generated $0.2 million during the year ended December 31,
2008.  Licensing fees increased $0.2 million during the year
ended December 31, 2008.





Our
aggregate sales growth was comprised of $0.5 million in the U.S. and
$1.5 million from international markets. The U.S. growth was fueled by the
recent launch of two new product lines. International sales growth came from all
product lines and primarily came from two regions, $1.2 million from the
Europe and Other region, and $0.4 million from the Americas; offset by a
decrease of $0.2 million in the Far East and $0.1 million in the Middle East.
Our licensing fees increased $0.2 million primarily due to fees received
under our agreement with Rohto.  We believe, depending upon its
duration and severity, that a continued U.S. economic slow down may negatively
impact our future net sales.





Gross margin percentage.
    Our gross margin percentage decreased to 80.9%, for the
year ended December 31, 2008 compared to 82.4% for the year ended December
31, 2007. The overall decline is primarily attributable to a decline in gross
margin for our physician dispensed segment, which decreased to 80.2% compared to
81.7% for the same period last year.  The decline is primarily as a
result of: (i) a $0.9 million increase in discounting promotional activities;
and (ii) a $0.5 million increase in inventory reserves related to short dated
product in our Therapeutic and Other product categories.  The decline
in our physician dispensed segment was offset by the gross margin for our
licensing segment, which increased to 97.2% compared to 96.9% for the same
period last year.  Cost of sales also consists of outbound shipping
and handling, work order scrap, licensing and royalty fees related to licensed
intellectual property, depreciation and amortization attributable to products
sold, and an inventory reserve for shrinkage and write-downs.




46




Selling, general and
administrative.     Selling, general and
administrative expense consists primarily of salaries and other
personnel-related costs, professional fees, insurance costs, stock based
compensation, depreciation and amortization not attributable to products sold,
warehousing costs, advertising, travel expense and other selling expenses.
Selling, general and administrative expenses increased $8.0 million to
$59.4 million during the year ended December 31, 2008, as compared to
$51.4 million for the year ended December 31, 2007. This increase is
primarily due to the following: (i) a $4.0 million increase due to an
increase in headcount, largely direct sales, marketing and operational
personnel; (ii) a $2.1 million increase in costs related to the preparation,
launch and on-going marketing activities related to SoluCLENZ, which was
launched in August 2008; (iii) a $0.7 million increase in volume driven activities;
(iv) a $0.6 million increase in marketing costs, primarily related to the launch
of our national consumer awareness campaign during launched in the third quarter
of 2008; (v) a $0.6 million increase in expenses related to severance
and compensation expense for Stephen A. Garcia, our former Chief Financial
Officer, and other former employees; (vi) a $0.5 million increase in rent and
related expenses due to the relocation of our corporate headquarters during the
second half of 2008; (vii) a $0.4 million increase in non-cash
compensation primarily due to restricted stock units and stock options granted
during the year ended; (viii) a $0.3 million increase in technical support
fees due to the implementation of a new enterprise resource planning system;
(ix) a $0.3 million increase in other expenses; offset by (i) a $1.4
million decrease in expenses  related to operating as a public
company, primarily consisting of professional fees; and (ii) a $0.1 million
decrease in depreciation and amortization. As a percentage of net sales, selling,
general and administrative expenses in the year ended December 31, 2008
were 57% as compared to 50% in the year ended December 31, 2007. We expect to
minimize additional operating costs, such as professional fees and insurance
costs, due to the downturn in the economy. We intend to maintain or decrease
selling, general and administrative expenses as a percentage of net
sales.





Research and development.
    Research and development expenses decreased
$0.2 million to $5.3 million for the year ended December 31, 2008
as compared to $5.5 million for the year ended December 31, 2007. The
decrease is primarily due to the following:  (i) a $0.1 million
decrease in salaries and related benefits during the year ended December 31,
2008 as compared to the year ended December 31, 2007 due to a decrease in
headcount; and (ii) a $0.1 million decrease in royalties paid to Dr. Obagi
pursuant to the June 29, 2006 Services Agreement. As a percentage of net sales,
research and development costs in the year ended December 31, 2008 were 5%
as compared to 5% in the year ended December 31, 2007.





Interest income and Interest
expense.     Interest expense was $0.2 million
during the year ended December 31, 2008, as compared to $2.4 million for
the year ended December 31, 2007. During the year ended December 31, 2007,
we made $23.5 million in prepayments, $7.0 million of which came from
the net proceeds received in our secondary public offering completed in October
2007, in addition to our regularly scheduled payments of $0.8 million and
an excess cash payment of $1.3 million. The additional prepayments resulted
in a complete paydown of our outstanding debt. Interest expense incurred during
the year ended December 31, 2008 partly relates to amortization of debt issuance
costs of approximately $0.1 million related to our line of credit obtained in
conjunction with the Credit Agreement.  In connection with entering a
new line of credit agreement with Comerica (see further discussion in the
“Liquidity and Capital Resources” section of “Management’s Discussion and
Analysis of Financial Condition and Results of Operations”), the previous Credit
Agreement, dated as of January 28, 2005 (as amended) was
terminated.  Termination of the agreement resulted in a write off of
debt issuance costs of approximately $0.1 million during the year ended December
31, 2008 and was charged to interest expense.  Interest income
increased $0.2 million to $0.4 million during the year ended December 31,
2008, as compared to $0.2 million for the year ended December 31, 2007. The
increase is primarily due to an increase in our average cash and short-term
investments balance to $21.3 million during the year ended
December 31, 2008, compared to $8.6 million during the year ended
December 31, 2007.





Income taxes.
    Income tax expense decreased $2.8 million to
$7.5 million for year ended December 31, 2008, as compared to
$10.3 million for the year ended December 31, 2007. Our effective tax rate
decreased 2.9% to 37.4% for the year ended December 31, 2008, compared to
40.3% for the year ended December 31, 2007. The decrease is primarily due to a
decrease in state taxes, a decrease in nondeductible expenses for tax purposes,
and the increase in the tax benefit, as a percentage of net income, derived from
the research and development credit during the year ended December 31,
2008.





The year ended December 31, 2007
compared the year ended December 31, 2006





Net sales.
    The following table compares net sales by product line
and certain selected products for the year ended December 31, 2007 and
2006:


Year
      Ended December 31,2007
                                      
                                      
                                      2006
                                      
                                      
                                      Change(in
      thousands)Net
      sales by product category:Physician
      dispensedNu-Derm
                                      
                                      $
                                      62,184
                                      
                                      
                                      $
                                      53,836
                                      
                                      
                                      
                                      16
                                      %Vitamin C
                                      
                                      
                                      11,438
                                      
                                      
                                      
                                      9,986
                                      
                                      
                                      
                                      15
                                      %Elasticity
                                      
                                      
                                      8,356
                                      
                                      
                                      
                                      2,278
                                      
                                      
                                      
                                      267
                                      %Therapeutic
                                      
                                      
                                      5,753
                                      
                                      
                                      
                                      180
                                      
                                      
                                      
                                      3096
                                      %Other
                                      
                                      
                                      10,261
                                      
                                      
                                      
                                      7,660
                                      
                                      
                                      
                                      34
                                      %Total
                                      
                                      
                                      97,992
                                      
                                      
                                      
                                      73,940
                                      
                                      
                                      
                                      33
                                      %Licensing
                                      
                                      
                                      4,656
                                      
                                      
                                      
                                      4,056
                                      
                                      
                                      
                                      15
                                      %Total
      net sales
                                      
                                      $
                                      102,648
                                      
                                      
                                      $
                                      77,996
                                      
                                      
                                      
                                      32
                                      %United
      States
                                      
                                      
                                      85
                                      %
                                      
                                      
                                      82
                                      %International
                                      
                                      
                                      15
                                      %
                                      
                                      
                                      18
                                      %








47




Net sales
increased by $24.6 million, or 32%, to $102.6 million during the year
ended December 31, 2007, as compared to $78.0 million during the year ended
December 31, 2006. During the year ended December 31, 2007, we experienced
Nu-Derm sales growth of $8.3 million. In addition, we saw sales growth of
$1.4 million and $2.6 million in the Vitamin C and Other categories,
respectively. The two product categories formally launched in 2008, Elasticity
and Therapeutic, increased $6.1 million and $5.6 million,
respectively. Licensing fees increased $0.6 million during the year ended
December 31, 2007. Our sales growth was comprised of $23.1 million of
growth in the United States and $1.5 million in growth from international
markets. U.S. growth was fueled by the overall growth in the skin care market,
the recent launch of two new product lines and the expansion of our sales force.
Over 83% of the product category sales growth experienced was attributable to
unit volume growth. The Nu-Derm product category growth was largely driven by
the expansion of our sales force, the promotional and educational efforts of our
professional sales force and the launch of Nu-Derm Condition & Enhance for
Botox® in July 2006 and the launch of two Condition & Enhance Systems in
August 2007, which on a combined basis contributed $9.1 million. The growth
in the Vitamin C category was primarily driven by the strong sales performance
by the Obagi-C Rx product line. The Elasticity product category growth was due
to a full year of sales of our ELASTIderm Eye Cream product during the year
ended December 31, 2007 as compared to only 3 months during the year ended
December 31, 2006 and the February 2007 launch of the second product in the
category, ELASTIderm Eye Gel. The Therapeutic product category growth is
attributable to the official launch of our CLENZIdermTM product line in February
2007 and the launch of the second CLENZIderm system in July 2007. The Other
product category growth was driven by the continued success of our system
approach concept launched in early 2005. The system approach is designed to
educate physicians on the benefits of prescribing the complete Nu-Derm system as
opposed to partial systems. International sales growth was primarily in the
Elasticity, Vitamin C and Therapeutic product lines and primarily came from four
regions, $0.5 million from the Europe and Other region, $0.2 million
from North America excluding the United States, $0.1 million from the
Middle East, and $0.1 million from the Far East. Our licensing fees
increased $0.6 million primarily due to fees received under our agreement
with Rohto.





Gross margin percentage.
    Our gross margin percentage decreased to 82.4%, for the
year ended December 31, 2007 compared to 82.7% for the year ended
December 31, 2006, primarily as a result of: (i) the $5.6 million
increase in Therapeutic sales, which solely consist of our CLENZIderm product
line that has a lower gross margin compared to our other product line offerings;
(ii) start up manufacturing costs for the BPO serum gel burden on the
initial units produced and sold; and (iii) a decline in our Vitamin C
margin due to a reserve for obsolete inventories arising from product
reformulation of approximately $0.1 million. This was partially offset by
improved margins on products in our Other product line due to new contract
volume purchasing discounts with the manufacturer. Although we anticipate
gaining efficiency in our manufacturing processes for CLENZIderm, we believe our
margins will remain slightly lower in the near future as we ramp up the sales
volume of our CLENZIderm product line. Cost of sales also consists of outbound
shipping and handling, work order scrap, licensing and royalty fees related to
licensed intellectual property, depreciation and amortization attributable to
products sold, and an inventory reserve for shrinkage and
write-downs.





Selling, general and
administrative.     Selling, general and
administrative expense consists primarily of salaries and other
personnel-related costs, professional fees, insurance costs, stock based
compensation, depreciation and amortization not attributable to products sold,
warehousing costs, advertising, travel expense and other selling expenses.
Selling, general and administrative expenses increased $10.5 million to
$51.4 million during the year ended December 31, 2007, as compared to
$40.9 million for the year ended December 31, 2006. This increase is
primarily due to the following: (i) a $5.5 million increase due to the
hiring of additional employees, largely direct sales and administrative support
personnel, during the year ended December 31, 2007, as compared to the year
ended December 31, 2006; (ii) a $1.3 million increase in expenses
for physician training, practice building and patient acquisition;
(iii) $1.2 million increase primarily consisting of market research
targeting physicians and patients and for product development; (iv) a
$1.1 million increase in non-cash compensation expense due to the adoption
of SFAS No. 123R on January 1, 2006; (v) a $1.1 million
increase due to expenses related to the secondary offering completed in October
2007; (vi) a $0.7 million increase in insurance; (vii) a
$0.5 million increase in volume driven activities; (viii) a
$0.5 million increase in operational and manufacturing support activities;
(ix) a $0.2 million increase in depreciation and amortization; and
(x) a $0.1 million increase in advertising costs; offset by,
(i) a $1.0 million decrease in expenses relating to operating as a
public company; (ii) a $0.4 million decrease in management fees; and
(iii) a $0.3 million decrease in professional fees. As a percentage of
net sales, selling, general and administrative expenses in the year ended
December 31, 2007 were 50% as compared to 52% in the year ended
December 31, 2006. We expect to incur additional operating costs, such as
professional fees and insurance costs, related to the growth of our
business.





Research and development.
    Research and development expenses decreased
$0.4 million to $5.5 million for the year ended December 31, 2007 as
compared to $5.9 million for the year ended December 31, 2006. This
decrease is primarily due to a one-time payment of $0.4 million to
Dr. Zein Obagi, or Dr. Obagi, one of our principal stockholders and
one of our former officers and directors, under a noncompete agreement during
the year ended December 31, 2006. There were no such payments made in 2008.
As a percentage of net sales, research and development costs in the year ended
December 31, 2007 were 5% as compared to 8% in the year ended December 31,
2006.





Interest income and Interest
expense.     Interest expense was $2.4 million
during the year ended December 31, 2007, as compared to $8.2 million for
the year ended December 31, 2006. The decline is primarily attributable to
the prepayment of $35.0 million in debt with the net cash proceeds received
in our initial public offering completed in December 2006. During the year ended
December 31, 2007 we made $23.5 million in prepayments, $7.0 million
of which came from the net proceeds received in our secondary public offering
completed in October 2007, in addition to our regularly scheduled payments of
$0.8 million and an excess cash
payment of $1.3 million. The additional prepayments resulted in a complete
paydown of our outstanding debt. Interest income increased $177,000 to $190,000
during the year ended December 31, 2007, as compared to $13,000 for the year
ended December 31, 2006. The increase is primarily due to an increase in
our average cash balance to $8.6 million during the year ended December 31,
2007, compared to $4.1 million during the year ended December 31,
2006.





Income taxes.
    Income tax expense increased $6.8 million to
$10.3 million for year ended December 31, 2007, as compared to
$3.5 million for the year ended December 31, 2006. Our effective tax
rate increased 4% to 40% for the year ended December 31, 2007, compared to 36%
for the year ended December 31, 2006. The increase is primarily due to the
decrease in the tax benefit, as a percentage of net income, derived from the
research and development credit and certain costs incurred during the secondary
offering completed in October 2007 not being deductible for tax purposes
during the year ended December 31, 2007.




48




Liquidity
and Capital Resources





Trends
and uncertainties affecting liquidity





Our
primary sources of liquidity are our cash generated by operations and
availability under our Revolving Credit Agreement (the “Facility”) entered into
in November 2008.   As of December 31, 2008 we had
approximately $19.9 million in cash and cash equivalents and short-term
investments and $20.0 million available under the Facility.  We
currently believe that our existing cash balances and cash generated by
operations, together with our available credit capacity, will enable us to meet
foreseeable liquidity requirements.  The following has or is expected
to impact liquidity:





§
            we
      expect to continue to invest in our Enterprise Resource Planning (“ERP”)
      system;





§
            on
      August 5, 2008, the board of directors gave us the authority to repurchase
      up to $10 million of our outstanding common shares in the open market
      over the next two years.  During the year ended December 31,
      2008, we purchased $4.0 million of our outstanding stock;
      and





§
            our
      days sales outstanding (“DSO”) has increased from 59 days at December 31,
      2007 to 74 at December 31, 2008.  In response, we have increased
      our allowance for doubtful accounts and sales returns to $1.2 million for
      the year ended December 31, 2008, compared to $0.8 million for the year
      ended December 31, 2007.





We are
operating in an uncertain and volatile economic environment, which could have
unanticipated adverse effects on our business. The pharmaceutical industry has
been impacted by recent volatility in the financial markets, including declines
in stock prices, and by uncertain economic conditions. Increases in food and
fuel prices, changes in the credit and housing markets leading to the current
financial and credit crisis, actual and potential job losses among many sectors
of the economy, significant declines in the stock market resulting in large
losses to consumer retirement and investment accounts, and uncertainty regarding
future federal tax and economic policies have all added to declines in consumer
confidence and curtailed consumer spending.





We expect
the weak economic environment to continue and do not expect macroeconomic
conditions to be conducive to growth in 2009. Achieving financial results that
compare favorably with year-ago results will be challenging in the first half of
2009. In the first quarter of 2009, we expect a sales decline that is more or
less consistent with the fourth quarter 2008 trend. We intend to moderate our
growth plans and avoid credit and market risk. We expect to continue to generate
positive working capital through our operations and, at this time, we do not
anticipate drawing on our Facility.





As of
December 31, 2008, we had no outstanding balance on the
Facility.  However, as of December 31, 2008, we were not in compliance
with the non-financial covenant, requiring us to report monthly, a listing of
our intellectual property.  Subsequent to year end, we obtained a
waiver for the months of November 2008, December 2008 and January 2009 with
respect to this covenant. We expect to be in compliance with both our
non-financial and financial covenants during the remainder of 2009; however
economic conditions or the occurrence of events discussed above under “Risk
Factors” could cause noncompliance within our financial covenants.





We expect
to be able to manage our working capital levels and capital expenditure amounts
to maintain sufficient levels of liquidity. As of December 31, 2008 and
2007, we had approximately $44.1 million and $34.2 million,
respectively, in working capital.  We have invested approximately $4.1
million in capital expenditures during the year ended December 31, 2008, which
largely consist of expenses related to our new corporate headquarters and ERP
system.  In 2009, we expect to spend approximately $1.5 million in
capital expenditures, primarily related to the completion of our ERP system,
sales force automation and IT upgrades.  We do expect to slow down our
investing activities in response to the current economic
conditions.  We intend to maintain our strong balance
sheet.





Cash
requirements for our business





Historically,
we have generated cash from operations in excess of working capital requirements
and through private and public sales of common stock. We currently invest our
cash and cash equivalents in large money market funds and certificates of deposit
with maturities no greater than one year. As of December 31, 2008 and 2007,
we had approximately $19.9 million and $14.1 million, respectively, of cash
and cash equivalents and short-term investments, respectively.





Pursuant to
the third amendment of our Credit Agreement entered into in November 2006 with GE Business Financial
Services, Inc. (formerly known as Merrill Lynch Business Financial Services,
Inc.),during the year ended December 31, 2007, we made a mandatory
$1.3 million excess cash payment, $0.8 million in principal payments
and $23.5 million in optional principal repayments on the outstanding
balance of the terms loans. Approximately $9.2 million of the net proceeds
generated from our secondary public offering on October 12, 2007 was
utilized to pay down our outstanding balance of our term loans and our revolving
line of credit under the Credit Agreement. As of December 31, 2007, we had
completely paid down the outstanding debt under the Credit Agreement. Borrowings
under the Credit Agreement were subject to certain financial and operating
covenants that included, among other provisions, maintaining a maximum Debt to
EBITDA Ratio and minimum EBITDA levels and restrictions on our ability to pay
dividends. Under the terms of the Credit Agreement, if Stonington ceased to own
at least 20% of our outstanding common stock, it would be considered an event of
default. Certain covenants also limited annual capital expenditures and use of
proceeds from the issuance of debt and equity securities. We were in compliance
with all financial and non-financial covenants as of December 31,
2007.





On
November 21, 2008, we entered into the Facility with Comerica Bank for $20.0
million.  The Facility has an initial term of three years,
ending on November 21, 2011, unless terminated earlier in accordance with
its provisions.  Any borrowings on the Facility bear variable
interest based on a margin, at our option, over prime rate or LIBOR as defined
in the Facility.  All amounts borrowed under the Facility are
secured by a first priority security interest in all of our tangible and
intangible assets. The Facility contains certain financial and non-financial
covenants. Non-financial covenants include, among other things, certain
limitations on annual capital expenditures and asset or equity based investments
and monthly and quarterly reporting of a listing of our intellectual property.
Financial covenants include requirements for maintaining a (i) minimum quick
ratio; (ii) maximum ratio of total liabilities to net worth; (iii) no loss for
two consecutive quarters; (iv) minimum level of profitability; (v) maximum
annual capital expenditures; (vi) stock repurchases not to exceed $10.0 million;
(vii) maximum dividend distribution not to exceed 25% of net income for the
fiscal year; and (viii) joint venture investment not to exceed $2.0 million. See
below for covenant compliance:




49





Facility
      Covenants
                As
      of 12/31/08
                
                RequirementMinimum quick
      ratio
                4.0
                
                1.0Maximum ratio of
      total liabilitiesto
      effective tangible net worth
                0.23
                
                1.75Quarterly
      Results
                No
      net loss for any quarter ended in 2008
                
                No
      net loss for two consecutive quartersMinimum annual
      profitability
                $12.6
      million
                
                $1
      millionMaximum annual
      capital expenditures
                $4.1
      million
                
                $6
      millionMaximum stock
      repurchase
                $4
      million
                
                $10
      millionMaximum dividend
      distribution
                $0
                
                $3.1
      millionJoint venture
      investment
                $0
                
                $2
      million




As of
December 31, 2008, we had no outstanding balance on the Facility. As noted
earlier, as of December 31, 2008, we were not in compliance with the
non-financial covenant requiring us to report monthly a listing of our
intellectual property.  Subsequent to year end, we obtained a waiver
with respect to this covenant.  We believe that we will be in
compliance with all financial and non-financial debt covenants during the
remainder of 2009.





In
connection with establishing the Facility, the previous Credit Agreement, dated
as of January 28, 2005 (as amended) was terminated.  We were not in
default under this Credit Agreement, nor did it have any outstanding
balance on the Credit Agreement with GE Business Financial Services, Inc.
at the time of termination.  Termination of the agreement
resulted in a write off of debt issuance costs of approximately $0.1 million
during the year ended December 31, 2008.





On August
5, 2008, the board of directors authorized the repurchase of up to $10 million
of our outstanding common shares over a period of two years.  The
purchases are to be made in the open market or in privately negotiated
transactions from time to time as permitted by securities laws and other legal
requirements.  The timing manner, price and amount of any repurchases
are determined by a three person committee, consisting of members of our board
and management, at its discretion and will be subject to economic and market
conditions, stock price, applicable legal requirements and other factors that
may be discontinued at any time.  During the year ended December 31,
2008, we purchased 627,367 shares of our outstanding stock for a cost of $4.0
million.





We continually evaluate new
opportunities for therapeutic systems or products and, if and when appropriate,
intend to pursue such
opportunities through the acquisitions of companies, products or technologies
and our own development activities. Our ability to execute on such opportunities
in some circumstances may be dependent, in part, upon our ability to raise
additional capital on commercially reasonable terms. There can be no assurance
that funds from these sources will be available when needed or on terms
favorable to us or our stockholders. If additional funds are raised by issuing
equity securities, the percentage ownership of our stockholders will be reduced,
stockholders may experience additional dilution or such equity securities may
provide for rights, preferences or privileges senior to those of the holders of
our common stock.





On November 27, 2006, our board of
directors approved an amended and restated certificate of incorporation and
amended and restated bylaws in preparation for our initial public offering. This
amended and restated certificate of incorporation was approved by the
stockholders on November 28, 2006 and was filed with the Secretary of State
of the State of Delaware in December 2006. The changes included:
(i) increasing our total authorized shares to 110,000,000 (100,000,000
common and 10,000,000 preferred); (ii) modifying the classes, term and
number of the members of the board of directors; and (iii) implementing
other changes deemed necessary for a public reporting company. We also revised
our compensation committee and nominating committee charters and adopted new
policies to follow current best practices for public companies.





Inflation





Although at reduced levels in recent
years, inflation continues to apply upward pressure on the cost of goods and
services that we use. The competitive environments in many markets substantially
limit our ability to fully recover these higher costs through increased selling
prices. We continually seekto
mitigate the adverse effects of inflation through cost containment and improved
productivity and manufacturing processes.





