**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-K**

**(Mark One)**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

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

**Forthe transition period from                to                **

**Commissionfile number:  001-33204**

**OBAGI MEDICAL PRODUCTS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     |   | **22-3904668**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **310 Golden Shore, Long Beach, CA**                             |   | **90802**                             |
| (Address of  principal executive offices)                        |

 

**(562) 628-1007**

(Registrant’s telephonenumber, including area code)

**Not applicable**

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

Securities registeredpursuant to Section 12(b) of the Act:

| Title of class                            | ** ** | **Name of each  exchange on which registered** |
|-------------------------------------------|------------|------------------------------------------------|
| Common Stock, par  value $0.001 per share |       | Nasdaq Stock  Market LLC                       |

 

Securities registered pursuant to Section 12(g) ofthe Act:

**Notapplicable**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes  o      No  x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.  Yes  o      No  x

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer, as defined in Rule 12b-2 of the Exchange Act.Large accelerated filer  o    Acceleratedfiler  o    Non-acceleratedfiler  x

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

The aggregate market valueof the voting and non-voting common equity held by non-affiliates of theregistrant was approximately $77,947,000 as of February 15, 2007 basedupon the closing sale price on the Nasdaq Global Market reported for such date.Shares of common stock held by each officer and director and by each person whoowns 5% or more of the outstanding common stock have been excluded in that suchpersons may be deemed to be affiliates. This determination of affiliate statusis not necessarily a conclusive determination for other purposes.

There were 21,801,961shares of the registrant’s common stock issued and outstanding as of March 14,2007.

DOCUMENTS INCORPORATED BYREFERENCE

Part III incorporatesinformation by reference from the definitive proxy statement for the AnnualMeeting of Stockholders to be held on June 7.

 

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**OBAGI MEDICAL PRODUCTS, INC.**

**ANNUAL REPORT ON FORM 10-K**

**TABLE OF CONTENTS**

|               | ** ** |                                                                                                                        | ** ** | **PAGE**   | ** ** |
|---------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| ** **    | ** ** | **PART I**                                                                                                        | ** ** | ** ** | ** ** |
| **Item 1.**   | ** ** | **Business**                                                                                                           | ** ** | **2**      | ** ** |
| **Item 1A.**  | ** ** | **Risk  Factors**                                                                                                      | ** ** | **28**     | ** ** |
| **Item 1B.**  | ** ** | **Unresolved SEC Staff Comments**                                                                                      | ** ** | **45**     | ** ** |
| **Item 2.**   | ** ** | **Properties**                                                                                                         | ** ** | **45**     | ** ** |
| **Item  3.**  | ** ** | **Legal  Proceedings**                                                                                                 | ** ** | **46**     | ** ** |
| **Item 4.**   | ** ** | **Submission of Matters to a Vote of Security Holders**                                                                | ** ** | **46**     | ** ** |
| ** **    | ** ** | **PART II**                                                                                                       | ** ** | ** ** | ** ** |
| **Item 5.**   | ** ** | **Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities** | ** ** | **48**     | ** ** |
| **Item  6.**  | ** ** | **Selected  Financial Data**                                                                                           | ** ** | **51**     | ** ** |
| **Item 7.**   | ** ** | **Management’s Discussion and Analysis of Financial  Condition and Results of Operations**         | ** ** | **53**     | ** ** |
| **Item 7A.**  | ** ** | **Quantitative and Qualitative Disclosures About Market  Risk**                                                        | ** ** | **70**     | ** ** |
| **Item 8.**   | ** ** | **Financial Statements and Supplementary Data**                                                                        | ** ** | **70**     | ** ** |
| **Item 9.**   | ** ** | **Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure**          | ** ** | **70**     | ** ** |
| **Item  9A.** | ** ** | **Controls  and Procedures**                                                                                           | ** ** | **70**     | ** ** |
| **Item  9B.** | ** ** | **Other  Information**                                                                                                 | ** ** | **73**     | ** ** |
| ** **    | ** ** | **PART III**                                                                                                      | ** ** | ** ** | ** ** |
| **Item 10.**  | ** ** | **Directors, Executive Officers and Corporate Governance**                                                             | ** ** | **74**     | ** ** |
| **Item  11.** | ** ** | **Executive  Compensation**                                                                                            | ** ** | **74**     | ** ** |
| **Item 12.**  | ** ** | **Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters**               | ** ** | **74**     | ** ** |
| **Item 13.**  | ** ** | **Certain Relationships and Related Transactions, and  Director Independence**                                         | ** ** | **74**     | ** ** |
| **Item 14.**  | ** ** | **Principal Accountant Fees and Services**                                                                             | ** ** | **74**     | ** ** |
| ** **    | ** ** | **PART IV**                                                                                                       | ** ** | ** ** | ** ** |
| **Item 15.**  | ** ** | **Exhibits and Financial Statement Schedules**                                                                         | ** ** | **75**     | ** ** |

 

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**Forward-lookingstatements**

We have made forward-looking statements in this AnnualReport on Form 10-K, including the sections entitled “Management’sdiscussion and analysis of financial condition and results of operations” and “Business,”that are based on our management’s beliefs and assumptions and on informationcurrently available to our management. Forward-looking statements include theinformation concerning our possible or assumed future results of operations,business strategies, financing plans, competitive position, industryenvironment, potential growth opportunities, the effects of future regulationand the effects of competition. Forward-looking statements include allstatements that are not historical facts and can be identified by the use of forward-lookingterminology such as the words “believe,” “expect,” “anticipate,” “intend,” “plan,”“estimate” or similar expressions.

Forward-looking statementsinvolve risks, uncertainties and assumptions. Actual results may differmaterially from those expressed in the forward-looking statements. We do nothave any intention to update forward-looking statements after this AnnualReport of Form 10-K is filed. You should understand that manyimportant factors, in addition to those discussed elsewhere in this AnnualReport on Form 10-K, could cause our results to differ materiallyfrom those expressed in the forward-looking statements.

**PART I**

**ITEM 1: BUSINESS**

**Corporateinformation**

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

Our principal executiveoffices are located at 310 Golden Shore, Long Beach, California 90802 andour telephone number is (562) 628-1007. Our website address ishttp://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 withthe Securities and Exchange Commission, or the SEC, can be obtained, free ofcharge as soon as reasonably practicable after such material is electronicallyfiled with, or furnished to the SEC, by calling Ina McGuinness at IntegratedCorporate Relations at (310) 954-1100, through the SEC’s website byclicking the SEC Filings link from the Investor Relations page on ourwebsite at www.obagi.com or directly from the SEC’s website at www.sec.gov. Ourwebsite and the information contained therein or connected thereto are notintended to be incorporated into this Annual Report on Form 10-K.

**Overview**

We are a specialty pharmaceutical company focused onthe aesthetic and therapeutic skin health markets. We develop and commercializeprescription-based, topical skin health systems that enable physicians to treata range of skin conditions, including pre-mature aging, photo-damage,hyperpigmentation (irregular or patchy discoloration of the skin), acne andsoft tissue deficits, such as fine lines and wrinkles. Our products aredesigned to improve the underlying health of patients’ skin, and our clinicalstudies have demonstrated that the use of our Obagi Nu-Derm System results inskin that looks and acts younger and healthier. We focus our research anddevelopment activities on improving the efficacy of 

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established prescriptionand over-the-counter, or OTC, therapeutic agents by enhancing the penetrationof these agents across the skin barrier using proprietary technologies collectivelyknown as Penetrating TherapeuticsTM. Through our own domestic sales force andforeign distribution partners, we market and sell physician-dispensed skin caresystems directly to plastic surgeons, dermatologists and other physicians whoare focused on aesthetic and therapeutic skin care. We are the market leader inthe growing physician-dispensed skin care channel, according to an independent2006 study by Kline & Co. Our net sales have grown from approximately$35.6 million in 2001 to approximately $78.0 million in 2006.

We currently market and sell a range of systems andrelated products for the enhancement of skin health. Our leading product lineis our Obagi Nu-Derm System. This system was launched in 1988, and since thattime, we have made substantial enhancements to the system through theapplication of our Penetrating Therapeutics technology. We believe that ourObagi Nu-Derm System is the only clinically proven, prescription-based topicalskin health system on the market that has been shown to enhance the skin’soverall health by correcting photo-damage using drugs that, by definition, workat the cellular level, resulting in a reduction of the visible signs of aging.We have further leveraged our Penetrating Therapeutics technology through the systemsthat we market. In 2004, we launched the Obagi-C Rx System, which we believe isthe only prescription-based system that reduces the early effects of sun damageand 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 thistechnology. In 2005, we launched Professional-C, a series of high potencyantioxidant Vitamin C serums that help to counteract the effects of ultravioletradiation and other environmental influences. Professional-C represents animproved product line with more effective skin barrier penetration replacingour Vitamin C serum offerings marketed under the Cffectives and Obagi-Cbrands that we introduced in 2000. In July 2006, we launched Nu-DermCondition and Enhance targeted for use with Botox. This system providesadjunctive therapy following Botox injections, which was designed to enhanceaesthetic outcomes and improve overall patient satisfaction. In October 2006,we introduced the first product in the ELASTIdermTM product line, ELASTIdermTMEye Cream, a nighttime eye cream for treatment of skin laxity around the eye.In February 2007, we launched a second product in the ELASTIderm line fordaytime use, ELASTIdermTM Eye Gel, to use along with our ELASTIderm Eye Cream,as an eye therapy system. ELASTIderm products are formulated with a patentpending bi-mineral complex, which is clinically shown to help the body’s ownnatural ability to increase epidermal thickness, augment hypodermal fat andincrease elastin levels. In February 2007, we launched CLENZIderm M.D.TM, asystem of products for acne treatment featuring a novel formulation of BenzoylPeroxide, or BPO. Our clinical studies have shown that CLENZIderm M.D.penetrates more readily into the skin follicle than current creams or gelsbecause it is in solution form (1/100th - 1/1000th of the size of current BPO particles). Webelieve that our solution-based acne system is a more effective treatment foracne because a greater amount of the active ingredient, BPO, will penetrate thehair follicle to more rapidly kill P. acne bacteria.

In addition, we offer tretinoin, a generic equivalentto Retin-A, which has been among the most widely used acne treatments forapproximately 25 years. We currently distribute a Food and DrugAdministration, or FDA, approved generic equivalent in the physician-dispensedchannel under an exclusive license agreement with Triax Pharmaceuticals, LLC.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 peelprocedures. While the Obagi Blue Peel products are not dispensed for daily homeuse in a system and are therefore not a significant source of our revenue, theyare used to aid the physician in skin peeling activities. Acceptance andawareness of the Obagi Blue Peel among physicians give it an intrinsic value asa marketing tool in driving new account growth.

We believe that our products have the potential to beused in a number of applications and procedures beyond their current use. Forexample, our Obagi Systems may complement and enhance commonly performedcosmetic procedures, such as Botox injections, as well as shorten healing timesand 

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reduce thepost-inflammatory hyperpigmentation that typically follow laser therapy andbasal cell carcinoma excisions, and we are conducting clinical studies toevaluate the adjunctive use of our systems before and after these types ofprocedures. We expanded this initiative in 2005, and are working withphysicians and physicians’ associations to evaluate the use of our ObagiNu-Derm System in enhancing skin healing in ablative and non-ablative laserprocedures. In late 2005 and through 2006, we conducted a study targeting morethan 5,000 patients and supporting independent clinical research on oursystems. The study entails physician and patient evaluations of skin quality onpatients using our Obagi Nu-Derm System in conjunction with other cosmetic facialprocedures. Based on the results of the clinical use study, in which patientoutcomes have been documented for 2,697 patients, we launched new systems foruse before and after commonly performed cosmetic procedures in July 2006.These systems are positioned under the Nu-Derm Condition and Enhance brand,with an initial focus on use in conjunction with Botox injections (Botox is aregistered trademark of Allergan, Inc.). We are using this data toevaluate possible individual clinical studies on the use of Nu-Derm Conditionand Enhance with  specific procedures.For example, in February 2007, we entered into an agreement with Syneronto perform a joint clinical use study of Nu-Derm Condition and Enhance systemused as an adjunct therapy with Syneron’s energy based systems, with physicianswho are experienced with Syneron’s systems, in order to evaluate the enhancedaesthetic outcomes and improved overall patient satisfaction. However, thisstudy has not yet been undertaken and will require the cooperation ofphysicians not yet identified, and as such, there can be no assurance that theend results of this study will be positive. We plan to continue to buildclinical support for the benefits of our systems in conditioning the skin andenhancing the outcomes of the most commonly performed cosmetic procedures, suchas chemical peels, dermabrasion, and laser resurfacing, as well as theaesthetic and wound healing aspects of surgical procedures such as basal cellcarcinoma excisions.

We engage in an active development program using ourPenetrating Therapeutics technology to enhance the efficacy of establishedFDA-approved and OTC active ingredients. Positive findings from completed pilotstudies of these new systems may not be duplicated in the larger studies thatwe are currently completing, or the incidence of side effects in these largerstudies may force us to reformulate our products. We will continue to seek additionalmarket opportunities where we believe we can improve the effectiveness ofexisting products through the application of our Penetrating Therapeuticstechnology to address conditions such as fungal infections, dermatitis,psoriasis, hair loss and hair removal.

We also advance our development objectives throughproduct and license agreements with third parties. These agreements may includepatent and technology licenses, product licenses and new product collaborationagreements. For example, we are developing products for the regeneration ofelasticity in skin which are covered by claims contained in a patentapplication which we license from JR Chem LLC. The initial focus will becentered on products applied around the eyes, on the neck and on the back ofthe hands, where the break down in skin elasticity is most visible in agingskin. The first products to result from our collaboration with JR Chem are theproducts in our ELASTIderm product line. In addition, in December 2005, weentered into a product supply and collaboration agreements with TriaxPharmaceuticals, LLC for the supply of certain of its tretinoin products and toprovide Obagi-branded tretinoin products in various concentrations.

In the United States, we sell our systems and relatedproducts directly to physicians through our internal sales force, which as of December 31,2006 consisted of 109 sales, marketing and education specialists, including 96direct sales representatives and managers. Physicians dispense our productsin-office, directly to their patients, a distribution method commonly referredto as the “physician-dispensed” channel. We believe that thephysician-dispensed distribution model ultimately results in higher patientsatisfaction because it is better suited to the provision of system-based skincare than traditional drug distribution channels. Our physician customer baseconsists primarily of plastic surgeons and dermatologists, but also includes anincreasing number of physicians from other practice areas, such as internalmedicine and obstetrics and gynecology, or OBGYN, who are adding skin care totheir practices. 

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As of December 31,2006, we sold our products to approximately 4,400 accounts in the UnitedStates, which we believe represented over 6,000 individual practicingphysicians. Based on a 2006 study by Kline & Co., an independentmarket research firm, we are the leading skin health company in thephysician-dispensing channel, with an estimated 27% market share and nearlythree times the market share of the next largest competitor. Outside the UnitedStates, we utilize distribution partners for the sale of our systems andrelated products. We currently have 12 distribution partners who sell ourproducts through their own dedicated sales forces in approximately 35 countries.

We also compete in theJapanese retail skin care markets through a strategic licensing agreement withRohto Pharmaceutical Co., Ltd., or Rohto. Rohto is a Japanesepharmaceutical manufacturer and distributor. Under our agreement, Rohto islicensed to manufacture and sell a series of OTC products under the Obagi brandname, including Obagi-C (a Vitamin C based topical serum in variousconcentrations), in the Japanese drug store channel and we receive a royaltybased upon sales of Obagi branded products in Japan by Rohto. We have otherlicensing arrangements in Japan to market and sell OTC product systems underthe Obagi brand, both for in-office use in facial procedures, as well as forsale as a take-home product kit in the spa channel. Our net licensing revenuefrom skin health systems and products in Japan was approximately $4.1 millionin 2006.

**Background**

***Skin damage and disorders***

The skin is the largest organ in the body, consistingprimarily of two layers: the epidermis, a thin outer layer; and the dermis, arelatively thick inner layer. The epidermis is comprised of specialized cellssuch as keratinocytes and melanocytes. Keratinocytes are formed in theepidermis and travel to the skin’s surface and are exfoliated, or shed off, asthey 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 andprotects the body from ultraviolet radiation. The dermis is comprised largelyof connective tissue fibers made of collagen and elastin. Collagen is a tough,fibrous protein that helps give skin its strength and resiliency. Elastin is atissue that helps maintain healthy skin tension and gives skin its shape, butdoes not readily regenerate post-puberty and degrades over time. As the elastindegrades, skin tone and elasticity become diminished, resulting in loose,sagging skin.

The health and appearance of a person’s skin isimpacted by a variety of intrinsic and extrinsic factors, including pre-matureaging, photo damage, hormones, stress, pollutants, diets and skin diseases.These factors cause newly created cells to be damaged which leads to anincrease in the skin cell maturation cycle. The result is that skin cells aredisorganized and pigment cell activity is increased. The damaged epidermalcells cause a wide variety of conditions such as mottled pigmentation (variedpigment density across the skin), melasma (skin discoloration often caused byhormonal changes such as those from pregnancy), age spots, fine lines and drythickened sallow skin. In the dermis of extrinsic or intrinsic aged skin, theamount of new collagen and elastin produced decreases, resulting in fibers thatdo not support the structure and the dermis becoming thinner. As a result deeplines, wrinkles and sagging skin make the appearance of skin significantlyworse. Skin health is also impacted by diseases such as acne, rosacea,dermatitis, and psoriasis. Imbalanced production of skin oils such as sebumencourages accelerated growth of microbes in the skin such as Propionibacteriumacnes, or P.acne. The skin can also become host to viral or fungal infections.

While these conditions anddiseases are not life-threatening, they are readily apparent, sometimesdisfiguring, usually chronic and can be debilitating in terms of a person’sself image and confidence. As a result, people are often highly motivated toseek treatment programs to restore the look and feel of their skin.

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***The skin care market***

In 2005, the global skin care market was estimated tobe $36.2 billion, of which over 62% were facial skin care products,according to Global Industry Analysts, Inc., a market research firm.Additionally, the independent research firm, Kalorama Information, estimatesthat from 2005 to 2010, over 70 million people in the United States alonewill receive cosmetic facial procedures for which they will pay over$60 billion. We believe this reflects a growing desire and acceptanceamong the aging population to seek aesthetic facial products and proceduresfrom their physicians. A key driver of this trend is the aging of the “babyboomer” segment of the U.S. population. In addition, life expectancy in theUnited States has extended in recent years, leading to a further increase inthe average age of the country’s population. Because healthcare needs,including the treatment of skin disorders, tend to increase with age, we expectthe demand for dermatologic products to continue to increase over time. Inparticular, women tend to demonstrate a higher motivation than men to improvetheir 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 tohave grown 35% between 1990 and 2004. With this segment’s strong desire toreduce the signs of pre-mature aging, we expect the aging female population tocontinue to increase the market opportunity for skin care products.

Consumer demand for physician-dispensed skin careproducts and procedures has been steadily growing. We believe this growth isdue to consumers realizing that many non-prescription consumer cosmeticproducts are unable to fully meet their needs. Consumers have increasinglyturned to their physicians for products and simple in-office procedures thatcan provide better results than consumer cosmetics. For example,physician-directed cosmetic products and commonly performed cosmetic proceduressuch as Botox injections, laser hair removal and microdermabrasion (a cosmeticprocedure that removes the outermost layer of the skin to promote skinrejuvenation), have experienced substantial growth as consumers learn that theycan achieve positive cosmetic results with minimally invasive techniques.According to the American Society of Plastic Surgeons, or ASPS, the number ofminimally-invasive cosmetic office procedures performed increased 72% fromapproximately 4.9 million in 2002 to approximately 8.4 million in2005. This increase was led by facial procedures such as Botox, up 242% in 2005compared to 2002, and injectable fillers, which were first measured by ASPS in2003, and increased 990% in 2005 compared to 2003.

Beyond anti-aging and aesthetic treatments, there issignificant market demand for effective treatments of skin diseases such asacne, rosacea, psoriasis, and eczema (dermatitis). While a number of therapiesand treatments exist for such diseases, most treatments consist of eithertopical applications with efficacy that is limited by their inability to crossthe skin barrier effectively, or systemic (oral) applications that carrysignificant potential side effects.

According to Kline & Co., in 2006, there wereapproximately 22,700 practicing dermatologists and plastic surgeons in theUnited States. Based on our experience with physicians who have opened accountswith us, we believe a growing number of general practice, family practice andOBGYN physicians are also dedicating resources in their practices to skin care.We believe that these physicians are responding to the rapid increase inconsumer demand for non-invasive skin care treatments. Furthermore, many ofthese physicians are dispensing prescription and non-prescription skin careproducts directly to their patients. According to a 2006 Kline & Co.study, a combined number of approximately 10,100 physicians dispensed skin careproducts directly to their patients.

Outside the United States,the physician-dispensed skin care market varies by country due to culturaldifferences and regulatory variations. Cultural desires for skin with lighterand more even pigmentation have created large and growing aesthetic skin caredemand across the Pacific Rim countries, particularly Japan, China and Korea.European and certain South American countries such as Brazil also present largeskin care markets due to the complementary growth in cosmetic procedures andwillingness on the part of 

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theirconsumers to spend discretionary income on aesthetic enhancements. We believethat the growth in major international markets will also be driven by culturaldesires to remove skin darkening caused by exposure to sun, aging populationsand a heightened awareness and acceptance of physician-dispensed products andprocedures. Additionally, while physician dispensing is common in mostcountries, certain countries prohibit or limit the types of products that canby dispensed from the physician office, requiring physicians to either partnerwith a retail pharmacy or drug store, or to simply forgo dispensing.

***Limitations of traditional products and procedures***

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

·       Theouter layer of human skin is a highly effective protective barrier against theentry of foreign particles into the body. The active agents in many competingtopical products and procedures lack the ability to effectively penetrate theskin barrier, reducing their ability to improve the health of the skin at thestratum corneum, epidermis and dermis level. The most commonly used skin careproducts are cosmetics by definition under the U.S. Food, Drug and CosmeticAct, or the FDCA, consisting largely of surface covers and moisturizers, whichonly add water to the cells on the surface of the skin, providing superficialand temporary improvement in the appearance of the skin. Moisturizers are notcapable of causing the skin to generate healthy new cells to replace older, damagedones that make up the epidermis.

·       Most traditional approachesto skin care are not comprehensive programs designed to integrate complementaryproducts. As a result, individual products, even those that are widely used byconsumers (such as facial soaps or sunscreens) are not generally designed towork together, and therefore may cause unintended side effects or reducedeffectiveness when used in combination. Furthermore, the range of skin types inany given patient population is highly varied and different skin types responddifferently to treatment, yet few products are capable of treating the specificneeds of the individual patient’s overall skin health.

***The Obagi Medical Products approach***

We believe theeffects of aging and skin disorders are best addressed not at the surface ofthe skin but at a deeper level, where the skin’s natural regeneration processesoccur. Our Obagi Nu-Derm and Obagi-C Rx Systems improve the overall health ofthe skin by improving cellular processes such as collagen and elastinproduction, keratinocyte clearing, and melanocyte regulation, using drugs that,by definition, work at the cellular level. With improved underlying skinhealth, we believe a patient’s skin shows fewer signs of aging, is lesssusceptible to disease, and better able to combat exposure to the elements. Wehave developed skin care systems that we believe address the limitations oftraditional skin care products and procedures, including the following:

·       OurObagi Nu-Derm and Obagi-C Rx Systems are drug-based systems designed topenetrate below the skin’s surface to correct damage in all layers of the skin(the stratum corneum, the epidermis and the dermis) and accelerate cellularturnover. We have demonstrated in clinical studies that by enhancing thepenetration of the intended active ingredient (tretinoin), more of this druggets to the targeted tissue, improving patient outcomes. The increasedpenetration of a system of active ingredients triggers a therapeutic cascadethat (i) pushes fresher cells to the surface faster, for smoother skin,reduced wrinkles and increased tolerance, (ii) corrects currenthyperpigmentation (including freckles and age spots) and prevents theappearance of new hyperpigmentation, 

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(iii) promotes moreuniform cells at the deepest layer for better skin structure and balanced, evenskin tone, (iv) helps stimulate collagen and elastin for firmer, moreresilient skin, and (v) helps increase natural hydration and circulationfor supple, healthy-looking skin.

·       To achieve improved skinhealth, our Penetrating Therapeutics technology integrate proprietaryformulations of existing prescription and non-prescription skin care productsinto treatment programs specially designed and physician-tailored to addressthe unique needs of each patient’s skin. The individual products within oursystems are formulated to work synergistically using our proprietaryPenetrating Therapeutics technology in formulations that enhance the stabilityand efficacy of what are often otherwise unstable molecules. When this systemof products is applied within a physician directed protocol tailored to thepatient’s skin health needs, overall penetration of the active ingredient tothe appropriate layer of skin is achieved, resulting in greater efficacy andimproved patient outcomes.

**Our businessstrategy**

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

·       ***Leveraging the strength of our physician-dispensedmarketing and distribution channel to increase market share and introduce newObagi products.***   We believe that our market-leadingposition in the physician-dispensed channel presents us with the opportunity toincrease the market share of our existing products and to launch a range of newObagi Systems and products. We have built long-term relationships with skinhealth professionals based on the success of our products during the18 years since the first Obagi Systems and products were launched. We willcontinue our sales and marketing efforts aimed at helping physicians understandhow our systems’ products can meet growing patient demand for effective skincare treatments, thereby generating additional sources of revenue for physicianpractices. Furthermore, we believe that our systems’ product offerings, and ourexperienced sales force, uniquely position us to benefit from growth in thenumber of physicians who dispense skin care products directly to theirpatients. According to Kline & Co., in 2006 only about 43% of theapproximately 22,700 practicing plastic surgeons and dermatologists in the UnitedStates dispense professional skin care products. According to the results of astudy we sponsored by Wirthlin Worldwide Company, an additional 40% ofnon-dispensing surveyed physicians indicated that they are consideringdispensing skin care products.

·       ***Continuing to develop and market newindications for Obagi Systems.  ***We believe a significantopportunity exists to use current Obagi Systems as non-invasive adjunctivetherapies to improve certain current skin care procedures, resulting in overallbetter patient outcomes and satisfaction. Many cosmetic procedures are limitedin their ability to provide healthier skin and an overall enhanced aestheticoutcome. For example, Botox injections for cosmetic wrinkles affect mostly theforehead and have no effect on the skin’s color, hyperpigmentation, age spots,acne or the overall health of the skin. We believe patients who are treatedwith our Obagi Systems following Botox injections will achieve greater overallaesthetic outcomes and satisfaction, and we are conducting clinical studies toevaluate the adjunctive use of our systems before and after these types ofprocedures. We expanded this initiative in 2005, including working withphysicians and physicians’ associations to evaluate the use of our Obagi Nu-DermSystem in conjunction with these types of procedures in more than 5,000patients. Based on the results of the study, in which patient outcomes havebeen documented for 2,697 of the patients, we launched new systems for usebefore and after commonly performed cosmetic procedures in July 2006. Thesystems are positioned under the Nu-Derm Condition and Enhance brand, with aninitial focus on use in conjunction with Botox injections. We plan to continueto build clinical support for the benefits of our systems in 

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conditioning the skin andenhancing the outcomes of the most commonly performed cosmetic procedures, suchas chemical peels, dermabrasion, laser resurfacing and basal cell carcinomaexcisions.

·       ***Creating additional clinically proven Obagi Systemsthat increase the efficacy of commonly prescribed dermatological agents inaddressing new areas of skin disease.***   We focus ourresearch and development efforts on increasing the ability of FDA-allowed skinagents to penetrate the skin barrier, thereby increasing the effectiveness ofsuch agents within the Generally Recognized As Safe, or GRAS, OTC or DrugEfficacy Study Indication, or DESI, classification as defined by the FDA. Thisapproach accelerates the commercialization timeline and avoids the lengthyclinical development processes typically required to obtain new drug approvals.We intend to further differentiate our products and systems by supporting themwith randomized and comparative clinical studies conducted by leading expertsin the markets in which we are developing products. Supporting this strategy weinitiated more than eighteen (18) clinical studies in 2005 and 2006 in theareas of acne and elasticity.

·       ***Establishing new strategiccollaborations and relationships.  ***We intend to continueaccessing new and complementary products through in-licensing, strategiccollaborations and strategic acquisitions. We also intend to explore newproduct distribution partnerships in high growth channels such as the spa andsalon channel, in which manufacturers’ sales of skin care products areestimated at over $460 million in 2006, according to Kline & Co.We plan to target new products and channels, which will expand the Obagi brandand System concept but will not compete directly with the physician-dispensedchannel or products. We believe that skin health professionals will bereceptive to new products we introduce under the Obagi brand name, and that thebrand credibility that exists among skin health professionals will allow formore rapid trial and acceptance. This belief is supported by a 2003 study wesponsored by Wirthlin Worldwide Company of 1,000 medical professionals(primarily consisting of plastic surgeons, dermatologists, and medical skincare professionals), which found that the Obagi brand had the highest totalawareness, at 97%, among leading physician-dispensed brands.

·       ***Continuing to expand intellectualproperty protection***.   Our intellectual property protectionis based on a combination of issued patents, patent applications, licensedpatents, licensed product methods and technologies and trade secrets. As of December 31,2006, we were the sole licensee of four patents, and have filed more than 37additional U.S. provisional and non-provisional patent applications since thebeginning of 2004. We will continue to pursue additional invention and methodpatents as we find new applications and improvements to our existingintellectual property. We also pursue an aggressive trademark registrationpolicy as a means to increase brand recognition and product differentiation inthe market.

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**Our Obagi Systemsand related products**

Wecurrently market and sell our systems and related products to physicians forthe treatment of age-related skin disorders, incorporating a range ofindividual prescription and non-prescription therapeutic agents, as well ascosmetic ingredients. The individual components of each system have beenformulated to complement one another, enhancing the effectiveness of the systemas a whole and allowing the physician to tailor the treatment program to thespecific needs of the patient. The design of our systems is proprietary to us,and we are the sole licensee of U.S. patents and have patent applications forthe composition of certain of the products.

| **System and  related products** | ** ** | **Segment/product  category** | ** ** | **Description**                                                                                          | ** ** | **Applications**                                                                               | ** ** | **Launch  date** |
|----------------------------------|------------|-------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------|
| Obagi Nu-Derm System             |       | Skin Health / Nu-Derm         |       | Comprehensive system of six products including  prescription and OTC drugs                               |       | Fine lines, wrinkles, acne, photo damage,  hyperpigmentation, melasma, laxity, skin sallowness |       | 1988             |
| Obagi-C Rx System                |       | Skin Health /  Vitamin C |       | Highly stable  Vitamin C serum with 4% hydroquinone system; prescription-based                      |       | Fine lines, wrinkles,  hyperpigmentation, skin sallowness                                      |       | 2004             |
| Professional-C and  Cffectives   |       | Skin Health /  Vitamin C |       | Highly stable  Vitamin C serums; non-prescription                                                   |       | Antioxidant protection,  fine lines, wrinkles, hyperpigmentation                               |       | 2005(1)          |
| ELASTIdermTM System          |       | Skin Health / 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 and face                                            |       | 2006             |
| CLENZIderm M.D.TM  System    |       | Skin Health / Other           |       | System for acne treatment  built around a novel formulation of Benzoyl Peroxide, or BPO                  |       | Acne                                                                                           |       | 2007             |
| Tretinoin                        |       | Skin Health / Other           |       | Generic equivalent of  Retin-A available in the United States through an exclusive license               |       | Acne                                                                                           |       | 2002             |
| Obagi Blue Peel  System          |       | Skin Health / Other           |       | Topical system to aid in  the application of TCA (trichloroacetic acid) chemical peels                   |       | Fine lines, wrinkles,  hyperpigmentation                                                       |       | 1988             |

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(1)             Professional-C includes improved formulationsand higher concentrations of vitamin C, and replaces our Cffectives and   Obagi-C brands that were firstintroduced in 2000.

***Obagi Nu-Derm System***

Our Obagi Nu-Derm System consists of a combination ofsix prescription and OTC drugs and adjunctive cosmetic skin care products totreat visible skin conditions such as photo damage and hyperpigmentationresulting from extrinsic damage and intrinsic changes to the skin. The ObagiNu-Derm cosmetic skin care products include cleansers and exfoliating creams.Three of these products contain the drug hydroquinone in a 4% prescriptionconcentration, which acts as a bleaching agent that is designed to correct skinpigmentation problems by normalizing the production of new melanin in theepidermis. Physicians also prescribe the drug tretinoin as part of the system,in various concentrations, depending on the physician’s judgment of patientneed. We believe that the use of these prescription drugs, the ability of thedrugs to penetrate the skin’s surface and the order of applicationdistinguishes our Obagi Nu-Derm 

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System from other commonlyprescribed regimens. While we have designed our Obagi Nu-Derm System to includeproducts that patients can use in a systematic treatment regimen, we also makethe component products available for individual sale. We believe thatphysicians who dispense the Obagi Nu-Derm System generally encourage theirpatients to use the component products together in a systematic treatment regimen.However, we also believe that some patients elect to use the products that makeup the system individually. Products that are used individually at timesinclude the sun screen products and Obagi Nu-Derm Clear, which physicians maydispense on occasion to address localized pigmentation problems. Side effectsfrom use of the products may include redness, mild to moderate irritationand/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 withcertain sensitive individuals, in a few days upon discontinuance of use.

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

The Obagi Nu-Derm System accounted for over 68% of ourconsolidated net revenues in 2006. We sell our Obagi Nu-Derm System primarilyas a single-price bundle of component products. Although volumes of sales foreach individual product within the system varies, we believe the majority ofour sales of each component product is due to the fact that they are sold aspart of the system.

*Clinical StudySupport;*Our products aredesigned to improve the underlying health of patients’ skin. Clinical studiesconducted with our Obagi Nu-Derm System that we have sponsored havedemonstrated that the use of our Obagi Nu-Derm System results in skin thatlooks and acts younger and healthier. Those studies include a randomizedclinical study comparing four treatment groups over a 24-week period,involving 387 women with moderate photodamage assessments. The study wascompleted by 301 of the participating women. The study compared usage of ObagiNu-Derm System (Group 1) versus other commonly prescribed therapies usingtretinoin alone (Group 2) and hydroquinone alone (Group 3), as wellas a leading facial moisturizer (Group 4). The mean changes observed inGroup 1 (Obagi Nu-Derm System) were statistically significant and wereconsistently larger than, and statistically superior to, the changes producedwith the other treatment groups, particularly with respect to perioral finewrinkles, mottled hyperpigmentation, and laxity.

Mean values for clinical grading parameters at weeksone, two, 12, 18, and 24, and ultrasound measurements at weeks 12 and 24 werecompared with mean baseline values. Changes from baseline were compared amongthe four test groups using analysis of variance with paired comparisons.P values less than or equal to 0.05 were considered statisticallysignificant. Mean percent change from baseline and the incidence of improvementwere calculated for all attributes at each time point. Silicone replicas takenat baseline and weeks 12 and 24 and 24-week biopsy samples were referredto reference laboratories.

Our clinical resultsprovide objective and subjective support that our Obagi Nu-Derm Systemcontributes to skin that looks and acts younger and healthier, in that theimprovement in attributes related to skin tone, tissue content, skin laxity andwrinkling, are directly consistent with attributes found in comparativelyyounger skin.

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***Obagi-C Rx System***

The Obagi-C Rx Systemconsists of a combination of four prescription and OTC drugs and adjunctivecosmetic skin care products to treat skin conditions resulting from sun damageand the oxidative damage of free radicals. The central ingredients in thesystem are 4% hydroquinone, a prescription drug and Vitamin C. Thiscombination distinguishes Obagi-C Rx from other Vitamin C based productsavailable in the physician office. Two Obagi-C Rx System products contain thisconcentration of hydroquinone, which is designed to correct skin pigmentationproblems by normalizing the production of new melanin in the epidermis. TheObagi-C Rx System includes cosmetic skin care cleansers and exfoliatinglotions. When combined in a system, we believe hydroquinone, Vitamin C anda sunscreen provide correction of, and protection against, premature skinaging. As with the Obagi Nu-Derm System, the products that make up the Obagi-CRx System are generally used together in a coordinated regimen by the majorityof patients. Side effects from use of these products may include redness and/ormild to moderate irritation of the treated skin. Side effects generally resolveafter 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 theUniversity of California, Irvine in September 2003 to evaluate thepercutaneous absorption and bioavailability of our patented 10% Vitamin Cand 4% hydroquinone combination product compared with the leadingVitamin C competitor, SkinCeuticals 20 Vitamin C. Our productdemonstrated, with statistical significance, more Vitamin C in all layers ofthe skin than SkinCeuticals 20 Vitamin C serum.