Foreign
Currency Fluctuations





Approximately 5% of our net sales in
2008 were derived from operations outside the United States and were denominated
in Japanese Yen. None of our international cost structure is denominated in
currencies other than the U.S. dollar. As a result, we are subject to
fluctuations in sales and earnings reported in U.S. dollars due to changing
currency exchange rates. We do not believe, however, that we currently have
significant direct foreign currency exchange rate risk and have not hedged
exposures denominated in foreign currencies.





50




Cash
Flow





Year ended December 31,
2008.     For the year ended December 31, 2008,
net cash provided by operating activities was $14.0 million. The primary
sources of cash were $12.6 million in net income, including the effect of:
(i) adjusting for non-cash items; (ii) a net increase in accounts
payable and accrued liabilities through timing of payment for operational,
promotional and inventory purchases; (iii) a decrease in prepaid
and  other current assets; offset by (i) an increase of inventory
through a decline in our inventory turn ratio from 2.8 to 2.7; (ii) an
increase in accounts receivable from high sales volumes and an increase in days
sales outstanding, or DSO, from 59 days to 74 days; and (iii) an
increase in our income tax receivable.





Net cash used in investing activities
was $10.3 million for the year ended December 31, 2008. The primary
uses of cash were due to the following: (i) investment in certificates of
deposit during the year ended, which have maturity dates no greater than one
year; (2) capital invested in information technology equipment and software
upgrades; and (iii) the investment in intellectual property, primarily patents,
relating to both our new product line offerings and our core product line
offerings; offset by cash received from our landlord for tenant improvements for
our new corporate headquarters. We anticipate spending approximately
$1.5 million for total capital expenditures in 2009. The capital
expenditures anticipated in 2008 is primarily due planned investments in our new
enterprise resource planning software system, sales force automation and IT
upgrades.





Net cash used in financing activities
was $3.9 million for the year ended December 31, 2008. This was
primarily due to purchase of $4.0 million of our outstanding stock during the
year, offset by proceeds received from the exercise of stock
options.





Year ended December 31,
2007.     For the year ended December 31, 2007,
net cash provided by operating activities was $14.3 million. The primary
sources of cash were $15.2 million in net income, including the effect of:
(i) adjusting for non-cash items; (ii) a net increase in accounts
payable through timing of payment for operational, promotional and inventory
purchases; (iii) a decrease of inventory through an improvement in our
inventory turn ratio from 2.0 to 2.8; offset by (i) an increase in accounts
receivable from high sales volumes and an increase in days sales outstanding, or
DSO, from 44 days to 59 days; and (ii) an increase in prepaid and
other current assets.





Net cash used in investing activities
was $1.0 million for the year ended December 31, 2007. This was
primarily through capital invested in information technology equipment and
software upgrades. In addition, we invested in intellectual property, primarily
patents, relating to both our new product line offerings and our core product
line offerings.




Net cash used in financing activities
was $10.5 million for the year ended December 31, 2007. This was
primarily due to the complete paydown of our outstanding debt of
$25.7 million in 2007. The paydown of our debt was offset by the net
proceeds received, net of underwriter commissions and offering costs, from our
sale of 800,000 shares of our common stock in our secondary public offering on
October 12, 2007, of $14.3 million.





Off-balance Sheet
Arrangements





We do not have any off-balance sheet
arrangements.





Commitments
and Contractual Obligations





Our major outstanding contractual
obligations relate to operating leases and capital leases. These contractual
obligations as of December 31, 2008 are as follows:





Payments
      due by periodTotal
                                                              
                                                              
                                                              Less
      than 1 year
                                                              
                                                              
                                                              1-3 years
                                                              
                                                              
                                                              3-5 years
                                                              
                                                              
                                                              More
      than 5 yearsContractual obligationsCapital lease
      obligations
                                                              
                                                              $
                                                              67
                                                              
                                                              
                                                              $
                                                              48
                                                              
                                                              
                                                              $
                                                              19
                                                              
                                                              
                                                              $
                                                              —
                                                              
                                                              
                                                              $
                                                              —Operating lease
      obligations
                                                              
                                                              
                                                              13,396
                                                              
                                                              
                                                              
                                                              1,832
                                                              
                                                              
                                                              
                                                              3,065
                                                              
                                                              
                                                              
                                                              2,755
                                                              
                                                              
                                                              
                                                              5,744Dr. Obagi
      services agreement obligation
                                                              
                                                              
                                                              1,537
                                                              
                                                              
                                                              
                                                              615
                                                              
                                                              
                                                              
                                                              922
                                                              
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              
                                                              —Ventiv agreement
      obligation
                                                              
                                                              
                                                              4,669
                                                              
                                                              
                                                              
                                                              2,921
                                                              
                                                              
                                                              
                                                              1,748
                                                              
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              
                                                              —Other services
      agreement obligation
                                                              
                                                              
                                                              100
                                                              
                                                              
                                                              
                                                              100
                                                              
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              
                                                              —FIN 48
      liability
                                                              
                                                              
                                                              230
                                                              
                                                              
                                                              
                                                              109
                                                              
                                                              
                                                              
                                                              121
                                                              
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              
                                                              —Total
                                                              
                                                              $
                                                              19,999
                                                              
                                                              
                                                              $
                                                              5,625
                                                              
                                                              
                                                              $
                                                              5,875
                                                              
                                                              
                                                              $
                                                              2,755
                                                              
                                                              
                                                              $
                                                              5,744




51




Capital leases.     We lease certain office equipment
for use in our operations which are classified under capital leases. Our payment
obligations under capital leases represent both principle and interest at
implied fixed rates. The leases expire through July 2010. During the year ended
December 31, 2008, we amended one of our leases to expire in December
2010.





Operating leases.
    We lease our corporate offices in Long Beach, California
and distribution center in Carson, California under separate leases expiring in
October 2018 and October 2013, respectively. We entered into a lease for our new
headquarters with a new landlord in Long Beach, CA. We lease our
manufacturing facility in Milford, Connecticut under a lease expiring in
November 2013. In addition, we lease automobiles for our sales representatives
under 36-month contracts.





Ventiv
Agreement.In July 2008, we entered into a service agreement
with Ventiv.  Pursuant to the agreement, Ventiv is to provide us with
20 field sales representatives who are to market, sell and distribute SoluCLENZ,
including related product samples and literature.  In addition, Ventiv
is to provide all administrative support and oversight of the 20 field sales
representatives.  We agreed to pay an up front base fee and escalating
fixed monthly fees over the two year period of the contract.  The
agreement may be renewed for additional one year periods upon written agreement
of both parties to be executed at least 90 days prior to the end of the
term.  If the agreement is terminated, we may be liable for up to the
entire amount remaining under the agreement, unless terminated for specified
reasons, in which case we may be liable for up to two months of fixed
fees.  In addition, we may be liable for payment obligations for early
termination of equipment leased by Ventiv and provided to the 20 field sales
representatives, subject on the part of Ventiv to mitigate these fixed fees and
redeploy them in the field under other contractual arrangements.  In
October 2008, we entered into an amendment to the agreement with Ventiv whereby
they prepare certain managed care and third party payer reimbursement analysis
for us.    This agreement ends on April 1, 2009 unless we
choose to extend it.  If we choose to terminate this agreement early,
we are obligated to pay Ventiv one-month’s worth of service fees.





Services agreement.
    On July 18, 2005, we entered into a consulting
agreement with a third party. We agreed to pay this third party a minimum fee of
$100,000 per year for five years plus reasonable and customary expenses incurred
at our request in connection with the provision of such services, commencing on
January 1, 2005, for product formulation, product development and
regulatory work. This agreement can be extended for up to two, one-year renewal
terms. We agreed to pay a tiered royalty for successful commercialization of
products developed or identified by the third party based on annual net sales,
with a maximum royalty paid per product, subject to a payment cap per year.
Tiered royalty payable for each new product will be based on annual net sales.
See "Certain Material Agreements—Jose Ramirez and JR Chem" for additional
information.





In June 2006, we leased our Marketing
and Training Center in Beverly Hills, California from an affiliate of
Dr. Obagi. We prepaid rent due under this five year lease expiring in July
2011. We have one five year extension. Since we have prepaid all amounts owing
under this lease, no amounts from this lease were included in the table
above.





In June 2006, we entered into a
services agreement with Zein E. Obagi, MD Inc. ("Obagi, Inc."),
Dr. Obagi, Samar Obagi, the Zein and Samar Obagi Family Trust and Skin
Health Properties, Inc. Wehave
agreed to pay Obagi, Inc. an annual retainer of $570,000 for advising and
formulating services and marketing and support services. In addition, the
Company has agreed to pay Obagi, Inc. an annual fee of $200,000 for the
first two years of the agreement for the development of Proderm products. At the
end of the two years, the Company had an option to continue to sell Proderm
products, in which case the Company will pay Obagi, Inc. an annual royalty
payment.  The Company has chosen not to exercise this
right.  The Company will also pay Obagi, Inc. royalty fees for
developing other products identified in the agreement equal to a percentage of
the Company's net revenues from sales of those products. In addition, the
Company reimbursed up to 50% of all invoiced commercially reasonable marketing
design and development expenses associated with the opening of the property in
Beverly Hills, subject to a $100,000 cap. Unless otherwise terminated in
accordance with its terms, the agreement's initial term is five years, and it
may be renewed for additional terms upon the mutual consent of the parties upon
written notice received within a specified term prior to the end of the initial
term.





FIN 48.In
connection with the adoption of FIN 48, at
December 31, 2008, we have approximately $0.1 million and $0.1 million
of short term and long term liabilities, respectively, associated with uncertain
tax positions.





Recent
Accounting Pronouncements





New
Accounting Standards





In May 2008, the FASB issued SFAS No. 162 ("SFAS No. 162"), The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. GAAP for nongovernmental entities. SFAS No.
162 was effective 60 days following the SEC's approval of the Public Company
Accounting Oversight Board auditing amendments to AU Section 411, The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles. Adoption of
SFAS No. 162 did not have a material effect on our consolidated financial
statements.





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 142-3 ("FSP FAS
142-3"), Determination of the
Useful Life of Intangible Assets , which amends the factors that should
be considered in developing renewal or extension assumptions used to determine
the useful life of a recognized intangible asset under FASB Statement No. 142,
Goodwill and Other Intangible
Assets . FSP FAS 142-3 allows an entity to use its own historical
experience in renewing or extending similar arrangements, adjusted for specified
entity-specific factors, in developing assumptions about renewal or extension
used to determine the useful life of a recognized intangible asset. Additional
disclosures are required to enable financial statement users to assess the
extent to which the expected future cash flows associated with the asset are
affected by the entity’s intent and/or ability to renew or extend the
arrangement. The guidance for determining the useful life of a recognized
intangible asset is to be applied prospectively to intangible assets acquired
after the effective date. The disclosure requirements are to be applied
prospectively to all intangible assets recognized as of, and subsequent to, the
effective date. FSP FAS 142-3 is effective for fiscal years and interim periods
within those fiscal years, beginning on or after December 15, 2008, with early
adoption prohibited. We do not believe the adoption of FSP FAS 142-3 will have a
material impact on our consolidated financial statements.




52




In
December 2007, the FASB issued SFAS No. 141(revised 2007) ("SFAS
No. 141(R)"), Business
Combinations, which among other things, requires us to record fair value
estimates of contingent consideration and certain other potential liabilities
during the original purchase price allocation, expense acquisition costs as
incurred and does not permit certain restructuring activities previously allowed
under Emerging Issues Task Force Issue ("EITF") No. 95-3, Recognition of Liabilities in
Connection with a Purchase Business Combination, to be recorded as a
component of purchase accounting. This statement is effective as of the
beginning of an entity's first fiscal year beginning after December 15,
2008. We will adopt the provisions of this standard beginning January 1,
2009. The provisions of SFAS No. 141(R) will only impact us if we are party
to a business combination after the standard has been adopted.





In
December 2007, the FASB issued SFAS No. 160 ("SFAS No. 160"), Noncontrolling Interests in
Consolidated Financial Statements—an amendment of ARB No. 51, which
causes noncontrolling interests in subsidiaries to be included in the equity
section of the balance sheet. This statement is effective as of the beginning of
an entity's first fiscal year beginning after December 15, 2008. We will
adopt the provisions of this standard beginning January 1, 2009. We do not
believe the adoption of SFAS No.160 will have an impact on our consolidated
financial statements.




In June
2007, the FASB issued EITF Issue No. 07-03 ("EITF 07-03"), Accounting for Non-Refundable
Advance Payments for Goods or Services to Be Used in Future Research and
Development Activities . EITF 07-03 provides guidance on whether
non-refundable advance payments for goods that will be used or services that
will be performed in future research and development activities should be
accounted for as research and development costs or deferred and capitalized
until the goods have been delivered or the related services have been rendered.
We adopted the provisions of this issue beginning January 1, 2008. The
adoption of EITF 07-03 did not have an impact on our consolidated financial
statements.




In February
2007, the FASB issued SFAS No. 159 ("SFAS No. 159"), The Fair Value Option for Financial
Assets and Financial Liabilities, to permit all entities to choose to
elect, at specified election dates, to measure eligible financial instruments at
fair value. An entity shall report unrealized gains and losses on items for
which the fair value option has been elected in earnings at each subsequent
reporting date, and recognize upfront costs and fees related to those items in
earnings as incurred and not deferred. SFAS No. 159 became effective for us as
of January 1, 2008.  We did not elect the fair value option for any
financial assets or liabilities.




In
September 2006, the FASB issued SFAS No. 157 (“SFAS No. 157”), Fair Value Measurements. This
new standard provides guidance for using fair value to measure assets and
liabilities. Under SFAS No. 157, fair value refers to the price that would
be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants in the market in which the reporting
entity transacts. In this standard, the FASB clarifies the principle that fair
value should be based on the assumptions market participants would use when
pricing the asset or liability. In support of this principle, SFAS No. 157
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. The fair value hierarchy gives the highest priority
to quoted prices in active markets and the lowest priority to unobservable data
for example, the reporting entity's own data. Under the standard, fair value
measurements would be separately disclosed by level within the fair value
hierarchy. The provisions of SFAS No. 157 are effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. However, FSP No. 157-2, Effective Date of FASB Statement
No. 157, was issued in February 2008 which defers the effective date
of SFAS No. 157 for nonfinancial assets and liabilities, except for items
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually), to fiscal years beginning after
November 15, 2008, and interim periods within those fiscal years.
Accordingly, our adoption of this standard as of January 1, 2008 was
limited to financial assets and liabilities. The adoption of the provisions of
SFAS No. 157 relating to financial assets and liabilities did not have an
impact on our consolidated financial statements. We will adopt the provisions
related to nonfinancial assets and liabilities beginning January 1, 2009.
We do not expect the adoption of the provisions related to nonfinancial assets
and liabilities to have a material impact on our consolidated financial
statements.





ITEM
7A:    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





We invest
our excess cash primarily in large money market funds and certificates of
deposit with maturity dates no greater than one year. We do not utilize
derivative financial instruments, derivative commodity instruments or other
market risk sensitive instruments, positions or transactions in any material
fashion. Accordingly, we believe that we are not subject to any material risks
arising from changes in interest rates, foreign currency exchange rates,
commodity prices, equity prices or other market changes that affect market risk
sensitive instruments.




Although
substantially all of our sales and purchases are denominated in U.S. dollars,
future fluctuations in the value of the U.S. dollar may affect the price
competitiveness of our products outside the U.S. We do not believe, however,
that we currently have significant direct foreign currency exchange rate risk
and have not hedged exposures denominated in foreign currencies.




Interest
Rate Risk




Our
interest income and expense is more sensitive to fluctuations in the general
level of U.S. prime rate and LIBOR interest rates than to changes in rates in
other markets. Changes in U.S. LIBOR interest rates affect the interest earned
on our cash and cash equivalents. At December 31, 2008, we had approximately
$13.9 million of cash and cash equivalents. If the interest rates on our
cash and cash equivalents were to increase or decrease by 1% for the year,
annual interest income would increase or decrease by approximately
$0.1 million.




Other
Risks




Generally
we have been able to collect our accounts receivable in the ordinary course of
business.  We continuously monitor collections and payments from
customers and maintain a provision for estimated credit losses as deemed
appropriate based upon historical experience and any specific customer
collection issues that have been identified. Although our DSO has increased from
59 days at December 31, 2007 to 74 at December 31, 2008, and we continue to see
a weakened economic environment, we do not believe that our accounts receivable
balance represents a credit risk based upon our past collection
experience.




The
current economic downturn has had an adverse impact on the financial services
industry, including insurance companies, some of whom we currently are insured
by.  To the extent we have any claims in the future and such insurance
providers are unable, due to their financial condition, to pay covered claims,
we could experience adverse impacts on our cash flow and cash
reserves.  We have no way of knowing whether or not any new insurance
providers that are financially stable at this time will experience financial
difficulties in the future that could impact their ability to pay covered
claims.





ITEM 8:    FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA





The information required by this Item
is incorporated herein by reference to the financial statements set forth in
Item 15(a) of Part IV of this report.


53


ITEM 9:    CHANGES IN AND
DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURES





Not applicable.





ITEM 9A:    CONTROLS AND
PROCEDURES





Disclosure
Controls and Procedures





As of the end of the period covered by
this report, the Company carried out an evaluation, under the supervision and
with the participation of its management, including the Chief Executive Officer
and the Chief Financial Officer, of the effectiveness of the design and
operation of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as
amended). Based upon that evaluation, the Company's Chief Executive Officer and
Chief Financial Officer have concluded that the Company's disclosure controls
and procedures are effective in providing reasonable assurance that information
is recorded, processed, summarized and reported within the time periods
specified in the SEC's rules, regulations and forms, and that suchinformation is accumulated and
communicated to the Company's management, including the Chief Executive Officer
and the Chief Financial Officer as appropriate, to allow timely decisions
regarding required disclosure.





Management's
Report on Internal Control Over Financial Reporting





Management is responsible for
establishing and maintaining adequate internal control over financial reporting
(as defined in Rules 13a-15(f) and 15(d)-15(f) of the Securities Exchange
Act of 1934, as amended). Under the supervision and with the participation of
the Company's management, including the Chief Executive Officer and the Chief
Financial Officer, the Company conducted an evaluation of the effectiveness of
its internal control over financial reporting based upon the framework in Internal Control — Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  Based on that evaluation, the Company's
management concluded that its internal control over financial reporting was
effective as of December 31, 2008.




The effectiveness of the Company's
internal control over financial reporting as of December 31, 2008 has been
audited by PricewaterhouseCoopers LLP, an independent registered public
accounting firm, as stated in their Report of Independent Registered Public
Accounting Firm under Part IV, Item 15 of this
Form 10-K.





Changes
in Internal Control Over Financial Reporting





There has been no change in the
Company's internal control over financial reporting during the Company's most
recent fiscal quarter that has materially affected, or is reasonably likely to
materially affect, the Company's internal control over financial
reporting.




ITEM
9B:    OTHER INFORMATION




Effective December 31, 2008,
Steven R. Carlson's employment agreement was amended to ensure compliance
with Section 409A of the Internal Revenue Code of 1986, as amended. The revision
provides that any severance that would otherwise be payable to Mr.
Carlson within the first six months following a termination event giving rise to
a severance payment will accrue but not be paid to Mr. Carlson until the first
day of the seventh month following termination. Such amounts will continue to be
paid in a lump sum.




54





PART III





ITEM 10:    DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE





The information required by this item
is incorporated into this Annual Report on Form 10-K by reference to the
definitive proxy statement for our 2009 Annual Meeting of Stockholders (the
"Proxy Statement").





ITEM 11:    EXECUTIVE
COMPENSATION





The information required by this item
is incorporated into this Annual Report on Form 10-K by reference to the
Proxy Statement.





ITEM 12:    SECURITY OWNERSHIP OF
CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS





The information required by this item
is incorporated into this Annual Report on Form 10-K by reference to the
Proxy Statement.





ITEM 13:    CERTAIN RELATIONSHIPS
AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE





The information required by this item
is incorporated into this Annual Report on Form 10-K by reference to the
Proxy Statement.





ITEM 14:    PRINCIPAL ACCOUNTING
FEES AND SERVICES





The information required by this item
is incorporated into this Annual Report on Form 10-K by reference to the
Proxy Statement.





55





PART
IV





ITEM 15:    EXHIBITS AND
FINANCIAL STATEMENT SCHEDULES





(a)1. Consolidated Financial Statements
and Supplementary Data:




The following financial statements are
included as a separate section of this report commencing on
page F-1:





Report of Independent Registered Public
      Accounting Firm
              F-1Consolidated Balance Sheets as of December 31,
      2008 and 2007
              F-2Consolidated Statements of Income for the years
      ended December 31, 2008, 2007, and 2006
              F-3Consolidated Statements of Stockholders'
      Equity and Comprehensive Income (Loss) for the years ended
      December 31, 2008, 2007, and 2006
              F-4Consolidated Statements of Cash Flows for the years
      ended December 31, 2008, 2007, and 2006
              F-5Notes to Consolidated Financial
      Statements
              F-6Quarterly Data (unaudited)
              F-30





(a)2.
Financial Statement
Schedules:





Schedule II—Valuation
and Qualifying Accounts





Other than set forth below, all other
schedules have been omitted for the reason that the required information is
presented in financial statements or notes thereto, the amounts involved are not
significant or the schedules are not applicable.





(in
      thousands)
                
                Balance
      at Beginning of Period
                
                
                Charged
      to Cost and Expense
                
                
                Charged
      to Contra-Revenue
                
                
                Deductions
                
                
                Balance
      at End of PeriodYear
      ended December 31, 2006Allowance
      for doubtful accountsand
      sales return reserve
                
                $
                501
                
                
                $
                180
                
                
                $
                142
                
                
                $
                (172
                )
                
                $
                651Reserve
      for inventories
                
                
                437
                
                
                
                81
                
                
                
                —
                
                
                
                (242
                )
                
                
                276Year
      ended December 31, 2007Allowance
      for doubtful accountsand
      sales return reserve
                
                $
                651
                
                
                $
                285
                
                
                $
                214
                
                
                $
                (305
                )
                
                $
                845Reserve
      for inventories
                
                
                276
                
                
                
                303
                
                
                
                —
                
                
                
                (110
                )
                
                
                469Year
      ended December 31, 2008Allowance
      for doubtful accountsand
      sales return reserve
                
                $
                845
                
                
                $
                660
                
                
                $
                (88
                )
                
                $
                (179
                )
                
                $
                1,238Reserve
      for inventories
                
                
                469
                
                
                
                841
                
                
                
                —
                
                
                
                (613
                )
                
                
                697




(a)3.
Exhibits:





Exhibit
            
            Exhibit
      title3.1
            
            Amended
      and Restated Certificate of Incorporation of the Company.
            
            (1)3.2
            
            Second
      Amended and Restated Bylaws of the Company.
            
            (5)4.1
            
            Specimen
      Stock Certificate.
            
            (1)4.2
            
            Investor's
      Rights Agreement, by and between the Company and Austin T. McNamara, dated
      April 1, 2002.
            
            (1)4.3
            
            Investor's
      Rights Agreement, by and among the Company, Mandarin Partners LLC and
      the Zein & Samar Obagi Family Trust dated December 2, 1997,
      as amended and assigned.
            
            (1)10.1
            
            OMP, Inc.
      2000 Stock Option/Stock Issuance Plan and forms of award
      agreements.**
            
            (1)10.2
            
            Amended
      and Restated Obagi Medical Products, Inc. 2005 Stock Incentive Plan
      and forms of award agreements.**
            
            (1)10.3
            
            Catalina
      Landing Amended and Restated Office Lease, by and between the Company and
      AC-Catalina Landing, LLC, dated May 9, 2003, as
      amended.
            