***Obagi Professional-C***

The Obagi Professional-Cproducts are a complete line of proprietary, non-prescription products, whichconsist of Vitamin C serums used to reduce the appearance of damage to theskin caused by ultraviolet radiation and other environmental influences.Vitamin C (L-ascorbic acid) acts as a potent antioxidant. The ObagiProfessional-C line consists of a 5% serum for the area around the eyes and10%, 15% and 20% serums for the face, neck and chest. Professional-C representsan expanded line that replaced our 5% and 10% Vitamin C serum offeringsmarketed under the Cffectives brand domestically, and Obagi-C brandinternationally, as introduced in 2000. Obagi Professional-C products aresold individually and are used on their own, or in combination with other Obagisystem products. These products are classified as cosmetics and side effectsare not generally associated with their use, however certain sensitiveindividuals may experience mild irritation of the skin where product isapplied. In addition, the product has been shown in studies we sponsored at theUniversity of California, Irvine in September 2003 and July 2005 topenetrate all levels of skin better than SkinCeuticals 20 Vitamin C serum.

***Obagi ELASTIdermTM***

Our ELASTIderm productline consists of products for the treatment of skin laxity featuring novelmineral complexes which may help the body’s own natural ability to increaseepidermal thickness, augment hypodermal fat and increase elastin levels bysupplying increased local concentrations of natural mineral actives to therelevant tissue, thereby improving the elasticity and skin tone around theeyes. We believe this is the first clinically proven skin health system to aidin the regeneration of elastin, which we believe is a new and novel topicalapplication for anti-aging. An eight-week treatment, randomized, double-blindclinical study was conducted with 33 subjects to determine the efficacy of ournovel under eye elastin regeneration product. The primary endpoints wereappearance in under eye skin elasticity, fine line wrinkles and moisturization.The treatment improved the appearance of the under eye skin. We believe that amore rapid improvement in elasticity is essential to earning customercompliance and repurchase. Based on clinically significant improvements inmeasured collagen and elastin in skin treated over the eight week period, welaunched a single nighttime eye cream product under the Obagi ELASTIderm brandname in mid-October 2006. In February 2007, we launched a daytime eyegel which is the second product under the Obagi ELASTIderm brand.

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***Tretinoin***

Tretinoin creams andrelated adjunctive acne care products are used for the topical treatment ofacne in the United States. Tretinoin, the active ingredient in the prescriptionacne drug Retin-A, is a Vitamin A derivative and has been the primaryprescription acne therapy for approximately 25 years. Topical tretinoinnormalizes the growth rate of skin cells, disrupting the onset of acne. Weoffer FDA-approved formulations of tretinoin through an exclusive license inthe physician-dispensed channel. Our Tretinoin cream line is available inconcentrations of 0.1%, 0.05% and 0.025%. These products are sold individuallyand are used by doctors as a single therapy, in combination with Obagi Nu-Derm,or in combination with other acne therapies including but not limited tosalicylic acid and clindamyacin. Side effects include excessively red,edematous, blistered, or crusted skin for certain sensitive individuals. Ifthese effects occur, the medication should either be discontinued until theintegrity of the skin is restored, or the medication should be adjusted to alevel the patient can tolerate. To date, generally adverse effects have beenreversible upon discontinuation of therapy.

***Obagi Blue Peel***

Obagi Blue Peel is atopical system to aid in the application of TCA chemical peels used to smooththe surface of skin, improve skin tone and color, diminish wrinkles and shrinkpore sizes. Chemical peels are an in-office procedure performed either by a physicianor 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 andapplied 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 withnew, healthy skin cells. The Obagi Blue Peel provides for an even applicationand slows the penetration of the solution into the skin, allowing physicians tomore accurately monitor the peel. This produces a more uniform and consistentapplication, which reduces the risk of complications. We believe that the ObagiBlue Peel is especially effective as a complementary treatment to our ObagiNu-Derm System. The Obagi Blue Peel products have no known side effects in andof themselves. Patients receiving blue peel products as part of an acid peelprocedure can expect to experience side effects that are associated with suchprocedures.

**Expandedapplications for existing products**

We believe that many ofour products have applications in areas beyond their current uses. For example,we are conducting studies to evaluate the adjunctive use of our systems withcommonly performed cosmetic procedures such as laser therapy, Botox injectionsand basal cell carcinoma excisions. In July 2006, we launched our Nu-DermCondition and Enhance System, for use primarily with Botox injections.

**Nu-Derm**

*Marketopportunity.**  *Accordingto the American Society of Plastic Surgeons, or ASPS, the number ofminimally-invasive cosmetic office procedures performed increased 72% fromapproximately 4.9 million in 2002 to approximately 8.4 million in2005. This increase was led by facial procedures such as Botox, up 242% in 2005compared to 2002, and injectable fillers, which were first measured by ASPS in2003, and increased 990% in 2005 compared to 2003.

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Our Obagi Nu-Derm System restores skin to a healthierstate and helps regulate skin cell functions and improve circulation. Thisimproves the skin’s ability to constantly renew itself, repair damage, and actas an effective barrier. It also restores the skin to an active and tolerantstate so that it responds better to the trauma of surgical procedures, healsfaster and is less likely to exhibit an undesirable post-procedure response.Anecdotal evidence provided to us by clinicians who use our products suggests adecreased recovery period, improved rate of healing and reduction inpost-inflammatory hyperpigmentation. Another proposed advantage of pre-treatingpatients undergoing laser resurfacing with our Obagi Nu-Derm System is thatpriming collagen might enhance the response to laser resurfacing, therebyimproving cosmetic results. Further, our Obagi Nu-Derm System, when used asadjunctive therapy following Botox injections, has indicated the possibility ofenhanced aesthetic outcomes and improved overall patient satisfaction assuggested to us anecdotally by several dermatologists and plastic surgeons andsupported by our physician use study.

*Clinical development.**  *In January 2006, we initiateda large, multi-center, physician use study targeted for over 5,000 patients.This study will broadly assess the outcomes and practice patterns of our ObagiNu-Derm System used as an adjunct therapy to a wide variety of commonlyperformed cosmetic procedures. To date, we have received procedure evaluationson over 2,697 of the patients. The results indicate enhanced patient outcomesand are achieved with several commonly performed cosmetic procedures includingBotox and facial laser resurfacing.
| Product line                                                        | ** ** | **Description**                                                                                | ** ** | **Applications**                                             | ** ** | **Launch  date/target  launch date** |
|---------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------|
| Obagi Nu-Derm  Condition and Enhance for Botox                      |       | Line extension of Nu-Derm System designed for use  after soft tissue filler injections         |       | Enhances outcomes for Botox and other injectible  procedures |       | 2006                                 |
| Obagi Nu-Derm  Condition and Enhance for Laser                      |       | Line extension of Nu-Derm System designed for use  before and after cosmetic laser procedures  |       | Enhances outcomes for cosmetic laser procedures              |       | 2007*                                |
| Obagi Nu-Derm  Condition and Enhance for Basal Cell Carcinoma (BCC) |       | Line extension of Nu-Derm System designed for use  before and after BCC excision and cutterage |       | Enhances outcomes for BCC treatment procedures               |       | 2008*                                |

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*                    Thesetarget launch dates are forecasted on the assumption that results of ourclinical studies will be favorable, which may not be the case.

***Obagi Nu-Derm Condition and Enhance for Botox***

According to ASPS, therewere approximately 3.8 million Botox injections performed in 2005. Botoxis a non-surgical, physician administered cosmetic treatment that cantemporarily reduce moderate to severe frown lines between eye brows (glabellarlines associated with corrugator and/or procerus muscle activity) for up tofour months. In order to maintain the results, a patient needs to be injectedevery three to four months. We are planning to conduct a 12-weekmulti-center, randomized, single-blind, post-market study comparing theaesthetic outcome of the application of Botox alone to the application of Botoxwith post treatment with our Obagi Nu-Derm System. The primary endpoints willbe additive improvements in perioral and periocular fine wrinkles, facialmottled hyperpigmentation, clarity, sallowness, laxity, tactile roughness andoverall patient satisfaction. We anticipate initiating this study by mid-2007for completion prior to 2007 year-end.

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***Obagi Nu-Derm Condition and Enhance for Laser***

We are evaluating andsponsoring studies to evaluate the use of Obagi Nu-Derm products in aiding skinhealing in skin peel procedures and ablative laser procedures, which areprocedures using lasers that work primarily by removing the top layer of theskin, while the subsequent layer is heated. These initiatives are based onanecdotal evidence, supplied by physicians who are experienced with our ObagiNu-Derm System, that indicates the possibility of improved recovery and healingtime when our Obagi Nu-Derm System is used with ablative laser procedures. Wealso agreed to work jointly with Syneron Medical Ltd. to conduct physician sitestudies using our Nu-Derm Condition and Enhance Systems in conjunction withtheir elōstechnology. However, these evaluations and studies have not yet been completed,and there can be no assurance that the end results will be positive.

***Obagi Nu-Derm Condition and Enhance for Basal CellCarcinoma***

According to the AmericanSociety for Dermatologic Surgery, approximately 1.7 million procedures totreat skin cancer were performed in the United States in 2005. Basal cellcarcinoma is the most common skin cancer. Electrodessication and curettage is acommonly employed treatment in which superficial skin cancers are scraped witha curette followed by electrocautery of the site in three successive cycles.Electrodessication and curettage usually leaves a scar and hypopigmented, firm,and demarcated skin. We have initiated a multi-center, randomized,single-blind, controlled study comparing the efficacy of pre-treatment andpost-treatment with our Obagi Nu-Derm System with a commonly prescribed regimenof gentle cleanser and emollient on skin healing. The primary endpoint willinclude an improvement in healing rates, less scar formation and lesshypopigmented, firm, demarcated skin.

**New Products andProduct Lines**

**ELASTIdermTM—*Anti-Aging***

*Marketopportunity.**  *Elastinis a protein found in the dermis which allows the skin to resume its normalshape after stretching. As skin ages, it loses its elasticity and begins tosag, particularly around the eyes, on the neck and on the hands. According toKline & Co., in 2006, the eye, hand and neck skin care market in thespa and salon channel was estimated at over $170 million per year,comprised of products that are primarily designed to improve skin appearancethrough added moisturization, or building collagen in the skin. We conducted asoft-launch of an eye cream product under the Obagi ELASTIderm brand name inmid-October 2006, limited to our aesthetic sales force and targeted forexisting accounts. In February 2007, we announced the formal launch of anELASTIderm Eye Therapy system, including both the eye cream and a new eye gelproduct.

We are also evaluating the use of future ELASTIdermproducts on other areas of the body which may help the body’s own naturalability to increase epidermal thickness, augment hypodermal fat and increaseelastin levels by supplying increased local concentrations of natural mineralactives to the relevant tissue, thereby improving the elasticity and skin tone.These areas may include the neck, hands, full face, arms and other areas of thebody. However, there can be no assurance that additional products will besuccessfully developed in the future. The commercial acceptance of the recentlyintroduced product cannot yet be determined, and there can be no assurance thatadditional products will be successfully developed in the future.

*Clinicaldevelopment.**  *Aneight-week treatment, single blind clinical study was conducted with 33subjects to determine the efficacy of our ELASTIderm product which contains abi-mineral complex known as “copper zinc manonate.” The primary endpoints wereappearance in under eye skin elasticity (Cutometer® Evaluation), fine linewrinkles (Skin Replica Analysis) and moisturization (Corneometer® Evaluation). Twicedaily application of this novel bi-mineral complex resulted in significantimprovements in elasticity in as early as week 2. Improvements in elasticityincreased with each successive visit, with a 

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peak 46% improvementrelative to baseline at week 9. P values in each week of the study ranged from..01 to .001, and were considered statistically significant.

A significant reduction inthe number of coarse periorbital (skin around the eyes) wrinkles was alsoevident, in objective measurements of wrinkles using soft silicone impressions,which showed a maximal reduction of 16% (p ≤ 0.05) at week nine. Subjectivefeedback further showed a 214% increase, from baseline, in the number ofsubjects that considered their periorbital wrinkles to be not perceptible ormild to barely noticeable at week nine. Moreover, standardized digitalphotography demonstrated visible improvements in the appearance of periorbitalfine lines and wrinkles in as little as two weeks. Our clinical results provideobjective and subjective support that our novel bi-mineral complex waseffective at improving photodamaged (sun damaged) periorbital skin elasticityand fine lines and wrinkles. Previously mentioned quantitative measurements ofelasticity were supported by subjective feedback that demonstrated a 75%increase, from baseline, in the number of subjects that considered thelax/loose appearance of their periorbital skin to be non-existent or mild tobarely noticeable at week nine. 

***CLENZIderm M.D.TM—***Acne

*Marketopportunity.**  *Acneis an inflammatory disease of the skin that results from a blockage offollicles or pores, as a consequence of accumulating dead skin cells and sebum,together which create a perfect medium for bacteria. The bacterium, P.acne, isa gram positive anaerobic bacterium that colonizes the sebaceous follicles andis implicated in the pathogenesis of acne. The prescription topical anti-acnemarket primarily includes BPO as a single active ingredient, or monotherapyproduct, BPO combination products (with antibiotics), topical retinoids, suchas Retin-A, and topical antibiotics. Kalorama projects that the global marketfor prescription acne and rosacea drugs, including BPO, retinoids, andantibiotics, will increase 13% from $1.6 billion to $1.8 billion overthe five years from 2005 to 2010.

Currentformulations of BPO are emulsions, comprised of large, highly insolubleparticles which do not pass easily into the skin follicle to treat theunderlying causes of acne. As a result, the efficacy of existing formulationsof currently marketed BPO products is limited. We have developed proprietarytechnologies that we believe will increase the ability of BPO to penetrate theepidermis and compromised sebaceous follicle.

*ObagiCLENZIderm M.D.**  *We havedeveloped a system of products for acne treatment featuring a novel formulationof BPO which our clinical studies show to penetrate more readily into the skinfollicle than current creams or gels because it is in solution form (1/100th—1/1000thof the size of current particles). We believe that our solution-based acnesystem will be a more effective treatment for acne because a greater amount ofthe active ingredient, BPO, will penetrate the hair follicle to act on P.acnebacteria.

*Clinicaldevelopment.**  *Weconducted several clinical studies that demonstrated that our novel BPO aloneachieved greater intrafollicular and skin surface bactericidal activity (orkill) against P. acnes than both a prescription generic BPO formulation and aprescription BPO/antibiotic combination product. We also conducted arandomized, 2 week split face study to evaluate the efficacy of our acnetherapeutic system,  with our novel 5%BPO serum gel and 2% Salicylic Acid toner, compared to BenzaClin®, a commercialprescription BPO/antibiotic combination product. The primary efficacy endpointmeasured changes in inflammatory and non inflammatory lesions from baseline andat week 2. Our acne therapeutic system resulted in faster reduction in acnelesions than the BPO combination product, as demonstrated in week 1 results;23% lesion reduction versus 12% reduction in inflammatory lesions and 13%reduction in non inflammatory lesions versus 5%. After 2 weeks of treatment,our acne therapeutic system had achieved a greater reduction innon-inflammatory lesions (34%) than the prescription BPO/Clindamycincombination (21%) and a comparable reduction in inflammatory lesions (52% and50%, respectively). The 

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expert assessments showedthat 81% of the subjects improved from moderate or severe acne categories tomild, almost clear or clear.

Additionally, we conducted a 3 week, full-face, singlecenter, investigator blinded, randomized study with 41 subjects to evaluate theefficacy and tolerability of our CLENZIderm M.D. System with 3 different dosingregimens. All 3 dosing regimens showed statistically significant (P values lessthan .001) reductions in inflammatory and non-inflammatory lesion counts; 62%,68%, 73% respectively at day 21 for inflammatory lesions and 47%, 54%, 56% fornon inflammatory lesions. There was no statistical difference in lesionreduction between the 3 dosing regimens. All treatment regimens were welltolerated with mean levels of erythema, dryness, itching and irritation lessthan mild throughout the study.

We believe these studiesshow the efficacy of our novel BPO formulations in reducing P.acnes andclearing visible acne lesions on the skin. Additionally, in mid-November 2006,we conducted under the CLENZIderm M.D. brand name, a controlled experiencetrial with select dermatologists who currently prescribe the existing Obagisystems. Based on the results of that trial, we began a full commercial launchof the CLENZIderm M.D. anti-acne system in February 2007.

***Areas of future growth***

We believe that our Penetrating Therapeuticstechnology may be applicable in other skin health areas. We are currentlyscreening therapeutic candidates in related fungal infections,dermatitis/seborrhea, hair growth and topical hair removal. According toKalorama, in 2005 these therapeutic areas represented markets ranging from$500 million to over $2.8 billion in size.

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

We seek to demonstrate through clinical studies theimproved efficacy of various topical agents when used as part of our systems.We are conducting and plan to initiate numerous clinical studies to demonstratethe advantages of our products in both blinded, randomized controlled studiesand direct comparative studies. We will seek to conduct clinical studies thatprovide both clinically and statistically significant results. We will workwith leading researchers and clinicians in their respective fields ofapplications and markets. We intend to use these results in marketing ourproducts.

**Sales and marketing**

***Domestic.******  ***We believe weare the market leader in the physician-dispensed skin care channel with a 27%share and nearly three times the market share of the next largest competitor,according to a 2006 study by Kline & Co. As of December 31, 2006,we had approximately 4,400 active accounts in the United States. Each accounthas at least one licensed physician on-site and we estimate that there areapproximately 6,000 physicians in total practicing under these active accounts.This includes physicians on-site at a small but rapidly growing number ofmedical spas.

The U.S. market accounted for 82% of our net sales in2006. In the United States, we focus our sales and marketing efforts primarilytoward plastic surgeons, dermatologists and other physicians with an aestheticskin care focus using our direct sales force. As of December 31, 2006, wehad 109 sales, marketing and education specialists, including 96 dedicatedsales representatives and managers. We believe that we have sufficient salesrepresentation to enable us to effectively target the plastic surgeons,dermatologists and aesthetic skin care physicians who dispense skin careproducts in the United States. According to a 2006 Kline & Co. study,there were approximately 10,100 of these physicians in the United States.

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In addition to effective systems, we also offerturn-key practice building programs and patient events that help the physiciansgrow their practices. These resources help each physician practice improvetheir recurring patient visits and revenue streams.

Our marketing efforts have a dual focus. First, wemarket directly to physicians in an attempt to both create treatment awarenessand encourage the use of our products by both new and existing physicianclients. To support this effort, we use medical journal advertising, directmail, sales aids, video, CD and slide demonstrations, physician-to-physicianspeaker presentations, trade shows, reminder items, educational and trainingsupport, internet resources, and telemarketing. Second, we attempt to createand then build upon the relationships with our physician customers by marketingour products to their patients through their medical practices. To support thiseffort, we provide patient education booklets and videos, funding forcooperative advertising, training and direct assistance in patient seminars andother programs, continuous product education and direct to consumer advertisingand public relations programs for patient referrals.

In addition, our research and development staff isdesigning and coordinating clinical studies to support the application of ourexisting product lines in new markets and to enhance our current marketingefforts. We have conducted numerous studies with the Department of Dermatologyat the University of California, Irvine and Education and Research Foundation,Lynchburg, VA. In addition, we are currently in discussions with leadingdermatologists associated with numerous reputable institutions, to coordinateadditional clinical studies for new product applications and formulations. Webelieve evidence from our clinical studies may validate the performance of ourexisting products and provide a platform for the development of new productsand product applications.

***International.******  ***Internationalmarkets accounted for 18% of net sales in 2006. We address internationalmarkets through 12 international distribution partners that have sales andmarketing activities in approximately 35 countries outside of the UnitedStates, and two trademark and know-how license agreements for the drug storeand aesthetic spa channel of Japan. We target distribution partners who arecapable and willing to mirror our sales and distribution model in the UnitedStates and who have an established business and reputation in the physicianchannel. Much like our business model in the United States, these distributorsaddress their territories through direct sales representatives selling to physicians,or through alternative distribution channels, depending on regulatoryrequirements and industry practices. The sale of skin health and restorationproducts through physician offices is not as widely established internationallyas it is in the United States. For example, some of our more successfulinternational distribution partners include our partners in the Southeast Asia,the Middle East and the Philippines. In these territories, our partners utilizeObagi-branded medical centers to employ trained physicians for patient sales,as well as a training center to provide product and sales training to regionalphysicians and their staff. Separately, some of our distribution partners, suchas our partners for Mexico and Canada, leverage their existing complimentaryproduct offerings to gain rapid account penetration for Obagi Systems in theirterritories. International sales are diversified, and our largest individualmedical channel distribution partner purchased approximately $2.4 millionfrom us during 2006.

We intend to continue expanding our internationalpresence by entering into strategic relationships in key locations such asAsia, Europe and South America. We believe that there is potential forsignificant sales growth of our products in international markets due tocultural emphasis on overall skin health and appearance and the continueddevelopment and acceptance of surgical and non-surgical cosmetic proceduresthroughout many countries of the world.

***Licensing.******  ***Where thephysician-dispensed channel is underdeveloped we will look for alternativemodels to build a presence and brand awareness for our products. For example,in Japan we have pursued three separate distribution channels for our brand andproduct concepts. In 2002, we launched our first formal long-term relationshipin Japan by entering into a 10-year trademark and know-how license 

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agreement with Rohto tomarket and sell our Obagi-developed products in Japan. Rohto is a Japanesepharmaceutical manufacturer and distributor. Under our agreement, Rohto islicensed to manufacture and sell a series of OTC products under the Obagi brandname, including Obagi-C (a vitamin C based topical serum in variousconcentrations) in the Japanese drug store channel. Rohto’s Obagi brandedproducts achieved retail annual sales of over $57 million in 2006 throughapproximately 5,000 high-end drug stores. We have additional licensingarrangements in Japan as well to market and sell OTC product systems under theObagi brand, both for in-office use in facial procedures, as well as for saleas a take-home product kit. Separately, in early 2004, we entered into adistribution agreement with Koken Ltd., granting Koken exclusive rights todistribute certain prescription based Obagi Systems in the physician-dispensedchannel. Our strategic partners in Japan have engaged in aggressive direct toconsumer advertising, which we believe has raised consumer demand in Japanwhich creates greater brand awareness in the physician channel to the benefitof our core prescription lines. In 2006, these separate distribution channelsin Japan generated approximately $4.1 million in net sales for us.

We will continue to lookfor credible partners to address new geographies, and to evaluate mass marketchannel opportunities in countries where it make sense in order to drive brandawareness and more rapid overall market penetration.

**Manufacturing**

We believe our manufacturing processes are acompetitive advantage, which we have developed through years of experienceformulating skin care products. We maintain manufacturing scalability andflexibility by maintaining manufacturing with five qualified contractmanufacturers. For all of our proprietary product concepts, we also own therelated manufacturing processes, methods and formulations. In the fourthquarter of 2005, we invested in our own manufacturing facility in order todevelop the ability to manage and protect the manufacturing process withrespect to certain of our new product pipeline concepts. Currently, we plan touse this facility solely for the purpose of smaller scale product manufacturingin connection with new product technologies and smaller market introductionquantities. This facility will allow us to protect intellectual propertyrelated to our products in the initial stages unless and until we believe wecan transfer such know-how to third-party manufacturers with full protection ofrelated intellectual property.

We use only FDA compliant manufacturers who specializein the manufacture of prescription and OTC pharmaceutical and/or cosmeticproducts. These parties manufacture products pursuant to our specifications.All of these manufacturers are required by law and by our manufacturingstandards to comply with current Good Manufacturing Practice, or cGMP. Wepre-qualify and continually monitor our manufacturers for quality andcompliance. We also require documentation of compliance and quality from thosemanufacturers that we act as representative for in connection with thepromotion and sale of their products. For most of our key products, we have twoor more qualified manufacturers. Certain products, including some of our sunprotection products, are supplied by a single source. We have one supplier forour Healthy Skin Protection and Sun Block sunscreen products. That supplyarrangement can be terminated at any time, and there is no guarantee that wecould replace the aesthetic qualities or exact formulation of those sun screenproducts.

In addition, whilephysicians can and in many cases do write a prescription for tretinoin to befulfilled by a pharmacy in conjunction with our Obagi Nu-Derm System, we alsopurchase tretinoin directly from Triax Pharmaceuticals, LLC in order to providephysicians the option of dispensing tretinoin directly from the office alongwith the Obagi products. These products are currently purchased under afive-year product supply agreement, entered into in December 2005, whichalso provides Obagi with the right to develop Obagi branded product offerings.

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**Intellectualproperty**

Our success depends in part on our ability to obtainand maintain proprietary protection for our product candidates, technology andknow-how, to operate without infringing the proprietary rights of others and toprevent others from infringing our proprietary rights. Our policy is to seek toprotect our proprietary position by, among other methods, filing United Statesand foreign patent applications related to our proprietary technology,inventions and improvements that are important to the development of ourbusiness. We also rely on trade secrets, know-how, continuing technologicalinnovation and in-licensing opportunities to develop and maintain ourproprietary position.

We have pursued an aggressive trademark registrationpolicy as a means to achieve brand recognition and product differentiation inthe market. We own various U.S. and foreign trademark registrations andapplications and common law marks. In connection with developing new productsand product applications, we have filed more than 37 U.S. provisional andnon-provisional patent applications. We do not own any issued patents withclaims covering any of our Obagi Nu-Derm products.

We have also licensed certain patent applicationsowned by JR Chem LLC. We have relied on services provided by JR Chem LLC in thedevelopment of new products to address acne and skin elasticity products, undera five-year contract. We also have licensed the rights to four patents owned byAvon Products, Inc., one of which expires in 2008 while the remainingthree expire between 2013 and 2018, covering methods and formulations forstabilizing Vitamin C in a serum for facial skin benefits, which is in ourObagi-C Rx C-Clarifying serum, Professional-C 5% serum and Professional-C 10%serum. We entered into the license in June 2003, for an initial three-yearterm, 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, selland, in some cases, make products pursuant to license agreements with thirdparties. Such agreements contain provisions which require us to meetrequirements under these agreements, such as payment or royalty obligations, inorder to maintain the rights granted under the agreements.

Below is a table that includes the patents we licensethat are material to our business as of December 31, 2006:

| **Patent title**                                                                            | ** ** | **Country in which  patent is issued** | ** ** | **Licensor** | ** ** | **Expiration date of  patent/license** |
|---------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------|------------|----------------------------------------|
| Cosmetic Preparation Incorporating Stabilized Ascorbic  Acid                                |       | United States                          |       | Avon         |       | January 8, 2008                   |
| Use of Ascorbic Acid to  Reduce Irritation of Topically Applied Active Ingredients          |       | United States                          |       | Avon         |       | May 14, 2013                      |
| Ascorbic Acid  Compositions for Reducing Irritation of Topically Applied Active Ingredients |       | United States                          |       | Avon         |       | April 26, 2013                    |
| Stable Ascorbic Acid  Preparation for Topical Use                                           |       | United States                          |       | Avon         |       | September 10, 2018                |

 

**Certain MaterialAgreements**

***Triax Pharmaceuticals***

Under a product supplyagreement with Triax Pharmaceuticals, LLC, or 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 channel in theUnited States (including all territories of the United States). If  we do not purchase a minimum of 100,000 unitsof products each year in any combination of concentrations, we will lose ourexclusive selling rights in the United States. During the year ended December31, 2006, we met the minimum purchase requirements. Under the terms of the 

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agreement,we are required to pay Triax Pharmaceuticals a fixed price for the products,subject to volume discounts we may receive if we purchase a certain number ofproducts and those products are sold to our customers within 90 days. Thesevolume discounts are based on calendar year performance and applied tocumulative quarterly purchases. The initial term of our agreement isfive years, with an automatic renewal for a successive five year termunless written notice is provided by either party at least 120 days beforethe end of the current term. Each party has the right to terminate theagreement upon 30 days’ prior written notice in the case of materialbreach and failure to take action to cure such a breach within such 30 dayperiod. Each party also has the option to terminate the agreement by writtennotice if the other party ceases to carry on its business or becomes thesubject of any proceeding under state or federal law for the relief of debtorsor otherwise becomes insolvent, bankrupt or makes an assignment for the benefitof creditors, or upon the appointment of a receiver for the other party or thereorganization of the other party for the benefit of creditors.

***Jose Ramirez and JR Chem***

Pursuant to a consultant services and confidentialityagreement with Jose Ramirez and JR Chem LLC, or JR, we have hired JR to performresearch and development activities including product formulation, productdevelopment 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 withus or during the one year period thereafter if such inventions involve or arerelated to our actual or anticipated research or development, or incorporate orare based on any of our confidential information or ideas. We agreed to pay JRa minimum fee of $100,000 per year for five years plus reasonable and customaryexpenses incurred at our request in connection with the provision of suchservices, commencing on January 1, 2005, for this product formulation,product development and regulatory work. We also agreed to pay a tiered royaltyfor successful commercialization of products developed or identified by JRbased on annual net sales, with a maximum royalty paid per product, capped at$5.0 million per year. The tiered royalty payable for each new productwill be 3% on annual net sales from $0 to $50 million; 4% on annual netsales from $50 million to $75 million; and 5% on annual net salesabove $75 million.

We have a right of first refusal for the exclusivelicense of any and all of JR’s inventions related to skin healthcare that aredeveloped or reduced to practice by JR during the term of the agreement, butnot in connection with certain service activities documented in the agreementor certain various statements of work, that are not assignable to us under theterms of the agreement. We would pay a royalty fee for any such exclusivelicenses.

The initial term of the agreement is five years,starting in the beginning of 2005, and may be extended for up to two, one-yearrenewable terms with the mutual written agreement of each party within60 days prior to the expiration of the then-current term. We have theright to terminate the agreement at any time in our sole discretion with30 days’ notice by exercising an option to buy-out JR’s remaining serviceobligation for the then-current term. In our sole discretion, we may pay forthe buy-out option with our stock or a combination of stock and cash at a fairmarket valuation. We have the right to terminate the agreement, withouttriggering the buy-out option, upon 30 days’ notice for any violation byJR of this agreement, unless JR is able to cure such violation within such30 day period. We also have the right to immediately terminate theagreement, without triggering the buy-out option, if JR is convicted of afelony or other crime involving material harm to our standing or reputation,for JR’s nonfeasance or willful misconduct, for conduct that brings us intopublic disgrace or disrepute, or for continuous inattentiveness to JR’s dutiesafter written notice of the same. If we exercise our right to terminate theagreement, all of our obligations to JR, except for royalty obligations, shallcease immediately.

To date, pursuant to thisagreement, we have licensed six pending patent applications that cover novelmethods and formulations for the treatment of acne, which we plan on using asthe basis for our new acne 

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systemto be marketed under the CLENZIderm M.D.TM brand, including the first productlaunched in February 2007. We have also licensed three pending patentapplications dealing with composition of matter, wound healing and method ofanti-aging treatment, which we plan on using as the basis for our newELASTIdermTM System, including the first product launched in October 2006and the second product launched in February 2007.

***Avon***

Under a license agreementwith Avon Products, Inc., dated June 26, 2003, we have an exclusiveworldwide license to manufacture and sell skin care products containing anascorbic acid component directly to physicians and medical spas. Under theterms of the agreement, we also have a non-exclusive license to manufacture andsell such products directly to drug stores outside of the United States. Wehave agreed to pay Avon a non-refundable license issue fee of $400,000, payablein three installments. Additionally, we pay a non-refundable annual renewal feeof $100,000. We have the option to renew the agreement annually until the lastof the licensed patents expires on September 10, 2018. Each party, at itsoption, may terminate the agreement upon 45 days’ prior written notice inthe case of default in the performance of any obligation under the agreement bythe other party and failure to take action to cure such a default within such45 day period. If we become bankrupt or insolvent, or file a petitionfor bankruptcy, or if our business is placed in the hands of a receiver,assignee or trustee from which we cannot extract ourselves within120 days, or if we are liquidated or substantially all of our assets orshares are sold, exchanged or transferred, or in the event of a merger orconsolidation to which we are a party and to which Avon reasonably objects, theagreement shall immediately terminate without notice.

**Competition**

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

·       productefficacy and uniqueness;

·       brandawareness and recognition;

·       productquality, reliability of performance and convenience of use;

·       cost-effectiveness;

·       breadthof product offerings;

·       salesand marketing capabilities and methods of distribution;

·       resourcesdevoted to product education and technical support; and

·       speedof 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 marketingcapabilities and greater financial resources than we do. These competitors mayhave developed, or could in the future develop, new technologies that competewith our products or render our products obsolete. We are also likely toencounter increased competition as we enter new markets and as we attempt tofurther penetrate existing markets. Some of our competitors have in the pastand may in the future compete by lowering prices on their products. We mayrespond by lowering our prices, exiting the market or competing by investing inthe development of new, improved products.

We believe our directcompetitors in the physician-dispensed channel include BioMedic from La-RochePosay, TNS from Skin Medica, Inc., Kinerase from Valeant PharmaceuticalsInternational, various 

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productsfrom SkinCeuticals, a division of L’Oreal S.A., M.D. Forté and PREVAGEfrom Allergan, Inc., Vitamin C and various products from IS Clinical,and Neova from PhotoMedex, Inc.

We believe our indirectcompetitors which generally sell skin care products directly to consumersconsist of large cosmetic companies, including but not limited to The EsteeLauder Companies Inc., Helene Curtis Industries, Inc., L’Oreal S.A.,Matrix Essentials, Inc., a division of L’Oreal, Procter & GambleCompany, Neutrogena, a division of Johnson & Johnson, Revlon, Inc.and Unilever N.V. Other companies use medical devices to treat facialaesthetics.

Our acne product willcompete with Triaz from Medicis Pharmaceutical Corporation, Benzaclin fromDermik Laboratories, Inc., Brevoxyl and Duac from StiefelLaboratories Inc., Benzac® from Galderma Laboratories, L.P. and ZoDermfrom Bradley Pharmaceuticals, Inc. Our acne product will also indirectlycompete with OTC anti-acne products.

Our elasticity system hasdemonstrated clinical evidence of aiding the restoration of elasticity andmature elastin in aged skin. We currently know of no products which haveclinical evidence to support this claim. However, there are several productswhich claim to enhance elastin.

Our products also competewith current and future medical devices, such as lasers, which are or will bepositioned for a variety of skin enhancements such as facial rejuvenation,dermal thickening, acne and other uses. However, we believe our Obagi Systemsare complementary to many of these procedures.

**Government regulation**

Federal, state and localgovernmental authorities in the United States and other countries regulate,among other things, the testing, production, distribution and sale ofprescription and over-the-counter drugs and cosmetics. In the United States,the FDA, acting under the FDCA and other federal statutes and Agencyimplementing regulations, regulates products primarily on the basis of theirintended use, as determined by the labeling claims made for the product.

***FDA regulation ofcosmetics***

The FDCA defines cosmeticsas products and their components intended to be rubbed, poured, sprinkled, orsprayed on, introduced into, or otherwise applied to the human body or any partthereof for cleansing, beautifying, promoting attractiveness, or altering theappearance. Cosmetic products are not subject to FDA pre-market approvalauthority, although the FDA can take enforcement action for marketed cosmeticproducts that are adulterated or misbranded, including violations of productsafety requirements, use and quantity of ingredients, labeling and promotionand methods of manufacture. Additionally, the FDA monitors compliance ofcosmetic products through random inspections of cosmetic manufacturers anddistributors. The labeling of cosmetic products is subject to the requirementsof the FDCA, the Fair Packaging and Labeling Act and other FDA regulations.

We believe that many ofour products in the Obagi Nu-Derm, Obagi-C Rx, Obagi Professional-C, ELASTIdermTM,CLENZIderm M.D.TM and other product lines, as labeled and intended for use, fallwithin the FDA definition of cosmetics and therefore do not require pre-marketreview and approval. Cosmetics may be sold both over the counter and through aphysician’s office, subject to state laws governing the commercial practices ofphysicians.

***FDA regulation ofdrug products***

The FDCA defines drugs asproducts intended to cure, mitigate, treat or prevent a disease or to affectthe structure or any function of the human body. Drug products are subject tomore comprehensive safety and effectiveness requirements of the FDCA and itsimplementing regulations. In general, products falling within the FDCA’sdefinition of “new drugs” require pre-marketing clearance by the FDA. Productsfalling within the FDCA’s definition of “drugs” that are not “new drugs” andthat are generally recognized as 

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“safeand effective” for the indication for which they are being marketed generallydo not require pre-market review and approval from the FDA. Such drug productsare commonly commercialized under the FDA Compliance Policy Guide entitledMarketed New Drugs Without Approved New Drug Applications or Abbreviated NewDrug Applications and are subject to compliance with FDA regulations concerningmanufacture, labeling, distribution, and recordkeeping for drug products.

We market a number ofsunscreen products that are regulated by the FDA as OTC drug products subjectto 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 believeare not “new drug” products and that are generally recognized as safe andeffective for the indications for which they are being marketed. We also marketa number of products containing 4% hydroquinone that are currently not subjectto FDA pre-market approval. In August 2006, the FDA issued a proposed rule thatstated that OTC skin bleaching products containing hydroquinone and currentlymarketed outside the physician channel at 2% concentrations or less, were notgenerally recognized as safe and effective, were misbranded, and are new drugswithin the meaning of the FDCA. The FDA proposed that because of thecarcinogenic and ochronosis potential of hydroquinone, its use in skin bleachingdrug products should be restricted to prescription use only, and users of suchproducts should be closely monitored under medical supervision. The FDA alsowithdrew a tentative proposed monograph that concluded that hydroquinoneproducts were generally recognized as safe and effective and stated its intentto require New Drug Application approval for continued marketing ofprescription hydroquinone products at the time of publication of the finalrule. The FDA is presently reviewing public comments received in response tothe August 2006 Proposed Rule. Finally, our tretinoin prescription drugproduct offerings are licensed from and supplied by Triax Pharmaceuticals, LLC,which, through Spear Pharma, holds FDA approval of Abbreviated New DrugApplications, or ANDAs, for those products.

***FDA regulation of “newdrug” products***

The steps required beforea “new drug” may be marketed in the United States include (i) pre-clinicallaboratory and animal testing, (ii) submission to the FDA of anInvestigational New Drug, or IND, application which must become effectivebefore clinical trials may commence, (iii) adequate and well-controlledclinical trials to establish the safety and efficacy of the drug, (iv) submissionto the FDA of a New Drug Application, or NDA, and (v) FDA approval of theNDA prior to any commercial sale or shipment of the drug. An Abbreviated NewDrug Application, or ANDA, is required to be submitted and approved when thedrug product intended for commercialization is bioequivalent to an already approvedNDA product; an ANDA application does not need to repeat the clinical trialsthat were required for approval of the NDA, or reference listed drug. Inaddition to obtaining FDA approval for each product, each domesticdrug-manufacturing establishment must be registered with the FDA. Drug productmanufacturing establishments located in California also must be licensed by theState of California in compliance with separate regulatory requirements.

Pre-clinical testing isgenerally conducted on laboratory animals to evaluate the potential safety andthe efficacy of a drug. The results of these studies are submitted to the FDAas a part of an IND, which must be approved before clinical trials in humanscan begin. Typically, clinical evaluation involves a time consuming and costlythree-phase process. In Phase I, clinical trials are conducted with asmall number of subjects to determine the early safety profile, the pattern ofdrug distribution and metabolism. In Phase II, clinical trials are conductedwith groups of patients afflicted with a specific disease to determinepreliminary efficacy, optimal dosages and expanded evidence of safety. InPhase III, large-scale, multi-center, comparative trials are conductedwith patients afflicted with a target disease to provide sufficient data todemonstrate the efficacy and safety required by the FDA. The FDA closelymonitors the progress of each of the three phases of clinical trials and may,at its discretion, re-evaluate, alter, suspend or terminate the testing basedupon the data that have been accumulated to that point and its assessment ofthe risk/benefit ratio to the patient.

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*The OTC monographsystem*

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

OTC drug ingredients are classified by the FDA in oneof three categories: Category I ingredients which are deemed generallyrecognized as “safe and effective and not misbranded” for OTC use;Category II ingredients which are deemed “not generally recognized as safeand effective or would result in misbranding” for OTC use; andCategory III ingredients which are those for which “available data isinsufficient” to classify them in Category I or II. Based upon the resultsof ongoing studies, the FDA may reclassify all Category III ingredients asCategory I or Category II ingredients.

For most categories of OTC drugs not yet subject to afinal monograph, the FDA usually permits such drugs to continue to be marketeduntil a final monograph becomes effective, unless the drug will pose apotential health hazard to consumers. The FDA’s policy also generally appliesto prescription drugs containing the same active ingredients as a marketed OTCproduct for the same or similar uses as the OTC product.

Drugs subject to final monographs, as well as drugsthat are subject only to proposed monographs, are subject to various FDAregulations concerning, for example, manufacturing in accordance with cGMPs,general and specific labeling requirements and prohibitions against promotionfor conditions other than those stated in the labeling. Drug manufacturingfacilities are subject to FDA inspection, and failure to comply with applicableregulatory requirements may lead to administrative or judicially imposedpenalties.

The active ingredient inTolereen, hydrocortisone, the active ingredient in Bacitracin, bacitracin zincand the active ingredient in Sunblock, zinc oxide, are currently classified bythe FDA as Category I ingredients. We currently market these products andmust do so in accordance with FDA’s final monographs for their respectivetherapeutic categories.

*FDA enforcementdiscretion for marketed unapproved drug products*

The Obagi Nu-Derm Clear,Blender and Sunfader products and the Obagi-C Rx C-Clarifying Serum and C-NightTherapy products contain the active ingredient hydroquinone at a 4%concentration and are marketed as prescription drugs under the FDA CompliancePolicy Guide, or CPG, entitled Marketed New Drugs Without Approved New DrugApplications or Abbreviated New Drug Applications. These hydroquinone productsmust be administered under the supervision of a physician but are not subjectto prior FDA approval when formulated and labeled in accordance with guidelinesfor prescriber information under direction of a physician. 4% Hydroquinone isknown as a DESI II drug, as its active ingredient was marketed prior toFDA’s 1962 institution of drug effectiveness requirements. To date, the FDA hasnot required NDA approval for the continued marketing of hydroquinone. In itsAugust 2006 proposed rule, regarding OTC hydroquinone, the FDA indicatedits intent to require NDA approval for prescription 4% hydroquinone products.See risks related to regulatory matters beginning on page 17, and FDAregulation of drug products on page 94. If the FDA does change the statusof 4% hydroquinone to require an NDE, and if the FDA does not grant us timecomply with such new requirement as imposed, or if the FDA does not approve anNDA filed by us or a third party for 4% hydroquinone drug product, then we willno longer be able to rely on the CPG to market our Obagi Nu-Derm andObagi-C Rx Systems containing hydroquinone. FDA approval of a 4%hydroquinone drug product under an NDA may adversely affect our ability tocontinue to market our products under the CPG.

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*FDA regulation ofdrug manufacturing*

We and the third-partymanufacturers on which we rely for the manufacture of our products are subjectto requirements that drugs be manufactured, packaged and labeled in conformitywith cGMPs. To comply with cGMPs, manufacturers must continue to spend time,money and effort to meet requirements relating to personnel, facilities,equipment, production and process, labeling and packaging, quality control,recordkeeping and other requirements. The FDA periodically inspects drugmanufacturing facilities to evaluate compliance with cGMPs.

***FDA Regulation of Our Products and Product Candidates***

Thefollowing table summarizes the current status of the active ingredients in, FDApre-marketing approval (if any) required for, FDA regulatory category of, andlaunch date or expected launch date for our material products and productcandidates:

| **Product**                                       | ** ** | ** **                                                    | ** ** | **Main  Functioning or Active  Ingredients(1)** | ** ** | **FDA  Pre-Marketing  Approval  Required** | ** ** | **Product  Status(1)** | ** ** | **Date  Launched  /Expected  Launch Date** |
|---------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------|------------|------------------------|------------|--------------------------------------------|
| Obagi Nu-Derm Gentle Cleanser                     |       | Mild Cleansers                                                |       |                                            | No         |                                       |       | Cosmetic               |       | 1988                                       |
| Obagi Nu-Derm Foaming Gel                         |       | Mild Cleansers                                                |       |                                            | No         |                                       |       | Cosmetic               |       | 1988                                       |
| Obagi Nu-Derm Toner                               |       | Hamamelis Virginiana (Witch Hazel) Distillate                 |       |                                            | No         |                                       |       | Cosmetic               |       | 1988                                       |
| Obagi Nu-Derm Clear                               |       | Hydroquinone 4%                                               |       |                                            | No         |                                       |       | DESI II                |       | 1988                                       |
| Obagi Nu-Derm Exfoderm                            |       | Phytic Acid                                                   |       |                                            | No         |                                       |       | OTC                    |       | 1988                                       |
| Obagi Nu-Derm Exfoderm Forte                      |       | Glycolic Acid, Lactic Acid                                    |       |                                            | No         |                                       |       | Cosmetic               |       | 1988                                       |
| Obagi Nu-Derm Blender                             |       | Hydroquinone 4%                                               |       |                                            | No         |                                       |       | DESI II                |       | 1988                                       |
| Obagi Nu-Derm Sun Block SPF 32               |       | zinc oxide 18.5%                                              |       |                                            | No         |                                       |       | OTC                    |       | 2004                                       |
| Obagi Nu-Derm HSP SPF 35                     |       | Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%;                 |       |                                            | No         |                                       |       | OTC                    |       | 2002                                       |
| Obagi Nu-Derm Sunfader                            |       | Hydroquinone 4% Octyl Methoxycinnamate 7.5%,  Oxybenzone 5.5% |       |                                            | No         |                                       |       | DESI II                |       | 1984                                       |
| Obagi Nu-Derm Eye Cream                           |       | Mild Moisturizers                                             |       |                                            | No         |                                       |       | Cosmetic               |       | 1984                                       |
| Obagi-C Rx C-Cleansing Gel                        |       | Mild Cleansers                                                |       |                                            | No         |                                       |       | Cosmetic               |       | 2004                                       |
| Obagi-C Rx C-Exfoliating Day Lotion               |       | Glycolic Acid                                                 |       |                                            | No         |                                       |       | OTC                    |       | 2004                                       |
| Obagi-C Rx C-Clarifying Serum                     |       | Hydroquinone 4%                                               |       |                                            | No         |                                       |       | DESI II                |       | 2004                                       |
| Obagi-C Rx C-Therapy Night Cream                  |       | Hydroquinone 4%                                               |       |                                            | No         |                                       |       | DESI II                |       | 2004                                       |
| Obagi-C Rx C-Sungaurd SPF 30                 |       | Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%                  |       |                                            | No         |                                       |       | OTC                    |       | 2004                                       |
| Obagi Professional-C Serum                        |       | L Ascorbic Acid (Vitamin C) 5% to 20% concentrations          |       |                                            | No         |                                       |       | Cosmetic               |       | 2005                                       |
| Obagi Nu-Derm Tretinoin                           |       | Tretinoin 0.025% to 0.1%                                      |       |                                            | Yes        |                                       |       | ANDA                   |       | 2006(3)                                    |
| Obagi CLENZIderm M.D. Daily Care Foaming Cleanser |       | Salicylic Acid 2%                                             |       |                                            | No         |                                       |       | OTC                    |       | February 2007                         |
| Obagi CLENZIderm M.D. Pore Therapy                |       | Salicylic Acid 2%                                             |       |                                            | No         |                                       |       | OTC                    |       | February 2007                         |
| Obagi CLENZIderm M.D. Serum Gel                   |       | Benzoyl Peroxide 5%                                           |       |                                            | No         |                                       |       | OTC                    |       | February 2007                         |
| Obagi ELASTIderm Eye Cream                        |       | Mineral complexes                                             |       |                                            | No         |                                       |       | Cosmetic               |       | 2006                                       |
| Obagi ELASTIderm Eye Gel                          |       | Mineral complexes                                             |       |                                            | No         |                                       |       | Cosmetic               |       | February 2007                         |

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(1)             By definition, products classified as cosmetics do nothave active ingredients. For cosmetics, the main functioning ingredient islisted.

(2)             Product Status Definitions:

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

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DESI II products are defined as products that areconsidered drugs that require physician prescription, but are not subject toFDA pre-marketing approval as they are generally recognized as safe andeffective for their intended uses and are commercialized under an FDACompliance Policy Guide for marketed unapproved drugs, which includes DrugEfficacy Study Indication, or DESI drugs. ANDA products are defined as drugsthat have received FDA approval under an abbreviated new drug application; ouronly ANDA product requires physician prescription.

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

(3)             Obagi Nu-Derm Tretinoin is manufactured byTriax Pharmaceuticals, and was launched under the Obagi brand in 2006, however,we have been selling tretinoin supplied by Triax Pharmaceuticals under theSpear brand since 2003.

***Federal regulation of advertising and promotion***

The FDA regulates the advertisement of prescriptiondrug products. The U.S. Federal Trade Commission, or FTC, and state authoritiesregulate the advertising of OTC drugs and cosmetics, as well as exercisegeneral authority to prevent unfair or deceptive trade practices.

In addition to FDA restrictions on marketing ofprescription products, several other types of state and federal laws have beenapplied to restrict certain marketing practices in the pharmaceutical industryin recent years. These laws include anti-kickback statutes and false claimsstatutes. The federal healthcare program anti-kickback statute prohibits, amongother things, knowingly and willfully offering, paying, soliciting or receivingremuneration to induce or in return for purchasing, leasing, ordering orarranging for the purchase, lease or order of any healthcare item or servicereimbursable under Medicare, Medicaid or other federally financed healthcareprograms. This statute has been interpreted to apply to arrangements betweenpharmaceutical manufacturers on the one hand and prescribers, purchasers andformulary managers on the other. Violations of the anti-kickback statute arepunishable by imprisonment, criminal fines, civil monetary penalties andexclusion from participation in federal healthcare programs. Although there area number of statutory exemptions and regulatory safe harbors protecting certaincommon activities from prosecution or other regulatory sanctions, theexemptions and safe harbors are drawn narrowly, and practices that involveremuneration intended to induce prescribing, purchases or recommendations maybe subject to scrutiny if they do not qualify for an exemption or safe harbor.

Federal false claims laws prohibit any person fromknowingly presenting, or causing to be presented, a false claim for payment tothe federal government, or knowingly making, or causing to be made, a falsestatement to have a false claim paid. Recently, several pharmaceutical andother healthcare companies have been prosecuted under these laws for allegedlyinflating drug prices they report to pricing services, which in turn are usedby the government to set Medicare and Medicaid reimbursement rates, and forallegedly providing free product to customers with the expectation that thecustomers would bill federal programs for the product. In addition, certainmarketing practices, including off-label promotion, may also violate falseclaims laws. The majority of states also have statutes or regulations similarto the federal anti-kickback law and false claims laws, which apply to itemsand services reimbursed under Medicaid and other state programs, or, in severalstates, apply regardless of the payer.

Also, as part of the sales and marketing process,pharmaceutical companies frequently provide samples of approved drugs tophysicians. This practice is overseen by the FDA and other governmentalauthorities under the Prescription Drug Marketing Act and regulations that includerequirements concerning record keeping and control procedures.

Certain states, includingCalifornia, have also recently begun regulating the promotion of prescriptiondrug products and require compliance with annual certification and disclosurerequirements regarding our policies for drug promotion and the amount of moneywe spend per prescribing physician on drug promotion. Compliance with changingfederal and state laws and regulations on prescription product promotionrequires a great deal of time and effort.

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***Other government regulation***

We and our suppliers orthird-party manufacturers may also be subject to regulations under otherfederal, state, and local laws, including the Occupational Safety and HealthAct, the Environmental Protection Act, the Clean Air Act and import, export andcustoms regulations as well as the laws and regulations of other countries.

**Employees**

As of December 31,2006, we had 153 employees, all of whom were located in the United States. Ouremployees include 109 in sales and marketing, 19 in product development,manufacturing and distribution and 25 in administrative functions. Ouremployees are all non-unionized, and we believe our relations with ouremployees are good.

**ITEM 1A:**       RISKFACTORS

*An investment in our common stock involves a highdegree of risk. You should consider carefully the following risks and otherinformation contained in this Annual Report on Form 10-K before youdecide whether to buy our common stock. If any of the events contemplated bythe following discussion of risks should occur, our business, results ofoperations and financial condition could suffer significantly. As a result, themarket price of our common stock could decline, and you may lose all or part ofthe money you paid to buy our common stock.*

**Risks related toour business**

***Our revenues and financial results dependsignificantly on sales of our Obagi Nu-Derm System. If we are unable tomanufacture or sell our Obagi Nu-Derm System in sufficient quantities and in atimely manner, or maintain physician and/or patient acceptance of our ObagiNu-Derm System, our business will be materially and adversely impacted.***

To date, substantially allof our revenues have resulted from sales of our principal product line, ourObagi Nu-Derm System and related products. Our Obagi Nu-Derm System and relatedproducts accounted for approximately 72%, 72% and 68% of our net sales for theyear ended December 31, 2004, 2005 and 2006, respectively. Although we have introduced new products such asObagi-C Rx, and intend to introduce additional products, we expect sales of ourObagi Nu-Derm System and related products to account for a significant majorityof our sales for the foreseeable future. Because our business is highlydependent on our Obagi Nu-Derm System and related products, factors adverselyaffecting the pricing of, or demand for, these products could have a materialand adverse effect on our business. Additionally, our commercial successdepends in large part on our ability to sustain market acceptance of our ObagiNu-Derm System. If existing users of our products determine that our productsdo not satisfy their requirements, or if our competitors develop a product thatis perceived by patients or physicians to better satisfy their respectiverequirements, sales of our Obagi Nu-Derm System and related products maydecline, and our total net sales may correspondingly decline. We cannot assureyou that we will be able to continue to manufacture these products incommercial quantities at acceptable costs. Our inability to do so wouldadversely affect our operating results and cause our business to suffer.

***We face intense competition, in some cases fromcompanies that have significantly greater resources than we do, which couldlimit our ability to generate sales.***

The market for aestheticand therapeutic skin health products is highly competitive and we expect theintensity of competition to increase in the future. We also expect to encounterincreased competition as we enter new markets and as we attempt to penetrate existingmarkets with new products. We may not be able to compete effectively in thesemarkets, we may face significant pricing pressure from our competitors and 

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we maylose 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, adivision of L’Oreal S.A., Allergan, Inc., IS Clinical, and PhotoMedex, Inc.

We believe our indirectcompetitors, who generally sell skin care products directly to consumers,consist of large cosmetic companies, including but not limited to, The EsteeLauder 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 companiesoffering products used to enhance the skin’s appearance to physicians, such asCandela, Cool Touch, Cynosure, Lumenis, Reliant Technologies, Syneron andThermage.

***We may not be ableto successfully expand the use of our current product lines or develop newproducts.***

We are working to improve,extend and reformulate many of our existing products. Continued marketacceptance of our products will depend on our ability to successfully developadditional applications of our existing products. The development of additionalapplications will require significant commitments of personnel and financialresources and we cannot assure you that they will be successful. If theattempted extensions of our product lines are not commercially successful, ourbusiness will be adversely affected.

We are also developing newproduct lines by applying our Penetrating Therapeutics technology to newagents. We also have acquired rights to certain patents covering additionalmethods and formulations. New products, in various stages of development,include acne and skin elasticity products and systems. These developmentactivities, as well as clinical studies, which must be completed before theseproducts can be marketed and sold, will require significant commitments ofpersonnel and financial resources. We cannot assure you that we will be able todevelop new products or technologies in a timely manner, or at all. Delays inthe development or testing processes will cause a corresponding delay inrevenue generation from those products. Regardless of whether such new productsor 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 beable to recover such expenses.

We reevaluate ourdevelopment efforts regularly to assess whether our efforts to develop aparticular new product or technology are progressing at a rate that justifiesour continued expenditures. On the basis of these reevaluations, we haveabandoned in the past, and may abandon in the future, our efforts on aparticular product or technology. New products that we develop may not besuccessfully commercialized. If we fail to take a product or technology fromthe development stage to market on a timely basis, we may incur significantexpenses without a near-term financial return or any financial return.

***Our failure tosuccessfully in-license or acquire additional products and technologies wouldimpair our ability to grow.***

We intend to in-license,acquire, develop and market new products and technologies. Because we havelimited internal research capabilities, our business model depends in part onour ability to license patents, products and/or technologies from thirdparties. The success of this strategy also depends upon our ability and theability of our third-party formulators to formulate products under suchlicenses, as well as our ability to manufacture, market and sell such licensedproducts.

We may not be able tosuccessfully identify any new products to in-license, acquire or internallydevelop. Moreover, negotiating and implementing an economically viableacquisition is a lengthy and complex process. Other companies, including thosewith substantially greater financial, marketing and sales resources, maycompete with us for the acquisition of products. We may not be able to acquireor in-license the rights to such products on terms that we find acceptable, orat all. As a result, our ability to grow our business or increase our profitscould be adversely impacted.

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***Our marketed products and our products underdevelopment could be rendered obsolete by technological or medical advances.***

Our marketed products andour products under development may be rendered obsolete or uneconomical by thedevelopment of medical advances to treat the conditions that our products aredesigned to address. The treatment of skin conditions and the enhancement ofthe appearance of skin, which is what all of our products target, are thesubjects of active research and development by many potential competitors,including major pharmaceutical companies, such as Johnson & Johnsonand Galderma, specialized biotechnology firms, such as Allergan and Medicis,universities and other research institutions. Competitive advances may alsoinclude the potential development of new laser or radio frequency therapiesbeing developed by manufacturers such as Candela, Syneron and Thermage, aimedat treating hyperpigmentation and photo-damaged skin. While we intend to expandour technological capabilities to remain competitive, research and development byothers may render our technology or products obsolete or noncompetitive orresult in treatments superior to any therapy we develop, as our competitors maydevelop and patent products which are better than ours, which could harm ourcompetitive position.

***If we lose key personnel or are unable to attract andretain other qualified personnel, we may be unable to execute our business planand our business would be materially adversely affected.***

As of December 31,2006, we had 153 employees. Our success depends on our continued ability toattract, retain and motivate highly qualified management, business development,sales and marketing, product development and other personnel. In the future wemay not be able to recruit and retain qualified personnel, particularly forsenior sales and marketing and research and product development positions dueto intense competition for personnel among businesses like ours, and thefailure to do so could have a significant negative impact on our future productsales and business results. Our success depends in large part on the effortsand abilities of Steven Carlson, our Chief Executive Officer, Stephen Garcia,our Chief Financial Officer, Curtis Cluff, our Executive Vice President ofCorporate Development, and David Goldstein, our Executive Vice President ofSales, as well as other members of our senior management and our scientific andtechnical personnel. Although we have agreements with certain of these officersthat contain certain provisions related to severance and bonus payments, asidefrom Mr. Carlson, we have not entered into employment agreements with anyof these officers. 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 ourexecutive officers that would compensate us for the loss of their services. Ifwe lose the services of one or more of these individuals, finding a replacementcould be difficult, may take an extended period of time and could significantlyimpede the achievement of our business objectives. This may have a materialadverse effect on our results of operations and financial condition.

***To sustain our continued growth, we will need toincrease the size of our organization, and we may encounter difficultiesmanaging our growth, which could adversely affect our results of operations.***

If we are able tosuccessfully develop additional products and extend the use of our currentproducts, we may experience growth in the number of our employees and the scopeof our operations. To the extent that we acquire and launch additionalproducts, the resulting growth and expansion of our sales force will place asignificant demand on our financial, managerial and operational resources.Since many of the new products or systems we are working on may involve newtechnologies or entering new markets, we may not be able to accurately forecastthe number of employees required, the timing of their hire or the associatedcost. The extent of any expansion we may experience will be driven largely bythe success of our new products and systems. As a result, management’s abilityto project the size of any such expansion and its cost to the company islimited by the following uncertainties: (i) we will not have previouslysold any of the new products and technologies and the ultimate success of thesenew products and technologies is 

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unknown;(ii) we will be entering new markets; and (iii) the costs associatedwith any expansion will be partially driven by factors that may not be fully inour control (e.g., timing of hire, market salary rates). Subject to theseuncertainties, we believe that our current business plan may require us to hirebetween 30 and 40 new employees within the next 12 months at anincremental cost of between $3.0 million and $4.0 million. Due to theuncertainty surrounding the new product lines, this estimate may prove to beincorrect, and our costs could be significantly higher. Our success will alsodepend on the ability of our executive officers and senior management tocontinue to implement and improve our operational, information management andfinancial control systems, particularly in light of our status as a newlypublic company subject to the reporting requirements of the Securities ExchangeAct of 1934, or the Exchange Act, and to expand, train and manage our employeebase. Our inability to manage growth effectively could cause our operatingcosts to grow even faster than we are currently anticipating and adverselyaffect our results of operations.

***Because we have limited research and developmentcapabilities, we will be dependent on third parties to perform research anddevelopment for us.***

We have limited internal research and developmentcapabilities and currently outsource all of our product research anddevelopment to third-party research labs. In particular, we have licensedpatents that may issue under certain patent applications filed by JR Chem LLC,and have relied heavily on services provided by JR Chem LLC in the developmentof new products to address acne and skin elasticity. We have receivedsufficient support from our third-party research labs to drive our current newproduct development, and we expect to continue to rely on third parties toresearch and develop new products.

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

Reliance on third-party research and development labsentails risks to which we would not be subject if we performed the research anddevelopment ourselves, including reliance on the third party for maintainingthe confidentiality of the proprietary information relating to the product beingdeveloped and for maintaining quality assurance, the possibility of breach ofthe research and development agreement by the third party, and the possibilityof termination or non-renewal of the agreement by the third party.

Dependence upon thirdparties for the research and development of our future products may limit ourability to commercialize and deliver products on a timely and competitivebasis.

***Because we currently have limited commercialmanufacturing capabilities, we will continue to be dependent on third partiesto manufacture products for us for some time.***

We have limited commercial manufacturing experienceand currently outsource all of our non-Benzoyl Peroxide product manufacturingto third-party contract manufacturers. Although we have received sufficientmaterial from our manufacturers to meet our current needs, we do not havelong-term contracts with most of these third parties. Triax Pharmaceuticals,LLC is our sole supplier and manufacturer of tretinoin pursuant to a contractthat has an initial termination in 2010. The termination of that agreement orany loss of services under that agreement would be difficult for us to replace.We expect to continue to rely on third parties to produce materials requiredfor clinical trials and for the commercial production of our products.

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

Reliance on third-party manufacturers entails risks towhich we would not be subject if we manufactured products ourselves, includingreliance 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 thirdparty.

We have developed manufacturing dedicated to theproduction of our CLENZIderm M.DTM Serum Gel. We may expand the capabilities ofthat manufacturing site and may in the future elect to manufacture certain newproducts developed or certain existing products without the assistance of thirdparties. However, in order to make that election, we will need to investsubstantial additional funds and recruit qualified personnel in order tooperate our development manufacturing facility on a commercial basis. There canbe no assurance that we will successfully manufacture our own products, and ifwe are not able to make or obtain adequate supplies of our products, it will bemore difficult for us to launch CLENZIderm M.D.TM, or other new products andcompete effectively.

Dependence upon thirdparties for the manufacture of our products may reduce our profit margins, orthe sale of our products and may limit our ability to develop and deliverproducts on a timely and competitive basis.

***Our growth may suffer if an economic downturn in anyof our major markets inhibits people from spending their disposable income onaesthetic and skin health products.***

Our growth dependssignificantly on continued economic growth in the markets where we sell ourproducts. Because many treatments in which our products are used are consideredcosmetic in nature, they are typically paid directly by the patient out ofdisposable income and are not subject to reimbursement by third-party payerssuch as health insurance organizations. As a result, an economic downturn inany of our major markets, such as North America, the Pacific Rim and the MiddleEast, could have an adverse effect on the sales and profitability of ourproducts.

***Our products may cause undesirable side effects thatcould limit their use, require their removal from the market or prevent furtherdevelopment.***

The most common side effects associated with ourtherapeutic products are temporary redness, stinging, burning sensation, skinpeeling, flaking, acne flare-ups and photo-sensitivity normally experiencedwithin approximately the first ten weeks of use. While these side effectsgenerally are not severe, they may limit the use of our products, particularlyif physicians or patients perceive that the risks or discomfort outweigh thebenefits or if they perceive that the side effects of competitive products areless significant.

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

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

In August 2006, the FDA issued a proposed rule whichcites some evidence that hydroquinone may be a carcinogen, if orallyadministered, and may be related to a skin condition called ochronosis, whichresults in the darkening and thickening of the skin, and the appearance ofsmall bumps and grayish-brown spots. Hydroquinone is an active ingredientcontained in our Obagi Nu-Derm Clear, Obagi Nu-Derm Blender and Obagi Nu-DermSunfader products, which are part of our Obagi Nu-Derm System, and in ourObagi-C Rx C-Clarifying Serum and Obagi-C Rx C-Night Therapy products, whichare part of our Obagi-C Rx System. The FDA also concluded that it could not rule outthe potential carcinogenic risk from topically applied hydroquinone. Afterfurther review of the evidence cited in the notice, or information provided inthe public comments on the proposed rule, or if additional evidence of canceror ochronosis, or other side effects associated with any of our products wereto be reported to or observed by the FDA or other regulatory authorities, wecould be required to suspend the marketing of our products that containhydroquinone, conduct additional safety tests and potentially cease the sale ofaffected products, which would harm our business. In addition, patients whoexperience side effects from our products may bring product liability claimsagainst us.

All of our products whichcontain hydroquinone are prescription-based. The FDA is considering regulatingall hydroquinone products, including prescription-based hydroquinone products,as new drugs, and may conclude that the continued use of prescription-basedhydroquinone products will require the submission and approval of an NDA. If weare 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 whilewe 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 ourproducts during the NDA process, and we may be required to suspend marketing ofour prescription-based hydroquinone products until such time as an NDA isapproved. In addition, there can be no assurance that any NDA we submit for ourprescription-based hydroquinone products will be approved. If we are requiredto 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 ourproducts.***

Our business exposes us tothe risk of product liability claims that are inherent to the development,clinical testing and marketing of aesthetic and skin health products. Theselawsuits may divert our management from pursuing our business strategy and maybe costly to defend. In addition, if we are held liable in any of theselawsuits, we may incur substantial liabilities and may be forced to limit orforgo further commercialization of those products. Although we maintain generalliability and product liability insurance in an amount that we believe isreasonably adequate to insulate us from potential claims, this insurance maynot fully cover potential liabilities. In addition, our inability to obtain ormaintain sufficient insurance coverage at an acceptable cost or to otherwiseprotect against potential product liability claims could prevent or inhibit thecommercial production and sale of our products, which could adversely affectour business.

***We are subject to risks associated with doing businessinternationally.***

Our internationalsales currently depend upon the marketing efforts of and sales by certaindistributors and licensees, particularly Rohto Pharmaceuticals, a licensee ofcertain of our trademarks and products for the retail drug store channel inJapan, from whom we receive royalties that accounted for 4% of our net salesand 5% of our gross margin in 2006. Because incremental costs associated withthis agreement are minimal, a material decline in licensing revenues from ortermination of this agreement would have a material adverse effect on our netincome. While no other international distribution or 

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licensepartner accounted for more than 4% of our net sales in 2006, our business issubject to certain risks inherent in international business, many of which are beyondour control. These risks include:

·       adversechanges in tariff and trade protection measures;

·       unexpectedchanges in foreign regulatory requirements;

·       potentiallynegative consequences from changes in tax laws;

·       thepotential business failure of one or more of our distribution partners;

·       changingeconomic conditions in countries where our products are sold or manufactured inother countries;

·       exchangerate risks;

·       potentialpolitical unrest and hostilities;

·       differingdegrees of protection for intellectual property; and

·       difficultiesin coordinating foreign distribution.

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

***Potential business combinations could requiresignificant management attention and prove difficult to integrate with ourbusiness, which could distract our management, disrupt our business, dilutestockholder value and adversely affect our operating results.***

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

·       failureto integrate management information systems, personnel, research anddevelopment and marketing, operations, sales and support;

·       disruptionof our ongoing business and diversion of management’s attention from otherbusiness matters;

·       potentialloss of the acquired company’s customers;

·       failureto develop further the acquired company’s technology successfully;

·       unanticipatedcosts and liabilities; and

·       otheraccounting consequences.

In addition, we may notrealize benefits from any business combination we may undertake in the future.If we fail to successfully integrate such businesses, or the technologiesassociated with such business combinations into our Company, the revenue andoperating results of the combined company could be adversely affected. Anyintegration process would require significant time and resources, and we maynot be able to manage the process successfully. If our customers are uncertainabout our ability to operate on a combined basis, they could delay or cancelorders for our products. We may not successfully evaluate or utilize theacquired technology or accurately forecast the financial impact of acombination, including accounting charges or volatility in the stock price ofthe combined entity. If we fail to successfully integrate other companies withwhich we may combine in the future, our business could be adversely affected.

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**Risks related toregulatory matters**

***Our ability to commercially distribute our productsand our business may be significantly harmed if the regulatory environmentgoverning our products changes, if the FDA takes enforcement action against usor our competitors marketing similar products, or if a third party obtains FDAapproval of an NDA, for 4% hydroquinone for the same uses for which we marketour hydroquinone products.***

The FDA and comparable agencies of other countriesregulate our products. In the United States, FDA regulations govern, amongother 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 andfailures, and distribution.

In addition, the Obagi Nu-Derm and Obagi-C Rx Systemscontain products that include 4% hydroquinone as an active ingredient and aremarketed in the United States without an FDA-approved marketing application. Webelieve that these products are not currently subject to FDA pre-market approval.In August 2006, the FDA issued a proposed rule that, if adopted inits current form, would establish that OTC skin bleaching drug products, suchas hydroquinone, are not generally recognized as safe and effective and aremisbranded, and could seek to require NDAs for new products using skinbleaching drug products, including prescription skin bleaching drug products.The FDA has indicated that upon adoption of the final rule it intends toconsider all skin bleaching drug products, whether currently marketed on aprescription or OTC basis, to be new drugs requiring an approved NDA forcontinued marketing. This may require us to withdraw the Obagi Nu-Derm andObagi-C Rx Systems until required clinical trials are performed and new drugapprovals are obtained, in effect foreclosing us from selling the Obagi Nu-Dermand Obagi-C Rx Systems. If we are required to seek new drug approval for theseproducts, our attention and resources will be dedicated to the process ofobtaining new drug approval, which may be time-consuming and expensive. Inaddition, we may not successfully obtain such approval. If we are unable toobtain such approval, we would be prohibited from selling the Obagi Nu-Derm andObagi-C Rx Systems, which would have a material adverse impact on our business.

Finally, as discussed above, the August 2006proposed rule cites some evidence that hydroquinone may be a carcinogenand may be related to ochronosis. If new studies are published that corroboratesuch evidence, or if based on further review of the current evidence, the FDAdetermines that such potential health risks warrant a ban on the sale of 4%hydroquinone, such determinations would have a material adverse effect on oursale of the Obagi Nu-Derm and Obagi-C Rx Systems. The FDA’s proposed rulemakingitself, and the concerns expressed therein relating to the use of hydroquinone,could have an adverse impact on the sales of our Obagi Nu-Derm and Obagi-C RxSystems. Certain of our competitors are attempting to use the FDA’s proposedrulemaking in order to convince physicians and patients not to use our productscontaining hydroquinone. To date, these marketing efforts by our competitorshave not had a negative impact on our sales levels. However, we cannot provideassurance that such marketing efforts will not have a negative impact on oursales levels in the future.

FDA and FTC regulations limit the type of marketingclaims we can make about our products. If the FDA determines that any of ourmarketing claims are false or misleading, or suggest a clinical benefit that isnot supported in the studies we have done, we may be required to cease makingthe challenged marketing claims, issue corrective communications, pay fines, orstop selling products until the incorrect claims have been corrected. FDA orFTC enforcement actions regarding promotional claims, including warningletters, would also divert management attention and create public relationsissues for our customers and opportunities for our competitors.