            (1)10.4
            
            Standard
      Sublease, by and between the Company and Marlog Cargo USA, Inc.,
      dated July 26, 2004.
            
            (1)10.5
            
            Lease
      Agreement between the Company and D'Amato Investments, LLC, dated
      December 1, 2005.
            
            (1)10.6
            
            Distribution
      Agreement, by and between the Company and Cellogique Corporation, dated
      November 10, 2005, as amended.+
            
            (1)10.7
            
            Know-How
      and Trademark License Agreement, by and between the Company and Rohto
      Pharmaceutical Co, Ltd., dated September 13, 2002, as
      amended.+
            
            (1)10.8
            
            Agreement
      by and between the Company and Dr. Zein E. Obagi, Inc, dated as of
      June 29, 2006.
            
            (1)  56
  10.9
            
            Separation
      and Release Agreement between the Company and Zein Obagi, M.D., dated
      June 29, 2006.
            
            (1)10.10
            
            Retail
      Lease Agreement by and between Skin Health Properties, Inc. as
      Landlord and OMP, Inc. as Tenant, dated as of June 29,
      2006.
            
            (1)10.11
            
            Letter
      Agreement between the Company and Skin Health Properties, Inc., dated
      June 29, 2006.
            
            (1)10.12
            
            Employment
      Agreement, by and between the Company and Austin T. McNamara, dated
      September 1, 2001.**
            
            (1)10.13
            
            Employment
      Agreement, by and between the Company and Steven R. Carlson, dated
      March 1, 2005.**
            
            (1)10.14
            
            Form
      of Severance Agreement.**
            
            (1)10.15
            
            Distributorship
      Agreement between the Company and CNO Chinese Obagi Corporation, dated
      September 23, 1997.
            
            (1)10.16
            
            Distributorship
      Agreement the Company and between VNO Vietnamese Obagi Corporation, dated
      September 23, 1997.
            
            (1)10.17
            
            Management
      Services Agreement, by and between the Company and Mandarin Management
      Partners, Inc, dated December 2, 1997, assigned to Lighthouse Venture
      Group, as amended.
            
            (1)10.18
            
            Credit
      Agreement, by and between the Company and Merrill Lynch Capital, dated
      January 28, 2005, as amended.
            
            (1)10.19
            
            Product
      Supply Agreement, by and between the Company and Triax
      Pharmaceuticals, LLC, dated December 8, 2005.+
            
            (1)10.20
            
            Consultant
      Services and Confidentiality Agreement, dated July 18, 2005, by and
      among the Company, Jose Ramirez, and JR Chem LLC.+
            
            (1)10.21
            
            Form
      of indemnification agreement.**
            
            (1)10.22
            
            Management
      Services Agreement, dated December 18, 2002, between Stonington
      Partners, Inc. and the Company.
            
            (1)10.23
            
            Patent
      License Agreement by and between the Company and Avon Products, Inc.,
      dated June 26, 2003.+
            
            (1)10.24
            
            Letter
      Agreement re Repurchase of Series A Preferred Stock among the
      Company, Stonington Capital Appreciation 1994 Fund LP and the Zein
      and Samar Obagi Family Trust, dated January 25, 2005.
            
            (1)10.25
            
            Financial
      Advisory Services Agreement, by and between the Company and Stonington
      Partners, Inc., dated November 19, 2004.
            
            (1)10.26
            
            Non-Employee
      Director Compensation Policy, adopted November 14,
      2006.**
            
            (1)10.27
            
            Form
      of Subordinated Promissory Note tendered to McNamara Family Trust, dated
      November 17, 2006.
            
            (1)10.28
            
            Form
      of Subordinated Promissory Note tendered to McNamara Family Irrevocable
      Trust, dated November 17, 2006.
            
            (1)10.29
            
            Subordination
      Agreement, by and between Merrill Lynch Capital, McNamara Family
      Irrevocable Trust Under Agreement Dated December 17, 2004, McNamara
      Family Trust, OMP, Inc. and the Company, dated June 2,
      2005.
            
            (1)10.30
            
            Employment
      Agreement by and between the Company and Curtis Cluff, dated
      November 30, 2001.**
            
            (1)10.31
            
            Employment
      Agreement by and between the Company and David Goldstein, dated
      August 10, 1999.**
            
            (1)10.32
            
            Employment
      Agreement by and between the Company and Stephen Garcia, dated
      June 13, 2003.**
            
            (1)10.33
            
            Employment
      Agreement by and between the Company and Judith Hattendorf, dated
      August 23, 2000.**
            
            (1)10.34
            
            Settlement
      and Consent Agreement and Mutual Release, dated May 29,
      2007.
            
            (2)10.35
            
            Form
      of Amendment to Executive Employment Agreements.**
            
            (3)10.36
            
            Separation
      Agreement and General Release between the Company and Curtis A. Cluff
      dated September 7, 2007.
            
            (4)10.37
            
            Credit
      Facility Fee Letter, dated January 28, 2008.
            
            (6)10.38
            
            Second
      Amendment to Employment Agreement by and between the Company and Steven
      Robert Carlson dated as of March 1, 2008.**
            
            (7)10.39
            
            Letter
      Agreement by and between the Company and Stephen Garcia dated March 24,
      2008.
            
            (8)10.41
            
            Lease
      Agreement between OMP, Inc. and Kilroy Realty, L.P. dated
      April 30, 2008.
            
            (9)10.42
            
            Employment
      Agreement by and between the Company and Preston S. Romm, dated as of June
      16, 2008.**
            
            (10)10.43
            
            Implementation
      and Support Agreement by and between the Company and Specialists in Custom
      Software, Inc., dated June 24, 2008.
            
            (11)10.44
            
            Lease
      Agreement between OMP, Inc. and Cypress-Southbay, LLC. and related
      construction rider, dated July 8, 2008.
            
            (11)10.45
            
            Amendment
      to Lease Agreement between OMP, Inc. and Kilroy Realty, L.P., dated August
      6, 2008.
            
            (11)10.46
            
            Revolving
      Credit Agreement, by and between the Company and Comerica Bank, dated as
      of November 21, 2008
            
            (12)10.47
            
            Employment
      Agreement by and between the Company and Laura Hunter, dated as of
      September 4, 2008.**
            
            *10.48
            
            Amendment
      and Addendum to Know-How and Trademark License Agreement, by and
      between the Company and Rohto Pharmaceutical Co, Ltd., dated December
      4, 2008.
            
            *+10.49
            
            License
      and Supply Agreement, by and between the Company and Rohto Pharmaceutical
      Co, Ltd., dated December 4, 2008.
            
            *+10.50
            
            Service
      Agreement, by and between the Company and Ventiv Commercial Services, LLC,
      dated July 1, 2008
            
            *+10.51
            
            First
      Amendment to Services Agreement by and between the Company and Ventiv
      Commercial Services, LLC, dated July 1, 2008
            
            *+10.52
            
            Amendment
      and Addendum to Consultant Services and Confidentiality Agreement by and
      between the Company and Jose Ramirez, and JR Chem LLC.
            
            *+21.1
            
            Subsidiaries
      of the Company.
            
            (1)23.1
            
            Consent
      of PricewaterhouseCoopers LLP, Independent Registered Public
      Accounting Firm.
            
            *31.1
            
            Certification
      of Principal Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.
            
            *31.2
            
            Certification
      of Principal Accounting Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.
            
            *32.1
            
            Certification
      of Principal Executive Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
            
            *32.2
            
            Certification
      of Principal Accounting Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
            
            *


57




*   Filed
herewith





+  Material
has been omitted pursuant to a request for confidential treatment and such
material has been filed separately with the Commission.





**  Management
contracts or compensatory plans and arrangements required to be filed pursuant
to Item 601(b)(10)(ii)(A) or (iii) of
Regulation S-K.





(1)  Incorporated
herein by reference to the Company's Registration of Form S-1/A
(Registration No. 333-137272), previously filed with the
Commission.





(2)  Incorporated
herein by reference to the exhibits filed with the Company's Form 10-Q for
the quarter ended June 30, 2007, previously filed with the
Commission.





(3)  Incorporated
herein by reference to the exhibits filed with the Company's Form 8-K filed
with the Commission on August 7, 2007.





(4)  Incorporated
herein by reference to the exhibits filed with the Company's Form 8-K filed
with the Commission on September 11, 2007.





(5)  Incorporated
herein by reference to the exhibits filed with the Company's Form 8-K filed
with the Commission on February 29, 2008.




(6)  Incorporated
herein by reference to the exhibits filed with the Company’s Annual Report on
Form 10-K filed with the Commission on March 4, 2008.





(7)Incorporated
      herein by reference to the exhibits filed with the Company's Form 8-K
      filed with the Commission on March 7,
2008.





(8)Incorporated
      herein by reference to the exhibits filed with the Company's Form 8-K
      filed with the Commission on March 27,
2008.





(9)  Incorporated
      herein by reference to the exhibits filed with the Company's Form 8-K
      filed with the Commission on May 6,
2008.





(10)  Incorporated
      herein by reference to the exhibits filed with the Company's Form 8-K
      filed with the Commission on June 23,
2008.





(11)  Incorporated
      herein by reference to the exhibits filed with the Company’s Quarterly
      Report on Form 10-Q filed with the Commission on August 11,
      2008.





(12)  Incorporated
      herein by reference to the exhibits filed with the Company's Form 8-K
      filed with the Commission on November 26,
2008.




58


SIGNATURES





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




OBAGI
      MEDICAL PRODUCTS, INC.Date: 
      March 13, 2009
              By:
              /s/  
      STEVEN R. CARLSONSteven
      R. CarlsonChief
      Executive Officer(Principal
      Executive Officer)
 Date: 
      March 13, 2009
                By:
                /s/  
      PRESTON S. ROMMPreston
      S. RommChief
      Financial Officer(Principal
      Financial Officer)




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





Signature
            
            Title
            
            Date/s/  
      STEVEN R. CARLSON
              Steven
      R. Carlson
            
            Chief
      Executive Officer, President and Director (Principal Executive
      Officer)
            
            March 13,
      2009/s/   PRESTON S. ROMM
              
              Preston
      S. Romm
            
            Chief
      Financial Officer (Principal Financial and Accounting
    Officer)
            
            March 13,
      2009/s/  
      ALBERT J. FITZGIBBONS III
              
              Albert
      J. Fitzgibbons III
            
            Chairman
      of the Board of Directors
            
            March 13,
      2009/s/  
      JOHN A. BARTHOLDSON
              
              John
      A. Bartholdson
            
            Director
            
            March 13,
      2009/s/  
      JOHN H. DUERDEN
              
              John
      H. Duerden
            
            Director
            
            March 13,
      2009/s/  
      EDWARD A. GRANT
              
              Edward
      A. Grant
            
            Director
            
            March 13,
      2009/s/  
      ALBERT F. HUMMEL
              
              Albert
      F. Hummel
            
            Director
            
            March 13,
      2009/s/   RONALD
      P. BADIE
              
              Ronald
      P. Badie
            
            Director
            
            March 13,
      2009





59


Report of Independent Registered Public Accounting
Firm





To the
Board of Directors and Stockholders of


Obagi
Medical Products, Inc.





In our
opinion, the consolidated financial statements listed in the index appearing
under Item 15(a)(1) present fairly, in all material respects, the financial
position of Obagi Medical Products, Inc. and its subsidiaries at December 31,
2008 and 2007, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 2008 in conformity with
accounting principles generally accepted in the United States of
America.  In addition, in our opinion, the financial statement
schedulelisted in
the index appearing under Item 15(a)(2)presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidatedfinancial
statements.  Also in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2008, based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Company's management is responsible
for these financial statements and financial statement schedule, for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting, included in
Management's Report on Internal Control Over Financial Reporting, appearing
under Item 9A.  Our responsibility is to express opinions on these
financial statements, on the financial statement schedule, and on the Company's
internal control over financial reporting based on our audits (which were
integrated audits in 2008 and 2007).  We conducted our audits in
accordance with the standards of the Public Company Accounting Oversight Board
(United States).  Those standards require that we plan and perform the
audits to obtain reasonable assurance about whether the financial statements are
free of material misstatement and whether effective internal control over
financial reporting was maintained in all material respects.  Our
audits of the financial statements included examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation.  Our audit of
internal control over financial reporting included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, and testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk.  Our
audits also included performing such other procedures as we considered necessary
in the circumstances. We believe that our audits provide a reasonable basis for
our opinions.





As
discussed in the notes to the consolidated financial statements, the Company
changed the manner in which it accounts for uncertain tax positions as of
January 1, 2007 (Note 6) and share-based compensation as of January 1, 2006
(Note 2).





A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company’s internal
control over financial reporting includes those policies and procedures that
(i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and
(iii) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the company’s assets that
could have a material effect on the financial statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





/s/
PRICEWATERHOUSECOOPERS





Los
Angeles, California


March 13,
2009





F-1





Obagi Medical
Products, Inc.


Consolidated
Balance Sheets


(Dollars
in thousands, except share and per share amounts)





December
      31,2008
                                                  
                                                  
                                                  2007AssetsCurrent
    assetsCash and cash
      equivalents
                                                  
                                                  $
                                                  13,938
                                                  
                                                  
                                                  $
                                                  14,054Short-term
      investments
                                                  
                                                  
                                                  6,000
                                                  
                                                  
                                                  
                                                  —Accounts
      receivable, net of allowance for doubtful accounts and sales returns of
      $1,238 and $845 as of December 31, 2008and 2007,
      respectively
                                                  
                                                  
                                                  20,648
                                                  
                                                  
                                                  
                                                  17,370Accounts
      receivable from related parties, net of allowance for doubtful accounts of
      $169 and $0 as of December 31, 2008and 2007,
      respectively
                                                  
                                                  
                                                  518
                                                  
                                                  
                                                  
                                                  982Inventories,
      net
                                                  
                                                  
                                                  6,845
                                                  
                                                  
                                                  
                                                  6,047Deferred
      income taxes
                                                  
                                                  
                                                  1,501
                                                  
                                                  
                                                  
                                                  1,841Prepaid
      expenses and other current assets
                                                  
                                                  
                                                  2,832
                                                  
                                                  
                                                  
                                                  3,382Income taxes
      receivable
                                                  
                                                  
                                                  2,071
                                                  
                                                  
                                                  
                                                  559Total
      current assets
                                                  
                                                  
                                                  54,353
                                                  
                                                  
                                                  
                                                  44,235Property and
      equipment, net
                                                  
                                                  
                                                  5,340
                                                  
                                                  
                                                  
                                                  2,759Goodwill
                                                  
                                                  
                                                  4,629
                                                  
                                                  
                                                  
                                                  4,629Intangible assets,
      net
                                                  
                                                  
                                                  5,267
                                                  
                                                  
                                                  
                                                  5,760Deferred income
      taxes
                                                  
                                                  
                                                  1,855
                                                  
                                                  
                                                  
                                                  1,179Other
      assets
                                                  
                                                  
                                                  815
                                                  
                                                  
                                                  
                                                  1,201Total
      assets
                                                  
                                                  $
                                                  72,259
                                                  
                                                  
                                                  $
                                                  59,763Liabilities
      and Stockholders' EquityCurrent
      liabilitiesAccounts
      payable
                                                  
                                                  $
                                                  6,478
                                                  
                                                  
                                                  $
                                                  6,664Current
      portion of long-term debt
                                                  
                                                  
                                                  47
                                                  
                                                  
                                                  
                                                  54Accrued
      liabilities
                                                  
                                                  
                                                  3,510
                                                  
                                                  
                                                  
                                                  3,139Amounts due
      to related parties
                                                  
                                                  
                                                  169
                                                  
                                                  
                                                  
                                                  135Total
      current liabilities
                                                  
                                                  
                                                  10,204
                                                  
                                                  
                                                  
                                                  9,992Long-term
      debt
                                                  
                                                  
                                                  18
                                                  
                                                  
                                                  
                                                  42Other long-term
      liabilities
                                                  
                                                  
                                                  1,516
                                                  
                                                  
                                                  
                                                  —Total
      liabilities
                                                  
                                                  
                                                  11,738
                                                  
                                                  
                                                  
                                                  10,034Commitments
      and contingencies (Note 10)Stockholders'
      equityCommon stock, $.001
      par value; 100,000,000 shares authorized, 22,691,238 and 22,653,349 shares
      issued and 22,044,872and 22,643,564
      shares outstanding at December 31, 2008 and 2007,
    respectively
                                                  
                                                  
                                                  23
                                                  
                                                  
                                                  
                                                  23Additional paid-in
      capital
                                                  
                                                  
                                                  58,026
                                                  
                                                  
                                                  
                                                  55,805Accumulated
      earnings (deficit)
                                                  
                                                  
                                                  6,557
                                                  
                                                  
                                                  
                                                  (6,031
                                                  )Treasury stock, at
      cost; 627,367 shares at December 31, 2008
                                                  
                                                  
                                                  (4,016
                                                  )
                                                  
                                                  
                                                  —Accumulated other
      comprehensive loss
                                                  
                                                  
                                                  (69
                                                  )
                                                  
                                                  
                                                  (68
                                                  )Total
      stockholders' equity
                                                  
                                                  
                                                  60,521
                                                  
                                                  
                                                  
                                                  49,729Total
      liabilities and stockholders' equity
                                                  
                                                  $
                                                  72,259
                                                  
                                                  
                                                  $
                                                  59,763





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




F-2





Obagi
Medical Products, Inc.


Consolidated
Statements of Income


(Dollars
in thousands, except share and per share amounts)




Year
      Ended December 31,2008
                                                                  
                                                                  
                                                                  2007
                                                                  
                                                                  
                                                                  2006Net
      sales
                                                                  
                                                                  $
                                                                  104,593
                                                                  
                                                                  
                                                                  $
                                                                  102,648
                                                                  
                                                                  
                                                                  $
                                                                  77,996Cost
      of sales
                                                                  
                                                                  
                                                                  19,931
                                                                  
                                                                  
                                                                  
                                                                  18,049
                                                                  
                                                                  
                                                                  
                                                                  13,467Gross
      Profit
                                                                  
                                                                  
                                                                  84,662
                                                                  
                                                                  
                                                                  
                                                                  84,599
                                                                  
                                                                  
                                                                  
                                                                  64,529Selling,
      general and administrative expenses
                                                                  
                                                                  
                                                                  59,380
                                                                  
                                                                  
                                                                  
                                                                  51,400
                                                                  
                                                                  
                                                                  
                                                                  40,863Research
      and development expenses
                                                                  
                                                                  
                                                                  5,284
                                                                  
                                                                  
                                                                  
                                                                  5,497
                                                                  
                                                                  
                                                                  
                                                                  5,919Income
      from operations
                                                                  
                                                                  
                                                                  19,998
                                                                  
                                                                  
                                                                  
                                                                  27,702
                                                                  
                                                                  
                                                                  
                                                                  17,747Interest
      income
                                                                  
                                                                  
                                                                  368
                                                                  
                                                                  
                                                                  
                                                                  190
                                                                  
                                                                  
                                                                  
                                                                  13Interest
      expense
                                                                  
                                                                  
                                                                  (243
                                                                  )
                                                                  
                                                                  
                                                                  (2,414
                                                                  )
                                                                  
                                                                  
                                                                  (8,186
                                                                  )Income
      before provision for income taxes
                                                                  
                                                                  
                                                                  20,123
                                                                  
                                                                  
                                                                  
                                                                  25,478
                                                                  
                                                                  
                                                                  
                                                                  9,574Provision
      for income taxes
                                                                  
                                                                  
                                                                  7,535
                                                                  
                                                                  
                                                                  
                                                                  10,275
                                                                  
                                                                  
                                                                  
                                                                  3,458Net
      income
                                                                  
                                                                  $
                                                                  12,588
                                                                  
                                                                  
                                                                  $
                                                                  15,203
                                                                  
                                                                  
                                                                  $
                                                                  6,116Net
      income attributable to common sharesBasic
                                                                  
                                                                  $
                                                                  0.56
                                                                  
                                                                  
                                                                  $
                                                                  0.69
                                                                  
                                                                  
                                                                  $
                                                                  0.34Diluted
                                                                  
                                                                  $
                                                                  0.56
                                                                  
                                                                  
                                                                  $
                                                                  0.69
                                                                  
                                                                  
                                                                  $
                                                                  0.34Weighted
      average common shares outstandingBasic
                                                                  
                                                                  
                                                                  22,598,474
                                                                  
                                                                  
                                                                  
                                                                  21,989,121
                                                                  
                                                                  
                                                                  
                                                                  17,996,158Diluted
                                                                  
                                                                  
                                                                  22,607,689
                                                                  
                                                                  
                                                                  
                                                                  22,100,737
                                                                  
                                                                  
                                                                  
                                                                  18,071,048
 The
accompanying notes are an integral part of these consolidated financial
statements.




F-3





Obagi Medical
Products, Inc.