We are also subjectto review, periodic inspection and marketing surveillance by the FDA todetermine our compliance with regulatory requirements. Our manufacturingprocesses, any clinical trials that we perform, and our promotional activitiesare subject to ongoing regulatory obligations. If the FDA finds that we havefailed to comply with these requirements or later discovers previously unknown 

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problemswith our products, including unanticipated adverse events of unanticipatedseverity or frequency, or our manufacturer or manufacturing processes, it caninstitute a wide variety of enforcement actions, ranging from a public warningletter to more severe sanctions, including:

·       fines,injunctions and civil penalties;

·       recallor seizure of our products;

·       restrictionson our products or manufacturing processes, including operating restrictions,partial suspension or total shutdown of production;

·       denialof requests for approvals of product candidates;

·       withdrawalof approvals already granted;

·       disgorgementof profits; and

·       criminalprosecution.

Any of these enforcementactions could affect our ability to commercially distribute our products in theUnited States and may also harm our ability to conduct the clinical trialsnecessary to support the marketing, clearance or approval of these products andcould materially and adversely affect our business.

***New regulations could prohibit physicians fromdispensing our products directly.***

In our primary market, theUnited States, we market our products and systems directly to physicians todispense in their offices. Most of the products and systems we sell aredispensed by physicians directly to their patients in their offices, althoughsome patients choose to have prescriptions for our products filled bypharmacies instead of the treating physician. In the event state regulationschange to limit or prohibit the ability of physicians to dispense our productsdirectly to patients in their offices, patients may be required to purchase ourproducts in pharmacies, as opposed to directly from their physicians. If patientsare unable to purchase our products directly from physicians, it could resultin patients purchasing less of our product than they otherwise would, whichwould harm our business.

***Failure to obtain regulatory approvals in foreignjurisdictions would prevent us from marketing our products internationally.***

We market our productsoutside of the United States. In order to market our products in many non-U.S.jurisdictions we must obtain separate regulatory approvals and comply withnumerous and varying regulatory requirements. In others, we do not have toobtain prior regulatory approval but do have to comply with other regulatoryrestrictions on the manufacture, marketing and sale of our products. We may beunable to file for regulatory approvals and may not receive necessary approvalsto commercialize our products in any market. The approval procedure variesamong countries and can involve additional testing and data review. The timerequired to obtain approval in non-U.S. jurisdictions may differ from thatrequired to obtain FDA approval. The foreign regulatory approval process mayinclude all of the risks associated with obtaining FDA approval. We may notobtain foreign regulatory approvals on a timely basis, if at all. If we getapproval by the FDA, that does not ensure approval by regulatory agencies inother countries, and approval by one foreign regulatory authority does notensure approval by regulatory agencies in other foreign countries or by theFDA. The failure to obtain these approvals could harm our business.

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***If any of our third-party manufacturers do not operatein accordance with current Good Manufacturing Practices, we could be subject toFDA enforcement actions, including the seizure of our products and the halt ofour production.***

Third-party manufacturers thatwe currently rely on or will rely on in the future must continuously adhere tothe current cGMPs set forth in the FDA’s regulations and guidance documents. Incomplying with cGMPs, we and our third-party manufacturers must expendsignificant time, money and effort in development, testing, production, recordkeeping and quality control to assure that our products meet applicablespecifications and other regulatory requirements. The failure to comply withthese specifications and other requirements could result in an FDA enforcementaction, including the seizure of products and shutting down of production. Ourthird-party manufacturers may also be subject to comparable or more stringentregulations of foreign regulatory authorities. If our third-party manufacturersare unable to comply with cGMPs and applicable foreign regulatory requirements,our ability to develop, produce and sell our products could be impaired.

**Risks related tointellectual property**

***If we ar***e*** unable to protect our proprietaryrights, we may not be able to compete effectively.***

Our success dependssignificantly on our ability to protect our proprietary rights to thetechnologies used in our products. We rely primarily on maintaining theconfidentiality of our trade secrets and the protection of trade secret laws,as well as a combination of patent, copyright, and trademark (including commonlaw trademark) laws, and nondisclosure, confidentiality and other contractualrestrictions, to protect our proprietary technology. However, these legal meansafford only limited protection and may not adequately protect our rights orpermit us to gain or keep any competitive advantage. For example, our tradesecrets may be misappropriated by current or former employees, contractors, orparties with whom we partner, or may be inadvertently disclosed or obtained bybreach of a confidentiality agreement. We do not own any issued patents withclaims covering any of our Obagi Nu-Derm products. We have recently applied forseveral patents both in the United States and abroad. These patent applicationsmay not issue as patents at all, or the applications may not issue as a patentin a form that will be advantageous to us or may issue and be subsequentlysuccessfully challenged by others and invalidated or rendered unenforceable.Both the patent application process and the process of managing patent disputescan be time-consuming and expensive. Competitors may be able to design aroundour patents or develop products that provide outcomes comparable to ours even withoutmisappropriating our trade secrets. Although we have taken steps to protect ourintellectual property and proprietary technology, including entering intoconfidentiality agreements and intellectual property assignment agreements withour employees, consultants and advisors, such agreements may not be enforceableor may not provide meaningful protection for our trade secrets or otherproprietary information in the event of unauthorized use or disclosure or otherbreaches of the agreements. Further, the parties with whom we enter intoconfidentiality and intellectual property assignment agreements could disputethe ownership of intellectual property developed under these agreements. Inaddition, the laws of some foreign countries may not protect our intellectualproperty rights to the same extent as the laws of the United States.

***If we are involved in intellectual property claims andlitigation, the proceedings may divert our resources and subject us tosignificant liability for damages, substantial litigation expense and the lossof our proprietary rights.***

In order to protect or enforce our patent rights, wemay initiate patent litigation. In addition, others may initiate patentlitigation against us. Companies against whom we might initiate litigation or whomight initiate litigation against us may be better able to sustain the costs oflitigation because they have substantially greater resources. We may becomesubject to interference proceedings conducted in patent and trademark officesto determine the priority of inventions. There are numerous issued and pendingpatents in the skin care product field. The validity and breadth of suchpatents may involve complex legal 

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and factual questions forwhich important legal principles may remain unresolved. If third parties fileoppositions to our patent applications in foreign countries, we may also haveto participate in opposition proceedings in foreign tribunals to defend thepatentability of our filed foreign patent applications.

Litigation may benecessary for us to assert or defend against infringement claims, enforce ourissued and licensed patents, protect our trade secrets or know-how or determinethe enforceability, scope and validity of the proprietary rights of others. Ourinvolvement in intellectual property claims and litigation could:

·       divertexisting management, scientific and financial resources;

·       subjectus to significant liabilities;

·       resultin a ruling that allows our competitors to market competitive products withoutobtaining a license from us;

·       requireus to enter into royalty or licensing agreements, which may not be available onterms acceptable to us, if at all; or

·       forceus to discontinue selling or modify our products, or to develop new products.

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

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

We have licensed four patents, including patentsrelated to our Vitamin C serums, from Avon. We entered into the license inJune 2003, for an initial three-year term, and the license is renewed yearto 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 ourObagi-C Rx C-Clarifying serum, Professional-C 5% serum andProfessional-C 10% serum. If one or more of our licenses with Avon orlicenses we have with other parties terminate, if we violate the terms of ourlicenses or otherwise lose our rights to these patents, we may be unable tocontinue developing and selling our products that are covered by claims in thepatents we license. Our licensors or others may dispute the scope of our rightsunder any of these licenses. The licensors under these licenses may breach theterms of their respective agreements or fail to prevent infringement of thelicensed patents by third parties. Loss of any of these licenses for any reasoncould materially and adversely affect our financial condition and operatingresults.

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

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

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**Risks related toour capital requirements and finances**

***If we fail to generate sufficient cash flow from ouroperations, we will be unable to continue to develop and commercialize newproducts.***

We expect capitaloutlays and operating expenditures to increase over the next several years aswe expand our infrastructure, and our commercialization, clinical trials,research and development and manufacturing activities. We believe that our netcash provided by operating activities and existing cash and cash equivalentswill 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:

·       thelevel of research and development investment required to maintain and improveour competitive position;

·       thesuccess of our product sales and related collections;

·       ourneed or decision to acquire or license complementary businesses, products ortechnologies or acquire complementary businesses;

·       costsrelating to the expansion of the sales force, management and operationalsupport;

·       competingtechnological and market developments; and

·       costsrelating to changes in regulatory policies or laws that affect our operations.

As a result of thesefactors, we may need to raise additional funds, and we cannot be certain thatsuch funds will be available to us on acceptable terms when needed, if at all.In addition, if we raise additional funds through collaboration, licensing orother similar arrangements, it may be necessary to relinquish potentiallyvaluable rights to our future products or proprietary technologies, or grantlicenses on terms that are not favorable to us. If we cannot raise funds onacceptable terms, we may not be able to expand our operations, develop newproducts, take advantage of future opportunities or respond to competitivepressures or unanticipated customer requirements.

***Our quarterly operating results are variable, whichmay cause our stock price to decline.***

Our quarterlyresults of operations have varied in the past and are likely to varysignificantly in the future due to a number of factors, many of which areoutside of our control, including:

·       demandfor and market acceptance of our products;

·       thedevelopment of new competitive products by others;

·       changesin regulatory classifications of our products;

·       changesin physician or patient acceptance of the use of physician-dispensed products;

·       changesin treatment practices of physicians who currently prescribe our products;

·       delaysbetween our expenditures to acquire new product lines or businesses and thegeneration of revenues from those acquired products or businesses;

·       thetiming, release and competitiveness of our products;

·       increasesin the cost of raw materials used to manufacture our products;

·       themix of products that we sell during any time period;

·       increasedprice competition; and

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·       adversechanges in the level of economic activity in the United States and other majorregions in which we do business.

Due to the factorssummarized above, we do not believe that period-to-period comparisons of ourresults of operations are necessarily meaningful and should not necessarily berelied upon to predict future results of operations. It is also possible thatin future periods, our results of operations will not meet the expectations ofinvestors or analysts, or any published reports or analyses regarding ourcompany. In that event, the price of our common stock could decline, perhapssubstantially.

***Changes in, or interpretations of, accounting rules andregulations, such as expensing of stock options, could result in unfavorableaccounting charges or require us to change our compensation policies.***

Changes to, orinterpretations of, accounting methods or policies in the future may require usto reclassify, restate or otherwise change or revise our financial statements,including those contained in this Annual Report on Form 10-K. Forexample, the Financial Accounting Standards Board, or FASB has adopted a newaccounting pronouncement requiring the recording of expense for the fair valueof stock options granted. Beginning January 1, 2006, we have adoptedStatement of Financial Accounting Standards, or SFAS, No. 123R, *Share-Based Payment*, which required us tochange our accounting policy to record expense for the fair value of stockoptions granted, and as a result, our operating expenses will increase. We relyon stock options to motivate current employees and attract new employees. As aresult of the requirement to expense stock options, we may choose to reduce ourreliance on stock options as a recruitment or motivation tool. If we reduce ouruse of stock options, it may be more difficult for us to attract and retainqualified employees. However, if we do not reduce our reliance on stockoptions, our operating expenses may increase.

***Impairment of our significant intangible assets mayreduce our profitability.***

The costs of our goodwill,acquired product rights, distribution rights, and trademark are recorded asintangible assets and all, except for goodwill, are amortized over the periodthat we expect to benefit from the assets. As of December 31, 2006,acquired net intangible assets and goodwill comprised approximately 21% of ourtotal assets. We evaluate periodically the recoverability and the amortizationperiod of our intangible assets. Some factors we consider important inassessing whether or not impairment exists include performance relative toexpected historical or projected future operating results, significant changesin the manner of our use of the assets or the strategy for our overallbusiness, and significant negative industry or economic trends. These factors,assumptions, and changes in them could result in an impairment of ourlong-lived assets. Any impairment of our intangible assets may reduce ourprofitability and have a material adverse effect on our results of operationsand financial condition.

***Fluctuations in demand f***o***rour products could create inventory maintenance uncertainties and couldadversely affect our business.***

As a result of customer buying patterns, a substantialportion of our revenues has been recognized in the last month of each quarterand the last month of the year. We schedule our inventory purchases to meetanticipated customer demand. As a result, relatively small delays in thereceipt of manufactured products by us could result in revenues being deferredor lost. Our operating expenses are based upon anticipated sales levels, and ahigh percentage of our operating expenses are relatively fixed in the shortterm. Consequently, variations in the timing of sales could cause significantfluctuations in operating results from period to period and may result inunanticipated periodic earnings shortfalls or losses.

If we overestimate demand,we may be required to write off inventories and increase our reserves forproduct returns. If we underestimate demand, we may not have sufficientinventory of products to ship to our customers. Our products have expirationdates that range from 24 to 36 months from the date of 

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manufacture.We establish reserves for potentially excess, dated or otherwise impairedinventories. We may not be able to accurately estimate the reserve requirementthat will be needed in the future. Although our estimates are reviewedquarterly for reasonableness, our product return, rebate or chargeback activitycould differ significantly from our estimates. Judgment is required inestimating these reserves and we rely on data from third parties, including,but not limited to, distributor forecasts and independent market researchreports. The actual amounts could be different from our estimates, anddifferences are accounted for in the period in which they become known. If wedetermine that the actual amounts exceed our reserve amounts, we will record acharge to earnings to approximate the difference. A material reduction inearnings resulting from a charge could have a material adverse effect on ournet income, results of operations and financial condition.

***We may be sued by the estate of Austin McNamara, ourformer Chairman and Chief Executive Officer, and certain trusts established by Mr. McNamara.***

An Investor’s Rights Agreement between us and Mr. McNamaraand trusts established by Mr. McNamara contained a repurchase obligationunder which we were required, upon exercise of the repurchase right containedin the Investor’s Rights Agreement, to repurchase shares held by the trusts. Mr. McNamaradied in December 2006. Our repurchase obligation was to be subordinated toour Credit Agreement, which restricts payments on the liability for sharessubject to repurchase to a maximum of $1.5 million in any fiscal year, notto exceed $5.0 million in the aggregate while the Credit Agreement is inplace. On November 17, 2006, we tendered promissory notes in the aggregateprincipal amount of $28.2 million, and a cash payment of $1.5 millionas a partial prepayment of the notes, to the trusts established by Mr. McNamarain order to close on our repurchase of the shares held by the trusts inaccordance with the terms of the Investor’s Rights Agreement described above.The trusts refused to accept our tender of these payments and refused to tendertheir shares and close on our repurchase of the shares that they hold. As aresult, we believe that Mr. McNamara and the trusts are in material breachof their obligations under the Investor’s Rights Agreement.

As a further result of this material breach and forother reasons, we believe that we are no longer required to repurchase theshares held by such trusts pursuant to the Investor’s Rights Agreement and thatthe right of the trusts to require us to repurchase the shares held by thetrusts pursuant to the Investor’s Rights Agreement has expired and can nolonger be enforced against us. Mr. McNamara’s estate and the trusts haveclaimed that we have materially breached our obligation in the Investor’sRights Agreement to repurchase the shares held by the trusts. It is ourunderstanding that the primary claim asserted by Mr. McNamara’s estate andthe trusts to support their assertion of our breach is that the form of note wetendered did not comply with the terms of the Investor’s Rights Agreement. Webelieve that the form of note complied with the terms of the Investor’s RightsAgreement and that we have complied with all of our obligations to the trustsunder the Investor’s Rights Agreement. It is our position that the trusts arebound by the subordination provisions of the Investor’s Rights Agreement and bya subsequent subordination agreement entered into by them with respect to theCredit Agreement.

The trusts have agreed to be subordinated to the loansrepresented by the Credit Agreement, which limits payments to the trusts to amaximum of $1.5 million in any fiscal year, not to exceed $5.0 millionin the aggregate while the Credit Agreement is in place. The Investor’s RightsAgreement contains no exclusive requirements with respect to the terms of thenote to be granted thereunder, but does refer generally to principal, interest,prepayment and subordination and that the note be unsecured. The subordinatedpromissory notes tendered to the trusts were negotiated with and approved bythe lenders party to the Credit Agreement and it is our position that thesesubordinated promissory notes included payment provisions consistent with theterms of the Credit Agreement. We have been advised by the attorneyrepresenting the trusts that, among other unspecified objections, the trustsobject to the form of note tendered because it includes a provision providingfor tax withholding and offset with respect to taxes 

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that may be due inconnection with payments under the notes or upon the exercise of the optionsunderlying the shares to have been repurchased. In addition, the trusts objectto a provision prohibiting the trusts from prosecuting any claim challengingthe enforceability or priority of the senior indebtedness.

We can make no assurancesthat Mr. McNamara’s estate and the trusts will not sue us in order toassert the foregoing claims and additional claims against us for breach of ourobligations under the Investor’s Rights Agreement relating to the repurchase ofthe shares held by the trusts. There can be no assurance that we will be ableto successfully defend these claims or any other claims Mr. McNamara’sestate and the trusts may bring against us, including employment relatedclaims. If Mr. McNamara’s estate and the trusts were able to obtain ajudgment against us, such judgment could require us to make significant cashpayments, which we may not have the funds to pay, and may require us to makepayments in a manner that may cause us to be in default under our CreditAgreement, which would adversely affect our financial condition.

***We have debt and have the ability to incur substantialadditional debt. The principal and interest payment obligations of such debtmay restrict our operations and adversely affect our business.***

As of December 31, 2006, we have approximately$25.8 million of outstanding indebtedness. In addition, the covenants governingour credit facilities permit us to incur additional debt under certaincircumstances.

The incurrence ofsubstantial amounts of debt may:

·       makeit more difficult for us to satisfy our financial obligations;

·       requireus to dedicate a substantial portion of any cash flow from operations to thepayment of interest and principal due under our debt, which will reduce fundsavailable for other business purposes;

·       increaseour vulnerability to general adverse economic and industry conditions;

·       limitour flexibility in planning for, or reacting to, changes in our business andthe industries in which we operate;

·       placeus at a competitive disadvantage compared with some of our competitors thathave less debt; and

·       limitour ability to obtain additional financing required to fund working capital andcapital expenditures and for other general corporate purposes.

Our ability to satisfy ourobligations and to reduce our total debt depends on our future operatingperformance and on economic, financial, competitive and other factors, many ofwhich are beyond our control. Our business may not generate sufficient cashflow, and future financings may not be available to provide sufficient netproceeds to meet these obligations or to successfully execute our business strategy.

***The agreementsgoverning our credit facilities impose restrictions on our business that maylimit our business opportunities and hinder our ability to execute our businessstrategy.***

Our senior secured credit facilities contain, andother agreements we may enter into in the future may contain, covenantsimposing significant restrictions on our business. These restrictions mayaffect our ability to operate our business and may limit our ability to takeadvantage of potential business opportunities as they arise. These covenantsplace restrictions on our ability to, among other things, incur additionaldebt, create liens, make investments, enter into transactions with affiliates,sell assets, guarantee debt, declare or pay dividends, redeem common stock ormake other distributions to stockholders, and consolidate or merge.

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Our ability to comply withthese covenants may be affected by events beyond our control, includingprevailing economic, financial, and industry conditions. An event of defaultunder our debt agreements would permit our lenders to declare all amounts borrowedfrom them to be due and payable, together with accrued and unpaid interest. Ifwe were unable to repay debt to our senior lenders, these lenders could proceedagainst the collateral securing that debt.

***We will be subjectto the requirements of Section 404 of the Sarbanes-Oxley Act. If we areunable to comply with Section 404 in a timely manner it may affect thereliability of our internal control over financial reporting.***

Assessing our staffing and training procedures toimprove our internal control over financial reporting is an ongoing process.For the year ending December 31, 2007, pursuant to Section 404 of theSarbanes-Oxley Act, management will be required to deliver a report thatassesses the effectiveness of our internal control over financial reporting.Our auditors will be required to deliver an attestation report on management’sassessment of, and the operating effectiveness of, our internal control overfinancial reporting beginning either with the year ended December 31, 2007or the year ending December 31, 2008 depending upon whether we are anaccelerated or non-accelerated filer. We will not be able to determine if weare an accelerated filer until June 30, 2007. We have a substantial effortahead of us to implement appropriate processes, document the system of internalcontrol over key processes, assess their design, remediate any deficienciesidentified and test their operation. In the past, we have identified severalmaterial weaknesses in our internal controls over financial reporting. We haveremediated these identified material weaknesses, but we cannot give anyassurances that all material weaknesses have been identified or that additionalmaterial weaknesses will not be identified in the future in connection with ourcompliance with the provisions of Section 404 of the Sarbanes-Oxley Act of2002 beginning in the year ending December 31, 2007. The existence of oneor more material weaknesses would preclude a conclusion by management that wemaintained effective internal control over financial reporting.

We cannot be certain atthis time that we will be able to successfully complete the procedures,certification and attestation requirements of Section 404 or that we orour independent registered public accounting firm will not identify additionalmaterial weaknesses in our internal control over financial reporting. If wefail to comply with the requirements of Section 404 or if we or ourindependent registered public accounting firm identify and report a materialweakness, it may affect the reliability of our internal control over financialreporting.

***We will incurincreased costs as a result of being a public company.***

As a public company, wewill incur significant legal, accounting and other expenses that we did notincur as a private company. We will incur costs associated with our publiccompany reporting requirements. We also anticipate that we will incur costsassociated with recently adopted corporate governance requirements, includingrequirements under the Sarbanes-Oxley Act of 2002. We expect these rules andregulations to increase our legal and financial compliance costs and to makesome activities more time-consuming and costly. While we have taken steps toimprove our financial accounting organization and processes to date, we may stillneed to make additional changes, including adding staff in the areas of,internal controls and internal audit. We may also need to adopt and implementadditional policies and procedures to further strengthen our financialreporting capability. However, the process of designing and implementing aneffective financial reporting system is a continuous effort that will requireus to anticipate and react to changes in our business and the economic andregulatory environments. All of this will also require us to expend significantresources. We also expect these rules and regulations may make it moredifficult and more expensive for us to obtain director and officer liabilityinsurance, and we may be required to accept reduced policy limits and coverageor incur substantially higher costs to obtain the same or similar coverage. Weare currently evaluating these new rules, and we cannot predict or estimate theamount of additional costs we may incur or the timing of such costs.

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***Our board ofdirectors can issue preferred stock without stockholder approval of the termsof such stock.***

Our amended and restatedcertificate of incorporation authorizes our board of directors, withoutstockholder approval, to issue up to 10,000,000 shares of preferred stock inone or more series and to fix the rights, preferences, privileges, andrestrictions granted to or imposed upon the preferred stock, including votingrights, dividend rights, conversion rights, terms of redemption, liquidationpreference, sinking fund terms, subscription rights, and the number of sharesconstituting any series or the designation of a series. Our board of directorscan issue preferred stock with voting and conversion rights that couldadversely affect the voting power of the holders of common stock, withoutstockholder approval. As of December 31, 2006, no shares of preferredstock were outstanding and we have no present plan to issue any shares ofpreferred stock.

**Risks related toour common stock**

***The interests of our controlling stockholder mayconflict with the interests of our other stockholders.***

As of December 31, 2006, Stonington CapitalAppreciation 1994 Fund, L.P., or Stonington, beneficially owned approximately45.3% of the outstanding shares of our voting capital stock, without givingeffect to the exercise of outstanding options. As a result, Stonington hassignificant influence over the outcome of matters requiring stockholderapproval, including:

·       theelection and removal of our directors; and

·       theapproval of mergers, consolidations or the sale of all or substantially all ofour assets.

Currently, John A.Bartholdson, Albert J. Fitzgibbons III and Bradley J. Hoecker,all of whom serve on our board of directors, are employees of Stonington andserve on the board of directors of Stonington’s general partner. Thisconcentration of stock ownership could limit the ability of our otherstockholders to influence corporate matters and could have the effect ofdelaying, deferring or preventing a change in control of the company, orimpeding a merger or consolidation, takeover or other business combination or asale of all or substantially all of our assets. In addition, the significantconcentration of stock ownership may adversely affect the trading price of ourcommon stock due to investors’ perception that conflicts of interest may existor arise.

***Future sales of ourcommon stock, or the perception in the public markets that these sales mayoccur, could depress our stock price.***

Sales of substantial amounts of our common stock inthe public market, or the perception in the public markets that these sales mayoccur, could cause the market price of our common stock to decline. This couldalso impair our ability to raise additional capital through the sale of ourequity securities. As of December 31, 2006, we had 21,801,961 shares ofour common stock outstanding. In addition, we had outstanding options topurchase a total of 1,285,116 shares under our 2000 Stock Option/Stock IssuancePlan and 2005 Stock Incentive Plan of which 214,277 were vested. InFebruary 2007, we filed a Form S-8 registration statement toregister all the shares of common stock issuable under our equity incentiveplans, including the 2005 Stock Incentive Plan. Approximately 16,431,898 sharesof our common stock, on a fully-diluted basis assuming exercise of alloutstanding options, were subject to a 180-day “lock-up” period followingour initial public offering. Following the expiration of the 180-day“lock-up” period, the holders of those shares will generally be entitled tofreely transfer those shares. Moreover, JPMorgan Securities Inc. may, in itssole discretion and at any time without notice, release those holders from thesale restrictions on their shares. In addition to the adverse effect a pricedecline could have on holders of our common stock, such a decline could impedeour ability to raise capital or to make acquisitions through the issuance ofadditional shares of our common stock or other equity securities. Trustsestablished by Austin McNamara, which own approximately 1,875,001 shares of ourcommon stock, have not signed lock-up 

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agreements with theunderwriters. They are subject to a 180 day lock-up agreement under theterms of the Investor’s Rights Agreement with us. We have been advised by thetrusts that they do not believe such lock-up agreement is enforceable. Webelieve it is enforceable, but we cannot provide assurance that the trusts willnot seek to have a court declare such lock-up agreement to be unenforceable. Ifthey are successful, the trusts may be able to sell their shares prior to theexpiration of the 180 day lock-up period and claim damages against usresulting from our refusal to allow a sale of their shares prior to the end ofthe lock-up period.

Each of Stonington, the holder of approximately9,867,285 shares of our common stock, the Zein and Samar Obagi Family Trust,the holder of approximately 4,064,167 shares of our common stock, the McNamaraFamily Irrevocable Trust, the holder of approximately 416,667 shares of ourcommon stock, and the McNamara Family Trust, the holder of approximately1,458,334 shares of our common stock, has rights to demand the registration oftheir shares or include their shares in registration statements that we mayfile on our behalf or on behalf of other stockholders.

The partnership throughwhich Stonington holds its shares has a termination date of March 29,2007. Although Stonington may return the investment through a distribution ofshares to the fund’s investors, Stonington has also exited its investments inpublicly traded companies through a combination of sales under Rule 144,registered secondary offerings, and the distribution of shares to the fund’sinvestors. By exercising its registration rights and selling a large number ofshares, Stonington could cause the price of our common stock to decline, whichcould impede our ability to make acquisitions through the issuance ofadditional shares of our common stock. Furthermore, if we file a registrationstatement to offer additional shares of our common stock and have to includeshares held by Stonington or other holders of registration rights, it couldimpair our ability to raise needed capital by depressing the price at which wecould sell our common stock.

**ITEM 1B:  UNRESOLVED SEC STAFF COMMENTS**

None.

**ITEM 2:  PROPERTIES**

As of December 31,2006, we leased the following facilities:

| **Function**                          | ** ** | ** **        | ** ** | **Location** | ** ** | **Square feet** | ** ** | **Lease expiration** | ** ** |
|---------------------------------------|------------|-------------------|------------|--------------|------------|----------------------|------------|---------------------------|------------|
| Headquarters                          |       | Long  Beach, CA   |       |         | 16,000     |                 |       | July 2008            |       |
| Distribution  Center                  |       | Carson,  CA       |       |         | 21,000     |                 |       | October 2008         |       |
| Manufacturing                         |       | Milford,  CT      |       |         | 2,400      |                 |       | November 2008        |       |
| Marketing &  Training Center |       | Beverly Hills, CA |       |         | 2,100      |                 |       | July 2011            |       |

 

We believe our facilities are adequate for theirintended use and are sufficient for our current level of operations.

Our skin health and licensing activities are initiatedand coordinated from our Long Beach headquarters. Our skin health developmentefforts are based at our Long Beach headquarters, with development andmanufacturing facilities in Milford Connecticut. The lease for ourmanufacturing facility expires in November 2008. Our skin health trainingcenter for employees is also located at our Long Beach headquarters. Our cGMPcompliance training for distribution personnel and sales training for customerservice representatives is provided in Long Beach. In January 2007, weopened a marketing and training center in Beverly Hills to train physicians andaestheticians in the U.S. and internationally. This facility is leased from anaffiliate of Dr. Obagi.

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Our skin healthdistribution center is strategically located for quick, convenient and reliabledistribution with access to all major carriers in Southern California.

**ITEM 3:  LEGAL PROCEEDINGS**

On March 8, 2006, Austin McNamara, the formerchairman of our board, president and chief executive officer, filed a charge ofdiscrimination against us with the California Department of Fair Employment andHousing (“DFEH”). Mr. McNamara died in December 2006. Mr. McNamaraalleged that we demoted, harassed and otherwise discriminated against him dueto his purported physical disability and medical condition. Mr. McNamararequested an immediate right-to-sue notice. On March 20, 2006, the DFEHclosed its case. The DFEH did not conduct an investigation or make adetermination on the merits of the complaint. Mr. McNamara’s estate hasthe right to file a discrimination lawsuit in a state court action within oneyear of the DFEH’s letter closing its case. While Mr. McNamara did notallege a specific amount of damages, the remedies available under Californialaw include compensatory damages, as well as attorneys’ fees. Mr. McNamara  also threatened to file a wage claim with theCalifornia Labor Commissioner, though we are not aware of either Mr. McNamaraor his estate actually filing the claim. Mr. McNamara alleged that we didnot pay all wages, bonuses, and severance owed to him. Mr. McNamara servedas our chief executive officer from September 2001 until July 2005,and as our president from September 2001 until March 2005. He alsoserved on our board of directors and as chairman from September 2001 untilMay 2006. We cannot determine the outcome of these matters at this time.As discussed in the risk factor entitled “We may be sued by the Estate ofAustin McNamara, our former Chairman and Chief Executive Officer, and certaintrusts established by Mr. McNamara,” Mr. McNamara’s estate andcertain trusts he had established have claimed that we have materially breachedour obligation to repurchase shares of our common stock held by the trustpursuant to an Investor’s Rights Agreement. We have not been notified that anylegal action has been commenced with regard to this claim.

From time to time, we areinvolved in litigation and other legal matters in the normal course ofbusiness. Management does not believe that the outcome of any of these matterswill 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 SECURITYHOLDERS**

Our stockholders took the following actions by writtenconsent during the fourth quarter of fiscal year 2006:

On November 28, 2006, the holders of 15,281,452shares of our Common Stock voted for the amendment to our Certificate ofIncorporation to effect a 1-for-1.2 reverse stock split of ourCommon Stock in connection with our initial public offering. The holders of theremaining 2,517,731 shares of our outstanding Common Stock entitled to vote atthe time of this action by written consent abstained because we did not seektheir consent.

On November 28, 2006, the holders of 15,281,452shares of our Common Stock voted to approve the Amended and RestatedCertificate of Incorporation of the Company and the filing of the Amended andRestated Certificate of Incorporation upon the consummation of our initialpublic offering. The holders of the remaining 2,517,731 shares of ouroutstanding Common Stock entitled to vote at the time of this action by writtenconsent abstained because we did not seek their consent.

On November 28, 2006, the holders of 10,812,285shares of our Common Stock voted for the amendment and restatement of our 2005Stock Incentive Plan and the reservation of 1,500,000 shares of our commonstock for issuance under the Plan. The holders of the remaining 6,986,898shares of our outstanding Common Stock entitled to vote at the time of thisaction by written consent abstained because we did not seek their consent.

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On November 28, 2006, the holders of 10,812,285shares of our Common Stock voted, contingent upon the filing of our Amended andRestated Certificate of Incorporation with the Secretary of the State ofDelaware upon the consummation of our initial public offering, to elect each ofSteve R. Carlson, Albert J. Fitzgibbons III, John A.Bartholdson, Bradley J. Hoecker, Edward A. Grant, Albert F.Hummel and Ronald P. Badie to our Board of Directors to serve for aone-year term until the annual meeting of stockholders in 2007 and until theirrespective successors have been duly elected and qualified. The holders of theremaining 6,986,898 shares of our outstanding Common Stock entitled to vote atthe time of this action by written consent abstained because we did not seektheir consent.

On December 11, 2006, the holders of 10,812,285shares of our Common Stock voted for the amendment and restatement of our 2005Stock Incentive Plan to include a $1,000,000 limit on cash awards under thePlan. The holders of the remaining 6,986,898 shares of our outstanding CommonStock entitled to vote at the time of this action by written consent abstainedbecause we did not seek their consent.

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**PART II**

**ITEM 5:**               MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Information**

Our common stock is quotedon the Nasdaq Global Market under the symbol “OMPI” and has been quoted sinceour initial public offering on December 13, 2006. The initial publicoffering price of our common stock on December 14, 2006 was$11.00 per share. No sales of our common stock took place prior to December 14,2006. Between December 14, 2006 and December 31, 2006, inclusive, thehighest sales price of our common stock was $11.40 per share, and thelowest sales price of our common stock was $9.40 per share. Between January 1,2007 and March 12, 2007, inclusive, the highest sales price of our commonstock was $14.80 per share, and the lowest sales price of our common stockwas $8.75 per share. The closing price for our common stock on March 13,2007 was $11.67 per share.

**Holders**

The approximate number ofstockholders of record of our common stock was 1,021 as of March 6, 2007.Because many of the shares of our common stock are held by brokers and otherinstitutions on behalf of stockholders, we are unable to estimate the totalnumber of beneficial owners represented by these shareholders of record.

**Dividends**

During February 2005,we declared and paid a $3.60 per share common stock dividend, totalingapproximately $63.1 million, in cash. We currently intend to retain allavailable funds and any future earnings for use in the operation of ourbusiness and do not anticipate paying any cash dividends in the foreseeablefuture. Any future determination to declare cash dividends will be made at thediscretion of our board of directors, subject to compliance with certaincovenants under our credit facilities, which restrict or limit our ability todeclare or pay dividends, and will depend on our financial condition, resultsof operations, capital requirements, general business conditions, and otherfactors that our board of directors may deem relevant.

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**Securitiesauthorized for issuance under equity compensation plans**

Thefollowing table sets forth information regarding outstanding options and rightsand shares reserved for future issuance under our equity compensation plans asof December 31, 2006:

| **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     | ** ** |       | 1,285,116  |                                                                                                                                         |       |                                                                                                    | $          | 10.31                                                                                                                                                                                                               |       |   |   | 747,272 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                                         |       |                                                                                                    | —     |                                                                                                                                                                                                                |       |   | — |   |   |
| Total                                                       | ** ** |       | 1,285,116  |                                                                                                                                         |       |                                                                                                    | $          | 10.31                                                                                                                                                                                                               |       |   |   | 747,272 |   |   |

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(1)          The 2005 Plan providesthat the number of shares authorized for issuance will be cumulativelyincreased on January 1, 2007 and on each January 1 thereafter fornine years by the least of 500,000 shares, 3% of our outstanding commonstock as of the preceding December 31 and a number of shares determined byour board of directors or compensation committee.

**Recent sales ofunregistered securities**

Set forth below is information regarding the number ofshares of capital stock and options issued by us since September 2003.Also included is the consideration, if any, received by us for the securities. Webelieve that the transactions described below with respect to the issuance ofoption and restricted stock grants to our employees and directors and that the exerciseof the options were exempt from the registration requirements of the 1933 Actby reason of Rule 701 promulgated thereunder. In February 2007, wefiled a registration statement on Form S-8 to register future salesof the common stock to be issued upon exercise of the options and future issuancesof common stock under our 2005 Stock Incentive Plan.

As of September 30, 2006, we had granted andissued options to purchase 543,450 shares of our common stock with a weightedaverage price of $9.32 per share to a number of our employees, directors andconsultants pursuant to our 1997 Stock Option/Stock Issuance Plan and 2000Stock Option/Stock Issuance Plan. As of September 30, 2006, 1,628,525shares of common stock were issued upon exercise of these options.

During the quarter ended December 31, 2006, wegranted and issued options to purchase 750,000 shares of our common stock witha weighted average price of $11.00 per share to a number of our employees,directors and consultants pursuant to our 2005 Plan. As of December 31,2006, there were no shares of common stock that were issued upon exercise ofthese options.

During the quarter ended December 31,2006, we granted 2,728 shares of restricted stock to one of our independentdirectors pursuant to our 2005 Plan.

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**Performance Graph**

*The following information is not deemed to be ‘‘solicitingmaterial’’ or to be ‘‘filed’’ with the SEC or subject to the liabilities of Section 18of the Exchange Act, and the report shall not be deemed to be incorporated byreference into any prior or subsequent filing by the Company under theSecurities Act or the Exchange Act.*

ThePerformance Graph below represents a comparison of the total return of ourcommon stock, the NASDAQ Market Index and the SIC—Pharmaceutical Preparationsfor the period between December 14, 2006, and December 31, 2006. Thegraph assumes $100 was invested on December 14, 2006, and dividends arereinvested for the fiscal year ended December 31, 2006.

**COMPARISON OFCUMULATIVE TOTAL RETURNAMOUNG OBAGI MEDICAL PRODUCTS, INC.,NASDAQ MARKET INDEX AND SIC CODE INDEX**

**Use of Proceedsfrom sale of registered securities**

On December 19, 2006, we closed an initial publicoffering of our common stock consisting of 5,350,000 shares of commonstock. Of these shares, 4,000,000 were newly issued shares sold by us and1,350,000 were existing shares sold by the selling stockholders. The offeringwas effected pursuant to a Registration Statement on Form S-1 (File No. 333-137272), which the SECdeclared effective on December 13, 2006. J.P. Morgan Securities Inc.acted as the managing underwriter.

The public offering price was $11.00 per shareand $58.9 million in the aggregate. Underwriting discounts and commissionswere $0.77 per share and $4.1 million in the aggregate. Proceedsbefore expenses to us were $10.23 per share and $40.9 million in theaggregate. Proceeds, before expenses, to the selling stockholders were $10.23 pershare and $13.8 million in the aggregate.

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Thenet proceeds received by us in the offering were $38.1 million as follows:

| Aggregate  offering proceeds to the Company |   | $           | 44.0 million |   |
|---------------------------------------------|--------|-------------|--------------|--------|
| Underwriting  discounts and commissions     |   | 3.1 million |         |
| Finders fees                                |   | —      |         |
| Underwriter’s  fees                    |   | —      |         |
| Other fees and  expenses (estimated)        |   | 2.8 million |         |
| Total expenses  (estimated)                 |   | 5.9 million |         |
| Net proceeds to the  Company                |   | $           | 38.1 million |   |

 

We have used the netproceeds to us from our initial public offering to repay approximately$35.0 million of debt; and we intend to use the remainder for generalcorporate purposes.

**ITEM 6: SELECTEDFINANCIAL DATA**

The selected consolidated financial data set forthbelow are derived from our consolidated financial statements. The consolidatedstatements of income data for the years ended December 31, 2004, 2005, and2006, and consolidated balance sheet data as of December 31, 2005 and 2006,are derived from our audited consolidated financial statements for such yearsand as of such dates, which are included elsewhere in this Annual Report on Form 10-K.The consolidated statements of income data for the year ended December 31,2003, and consolidated balance sheet data as of December 31, 2004 arederived from our audited consolidated financial statements for such years andas of such dates. The consolidated statements of income data for the yearsended December 31, 2002, and the consolidated balance sheet data as of December 31,2002 and 2003, are derived from our unaudited consolidated financial statementsfor such years and as of such dates, which are not included in this AnnualReport on Form 10-K. The unaudited consolidated financial statementsinclude, in the opinion of management, all adjustments, consisting only ofnormal, recurring adjustments, that management considers necessary for a fairstatement of the results of those periods.

Theinformation in the following table should be read together with “Management’sdiscussion and analysis of financial condition and results of operations” andour consolidated financial statements and the related notes included elsewherein this Annual Report on Form 10-K.

| ** **                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | **(unaudited)**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Consolidated statements of  income data:**             | ** ** |                                       | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                |       |                                       | $          | 46,316 | ** ** |   | $ | 49,261 |   | $ | 56,256 |   | $ | 64,941 |   | $ | 77,996 |   |
| Income from  operations                                  |       |                                       | 13,078     | ** ** |   | 18,030 |   | 21,395 |   | 21,084 |   | 17,747 |   |
| Income from  operations attributable to common shares(1) |       |                                       |       | ** ** |   |   |   |   |   |   |   |   |   |
| Basic                                                    |       |                                       | $          | 0.88 | ** ** |   | $ | 1.11 |   | $ | 1.34 |   | $ | 1.20 |   | $ | 0.99 |   |
| Diluted                                                  |       |                                       | $          | 0.82 | ** ** |   | $ | 1.03 |   | $ | 1.24 |   | $ | 1.19 |   | $ | 0.98 |   |

 

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| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2002**              | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | **(unaudited)**       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Consolidated balance sheet  data:** | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                          |       | $                     | 34,397     |   | $ | 35,468 |   | $ | 48,704 |   | $ | 45,947 |   | $ | 52,961 |   |
| Long-term debt  less current portion  |       | 34                    |       | 44 |   | 30 |   | 63,195 |   | 23,052 |   |
| Redeemable  preferred stock           |       | $                     | 22,409     |   | $ | 22,175 |   | $ | 22,511 |   | $ | — |   | $ | — |   |
| Cash dividends declared and paid      |       | $                     | —     |   | $ | — |   | $ | — |   | $ | 63,088 |   | $ | — |   |
| Per share(1)                          |       | $                     | —     |   | $ | — |   | $ | — |   | $ | 3.60 |   | $ | — |   |

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(1)          On November 27, 2006,the Board of Directors of the Company approved an amended and restatedCertificate of Incorporation and amended and restated Bylaws in preparation fora contemplated initial public offering. This amended and restated Certificateof 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 theeffectiveness of the Company’s Registration Statement on Form S-1.All share and per share amounts included in our financial statements have beenadjusted to reflect this 1-for-1.2 reverse stock split for allperiods presented.

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**ITEM 7:**               MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*You should read the following discussion and analysisof our financial condition and results of operations together with ourfinancial statements and related notes appearing elsewhere in this AnnualReport on Form 10-K. Some of the information contained in thisdiscussion 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 businessand related financing, includes forward-looking statements that involve risksand uncertainties. You should review the “Risk Factors” section of this AnnualReport on Form 10-K for a discussion of important factors that couldcause our actual results to differ materially from the results described in orimplied by the forward-looking statements contained in the following discussionand analysis.*

**Overview**

We are a specialty pharmaceutical company focused onthe aesthetic and therapeutic skin health markets. We develop and commercializeprescription-based, topical skin health systems that enable physicians to treata range of skin conditions, including pre-mature aging, photo-damage, skinlaxity, hyperpigmentation, acne and soft tissue deficits, such as fine linesand wrinkles.

*Currentproducts.**  *Ourprimary product is the Obagi Nu-Derm System, which we believe is the onlyclinically proven, prescription-based, topical skin health system on the marketthat has been shown to enhance the skin’s overall health by correctingphoto-damage at the cellular level, resulting in a reduction of the visiblesigns of aging. The primary active ingredients in this system are 4%hydroquinone and OTC skin care agents. In April 2004, we introduced theObagi-C Rx System consisting of a combination of prescription and OTC drugs andadjunctive cosmetic skin care products to treat skin conditions resulting fromsun damage and the oxidative damage of free radicals. The central ingredientsin this system are 4% hydroquinone and Vitamin C. In October 2005, welaunched the Obagi Professional-C products, a complete line of proprietary,non-prescription products, which consists of Vitamin C serums used toreduce the appearance of damage to the skin caused by ultraviolet radiation andother environmental influences. In July 2006, we launched our Nu-DermCondition and Enhance System, for use in conjunction with commonly performedcosmetic procedures including Botox injections. In October 2006, welaunched our first product in the ELASTIdermTM product line, an eye cream forimproving the elasticity and skin tone around the eyes. We also markettretinoin, used for the topical treatment of acne in the United States, andObagi Blue Peel products, used to aid the physician in the application of skinpeeling actives.

*Futureproducts.**  *Wefocus our research and new product development activities on improving theefficacy of established prescription and OTC therapeutic agents by enhancingthe penetration of these agents across the skin barrier using our proprietarytechnologies collectively known as Penetrating Therapeutics. We introduced the CLENZIdermM.D.TM and ELASTIderm TM systemsto address acne and skin elasticity, respectively, based on positive interimclinical results, in February 2007; however there can be no assurance thatthese systems will be successful in the markets we compete. In addition, therecan be no assurance that we will be able to introduce any additional systemswithin these product lines.

*U.S.distribution.**  *Wemarket all of our products through our direct sales force in the United Statesprimarily to plastic surgeons, dermatologists and other physicians who arefocused on:

*Aesthetic skin care.*   Asof December 31, 2006, we sold our products to over 4,400 physician-dispensingaccounts in the United States, with no single customer accounting for more than5% of our net sales. Our current products are not eligible for reimbursement byMedicare or other third-party payors. We generated U.S. net sales of $52.9 millionduring the year ended December 31, 2005, and $63.9 million duringyear ended December 31, 2006.

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*International distribution.**  *We market our productsinternationally through 12 international distribution partners that have salesand marketing activities in approximately 35 countries outside of the UnitedStates. Much like our business model in the United States, these distributorssell our products through direct sales representatives to physicians, orthrough alternative distribution channels depending on regulatory requirementsand industry practices. We generated international net sales of$8.7 million during the year ended December 31, 2005, and$10.0 million during the year ended December 31, 2006.

*Licensing.**  *We market our products in theJapanese retail markets through a trademark and know-how license agreement withRohto Pharmaceutical Co., Ltd., or Rohto. Under our agreement, Rohto islicensed to manufacture and sell a series of OTC products under the Obagi brandname in the Japanese drug store channel, and we receive a royalty based uponsales of Obagi branded products in Japan by Rohto. Rohto’s Obagi brandedproducts are sold through approximately 5,000 high-end drug stores. We haveother licensing arrangements in Japan to market and sell OTC product systemsunder the Obagi brand, both for in-office use in facial procedures, as well asfor sale as a take-home product kit in the spa channel. We receive royaltiesbased upon these arrangements. We generated licensing revenue of$3.4 million during the year ended December 31, 2005, and$4.1 million during the year ended December 31, 2006.

*Sales growth.**  *Our total net sales have grown from$56.3 million for the year ended December 31, 2004 to$64.9 million and $78.0 million for the years ended December 31, 2005and 2006, respectively. Our sales growth has been driven primarily by continuedObagi Nu-Derm System sales growth fueled by the launch of Nu-Derm Condition andEnhance, Obagi-C Rx System sales following its launch in April 2004,Professional-C sales following its launch in October 2005 and ELASTIdermsales following its soft launch in October 2006. We believe that the keyfactors underlying the growth of our sales include:

·       *Our professional marketing efforts to physicians.  *Ourprofessional sales force targets physicians who are providing aesthetictreatments and educates them on how to best provide our products to theirpatients. Our professional sales force also provides education to physicians,aestheticians, other staff and patients about the benefits of promoting skinhealth. We have increased our sales force from 42 employees as of January 1,2004 to 96 employees as of December 31, 2006. We will continue to investin expanding our sales force as warranted by the success of new productofferings and continued core product growth.

·       *Strong growth in the aesthetic skin care market.  *In2005, the global skin care market was estimated to be $36.2 billion, ofwhich over 62% were facial skin care products, according to Global IndustryAnalysts, Inc., a market research firm. Additionally, the independentresearch firm, Kalorama Information, estimates that from 2005 to 2010, over70 million people in the United States will receive cosmetic facialprocedures for which they will pay over $60 billion. We believe thisreflects a growing desire and acceptance among the aging population to seek aestheticfacial products and procedures from their physicians. With our leading positionin the physician-dispensed channel, the clinically proven aesthetic benefits ofour products and the potential of our systems to enhance or complement manyother facial procedures, we believe we are well positioned to meet this growingpatient demand.

·       *Conducting clinical studies on our products.  *Wehave completed 27 clinical studies since 2003 to demonstrate the efficacy ofour products. We believe that these clinical studies provide our products addedscientific credibility in the physician-dispensed market. We are currentlyconducting five clinical studies on new and existing products and plan oninitiating four additional clinical studies by December 31, 2007.

·       *International.  *We have formaldistribution agreements with 12 distribution partners covering over 50countries and a trademark and product know-how license agreement in the OTCmarket of 

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Japan. Currently, thosedistributors have sales activities in approximately 35 countries, with growthin 2005 and 2006 coming primarily from the Middle East, Far East, Europe, andNorth America (excluding the United States).

*Resultsof operations.**  *Wecommenced operations in 1997, and as of December 31, 2006, we had anaccumulated deficit of $21.1 million. The accumulated deficit arose whenwe paid a $63.1 million common stock dividend in February 2005. At December 31,2004, we had accumulated earnings of $20.4 million. We reported net incomeof $9.0 million and $6.1 million for the years ended December 31,2005 and December 31, 2006, respectively.

*Seasonality.**  *Sales of our products havehistorically been higher between September and March. We believe this isdue to increased product use and patient compliance during these months. Webelieve this increased usage and compliance relates to several factors such as higherpatient tendencies toward daily compliance inversely proportionate to theirtendency to travel and/or engage in other disruptive activities during summermonths.

*Future growth.**  *We believe that our future growthwill be driven by increased direct sales coverage, ongoing marketing efforts tocreate increased awareness of the Obagi brand and the benefits of skin healthand new product offerings. We plan to continue to invest significant resourceson the commercialization of new applications of our current products, thecontinuing development of our pipeline products and the in-licensing oracquisition of new product opportunities. Our on-going profitability isprimarily dependent upon the continued success of our current productofferings.

**Critical accountingpolicies and use of estimates**

Our discussion and analysis of our financial conditionand results of operations is based upon our financial statements which havebeen prepared in accordance with accounting principles generally accepted inthe United States. The preparation of financial statements requires managementto make estimates and judgments that affect the reported amounts of assets andliabilities, sales and expenses, and disclosures of contingent assets andliabilities at the date of the financial statements. On a periodic basis, weevaluate our estimates, including those related to revenue recognition, salesreturn reserve, accounts receivable, inventory and goodwill and otherintangible assets. We use authoritative pronouncements, historical experienceand other assumptions as the basis for making estimates. By their nature, theseestimates are subject to an inherent degree of uncertainty. As a result, wecannot assure you that actual results will not differ significantly fromestimated results. Our significant accounting policies are further described inNote 2 to our audited consolidated financial statements included elsewherein this Annual Report on Form 10-K.

We believe the following critical accounting policiesaffect our more significant judgments and estimates used in the preparation ofour financial statements.

*Revenuerecognition.**  *Werecognize revenues in accordance with Securities and Exchange Commission (SEC)Staff Accounting Bulletin (SAB) No. 104, *RevenueRecognition in Financial Statements,* which provides guidance on therecognition, presentation and disclosure of revenue in financial statementsfiled with the SEC. SAB No. 104 outlines the basic criteria that must bemet to recognize revenue and provides guidance for disclosure related torevenue recognition policies. We recognize revenue when (i) persuasiveevidence of an arrangement exists, (ii) shipment of products has occurredor services have been rendered, (iii) the sales price charged is fixed ordeterminable and (iv) collection is reasonably assured. Our shipment termsare FOB shipping point as outlined in our sales agreements.

Our domestic sales agreements do not provide forrights of return or price protection. However, we may approve returns on acase-by-case basis at our discretion. Certain international distributionagreements do provide for rights of return and price protection. Generally,such return rights are for a 

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period of not more than90 days after the products have been shipped to the distributors. Inaccordance with SFAS No. 48, *RevenueRecognition When Right of Return Exists,* we continuously monitor andtrack product returns and record a provision for the estimated future amount ofsuch future returns, based on historical experience and any notification wereceive of pending returns. We do not grant any warranty provisions on ourproducts. We provide for discounts and allowances based on historicalexperience at the time revenue is recognized as a reduction to revenue. To datesuch provisions have approximated management’s estimates. Other than ourprovision for future returns, the only estimates that we have to make regardingrevenue recognition pertain to the collectibility of the resulting receivable,both of which are discussed below.

We grant price protection rights to certaininternational distributors. Such price protection rights require us to pay the distributorif there is a reduction in the list price of our products. Price protectionpayments would be required for the distributor’s inventory on-hand orin-transit on the date of the price reduction, for a period not to exceed90 days prior to the date of the price reduction. We have not recorded aliability in connection with such price protection rights as we have neverreduced the list prices of our products.

In September 2002, we entered into a licensingagreement with Rohto (see Note 8 to our financial statements), a largeJapan-based company that specializes in the distribution and marketing of OTCmedical 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), adiversified Japanese consumer products and services company, which also ownsand operates a large chain of aesthetic spas in Japan. We recognize royaltyrevenue related to the licensing agreement based on Rohto’s sale of relatedproducts. This royalty revenue is recognized as earned and is based upon apredetermined rate within the licensing agreement.

*Salesreturns and allowances.**  *When we sell our products, we reduce the amount ofrevenue recognized from such sales by an estimate of future product returns andother sales allowances. Sales allowances include cash discounts, rebates andsales incentives relating to products sold in the current period. Factors thatare considered in our estimates regarding sales returns include the historicalrate of returns and current market conditions. We maintain a return policy thatallows our customers to return product within a specified period after shipmentof the product has occurred. Factors that are considered in our estimatesregarding sales allowances include quality of product and recent promotionalactivity. If actual future experience for product returns and other salesallowances exceed the estimates we made at the time of sale, our financialposition, results of operations and cash flow would be negatively impacted. Todate, such provisions have approximated management’s estimates.

*Accountsreceivable.**  *Weperform periodic credit evaluations of our customers and adjust credit limitsbased upon payment history and the customer’s current creditworthiness, asdetermined by our review of current credit information. We monitor collectionsand payments from our customers and maintain an allowance for doubtful accountsbased upon our historical experience and any specific customer collectionissues that we have identified. Receivables are charged to the allowance fordoubtful accounts when an account is deemed to be uncollectible, taking into considerationthe financial condition of the customer and the value of any collateral.Recoveries of receivables previously charged off as uncollectible are creditedto the allowance. If the financial condition of our customers deteriorates,resulting in an impairment of their ability to make payments and this exceedsour estimates of the balance sheet date, we would need to charge additionalreceivables to our allowances, and our financial position, results of operationand cash flow would be negatively impacted. Our credit losses have historicallybeen within our expectations and the allowance established.

*Inventory.**  *We state our inventories at thelower of cost or market, computed at actual cost on a first-in, first-out basisand market being determined as the lower of replacement cost or net realizablevalue. Inventory reserves are established when conditions indicate that theselling price could be less than cost 

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due to physicaldeterioration, usage, obsolescence, reductions in estimated future demand and reductionsin selling prices. Inventory reserves are measured as the difference betweenthe cost of inventory and estimated market value. Inventory reserves arecharged to cost of sales and establish a lower cost basis for the inventory. Webalance the need to maintain strategic inventory levels with the risk ofobsolescence due to changing technology, new product offerings and customerdemand levels. Unfavorable changes in market conditions may result in a needfor additional inventory reserves that could adversely impact our grossmargins. Conversely, favorable changes in demand could result in higher grossmargins. To date, actual reserve requirements approximated management’sestimates.

*Goodwilland other intangible assets.**  *Effective January 1, 2002, we adopted SFASNo. 142, *Goodwill and Other IntangibleAssets,* which requires, among other things, the use of anonamortization approach for purchased goodwill and certain intangibles. Undera nonamortization approach, goodwill and intangibles having an indefinite lifeare not amortized, but instead will be reviewed for impairment at leastannually or if an event occurs or circumstances indicate the carrying amountmay be impaired. Events or circumstances which could indicate an impairmentinclude a significant change in the business climate, economic and industrytrends, legal factors, negative operating performance indicators, significantcompetition, changes in our strategy or disposition of a reporting unit or aportion thereof. Goodwill impairment testing is performed at the reporting unitlevel.

SFAS No. 142 requires that goodwill be tested forimpairment using a two-step process. The first step of the goodwill impairmenttest, used to identify potential impairment, compares the fair value of areporting unit with its carrying amount, including goodwill. If the fair valueof a reporting unit exceeds its carrying amount, goodwill of the reporting unitis not considered to be impaired and the second step of the impairment test isunnecessary. If the carrying amount of a reporting unit exceeds its fair value,the second step of the goodwill impairment test must be performed to measurethe amount of impairment loss, if any. The second step of the goodwillimpairment test compares the implied fair value of reporting unit goodwill withthe carrying amount of that goodwill. The implied fair value of goodwill isdetermined in the same manner as the amount of goodwill recognized in abusiness combination. If the carrying amount of the reporting unit goodwillexceeds the implied fair value of that goodwill, an impairment loss isrecognized in an amount equal to that excess.

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

We have selected September 30 as the date onwhich we will perform our annual goodwill impairment test. Based on ouranalyses, no impairment charges were recognized for the  years ended December 31, 2006, 2005 and2004.

Other intangible assets consist of trademarks,distribution rights, covenants not-to-compete, patents, customer lists, andproprietary formulations. Other intangible assets are amortized over theexpected period of benefit using the straight-line method over the followinglives: trademarks (20 years); distribution rights (ten years); covenantsnot-to-compete (seven years); and other intangible assets (three to17 years). Any unfavorable changes in market conditions or our productlines may result in the impairment of goodwill or an intangible asset, whichcould adversely impact our net income.

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

For leases with renewalperiods at our option, we generally consider the lease term to consist of theinitial lease term, as exercise of the renewal options as determined at leaseinception are not considered to be reasonably assured of exercise. However, iffailure to exercise a renewal option imposes an economic penalty of sufficientmagnitude to us, then the renewal, at inception, is reasonably assured and willbe included in the determination of the appropriate lease term.

In certain instances, wedisburse cash for leasehold improvements, furnishings, fixtures and equipmentto renovate leased premises. If costs are paid directly by the landlord orreimbursed to us by the landlord, we record a deferred rent liability andamortize the deferred rent liability over the lease term as a reduction to rentexpense. In other instances, we may expend cash for landlord additions that wemake to lease premises that are reimbursed to us by the landlord. Based on thespecifics of the leased space and the lease agreement, during the renovationperiod, amounts paid will be recorded as prepaid rent and any landlordreimbursement will be recorded as an offset to prepaid rent.

*Stock-based compensation.**  *We account for stock-basedcompensation in accordance with the provisions of SFAS No. 123R, *Share-Based Payment*. In connection withour January 2006 adoption of SFAS No. 123R, we adopted the modifiedprospective transition method in the first quarter of fiscal 2006, and as aresult, did not retroactively adjust results from prior periods. Under thistransition method, stock-based compensation is recognized for: (i) expenserelated to the remaining unvested portion of all stock option awards grantedduring the one year period preceding our initial public offering, based on thegrant date fair value estimated in accordance with the original provisions ofSFAS No. 123; and (ii) expense related to all stock option awardsgranted on or subsequent to January 1, 2006, based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123R. Inaccordance with SAB No. 107, the remaining unvested options we issuedprior to the one year period preceding our initial public offering, with theexception of the October 2005 grants, are not included in the SFAS No. 123Roption pool as they were valued using the minimum value method. As a result,unless subsequently modified, repurchased or cancelled, such unvested optionswill not be included in stock-based compensation. Determining the appropriatefair-value model and calculating the fair value of stock-based awards at thedate of grant using any valuation model requires judgment. We use theBlack-Scholes option-pricing model, which requires the input of highlysubjective assumptions. These assumptions include estimating the length of timeemployees will retain their stock options before exercising them (“expectedterm”), the estimated volatility of our common stock price over the expectedterm and the number of options that will ultimately not complete their vestingrequirements (“forfeitures”). We estimated our options’ expected terms usingour best estimate of the period of time from the grant date that we expect theoptions to remain outstanding. If we determine another method to estimateexpected volatility or expected term was more reasonable than our currentmethods, or if another method for calculating these input assumptions isprescribed by authoritative guidance, the fair value calculated for stock-basedawards could change significantly. Higher volatility and expected terms resultin a proportional increase to stock-based compensation determined at the dateof grant. The expected dividend rate and expected risk-free rate of return arenot as significant to the calculation of fair value.

As a result of adoptingSFAS No. 123R, the impact to our Consolidated Statement of Income for theyear ended December 31, 2006 on income before income taxes and net incomewas $305,000 and $195,000, respectively, and does not have a material effect onbasic and diluted earnings per share, respectively. In addition, prior to theadoption of SFAS No. 123R, we presented the tax benefit resulting from theexercise 

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of stockoptions as operating cash inflows in our Consolidated Statements of Cash Flows.Upon the adoption of SFAS No. 123R, the excess tax benefits for thoseoptions are classified as financing cash inflows.

Given the absence of anactive market for our common stock, our board of directors, the members ofwhich we believe have extensive business, finance and investment experience,were required to estimate the fair value of our common stock at the time ofeach option grant for purposes of determining stock-based compensation expensefor the periods presented herein. In response to that requirement, our board ofdirectors appointed members of the compensation committee to analyze our stockvalue and recommend common stock valuation estimates. For economic reasons, weinitially chose to value our options using a model that employed a market basedapproach based principally upon applying appropriate valuation multiples to theEBITDA and revenue and not to obtain a contemporaneous valuation by anindependent third party. As a privately held company, we believed that themembers of our compensation committee had the requisite experience andexpertise to determine the fair value of the options. If a valuation modelusing different input variables and assumptions had been used, our common stockvaluation may have been different.

If we had made differentassumptions and estimates, the amount of our recognized and to be recognizedstock-based compensation expense, net income and net income per share amountscould have been materially different. We believe that we have used reasonablemethodologies, approaches and assumptions consistent with the AmericanInstitute of Certified Public Accountants Practice Guide, *Valuation of Privately-Held-Company Equity SecuritiesIssued as Compensation*, to determine the fair market value of ourcommon stock.

**Results of operations**

***The year ended December 31,2006 compared the year ended December 31, 2005***

*Net sales.**  *The following table compares net sales by productline and certain selected products for the year ended December 31, 2006and 2005:

| ** **                                        | ** ** | **Year ended December 31,** | ** ** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|------------|
| ** **                                        | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **Change** | ** ** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                         | ** ** | ** ** | ** ** | ** ** |
| Net Sales by Product  Category:    |       |                                       |       |       |   |   |   |   |
| Skin Health                                       |       |                                       |       |       |   |   |   |   |
| Nu-Derm                                           |       | $                                          | 53,228     |       | $ | 46,609 |   | 14 | % |   |
| Vitamin C                                    |       | 9,814                                      |       | 8,438      |   | 16 |   |   |
| Skin laxity                                       |       | 2,278                                      |       | —     |   | — |   |   |
| Other                                             |       | 8,620                                      |       | 6,492      |   | 33 |   |   |
| Total                                             |       | 73,940                                     |       | 61,539     |   | 20 |   |   |
| Licensing fees                                    |       | 4,056                                      |       | 3,402      |   | 19 |   |   |
| Total net sales                                   |       | $                                          | 77,996     |       | $ | 64,941 |   | 20 | % |   |
| United States                                     |       | 82                                         | %          | 81         | % |   |   |   |
| International                                     |       | 18                                         | %          | 19         | % |   |   |   |

 

Net sales increased by$13.1 million, or 20%, to $78.0 million during the year ended December 31,2006, as compared to $64.9 million during the year ended December 31,2005. During the year ended December 31, 2006, we experienced Nu-Dermsales growth of $6.6 million, which was largely driven by the launch ofour Nu-Derm Condition and Enhance System for Botox® in July 2006.In addition, we saw a combined sales growth of $3.5 million in theVitamin C and Other product categories, new sales of $2.3 millionfrom the launch of the our ELASTIdermTM product within the Skin laxity productcategory and $0.7 million of growth in licensing fees. This sales growthwas comprised of $11.1 million of growth in the 

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UnitedStates and $2.0 million in growth from international markets. U.S. growthwas fueled by the overall growth in the skin care market. Over 79% of theproduct category sales growth experienced was attributable to unit volumegrowth. The Nu-Derm product category growth was largely driven by the expansionof our sales force, the promotional and educational efforts of our professionalsales force and the launch of Nu-Derm Condition and Enhance for Botox, whichcontributed $4.9 million. The growth in the Vitamin C category wasprimarily due to the successful launch of a new Vitamin C line during 2005and early 2006, and a strong sales performance by the Obagi-C Rx. The skinlaxity product category growth was driven by the launch of the first productwithin the ELASTIderm product line in the latter half of October 2006. TheOther product category growth was driven by the launch of a new product and asystem approach concept launched in early 2005. The system approach is designedto educate physicians on the benefits of prescribing the complete Nu-Dermsystem as opposed to partial systems. International sales growth was primarilyin the Nu-Derm product line and primarily came from four regions,$0.6 million from the Middle East, $0.3 million from North Americaexcluding the United States, $0.3 million from the Far East, and $0.1 millionfrom the Europe and Other region. Our licensing fees increased $0.7 millionprimarily due to fees received under our agreement with Tokyo Beauty CentersGroup, Inc.

*Gross margin percentage.**  *Our gross margin percentageincreased to 82.7%, for the year ended December 31, 2006 compared to 82.2%for the year ended December 31, 2005, primarily as a result of: (i) the$1.4 million increase in Vitamin C sales, which have an improvedgross margin over the prior year; and (ii) improved margins on products inour Other product line due to new contract volume purchasing discounts with themanufacturer. We launched a new vitamin C line in October 2005 and January 2006to replace third-party-produced Vitamin C with our own branded product,which has significantly higher margins. The Nu-Derm product line gross margin percentagefor the year ended December 31, 2006 declined slightly when compared tothe year ended December 31, 2005, primarily due to an increase in practicebuilding initiatives. During the introduction of the first product in theELASTIderm product line, the Company used pricing promotions as part of its launch strategy to drive ELASTIderminto its existing customer base. These pricing promotions slightly reducedoverall margins.  Our cost of salesincludes the cost of our finished goods, which includes product and packagingmaterials purchased from third party vendors and bulk and fill purchased fromindependent manufacturers. Cost of sales also consists of outbound shipping andhandling, work order scrap, licensing and royalty fees related to licensedintellectual property, depreciation and amortization attributable to productssold, and an inventory reserve for shrinkage and write-downs.

*Selling, general andadministrative.**  *Selling,general and administrative expense consists primarily of salaries and otherpersonnel-related costs, professional fees, insurance costs, stock basedcompensation, depreciation and amortization not attributable to products sold,warehousing costs, advertising, travel expense and other selling expenses.Selling, general and administrative expenses increased $11.9 million to$40.9 million during the year ended December 31, 2006, as compared to$29.0 million for the year ended December 31, 2005. This increase isprimarily due to the following: (i) a $4.0 million increase due tothe hiring of additional employees, largely direct sales and administrative supportpersonnel, during the year ended December 31, 2006, as compared to theyear ended December 31, 2005; (ii) a $2.9 million increase inmarketing and sales expenses related to our acne and elasticity product lines; (iii) a$2.3 million increase in market research and promotion activity aimedtowards targeting physicians and patients; (iv) a $1.8 millionincrease in expenses related to our initial public offering; (v) aone-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 non compete agreement; (vi) a $0.4 million increase indepreciation and amortization; (vii) a $0.4 million increase in legalfees; (viii) a $0.3 million increase in new indication sales researchand promotions ; and (ix) a $0.3 million increase in non-cashcompensation expense due to the adoption of SFAS No. 123R on January 1,2006; offset by (x) a $0.9 million decline in advertising costs. As apercentage of net sales, selling, general and administrative expenses in theyear ended December 31, 2006 were 52% as compared to 45% in the year endedDecember 31, 2005. We expect to incur additional 

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operating costs,such as professional fees and insurance costs, related to the growth of ourbusiness and our operations as a public company. However, we believe selling,general and administrative expenses will decrease as a percentage of net sales.

*Research and development.**  *Research and development expenses increased $2.6 millionto $5.9 million for the year ended December 31, 2006 as compared to$3.3 million for the year ended December 31, 2005. This increase isprimarily due to the following: (i) a $3.0 million increase indevelopment costs related to our acne and elasticity product lines and futureproduct pipeline development; and (ii) a $0.5 million increase due tothe employment of additional employees during the year ended December 31,2006, as compared to the year ended December 31, 2005, offset by a $0.9 milliondecline in research and development expenses related to our existing products. Asa percentage of net sales, research and development costs in the year ended December 31,2006 were 8% as compared to 5% in the year ended December 31, 2005. 

*Interest income andInterest expense.**  *Interestexpense was $8.2 million during the year ended December 31, 2006, ascompared to $6.1 million for the year ended December 31, 2005.Approximately $1.3 million of the increase is due to the write down indebt issuance costs resulting from a prepayment of $35.0 million in debtwith the net cash proceeds received in our initial public offering. Theremaining increase is due to the fact that we only recorded eleven months ofinterest for the facility for the year ended December 31, 2005, as weobtained a $70.0 million Credit Agreement on January 28, 2005,compared to twelve months of interest being recorded for the year ended December 31,2006. Interest income decreased $48,000 to $13,000 during the year ended December 31,2006, as compared to $61,000 for the year ended December 31, 2005. Thedecrease is primarily due to a decline in our average cash balance to$4.1 million during the year ended December 31, 2006, compared to$5.4 million during the year ended December 31, 2005.

*Income taxes.**  *Income tax expense decreased$2.5 million to $3.5 million for year ended December 31, 2006,as compared to $6.0 million for the year ended December 31, 2005. Oureffective tax rate declined 4% to 36% for the year ended December 31, 2006,compared to 40% for the year ended December 31, 2005. The decline isprimarily due to the impact of the research and development credit recordedduring the year ended December 31, 2006.

***Year ended December 31,2005 compared to year ended December 31, 2004***

*Net sales.**  *The following table compares net sales by productline and certain selected products for the years ended December 31, 2005and 2004:

| ** **                      | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                      | ** ** | **(in thousands)**                    | ** ** | ** ** | ** ** |
| Net Sales by  Product Category: |       |                                       |       |   |   |   |   |
| Skin Health                     |       |                                       |       |   |   |   |   |
| Nu-Derm                         |       | $                                          | 46,609     |   | $ | 40,567 |   | 15 | % |
| Vitamin C                  |       | 8,438                                      |       | 6,974 |   | 21 |   |
| Other                           |       | 6,492                                      |       | 5,231 |   | 24 |   |
| Total                           |       | 61,539                                     |       | 52,772 |   | 17 |   |
| Licensing fees                  |       | 3,402                                      |       | 3,484 |   | (2 | ) |
| Total net sales                 |       | $                                          | 64,941     |   | $ | 56,256 |   | 15 | % |
| United States                   |       | 81                                         | %          | 80 | % |   |   |
| International                   |       | 19                                         | %          | 20 | % |   |   |

 

Net sales increased by $8.6 million, or 15%, to$64.9 million during the year ended December 31, 2005, as compared to$56.3 million during the year ended December 31, 2004. During 2005,we 

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experienced Nu-Derm salesgrowth of $6.0 million, a combined sales growth of $2.7 million inthe Vitamin C and Other product categories offset by a decline of$0.1 million in licensing fees. This sales growth was comprised of$7.7 million of growth in the United States and $0.9 million ingrowth from international markets. U.S. growth was fueled by the overall growthin the skin care market. Over 81% of the product line sales growth experiencedwas attributable to unit volume growth. The Nu-Derm product category growth waslargely driven by the expansion of our sales force and the promotional andeducational efforts of our professional sales force. The growth in theVitamin C category was primarily due to the successful launch of a newVitamin C line during 2005. International sales growth was primarily inthe Nu-Derm product category and came from two regions, $0.8 million fromthe Far East, and $0.4 million from North America (excluding the UnitedStates). This growth was partially offset by a $0.3 million decline in ourEurope and Other region. Our licensing fees declined $0.1 millionprimarily due to a 2% decrease in the average exchange rate of the U.S. dollarand Yen from 2004 to 2005 and a decrease in sales of one of the existinglicensed product lines, which was offset by the launch of a new retinol productline in the drug store channel in Japan.