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Dollars
in thousands, except share and per share amounts)




Common
      Stock
                                                                                                                          
                                                                                                                          Additional
      Paid—In
                                                                                                                          
                                                                                                                          Accumulated
      Earnings
                                                                                                                          
                                                                                                                          Treasury
      Stock
                                                                                                                          
                                                                                                                          Stockholder
                                                                                                                          
                                                                                                                          
                                                                                                                          Accumulated
      Other ComprehensiveShares
                                                                                                                          
                                                                                                                          Amount
                                                                                                                          
                                                                                                                          Capital
                                                                                                                          
                                                                                                                          (Deficit)
                                                                                                                          
                                                                                                                          Shares
                                                                                                                          
                                                                                                                          Amount
                                                                                                                          
                                                                                                                          Receivable
                                                                                                                          
                                                                                                                          
                                                                                                                          Loss
                                                                                                                          
                                                                                                                          
                                                                                                                          TotalBalances,
      as of December 31, 2005
                                                                                                                          
                                                                                                                          
                                                                                                                          17,792,583
                                                                                                                          
                                                                                                                          $
                                                                                                                          18
                                                                                                                          
                                                                                                                          $
                                                                                                                          900
                                                                                                                          
                                                                                                                          $
                                                                                                                          (27,260
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          $
                                                                                                                          —
                                                                                                                          
                                                                                                                          $
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          (19
                                                                                                                          )
                                                                                                                          
                                                                                                                          $
                                                                                                                          (26,361
                                                                                                                          )Comprehensive
      income:Translation
      adjustment, net of tax effect ($17 benefit)
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (27
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          (27
                                                                                                                          )Net income for the
      year ended December 31, 2006
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          6,116
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          6,116Total
      comprehensive income
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          6,089Issuance
      of common stock upon exercise of incentivestock
      options
                                                                                                                          
                                                                                                                          
                                                                                                                          6,600
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          9
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          9From
      exercise of stock options
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (222
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (222
                                                                                                                          )Stock
      compensation expense
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          305
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          305Issuance
      of common stock in initial public offering, netof offering
      costs
                                                                                                                          
                                                                                                                          
                                                                                                                          4,000,000
                                                                                                                          
                                                                                                                          
                                                                                                                          4
                                                                                                                          
                                                                                                                          
                                                                                                                          38,094
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          38,098Issuance
      of common stock in exchange for stockholderreceivable
                                                                                                                          
                                                                                                                          
                                                                                                                          2,778
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          23
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (23
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —Balances,
      as of December 31, 2006
                                                                                                                          
                                                                                                                          
                                                                                                                          21,801,961
                                                                                                                          
                                                                                                                          
                                                                                                                          22
                                                                                                                          
                                                                                                                          
                                                                                                                          39,109
                                                                                                                          
                                                                                                                          
                                                                                                                          (21,144
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (23
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          (46
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          17,918Cumulative
      effect of adoption of FIN 48
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (90
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (90
                                                                                                                          )Balances,
      as of January 1, 2007, as adjusted
                                                                                                                          
                                                                                                                          
                                                                                                                          21,801,961
                                                                                                                          
                                                                                                                          
                                                                                                                          22
                                                                                                                          
                                                                                                                          
                                                                                                                          39,109
                                                                                                                          
                                                                                                                          
                                                                                                                          (21,234
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (23
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          (46
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          17,828Comprehensive
      income:Translation
      adjustment, net of tax effect ($14 benefit)
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (22
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          (22
                                                                                                                          )Net income for the
      year ended December 31, 2007
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          15,203
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          15,203Total
      comprehensive income
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          15,181Stock
      compensation expense
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          1,557
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          1,557Payment
      received on stockholder receivable
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          23
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          23Issuance
      of common stock in public offering, netof offering
      costs
                                                                                                                          
                                                                                                                          
                                                                                                                          800,000
                                                                                                                          
                                                                                                                          
                                                                                                                          1
                                                                                                                          
                                                                                                                          
                                                                                                                          15,027
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          15,028Issuance
      of vested restricted stock
                                                                                                                          
                                                                                                                          
                                                                                                                          9,869
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —Tax
      benefit from exercise of stock options
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          10
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          10Issuance
      of common stock upon exercise of incentivestock
      options
                                                                                                                          
                                                                                                                          
                                                                                                                          31,734
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          102
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          102Balances,
      as of December 31, 2007
                                                                                                                          
                                                                                                                          
                                                                                                                          22,643,564
                                                                                                                          
                                                                                                                          
                                                                                                                          23
                                                                                                                          
                                                                                                                          
                                                                                                                          55,805
                                                                                                                          
                                                                                                                          
                                                                                                                          (6,031
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (68
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          49,729Comprehensive
      income:Translation
      adjustment, net of tax effect ($1 benefit)
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (1
                                                                                                                          )
                                                                                                                          
                                                                                                                          
                                                                                                                          (1
                                                                                                                          )Net income for the
      year ended December 31, 2008
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          12,588
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          12,588Total
      comprehensive income
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          12,587Stock
      compensation expense
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          2,008
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          2,008Issuance
      of vested restricted stock
                                                                                                                          
                                                                                                                          
                                                                                                                          9,785
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —Tax
      benefit from exercise of stock options
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          39
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          39Issuance
      of common stock upon exercise of incentivestock
      options
                                                                                                                          
                                                                                                                          
                                                                                                                          18,890
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          174
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          174Repurchase
      of common stock
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          (627,367
                                                                                                                          )
                                                                                                                          
                                                                                                                          (4,016
                                                                                                                          )
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          
                                                                                                                          (4,016
                                                                                                                          )Balances,
      as of December 31, 2008
                                                                                                                          
                                                                                                                          
                                                                                                                          22,672,239
                                                                                                                          
                                                                                                                          $
                                                                                                                          23
                                                                                                                          
                                                                                                                          $
                                                                                                                          58,026
                                                                                                                          
                                                                                                                          $
                                                                                                                          6,557
                                                                                                                          
                                                                                                                          
                                                                                                                          (627,367
                                                                                                                          )
                                                                                                                          $
                                                                                                                          (4,016
                                                                                                                          )
                                                                                                                          $
                                                                                                                          —
                                                                                                                          
                                                                                                                          
                                                                                                                          $
                                                                                                                          (69
                                                                                                                          )
                                                                                                                          
                                                                                                                          $
                                                                                                                          60,521


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




F-4





Obagi Medical
Products, Inc.


Consolidated
Statements of Cash Flows


(Dollars
in thousands, except share and per share amounts)





Year
      Ended December 31,2008
                                                                        
                                                                        
                                                                        2007
                                                                        
                                                                        
                                                                        2006Cash
      flows from operating activitiesNet
      income
                                                                        
                                                                        $
                                                                        12,588
                                                                        
                                                                        
                                                                        $
                                                                        15,203
                                                                        
                                                                        
                                                                        $
                                                                        6,116Adjustments
      to reconcile net income to net cash provided byoperating
      activitiesDepreciation
      and amortization
                                                                        
                                                                        
                                                                        2,391
                                                                        
                                                                        
                                                                        
                                                                        2,788
                                                                        
                                                                        
                                                                        
                                                                        2,758Write
      down of debt issuance costs
                                                                        
                                                                        
                                                                        130
                                                                        
                                                                        
                                                                        
                                                                        781
                                                                        
                                                                        
                                                                        
                                                                        1,282Loss
      on disposal of property and equipment
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        1
                                                                        
                                                                        
                                                                        
                                                                        72Provision
      for doubtful accounts
                                                                        
                                                                        
                                                                        562
                                                                        
                                                                        
                                                                        
                                                                        194
                                                                        
                                                                        
                                                                        
                                                                        150Deferred
      income taxes
                                                                        
                                                                        
                                                                        (336
                                                                        )
                                                                        
                                                                        
                                                                        (49
                                                                        )
                                                                        
                                                                        
                                                                        (450
                                                                        )Stock
      compensation expense
                                                                        
                                                                        
                                                                        2,008
                                                                        
                                                                        
                                                                        
                                                                        1,557
                                                                        
                                                                        
                                                                        
                                                                        305Tax
      expense from exercise of stock options
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        (222
                                                                        )Changes
      in operating assets and liabilitiesAccounts
      receivable
                                                                        
                                                                        
                                                                        (3,671
                                                                        )
                                                                        
                                                                        
                                                                        (7,515
                                                                        )
                                                                        
                                                                        
                                                                        905Accounts
      receivable from related parties
                                                                        
                                                                        
                                                                        295
                                                                        
                                                                        
                                                                        
                                                                        519
                                                                        
                                                                        
                                                                        
                                                                        (356
                                                                        )Income
      taxes receivable
                                                                        
                                                                        
                                                                        (1,512
                                                                        )
                                                                        
                                                                        
                                                                        346
                                                                        
                                                                        
                                                                        
                                                                        1,945Inventories
                                                                        
                                                                        
                                                                        (798
                                                                        )
                                                                        
                                                                        
                                                                        219
                                                                        
                                                                        
                                                                        
                                                                        (3,158
                                                                        )Prepaid
      expenses and other current assets
                                                                        
                                                                        
                                                                        582
                                                                        
                                                                        
                                                                        
                                                                        (487
                                                                        )
                                                                        
                                                                        
                                                                        (876
                                                                        )Other
      assets
                                                                        
                                                                        
                                                                        173
                                                                        
                                                                        
                                                                        
                                                                        153
                                                                        
                                                                        
                                                                        
                                                                        875Cash
      received for reimbursable tenant improvements
                                                                        
                                                                        
                                                                        955
                                                                        
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Accounts
      payable
                                                                        
                                                                        
                                                                        (312
                                                                        )
                                                                        
                                                                        
                                                                        1,151
                                                                        
                                                                        
                                                                        
                                                                        3,187Accrued
      liabilities
                                                                        
                                                                        
                                                                        271
                                                                        
                                                                        
                                                                        
                                                                        (549
                                                                        )
                                                                        
                                                                        
                                                                        438Amounts
      due to related parties
                                                                        
                                                                        
                                                                        34
                                                                        
                                                                        
                                                                        
                                                                        (17
                                                                        )
                                                                        
                                                                        
                                                                        (53
                                                                        )Other
      long-term liabilities
                                                                        
                                                                        
                                                                        661
                                                                        
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Net
      cash provided by operating activities
                                                                        
                                                                        
                                                                        14,021
                                                                        
                                                                        
                                                                        
                                                                        14,295
                                                                        
                                                                        
                                                                        
                                                                        12,918Cash
      flows from investing activitiesPurchases
      of property and equipment
                                                                        
                                                                        
                                                                        (3,944
                                                                        )
                                                                        
                                                                        
                                                                        (603
                                                                        )
                                                                        
                                                                        
                                                                        (1,818
                                                                        )Purchase
      of other intangible assets
                                                                        
                                                                        
                                                                        (327
                                                                        )
                                                                        
                                                                        
                                                                        (391
                                                                        )
                                                                        
                                                                        
                                                                        (366
                                                                        )Purchase
      of short-term investments
                                                                        
                                                                        
                                                                        (6,000
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Net
      cash used in investing activities
                                                                        
                                                                        
                                                                        (10,271
                                                                        )
                                                                        
                                                                        
                                                                        (994
                                                                        )
                                                                        
                                                                        
                                                                        (2,184
                                                                        )Cash
      flows from financing activitiesPrincipal
      payments on term loans
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        (25,651
                                                                        )
                                                                        
                                                                        
                                                                        (40,849
                                                                        )Principal
      payments on capital lease obligations
                                                                        
                                                                        
                                                                        (30
                                                                        )
                                                                        
                                                                        
                                                                        (35
                                                                        )
                                                                        
                                                                        
                                                                        (35
                                                                        )Proceeds
      from the issuance of common stock, net of underwritingdiscounts
      and deferred offering costs
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        15,028
                                                                        
                                                                        
                                                                        
                                                                        38,098Proceeds
      from exercise of stock options
                                                                        
                                                                        
                                                                        174
                                                                        
                                                                        
                                                                        
                                                                        102
                                                                        
                                                                        
                                                                        
                                                                        9Payment
      received for stockholder receivable
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        23
                                                                        
                                                                        
                                                                        
                                                                        —Tax
      benefit from exercise of stock optionsand vesting ofrestricted
      stock
                                                                        
                                                                        
                                                                        39
                                                                        
                                                                        
                                                                        
                                                                        10
                                                                        
                                                                        
                                                                        
                                                                        —Debt
      issuance costs for the line of credit
                                                                        
                                                                        
                                                                        (32
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Repurchase
      of common stock
                                                                        
                                                                        
                                                                        (4,016
                                                                        )
                                                                        
                                                                        
                                                                        —
                                                                        
                                                                        
                                                                        
                                                                        —Net
      cash used in financing activities
                                                                        
                                                                        
                                                                        (3,865
                                                                        )
                                                                        
                                                                        
                                                                        (10,523
                                                                        )
                                                                        
                                                                        
                                                                        (2,777
                                                                        )Effect
      of exchange rate changes on cash and cash equivalents
                                                                        
                                                                        
                                                                        (1
                                                                        )
                                                                        
                                                                        
                                                                        (22
                                                                        )
                                                                        
                                                                        
                                                                        (26
                                                                        )Net
      increase (decrease) in cash and cash equivalents
                                                                        
                                                                        
                                                                        (116
                                                                        )
                                                                        
                                                                        
                                                                        2,756
                                                                        
                                                                        
                                                                        
                                                                        7,931Cash
      and cash equivalents at beginning of year
                                                                        
                                                                        
                                                                        14,054
                                                                        
                                                                        
                                                                        
                                                                        11,298
                                                                        
                                                                        
                                                                        
                                                                        3,367Cash
      and cash equivalents at end of year
                                                                        
                                                                        $
                                                                        13,938
                                                                        
                                                                        
                                                                        $
                                                                        14,054
                                                                        
                                                                        
                                                                        $
                                                                        11,298Supplemental
      disclosure of cash flow information:Cash
      paid during the year for:Interest,
      net of amount capitalized
                                                                        
                                                                        $
                                                                        83
                                                                        
                                                                        
                                                                        $
                                                                        1,235
                                                                        
                                                                        
                                                                        $
                                                                        5,822Income
      taxes, net of refunds
                                                                        
                                                                        $
                                                                        9,418
                                                                        
                                                                        
                                                                        $
                                                                        9,878
                                                                        
                                                                        
                                                                        $
                                                                        2,135Non
      cash investing and financing activitiesCapital
      lease obligations incurred
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        47Interest
      rate cap fair value adjustment
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        (3
                                                                        )
                                                                        
                                                                        $
                                                                        (16
                                                                        )Changes
      in accounts payable and accrued liabilitiesrelated
      to purchases of property and equipment
                                                                        
                                                                        $
                                                                        126
                                                                        
                                                                        
                                                                        $
                                                                        —
                                                                        
                                                                        
                                                                        $
                                                                        —





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


F-5
 Obagi Medical Products, Inc.
 Notes
to the Consolidated Financial Statements
 (Dollars
in thousands, except share and per share amounts)





Note 1: The Company





Obagi Medical Products, Inc. (the
"Company") is a specialty pharmaceutical company focused on the aesthetic and
skin health markets. The Company develops and commercializes prescription-based,
topical skin health systems. The Company is incorporated under the laws of the
state of Delaware. The Company markets its products through its own sales force
throughout the United States, and through 19 distribution and two licensing
partners in 42 other countries in regions including North America, Europe, the
Far East, the Middle East, Central America, and South America. The Company also
licenses certain non-prescription product concepts under the Obagi trademark to
a large Japanese based pharmaceutical company for sale through consumer
distribution channels in Japan.





Reverse
Stock Split





On November 27, 2006, the Board of
Directors approved, and on November 28, 2006, the stockholders approved, a
1-for-1.2 reverse stock split of the Company's common stock to become effective
upon the filing of a Certificate of Amendment with the Secretary of State of the
state of Delaware. The filing of the Certificate of Amendment was a condition
precedent to the Company's request that its Registration Statement on
Form S-1 be declared effective. The Company's Registration Statement on
Form S-1 was declared effective on December 13, 2006. All share and
per share amounts included in the Company's financial statements have been
adjusted to reflect this reverse stock split for all periods
presented.





Amended
and Restated Certificate of Incorporation and Amended and Restated
Bylaws





On November 27, 2006, the Board of
Directors of the Company approved an amended and restated Certificate of
Incorporation and an amended and restated Bylaws in preparation for a
contemplated initial public offering. This amended and restated Certificate of
Incorporation was approved by the stockholders on November 28, 2006 and was
filed by the Secretary of State of the State of Delaware prior to the
effectiveness of the Company's Registration Statement on Form S-1. The
changes included: (i) total authorized shares increased to 110,000,000
(100,000,000 common and 10,000,000 preferred); (ii) the classes, term and
number of the members of the board of directors were modified; and
(iii) other changes deemed necessary as for a public reporting
company.





Initial
Public Offering





On December 13, 2006, the Company
completed its initial public offering of 5,350,000 shares of common stock at a
price of $11.00 per share. The offering consisted of 4,000,000 newly issued
shares sold by the Company and 1,350,000 shares sold by selling stockholders.
The offering generated gross proceeds of approximately $44,000 and net proceeds
of $38,098.





Secondary
Public Offering





On October 17, 2007, the Company
completed a registered public offering of 7,245,000 shares of common stock at a
price of $20.00 per share. The offering consisted of 800,000 newly issued shares
sold by the Company and 6,445,000 shares sold by selling stockholders. The
offering generated gross proceeds of approximately $16,000 and net proceeds of
$14,287 after all offering expenses.





Note 2:
Summary of Significant Accounting Policies





Principles
of Consolidation





The consolidated financial statements
include the accounts of Obagi Medical Products, Inc. and its wholly owned
subsidiary, OMP, Inc. The consolidated financial statements of
OMP, Inc. include the accounts of its wholly owned subsidiaries and its
majority owned subsidiary, Obagi Singapore. All intercompany accounts and
transactions have been eliminated in consolidation.





Use
of Estimates





The preparation of financial statements
in conformity with accounting principles generally accepted in the United States
of America requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.




F-6
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share amounts)




Cash and Cash
Equivalents




Cash equivalents include demand
deposits and short-term investments with a maturity of three months or less when
purchased.  The
Company maintains its cash deposits at numerous banks located throughout the
United States, which at times, may exceed federally insured limits. The Company
has not experienced any losses in such accounts and believes it is not exposed
to any significant risk. At December 31, 2008 and 2007, cash on deposit was
in excess of the federally insured limit of $250 and $100,
respectively.




Short-term
Investments


The
Company accounts for short-term investments in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments
in Debt and Equity Securities. The Company determines the appropriate
classification of all short-term investments as held-to-maturity,
available-for-sale or trading at the time of purchase and re-evaluates such
classifications as of each balance sheet date. Short-term investments for which
the Company has the positive intent and ability to hold to maturity are
classified as “held-to maturity” and reported at amortized
cost.  There were no investments classified as available for sale or
trading at December 31, 2008 and 2007.   Short-term investments consist of
certificates of deposit with maturities of less than twelve months and are
stated at cost, which approximates fair value.





Accounts
Receivable





The Company performs periodic credit
evaluations of the financial condition of its customers, monitors collections
and payments from customers, and generally does not require collateral.
Receivables are generally due within 30 days. The Company provides for the
possible inability to collect accounts receivable by recording an allowance for
doubtful accounts. The Company writes off an account when it is considered to be
uncollectible. The Company estimates its allowance for doubtful accounts based
on historical write-offs as a percentage of sales less licensing fees, adjusted
specifically for accounts that are past due, non-performing, in bankruptcy or
otherwise identified as at risk for potential credit loss.  The
Company estimates its allowance for doubtful accounts pursuant to sales returns
based on the Company's historical rate of returns as a percent of gross sales
less licensing fees, historical aging of returns, the Company’s return policy
and current market conditions. To date, losses have been within the range of
management's expectations.





Concentrations
of credit risk, with respect to trade receivables, are limited due to the large
number of customers comprising the Company's customer base and their dispersion
across different geographic regions. As of December 31, 2008 and 2007, no
single customer represented more than 5% of the net accounts receivable
balance.





Inventories





Inventories consist of raw materials
and finished goods purchased from third parties and are valued at the lower of
cost or market. Cost is determined by the first-in, first-out
method.





Inventory reserves are established when
conditions indicate that the selling price could be less than cost due to
physical deterioration, usage, obsolescence, reductions in estimated future
demand and reductions in selling prices. Inventory reserves are measured as the
difference between cost of inventory and the estimated net realizable value.
Inventory reserves are charged to cost of sales. The Company's estimated
inventory reserve is provided for in the consolidated financial statements and
actual reserve requirements approximated management's estimates.





Impairment
of Long-lived Assets





The Company periodically assesses
potential impairments of its long-lived assets in accordance with the provisions
of SFAS No. 144, Accounting for the Impairment or
Disposal of Long-lived Assets. An impairment review is performed whenever
events or changes in circumstances indicate that the carrying value of an asset
may not be recoverable. Factors considered by the Company include, but are not
limited to, significant underperformance relative to expected historical or
projected future operating results; significant changes in the manner of use of
the acquired assets or the strategy for the overall business; and significant
negative industry or economic trends. When the carrying value of a long-lived
asset may not be recoverable based upon the existence of one or more of the
above indicators of impairment, the Company will assess the recoverability of
the assets by estimating the future undiscounted operating cash flows expected
to result from the use of the asset and its eventual disposition. If the sum of
the expected future undiscounted cash flows and eventual disposition is less
than the carrying amount of the asset, the Company recognizes an impairment
loss. An impairment loss is reflected as the amount by which the carrying amount
of the asset exceeds the fair value of the asset, based on the fair market value
if available, or discounted cash flows, if not. To date, the Company has not
recognized an impairment charge related to the write-down of long-lived
assets.




F-7
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)







Property and equipment are stated at
cost and are depreciated using the straight-line method over their estimated
useful lives, as follows:





Furniture
      and fixtures
              3-5
      yearsComputer
      software and equipment
              3-5
      yearsLab
      and office equipment
              3
      yearsLeasehold
      improvements
              Lesser
      of useful life or term of leaseCapital
      lease (office equipment)
              Lesser
      of useful life or term of
lease





Property and equipment are stated at
cost, less accumulated depreciation and amortization. Expenditures for major
renewals and betterments are capitalized, while minor replacements, maintenance
and repairs, which do not extend the assets useful lives, are charged to
operations asincurred. Upon sale or
disposition, the cost and related accumulated depreciation is removed from the
accounts and any gain or loss is included in operations.





Goodwill
and Other Intangibles





SFAS No. 142 ("SFAS
No. 142"), Goodwill and
Other Intangible Assets, requires the Company to test goodwill for
impairment on an annual basis and more frequently if there is reason to suspect
that the value has been diminished or impaired, with any corresponding
write-downs recognized as necessary.





SFAS No. 142 requires that
goodwill be tested for impairment using a two-step process. The first step of
the goodwill impairment test used to identify potential impairment compares the
fair value of a reporting unit with its carrying amount including goodwill. If
the fair value of a reporting unit exceeds its carrying amount, goodwill of the
reporting unit is not considered to be impaired and the second step of the
impairment test is unnecessary. If the carrying amount of a reporting unit
exceeds its fair value, the second step of the goodwill impairment test must be
performed to measure the amount of impairment loss, if any. The second step of
the impairment test compares the implied fair value of reporting unit goodwill
with the carrying amount of that goodwill. The implied fair value of goodwill is
determined in the same manner as the amount of goodwill recognized in a business
combination. If the carrying amount of the reporting unit goodwill exceeds the
implied fair value of that goodwill, an impairment loss is recognized in an
amount equal to that excess.





The Company has selected
September 30 as the date on which it will perform its annual goodwill
impairment test. The entire balance of goodwill of $4,629 is attributable to the
Company’s largest reporting unit, which is also an operating segment, the
Physician Dispensed segment (see Note 12).  The determination of fair
value of the Company’s goodwill considered the current and future economic,
market, and competitive conditions, and other relevant factors.  The
Company evaluated the fair value of goodwill using two
approaches.  For the first method, the Company derived valuation
multiples from historical earnings data of guideline companies within the same
industry as the Company and that compete in the Physician Dispensed market, and
then evaluated and adjusted the multiples based on the Company’s strengths and
weaknesses relative to the guideline companies.  The derived multiples
are then applied to the Company’s operating data to arrive at an indication of
fair value.  Cash-free invested capital multiples, representing a
marketable minority interest, were calculated for the guideline companies as of
September 30, 2008.  Revenue and earnings multiples were based on a
valuation of the guideline companies’ profit margins, historical growth
patterns, and a review of the Company’s market factors, primarily related to its
Physician Dispensed business.  The second method, the discounted cash
flow method, focused on the expected cash flows of the Company’s Physician
Dispensed business.  The Company evaluated its earnings projections
through 2013, trending the growth down to 3% in the terminal
year.  The discount rate for its Physician Dispensed segment was
determined by utilizing a weighted average cost of capital analysis, which
analyzed long-term government bonds, the Moody’s Seasoned AAA bond rate, the
cost of equity of similar companies relative to its Physician Dispensed
business, as well as the Company’s capital structure.  Both methods
were weighted 50%.  The analyses concluded that the fair value of the
Company’s Physician Dispensed segment significantly exceeded the carrying amount
of its goodwill.  There were no impairment triggers subsequent to
September 30, 2008.  As such, based on the Company's analysis, no
impairment charges were recognized for the years ended December 31, 2008,
2007, and 2006.





Application of the goodwill impairment
test requires judgment, including the identification of reporting units,
assignment of assets and liabilities to reporting units, assignment of goodwill
to reporting units, and determination of the fair value of each reporting unit.
The fair value of each reporting unit is estimated, in part, using a discounted
cash flow methodology. This requires significant judgments including estimation
of future cash flows, which is dependent on internal forecasts, estimation of
the long-term rate of growth of the Company's business, the useful life over
which cash flows will occur, and determination of the Company's weighted average
cost of capital. Changes in these estimates and assumptions could materially
affect the determination of fair value and/or goodwill impairment for each
reporting unit.


F-8
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)


Other
intangible assets consist of trademarks, distribution rights, covenants
not-to-compete, patents, customer lists, and proprietary formulations. Other
intangible assets are amortized over the expected period of benefit using the
straight-line method over  In accordance with
SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, long — lived assets (including
intangible assets that are amortized) are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable, such as a significant sustained change in the business
climate, during the interim periods. If an indicator of impairment exists for
any grouping of assets, an estimate of undiscounted future cash flows is
produced and compared to its carrying value. If an asset is determined to be
impaired, the loss is measured by the excess of the carrying amount of the asset
over its fair value as determined by an estimate of discounted future cash
flows. There were no indicators of impairment noted during the years ended
December 31, 2008, 2007 and 2006; therefore no tests were performed for
long-lived assets.