*Grossmargin percentage.**  *Ourgross margin percentage decreased by 0.9 percentage points to 82.2% in2005 compared to 83.1% in 2004. The decline is primarily a result of Nu-Dermproduct line gross margin percentage for the year ended December 31, 2005,which declined when compared to the year ended December 31, 2004, and the$1.5 million increase in Vitamin C and Other, due to launching twonew concentrations of our own branded product, which has a higher margin than thethird-party product that was replaced and Other sales, which have a lower grossmargin percentage than our Nu-Derm sales. In addition, the percentage oflicensing fees as a percentage of total net sales declined, which generallyhave a significantly higher gross margin percentage than our Other productlines.

*Selling, general andadministrative.**  *Selling,general and administrative expenses increased $5.2 million to$29.0 million during the year ended December 31, 2005, as compared to$23.8 million for the year ended December 31, 2004. This increase isprimarily due to the following: (i) an increase of $2.4 million dueto the employment of additional employees, largely direct sales and marketingpersonnel during 2005 as compared to 2004; (ii) an increase of$1.0 million in expenses related to an anticipated initial publicoffering; (iii) an increase of $1.0 million related to hiringemployees to fill senior strategic positions; (iv) an increase of$0.6 million due to sales and marketing volume driven activities; and (v) increaseof $0.2 million in professional and other consulting fees. As a percentageof net sales, selling, general and administrative expenses in the year ended December 31,2005 were 45% as compared to 42% in the year ended December 31, 2004.

*Research and Development.**  *Research and development costs increased $1.7 millionto $3.3 million during the year ended December 31, 2005, as compared to$1.6 million for the year ended December 31, 2004. This increase isprimarily due to the following:**(i) anincrease of $1.4 million in development costs related to ourVitamin C product line and future product pipeline development; and (ii) anincrease of $0.3 million due to the employment of additional employees during2005 as compared to 2004. As a percentage of net sales, research anddevelopment costs in the year ended December 31, 2005 were 5% as comparedto 3% in the year ended December 31, 2004.

*Interest income andInterest expense.**  *Interestexpense was $6.1 million during the year ended December 31, 2005, ascompared to $20,000 for the year ended December 31, 2004. The increase ininterest expense relates to outstanding loans under our Credit Agreement dated January 28,2005, which mature in January 2010 and January 2011, respectively.Interest income decreased $100,000 to $61,000 during the year ended December 31,2005, as compared to $161,000 for the year ended December 31, 2004. Thedecrease during the year ended December 31, 2005 is primarily due to ouraverage cash balance of approximately $5.4 million during the year ended December 31,2005, being lower as compared to approximately $12.1 million during theyear ended December 31, 2004.

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*Gain on legal settlements.**  *In 2004 we recorded a$0.2 million gain on legal settlements due to a favorable outcome on anintellectual property infringement lawsuit brought against former employees.There were no such settlements during 2005.

*Income taxes.**  *Income tax expense decreased$1.7 million to $6.0 million for the year ended December 31,2005, as compared to $7.7 million for the year ended December 31,2004. Our effective tax rate for the year ended December 31, 2005 was 40%compared to 35% for the year ended December 31, 2004.

**Liquidity and capital resources**

Management assesses ourliquidity by our ability to generate cash to fund our operations. Significantfactors in the management of liquidity are: funds generated by operations;levels of accounts receivable, inventories, accounts payable and capitalexpenditures; funds required for acquisitions; adequate credit facilities; andfinancial flexibility to attract long-term capital on satisfactory terms. As ofDecember 31, 2006, our accumulated deficit was $21.1 million. We currentlyinvest our cash and cash equivalents in large money market funds consisting ofdebt instruments of the U.S. government, its agencies and high-qualitycorporate issuers. Historically, we have generated cash from operations inexcess of working capital requirements and through private sales of commonstock. In January 2005, we entered into a credit agreement pursuant towhich we received $70.0 million as a term loan and established a revolvingline of credit for up to $10.0 million under certain conditions. We havenot had any outstanding balances under the revolving line of credit. Theavailability on the revolving line of credit ranged from $0 million to$10.0 million between January and December 2006. We had$10.0 million and $6.8 million available on the revolving line ofcredit on December 31, 2006 and 2005, respectively. The proceeds from theterm loans were used to pay approximately a $63.1 million dividend to existingshareholders, redeem our series A preferred stock and pay fees associated withobtaining the Credit Agreement. In December 2006, pursuant to the thirdamendment of the Credit Agreement entered into in November 2006, we made aprepayment of $35.0 million on the outstanding balance of the term loans withour net proceeds received from the completion of our initial public offering onDecember 19, 2006. As of December 31, 2006, we had $25.7 millionin outstanding debt under the Credit Agreement and no outstanding amounts underthe revolving line of credit. Borrowings under the Credit Agreement are subjectto certain financial and operating covenants that include, among otherprovisions, maintaining a maximum Debt to EBITDA Ratio and minimum EBITDAlevels and restrictions on our ability to pay dividends. Certain covenants alsolimit annual capital expenditures and use of proceeds from the issuance of debtand equity securities. We were in compliance with all financial andnon-financial covenants as of December 31, 2006 and 2005.

In April 2002, weentered into an Investor’s Rights Agreement with our former Chairman and ChiefExecutive Officer, Austin McNamara. Subsequently, trusts established by Mr. McNamarabecame the owners of the 1.88 million shares of the Company’s common stockowned by Mr. McNamara and parties to the Investor’s Rights Agreement. Mr. McNamararesigned as a member of our board of directors and as an employee in May 2006and died in December 2006. The Investor’s Rights Agreement contained arepurchase obligation under which we were required to repurchase the shares ofthe Company held by the trusts upon the exercise of a repurchase right.Subsequent to Mr. McNamara’s resignation, the trusts exercised thisrepurchase right. Pursuant to procedures set forth in the Investor’s RightsAgreement, three valuation firms were retained to prepare valuations of thestock held by the trusts and the total purchase price was to have been $ 28.2million.

Any obligation we wouldhave to repurchase the trusts’ shares was to have been subordinated to ourCredit Agreement, which restricts payments on such obligation to a maximum of$1.5 million in any fiscal year, not to exceed $5.0 million while the CreditAgreement is in place. The Investor’s Rights Agreement contains subordinationprovisions and the trusts signed an additional subordination agreement inconnection with the Credit Agreement pursuant to which they agreed to besubordinated to the loans 

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underthe Credit Agreement. On November 17, 2006, we tendered promissory notesin the aggregate principal amount of $28.2 million and a cash payment of $1.5million as partial prepayment of the notes, to the trusts in order to close onour repurchase of the shares held by the trusts pursuant to the terms of theInvestor’s Rights Agreement. The trusts refused to accept our tender of thesepayments and refused to tender their shares and close on the repurchase of theshares they hold. As a result, we believe the trusts are in material breach oftheir obligations under the Investor’s Rights Agreement. Based upon thismaterial breach by the trusts, as well as for other reasons, we believe we areno longer obligated to repurchase the shares held by the trusts pursuant to theInvestor’s Rights Agreement and the right of the trusts to require us torepurchase the shares has expired and can no longer be enforced against us.

The trusts have taken theposition that they did not breach their obligations under the Investor’s RightsAgreement and that instead we have breached our obligation to repurchase thetrusts’ shares under the Investor’s Rights Agreement. While we believe thetrusts’ claims to be without merit, there can be no assurance we would prevailif the trusts were to seek to enforce their claims through litigation. To ourknowledge, as of March 14, 2007 the trusts had not commenced litigationagainst us.

As of December 31,2006 and December 31, 2005, we had approximately $11.3 million and$3.4 million, respectively, of cash and cash equivalents and workingcapital of $21.9 million and $15.4 million, respectively, whichincludes a current deferred tax asset of $1.0 million and $0.9 million,respectively, related primarily to the future benefit of our net operatinglosses for tax purposes.

We expect to increase ourselling, marketing and administrative expenses, and our research anddevelopment expenses. We anticipate our selling and marketing expenses toincrease as we seek to: (i) expand our professional sales force; (ii) increaseour efforts towards physician training and patient awareness; (iii) supportthe launch of new products or expanded application of existing products; and (iv) expandour distribution to new physician specialties. We anticipate that ouradministrative expenses will increase to support our current growth plans andcompliance with our obligations as a public company. Our research and developmentexpenses will likely increase as a result of our current plans to (i) researchand develop new products and (ii) expand the application of currentproducts. We believe that our cash outflows related to acquiring products andentering into licensing agreements may increase as we seek to expand ourproduct portfolio. Additionally, if sales of our current products continue toincrease and/or we increase the number of products in our portfolio, we mayfind it necessary to consider alternative manufacturing relationships, whichmay include the acquisition of our own manufacturing facilities or additionalcapital expenditures for facilities and equipment of third-party manufacturersthat are dedicated to our products.

We continually evaluatenew opportunities for therapeutic systems or products and, if and whenappropriate, intend to pursue such opportunities through the acquisitions ofcompanies, products or technologies and our own development activities. Ourability to execute on such opportunities in some circumstances may bedependent, in part, upon our ability to raise additional capital oncommercially reasonable terms. There can be no assurance that funds from thesesources will be available when needed or on terms favorable to us or our stockholders.If additional funds are raised by issuing equity securities, the percentageownership of our stockholders will be reduced, stockholders may experienceadditional 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 ofincorporation and amended and restated bylaws in preparation for our initialpublic offering. This amended and restated certificate of incorporation wasapproved by the stockholders on November 28, 2006 and was filed with theSecretary of State of the State of Delaware prior to the effectiveness of ourregistration statement on Form S-1. The changes included: (i) totalauthorized shares increased to 110,000,000 (100,000,000 common and 10,000,000preferred); (ii) the classes, term and number of the members of the boardof directors were modified; and (iii) other changes deemed necessary asfor a public 

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reportingcompany. We also revised our compensation committee and nominating committeecharters and adopted new policies to follow current best practices for publiccompanies.

We have maintained apositive operating cash flow in each year since 2001, and we believe that thenet cash provided by operating activities and existing cash and equivalentswill provide us with sufficient resources to meet our expected working capitalrequirements, debt service and other cash needs for the foreseeable future.

***Inflation***

Although at reduced levelsin recent years, inflation continues to apply upward pressure on the cost ofgoods and services that we use. The competitive environments in many marketssubstantially limit our ability to fully recover these higher costs throughincreased selling prices. We continually seek to mitigate the adverse effectsof inflation through cost containment and improved productivity andmanufacturing processes.

***Foreign currencyfluctuations***

Approximately 4% of ournet sales in 2006 were derived from operations outside the United States andwere denominated in Japanese Yen. None of our international cost structure isdenominated in currencies other than the U.S. dollar. As a result, we aresubject to fluctuations in sales and earnings reported in U.S. dollars due tochanging currency exchange rates. We do not believe, however, that we currentlyhave significant direct foreign currency exchange rate risk and have not hedgedexposures denominated in foreign currencies.

**Cash flow**

*Year ended December 31,2006.**  *Forthe year ended December 31, 2006, net cash provided by operatingactivities was $12.9 million. The primary sources of cash were$6.1 million in net income, including the effect of: (i) adjustingfor non-cash items; (ii) a decrease of accounts receivable through animprovement of days sales outstanding, or DSO, from 56 days to44 days (The higher DSO in the fourth quarter of 2005 was due to thesignificant sales volumes and related accounts receivable experienced in thefourth quarter. The fourth quarter is seasonally our strongest quarter of theyear); (iii) a decrease in prepaid assets through the occurrence ofpreviously funded promotional initiatives; (iv) an increase of inventorythrough added stocking levels of the Nu-Derm System in anticipation of peakseasonal sales between the months of January through March, stockinglevels of the new Nu-Derm Condition and Enhance Systems, and for new productsin our CLENZIderm M.D.TM and ELASTIdermTM product lines scheduled for launch in October 2006and February 2007 (our inventory turn ratio decreased from 3.4 to 2.0);and (v) a net increase in accounts payable and current liabilities throughincreased costs associated with our initial public offering and timing ofpayment for operational and inventory purchases.

Net cash used in investingactivities was $2.2 million for the year ended December 31, 2006.This was primarily through capital invested in a marketing and training centerlocated within a building owned by Dr. Obagi, capital invested in our newmanufacturing facility, and the cost of general leasehold improvements,information technology equipment and software upgrades. We anticipate spendingapproximately $1.2 million for total capital expenditures in 2007.

Net cash used in financingactivities was $2.8 million for the year ended December 31, 2006.This was primarily due to scheduled principal payments of $5.8 million anda prepayment of $35.0 million made under the Credit Agreement. The paymentswere offset by the proceeds received, net of underwriter commissions andoffering costs, from our sale of 4,000,000 shares of our common stock in ourinitial public offering on December 19, 2006, of $38.1 million.

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*Yearended December 31, 2005.**  *Net cash provided by operatingactivities was $5.4 million. The primary source of cash was$9.0 million in net income, including the effect of: (i) adjustingfor non-cash items; (ii) an increase of accounts receivable resulting fromhigh sales volumes in December 2005 and an increase in DSO from50 days to 56 days; (iii) an increase of inventory through addedstocking levels of the new Vitamin C product launched in 2005 and anincrease in our inventory turn ratio increased from 3.1 to 3.4; (iv) aprepayment of certain 2006 promotional initiatives; and (v) a net increasein accounts payable and current liabilities due to the accrual of 2005 bonusand IPO consulting fees, which was partially offset by the prepayments ofcertain 2006 promotional incentives and $1.2 million in rent to anaffiliate of Dr. Obagi for lessor assets in connection with the lease ofour Marketing and Training Center.

Net cash used in investing activities was$2.3 million for the year ended December 31, 2005, primarily due to a$0.9 million capital investment in our Marketing and Training Centerleasehold improvements and equipment in our new manufacturing facility, and thecost of general leasehold improvements, information technology equipment and softwareupgrades.

Net cash used in financing activities was$17.9 million for the year ended December 31, 2005. We received$70.0 million of cash from a term loan under the Credit Agreement, whichwas offset by following: (i) the payment of $63.1 million in commonstock dividends; (ii) the redemption of $11.8 million of Series Apreferred stock; (iii) principal payments of $3.5 million under theCredit Agreement; (iv) the payment of $9.3 million in accrued Series Apreferred stock dividends; and (v) the payment of $2.9 million indebt issuance costs.

*Yearended December 31, 2004.**  *Net cash provided by operatingactivities was $15.1 million for the year ended December 31, 2004.The increase in net cash provided by operations during the year was primarilydue to net income of $14.1 million, including the effect of: (i) adjustingfor non-cash items; (ii) an increase of accounts receivable through highsales volumes in December 2004 resulting in a increase of days salesoutstanding of 48 days to 50 days; (iii) an increase in relatedparty receivables through the timing of payment from Cellogique, a distributormajority owned by Dr. Obagi; (iv) an increase in accounts payablethrough timing of payment; and (v) a decrease in related party payablesthrough the timing of payment to Dr. Obagi and Lighthouse Venture Group, aconsulting firm owned by Austin McNamara, the former chairman of our board ofdirectors, president and chief executive officer.

Net cash used in investing activities was$2.7 million for the year ended December 31, 2004, primarily due to a$1.3 million purchase of patent licensing rights in the country of Japan,a $0.3 million capital investment in a leasehold improvements, and generalcosts of leasehold improvements, and information technology equipment and softwareupgrades.

Net cash used in financingactivities was $2.9 million during the year ended December 31, 2004.Cash used in financing activities included the repayment of $1.9 millionin term loans and $1.1 million in debt issuance costs related to the CreditAgreement entered into in January 2005.

**Off-balance sheetarrangements**

We do not have anyoff-balance sheet arrangements.

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**Commitments andcontractual obligations**

Ourmajor outstanding contractual obligations relate to operating leases, long termdebt and capital leases. These contractual obligations as of December 31,2006 are as follows:

| ** **                                       | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                 | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                   | ** ** |
| Long-Term Debt  Obligations (including interest) |       | $                                         | 33,149     |   |   | $ | 4,993 |   |   | $ | 7,993 |   | $ | 20,163 |   |   | $ | — |   |   |
| Capital Lease  Obligations                       |       | 138                                       |       |   | 62 |   |   | 57 |   | 19 |   |   | — |   |   |
| Operating Lease  Obligations                     |       | 2,109                                     |       |   | 1,130 |   |   | 979 |   | — |   |   | — |   |   |
| Dr. Obagi  Services Agreement Obligation    |       | 2,865                                     |       |   | 770 |   |   | 1,240 |   | 855 |   |   | — |   |   |
| Other Services  Agreement Obligation             |       | 300                                       |       |   | 100 |   |   | 200 |   | — |   |   | — |   |   |
| Total                                            |       | $                                         | 38,561     |   |   | $ | 7,055 |   |   | $ | 10,469 |   | $ | 21,037 |   |   | $ | — |   |   |
|                                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Longterm obligations.**  *InJanuary 2005, we entered into an $80.0 million Credit Agreement whichwas structured utilizing two term loans and a revolving line of credit. Initialborrowings under the term loans consisted of $20.0 million (“TermLoan A”) and $50.0 million (“Term Loan B”) with scheduledpayments due through January 2011. We made total interest and principalpayments of $8.7 million and $11.8 million through December 31, 2005and 2006, respectively. In December 2006, we prepaid $35.0 million inprincipal with the net proceeds, net of underwriting commissions and offeringcosts, from the sale of 4,000,000 shares of our common stock in our initialpublic offering. All borrowings under this Credit Agreement bear interest at amargin over, at our discretion, the prime rate or LIBOR. The interest portionof our long-term debt obligation is derived based on our interest rates as of December 31,2005, of 8.12% and 8.37% for Term Loan A and Term Loan B,respectively. At December 31, 2006, Term Loan A was bearing interestat a LIBOR based rate of 9.35% and Term Loan B was bearing interest at a LIBORbased rate of 9.60%. This Credit Agreement is secured by a first priority lienon all of our personal and real property and requires that we maintaincompliance with covenants as defined therein.

*Capitalleases.**  *Welease certain office equipment for use in our operations which are classifiedunder capital leases. Our payment obligations under capital leases representboth principle and interest at implied fixed rates. The leases expire through July 2010.As of December 31, 2006, we amended one of our leases to expire in December 2010.

*Operatingleases.**  *Welease our corporate offices in Long Beach, California and distribution centerin Carson, California under separate leases expiring through October 2008.We lease our manufacturing facility in Milford, Connecticut under a leaseexpiring in November 2008. In addition, we lease automobiles for our salesrepresentatives under 36-month contracts.

*Servicesagreement.**  *OnJuly 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 fiveyears plus reasonable and customary expenses incurred at our request inconnection with the provision of such services, commencing on January 1,2005, for product formulation, product development and regulatory work. Thisagreement can be extended for up to two, one-year renewal terms. We agreed topay a tiered royalty for successful commercialization of products developed oridentified by the third party based on annual net sales, with a maximum royaltypaid per product, capped at $5.0 million per year. Tiered royalty payablefor each new product will be 3% on annual net sales from $0 to$50 million; 4% on annual net sales from $50 million to$75 million; and 5% on annual net sales above $75 million. See “CertainMaterial Agreements—Jose Ramirez and JR Chem” for additional information.

In June 2006, we leased our Marketing andTraining Center in Beverly Hills, California from an affiliate of Dr. Obagi.We prepaid rent due under this five year lease expiring in July 2011. Wehave one 

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five year extension. Sincewe have prepaid all amounts owing under this lease, no amounts from this leasewere included in the table above.

In June 2006, weentered into a services agreement with Zein E. Obagi, MD Inc. (“Obagi, Inc.”),Dr. Obagi, Samar Obagi, the Zein and Samar Obagi Family Trust and SkinHealth Properties, Inc. We have agreed to pay Obagi, Inc. an annualretainer of $570,000 for advising and formulating services and the marketingand 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 thedevelopment of Proderm products. At the end of the two years, the Company hasan option to continue sell Proderm products, in which case the Company will payObagi, Inc. an annual royalty payment of the greater of $200,000, or 5%,of the Company’s net Proderm revenues. The Company will also pay Obagi, Inc.royalty fees for developing other products identified in the agreement equal to5% of the Company’s net revenues from sales of those products. In addition, theCompany has agreed to reimburse up to 50% of all invoiced commerciallyreasonable marketing design and development expenses associated with theopening of the property in Beverly Hills, not to exceed $100,000. Unless otherwiseterminated in accordance with its terms, the agreement’s initial term is fiveyears, and it may be renewed for additional terms upon the mutual consent ofthe parties upon six months’ written notice prior to the end of the initialterm.

**Recent accountingpronouncements**

***New accounting standards***

During October 2004, the FASB ratified theconsensus reached by the Emerging Issues Task Force (“EITF”) with respect toEITF Issue No. 04-10 (“EITF 04-10”), *Determining Whether to Aggregate Operating SegmentsThat Do Not Meet the Quantitative Thresholds*, which clarifies theguidance in paragraph 19 of SFAS No. 131 (“SFAS No. 131”), *Disclosures about Segments of an Enterprise andRelated Information*. According to EITF 04-10, operatingsegments that do not meet the quantitative thresholds can be aggregated underparagraph 19 only if aggregation is consistent with the objective andbasic principle of SFAS No. 131, the segments have similar economiccharacteristics, and the segments share a majority of the aggregation criterialisted in items (a)-(e) in paragraph 17 of SFAS No. 131.The effective date of EITF 04-10 is applicable for fiscal yearsending after September 15, 2005. The adoption of EITF 04-10 didnot have an impact on our segment analysis.

In December 2004, the FASB issued SFAS No. 123R,which replaces SFAS No. 123 and supersedes Accounting Principals Board, orAPB, No. 25 *Accounting for Stock Issuedto Employees*. SFAS No. 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their grant date fair values. The provisionsof SFAS No. 123R, as supplemented by SAB No. 107, are effective nolater than the beginning of the next fiscal year that begins after June 15,2005. We adopted the new requirements using the modified prospective transitionmethod in the first quarter of fiscal 2006, and as a result, did notretroactively adjust results from prior periods. Under this transition method,compensation expense associated with stock options recognized in the fullfiscal year of 2006 includes: (i) expense related to the remainingunvested portion of all stock option awards granted prior to January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123 and (ii) expense related to allstock option awards granted subsequent to January 1, 2006, based on thegrant date fair value estimated in accordance with the provisions of SFAS No. 123R.We apply the Black-Scholes valuation model in determining the fair value ofshare-based payments to employees, which is then amortized on a straight-linebasis over the requisite service period. As a result of adopting SFAS No. 123R,the impact to the Consolidated Statement of Income for the year ended December 31,2006 on income before income taxes is approximately $305 and did not have amaterial effect on basic and diluted earnings per share.

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In May 2005, the FASB issued SFAS No. 154, “*Accounting Changes and Error Corrections—a replacementof APB Opinion No. 20 and FASB Statement No. 3,* whichchanges the requirements for the accounting and reporting of a change inaccounting principle. SFAS No. 154 eliminates the requirement to includethe cumulative effect of changes in accounting principle in the incomestatement and instead requires that changes in accounting principle beretroactively applied. SFAS No. 154 is effective for accounting changesand correction of errors made on or after January 1, 2006, with earlyadoption permitted. We began applying the provisions of this statement duringthe fourth quarter of 2005.

In February 2006, the EITF issued EITF No. 06-3(“EITF No. 06-3”), *How Sales Taxes Collectedfrom Customers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross Versus Net Presentation)*. EITF No. 06-3requires disclosures surrounding a company’s accounting policy (i.e., gross ornet presentation) regarding presentation of taxes within the scope of EITF No. 06-3.If taxes included in gross revenues are significant, a company should disclosethe amount of such taxes for each period for which an income statement ispresented. EITF No. 06-3 is effective for the first annual orinterim reporting period beginning after December 15, 2006. Thedisclosures are required for annual and interim financial statements for eachperiod for which an income statement is presented. The adoption of  EITF No. 06-3 is not expected tohave an impact on our consolidated financial statements.

In July 2006, the FASB issued FASB InterpretationNo. 48 (“FIN 48”), *Accounting forUncertainty in Income Taxes—an interpretation of FASB Statement No. 109*,which prescribes accounting for and disclosure of uncertainty in tax positions.This interpretation defines the criteria that must be met for the benefits of atax position to be recognized in the financial statements and the measurementof tax benefits recognized. The provisions of FIN 48 are effective as ofthe beginning of our 2007 fiscal year, with the cumulative effect of the changein accounting principle recorded as an adjustment to opening retained earnings.We are currently unable to finalize an estimate of the impact that adopting FIN48 will have on our financial statements.

In September 2006, FASB issued SFAS No. 157(“SFAS No. 157”), *Fair ValueMeasurements.* This new standard provides guidance for using fairvalue to measure assets and liabilities. Under SFAS No. 157, fair valuerefers to the price that would be received to sell an asset or paid to transfera liability in an orderly transaction between market participants in the marketin which the reporting entity transacts. In this standard, the FASB clarifiesthe principle that fair value should be based on the assumptions market participantswould use when pricing the asset or liability. In support of this principle,SFAS No. 157 establishes a fair value hierarchy that prioritizes theinformation used to develop those assumptions. The fair value hierarchy givesthe highest priority to quoted prices in active markets and the lowest priorityto unobservable data, for example, the reporting entity’s own data. Under thestandard, fair value measurements would be separately disclosed by level withinthe fair value hierarchy. The provisions of SFAS No. 157 are effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. We have not yet determinedthe impact that the adoption of SFAS No. 157 will have on our consolidatedfinancial position, results of operations or cash flows.

In September 2006,the SEC issued SAB No. 108 (“SAB No. 108”), *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements.*SAB No. 108 provides guidance on the consideration of the effects of prioryear misstatements in quantifying current year misstatements for the purpose ofa materiality assessment. SAB No. 108 establishes an approach thatrequires quantification of financial statement errors based on the effects ofeach of the Company’s balance sheet and statement of operations financialstatements and the related financial statement disclosures. The SAB permitsexisting public companies to record the cumulative effect of initially applyingthis approach in the first year ending after November 15, 2006, byrecording the necessary correcting adjustments to the carrying values of assetsand liabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings. Additionally, the use ofthe cumulative effect 

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transitionmethod requires detailed disclosure of the nature and amount of each individualerror being corrected through the cumulative adjustment and how and when itarose. The adoption of SAB No. 108 did not have an impact on our resultsof operations or financial position.

**ITEM 7A:QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

We invest our excess cash primarily in U.S. governmentsecurities and investment-grade marketable debt securities of financialinstitutions and corporations. Except for the interest rate cap required by ourCredit Agreement, 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 believethat, while the instruments we hold are subject to changes in the financialstanding of the issuer of such securities, we are not subject to any materialrisks arising from changes in interest rates, foreign currency exchange rates,commodity prices, equity prices or other market changes that affect market risksensitive instruments.

Although substantially allof our sales and purchases are denominated in U.S. dollars, future fluctuationsin the value of the U.S. dollar may affect the price competitiveness of ourproducts outside the U.S. We do not believe, however, that we currently havesignificant direct foreign currency exchange rate risk and have not hedgedexposures denominated in foreign currencies.

***Interest rate risk***

Our interest income and expense is more sensitive tofluctuations in the general level of U.S. prime rate and LIBOR interest ratesthan to changes in rates in other markets. Changes in U.S. LIBOR interest ratesaffect the interest earned on our cash and cash equivalents and the interestexpense on our debt. At December 31, 2006, we had approximately$25.7 million of variable rate debt. If the interest rates on the variablerate debt were to increase or decrease by 1% for the year, annual interestexpense would increase or decrease by approximately $0.3 million.

We purchased a LIBORinterest rate cap agreement as an economic hedge against our Credit Agreementborrowings. The interest rate cap is 6.0% on a decreasing notional amountstarting at $35.0 million decreasing to approximately $34.0 million.This agreement expires on January 1, 2008. We reflected the cap on theconsolidated balance sheet at its fair market value and any change in fairvalue is reported in interest expense. As of December 31, 2006, the fairvalue of the interest rate cap was approximately $3,000.

**ITEM 8: FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

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

**ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURES**

Not applicable.

**ITEM 9A: CONTROLS AND PROCEDURES**

**Disclosure Controls and Procedures**

We are not yet subject to Section 404 of theSarbanes-Oxley Act which, when applicable, will require us to includeManagement’s Annual Report on Internal Control Over Financial Reporting and anAttestation Report of an Independent Registered Public Accounting Firm in ourAnnual Report on 

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Form 10-K. Under theapplicable rules of the Securities and Exchange Commission, or SEC,Section 404 will not apply to us until the due date of our annual reportfor the year ending December 31, 2007. 

While our independent registered public accountingfirm has not attested to or reported on ourinternal control over financial reporting as of the end of fiscal 2006, ourmanagement, with the participation of the Chief Executive Officer and ChiefFinancial Officer, completed an evaluation of the effectiveness of the designand operation of the Company’s disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) of the Securitiesand Exchange Act of 1934, as amended (the “Exchange Act”)). Based on thisevaluation, the Company’s Chief Executive Officer and Chief Financial Officerhave concluded that, as of the end of the fiscal year covered by this Form 10-K,the Company’s disclosure controls and procedures were effective to ensure thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified by the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to management,including the Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosures.

**Remediation ofMaterial Weaknesses**

As disclosed in our Registration Statement Form S-1/Afiled with the Securities and Exchange Commission on December 13, 2006,our management had determined that, as of that date, three material weaknessesexisted. A material weakness is a control deficiency or combination of controldeficiencies that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. As discussed in more detail below, one material weaknessrelated to controls over the application and implementation of generallyaccepted accounting principles commensurate with our financial reporting, thesecond material weakness related to controls over the valuation of intangibleassets, and the third material weakness related to controls over the completenessand accuracy of accounts payable and accrued expenses.

As of December 31, 2006, we have remedied allthree of the reported material weaknesses in internal controls. The reportedmaterial weaknesses and remediation results are as follows:

*Material weakness related to theapplication and implementation of generally accepted accounting principles.  *Asof December 31, 2005, we did not maintain a sufficient complement ofpersonnel with appropriate skills, training and company-specific experience inthe selection, application and implementation of generally accepted accountingprinciples commensurate with our financial reporting requirements. This controldeficiency contributed to the two other noted material weaknesses furtherdiscussed below. Additionally, this control deficiency could have resulted in amisstatement of accounts and disclosures that would result in a materialmisstatement of the annual or interim consolidated financial statements thatwould not be prevented or detected. Accordingly, management concluded that thiscontrol deficiency constituted a material weakness.

*Remediation.**  *We have taken the following steps to remediate thematerial weakness related to the application and implementation of generallyaccepted accounting principles:

·       Wehired a controller in December 2005, an assistant controller in April 2006and additional accounting support staff during the year ended December 31,2006.

·       Wehired a staff accountant to assist with month end processes.

·       Wehave adopted and implemented additional policies and procedures to strengthenour financial reporting capability.

·       TheFinancial Reporting Manager conducts a full review of each item in our SECdisclosure checklist, which is subsequently reviewed by the Chief FinancialOfficer.

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·       Wehave involved outside subject matter experts. Specifically, we contracted witha consulting firm to perform a thorough review of our white papers to ensurethat we are properly applying generally accepted accounting principles.

Management has concluded that the material weaknessdescribed above has been remedied as of December 31, 2006 and no longerexisted as of that date.

*Materialweakness related to the valuation of intangible assets.**  *As of December 31, 2005, wedid not maintain effective controls over the valuation of our intangible assets.Specifically, we did not maintain effective controls to ensure that appropriateuseful lives were assigned to certain purchased intangible assets and thatamortization on these assets was calculated and recorded in accordance withgenerally accepted accounting principles. This control deficiency resulted inthe restatement of our 2003 and 2004 consolidated financial statements andaudit adjustments to the 2005 consolidated financial statements. Additionally,this control deficiency could have resulted in a misstatement of intangibleassets and amortization expense that would result in a material misstatement toannual or interim financial statements that would not be prevented or detected.Accordingly, management has concluded that this control deficiency constituteda material weakness.

*Remediation.**  *We have taken the following stepsto remediate the material weakness related to the valuation of intangibleassets:

·       Wehave involved outside subject matter experts. Specifically, we contracted witha valuation firm to perform a thorough review of our valuation of intangibleassets and their useful lives. We review the useful lives of our intangibleassets in accordance with SFAS No. 144 *Accounting for theImpairment or Disposal of Long-Lived Assets.*

Management has concluded that the material weaknessdescribed above has been remedied as of December 31, 2006, and no longerexisted as of that date.

*Materialweakness related to the completeness and accuracy of accounts payable andaccrued expenses.**  *Asof December 31, 2005, we did not maintain effective controls over thecompleteness and accuracy of accounts payable and accrued expenses. Specifically,we did not maintain effective controls over the completeness and accuracy ofaccounts payable and accrued expenses to ensure that such expenses wererecorded in the proper period in accordance with generally accepted accountingprinciples. This control deficiency resulted in audit adjustments to the 2005consolidated financial statements. Additionally, this control deficiency couldhave resulted in a misstatement of accounts payable, accrued expenses, cost ofsales, selling and administrative expenses, and research and developmentexpenses that would result in a material misstatement to annual or interimfinancial statements that would not be prevented or detected. Accordingly,management has concluded that this control deficiency constituted a materialweakness.

*Remediation.**  *We have taken the following stepsto remediate the material weakness related to the completeness and accuracy ofaccounts payable and accrued expenses:

·       Wehired additional staff in our accounts payable department in October 2006.

·       Wehired a staff accountant to assist with month end processes.

·       Wehave adopted and implemented additional policies and procedures for properexpense authorization and cut-off.

·       Wehave restructured our accounting department to increase supervision and timelyreview of accrued expenses.

Management has concludedthat the material weakness described above has been remedied as of December 31,2006, and no longer existed as of that date.

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**Changes in InternalControl Over Financial Reporting**

Except as discussed above,there were no changes made in our internal control over financial reporting, assuch term is defined in Rules 13a-15(f) and 15(d)-15(f) underthe Exchange Act, during the quarter ended December 31, 2006, that havematerially affected, or are reasonably likely to materially affect, thesecontrols.

**ITEM 9B: OTHERINFORMATION**

**None.**

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**PART III**

**ITEM 10: DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

The information requiredby this item is incorporated into this Annual Report on Form 10-K byreference to the definitive proxy statement for our 2007 Annual Meeting ofStockholders (the “Proxy Statement”).

**ITEM 11: EXECUTIVECOMPENSATION**

The information requiredby this item is incorporated into this Annual Report on Form 10-K byreference to the Proxy Statement.

**ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

The information requiredby this item is incorporated into this Annual Report on Form 10-K byreference to the Proxy Statement.

**ITEM 13: CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS, AND DIRECTOR INDEPENDENCE**

The information requiredby this item is incorporated into this Annual Report on Form 10-K byreference to the Proxy Statement.

**ITEM 14: PRINCIPALACCOUNTING FEES AND SERVICES**

The information required by this item is incorporatedinto this Annual Report on Form 10-K by reference to the ProxyStatement.

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**PART IV**

**ITEM 15: EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

(a) 1.   *Consolidated FinancialStatements and Supplementary Data:*

Thefollowing financial statements are included as a separate section of thisreport commencing on page F-1:

| Report of independent  registered public accounting firm                                                                                                   |   | F-1  |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------|--------|
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                                         |   | F-2  |   |
| Consolidated Statements of Income for the years ended  December 31, 2006, 2005 and 2004                                                               |   | F-3  |   |
| Consolidated Statements of Stockholders’ Equity  (Deficit) and Comprehensive Income (Loss) for the years ended  December 31, 2006, 2005 and 2004 |   | F-4  |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                                                           |   | F-5  |   |
| Notes to Consolidated Financial Statements                                                                                                                 |   | F-6  |   |
| Quarterly Data (unaudited)                                                                                                                                 |   | F-39 |   |

 

(a) 2.   *Financial Statement Schedules:*

**Schedule II—Valuationand Qualifying Accounts**

Allother schedules have been omitted for the reason that the required informationis presented in financial statements or notes thereto, the amounts involved arenot significant or the schedules are not applicable.

| ** **                                                | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to Cost  and Expense** | ** ** | **Charged to  Contra-  Revenue** | ** ** | **Deductions** | ** ** | **Balance at  End of  Period** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| ** **                                                | ** ** | **(in thousands)**                        | ** ** |
| **Year ended December 31,  2004**                    | ** ** |                                           | ** ** | ** **                                      |       |                                  | ** ** | ** **     |       |                                     | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Allowance for  doubtful accounts and sales return reserve |       |                                           | $          | 469                                             | ** ** |                                  |       | $              | (36        | )                                        |       |   | $ | 100 |   |   |   | $ | (141 | ) |   |   | $ | 392 | ** ** |   |
| Reserve for  inventories                                  |       |                                           | 502        | ** **                                      |       |                                  | 69         |           |       |                                     | —     |   |   |   | (255 | ) |   |   | 316 | ** ** |   |
| **Year ended December 31,  2005**                    | ** ** |                                           | ** ** | ** **                                      |       |                                  | ** ** | ** **     |       |                                     | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Allowance for doubtful  accounts and                      |       |                                           |       | ** **                                      |       |                                  |       |           |       |                                     |       |   |   |   |   |   |   |   |   | ** ** |   |
| sales return reserve                                      |       |                                           | $          | 392                                             | ** ** |                                  |       | $              | 344        |                                     |       |   | $ | (18 | ) |   |   | $ | (217 | ) |   |   | $ | 501 | ** ** |   |
| Reserve for  inventories                                  |       |                                           | 316        | ** **                                      |       |                                  | 339        |           |       |                                     | —     |   |   |   | (218 | ) |   |   | 437 | ** ** |   |
| **Year ended December 31,  2006**                    | ** ** |                                           | ** ** | ** **                                      |       |                                  | ** ** | ** **     |       |                                     | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Allowance for  doubtful accounts and sales return reserve |       |                                           | $          | 501                                             | ** ** |                                  |       | $              | 180        |                                     |       |   | $ | 142 |   |   |   | $ | (172 | ) |   |   | $ | 651 | ** ** |   |
| Reserve for inventories                                   |       |                                           | 437        | ** **                                      |       |                                  | 81         |           |       |                                     | —     |   |   |   | (242 | ) |   |   | 276 | ** ** |   |

 

75

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(a) 3.   *Exhibits:*

| Exhibit | ** ** | **Exhibit title** | ** ** | ** **                                                                                                                                                                                 | ** ** |
|---------|------------|------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|    | 3.1        |                   |       | Amended and Restated Certificate of Incorporation of  the Company.                                                                                                                         |       | (1) |   |
|    | 3.2        |                   |       | Amended and Restated Bylaws of the Company.                                                                                                                                                |       | (1) |   |
|    | 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) |   |
|    | 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) |   |

76

----

 

|        | 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.**                                                                                                                                |   | *   |   |
|   | 10.31 |   |   | Employment Agreement by  and between the Company and David Goldstein, dated August 10, 1999.**                                                                                                                               |   | *   |   |
|   | 10.32 |   |   | Employment Agreement by  and between the Company and Stephen Garcia, dated June 13, 2003.**                                                                                                                                  |   | *   |   |
|   | 10.33 |   |   | Employment Agreement by and  between the Company and Judith Hattendorf, dated August 23, 2000.**                                                                                                                             |   | *   |   |
|   | 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.                                                                                                                    |   | *   |   |

----

*                    Filed herewith

+                Material has beenomitted pursuant to a request for confidential treatment and such material hasbeen filed separately with the SEC.

**             Management contractsor compensatory plans and arrangements required to be filed pursuant to Item601(b)(10)(ii)(A) or (iii) of Regulation S-K.

(1)          Incorporated herein byreference to the Company’s Registration of Form S-1/A (Registration No. 333-137272, previously filed with theCommission.

77

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**SIGNATURES**

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

|                      | OBAGI MEDICAL PRODUCTS, INC. |
|----------------------|------------------------------|
|                 |                         |   |   |
|                 |                         |   |   |
| Date: March 15, 2007 | By:                          |   | /s/ STEVEN R.  CARLSON |
| ** **           | ** **                   |   | Steven R. Carlson |
| ** **           | ** **                   |   | Chief Executive Officer |
|                 |                         |   | (Principal Executive Officer) |
| ** **           | ** **                   | ** ** | ** ** |
| Date: March 15, 2007 | By:                          |   | /s/ STEPHEN A.  GARCIA |
| ** **           | ** **                   |   | Stephen A. Garcia |
| ** **           | ** **                   |   | Chief Financial Officer |
| ** **           | ** **                   |   | (Principal Financial Officer) |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.

|                               | **Signature** | ** **                                       | ** ** | ** **     | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------------|---------------|--------------------------------------------------|------------|----------------|-----------|------------|------------|------------|----------|------------|
| /s/ STEVEN R. CARLSON         |          | Chief Executive Officer,  President and Director |       | March 15, 2007 |
| Steven R. Carlson             |          | (Principal Executive Officer)                    |       |           |
| /s/ STEPHEN A. GARCIA         |          | Chief Financial Officer                          |       | March 15, 2007 |
| Stephen A. Garcia             |          | (Principal Financial and Accounting Officer)     |       |           |
| /s/ ALBERT J. FITZGIBBONS III |          | Chairman of the Board of  Directors              |       | March 15, 2007 |
| Albert J. Fitzgibbons III     |          |                                             |       |           |
| /s/ JOHN A. BARTHOLDSON       |          | Director                                         |       | March 15, 2007 |
| John A. Bartholdson           |          |                                             |       |           |
| /s/ BRADLEY J. HOECKER        |          | Director                                         |       | March 15, 2007 |
| Bradley J. Hoecker            |          |                                             |       |           |
| /s/ EDWARD A. GRANT           |          | Director                                         |       | March 15, 2007 |
| Edward A. Grant               |          |                                             |       |           |
| /s/ ALBERT F. HUMMEL          |          | Director                                         |       | March 15, 2007 |
| Albert F. Hummel              |          |                                             |       |           |
| /s/ RONALD P. BADIE           |          | Director                                         |       | March 15, 2007 |
| Ronald P. Badie               |          |                                             |       |           |

 

78

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**Reportof independent registered public accounting firm**

To the Board of Directors and Stockholders ofObagi Medical Products, Inc.

In our opinion, the consolidated financial statementslisted in the  index appearing under Item15(a)(1) present fairly, in all material respects, the financial positionof Obagi Medical Products, Inc. and its subsidiaries (the “Company”) at December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2006 inconformity with accounting principles generally accepted in the United Statesof America. In addition, in our opinion, the financial statement schedulelisted in the index appearing under Item 15(a)(2) presents fairly, in allmaterial respects, the information set forth therein when read in conjunctionwith the related consolidated financial statements. These financial statementsand the financial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and the financial statement schedule based on our audits. Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

As discussed in Note 2 tothe consolidated financial statements, the Company changed the manner in whichit accounts for share-based compensation in 2006.

/s/ PRICEWATERHOUSECOOPERS LLP

Los Angeles, CaliforniaFebruary 26, 2007

F-1

----

**Obagi Medical Products, Inc.Consolidated Balance Sheets***(Dollars in thousands, exceptshare and per share amounts)*
|                                                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                                                 |       |                  |       |   |   |
| Current assets                                                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                  |       | $                     | 11,298     |   | $ | 3,367 |   |
| Accounts receivable, net of allowance for doubtful  accounts and sales returns of $651 and $501 as of December 31, 2006 and  2005, respectively                                                       |       | 10,049                |       | 11,104 |   |
| Accounts receivable from related parties                                                                                                                                                                   |       | 1,501                 |       | 1,145 |   |
| Inventories, net                                                                                                                                                                                           |       | 6,266                 |       | 3,108 |   |
| Deferred income taxes                                                                                                                                                                                      |       | 1,000                 |       | 917 |   |
| Prepaid expenses and other current assets                                                                                                                                                                  |       | 2,895                 |       | 2,019 |   |
| Income taxes receivable                                                                                                                                                                                    |       | 905                   |       | 2,850 |   |
| Total current assets                                                                                                                                                                                       |       | 33,914                |       | 24,510 |   |
| Property and  equipment, net                                                                                                                                                                               |       | 3,749                 |       | 2,925 |   |
| Goodwill                                                                                                                                                                                                   |       | 4,629                 |       | 4,629 |   |
| Intangible assets,  net                                                                                                                                                                                    |       | 6,308                 |       | 6,884 |   |
| Deferred income  taxes                                                                                                                                                                                     |       | 1,971                 |       | 1,603 |   |
| Other assets                                                                                                                                                                                               |       | 2,390                 |       | 5,396 |   |
| Total assets                                                                                                                                                                                               |       | $                     | 52,961     |   | $ | 45,947 |   |
| **Liabilities  and Stockholders’ Equity (Deficit)**                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities                                                                                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                           |       | $                     | 5,512      |   | $ | 2,325 |   |
| Current portion of long-term debt                                                                                                                                                                          |       | 2,729                 |       | 3,423 |   |
| Accrued liabilities                                                                                                                                                                                        |       | 3,598                 |       | 3,160 |   |
| Amounts due to related parties                                                                                                                                                                             |       | 152                   |       | 205 |   |
| Total current liabilities                                                                                                                                                                                  |       | 11,991                |       | 9,113 |   |
| Long-term debt                                                                                                                                                                                             |       | 23,052                |       | 63,195 |   |
| Total liabilities                                                                                                                                                                                          |       | 35,043                |       | 72,308 |   |
| Commitments and contingencies  (Note 10)                                                                                                                                                                   |       |                  |       |   |   |
| Stockholders’ equity  (deficit)                                                                                                                                                                       |       |                  |       |   |   |
| Common stock, $.001 par value; 100,000,000 shares  authorized, 21,804,689 and 17,792,583 shares issued and 21,801,961 and  17,792,583 shares outstanding at December 31, 2006 and 2005,  respectively |       | 22                    |       | 18 |   |
| Additional paid-in capital                                                                                                                                                                                 |       | 39,109                |       | 900 |   |
| Accumulated deficit                                                                                                                                                                                        |       | (21,144               | )          | (27,260 | ) |
| Stockholder receivable                                                                                                                                                                                     |       | (23                   | )          | — |   |
| Accumulated other comprehensive loss                                                                                                                                                                       |       | (46                   | )          | (19 | ) |
| Total stockholders’ equity (deficit)                                                                                                                                                                  |       | 17,918                |       | (26,361 | ) |
| Total liabilities  and stockholders’ equity (deficit)                                                                                                                                                 |       | $                     | 52,961     |   | $ | 45,947 |   |

 

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, exceptshare and per share amounts)*

| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                            |       | $                                          | 77,996     |   | $ | 64,941 |   | $ | 56,256 |   |
| Cost of sales                                        |       | 13,467                                     |       | 11,572 |   | 9,484 |   |
| Gross profit                                         |       | 64,529                                     |       | 53,369 |   | 46,772 |   |
| Selling, general  and administrative expenses        |       | 40,863                                     |       | 29,023 |   | 23,808 |   |
| Research and  development expenses                   |       | 5,919                                      |       | 3,262 |   | 1,569 |   |
| Income from operations                               |       | 17,747                                     |       | 21,084 |   | 21,395 |   |
| Interest income                                      |       | 13                                         |       | 61 |   | 161 |   |
| Interest expense                                     |       | (8,186                                     | )          | (6,146 | ) | (20 | ) |
| Gain on legal  settlements                           |       | —                                     |       | — |   | 230 |   |
| Income before provision for income taxes             |       | 9,574                                      |       | 14,999 |   | 21,766 |   |
| Provision for  income taxes                          |       | 3,458                                      |       | 6,043 |   | 7,685 |   |
| Net income                                           |       | 6,116                                      |       | 8,956 |   | 14,081 |   |
| Dividends on  mandatorily redeemable preferred stock |       | —                                     |       | (140 | ) | (1,363 | ) |
| Net income attributable to common stockholders       |       | $                                          | 6,116      |   | $ | 8,816 |   | $ | 12,718 |   |
| Net income attributable  to common shares            |       |                                       |       |   |   |   |   |
| Basic                                                |       | $                                          | 0.34       |   | $ | 0.50 |   | $ | 0.79 |   |
| Diluted                                              |       | $                                          | 0.34       |   | $ | 0.50 |   | $ | 0.74 |   |
| Weighted average common  shares outstanding          |       |                                       |       |   |   |   |   |
| Basic                                                |       | 17,996,158                                 |       | 17,522,611 |   | 16,021,149 |   |
| Diluted                                              |       | 18,071,048                                 |       | 17,765,716 |   | 17,321,128 |   |

 

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

F-3

----

**Obagi MedicalProducts, Inc.**Consolidated Statements of Stockholders’ Equity (Deficit) andComprehensive Income *(Dollarsin thousands, except share and per share amounts)*
|                                                                                                             | ** ** | ** **            | ** ** | ** **     | ** ** | ** **      | ** ** | ** **              | ** **    | ** **      | ** ** | **Accumulated**   | ** **     | ** **     | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-----------------|------------|-------------------------|---------------|-----------------|------------|-------------------|----------------|----------------|------------|
| ** **                                                                                                  | ** ** | ** **            | ** ** | ** **     | ** ** | ** **      | ** ** | ** **              | ** **    | ** **      | ** ** | **Other**         | ** **     | ** **     | ** ** |
| ** **                                                                                                  | ** ** | ** **            | ** ** | **Additional** | ** ** | **Accumulated** | ** ** | ** **              | ** **    | ** **      | ** ** | **Comprehensive** | ** **     | ** **     | ** ** |
| ** **                                                                                                  | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Earnings**    | ** ** | **Treasury Stock** | ** **    | **Stockholder** | ** ** | **Income**        | ** **     | ** **     | ** ** |
| ** **                                                                                                  | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**     | ** ** | **(Deficit)**           | ** **    | **Shares**      | ** ** | **Amount**        | ** **     | **Receivable** | ** ** | **(Loss)** | ** ** | **Total** | ** ** |
| **Balances, as of December 31, 2003**                                                                  | 17,731,346 |                  |       | $ 18      |       |            |       | $ 5,089            |          |            |       | $ 7,850      |           |           | (1,826,649 | ) |   | $ (6,576 | ) |   |   | $ — |   |   |   | $  9 |   |   | $ 6,390 |   |
| Comprehensive  income:                                                                                      |       |                  |       |           |       |            |       |                    |          |            |       |              |           |           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Translation adjustment, net of tax effect ($38)                                                             |       | —                |       |           | —     |            |       |                    | —        |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | 69 |   |   | 69 |   |
| Net income for the year ended December 31, 2004                                                        |       | —                |       |           | —     |            |       |                    | —        |            |       |              | 14,081         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 14,081 |   |
| Total comprehensive income                                                                                  |       |                  |       |           |       |            |       |                    |          |            |       |              |           |           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 14,150 |   |
| Cancellation of common stock                                                                                |       | (30,000               | )          |           | —     |            |       |                    | (180          | )               |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | (180 | ) |
| Issuance of common stock upon exercise of incentive  stock options                                          |       | —                |       |           | —     |            |       |                    | —        |            |       |              | (123           | )              |       | 50,500 |   |   | 182 |   |   |   | — |   |   |   | — |   |   | 59 |   |
| Conversion of redeemable preferred stock into common  stock                                                 |       | —                |       |           | —     |            |       |                    | 80            |            |       |              | —         |           |       | 263,125 |   |   | 947 |   |   |   | — |   |   |   | — |   |   | 1,027 |   |
| Preferred stock dividends accrued ($11 and $5 per  share for Series A and Series B, respectively) |       | —                |       |           | —     |            |       |                    | —        |            |       |              | (1,363         | )              |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | (1,363 | ) |
| **Balances, as of December 31, 2004**                                                                  |       | 17,701,346            |       |           | 18         |            |       |                    | 4,989         |            |       |              | 20,445         |           |       | (1,513,024 | ) |   | (5,447 | ) |   |   | — |   |   |   | 78 |   |   | 20,083 |   |
| Comprehensive  income:                                                                                      |       |                  |       |           |       |            |       |                    |          |            |       |              |           |           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Translation adjustment, net of tax effect ($3)                                                              |       | —                |       |           | —     |            |       |                    | —        |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | (97 | ) |   | (97 | ) |
| Net income for the year ended December 31, 2005                                                        |       | —                |       |           | —     |            |       |                    | —        |            |       |              | 8,956          |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 8,956 |   |
| Total comprehensive income                                                                                  |       |                  |       |           |       |            |       |                    |          |            |       |              |           |           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 8,859 |   |
| Issuance of common stock upon  exercise of stock options                                                    |       | —                |       |           | —     |            |       |                    | (80           | )               |       |              | (1,994         | )              |       | 1,336,136 |   |   | 4,810 |   |   |   | — |   |   |   | — |   |   | 2,736 |   |
| Tax benefit from exercise of stock options                                                                  |       | —                |       |           | —     |            |       |                    | 3,652         |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 3,652 |   |
| Preferred stock dividends accrued ($11 and $5 per  share for Series A and Series B, respectively) |       | —                |       |           | —     |            |       |                    | —        |            |       |              | (140           | )              |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | (140 | ) |
| Common stock dividends paid ($3.60 per share)                                                               |       | —                |       |           | —     |            |       |                    | (8,561        | )               |       |              | (54,527        | )              |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | (63,088 | ) |
| Conversion of redeemable preferred stock into common  stock                                                 |       | 86,237                |       |           | —     |            |       |                    | 863           |            |       |              | —         |           |       | 176,888 |   |   | 637 |   |   |   | — |   |   |   | — |   |   | 1,500 |   |
| Issuance of common stock for services received                                                              |       | 5,000                 |       |           | —     |            |       |                    | 37            |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 37 |   |
| **Balances,  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          |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 6,116 |   |
| Total comprehensive income                                                                                  |       |                  |       |           |       |            |       |                    |          |            |       |              |           |           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 6,089 |   |
| Issuance of common stock upon exercise of incentive  stock options                                          |       | 6,600                 |       |           | —     |            |       |                    | 9             |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 9 |   |
| From exercise of stock options                                                                              |       | —                |       |           | —     |            |       |                    | (222          | )               |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | (222 | ) |
| Stock compensation expense                                                                                  |       | —                |       |           | —     |            |       |                    | 305           |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 305 |   |
| Issuance of common stock in initial public offering,  net of offering costs                                 |       | 4,000,000             |       |           | 4          |            |       |                    | 38,094        |            |       |              | —         |           |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   | 38,098 |   |
| Issuance of common stock in exchange for stockholder  receivable                                            |       | 2,778                 |       |           | —     |            |       |                    | 23            |            |       |              | —         |           |       | — |   |   | — |   |   |   | (23 | ) |   |   | — |   |   | — |   |
| **Balances,  as of December 31, 2006**                                                                 |       | 21,801,961            |       |           | $ 22  |            |       |                    | $ 39,109 |            |       |              | $ (21,144 | )              |       | — |   |   | $    — |   |   |   | $ (23 | ) |   |   | $ (46 | ) |   | $ 17,918 |   |

 

 

The accompanyingnotes are an integral part of these consolidated financial statements.

F-4

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**Obagi Medical Products, Inc.**Consolidated Statements of Cash Flows*(Dollars in thousands, exceptshare and per share amounts)*

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash flows from operating activities**                                          | ** ** | ** **                                 |       |   | * * | * * | * * |
| Net income                                                                        |       | $                                          | 6,116      |   | $ | 8,956 |   | $ | 14,081 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                    |       | 2,758                                      |       | 2,090 |   | 1,339 |   |
| Gain on legal settlements                                                         |       | —                                     |       | — |   | (180 | ) |
| Write down of debt  issuance costs                                                |       | 1,282                                      |       | — |   | — |   |
| Loss on disposal of  property and equipment                                       |       | 72                                         |       | — |   | — |   |
| Provision for doubtful  accounts                                                  |       | 8                                          |       | 128 |   | 36 |   |
| Deferred income taxes                                                             |       | (450                                       | )          | 487 |   | 440 |   |
| Issuance of common shares  to outside directors                                   |       | —                                     |       | 37 |   | — |   |
| Stock compensation  expense                                                       |       | 305                                        |       | — |   | — |   |
| Tax benefit (expense) from  exercise of stock options                             |       | (222                                       | )          | 3,652 |   | — |   |
| Changes in operating assets and liabilities                                       |       |                                       |       |   |   |   |   |
| Accounts receivable                                                               |       | 1,047                                      |       | (3,411 | ) | (1,679 | ) |
| Accounts receivable from  related parties                                         |       | (356                                       | )          | (264 | ) | 109 |   |
| Income taxes receivable                                                           |       | 1,945                                      |       | (2,850 | ) | 215 |   |
| Inventories                                                                       |       | (3,158                                     | )          | (296 | ) | (247 | ) |
| Prepaid expenses and  other current assets                                        |       | (876                                       | )          | (807 | ) | (245 | ) |
| Other assets                                                                      |       | 875                                        |       | (1,929 | ) | (41 | ) |
| Accounts payable                                                                  |       | 3,187                                      |       | (949 | ) | 1,183 |   |
| Accrued liabilities                                                               |       | 438                                        |       | 655 |   | 192 |   |
| Amounts due to related  parties                                                   |       | (53                                        | )          | (63 | ) | (145 | ) |
| Net cash provided by  operating activities                                        |       | 12,918                                     |       | 5,436 |   | 15,058 |   |
| **Cash flows from investing activities**                                          |       |                                       |       |   |   |   |   |
| Purchases of  property and equipment                                              |       | (1,818                                     | )          | (2,040 | ) | (930 | ) |
| Purchase of  licenses                                                             |       | —                                     |       | — |   | (1,275 | ) |
| Purchase of other  intangible assets                                              |       | (366                                       | )          | (264 | ) | (493 | ) |
| Net cash used in  investing activities                                            |       | (2,184                                     | )          | (2,304 | ) | (2,698 | ) |
| **Cash flows from financing activities**                                          |       |                                       |       |   |   |   |   |
| Principal payments  on term loans                                                 |       | (40,849                                    | )          | (3,500 | ) | (1,875 | ) |
| Principal payments  on capital lease obligations                                  |       | (35                                        | )          | (13 | ) | (9 | ) |
| Proceeds from the  issuance of common stock, net of offering costs                |       | 38,098                                     |       | — |   | — |   |
| Proceeds from  issuance of debt                                                   |       | —                                     |       | 70,000 |   | — |   |
| Proceeds from  exercise of stock options                                          |       | 9                                          |       | 2,736 |   | 59 |   |
| Dividends to  common stockholders                                                 |       | —                                     |       | (63,088 | ) | — |   |
| Dividends to  preferred stockholders                                              |       | —                                     |       | (9,329 | ) | — |   |
| Redemption of  redeemable preferred stock                                         |       | —                                     |       | (11,822 | ) | — |   |
| Debt issuance  costs                                                              |       | —                                     |       | (2,886 | ) | (1,109 | ) |
| Net cash used in  financing activities                                            |       | (2,777                                     | )          | (17,902 | ) | (2,934 | ) |
| Effect of exchange  rate changes on cash and cash equivalents                     |       | (26                                        | )          | (97 | ) | 69 |   |
| Net increase (decrease)  in cash and cash equivalents                             |       | 7,931                                      |       | (14,867 | ) | 9,495 |   |
| Cash and cash  equivalents at beginning of year                                   |       | 3,367                                      |       | 18,234 |   | 8,739 |   |
| Cash and cash  equivalents at end of year                                         |       | $                                          | 11,298     |   | $ | 3,367 |   | $ | 18,234 |   |
| **Supplemental disclosure of cash flow  information:**                            |       |                                       |       |   |   |   |   |
| Cash paid during the year for:                                                    |       |                                       |       |   |   |   |   |
| Interest, net of amount  capitalized                                              |       | $                                          | 5,822      |   | $ | 5,146 |   | $ | 8 |   |
| Income taxes, net of  refunds                                                     |       | $                                          | 2,135      |   | $ | 4,858 |   | $ | 7,034 |   |
| **Non cash investing and financing activities**                                   |       |                                       |       |   |   |   |   |
| Capital lease obligations  incurred                                               |       | $                                          | 47         |   | $ | 68 |   | $ | — |   |
| Accrual of dividends on  preferred stock                                          |       | $                                          | —     |   | $ | 26 |   | $ | 1,363 |   |
| Interest rate cap fair value adjustment                                           |       | $                                          | (16        | ) | $ | — |   | $ | — |   |

 

During the years ended December 31, 2005 and2004, the holder of the Series B preferred stock converted 9,065 and 6,400shares of Series B preferred stock, respectively, plus related cumulativeand unpaid dividends, into 315,750 shares of common stock in each period.

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

F-5

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

** **

**Note 1:    TheCompany**

Obagi Medical Products, Inc. (“the Company”) is aspecialty pharmaceutical company focused on the aesthetic and skin healthmarkets. The Company develops and commercializes prescription-based, topicalskin health systems. The Company is incorporated under the laws of the state ofDelaware. The Company has developed prescription-based skin health systems thatimprove the underlying health of patients’ skin and enable physicians to treata range of skin conditions, including premature aging, photo-damage,hyperpigmentation, acne and soft tissue deficits, such as fine lines andwrinkles. The Company’s main product lines are prescription-based skin healthsystems that improve the efficacy of established prescription andover-the-counter, or OTC, therapeutic agents by enhancing the penetration ofthese agents across the skin barrier using proprietary technologies. In 2005,the Company launched a series of high potency Vitamin C serums under theObagi Professional-C brand, which represent an improved product line with moreeffective skin barrier penetration. This new product line replaces the Company’sVitamin C serum offerings under the Cffectives and Obagi-C brands that theCompany introduced in 2000. In 2006, the Company launched its first productunder the ELASTIdermTM product line, a bi-mineral complex which increases thefunctional elasticity of the skin. In addition, the Company conductedcontrolled experience trials with its first product offering under theCLENZIderm M.D.TM product line, which is a prescription strength gel form ofsolubilized Benzoyl Peroxide that allows for more rapid and deeper penetrationinto the follicle to control acne.

The Company markets itsproducts through its own sales force throughout the United States, and throughtwelve distribution partners in 35 countries around the world including Canada,Europe, the Far East, the Middle East, Mexico, and South America. The Companyalso licenses certain non-prescription product concepts under the Obagitrademark to a large Japanese based pharmaceutical company for sale throughconsumer distribution channels in Japan.

***Reverse Stock Split***

On November 27, 2006,the Board of Directors approved, and on November 28, 2006, thestockholders approved, a 1-for-1.2 reverse stock split of the Company’scommon stock to become effective upon the filing of a Certificate of Amendmentwith the Secretary of State of the state of Delaware. The filing of theCertificate of Amendment was a condition precedent to the Company’s requestthat its Registration Statement on Form S-1 be declared effective.The Company’s Registration Statement on Form S-1 was declaredeffective on December 13, 2006. All share and per share amounts includedin the Company’s financial statements have been adjusted to reflect this reversestock split for all periods presented.

***Amended and Restated Certificate of Incorporation andAmended and Restated Bylaws***

On November 27, 2006,the Board of Directors of the Company approved an amended and restatedCertificate of Incorporation and an amended and restated Bylaws in preparationfor a contemplated initial public offering. This amended and restatedCertificate 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 tothe 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 

F-6

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

classes,term and number of the members of the board of directors were modified; and (iii) otherchanges 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 ofcommon stock at a price of $11.00 per share. The offering consisted of4,000,000 newly issued shares sold by the Company and 1,350,000 sharessold by selling stockholders. The offering generated gross proceeds ofapproximately $44,000 and net proceeds of $38,098.

**Note 2:    Summaryof significant accounting policies**

**Principles ofconsolidation**

The consolidated financialstatements include the accounts of Obagi Medical Products, Inc. and itswholly owned subsidiary, OMP, Inc. The consolidated financial statementsof OMP, Inc. include the accounts of its wholly owned subsidiaries and itsmajority owned subsidiary, Obagi Singapore. All intercompany accounts andtransactions have been eliminated in consolidation.

**Use of estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**Reclassifications**

Certain prior year amountshave been reclassified to conform to the current year’s presentation.

**Cash and cashequivalents**

Cash equivalents include demand deposits andshort-term investments with a maturity of three months or less when purchased.

The Company maintains itscash deposits at numerous banks located throughout the United States, which attimes, may exceed federally insured limits. The Company has not experienced anylosses in such accounts and believes it is not exposed to any significant risk.At December 31, 2006 and 2005, cash on deposit was in excess of thefederally insured limit of $100.

**Accounts receivable**

The Company performs periodic credit evaluations ofthe financial condition of its customers, monitors collections and paymentsfrom customers, and generally does not require collateral. Receivables aregenerally due within 30 days. The Company provides for the possibleinability to collect accounts receivable by recording an allowance for doubtfulaccounts. The Company writes off an account when it is considered to beuncollectible. The Company estimates its allowance for doubtful accounts basedon historical experience, aging of accounts receivable, and informationregarding the creditworthiness of its customers. The Company estimates itsallowance for doubtful accounts pursuant to sales returns based on 

F-7

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

the Company’s historicalrate of returns and current market conditions. To date, losses have been withinthe range of management’s expectations.

Concentrations of creditrisk, with respect to trade receivables, are limited due to the large number ofcustomers comprising the Company’s customer base and their dispersion acrossdifferent geographic regions. As of December 31, 2006 and 2005, no singlecustomer represented more than 10% of the net accounts receivable balance.

**Inventories**

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

Inventory reserves areestablished when conditions indicate that the selling price could be less thancost due to physical deterioration, usage, obsolescence, reductions inestimated future demand and reductions in selling prices. Inventory reservesare measured as the difference between cost of inventory and the estimated netrealizable value. Inventory reserves are charged to cost of sales. The Company’sestimated inventory reserve is provided for in the consolidated financialstatements and actual reserve requirements approximated management’s estimates.

**Impairment oflong-lived assets**

The Company periodicallyassesses potential impairments of its long-lived assets in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,*Accounting for the Impairment or Disposal ofLong-lived Assets*. An impairment review is performed whenever eventsor changes in circumstances indicate that the carrying value of an asset maynot be recoverable. Factors considered by the Company include, but are notlimited to, significant underperformance relative to expected historical orprojected future operating results; significant changes in the manner of use ofthe acquired assets or the strategy for the overall business; and significantnegative industry or economic trends. When the carrying value of a long-livedasset may not be recoverable based upon the existence of one or more of theabove indicators of impairment, the Company will assess the recoverability ofthe assets by estimating the future undiscounted operating cash flows expected toresult from the use of the asset and its eventual disposition. If the sum ofthe expected future undiscounted cash flows and eventual disposition is lessthan the carrying amount of the asset, the Company recognizes an impairmentloss. An impairment loss is reflected as the amount by which the carryingamount of the asset exceeds the fair value of the asset, based on the fairmarket value if available, or discounted cash flows, if not. To date, theCompany has not recognized an impairment charge related to the write-down oflong-lived assets.

**Property andequipment**

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

| Furniture and  fixtures           |   | 3-5 years                               |   |
|-----------------------------------|--------|-----------------------------------------|--------|
| Computer software  and equipment  |   | 3 years                                 |   |
| Lab and office  equipment         |   | 3 years                                 |   |
| Leasehold  improvements           |   | Lesser of useful life or  term of lease |   |
| Capital lease (office  equipment) |   | Lesser of useful life or term of lease  |   |

 

F-8

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

Property and equipment arestated at cost, less accumulated depreciation and amortization. Expendituresfor major renewals and betterments are capitalized, while minor replacements,maintenance and repairs, which do not extend the assets useful lives, arecharged to operations as incurred. Upon sale or disposition, the cost andrelated accumulated depreciation is removed from the accounts and any gain orloss is included in operations.

**Goodwill and otherintangibles**

SFAS No. 142 (“SFAS No. 142”), *Goodwill and Other Intangible Assets,* requires the Companyto test goodwill for impairment on an annual basis and more frequently if thereis reason to suspect that the value has been diminished or impaired, with anycorresponding write-downs recognized as necessary.

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

Application of the goodwill impairment test requiresjudgment, including the identification of reporting units, assignment of assetsand liabilities to reporting units, assignment of goodwill to reporting units,and determination of the fair value of each reporting unit. The fair value ofeach reporting unit is estimated using a discounted cash flow methodology. Thisrequires significant judgments including estimation of future cash flows, whichis dependent on internal forecasts, estimation of the long-term rate of growthof 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 inthese estimates and assumptions could materially affect the determination offair value and/or goodwill impairment for each reporting unit.

The Company has selected September 30 as the dateon which it will perform its annual goodwill impairment test. Based on theCompany’s analysis, no impairment charges were recognized for the years ended December 31,2006, 2005, and 2004.

Other intangible assetsconsist of trademarks, distribution rights, covenants not-to-compete, patents,customer lists, and proprietary formulations. Other intangible assets areamortized over the expected period of benefit using the straight-line methodover the following lives: trademarks (twenty years); distribution rights (tenyears); covenants not-to-compete (seven years); other intangible assets (threeto seventeen years).

F-9

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

**Intangible assets**

At December 31,2006 and 2005, the carrying amounts and accumulated amortization of intangibleassets is as follows:

| ** **               | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|--------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization**   | ** ** | **Net Book  Value** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| Trademarks               |       | $                               | 7,308      |                            |       | $ | (3,305 | ) |   |   | $ | 4,003 |   |   | $ | 7,265 |   |   | $ | (2,944 | ) |   |   | $ | 4,321 |   |   |
| Distribution  rights     |       | 1,082                           |       |                            | (768       | ) |   |   | 314 |   |   | 1,082 |   |   | (660 | ) |   |   | 422 |   |   |
| Covenant  not-to-compete |       | 931                             |       |                            | (798       | ) |   |   | 133 |   |   | 931 |   |   | (665 | ) |   |   | 266 |   |   |
| Licenses                 |       | 1,775                           |       |                            | (901       | ) |   |   | 874 |   |   | 1,675 |   |   | (698 | ) |   |   | 977 |   |   |
| Other intangible  assets |       | 3,071                           |       |                            | (2,087     | ) |   |   | 984 |   |   | 2,849 |   |   | (1,951 | ) |   |   | 898 |   |   |
|                     |       | $                               | 14,167     |                            |       | $ | (7,859 | ) |   |   | $ | 6,308 |   |   | $ | 13,802 |   |   | $ | (6,918 | ) |   |   | $ | 6,884 |   |   |

 

Amortization expense related to all intangible assets,including certain amounts reflected in cost of sales, for the years ended December 31,2006, 2005, and 2004 was $941, $1,078, and $1,085, respectively.

Futureestimated aggregate amortization expense for the next five years and thereafteris as follows:

| **Years ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2007                                         |       | $          | 941        |   |
| 2008                                         |       | 807        |       |
| 2009                                         |       | 764        |       |
| 2010                                         |       | 732        |       |
| 2011                                         |       | 657        |       |
| Thereafter                                   |       | 2,407      |       |
|                                         |       | $          | 6,308      |   |

 

**Debt issuance costs**

Direct costs incurred in connection with indebtednessagreements are capitalized as incurred and amortized on the effective interestmethod over the term of the related indebtedness. Debt issuance costs areincluded in other assets and represent fees and other costs incurred inconnection with the Senior Secured Credit Facility entered into on January 28,2005. In connection with this transaction, the Company incurred $2,886 in costsduring fiscal year 2005.

Pursuant to the ThirdAmendment of the Senior Secured Credit Facility, the Company made a repaymentof $35,000 in debt with the net cash proceeds received in the initial publicoffering consummated on December 13, 2006. As a result, the Companyrecorded a write down of debt issuance costs of $1,282 during the year ended December 31,2006. The write down is included as a component of interest expense. At December 31,2006 and 2005, the Company has debt issuance costs of $1,254, and $3,385,respectively, net of accumulated amortization of $1,459, and $610,respectively.

**Derivativefinancial instruments**

In 2001, the Company adopted SFAS No. 133 (“SFAS No. 133”),*Accounting for Derivative Instruments andHedging Activities* and its related amendments. As a result of theadoption of SFAS No. 133, the 

F-10

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

Company recognizesderivative financial instruments, such as its interest rate cap contract, aseither assets or liabilities in the consolidated financial statements at fairvalue.

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

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

**Income taxes**

Income taxes are determined using an annual effectivetax rate, which generally differs from the United States federal statutoryrate, primarily because of state taxes and research and development tax credits.The Company recognizes deferred tax assets and liabilities for temporarydifferences between the financial reporting basis and the tax basis of theCompany’s assets and liabilities, along with net operating loss and creditcarryforwards.

The effect on deferredtaxes of a change in tax rates is recognized in income in the period thatincludes the enactment date. Income tax benefits credited to stockholders’equity (deficit) relate to tax benefits associated with amounts that aredeductible for income purposes but do not impact net income. These benefits areprincipally generated from employee exercises of non-qualified stock options.