Intangible
Assets





At December 31, 2008 and 2007, the
carrying amounts and accumulated amortization of intangible assets is as
follows:





December
      31, 2008
                                        
                                        
                                        December
      31, 2007Gross
      Amount
                                        
                                        
                                        Accumulated
      Amortization
                                        
                                        
                                        Net
      Book Value
                                        
                                        
                                        Gross
      Amount
                                        
                                        
                                        Accumulated
      Amortization
                                        
                                        
                                        Net
      Book ValueTrademarks
                                        
                                        $
                                        7,367
                                        
                                        
                                        $
                                        (4,032
                                        )
                                        
                                        $
                                        3,335
                                        
                                        
                                        $
                                        7,343
                                        
                                        
                                        $
                                        (3,668
                                        )
                                        
                                        $
                                        3,675Distribution
      rights
                                        
                                        
                                        1,082
                                        
                                        
                                        
                                        (984
                                        )
                                        
                                        
                                        98
                                        
                                        
                                        
                                        1,082
                                        
                                        
                                        
                                        (876
                                        )
                                        
                                        
                                        206Covenant
      not-to-compete
                                        
                                        
                                        931
                                        
                                        
                                        
                                        (931
                                        )
                                        
                                        
                                        —
                                        
                                        
                                        
                                        931
                                        
                                        
                                        
                                        (931
                                        )
                                        
                                        
                                        —Licenses
                                        
                                        
                                        1,975
                                        
                                        
                                        
                                        (1,107
                                        )
                                        
                                        
                                        868
                                        
                                        
                                        
                                        1,875
                                        
                                        
                                        
                                        (1,107
                                        )
                                        
                                        
                                        768Other
      intangible assets
                                        
                                        
                                        3,530
                                        
                                        
                                        
                                        (2,564
                                        )
                                        
                                        
                                        966
                                        
                                        
                                        
                                        3,327
                                        
                                        
                                        
                                        (2,216
                                        )
                                        
                                        
                                        1,111$
                                        14,885
                                        
                                        
                                        $
                                        (9,618
                                        )
                                        
                                        $
                                        5,267
                                        
                                        
                                        $
                                        14,558
                                        
                                        
                                        $
                                        (8,798
                                        )
                                        
                                        $
                                        5,760





Amortization expense related to all
intangible assets, including certain amounts reflected in cost of sales, for the
years ended December 31, 2008, 2007, and 2006 was $820, $939, and $941,
respectively.





Future estimated aggregate amortization
expense for the next five years and thereafter is as follows:





Years
      ending December 31,2009
                    
                    $
                    7842010
                    
                    
                    7522011
                    
                    
                    6762012
                    
                    
                    6512013
                    
                    
                    651Thereafter
                    
                    
                    1,753$
                    5,267





Debt Issuance Costs





Direct costs incurred in connection
with indebtedness agreements are capitalized as incurred and amortized on the
effective interest method over the term of the related indebtedness. Debt
issuance costs are included in other assets and represent fees and other costs
incurred in connection with the Senior Secured Credit Facility (the "Credit
Agreement") entered into on January 28, 2005 and the Revolving Credit
Agreement (the “Facility”) with Comerica Bank entered into on November 21,
2008.





Pursuant to the Third Amendment of the
Credit Agreement, the Company made a repayment of $35,000 in debt with the net
cash proceeds received in the initial public offering consummated on
December 13, 2006. As a result, the Company recorded a write down of debt
issuance costs of $1,282 during the year ended December 31, 2006. During
the year ended December 31, 2007, the Company paid the remaining balance
outstanding under the Credit Agreement.   In conjunction with the
paydowns on the Credit Agreement, the Company wrote off $781 of debt issuance
costs during the year ended December 31, 2007. The remaining balance of
debt issuance costs was applicable to the Company's line of credit under the
Credit Agreement.





In
connection with establishing the Facility, the Credit Agreement was terminated
(see Note 4 for further discussion).  Termination of the Credit
Agreement resulted in a write off of debt issuance costs of $130 during the year
ended December 31, 2008.  In addition, the Company capitalized $32 in
debt issuance costs related to the Facility during the year ended December 31,
2008.





The
amortization and the writedowns of
debt issuance costs are included as a component of interest expense. At
December 31, 2008 and 2007, the Company had debt issuance costs of $31 and
$211, respectively.  Amortization of debt issuance costs was $82, $262
and $849 for the years ended December 31, 2008, 2007 and 2006,
respectively.


F-9
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





Derivative
Financial Instruments





In 2001,
the Company adopted SFAS No. 133 ("SFAS No. 133"), Accounting for Derivative
Instruments and Hedging Activities and its related amendments. As a
result of the adoption of SFAS No. 133, the Company recognizes derivative
financial instruments, such as its interest rate cap contract, as either an
asset or a liability in the consolidated financial statements at fair
value.





The
accounting for changes in the fair value (i.e., unrealized gains or losses)
of a derivative instrument depends on whether it has been designated and
qualifies as part of a hedging relationship and further, on the type of hedging
relationship. Derivatives that are not hedges must be adjusted to fair value
through current earnings.





The
Company enters into interest rate caps to manage its exposure to changes in
interest rates. Interest rate caps also allow the Company to raise funds at
floating rates and effectively cap the interest rate.





Income
Taxes





Income
taxes are determined using an annual effective tax rate, which generally differs
from the United States federal statutory rate, primarily because of state taxes
and research and development tax credits. The Company recognizes deferred tax
assets and liabilities for temporary differences between the financial reporting
basis and the tax basis of the Company's assets and liabilities, along with net
operating loss and credit carryforwards.





The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. Income tax benefits credited to
stockholders' equity relate to tax benefits associated with amounts that are
deductible for income purposes but do not impact net income. These benefits are
principally generated from employee exercises of non-qualified stock
options.





Fair
values of Financial Instruments





The following methods and
assumptions were used by the Company in estimating the fair value of its
financial instruments for disclosure purposes:





Short-term investments:
    The carrying value of the Company's short-term
investments approximates fair value. The carrying value of the Company's
short-term investments approximates fair value because the interest rate adjusts
to market interest rates.





Interest rate cap
agreement:The fair value of the interest rate cap agreement, as
previously disclosed, is the amount at which it could be settled.





Leases





The Company accounts for leases under
the provisions of SFAS No. 13, Accounting for Leases, and
subsequent amendments, which require that the Company's leases be evaluated and
classified as either operating leases or capital leases for financial reporting
purposes. Minimum base rents for the Company's operating leases, which generally
have scheduled rent increases over the term of the lease, are recorded on a
straight-line basis over the lease term. The initial lease term includes the
period from when the Company is given access and control over the leased
property, whether or not rent payments are due under the terms of the
lease.





For leases with renewal periods at the
Company's option, the Company generally considers the lease term to comprise
only of the initial lease term as exercise of the renewal options are not
considered to be reasonably assured of exercise as determined at lease
inception. However, if failure to exercise a renewal option imposes an economic
penalty of sufficient magnitude to the Company, then the renewal, at inception,
is reasonably assured and will be included in the determination of the
appropriate lease term.





In certain instances, the Company
disburses cash for leasehold improvements, furnishings, fixtures and equipment
to renovate leased premises. If costs are paid directly by the landlord or
reimbursed to the Company by the landlord, the Company records a deferred rent
liability and amortizes the deferred rent liability over the lease term as a
reduction to rent expense. In other instances, the Company may expend cash for
landlord additions that the Company makes to lease premises that are reimbursed
to the Company by the landlord. Based on the specifics of the leased space and
the lease agreement, during the renovation period, amounts paid will be recorded
as prepaid rent and any landlord reimbursement will be recorded as an offset to
prepaid rent.




F-10
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Treasury
Stock




The Company records treasury stock
under the cost method whereby the entire cost of the acquired stock is recorded
as treasury stock. The Company records reissuances of treasury stock at the fair
value of the underlying transactions. Differences between the fair value of the
issuance and the cost basis of the treasury stock that results in a gain is
recorded as an adjustment to additional paid-in capital.  If the
transaction results in a loss, the difference would be charged to additional
paid-in capital to the extent of any gains previously recorded, and the
remaining amount would be then charged to accumulated earnings
(deficit).





Revenue
Recognition





The Company recognizes revenue in the
physician dispensed segment in accordance with Securities and Exchange
Commission ("SEC") Staff Accounting Bulletin ("SAB") No. 104 ("SAB
No. 104"), Revenue
Recognition in Financial Statements, which provides guidance on the
recognition, presentation and disclosure of revenue in financial statements
filed with the SEC. SAB No. 104 outlines the basic criteria that must be
met to recognize revenue and provides guidance for disclosure related to revenue
recognition policies. In general, the Company recognizes revenue when
(i) persuasive evidence of an arrangement exists, (ii) shipment of
products has occurred, (iii) the sales price charged is fixed or
determinable, and (iv) collection is reasonably assured. The Company's
shipment terms are FOB shipping point as outlined in its sales agreements.





The Company's domestic sales agreements
do not provide for rights of return or price protection. However, the Company
may approve returns on a case-by-case basis at its discretion. Based on the
Company's historical experience, such returns generally approximate 1.7% of the
Company's total gross sales. Certain international distribution agreements do
provide for rights of return and price protection. Generally, such return rights
are for a period of not more than 90 days after shipment. In accordance
with SFAS No. 48 (“SFAS No. 48”), Revenue Recognition When Right of
Return Exists, the Company continuously monitors and tracks product
returns and records a provision for the estimated future amount of such future
returns, based on historical experience and any notification received of pending
returns. The allowance for future sales returns as of December 31, 2008 and
2007 was $451 and $538, respectively, and is recorded as a reduction to revenue.
The Company does not grant any warranty provisions on its products. The Company
provides for discounts and allowances based on historical experience at the time
revenue is recognized as a reduction to revenue. To date, actual provisions have
approximated management's estimates.





The Company grants price protection
rights to certain international distributors. Such price protection rights
require the Company to pay the distributor if there is a reduction in the list
price of the Company's products. Price protection payments would be required for
the distributor's inventory on-hand or in-transit on the date of the price
reduction, for a period not to exceed 90 days prior to the date of the
price reduction. The Company has not recorded a liability in connection with
such price protection rights as the Company has never reduced the list prices of
its products.





In September 2002, the Company entered
into a licensing agreement, as amended (as discussed in the royalty licensee
agreements footnote, Note 8) with an international distributor that
specializes in the distribution and marketing of over-the-counter medical
oriented products in the drug store and retail channels. In January 2006, the
Company entered into a licensing agreement with a diversified Japanese consumer
products and services company, which also owns and operates a large chain of
aesthetic spas in Japan. The Company recognizes royalty revenues related to the
licensing agreements based on the respective distributor's sale of related
products. These royalty revenues are recognized as earned and are based upon a
predetermined rate within the respective licensing agreement.





Included
in revenues are fees charged to customers for shipping and handling. Such
revenues amounted to $2,384, $2,430 and $1,831 for the years ended
December 31, 2008, 2007, and 2006, respectively. Shipping and handling
costs incurred in a sales transaction to ship products to customers are included
as a component of cost of sales.





Pharmacy
Rx Channel




During
the year ended December 31, 2008, the Company entered the pharmacy Rx channel
for the first time by launching SoluCLENZ Rx GelTM, a
solubilized benzoyl peroxide gel for the treatment of acne, which is available
only by prescription. The Company sells SoluCLENZ to pharmaceutical wholesalers,
who have the right to return purchased product prior to the units being
dispensed through patient prescriptions. Revenue for this product is recognized
in accordance with SAB No. 104 and SFAS No. 48.  Among its
criteria for revenue recognition from sale transactions where a buyer has a
right of return, SFAS No. 48 requires the amount of future returns to be
reasonably estimated.




During
the launch period only, the Company sold product to wholesalers with a
guaranteed sale provision, allowing the wholesalers to return the product within
120 days of shipment. Product shipments during the launch period were $1,569 for
the year ended December 31, 2008. As substantially all of the risks and rewards
of ownership did not transfer upon shipment, the Company is treating the sale of
product during the launch period and after the launch period under a consignment
model.  Under this consignment model, the Company did not recognize
revenue upon the shipment of product with the guaranteed sale provision and
accounted for inventory held by the wholesalers as consignment
inventory.  Due to the Company’s limited experience in the pharmacy Rx
channel, the Company is currently unable to reasonably estimate customer returns
and, therefore, will only recognize revenue related to SoluCLENZ units once the
units have been dispensed through patient prescriptions because units dispensed
to patients are not subject to
return. The Company obtains actual prescription units dispensed based on
distribution channel data provided by external, independent
sources.  As of December 31, 2008, amounts included as deferred
revenue in accrued liabilities in the consolidated balance sheet totaled
$398.


F-11
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Gross
product revenue and net product revenue (gross product revenue, net of cash
discounts, rebates and patient coupons) for prescription units dispensed was
$248 and $162, respectively, for the year ended December 31, 2008. Inventory on
consignment represents the cost of SoluCLENZ units shipped to wholesalers that
has not yet been dispensed to patients (see Note 3).




The
Company will continue to recognize revenue upon prescription units dispensed
until it can reasonably estimate product returns based on its product returns
experience. At that time, the Company will record a one-time increase in net
revenue related to the recognition of revenue previously deferred.  In
order to develop a methodology, and provide a basis, for estimating future
product returns on sales to its wholesalers at the time of shipment, the Company
has begun tracking the SoluCLENZ product return history, taking into
consideration product expiration dating at time of shipment and inventory levels
in the distribution channel. Revenue will also be reduced for estimates of
allowances for cash discounts, rebates and patient coupons based on historical
experience, and current contract prices and terms with wholesalers. If actual,
or expected wholesaler returns and revenue allowances differ from previous
estimates, adjustments of these estimates would be recognized in the period such
facts become known.





Advertising
Costs





Advertising costs are expensed the
first time the advertising takes place. Advertising and promotion costs incurred
for the years ended December 31, 2008, 2007, and 2006 were approximately
$235, $344, and $251, respectively. Advertising costs are recorded as a
component of selling, general and administrative expenses.





Foreign
Currency Translation





The financial statements of
subsidiaries outside the United States are measured using the local currency as
the functional currency. Assets and liabilities of these subsidiaries are
translated at the rates of exchange at the balance sheet date. Revenue and
expense items are translated at average monthly rates of exchange. The resultant
translation adjustments are recorded in comprehensive income (loss), a separate
component of stockholders' equity (deficit). Such adjustments amounted to an
unrealized loss of $1, $22 and $27 for the years ended December 31, 2008,
2007, and 2006, respectively.





Research
and Development





Research and development activities
have historically focused on improving the efficacy of existing pharmaceutical
ingredients by enhancing penetration. These activities primarily consist of
formulation, chemistry and analytical manufacturing controls and stability work.
Research and development expenses include, among other things, wages and
benefits, raw materials and supplies, facilities, outside professionals and
professional service provider fees. Clinical trials and certain support
functions in preparing protocols, reports and other regulatory documents are
performed by scientific consultants and third-party contract research
organizations. Research and development costs are expensed as
incurred.





Stock-based
Compensation





Prior to the January 1, 2006
adoption of Financial Accounting Standards Board ("FASB") Statement No. 123
(revised 2004) ("SFAS No. 123R"), Share-Based Payment , the
Company accounted for grants of options to employees to purchase its common
stock using the intrinsic value method in accordance with Accounting Principles
Board Opinion No. 25 ("APB No. 25"), Accounting for Stock Issued to
Employees , and FASB Interpretation No. 44, Accounting for Certain Transactions
Involving Stock Compensation . As permitted by SFAS No. 123 ("SFAS
No. 123"), Accounting for
Stock-Based Compensation, and as amended by SFAS No. 148 ("SFAS
No. 148"), Accounting for
Stock-Based Compensation-Transition and Disclosure, the Company had
chosen to continue to account for such option grants under APB No. 25 and
provide the expanded disclosures specified in SFAS No. 123, as amended by
SFAS No. 148.





Effective January 1, 2006, the
Company adopted SFAS No. 123R using the modified prospective transition
method, and as a result, did not retroactively adjust results from prior
periods. Under this transition method, stock-based compensation was recognized
for: (i) expense related to the remaining unvested portion of all stock
option awards granted during the one year period preceding the Company's initial
public offering, based on the grant date fair value estimated in accordance with
the original provisions of SFAS No. 123 and (ii) expense related to
all stock option awards granted on or subsequent to January 1, 2006, based
on the grant date fair value estimated in accordance with the provisions of SFAS
No. 123R. In accordance with Staff Accounting Bulletin No. 107 ("SAB
No. 107"), Share-Based
Payment , the remaining unvested options issued by the Company prior to
the one year period preceding the initial public offering, with the exception of
the October 2005 grants, are not included in the SFAS No. 123R option pool
as such options were valued using the minimum valuemethod. As a result, unless
subsequently modified, repurchased or cancelled, such unvested options will not
be included in stock-based compensation. The Company applies the Black-Scholes
valuation model in determining
the fair value of share-based payments to employees. The resulting compensation
expense is recognized on a straight-line basis over the requisite service
period, which equals the option vesting term of three
years.


F-12
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Upon adoption of SFAS No. 123R,
the Company utilized the "long form" method for calculating the tax effects of
stock-based compensation pursuant to SFAS No. 123R, paragraph 81.
Under the "long form" method, the Company determined the beginning balance of
the additional paid-in capital pool ("APIC pool") related to the tax effects of
the employee stock-based compensation "as if" the Company had adopted the
recognition provisions of SFAS No. 123 since its effective date of
January 1, 1995.





Compensation expense is recognized only
for those options expected to vest, with forfeitures estimated based on the
Company's historical experience and future expectations. Prior to the adoption
of SFAS No. 123R, the effect of forfeitures on the pro forma expense
amounts was recognized as the forfeitures occurred.





As a
result of adopting SFAS No. 123R, the impact on the Consolidated Statement
of Income for the year ended December 31, 2006 on income before income
taxes and net income was $305 and $195, and did not have a material effect on
basic and diluted earnings per share, respectively. For the year ended
December 31, 2007, the impact on income before income taxes and net income
was $1,557 and $930, respectively, and had a $0.04 and a $0.04 impact on basic
and dilutive earnings per share, respectively. For the year ended
December 31, 2008, the impact on income before income taxes and net income
was $2,008 and $1,257, respectively, and had a $0.06 and a $0.06 impact on basic
and dilutive earnings per share, respectively.  In addition, prior to
the adoption of SFAS No. 123R, the Company presented the tax benefit
resulting from the exercise of stock options as operating cash inflows in the
Consolidated Statements of Cash Flows. Upon the adoption of SFAS No. 123R,
the excess tax benefits for those options are classified as financing cash
inflows.The fair value of each option granted
to employees and directors is estimated using the Black-Scholes option-pricing
model with the following weighted-average assumptions for the years ended
December 31, 2008, 2007, and 2006:


Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Expected
      stock price volatility
                  
                  
                  33.2
                  %
                  
                  
                  32.9
                  %
                  
                  
                  33.5
                  %Expected
      dividend yield
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %Risk-free
      interest rate
                  
                  
                  3.1
                  %
                  
                  
                  4.2
                  %
                  
                  
                  4.6
                  %Expected
      life of options
                  
                  5.1
      years
                  
                  
                  6.0
      years
                  
                  
                  6.0
      years





Expected stock price volatility is
based on a combined average expected stock price volatility of publicly traded
peer companies deemed to be similar entities whose share or option prices are
publicly available. For fiscal years 2008, 2007, and 2006 the Company based its
expected stock price volatility on the combined average stock price volatility
of five publicly traded peer companies. Until such time that the Company has
enough historical data, it will continue to rely on peer companies' volatility
and will ensure that the selected peer companies are still appropriate. The
risk-free interest rate is based on the United States Treasury yield curve in
effect at the time of grant with an equivalent remaining term. The Company has
paid dividends only once in the past and does not currently plan to pay
dividends in the near future. The Company has applied the provisions of SAB
No. 107 and SAB No. 110, Share-Based Payment, Staff Views Regarding the
"Simplified" Method, in electing the simplified method for determining
the expected life of options granted subsequent to the date of the shareholder
transaction.





The aggregate intrinsic value for
options outstanding at December 31, 2008 was $21. This amount changes based
on the estimated fair market value of the Company's stock. Total intrinsic value
of options exercised for the year ended December 31, 2008 was $55. As of
December 31, 2008, total unrecognized stock-based compensation expense
related to nonvested stock options was approximately $2,589, which is expected
to be recognized over a weighted average period of approximately
2.23 years. Aggregate intrinsic value represents the total pretax intrinsic
value (the difference between the Company's estimated stock price on
December 31, 2008 and the exercise price, multiplied by the number of the
in-the-money options) that would have been received by the option holders had
all the option holders exercised their options on December 31,
2008.





Earnings per Common Share
("EPS")





The Company accounts for earnings per
share in accordance with SFAS No. 128, Earnings per Share. Basic
earnings per share are computed by dividing net income by the weighted-average
number of common shares outstanding. Diluted earnings per common share is
computed similar to basic earnings per share except that the denominator is
increased to include the number of additional common shares that would have been
outstanding if the potential common shares had been issued and if the additional
common shares were dilutive. Common share equivalents are excluded from the
computation if their effect is anti-dilutive. The Company's common share
equivalents consist of stock options issued under the Company's Stock Option
Plan as well as mandatory redeemable convertible preferred stock.





Under the treasury stock method, the
assumed proceeds calculation includes: (a) the actual proceeds
to-be-received from the employee upon exercise, (b) the average
unrecognized compensation cost during the period and (c) any tax benefits
that will be  credited
upon exercise to additional paid-in capital. The Company determines whether our
windfall pool of available excess tax benefits is sufficient to absorb the
shortfall. If so, the effect of the hypothetical deferred tax asset write-off
reduces the assumed proceeds in the treasury stock calculation. If there is no
pool of available excess tax benefits, or if the amount of the pool is
insufficient to absorb the entire hypothetical deficient tax deduction, the
amount of the deficiency that is charged to income tax expense is not considered
to be a reduction of the assumed proceeds. Currently, the Company has determined
that we have sufficient windfall pool available.


F-13
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





Basic and diluted earnings per common
share were calculated using the following units for the years ended
December 31, 2008, 2007, and 2006:




Year
      Ended December 31,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006Weighted
      average shares outstanding - basic
                                    
                                    
                                    22,598,474
                                    
                                    
                                    
                                    21,989,121
                                    
                                    
                                    
                                    17,996,158Effect
      of dilutive stock options
                                    
                                    
                                    9,215
                                    
                                    
                                    
                                    111,616
                                    
                                    
                                    
                                    74,890Weighted
      average shares outstanding - diluted
                                    
                                    
                                    22,607,689
                                    
                                    
                                    
                                    22,100,737
                                    
                                    
                                    
                                    18,071,048





For the years ended December 31,
2008, 2007 and 2006, diluted earnings per share does not include the impact of
common stock options then outstanding of 2,089,608, 172,015 and 970,823,
respectively, as the effect of their inclusion would be
anti-dilutive.





New
Accounting Pronouncements





In May
2008, the FASB issued SFAS No. 162 ("SFAS No. 162"), The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. GAAP for nongovernmental entities. SFAS No.
162 was effective 60 days following the SEC's approval of the Public Company
Accounting Oversight Board auditing amendments to AU Section 411, The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles. The adoption of
SFAS No. 162 did not have a material impact on the Company’s consolidated
financial statements.




In April
2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 142-3 ("FSP FAS
142-3"), Determination of the
Useful Life of Intangible Assets , which amends the factors that should
be considered in developing renewal or extension assumptions used to determine
the useful life of a recognized intangible asset under FASB Statement No. 142,
Goodwill and Other Intangible
Assets . FSP FAS 142-3 allows an entity to use its own historical
experience in renewing or extending similar arrangements, adjusted for specified
entity-specific factors, in developing assumptions about renewal or extension
used to determine the useful life of a recognized intangible asset. Additional
disclosures are required to enable financial statement users to assess the
extent to which the expected future cash flows associated with the asset are
affected by the entity’s intent and/or ability to renew or extend the
arrangement. The guidance for determining the useful life of a recognized
intangible asset is to be applied prospectively to intangible assets acquired
after the effective date. The disclosure requirements are to be applied
prospectively to all intangible assets recognized as of, and subsequent to, the
effective date. FSP FAS 142-3 is effective for fiscal years and interim periods
within those fiscal years, beginning on or after December 15, 2008, with early
adoption prohibited. The Company does not believe the adoption of FSP FAS 142-3
will have a material impact on its consolidated financial
statements.




In
December 2007, the FASB issued SFAS No. 141 (revised 2007) ("SFAS
No. 141(R)"), Business
Combinations, which among other things, requires the Company to record
fair value estimates of contingent consideration and certain other potential
liabilities during the original purchase price allocation, expense acquisition
costs as incurred and does not permit certain restructuring activities
previously allowed under Emerging Issues Task Force Issue ("EITF")
No. 95-3, Recognition of
Liabilities in Connection with a Purchase Business Combination, to be
recorded as a component of purchase accounting. This statement is effective as
of the beginning of an entity's first fiscal year beginning after
December 15, 2008. The Company will adopt the provisions of this standard
beginning January 1, 2009. The provisions of SFAS No. 141(R) will only
impact the Company if it is party to a business combination after the standard
has been adopted.




In
December 2007, the FASB issued SFAS No. 160 ("SFAS No. 160"), Noncontrolling Interests in
Consolidated Financial Statements—an amendment of ARB No. 51, which
causes noncontrolling interests in subsidiaries to be included in the equity
section of the balance sheet. This statement is effective as of the beginning of
an entity's first fiscal year beginning after December 15, 2008. The
Company will adopt the provisions of this standard beginning January 1,
2009. The Company believes that the adoption of SFAS No.160 will not have an
impact on its consolidated financial statements.





In June
2007, the FASB issued EITF Issue No. 07-03 ("EITF 07-03"), Accounting for Non-Refundable
Advance Payments for Goods or Services to Be Used in Future Research and
Development Activities . EITF 07-03 provides guidance on whether
non-refundable advance payments for goods that will be used or services that
will be performed in future research and development activities should be
accounted for as research and development costs or deferred and capitalized
until the goods have been delivered or the
related services have been rendered. The Company adopted the provisions of this
issue beginning January 1, 2008. The adoption of EITF 07-03 did not
have an impact on the Company’s consolidated financial
statements.


F-14
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




In February 2007, the FASB issued SFAS
No. 159 ("SFAS No. 159"),The Fair Value
Option for Financial Assets and Financial Liabilities,to permit all entities to choose to
elect, at specified election dates, to measure eligible financial instruments at
fair value. An entity shall report unrealized gains and losses on items for
which the fair value option has been elected in earnings at each subsequent
reporting date, and recognize upfront costs and fees related to those items in
earnings as incurred and not deferred. SFAS No. 159 became effective for the
Company as of January 1, 2008.  The Company did not elect the fair value
option for any financial assets or liabilities.




In
September 2006, the FASB issued SFAS No. 157 (“SFAS No. 157”), Fair Value Measurements. This
new standard provides guidance for using fair value to measure assets and
liabilities. Under SFAS No. 157, fair value refers to the price that would
be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants in the market in which the reporting
entity transacts. In this standard, the FASB clarifies the principle that fair
value should be based on the assumptions market participants would use when
pricing the asset or liability. In support of this principle, SFAS No. 157
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. The fair value hierarchy gives the highest priority
to quoted prices in active markets and the lowest priority to unobservable data;
for example, the reporting entity's own data. Under the standard, fair value
measurements would be separately disclosed by level within the fair value
hierarchy. The provisions of SFAS No. 157 are effective for financial
statements issued for fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. However, FSP No. 157-2, Effective Date of FASB Statement
No. 157, was issued in February 2008 which defers the effective date
of SFAS No. 157 for nonfinancial assets and liabilities, except for items
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually), to fiscal years beginning after
November 15, 2008, and interim periods within those fiscal years.
Accordingly, the Company's adoption of this standard as of January 1, 2008
was limited to financial assets and liabilities. The adoption of the provisions
of SFAS No. 157 relating to financial assets and liabilities did not have
an impact on the Company's consolidated financial statements. The Company will
adopt the provisions related to nonfinancial assets and liabilities beginning
January 1, 2009. The adoption of the provisions related to nonfinancial
assets and liabilities is not expected to have a material impact on the
Company's consolidated financial statements.





Note 3: Composition of Certain Financial
Statement Captions





Inventories


December
      31,2008
                        
                        
                        2007Inventories,
      netRaw
      materials
                        
                        $
                        2,957
                        
                        
                        $
                        2,610Finished
      goods
                        
                        
                        4,526
                        
                        
                        
                        3,906Inventory on
      consignment
                        
                        
                        59
                        
                        
                        
                        —7,542
                        
                        
                        
                        6,516Less reserve for
      inventories
                        
                        
                        (697
                        )
                        
                        
                        (469
                        )$
                        6,845
                        
                        
                        $
                        6,047





Inventory
on consignment represents the amount of SoluCLENZ shipped to wholesalers and
chain drug stores that had not been recognized as revenue (see Note
2).





General
and administrative expenses capitalized into inventory during the years ended
December 31, 2008 and 2007 was $974 and $554, respectively. As of
December 31, 2008 and 2007, general and administrative expenses included in
inventory was $256 and $209, respectively.





Property
and Equipment


December
      31,2008
                    
                    
                    2007Property
      and equipmentFurniture and
      fixtures
                    
                    $
                    733
                    
                    
                    $
                    776Computer software
      and equipment
                    
                    
                    3,494
                    
                    
                    
                    2,906Lab and office
      equipment
                    
                    
                    888
                    
                    
                    
                    543Leasehold
      improvements
                    
                    
                    4,054
                    
                    
                    
                    3,107Capital lease
      (office equipment)
                    
                    
                    115
                    
                    
                    
                    261Construction in
      progress
                    
                    
                    648
                    
                    
                    
                    1579,932
                    
                    
                    
                    7,750Less accumulated
      depreciation and amortization
                    
                    
                    (4,592
                    )
                    
                    
                    (4,991
                    )$
                    5,340
                    
                    
                    $
                    2,759


F-15
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Depreciation expense for the years
ended December 31, 2008, 2007, and 2006 was $1,489, $1,587, and $968,
respectively. At December 31, 2008 and 2007, accumulated depreciation for
fixed assets under capital lease was $96 and $193, respectively.





In October 2008, the Company moved to
new corporate headquarters located in Long Beach, California (see Note
10).  In connection with the move, the Company wrote off $1,889 in
property and equipment, primarily leasehold improvements related to the prior
location.  The write off did not result in a gain or loss as the
assets were fully depreciated.  During the year ended December 31,
2007, the Company recorded a loss on disposal of fixed assets of $1. The loss is
reported as a component of selling, general and administrative
expenses.





Accrued
Liabilities


December
      31,2008
                      
                      
                      2007Accrued
      liabilitiesSalaries
      and related benefits
                      
                      $
                      2,059
                      
                      
                      $
                      2,035Deferred
      revenue
                      
                      
                      489
                      
                      
                      
                      —Other
                      
                      
                      962
                      
                      
                      
                      1,104$
                      3,510
                      
                      
                      $
                      3,139




See Note 2 for further discussion on deferred revenue.





Note 4:
Line of Credit Notes Payable and Capital Lease Obligations





On
January 28, 2005, the Company entered into an $80,000 Credit Agreement with
GE Business Financial Services, Inc. (formerly known as Merrill Lynch Business
Financial Services, Inc.). The Credit Agreement was structured with two term
loans, collectively $70,000, and a revolving line of credit providing
availability of up to $10,000.  Pursuant to the third
amendment of the Credit Agreement, during the year ended
December 31, 2007, the Company made a mandatory $1,313 excess cash
payment, $805 in principal payments and $23,533 in optional principal repayments
on the outstanding balance of the terms loans. Approximately $9,172 of the net
proceeds generated from the Company’s secondary public offering on
October 12, 2007 was utilized to pay down the outstanding balance of the
term loans and the revolving line of credit under the Credit Agreement. As of
December 31, 2007, the optional prepayments resulted in the complete
paydown of the term loans. As of December 31, 2007, the availability under the
revolving line of credit was $10,000.  The Company did not incur any
prepayment penalties or premiums upon making the optional
prepayments.





Borrowings
under the Credit Agreement were subject to certain financial and operating
covenants that included, among other provisions, maintaining a maximum Debt to
EBITDA Ratio, minimum EBITDA levels and minimum Fixed Charge Ratio and
restrictions on the Company’s ability to pay dividends. Certain covenants also
limited annual capital expenditures and use of proceeds from the issuance of
debt and equity securities. As of December 31,
2007, the maximum Debt to EBITDA requirement was 1.50 and the minimum Fixed
Charge Ratio was 1.25. The Company was in compliance with all financial and
non-financial covenants as of December 31, 2007.





Loans
under the Credit Agreement bore variable interest based on a margin, at the
Company's option, over prime rate or LIBOR. The margins applicable to portions
of amounts borrowed vary depending on the Company's consolidated Debt to EBITDA
Ratio. As of October 17, 2007, the date of complete paydown, applicable
margins were 1.75% and 2.00% for prime rate borrowings and 3.25% and 3.50% for
LIBOR borrowings for Term Loan A and Term Loan B, respectively. The
weighted-average interest rate for borrowings under the Credit Agreement was
8.96% as of October 17, 2007. Interest expense incurred attributable to the
Credit Agreement for the years ended December 31, 2007 and 2006 was $1,179
and $5,749, respectively.




On
November 21, 2008, the Company entered into the Facility with Comerica Bank for
$20,000.  The Facility has an initial term of three years,
ending on November 21, 2011, unless terminated earlier in accordance with
its provisions.  Any borrowings under the Facility bear variable
interest based on a margin, at the Company’s option, over prime rate or LIBOR as
defined in the Facility.  All amounts borrowed under the Facility
are secured by a first priority security interest in all of the Company’s
tangible and intangible assets. The Facility contains certain financial and
non-financial covenants. Non-financial covenants include, among other
things, certain limitations on annual capital expenditures and asset or equity
based investments and monthly and quarterly reporting of a listing of our
intellectual property.  Financial covenants include requirements for
maintaining a (i) minimum quick ratio; (ii) maximum ratio of total liabilities
to net worth; (iii) no loss for two consecutive quarters; (iv) minimum level of
profitability; (v) maximum annual capital expenditures; (vi) stock repurchases
not to exceed $10,000; (vii) maximum dividend distribution not to exceed 25% of
net income for the fiscal year; and (viii) joint venture investment not to
exceed $2,000.  As of December 31, 2008, the Company was not in
compliance with the non-financial covenant, requiring it to report monthly, a
listing of its intellectual property.  Subsequent to year end, the
Company obtained a waiver for the months of November 2008 and December 2008 with
respect to this non-financial covenant.





In
connection with establishing this Facility, the previous Credit Agreement was
terminated.  The Company was not in default under this Credit
Agreement, nor did it have any outstanding balance on the Credit
Agreement at the time of termination.





The total annual maturities of capital lease obligations as of December 31,
2008 are as follows:





CapitalLeasesYear
      ending December 31,2009
                      
                      $
                      482010
                      
                      
                      1866Less amount
      representing future interest cost
                      
                      
                      (1
                      )$
                      65


F-16
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Interest
Rate Cap





In March 2005, the Company entered into
a LIBOR interest rate cap agreement as an economic hedge against the Credit
Agreement borrowings. The interest rate was capped at 6.0% on a decreasing
notional amount starting at $35,000 decreasing to approximately $34,038. The
interest rate cap was recognized on the Consolidated Balance Sheet at its fair
market value and any change in fair value was reported in interest expense. As
of December 31, 2007 and 2006, the fair value of the interest rate cap was
approximately $0 and $3 respectively.  The agreement expired on
January 1, 2008 and as a result, the Company no longer had an interest rate
cap as of December 31, 2008.





Note 5:
Common Stock





Stock
Repurchases





On August
5, 2008, the board of directors authorized the repurchase of up to $10,000 of
the Company’s outstanding common shares over a period of two
years.  The purchases are to be made in the open market or in
privately negotiated transactions from time to time as permitted by securities
laws and other legal requirements.  The timing, manner, price and
amount of any repurchases are determined by a three person committee, consisting
of members of the Company’s board and management, at its discretion and will be
subject to economic and market conditions, stock price, applicable legal
requirements and other factors that may be discontinued at any
time.  During the year ended December 31, 2008, the Company
repurchased 627,367 shares for $4,016 (including transaction costs) at an
average cost of $6.37 per share.  This amount is reflected in treasury
stock on the Consolidated Balance Sheet.





Note 6: Income Taxes





The
current and deferred provision for federal, state and foreign income taxes
consists of the following:


Year
      Ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006CurrentFederal
                        
                        $
                        6,673
                        
                        
                        $
                        8,378
                        
                        
                        $
                        3,123State
                        
                        
                        1,199
                        
                        
                        
                        1,946
                        
                        
                        
                        7857,872
                        
                        
                        
                        10,324
                        
                        
                        
                        3,908DeferredFederal
                        
                        
                        (222
                        )
                        
                        
                        (104
                        )
                        
                        
                        (313
                        )State
                        
                        
                        (115
                        )
                        
                        
                        55
                        
                        
                        
                        (137
                        )(337
                        )
                        
                        
                        (49
                        )
                        
                        
                        (450
                        )$
                        7,535
                        
                        
                        $
                        10,275
                        
                        
                        $
                        3,458





The
provision for income taxes differs from the amount that would result from
applying the federal statutory rate to pre-tax income for the years ended
December 31 as follows:





Year
      Ended December 31,2008
                              
                              
                              2007
                              
                              
                              2006Federal
      statutory income tax rate
                              
                              
                              35.0
                              %
                              
                              
                              35.0
                              %
                              
                              
                              35.0
                              %State
      income tax, net of federal benefit
                              
                              
                              3.5
                              %
                              
                              
                              5.1
                              %
                              
                              
                              4.4
                              %Research
      and development credit
                              
                              
                              (1.5
                              )%
                              
                              
                              (1.3
                              )%
                              
                              
                              (3.4
                              )%Other
                              
                              
                              0.4
                              %
                              
                              
                              1.5
                              %
                              
                              
                              0.1
                              %37.4
                              %
                              
                              
                              40.3
                              %
                              
                              
                              36.1
                              %


F-17
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




The significant components of the net deferred tax assets and liabilities at
December 31 are as follows:





December
      31,2008
                                        
                                        
                                        2007Deferred
      assetsFinancial
      statement reserves
                                        
                                        $
                                        895
                                        
                                        
                                        $
                                        781State
      taxes
                                        
                                        
                                        95
                                        
                                        
                                        
                                        219Depreciation
      and amortization
                                        
                                        
                                        —
                                        
                                        
                                        
                                        536Trademark
      expenses
                                        
                                        
                                        158
                                        
                                        
                                        
                                        179Compensation
      expense
                                        
                                        
                                        1,697
                                        
                                        
                                        
                                        947Prepaid
      royalty
                                        
                                        
                                        485
                                        
                                        
                                        
                                        489Debt
      issuance costs
                                        
                                        
                                        —
                                        
                                        
                                        
                                        5Foreign
      operating loss
                                        
                                        
                                        52
                                        
                                        
                                        
                                        57Tenant
      improvement allowance
                                        
                                        
                                        413
                                        
                                        
                                        
                                        —Deferred
      revenue
                                        
                                        
                                        206
                                        
                                        
                                        
                                        —Other
                                        
                                        
                                        412
                                        
                                        
                                        
                                        1364,413
                                        
                                        
                                        
                                        3,349Deferred
      liabilitiesPrepaid
      expenses
                                        
                                        
                                        (199
                                        )
                                        
                                        
                                        (272
                                        )Depreciation
      and amortization
                                        
                                        
                                        (806
                                        )
                                        
                                        
                                        —(1,005
                                        )
                                        
                                        
                                        (272
                                        )Net
      deferred assets
                                        
                                        
                                        3,408
                                        
                                        
                                        
                                        3,077Less
      valuation allowance
                                        
                                        
                                        (52
                                        )
                                        
                                        
                                        (57
                                        )$
                                        3,356
                                        
                                        
                                        $
                                        3,020





The Company recorded a deferred tax
asset of $52 and $57 related to the net operating loss carryover of its majority
owned subsidiary, Obagi Singapore, as of December 31, 2008 and 2007,
respectively. A full valuation allowance was provided for the loss carryover as
the Company believes that it is more likely than not that this deferred tax
asset will not be realized.





The Company adopted the provisions of
FIN 48 on January 1, 2007. As a result of the implementation of
FIN 48, the Company recognized approximately a $90 increase in the
liability for unrecognized tax benefits, which was accounted for as an increase
to the January 1, 2007 accumulated deficit balance. A reconciliation of the
beginning and ending amount of unrecognized tax benefits is as follows:


Year
      Ended December 31,2008
                        
                        
                        2007Balance
      as of January 1
                        
                        $
                        161
                        
                        
                        $
                        111Additions
      based on tax positions related to the current year
                        
                        
                        30
                        
                        
                        
                        50Reductions
      for tax positions of prior years
                        
                        
                        (15
                        )
                        
                        
                        —Balance
      as of December 31
                        
                        $
                        176
                        
                        
                        $
                        161


F-18
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Any change in the above unrecognized
tax benefits will impact the effective tax rate.





The Company does not believe there will
be any material changes in its unrecognized tax benefits within the next
12 months.





The Company recognizes interest and
penalties related to uncertain tax positions in income tax expense. During the
years ended December 31, 2008, 2007, and 2006, the Company recognized
approximately $14, $11 and $29 in interest and penalties, respectively. As of
December 31, 2008 and 2007, accrued interest related to uncertain tax
positions was $54 and $40, respectively.




The tax years 2003-2007 remain open to
examination by the major taxing jurisdictions to which we are
subject.





Note 7:
Concentrations of Credit Risk and Significant Customers





For the years ended December 31,
2008, 2007, and 2006, no single customer accounted for 5% or more of the
Company's net revenues.





The Company currently has limited
internal manufacturing capabilities and outsources most of its product
manufacturing. Additionally, the Company does not have long term contracts with
most of these third-party manufacturers. Although there are a limited number of
third-party manufacturers, management believes that other suppliers could
provide similar services on comparable terms. A change in suppliers, however,
could cause a delay in manufacturing and a possible loss of sales, which would
affect operating results adversely.





The Company currently has limited
internal research and development capabilities and primarily outsources its
product research and development to third-party research labs. Although there
are a limited number of third-party research labs, management believes that
other labs could provide similar services on comparable terms. A change in
providers, however, could cause a delay in the Company's ability to develop and
deliver products on a timely and competitive basis, which could affect operating
results adversely.





Note 8:
Royalty Licensee Agreements





Pursuant to the Patent License
Agreement dated June 26, 2003 with a third party, the Company licensed four
interlocking method and formulation patents in exchange for non-refundable
license fees for the first three years of the agreement.  The
agreement also calls for the Company to pay royalties on net sales of products
covered by the licensed patents.  Such royalties are to be paid on a
quarterly basis. For the years ended December 31, 2008, 2007, and 2006,
related royalties of $350, $297 and $179 have been included as a component of
cost of sales, respectively. The initial term of this agreement is three years
and is renewable annually at the option of the Company provided the Company
makes an annual non-refundable renewal license fee. The Patent License Agreement
may terminate at the licensor's option upon merger or acquisition of the Company
and may be cancelled by either party upon default.





In January 2006, the Company entered
into an Option and Product License Agreement with a third party to license
certain technology, in exchange for a non-refundable fee in the amount of $250,
with an additional $250 payable within 15 days of confirming successful
clinical results. The non-refundable fee of $250 was to either be offset against
future royalties payable under the agreement or offset against future purchases
of inventory. For the first product developed under this agreement, an
additional license payment was payable upon the product becoming commercially
available for distribution with another license fee due in the subsequent
quarter to that event. For each additional product developed, an additional
license payment is due up to a maximum dollar cap for all products developed.
The agreement also calls for the Company to pay royalties on the net sales of
products sold in a territory covered by the licensed patents, subject to minimum
annual payments.  In addition to the royalties, the Company shall also
pay one time milestone payments based upon achieving certain levels of net
sales. The term of this agreement is for the life of any licensed patent. The
Option and Product License Agreement may terminate at the licensor's option upon
the Company's failure to meet commercially reasonable development benchmarks.
Pursuant to this agreement, the initial payment of $250 was included in long
term Other assets as of December 31, 2007. Royalty payments will be
expensed as incurred. As of December 31, 2008, no additional payments have
been made.  As of December 31, 2009, there have been no commercially
viable products developed under this agreement.  As a result, during
the year ended December 31, 2008, the Company wrote-off the initial payment of
$250, which is included
as a component of research and development expense.


F-19
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





In March 2004, as part of an agreement
with a third-party international licensor, the Company received an ongoing,
non-exclusive right to market and sell any and all products marketed under the
"Obagi" brand containing a specific range of Kinetin concentration, limited to
existing channels of trade in Japan. Under the terms of the license agreement
with the same party, the Company's license rights are valid until the last of
the related patents expire in December 2014. In exchange for this right, the
Company paid, on April 2, 2004, an initial payment of $1,250, net of cash
receipts in the amount of $250 from a sublicensing arrangement with an
international distributor in Japan. In addition, the Company will pay royalties
up to an additional maximum amount of $500 based on future sales in Japan of
such skincare products. Pursuant to this agreement, the Company recorded the
initial netpayment as an intangible
asset and is amortizing such costs on a straight line basis over the license
period. During the years ended December 31, 2008, 2007 and 2006, the
Company recognized $106, $106 and $106 in amortization expense, respectively.
Such amounts are included as a component of cost of sales. Royalty payments are
expensed as incurred and have amounted to $27, $39 and $70 for the years ended
December 31, 2008, 2007, and 2006, respectively.




The Company also competes in the Japanese retail skin care markets through a
strategic licensing agreement with Rohto Pharmaceutical Co., Ltd.
("Rohto"). Rohto is a Japanese pharmaceutical manufacturer and distributor.
Under the agreement, Rohto is licensed to manufacture and sell a series of
over-the-counter (“OTC”) products under the Obagi brand name, including Obagi-C
(a Vitamin C based topical serum in various concentrations), in the Japanese
drug store channel and the Company receives a royalty based upon sales of Obagi
branded products in Japan by Rohto. The Company also has other licensing
arrangements in Japan to market and sell OTC product systems under the Obagi
brand, both for in-office use in facial procedures, as well as for sale as a
take-home product kit in the spa channel.





On
December 4, 2008, the Company entered into an amendment (the “Amendment”) to the
original agreement with Rohto.  The Amendment extends the term of
agreement to December 4, 2017 and amends the Territory (as defined) to
areas outside Japan, subject to separate written agreement(s) to be
developed.  The Channel (as defined) has been expanded to include
department stores, including mail-order and internet activities to support such
expansion, provided that the parties complete a joint development
plan.  The parties have also agreed to work together to up-brand the
Obagi products sold in the various channels and work cooperatively on messaging,
branding and product imaging.  Under the Amendment, the Company has
also agreed to provide an exclusive royalty bearing license to sell and/or
manufacture certain products developed by the Company, Rohto or jointly
developed by the Company and Rohto.





On
December 4, 2008, OMP and Rohto entered into a License and Supply Agreement (the
"Bi-mineral Agreement") whereby the Company granted Rohto an exclusive right to
manufacture, market and sell the Company’s bi-mineral collagen and elastin
enhancing products in all channels (other than the aesthetic and spa channels)
in Japan.  Rohto also has the right to develop improvements to such
products or new products related to the products.  The initial term of
the Bi-mineral Agreement is for five years, through December 4, 2013, with an
optional five year extension and calls for certain annual sales volume and
expense commitments on behalf of Rohto.   If such commitments are
not met, the Company shall have the right to terminate the Agreement or render
it non-exclusive.





As
consideration for the exclusive license, Rohto shall pay a development fee to
the Company over a five-year period as well as quarterly royalty fees based on
product sales.  If this Agreement should be terminated by either party
before all five installments of the development fee have been paid or even in
the event of early termination, then any unpaid installments will become due and
payable to the Company ten days before the effective termination
date.  The royalty rate is scaled over the term of the Agreement. The
Company will amortize the development fee over the life of the agreement and any
royalties received will be recognized as earned.  As of December 31,
2008, the Company received the first installment of the development fee of
$100.  Net licensing revenue from skin health systems and products in
Japan was approximately $4,817, $4,656 and $4,056 for the years ended
December 31, 2008, 2007 and 2006.





Note 9:
Related-party Transactions





Dr. Zein
Obagi, M.D.





On December 17, 2002, the Company
entered into an amended and restated employment agreement with Zein Obagi, M.D.,
the Company's former executive medical director and board member and one of its
current principal stockholders. The employment agreement was effective until
December 2, 2005 or upon triggering of the termination provisions of the
agreement. Unless either party notified the other in writing, the term of the
agreement was automatically extended by successive one-year terms. Under the
agreement, Dr. Obagi was entitled to a base salary of $330 per year subject
to an increase as determined by the Company's compensation committee. In
addition, Dr. Obagi was entitled to an incentive bonus of up to $225 as
determined by the Company's compensation committee. The compensation committee
based its determination on Dr. Obagi's success of specific activities
within his control and other Company-wide measures. The Company gave
Dr. Obagi notice of termination in 2005 as required by the agreement.
Subsequently, the agreement was extended until June 30,
2006.


F-20
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





Under the agreement, if Dr. Obagi
was terminated for cause, he would receive no severance. If Dr. Obagi was
terminated without cause upon 30 days' prior written notice, then he would
have been entitled to his then existing base salary for the entire period
remaining on the term of his employment agreement and certain rights with
respect to his stock. If Dr. Obagi terminated his employment upon
90 days' prior written notice, he would have been entitled to 90 days'
salary.





Dr. Obagi is also a prominent
physician in the medical community and was granted the right to purchase
products from the Company at a discount equal to the maximum discount offered to
the Company's unrelated customers. In addition to his primary medical practice
in Beverly Hills, California, Dr. Obagi is also a 75% owner of two other
dermatology clinics, Obagi Dermatology – San Gabriel Annex, Inc., formerly
Chinese Obagi Corporation, and Obagi Dermatology – Westminster Annex, Inc.,
formerly Vietnamese Obagi Corporation, (the "Clinics") that also purchase
products from the Company. The Clinics are located in Southern California and
cater to the local Chinese and Vietnamese communities. Other than the common
ownership interest by Dr. Obagi, the Company is otherwise unrelated to
these two corporations.





In 2005, the Company began negotiations
with an affiliate of Dr. Obagi to lease space for a marketing and training
center (the "Center"). The space is located in a property owned by the affiliate
of Dr. Obagi. In conjunction with these negotiations which were ongoing as
of December 31, 2005, the Company began renovations on the space. On
June 29, 2006, the Company entered into a lease agreement and a letter
agreement with this affiliate, making an advance to this affiliate on future
rent. As of December 31, 2008, amounts included in Prepaid expenses and
other current assets and Other assets totaled $184 and $291, respectively. As of
December 31, 2007, amounts included in Prepaid expenses and other current
assets and Other assets totaled $184 and $475, respectively.





2006 Services
Agreement.     On June 29, 2006, the Company
entered into an agreement with Zein E. Obagi, MD Inc. ("Obagi, Inc."),
Dr. Obagi, Samar Obagi, the Zein and Samar Obagi Family Trust and Skin
Health Properties, Inc ("SHP, Inc."). The agreement provides that
Dr. Obagi (and his affiliates that entered into the agreement, including
Obagi, Inc.) and/or SHP, Inc. (an entity controlled by Dr. Obagi
and his affiliates) will promote and provide services to support the marketing
of the Company's products, including oversight of the property the Company is
leasing in Beverly Hills, California. Additionally, Dr. Obagi (and his
affiliates that entered into the agreement) will be available to advise and
assist the Company in the formulation and clinical testing of new products on a
retainer basis, and he will also provide training and/or education seminars on a
fee basis and participate in at least one clinical study per year. The Company
has agreed to pay Obagi, Inc. an annual retainer of $570 for the advising
and formulating services and the marketing and support services described above,
as well as for Dr. Obagi's agreement to chair an annual Obagi Skin Health
Alumni Symposium and up to two clinical advisory meetings per year. In addition,
the Company has agreed to pay Obagi, Inc. an annual fee of $200 for the
first two years of the agreement for the development of Proderm products, a line
of skincare products. At the end of the two years, the Company has an option to
continue to sell Proderm products, in exchange for an annual royalty
payment.  The Company did not exercise this option. During the years
ended December 31, 2008, 2007 and 2006, the Company recorded $100, $200 and
$100, respectively, for the annual payment as research and development expense
as the research of new products in the Proderm line is still in progress. The
Company will also pay Obagi, Inc. royalty fees for developing other
products identified in the agreement equal to 5% of the Company's net revenues
from sales of those products. As there were no products commercialized under the
agreement, the Company did not pay any royalties pursuant to the agreement
during the years ended December 31, 2008 and 2007. The Company also agreed
to pay additional fees and expenses for training and educational services under
the agreement. In addition, the Company agreed to reimburse up to 50% of all
invoiced commercially reasonable marketing design and development expenses
associated with the opening of the property in Beverly Hills, not to exceed
$100. As of December 31, 2008 and 2007, the Company recorded a payable to
Dr. Obagi for $100 and $80, respectively, related to reimbursable expenses
for the opening of the Center.





The Company has also agreed to
indemnify Dr. Obagi and his affiliates for any claims against the Company's
products, or any claims arising out of the Company's acts or omissions or any
breach of warranties given by the Company contained in the
agreement.





Under the agreement, the Company has
been granted a perpetual, royalty-free, non-exclusive license to all accounts,
customer lists and other customer information and data (subject to federal and
state privacy laws) regarding Obagi, Inc.'s patients, as well as a
non-exclusive license to use and reproduce the marketing materials produced by
Obagi, Inc. and/or SHP, Inc. The Company granted to Obagi, Inc.
and/or SHP, Inc. a limited, non-exclusive, irrevocable license for the use
of certain of the Company's trademarks, as well as a non-exclusive license to
use and reproduce the marketing materials designated by the Company from time to
time for the promotion and marketing services being provided under the
agreement.





Under the agreement, the maximum
discount that the Company provides to independent third-party physicians in the
United States will apply to all products distributed by the Company that are
supplied by the Company to Obagi, Inc. and/or SHP, Inc. in connection
with the promotion andmarketing
services under the agreement, as well as those supplied to Obagi, Inc. in
connection with Dr. Obagi's practice within the United
States.





Unless otherwise terminated in
accordance with its terms, the agreement's initial term is five years, and it
may be renewed for


F-21
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)


additional
terms upon the mutual consent of the parties upon six months' written notice
prior to the end of the initial term.





2006 Separation
and Release Agreement.     In connection with the
2006 Services Agreement with Dr. Obagi described above, the Company entered
into a separation and release agreement, which contains non-competition
provisions, with Dr. Obagi effective as of June 29, 2006. Under the
agreement, Dr. Obagi agreed not to directly or indirectly compete with the
Company for a five year period. In connection with the agreement, the Company
paid Dr. Obagi $368.





2006 Lease
Agreement and Letter Agreement.     In connection
with the 2006 Services Agreement with Dr. Obagi described above, the
Company entered into a lease agreement for the Beverly Hills property described
above and a letter agreement with SHP, Inc. as landlord dated June 29,
2006. The lease has a term of five years beginning August 1, 2006 and can
be extended or terminated earlier under the terms of the lease. The base rent
under the lease is $87 per year, and will be raised at a rate of 3.5% per year
thereafter. During the years ended December 31, 2008 and 2007, the Company
recorded $184 and $184, respectively, in rent expense related to the lease
agreement.





The Company also entered into a letter
agreement in connection with the lease with SHP, Inc., dated June 29,
2006, that relates to leasehold improvements and prepayment of rent. Under the
letter agreement, SHP, Inc. acknowledges that the Company has paid $2,197
in respect of leasehold improvements and prepayment of rent under the lease, and
the Company will not be required to pay any additional amounts.





On
January 9, 2008, the Company entered into an Assignment Agreement with
ZSO, LP, an affiliate of Dr. Obagi, whereby the Company assigned its
rights under a construction contract with Legacy Construction
("Legacy") associated with space the Company leases for its marketing and
training center.




On
January 9, 2008, the Company entered into an Indemnification Agreement with
Dr. Obagi, and his affiliates, Zein E. Obagi, M.D., Inc., Samar Obagi,
the Zein and Samar Obagi Family Trust, Skin Health Properties, Inc., and
ZSO, LP (the "Indemnification Agreement"). The Indemnification
Agreement provided for the Company to place approximately $340 in escrow in
exchange for an indemnification for any liability arising from the underlying
Legacy construction contract. By the terms of the June 29, 2006 letter
agreement (the "2006 Agreement") by and among the Company, Dr. Obagi, Skin
Health Properties and others (the "Obagi Parties"), the Obagi Parties are
required to reimburse the Company for any amounts the Company spent on leasehold
improvements in excess of $1,817.  The $340 is above the $1,817 cap on
leasehold improvements that the Company was responsible for under the 2006
Agreement.




On
July 14, 2008, the Company entered into a binding settlement agreement and
stipulation agreement by and between Legacy, certain of the Obagi Parties and
Battaglia, Inc. In this agreement, the Company was formally released from
any and all remaining obligations to Legacy. In accordance with the agreement,
on July 25, 2008, the Company fulfilled its obligations under the
Indemnification Agreement by placing the agreed upon $340 in
escrow.




Pursuant
to the 2006 Agreement, as restated in the Indemnification Agreement, the Company
was released from any future claims related to, and entitled to reimbursement
for, the leasehold improvements of the marketing and training center over
and above $1,817.   As of December 31, 2008, payments in the
amount of approximately $421 over and above the $1,817 amount of leasehold
improvements that the Company was responsible for have not been repaid by the
Obagi Parties.





Cellogique
Corporation





Dr. Obagi is also a 75% beneficial
shareholder in Cellogique Corporation ("Cellogique"), one of the Company's
largest international distribution partners. On November 10, 2005, the
Company entered into a new Distribution Agreement with Cellogique. The agreement
granted Cellogique the exclusive right to promote, market, sell, distribute and
sub-distribute certain specified products to customers within the Middle East.
The agreement includes discounts off of the distributors' base price based on
volume purchases, and certain advertising and promotional activities. Such
discounts may at times be at a substantial discount off of the distributors'
base price listing. The agreement is for a term of 12 years effective
January 1, 2006. Prior to the new agreement, the agreement had the option
to renew in perpetuity.





Prior to the November 2005 agreement,
Cellogique was under a Product Distribution Agreement, which had a term of
30 months and was renewable each two years thereafter. Under this
superseded agreement, Cellogique received product discounts off of United States
doctor list prices based on volume purchases. The agreement granted Cellogique
the exclusive right to promote, market, sell, distribute and sub-distribute
certain specified products to customers within the Middle East.





Total sales made to Dr. Obagi,
Cellogique, and the Clinics, and the related cost of sales for the years ended
December 31, 2008, 2007, and 2006 are included in the Company's
consolidated statements of operations and are as follows:


Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Sales,
      net of discounts
                
                $
                2,947
                
                
                $
                3,182
                
                
                $
                3,214Costs
      of sales
                
                
                604
                
                
                
                600
                
                
                
                569


F-22
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Receivables
due from related parties as of at December 31, 2008 and 2007 are as
follows:





December
      31,2008
                        
                        
                        2007Due
      from Dr. Obagi
                        
                        $
                        249
                        
                        
                        $
                        500Due
      from Cellogique
                        
                        
                        242
                        
                        
                        
                        424Due
      from China Obagi Corporation
                        
                        
                        27
                        
                        
                        
                        58$
                        518
                        
                        
                        $
                        982





Austin
T. McNamara





In April 2002, the Company entered into
an Investor's Rights Agreement with its former Chairman of the Board, President
and Chief Executive Officer, Austin McNamara. Subsequently, trusts established
by Mr. McNamara, the McNamara Family Irrevocable Trust dated
December 17, 2004 and the McNamara Family Trust dated December 27,
2004 (the "Trusts"), became the owners of the 1,875,001 shares of the
Company'scommon stock owned by
Mr. McNamara and parties to the Investor's Rights Agreement.
Mr. McNamara resigned as a member of the Company's board of directors and
as an employee in May 2006 and died in December 2006. The Investor's Rights
Agreement contained a repurchase obligation under which the Company was required
to repurchase the shares of the Company held by the Trusts upon the exercise of
a repurchase right. Subsequent to Mr. McNamara's resignation, the Trusts
exercised this repurchase right. Pursuant to procedures set forth in the
Investor's Rights Agreement, three valuation firms were retained to prepare
valuations of the stock held by the trusts and the total purchase price was to
have been $28,201.





Any obligation the Company would have
had to repurchase the trusts' shares was to have been subordinated to its Credit
Agreement while the Credit Agreement was in place. The Investor's Rights
Agreement contains subordination provisions and the Trusts signed an additional
subordination agreement in connection with the Credit Agreement pursuant to
which they agreed to be subordinated to the loans under the Credit Agreement. On
May 18, 2006, the trusts' exercised the repurchase right contained in the
Investor's Rights Agreement to require the Company to repurchase the shares
owned by the trusts. On November 17, 2006, the Company tendered promissory
notes in the aggregate principal amount of $28,201 and a cash payment of $1,500
as partial prepayment of the notes, to the Trusts in order to close on the
Company's repurchase of the shares held by the Trusts pursuant to the terms of
the Investor's Rights Agreement. The Trusts refused to accept the Company's
tender of these payments and refused to tender their shares and close on the
repurchase of the shares they hold. As a result, the Company believed the Trusts
were in material breach of their obligations under the Investor's Rights
Agreement. Based upon this material breach by the Trusts, as well as for other
reasons, the Company believed it was no longer obligated to repurchase the
shares held by the Trusts pursuant to the Investor's Rights Agreement and the
right of the Trusts to require the Company to repurchase the shares had expired
and could no longer be enforced against the Company.





The Trusts had taken the position that
they did not breach their obligations under the Investor's Rights Agreement and
that instead the Company had breached its obligation to repurchase the Trusts'
shares under the Investor's Rights Agreement.





On May 29, 2007, the Company
entered into a Settlement and Consent Agreement and Mutual Release (the
"Settlement Agreement") with the estate of Austin T. McNamara, the Trusts, Lucy
B. McNamara, individually and as trustee of the Trusts and as executor of the
estate of Austin T. McNamara, and LVG.





Pursuant to the Settlement Agreement,
the Company and the McNamara Parties have released each other from all claims
they may have against each other, except for claims related to potential taxes
and related charges, should they arise, with respect to the past exercise of
certain stock options by the Trusts. No payments were made by the parties to
each other in connection with the settlement of the claims.





The settlement includes the release of
claims by the McNamara Parties, as described above, that the Company was
obligated to purchase the 1,875,001 shares of the Company's common stock then
owned by the Trusts and all claims related to Mr. McNamara's employment
with the Company and the termination of his employment. In connection with the
release, the Company wrote off a net receivable of approximately $143 for a
claimed compensation overpayment to a McNamara Party as of December 31, 2007.





The McNamara Parties also sold all of
their ownership in the Company's stock to an institutional investor in a
privately


F-23
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)


negotiated
transaction. As a condition to that transaction, the purchaser of the shares
signed the lock-up agreement executed by other Company stockholders in
connection with the Company's initial public offering. This lock-up agreement
expired on June 12, 2007.





Stonington
Capital Appreciation 1994 Fund, L.P.





In December 2002, the Company entered
into a management services agreement ("Services Agreement") with Stonington
Partners, Inc. ("Stonington"), an affiliate of Stonington Fund, our
majority stockholder. The agreement calls for Stonington to provide management
with consulting and business advisory services. As compensation for these
services, the Company pays Stonington an annual fee equal to 1.5% of its capital
invested in the Company plus expenses for services provided in the 2003 and 2002
fiscal years, and is renewable annually thereafter. This agreement terminated
upon the completion of the initial public offering. In addition, the Company, at
times, reimburses board members affiliated with Stonington, for expenses related
to travel to and from board meetings.  For the year ended
December 31, 2006, management fees totaled approximately $400 and are
included as a component of selling, general and administrative
expenses.





Amounts payable to Dr. Obagi for
any bonus, annual payment or royalties and interest, and to other stockholders
and their affiliates for management fees and other services as of
December 31, 2008 and 2007 are reflected in the accompanying Consolidated
Balance Sheets as amounts due to related parties as follows:





December
      31,2008
                        
                        
                        2007Dr.
      Obagi
                        
                        $
                        156
                        
                        
                        $
                        118Stonington
                        
                        
                        13
                        
                        
                        
                        17$
                        169
                        
                        
                        $
                        135





Note 10: Commitments and
Contingencies





Lease
Commitments




In
certain instances, the Company disburses cash for leasehold improvements,
furnishings, fixtures and equipment to renovate leased premises. If costs are
paid directly by the landlord or reimbursed to the Company by the landlord, the
Company records a deferred rent liability and amortizes the deferred rent
liability over the lease term as a reduction to rent expense. In other
instances, the Company may expend cash for landlord additions that the Company
makes to lease premises that are reimbursed to the Company by the landlord.
Based on the specifics of the leased space and the lease agreement, during the
renovation period, amounts paid will be recorded as prepaid rent and any
landlord reimbursement will be recorded as an offset to prepaid
rent.





On
August 6, 2008, the Company entered into a lease amendment with Kilroy
Realty, L.P. (“Kilroy”) for the lease of office space located in Long
Beach, California. The new facility consists of 30,884 rentable square feet and
the term of the lease is for ten years with an option to extend the lease term
for five years. The total lease payments over the initial term will approximate
$10,805. The Company took possession of the facility on July 1, 2008, and
the lease term commenced in October 2008 when the Company took occupancy and
relocated its corporate headquarters to the new facility. Pursuant to the
amendment, the Company was granted an improvement allowance of
$1,028.  The Company recorded the improvement allowance as a deferred
rent credit which is being amortized as a reduction to rent expense over the
life of the lease.  As of December 31, 2008, amounts recorded as a
deferred rent credit in accrued liabilities and other long-term liabilities in
the consolidated balance sheet totaled $100 and $879,
respectively.   As of December 31, 2008, amounts recorded as
deferred rent in other long-term liabilities in the consolidated balance sheet
totaled $516.





The
Company leases some of its facilities and equipment under operating leases. Some
of the leases require payment of property taxes and include rent escalation
clauses. Future minimum operating lease commitments under non-cancelable leases
are as follows as of December 31, 2008:




OperatingLeasesYear
      ending December 31,2009
                      
                      $
                      1,8322010
                      
                      
                      1,6222011
                      
                      
                      1,4432012
                      
                      
                      1,3842013
                      
                      
                      1,372Therafter
                      
                      
                      5,743Total
      minimum payments required
                      
                      $
                      13,396





Rent expense for the years ended
December 31, 2008, 2007, and 2006 was approximately $1,463, $906, and $639,
respectively.


F-24
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)


Indemnifications





The Company is a party to a variety of
agreements entered into in the ordinary course of business pursuant to which it
may be obligated to indemnify the other parties for certain liabilities that
arise out of or relate to the subject matter of the agreements. Some of the
agreements entered into by the Company require it to indemnify the other party
against losses due to property damage including environmental contamination,
personal injury, failure to comply with applicable laws, the Company's
negligence or willful misconduct, or breach of representations and warranties
and covenants.





The Company provides for
indemnification of directors, officers and other persons in accordance with
limited liability agreements, certificates of incorporation, bylaws, articles of
association or similar organizational documents, as the case may be. The Company
maintains directors' and officers' insurance which should enable the Company to
recover a portion of any future amounts paid.





While the Company's future obligations under certain agreements may
contain limitations on liability for indemnification, other agreements do not
contain such limitations and under such agreements it is not possible to predict
the maximum potential amount of future payments due to the conditional nature of
the Company's obligations and the unique facts and circumstances involved in
each particular agreement. Historically, no payments have been made under any of
these indemnities.





On September 1, 2006, the Company
entered into indemnification agreements with each of its directors and executive
officers that provide them with rights to indemnification and expense
advancement to the fullest extent permitted under the Delaware General
Corporation Law.





Employment
Agreements





On March 3, 2008, the Company and
Steven R. Carlson, the Company's Chief Executive Officer, amended
Mr. Carlson's employment agreement (the "Employment Agreement") effective
as of March 1, 2008. The Employment Agreement (i) increased
Mr. Carlson's base salary to $500 per year or such greater amount as the
compensation committee may from time to time determine; (ii) increased
Mr. Carlson's annual bonus to up to 75% of his base salary based upon
achievement of certain Company and individual targets; (iii) provided for
the grant of non-qualified options to purchase a total of an additional
225,000 shares of the Company's common stock, vesting over five years, at
an exercise price equal to 125% of the fair market value of the Company's
common stock on the date of the grant (the date of grant being that date in 2008
on which the Company's senior executives receive option grants, the "Option
Grant"); and (iv) extended the term of Mr. Carlson's employment
agreement until the occurrence of an Event of Termination (as defined in the
Employment Agreement). On May 1, 2008, upon the grant of stock options to
officers of the Company, Mr. Carlson received the Option Grant at an
exercise price of $10.91.  Effective December 31, 2008, the Employment Agreement was amended
to ensure compliance with Section 409A of the Internal Revenue Code of 1986, as
amended. The revision provides thatany severance that would otherwise be payable to Mr. Carlson
within the first six months following a termination event giving rise to a
severance payment will accrue but not be paid to Mr. Carlson until the first day
of the seventh month following termination. Such amounts will continue to be
paid in a lump sum.





On
March 24, 2008, the Company entered into a letter agreement with Stephen A.
Garcia, the Company's then Chief Financial Officer, regarding the transition
arrangements related to his resignation (the "Transition Agreement"), pursuant
to which Mr. Garcia's employment relationship with the Company ended on
July 15, 2008. During this period, Mr. Garcia continued to receive his
then current salary and benefits. Because Mr. Garcia satisfied all of the
conditions of the Transition Agreement, the Company is currently paying
Mr. Garcia a transition success payment equal to one year of pay at his
then current annual rate of compensation of $253. This payment is payable over a
period of one year (ending on July 15, 2009) in equal installments on the
Company's normal payroll schedule, less all normal payroll deductions.  In
addition, Mr. Garcia's stock options that would have vested between
July 15, 2008 and December 31, 2008, vested in full and were
immediately exercisable as of July 15, 2008 for a period of 90 days, 12,500
of which were exercised on September 29, 2008 at an exercise price of $8.40 per
share. Pursuant to the Transition Agreement, Mr. Garcia released and
discharged any claims that he may have had as of July 15, 2008 against the
Company and its current and former
owners, stockholders, employees, agents, attorneys, representatives, related
companies, assignees as well as other related parties. The Transition Agreement
also requires Mr. Garcia to maintain the confidentiality of all of the
Company's confidential and proprietary information.  Pursuant to the
Transition Agreement, the Company accrued $142 as of December 31, 2008 for the
transition success payment. In addition, the Company recognized $19 in non cash
compensation expense for the year ended December 31, 2008, related to the
accelerated vesting of his outstanding stock options.





On
June 18, 2008, the Company and Preston Romm, the Company's new Chief
Financial Officer, Executive Vice President, Finance, Operations and
Administration and Treasurer, entered into an employment agreement. Under the
agreement, Mr. Romm is entitled to a base salary of $320 per year, subject
to annual cost of living increases or such greater increase as may be approved
by the Company's Board of Directors, and an annual bonus of up to 60% of his
base salary based upon achievement of certain Company and individual targets.
For fiscal year 2008, Mr. Romm will receive a guaranteed bonus of $50, with
a potential additional amount of $50 based upon 2008 performance. In addition,
on July 1, 2008, Mr. Romm received an option to purchase 150,000
shares of the Company's common stock at an exercise price of $10.00 per share
which was equal to 125% of the fair market value of the Company's common stock
on the date of the grant.





On
September 3, 2008, the Company and Laura Hunter, the Company's new Vice
President, General Counsel and Secretary, entered into an employment agreement.
Under the agreement, Ms. Hunter is entitled to a base salary of $260 per
year, subject to annual cost of living increases or such greater increase as may
be approved by the Company's Board of Directors, an annual bonus up to 40% of
her base salary based upon achievement of certain Company and individual
targets, and a sign on bonus of $10 paid on December 31, 2008. In addition, on
September 3, 2008, Ms. Hunter received an option to purchase 40,000 shares
of the Company's common stock at an exercise price of $9.45, the fair market
value of the Company's common stock on the date of the grant.





Under the
agreements with Mr. Romm and Ms. Hunter, they or the Company may terminate their
employment at any time. If they are terminated for cause or terminate their own
employment, they are not entitled to severance. Mr. Romm and Ms. Hunter are
also subject to a confidentiality covenant, a covenant not to solicit any
employee to leave the Company's employment during the term of the agreement and
three years thereafter, and a covenant not to compete with the Company during
the same time period. However, if they are terminated without cause, such
covenants relating to competition with the Company lapse on the first
anniversary of their termination.


F-25
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





Letter
of Credit Agreements





As part
of the licensing requirements for four states, the Company had four letters of
credit outstanding to four state regulatory bodies totaling $305 to secure
payment of any possible future unpaid fines or penalties levied by those
states.   These letters of credit are renewed annually for one year
periods unless cancelled and were secured by the line of credit under our former
Credit Agreement.  Because the Company terminated its Credit Agreement and
in order to avoid any lapse in coverage to the state regulatory bodies, the
Company, through its new Facility, issued a letter of credit to GE Business
Financial Services (the party to the Credit Agreement) in the amount of $320 in
November 2008.  This letter of credit will be reduced as the Company
exchanges its original letters of credit under the Credit Agreement with
replacement letters of credit under the new Facility.   In order to
exchange out the original letters of credit and to avoid lapse in coverage, the
Company was required to first issue new letters of credit to each state
regulatory body prior to cancelling the original letter of credit. 
 In November 2008, the Company issued four letters or credit to the four
state regulatory bodies totaling $305.  As of December 31, 2008, the
Company exchanged out one letter of credit for $100 and is in the process of
collecting the original letters of credit back from the remaining three state
regulatory bodies.   The Company has not incurred any fines or
penalties and none of the letters of credit have been presented for
payment.





Surety
Bond




On
April 30, 2008, the Company provided a surety bond to the Florida
Department of Health in the amount of $100 to serve as a security device for the
Company's compliance with the requirements for wholesale distribution of
prescription drugs as set forth in the Florida Drug and Cosmetic Act and to
secure payment of any administrative fines or penalties. This surety bond will
remain in full force and effect for one year after the Company's permit ceases
to be valid.





Severance
Agreements





On September 1, 2006, the Company
entered into severance agreements with four of its executive officers. The
severance agreements provide that if one of these officers employment is
terminated within 12 months following a change of control without cause or
by the officer with good reason, the officer will be entitled, upon execution of
a release in a form acceptable to us, an amount equal to 100% of the officer's
then current annual base salary, payable over 12 consecutive
months.  These agreements were amended effective December 31, 2008 to
ensure compliance with Section 409A of the Internal Revenue Code of 1986, as
amended.





Litigation


From time to time, the Company is
involved in litigation and other legal matters in the normal course of business.
Management does not believe that the outcome of any current matters will have a
material adverse effect on the Company's consolidated financial position,
results of operations or cash flows.





Note 11:
Stock Options





In November 2000, the Company adopted
the 2000 Stock Option/Stock Issuance Plan (the "2000 Plan"). The terms of the
2000 Plan provided for the grant of options to purchase common stock to
employees, consultants, and directors. The Plan included incentive stock options
("ISOs") and nonqualified stock options ("NSOs"). The maximum number of shares
of common stock that were allowed to be issued over the term of the Plan was not
to exceed 375,000 shares of the Company's common stock. In addition, the maximum
number of shares of common stock issued to any person under the 2000 Plan in any
calendar year was not to exceed 150,000 shares. In September 2001, the Board of
Directors amended the 2000 Plan to increase the maximum number of shares of
common stock that may be issued over the term of the 2000 Plan to 2,083,334
shares. The vesting period of options granted under this plan ranged from one to
five years. Options expired within a period of not more than ten years from
thegrant date. In November 2005,
the Board of Directors amended the Plan to discontinue further option grants
under the Plan. At December 31, 2008 and 2007, due to the aforementioned
discontinuance of further option grants under the Plan, 151,795 shares are no
longer available for the granting of additional options.





In November 2005, the Company adopted
the 2005 Stock Incentive Plan (the "2005 Plan"). The 2005 Plan provides for the
grant of ISOs and NSOs to employees, consultants and directors. On
November 27, 2006, the Company's Board of Directors amended the Company's
2005 Plan. The amendments to the 2005 Plan included: (i) increasing the
number of authorized shares to 1,500,000; (ii) establishing an evergreen
clause that replenishes the 2005 Plan each year with a share amount equal to the
lesser of 500,000 or 3% of outstanding shares; (iii) and other
administrative provisions. The amended 2005 Plan was approved by the
stockholders of the Company on November 28, 2006. On January 9, 2007,
and February 27, 2008, the Board of Directors replenished the 2005 Plan with
500,000 shares on both dates, available for granting of additional
options.





Pursuant to the 2005 Plan, the exercise
price per share for both ISOs and NSOs shall not be less than 100% of the fair
market value per share of the Company's common stock on the grant date. The
exercise price per share for both ISOs and NSOs may not be less than 110% of the
fair market value of the Company's common stock on the grant date for an
individual who, at the time of grant, owns stock representing more than 10% of
the total combined voting power of all classes of the Company's stock. The right
to exercise the ISOs and the NSOs vests at a rate in accordance with the
individual stock option agreements. The vesting period of the options granted
under this plan typically ranges from one to three years. Options expire within
a period of not more than ten years from the grant date. ISOs granted to an
employee, who at the time of grant owns stock representing more than 10% of the
total combined voting power of all classes of stock of the Company, expire
within a period of not more than five years from the grant date.


F-26
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)


A total of 4,731,990 shares have been
authorized for issuance under the 2000 Plan and the 2005 Plan (the "Plans"). Of
the shares that have been authorized for issuance, 1,433,156 and 1,414,266
shares have been issued for options which have been exercised as of
December 31, 2008 and 2007, respectively, and 1,592,474 and 1,215,633
shares have been reserved for options that are outstanding as of
December 31, 2008 and 2007, respectively. At December 31, 2008 and
2007, there were 1,210,560 and 1,213,095 shares available for granting of
additional options, respectively.





During
the year ended December 31, 2006, the Company's board of directors granted
stock options to the Company's management and employees to purchase a total of
750,000 shares of the Company's common stock upon the consummation of an initial
public offering. The stock options were granted at the initial public offering
price of $11.00, which was the fair market value on the date of grant.
 During the year ended December 31, 2007, the Company's board of
directors granted 123,000 options with exercise prices ranging from $11.85 to
$20.34, which was equal to or greater than the fair value of the underlying
common stock on the date of each grant.During the year ended December 31, 2008, the Company's board of
directors granted 651,200 options with exercise prices ranging from $5.94 to
$16.25, which was equal to or greater than the fair value of the underlying
common stock on the date of each grant.





A summary
of the option activity under the Plans is as follows:




Weighted
      AverageExercise
      PriceShares
                  
                  
                  Per ShareOutstanding
      at December 31, 2005
                  
                  
                  558,384
                  
                  
                  $
                  9.22Granted
                  
                  
                  750,000
                  
                  
                  
                  11.00Exercised
                  
                  
                  (9,378
                  )
                  
                  
                  3.40Canceled
                  
                  
                  (13,890
                  )
                  
                  
                  9.12Outstanding
      at December 31, 2006
                  
                  
                  1,285,116
                  
                  
                  $
                  10.31Granted
                  
                  
                  123,000
                  
                  
                  
                  18.22Exercised
                  
                  
                  (31,734
                  )
                  
                  
                  3.21Canceled
                  
                  
                  (160,749
                  )
                  
                  
                  10.91Outstanding
      at December 31, 2007
                  
                  
                  1,215,633
                  
                  
                  $
                  11.21Granted
                  
                  
                  651,200
                  
                  
                  
                  11.83Exercised
                  
                  
                  (18,890
                  )
                  
                  
                  9.22Canceled
                  
                  
                  (255,469
                  )
                  
                  
                  12.90Outstanding
      at December 31, 2008
                  
                  
                  1,592,474
                  
                  
                  $
                  11.22Exercisable
      at December 31, 2006
                  
                  
                  214,277
                  
                  
                  $
                  9.05Exercisable
      at December 31, 2007
                  
                  
                  559,050
                  
                  
                  $
                  10.13Exercisable
      at December 31, 2008
                  
                  
                  744,064
                  
                  
                  $
                  10.42





A summary of options outstanding and
exercisable as of December 31, 2008 are as follows:





Options
      Outstanding
                              
                              Options
      ExercisableNumber
      of Shares
                              
                              Weighted
      Average
                              
                              Weighted
      Average
                              
                              Number
      of SharesRange
      of Exercise
                              
                              
                              Outstanding
      at
                              
                              Per
      Share
                              
                              Remaining
      Life
                              
                              Exercisable
      at
                              
                              Weighted
      AveragePrice
      Per Share
                              
                              
                              December
      31, 2008
                              
                              Exercise
      Price
                              
                              (Years)
                              
                              December
      31, 2008
                              
                              Exercise
      Price$1.20
      to $8.40
                              
                              
                              
                              278,818
                              
                              
                              $
                              8.28
                              
                              
                              
                              6.27
                              
                              
                              
                              268,318
                              
                              
                              $
                              8.36$9.31
      to $10.91
                              
                              
                              
                              548,401
                              
                              
                              $
                              10.52
                              
                              
                              
                              9.06
                              
                              
                              
                              72,201
                              
                              
                              $
                              10.78$11.00
      to $14.40
                              
                              
                              
                              562,255
                              
                              
                              $
                              11.33
                              
                              
                              
                              7.88
                              
                              
                              
                              385,374
                              
                              
                              $
                              11.41$16.25
      to $20.40
                              
                              
                              
                              203,000
                              
                              
                              $
                              16.84
                              
                              
                              
                              9.05
                              
                              
                              
                              18,171
                              
                              
                              $
                              18.731,592,474
                              
                              
                              $
                              11.22
                              
                              
                              
                              8.15
                              
                              
                              
                              744,064
                              
                              
                              $
                              10.42




F-27
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




On December 13, 2006, the Company
issued 2,728 shares of restricted common stock under the 2005 Plan to one of its
outside directors. During the years ended December 31, 2008 and 2007, the
Company issued a total of 18,999 and 16,926 shares of restricted common stock,
respectively, under the 2005 Plan to seven outside directors. The resulting
compensation expense from the restricted stock grants is recognized on a
straight-line basis over the requisite service period, which equals the
restricted stock vesting term of one year. The Company determined the fair
market value of the restricted stock granted on December 13, 2006, based
upon the initial public offering price of our stock, which was $11.00. The fair
market value of the restricted stock granted during the year ended
December 31, 2007 ranged from$13.11 to $17.36, which was based upon the fair value of the Company's common
stock on the date of each grant.  The fair market value of the
restricted stock granted during the year ended December 31, 2008 was $8.68,
which was based upon the fair value of the Company’s common stock on the date of
grant.





During
the year ended December 31, 2008, the Company's board of directors, through its
compensation committee, granted 651,200 options under the 2005 Plan to employees
of the Company, including officers, with an exercise price ranging from $5.94 to
$16.25, which was equal to or greater than the fair value of the underlying
common stock on the date of grant.




During
the year ended December 31, 2008, the Company's board of directors, through its
compensation committee, granted 45,000 restricted stock units under the 2005
Plan to officers of the Company. The fair market value of the restricted stock
units granted was $16.25, which was based upon the fair value of the Company's
common stock on the date of grant. The resulting compensation expense from the
restricted stock unit grants is recognized on a straight-line basis over the
requisite service period, which equals the restricted stock unit vesting term of
fifteen months. As of December 31, 2008, 7,500 of these restricted stock units
were cancelled.





Note 12:
Segments





SFAS
No. 131, Disclosures
about Segments of an Enterprise and Related Information, requires that
the Company disclose certain information about its operating segments where
operating segments are defined as components of an enterprise about which separate
financial information is available that is evaluated regularly by the chief
operating decision maker in deciding how to allocate resources and in assessing
performance. Generally, financial information is required to be reported on the
basis that is used internally for evaluating segment performance and deciding
how to allocate resources to segments.




As noted
earlier, during the year ended December 31, 2008, the Company launched
SoluCLENZ, a solubilized benzoyl peroxide gel for the treatment of acne, which
is available only by prescription, and is currently the only product that the
Company dispenses through the pharmacy Rx channel, the Company’s newest
operating segment. The Company now operates its business on the basis of three
reportable segments (i) physician dispensed (formerly known as “skin
health”), (ii) licensing and (iii) the pharmacy Rx channel. The physician
dispensed segment produces a broad range of topical skin health systems and
products that enable physicians to sell products to their patients to treat a
range of skin conditions, including pre-mature aging, photo-damage,
hyperpigmentation, acne and soft tissue deficits, such as fine lines and
wrinkles. The pharmacy Rx segment includes prescription and OTC dermatological
products that are dispensed through pharmacies.  The licensing segment
includes revenues generated from licensing arrangements with international
distributors that specialize in the distribution and marketing of OTC medical
oriented products in the drug store, retail and aesthetic spa
channels.




Management
evaluates its segments on a revenue and gross profit basis, which is presented
below. The United States information is presented separately as the Company's
headquarters reside in the United States. United States sales represented 84%
and 85% of total consolidated net sales for the year ended December 31, 2008 and
2007, respectively,  No other country or single customer generates
over 10% of total Company consolidated net sales.




All of
the Company's long-lived assets are located in the United States. The Company
does not disaggregate assets on a segment basis for internal management
reporting and, therefore, such information is not presented.


F-28
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)





Year
      Ended December 31,2008
                                                                                                
                                                                                                
                                                                                                2007
                                                                                                
                                                                                                
                                                                                                2006Net
      sales by segmentPhysician
      dispensed
                                                                                                
                                                                                                $
                                                                                                99,614
                                                                                                
                                                                                                
                                                                                                $
                                                                                                97,992
                                                                                                
                                                                                                
                                                                                                $
                                                                                                73,940Pharmacy Rx
                                                                                                
                                                                                                
                                                                                                162
                                                                                                
                                                                                                
                                                                                                
                                                                                                —
                                                                                                
                                                                                                
                                                                                                
                                                                                                —Licensing
                                                                                                
                                                                                                
                                                                                                4,817
                                                                                                
                                                                                                
                                                                                                
                                                                                                4,656
                                                                                                
                                                                                                
                                                                                                
                                                                                                4,056Net
      Sales
                                                                                                
                                                                                                $
                                                                                                104,593
                                                                                                
                                                                                                
                                                                                                $
                                                                                                102,648
                                                                                                
                                                                                                
                                                                                                $
                                                                                                77,996Gross
      profit by segmentPhysician
      dispensed
                                                                                                
                                                                                                $
                                                                                                79,874
                                                                                                
                                                                                                
                                                                                                $
                                                                                                80,089
                                                                                                
                                                                                                
                                                                                                $
                                                                                                60,650Pharmacy Rx
                                                                                                
                                                                                                
                                                                                                105
                                                                                                
                                                                                                
                                                                                                
                                                                                                —
                                                                                                
                                                                                                
                                                                                                
                                                                                                —Licensing
                                                                                                
                                                                                                
                                                                                                4,683
                                                                                                
                                                                                                
                                                                                                
                                                                                                4,510
                                                                                                
                                                                                                
                                                                                                
                                                                                                3,879Gross
      profit
                                                                                                
                                                                                                $
                                                                                                84,662
                                                                                                
                                                                                                
                                                                                                $
                                                                                                84,599
                                                                                                
                                                                                                
                                                                                                $
                                                                                                64,529Geographic
      informationUnited States
                                                                                                
                                                                                                $
                                                                                                87,516
                                                                                                
                                                                                                
                                                                                                $
                                                                                                87,040
                                                                                                
                                                                                                
                                                                                                $
                                                                                                63,929International
                                                                                                
                                                                                                
                                                                                                17,077
                                                                                                
                                                                                                
                                                                                                
                                                                                                15,608
                                                                                                
                                                                                                
                                                                                                
                                                                                                14,067Net
      sales
                                                                                                
                                                                                                $
                                                                                                104,593
                                                                                                
                                                                                                
                                                                                                $
                                                                                                102,648
                                                                                                
                                                                                                
                                                                                                $
                                                                                                77,996Year
      Ended December 31,2008
                                                                                                
                                                                                                
                                                                                                2007
                                                                                                
                                                                                                
                                                                                                2006Net
      sales by product linePhysician
      dispensedNu-Derm
                                                                                                
                                                                                                $
                                                                                                58,378
                                                                                                
                                                                                                
                                                                                                $
                                                                                                62,184
                                                                                                
                                                                                                
                                                                                                $
                                                                                                53,836Vitamin
      C
                                                                                                
                                                                                                
                                                                                                12,380
                                                                                                
                                                                                                
                                                                                                
                                                                                                11,438
                                                                                                
                                                                                                
                                                                                                
                                                                                                9,986Elasticity
                                                                                                
                                                                                                
                                                                                                11,643
                                                                                                
                                                                                                
                                                                                                
                                                                                                8,356
                                                                                                
                                                                                                
                                                                                                
                                                                                                2,278Therapeutic
                                                                                                
                                                                                                
                                                                                                6,098
                                                                                                
                                                                                                
                                                                                                
                                                                                                5,753
                                                                                                
                                                                                                
                                                                                                
                                                                                                180Other
                                                                                                
                                                                                                
                                                                                                11,115
                                                                                                
                                                                                                
                                                                                                
                                                                                                10,261
                                                                                                
                                                                                                
                                                                                                
                                                                                                7,660Total
                                                                                                
                                                                                                
                                                                                                99,614
                                                                                                
                                                                                                
                                                                                                
                                                                                                97,992
                                                                                                
                                                                                                
                                                                                                
                                                                                                73,940Pharmacy Rx
                                                                                                
                                                                                                
                                                                                                162
                                                                                                
                                                                                                
                                                                                                
                                                                                                —
                                                                                                
                                                                                                
                                                                                                
                                                                                                —Licensing
                                                                                                
                                                                                                
                                                                                                4,817
                                                                                                
                                                                                                
                                                                                                
                                                                                                4,656
                                                                                                
                                                                                                
                                                                                                
                                                                                                4,056Total net
      sales
                                                                                                
                                                                                                $
                                                                                                104,593
                                                                                                
                                                                                                
                                                                                                $
                                                                                                102,648
                                                                                                
                                                                                                
                                                                                                $
                                                                                                77,996


F-29
 Obagi
Medical Products, Inc.
 Notes
to the Consolidated Financial Statements (Continued)
 (Dollars
in thousands, except share and per share
amounts)




Note 13:
401(k) plan





On
February 1, 1999, the Company established an employee savings and
retirement plan and a 401(k) defined contribution retirement plan, covering
substantially all full-time employees. Beginning April 2006, the Company matched
100% of employee contributions up to 2% of employee compensation. Effective
January 1, 2008, the Company modified the 401(k) defined contribution retirement
plan to match 100% of employee contributions up to 3% of employee compensation
and 50% of employee contributions of the next 2% of employee compensation to a
maximum of 4% of employee compensation.  The Company may also make, at
the discretion of the board of directors, additional contributions subject to
statutory limits.





The
Company contributed approximately $548, $213, and $125 for the yearsended December 31, 2008, 2007,
and 2006, respectively. Administrative expenses paid on behalf of the plan were
nominal for each of the respective years.





Note 14:
Quarterly Financial Data (Unaudited)





Quarterly
financial data for the years ended December 31, 2008 and 2007 are as
follows:





Quarter
      EndedMarch
      31, 2008
                                                        
                                                        
                                                        June
      30, 2008
                                                        
                                                        
                                                        September
      30, 2008
                                                        
                                                        
                                                        December
      31, 2008Net
      sales
                                                        
                                                        $
                                                        25,374
                                                        
                                                        
                                                        $
                                                        27,772
                                                        
                                                        
                                                        $
                                                        26,012
                                                        
                                                        
                                                        $
                                                        25,435Gross
      profit
                                                        
                                                        $
                                                        20,653
                                                        
                                                        
                                                        $
                                                        22,719
                                                        
                                                        
                                                        $
                                                        20,898
                                                        
                                                        
                                                        $
                                                        20,392Net
      income
                                                        
                                                        $
                                                        2,993
                                                        
                                                        
                                                        $
                                                        4,504
                                                        
                                                        
                                                        $
                                                        2,907
                                                        
                                                        
                                                        $
                                                        2,184Net
      income attributable to common sharesBasic
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.20
                                                        
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.10Diluted
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.20
                                                        
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.10Quarter
      EndedMarch
      31, 2007
                                                        
                                                        
                                                        June
      30, 2007
                                                        
                                                        
                                                        September
      30, 2007
                                                        
                                                        
                                                        December
      31, 2007Net
      sales
                                                        
                                                        $
                                                        23,046
                                                        
                                                        
                                                        $
                                                        26,067
                                                        
                                                        
                                                        $
                                                        26,281
                                                        
                                                        
                                                        $
                                                        27,254Gross
      profit
                                                        
                                                        $
                                                        19,085
                                                        
                                                        
                                                        $
                                                        21,507
                                                        
                                                        
                                                        $
                                                        21,677
                                                        
                                                        
                                                        $
                                                        22,330Net
      income
                                                        
                                                        $
                                                        2,926
                                                        
                                                        
                                                        $
                                                        3,936
                                                        
                                                        
                                                        $
                                                        3,862
                                                        
                                                        
                                                        $
                                                        4,479Net
      income attributable to common sharesBasic
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.20Diluted
                                                        
                                                        $
                                                        0.13
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.18
                                                        
                                                        
                                                        $
                                                        0.20





Due to
the deteriorating economic conditions during the three months ended December 31,
2008, the Company increased its allowance for doubtful accounts and sales
returns by $300.





Note 15:
Subsequent Events





As of
November 30 and December 31, 2008 and January 31, 2009, the Company was not in
compliance with its non-financial covenant requiring it to submit a listing of
intellectual property to the lender each month.  On February 18, 2009,
a waiver was obtained by the Company for November 30 and December 31, 2008 and
January 31, 2009.





On March
3, 2009, the Company's board of directors, through its compensation committee,
granted 293,000 options under the 2005 Plan to employees of the Company,
including officers, with an exercise price ranging from $4.69 to $5.86, which
was greater than or equal to the fair value of the underlying common stock
on the date of grant.