**Fair values offinancial instruments**

The following methods and assumptions were used by theCompany in estimating the fair value of its financial instruments fordisclosure purposes:

*Long-termdebt:**  *Thecarrying value of the Company’s debt approximates fair value. The carryingvalue of the Company’s long-term debt approximates fair value because theinterest rate adjusts to market interest rates.

*Interest rate capagreement:*   The fair value of the interest ratecap agreement, as previously disclosed, is the amount at which it could besettled.

**Leases**

The Company accounts for leases under the provisionsof SFAS No. 13, *Accounting for Leases*, and subsequent amendments, which require that the Company’s leases beevaluated and classified as either operating leases or capital leases forfinancial reporting purposes. Minimum base rents for the Company’s operatingleases, which generally have scheduled rent increases over the term of thelease, are recorded on a straight-line basis over the lease term. The initiallease term includes the period from when the Company is given access andcontrol over the leased property, whether or not rent payments are due underthe terms of the lease.

For leases with renewal periods at the Company’soption, the Company generally considers the lease term to comprise only of theinitial lease term as exercise of the renewal options are not considered to bereasonably assured of exercise as determined at lease inception. However, iffailure to exercise a renewal 

F-11

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

option imposes an economicpenalty of sufficient magnitude to the Company, then the renewal, at inception,is reasonably assured and will be included in the determination of theappropriate lease term.

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

**Treasury stock**

The Company recordstreasury stock under the cost method whereby the entire cost of the acquiredstock is recorded as treasury stock. The Company records reissuances oftreasury stock at the fair value of the underlying transactions. Differencesbetween the fair value of the issuance and the cost basis of the treasury stockis recorded as either an adjustment to additional paid-in capital if thetransaction results in a gain or accumulated earnings (deficit) if thetransaction results in a loss.

**Revenue recognition**

The Company recognizes revenue in accordance withSecurities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 104(“SAB No. 104”), *Revenue Recognition inFinancial Statements,* which provides guidance on the recognition,presentation and disclosure of revenue in financial statements filed with theSEC. SAB No. 104 outlines the basic criteria that must be met to recognizerevenue and provides guidance for disclosure related to revenue recognitionpolicies. In general, the Company recognizes revenue when (i) persuasiveevidence of an arrangement exists, (ii) shipment of products has occurred,(iii) the sales price charged is fixed or determinable, and (iv) collectionis reasonably assured. The Company’s shipment terms are FOB shipping point asoutlined in its sales agreements.

The Company’s domestic sales agreements do not providefor rights of return or price protection. However, the Company may approvereturns on a case-by-case basis at its discretion. Based on the Company’shistorical experience, such returns generally approximate 2.1% of the Company’stotal gross sales. Certain international distribution agreements do provide forrights of return and price protection. Generally, such return rights are for aperiod of not more than 90 days after shipment. In accordance with SFAS No. 48,*Revenue Recognition When Right of ReturnExists*, the Company continuously monitors and tracks product returnsand records a provision for the estimated future amount of such future returns,based on historical experience and any notification received of pendingreturns. The allowance for future sales returns as of December 31, 2006and 2005 was $324, and $182, respectively, and is recorded as a reduction torevenue. The Company does not grant any warranty provisions on its products.The Company provides for discounts and allowances based on historicalexperience at the time revenue is recognized as a reduction to revenue. Todate, actual provisions have approximated management’s estimates.

The Company grants price protection rights to certaininternational distributors. Such price protection rights require the Company topay the distributor if there is a reduction in the list price of the Company’sproducts. Price protection payments would be required for the distributor’sinventory on-hand or in-transit on the date of the price reduction, for aperiod not to exceed 90 days prior to the date of the price 

F-12

----

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

reduction. The Company hasnot recorded a liability in connection with such price protection rights as theCompany has never reduced the list prices of its products.

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

Included in revenues arefees charged to customers for shipping and handling. Such revenues amounted to$1,831, $1,220, and $943 for the years ended December 31, 2006, 2005, and2004, respectively. Shipping and handling costs incurred in a sales transactionto ship products to customers are included as a component of cost of sales.

**Advertising costs**

Advertising costs areexpensed the first time the advertising takes place. Advertising and promotioncosts incurred for the years ended December 31, 2006, 2005 and 2004 wereapproximately, $251, $1,143, and $1,151, respectively. Advertising costs arerecorded as a component of selling, general and administrative expenses.

**Foreign currencytranslation**

The financial statementsof subsidiaries outside the United States are measured using the local currencyas the functional currency. Assets and liabilities of these subsidiaries aretranslated at the rates of exchange at the balance sheet date. Revenue andexpense items are translated at average monthly rates of exchange. Theresultant translation adjustments are recorded in comprehensive income (loss),a separate component of stockholders’ equity (deficit). Such adjustmentsamounted to an unrealized loss of $27 for the year ended December 31, 2006and an unrealized gain of $5, and $69 for the years ended December 31,2005 and 2004, respectively. During the year ended December 31, 2005, theCompany disposed of certain of its wholly owned, non-operating, subsidiariesoutside of the United States. As a result, the comprehensive income related toforeign currency translation was recognized as a gain in the accompanyingconsolidated financial statements. The total gain recognized was $111, $102 ofwhich related to foreign currency translation during the year ended December 31,2005.

**Research anddevelopment**

Research and development activities have historicallyfocused on improving the efficacy of existing pharmaceutical ingredients byenhancing penetration. These activities primarily consist of formulation,chemistry and analytical manufacturing controls and stability work. Researchand development expenses include, among other things, wages and benefits, rawmaterials and supplies, facilities, outside professionals and professionalservice provider fees. Clinical trials and certain support functions inpreparing protocols, reports and other regulatory documents are performed byscientific consultants and third-party contract research organizations.Research and development costs are expensed as incurred.

F-13

----

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

**Stock-basedcompensation**

Prior to the January 1, 2006 adoption ofFinancial Accounting Standards Board (“FASB”) Statement No. 123 (revised2004) (“SFAS No. 123R”), *Share-BasedPayment*, the Company accounted for grants of options to employees topurchase its common stock using the intrinsic value method in accordance withAccounting Principles Board Opinion No. 25 (“APB No. 25”), *Accounting for Stock Issued to Employees*,and FASB Interpretation No. 44, *Accountingfor Certain Transactions Involving Stock Compensation*. As permittedby SFAS No. 123 (“SFAS No. 123”), *Accountingfor Stock-Based Compensation*, and as amended by SFAS No. 148 (“SFASNo. 148”), *Accounting for Stock-BasedCompensation-Transition and Disclosure*, the Company had chosen tocontinue to account for such option grants under APB No. 25 and providethe expanded disclosures specified in SFAS No. 123, as amended by SFAS No. 148.

Effective January 1, 2006, the Company adoptedSFAS No. 123R using the modified prospective transition method, and as aresult, did not retroactively adjust results from prior periods. Under thistransition method, stock-based compensation was recognized for: (i) expenserelated to the remaining unvested portion of all stock option awards grantedduring the one year period preceding the Company’s initial public offering,based on the grant date fair value estimated in accordance with the originalprovisions of SFAS No. 123 and (ii) expense related to all stockoption awards granted on or subsequent to January 1, 2006, based on thegrant 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*, theremaining unvested options issued by the Company prior to the one year periodpreceding the initial public offering, with the exception of the October 2005grants, are not included in the SFAS No. 123R option pool as such optionswere valued using the minimum value method. As a result, unless subsequentlymodified, repurchased or cancelled, such unvested options will not be includedin stock-based compensation. The Company applies the Black-Scholes valuationmodel in determining the fair value of share-based payments to employees. Theresulting compensation expense is recognized on a straight-line basis over therequisite service period, which equals the option vesting term of three years.

Upon adoption of SFAS No. 123R, the Companyutilized the “long form” method for calculating the tax effects of stock-basedcompensation pursuant to SFAS No. 123R, paragraph 81. Under the “long form”method, the Company determined the beginning balance of the additional paid-incapital pool (“APIC pool”) related to the tax effects of the employeestock-based compensation “as if” the Company had adopted the recognitionprovisions of SFAS No. 123 since its effective date of January 1,1995.

Compensation expense is recognized only for thoseoptions expected to vest, with forfeitures estimated based on the Company’shistorical experience and future expectations. Prior to the adoption of SFAS No. 123R,the effect of forfeitures on the pro forma expense amounts was recognized asthe forfeitures occurred.

As a result of adopting SFAS No. 123R, the impactto the Consolidated Statement of Income for the year ended December 31,2006 on income before income taxes and net income was $305 and $195,respectively, and does not have a material effect on basic and diluted earningsper share, respectively. In addition, prior to the adoption of SFAS No. 123R,the Company presented the tax benefit resulting from the exercise of stockoptions as operating cash inflows in the Consolidated Statements of Cash Flows.Upon the adoption of SFAS No. 123R, the excess tax benefits for thoseoptions are classified as financing cash inflows.

F-14

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

Had compensation expensefor the Company’s option grants been determined based on their fair value atthe grant date for awards consistent with the provisions of SFAS No. 123,the Company’s net income per common share for the years ended December 31,2005 and 2004 would have been decreased to the adjusted pro forma amountsindicated below:

| ** **                                                                                                                                                                                                     | ** ** | **Year Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                                                                                     | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net income  attributed to common shares                                                                                                                                                                        | * *   | * *                               |       | * * | * * |
| As reported                                                                                                                                                                                                    |       | $                                      | 8,816      |   | $ | 12,718 |   |
| Equity-based employee compensation cost, net of  related tax effects, that would have been included in the determination of  net income attributed to common shares if the fair value method had been  applied |       | (166                                   | )          | (114 | ) |
| Adjusted                                                                                                                                                                                                       |       | $                                      | 8,650      |   | $ | 12,604 |   |
| Basic earnings  per common share:                                                                                                                                                                              |       |                                   |       |   |   |
| As reported                                                                                                                                                                                                    |       | $                                      | 0.50       |   | $ | 0.79 |   |
| Equity-based employee compensation cost, net of  related tax effects, that would have been included in the determination of  net income attributed to common shares if the fair value method had been  applied |       | (0.01                                  | )          | - |   |
| Adjusted                                                                                                                                                                                                       |       | $                                      | 0.49       |   | $ | 0.79 |   |
| Diluted earnings  per share:                                                                                                                                                                                   |       |                                   |       |   |   |
| As reported                                                                                                                                                                                                    |       | $                                      | 0.50       |   | $ | 0.74 |   |
| Equity-based employee compensation cost, net of  related tax effects, that would have been included in the determination of  net income attributed to common shares if the fair value method had been  applied |       | (0.01                                  | )          | (0.01 | ) |
| Adjusted                                                                                                                                                                                                       |       | $                                      | 0.49       |   | $ | 0.73 |   |

 

Thefair value of each option granted to employees and directors is estimated usingthe Black-Scholes option-pricing model with the following weighted-averageassumptions for the years ended December 31, 2006 and 2005 (no optionswere granted during the year ended December 31, 2004):

| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Expected stock  price volatility |       | 33.5                                       | %          | 16.9 | % |
| Expected dividend  yield         |       | 0.0                                        | %          | 0.0 | % |
| Risk-free  interest rate         |       | 4.6                                        | %          | 4.3 | % |
| Expected life of options         |       | 6.0 years                                  |       | 6.0 years |   |

 

Expected stock price volatility is based on a combinedaverage expected stock price volatility of publicly traded peer companiesdeemed to be similar entities whose share or option prices are publiclyavailable. For fiscal years 2006 and 2005, the Company based its expected stockprice volatility on the combined average stock price volatility of five andthree publicly traded peer companies, respectively. Until such time that theCompany has enough historical data, it will continue to rely on peer companies’volatility and will ensure that the selected peer companies are stillappropriate. The risk-free interest rate is based on the United States Treasuryyield 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 currentlyplan to pay 

F-15

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

dividends in the nearfuture. The expected term was derived under the “simplified” method provided inSAB No. 107.

Prior to the one-year period preceding the anticipatedinitial public offering, with the exception of the October 2005 grants,the Company used the minimum value method to determine fair value of optiongrants.

The aggregate intrinsic value for options outstandingat December 31, 2006 was $779. This amount changes based on the estimatedfair market value of the Company’s stock. Total intrinsic value of optionsexercised for the years ended December 31, 2006 was $45. As of December 31,2006, total unrecognized stock-based compensation expense related to nonvestedstock options was approximately $3,772, which is expected to be recognized overa weighted average period of approximately 2.81 years. Aggregate intrinsicvalue represents the total pretax intrinsic value (the difference between theCompany’s estimated stock price on December 31, 2006 and the exerciseprice, multiplied by the number of the in-the-money options) that would havebeen received by the option holders had all the option holders exercised theiroptions on December 31, 2006.

During the year ended December 31, 2005, theCompany issued stock options to certain employees. Given the absence of anactive market for the Company’s common stock, the board of directors wererequired to estimate the fair value of its common stock at the time of eachoption grant for purposes of determining stock-based compensation expense. Theboard of directors granted employees stock options during 2005 at exerciseprices ranging from $8.40 per share in March 2005 to $14.40 per share in October 2005.As the exercise price was determined to be equal to or greater than the fairvalue of the underlying common stock on the date of each grant, the Company didnot recognize stock-based compensation expense for the options granted in 2005.

In connection with thepreparation of the consolidated financial statements, the Company reassessedthe fair value of its employee stock options granted during 2005. In makingthis reassessment, the Company considered the guidance provided in AmericanInstitute of Certified Public Accountants Technical Practice Aid, *Valuation of Privately-Held Company Equity SecuritiesIssued as Compensation*. Based on this reassessment, the Companyconcluded that the fair value of the Company’s stock at March 2005 and October 2005was equal to or greater than the fair value of the underlying common stock onthe date of each grant. The Company did not recognize any additionalcompensation expense as the exercise prices of the stock options were at orabove the fair value of the common stock on the date of grant based on theCompany’s reassessed fair value.

**Earnings per commonshare (“EPS”)**

The Company accounts for earnings per share inaccordance with SFAS No. 128, *Earningsper Share*. Basic earnings per share are computed by dividing netincome by the weighted-average number of common shares outstanding. Dilutedearnings per common share is computed similar to basic earnings per shareexcept that the denominator is increased to include the number of additionalcommon shares that would have been outstanding if the potential common shareshad been issued and if the additional common shares were dilutive. Common shareequivalents are excluded from the computation if their effect is anti-dilutive.The Company’s common share equivalents consist of stock options issued underthe Company’s Stock Option Plan as well as mandatory redeemable convertiblepreferred stock.

Under the treasury stock method, the assumed proceedscalculation includes: (a) the actual proceeds to-be-received from theemployee upon exercise, (b) the average unrecognized compensation costduring 

F-16

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

the period and (c) anytax benefits that will be credited upon exercise to additional paid-in capital.The Company determines whether our windfall pool of available excess taxbenefits is sufficient to absorb the shortfall. If so, the effect of thehypothetical deferred tax asset write-off reduces the assumed proceeds in thetreasury stock calculation. If there is no pool of available excess taxbenefits, or if the amount of the pool is insufficient to absorb the entirehypothetical deficient tax deduction, the amount of the deficiency that ischarged to income tax expense is not considered to be a reduction of theassumed proceeds. Currently, the Company has determined that we have sufficientwindfall pool available.

Basicand diluted earnings per common share were calculated using the following unitsfor the years ended December 31, 2006, 2005 and 2004:

| ** **                                                             | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  shares outstanding—basic                        |       | 17,996,158                                 |       | 17,522,611 |   | 16,021,149 |   |
| Effect of dilutive stock options                                       |       | 74,890                                     |       | 90,275 |   | 883,711 |   |
| Effect of dilutive mandatorily redeemable  convertible preferred stock |       | —                                     |       | 152,830 |   | 416,268 |   |
| Weighted average shares  outstanding—diluted                      |       | 18,071,048                                 |       | 17,765,716 |   | 17,321,128 |   |

 

For the years ended December 31,2006 and 2005, diluted earnings per share does not include the impact of commonstock options then outstanding of 970,823 and 807,991, respectively, as theeffect of their inclusion would be anti-dilutive.

**New accountingpronouncements**

During October 2004, the FASB ratified theconsensus reached by the Emerging Issues Task Force (“EITF”) with respect toEITF Issue No. 04-10 (“EITF 04-10”), *Determining Whether to Aggregate Operating SegmentsThat Do Not Meet the Quantitative Thresholds*, which clarifies theguidance in paragraph 19 of SFAS No. 131 (“SFAS No. 131”), *Disclosures about Segments of an Enterprise andRelated Information*. According to EITF 04-10, operatingsegments that do not meet the quantitative thresholds can be aggregated underparagraph 19 only if aggregation is consistent with the objective andbasic principle of SFAS No. 131, the segments have similar economiccharacteristics, and the segments share a majority of the aggregation criterialisted in items (a)-(e) in paragraph 17 of SFAS No. 131.The effective date of EITF 04-10 is applicable for fiscal yearsending after September 15, 2005. The adoption of EITF 04-10 didnot have an impact on the Company’s segment analysis.

In December 2004, the FASB issued SFAS No. 123R,which replaces SFAS No. 123 and supersedes APB No. 25. SFAS No. 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on theirgrant date fair values. The provisions of SFAS No. 123R, as supplementedby SAB No. 107, are effective no later than the beginning of the nextfiscal year that begins after June 15, 2005. The Company adopted the newrequirements using the modified prospective transition method in the firstquarter of fiscal 2006, and as a result, did not retroactively adjust resultsfrom prior periods. Under this transition method, compensation expenseassociated with stock options recognized in the full fiscal year of 2006includes: (i) expense related to the remaining unvested portion of allstock option awards granted prior to January 1, 2006, based on the grantdate fair value estimated in accordance with the original provisions of SFAS No. 123;and 

F-17

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

(ii) expense relatedto all stock option awards granted subsequent to January 1, 2006, based onthe grant date fair value estimated in accordance with the provisions of SFAS No. 123R.The Company applies the Black-Scholes valuation model in determining the fairvalue of share-based payments to employees, which is then amortized on astraight-line basis over the requisite service period. As a result of adoptingSFAS No. 123R, the impact to the Consolidated Statement of Income for theyear ended December 31, 2006 on income before income taxes isapproximately $305 and did not have a material effect on basic and dilutedearnings per share.

In May 2005, the FASB issued SFAS No. 154 (“SFASNo. 154”), *Accounting Changes and ErrorCorrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3,*which changes the requirements for the accounting and reporting of a change inaccounting principle. SFAS No. 154 eliminates the requirement to includethe cumulative effect of changes in accounting principle in the incomestatement and instead requires that changes in accounting principle beretroactively applied. SFAS No. 154 is effective for accounting changesand correction of errors made on or after January 1, 2006, with earlyadoption permitted. The Company began applying the provisions of this statementduring the fourth quarter of 2005.

In February 2006, the EITF issued EITF No. 06-3(“EITF No. 06-3”), *How Sales Taxes Collectedfrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement (That Is, Gross Versus Net Presentation)*.EITF 06-3 requires disclosures surrounding a company’s accountingpolicy (i.e., gross or net presentation) regarding presentation of taxes withinthe scope of EITF No. 06-3. If taxes included in gross revenues aresignificant, a company should disclose the amount of such taxes for each periodfor which an income statement is presented. EITF 06-3 is effectivefor the first annual or interim reporting period beginning after December 15,2006. The disclosures are required for annual and interim financial statementsfor each period for which an income statement is presented. The Company willbegin applying the provisions of EITF 06-3 as of January 1, 2007. Theadoption of EITF No. 06-3 is not expected to have an impact on theCompany’s consolidated financial statements.

In July 2006, the FASB issued FASB InterpretationNo. 48 (“FIN 48”), *Accounting forUncertainty in Income Taxes—an interpretation of FASB Statement No. 109*,which prescribes accounting for and disclosure of uncertainty in tax positions.This interpretation defines the criteria that must be met for the benefits of atax position to be recognized in the financial statements and the measurementof tax benefits recognized. The provisions of FIN 48 are effective as ofthe beginning of the Company’s 2007 fiscal year, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings. The Company is currently unable to finalize an estimate ofthe impact that adopting FIN 48 will have on its financial statements.

In September 2006, FASB issued SFAS No. 157(“SFAS No. 157”), *Fair ValueMeasurements.* This new standard provides guidance for using fairvalue to measure assets and liabilities. Under SFAS No. 157, fair valuerefers to the price that would be received to sell an asset or paid to transfera liability in an orderly transaction between market participants in the marketin which the reporting entity transacts. In this standard, the FASB clarifiesthe principle that fair value should be based on the assumptions marketparticipants would use when pricing the asset or liability. In support of thisprinciple, SFAS No. 157 establishes a fair value hierarchy that prioritizesthe information used to develop those assumptions. The fair value hierarchygives the highest priority to quoted prices in active markets and the lowestpriority to unobservable data, for example, the reporting entity’s own data.Under the standard, fair value measurements would be separately disclosed bylevel within the fair value hierarchy. The provisions of SFAS No. 157 areeffective for financial statements issued for fiscal years beginning after November 15,

F-18

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

2007, and interim periodswithin those fiscal years. The Company has not yet determined the impact thatthe adoption of SFAS No. 157 will have on its consolidated financialposition, results of operations or cash flows.

In September 2006,the SEC issued SAB No. 108 (“SAB No. 108”), *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements.*SAB No. 108 provides guidance on the consideration of the effects of prioryear misstatements in quantifying current year misstatements for the purpose ofa materiality assessment. SAB No. 108 establishes an approach thatrequires quantification of financial statement errors based on the effects ofeach of the Company’s balance sheet and statement of operations financialstatements and the related financial statement disclosures. The SAB permitsexisting public companies to record the cumulative effect of initially applyingthis approach in the first year ending after November 15, 2006 byrecording the necessary correcting adjustments to the carrying values of assetsand liabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings. Additionally, the use ofthe cumulative effect transition method requires detailed disclosure of the natureand amount of each individual error being corrected through the cumulativeadjustment and how and when it arose. The adoption of SAB No. 108 did nothave an impact on the Company’s results of operations or financial position.

**Note 3:   Composition of certain financialstatement captions**

| ** **                   | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Inventories,  net**        | ** ** | ** **            |       | ** ** |   |
| Raw materials                |       |  $ 3,251    |       |  $ 1,309 |   |
| Finished goods               |       | 3,291                 |       | 2,236 |   |
|                         |       | 6,542                 |       | 3,545 |   |
| Less reserve for inventories |       | (276                  | )          | (437 | ) |
|                         |       |  $ 6,266    |       |  $ 3,108 |   |

 

| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Property  and equipment**                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| Furniture and fixtures                         |       | $                     | 776        |   | $ | 675 |   |
| Computer software and equipment                |       | 2,443                 |       | 1,557 |   |
| Lab and office equipment                       |       | 494                   |       | 400 |   |
| Leasehold improvements                         |       | 3,111                 |       | 1,034 |   |
| Capital lease (office equipment)               |       | 256                   |       | 209 |   |
| Construction in progress                       |       | 73                    |       | 1,624 |   |
|                                           |       | 7,153                 |       | 5,499 |   |
| Less accumulated depreciation and amortization |       | (3,404                | )          | (2,574 | ) |
|                                           |       | $                     | 3,749      |   | $ | 2,925 |   |

 

Depreciation expense for the years ended December 31,2006, 2005 and 2004 was $968, $402, and $254, respectively. At December 31,2006 and 2005, accumulated depreciation for fixed assets under capital leasewas $154 and $121, respectively. Interest costs that were capitalized intoconstruction in progress and other property and equipment totaled $157, and $70for the years ended December 31, 2006 and 2005, respectively.

F-19

----

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

Duringthe year ended December 31, 2006, the Company recorded a loss on disposalof fixed assets of $72. The loss is reported as a component of selling, generaland administrative expenses.

| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Accrued  liabilities**      | ** ** | ** **            | ** ** | ** ** | ** ** |
| Salaries and related benefits |       | $                     | 2,535      |   | $ | 1,801 |   |
| Other                         |       | 1,063                 |       | 1,359 |   |
|                          |       | $                     | 3,598      |   | $ | 3,160 |   |

 

**Note 4:   Lineof credit, notes payable and capital lease obligations**

Notespayable and capital lease obligations consist of the following at December 31,2006 and 2005:

| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Senior Secured  Credit Facility |       |                  |       |   |   |
| Term A                          |       | $                     | 5,556      |   | $ | 17,000 |   |
| Term B                          |       | 20,095                |       | 49,500 |   |
| Capital lease  obligations      |       | 130                   |       | 118 |   |
|                            |       | 25,781                |       | 66,618 |   |
| Less current  maturities        |       | (2,729                | )          | (3,423 | ) |
|                            |       | $                     | 23,052     |   | $ | 63,195 |   |

 

On January 28, 2005, the Company entered into an$80,000 Senior Secured Credit Facility (the “Facility”). The Facility isstructured with two term loans and a revolving line of credit. The term loansinclude: (i) $20,000 in principal borrowings under Senior Secured TermLoan A (the “Term Loan A”) maturing January 28, 2010; and (ii) $50,000in principal borrowings under Senior Secured Term Loan B (the “TermLoan B”) maturing January 1, 2011. The Senior Secured RevolvingCredit Facility (the “Revolver”) provides availability up to $10,000 forworking capital needs. Borrowings under this Facility are collateralized by afirst lien on all of the assets of the Company. The Company pays an unused linefee of 0.5% monthly on the unused balance of the Revolver. There was nooutstanding balance on the Revolver as of December 31, 2006 and 2005. Theavailability of the Revolver is based upon a multiple of 3.25 times theCompany’s EBITDA less outstanding debt. As of December 31, 2006 and 2005,the availability of the Revolver was approximately $10,000 and $6,767,respectively.

Loans under the Facility bear variable interest basedon a margin, at the Company’s option, over prime rate or LIBOR. The marginsapplicable to portions of amounts borrowed vary depending on the Company’sconsolidated Debt to EBITDA Ratio. As of December 31, 2006, applicablemargins were 2.50% and 2.75% for prime rate borrowings and 4.00% and 4.25% forLIBOR borrowings for Term Loan A and Term Loan B, respectively. As ofand December 31, 2005, the applicable margins were 2.25% and 2.50% forprime rate borrowings and 3.75% and 4.00% for LIBOR borrowings, for TermLoan A and Term Loan B, respectively. As of December 31, 2006,Term Loan A was bearing interest at a LIBOR based rate of 9.35% and TermLoan B was bearing interest at a LIBOR based rate of 9.60%. As of December 31,2005, both Term Loan A and Term Loan B were bearing interest at LIBORbased rates of 8.12% and 8.37%, respectively. The weighted-average interestrate for borrowings under this Facility was 

F-20

----

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

9.15% and 8.50% as of December 31, 2006and 2005, respectively. Interest expense incurred attributable to this Facilityfor the years ended December 31, 2006 and 2005 was $5,749 and $5,435,respectively.

The Facility contains certain financial andnon-financial covenants. Such non-financial covenants include certainlimitations on annual capital expenditures and use of proceeds from theissuance of debt and equity securities, and prohibit the Company from makingdividend distributions. The financial covenants contained in the agreementinclude, among other provisions, maintaining a minimum EBITDA, a maximum Debtto EBITDA Ratio and a minimum Fixed Charge Ratio. On September 6, 2006,the Company entered into the Second Amendment to the Senior Secured CreditFacility. Pursuant to the Amendment, the calculation of EBITDA and Total Debtused in the covenant calculations were modified. On November 13, 2006, theCompany entered into the Third Amendment to the Senior Secured Credit Facility.Pursuant to the Amendment, certain terms were modified, some of which tookeffect upon the completion of the initial public offering, to change theCompany’s (i) ability to make payments to subordinated debt, (ii) useof proceeds from an initial public offering, (iii) calculation of TotalDebt used in the covenant calculations, (iv) negative covenants and (v) financialreporting requirements.

In accordance with the Third Amendment of the SeniorSecured Credit Facility, the Company made a repayment of $35,000 in debt withthe net cash proceeds received in the initial public offering consummated on December 13,2006.

As of December 31, 2006 and 2005, the maximumDebt to EBITDA requirement was 2.50 and 3.00, respectively, and the minimumFixed Charge Ratio was 1.20 and 1.10, respectively. The Company was incompliance with all financial and non-financial covenants as ofDecember 31, 2006 and 2005.

As of December 31, 2005, under the terms of theFacility, the Company was subject to mandatory principal prepayments equal to50% or 75% of Consolidated Excess Cash Flow, as defined in the Facility, basedon the Company’s Debt to EBITDA ratio. As of December 31, 2005, theCompany made no mandatory principal prepayments. Pursuant to the ThirdAmendment, the mandatory principal prepayment was modified to equal 25% to 50%of Consolidated Excess Cash Flow. As of December 31, 2006, the Company issubject to a $1,313 mandatory principal prepayment due 95 days subsequent toyear end. As a result, the mandatory principal prepayment is included in thecurrent portion of long-term debt.

Thetotal annual maturities of long-term debt and capital lease obligations as ofDecember 31, 2006 are as follows:

| ** **                                     | ** ** | **Long-Term** | ** ** | **Capital** | ** ** |
|------------------------------------------------|------------|---------------|------------|-------------|------------|
| ** **                                     | ** ** | **Debt**      | ** ** | **Leases**  | ** ** |
| **Years ending December 31,**             | ** ** |          | ** ** | ** **  |       |   | ** ** | ** ** |   |
| 2007                                           |       |          | $          | 2,672       | ** ** |   |   | $ | 62 |   |   |
| 2008                                           |       |          | 1,817      | ** **  |       |   | 32 |   |   |
| 2009                                           |       |          | 2,121      | ** **  |       |   | 25 |   |   |
| 2010                                           |       |          | 14,420     | ** **  |       |   | 19 |   |   |
| 2011                                           |       |          | 4,621      | ** **  |       |   | — |   |   |
|                                           |       |          | $          | 25,651      | ** ** |   |   | 138 |   |   |
| Less amount  representing future interest cost |       |          |       | ** **  |       |   | (8 | ) |   |
|                                           |       |          |       | ** **  |       |   | $ | 130 |   |   |

 

F-21

----

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

**Interest rate cap**

In March 2005, theCompany entered into a LIBOR interest rate cap agreement as an economic hedgeagainst Facility borrowings. The interest rate is capped at 6.0% on adecreasing notional amount starting at $35,000 decreasing to approximately$34,038. The agreement expires on January 1, 2008. The interest rate capis recognized on the Consolidated Balance Sheet at its fair market value andany change in fair value is reported in interest expense. As of December 31,2006 and 2005, the fair value of the interest rate cap was approximately $3 and$19, respectively.

**Letter of creditagreements**

On May 18, 2006, the Company provided anirrevocable standby letter of credit to the Florida Department of Health in theamount of $100, which may be drawn upon to satisfy any unpaid administrativefines or penalties. This letter of credit expires on May 17, 2007 and maybe renewed for a period of one year.

On May 23, 2006, theCompany provided an irrevocable standby letter of credit to the CaliforniaState Board of Pharmacy in the amount of $100, to serve as a security devicefor the performance of the Company of its obligations under the Business andProfessions Code. This letter of credit expires on May 22, 2007.

**Note 5:   Commonstock and mandatorily redeemable preferred stock**

**Common stock**

In 2003, the Company repurchased 2,090,524 shares ofits common stock from several of its existing stockholders at a price of $3.60per share. The Company recorded the repurchases as treasury stock utilizing thecost method since the Company intended to reissue such shares in the future.During 2005 and 2004, the Company reissued treasury shares as a result of theexercise of stock options and the conversion of Series B mandatorilyredeemable preferred stock into common stock.

In December 2005, theCompany recorded compensation expense of $37 related to the issuance of 5,000shares of common stock to two new board members for consideration of theseindividuals joining the board. The compensation expense and related additionalpaid-in-capital was recorded at the fair market value at the time of grant. TheCompany determined the fair market value of its common stock after board ofdirector and management consideration of a number of objective and subjectivefactors.

**Mandatorilyredeemable preferred stock**

The Company was authorized to issue 146,200 and 40,000shares of Series A and Series B mandatorily redeemable preferredshares, respectively. Series A preferred stock was not convertible, wasnonvoting and the holder was entitled to cumulative dividends at a rate of 11%of the original issue price per share per annum at the end of each quarter. TheSeries A preferred stock had a liquidation preference of its originalissue price of $100 per share and any amount equal to declared or accrued butunpaid dividends. Series B mandatorily redeemable preferred stock wasconvertible, nonvoting and the holder was entitled to cumulative dividends at arate of 5% of the original issue price per share per annum at the end of eachquarter beginning September 30, 2002. The Series B mandatorilyredeemable preferred stock had a 

F-22

----

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

liquidation preference ofits original issue price of $100 per share and any amount equal to declared oraccrued but unpaid dividends.

Informationrelating to the redeemable preferred stock for the years ended December 31,2005 and 2004 is as follows:

| ** **                                   | ** ** | **Shares**        | ** ** | **Amounts**       | ** ** |
|----------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **Series A** | ** ** | **Series B** | ** ** | **Total** | ** ** | **Series A** | ** ** | **Series B** | ** ** | **Total** | ** ** |
| **Balance,  December 31, 2003**         |       | 118,215           |       |              | 15,465     |   |   | 133,680 |   | $ | 19,733 |   | $ | 2,442 |   | $ | 22,175 |   |
| Conversion of  Series B to common stock |       | —            |       |              | (6,400     | ) |   | (6,400 | ) | — |   | (1,027 | ) | (1,027 | ) |
| Accrued preferred  stock dividends           |       | —            |       |              | —     |   |   | — |   | 1,304 |   | 59 |   | 1,363 |   |
| **Balance,  December 31, 2004**         |       | 118,215           |       |              | 9,065      |   |   | 127,280 |   | 21,037 |   | 1,474 |   | 22,511 |   |
| Stock repurchase                             |       | (118,215          | )          |              | —     |   |   | (118,215 | ) | (21,151 | ) | — |   | (21,151 | ) |
| Conversion of  Series B to common stock |       | —            |       |              | (9,065     | ) |   | (9,065 | ) | — |   | (1,500 | ) | (1,500 | ) |
| Accrued preferred  stock dividends           |       | —            |       |              | —     |   |   | — |   | 114 |   | 26 |   | 140 |   |
| **Balance, December 31, 2005**          |       | —            |       |              | —     |   |   | — |   | $ | — |   | $ | — |   | $ | — |   |

 

The Company could have, at its election, redeemedshares of Series A and Series B preferred stock at a redemption priceequal to the liquidation preference plus the amount of all accrued and unpaiddividends. Shares of Series A and Series B were required to beredeemed by the Company upon the earlier of: (i) the close of the Company’ssale of its common stock in a public offering, (ii) the liquidation,dissolution or winding up of the Company, and (iii) the acquisition of theCompany by another entity under certain terms. The Company did not accrete themandatorily redeemable preferred stock to its redemption value due to theuncertainty of such redemption events occurring. The shares of Series Apreferred stock were redeemable at a sum equal to $100 per share plus all unpaiddividends on such shares. The Series B preferred stock were redeemable ata sum equal to $100 per share, all unpaid dividends on such shares, and apremium of $50.42 per share.

On February 10, 2005, the Company redeemed$11,822, or 100%, of the then outstanding Series A preferred stock andpaid the holders of such stock $9,329, or 100%, of the Series A preferredstock dividend that had accrued since the date of issuance (December 1997)through the date of redemption. The remaining 9,065 outstanding preferredshares of Series B convertible preferred stock were converted into 263,125shares of common stock in August 2005.

As discussed in Note 1,the Company amended and restated its Articles of Incorporation on November 27,2006. Pursuant to the amended and restated Articles of Incorporation, the Boardof Directors is authorized to (i) issue Preferred Stock in series, (ii) establishthe number of shares in each series, (iii) assign designation, powers,preferences and rights of each series, and (iv) establish qualifications,limitations or restrictions of each series.

F-23

----

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

**Note 6:   Incometaxes**

Thecurrent and deferred provision for federal, state and foreign income taxesconsists of the following:

| ** **   | ** ** | **Year Ended December 31,** | ** ** |
|--------------|------------|--------------------------------------------|------------|
| ** **   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Current**  | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal      |       | $                                          | 3,123      |   | $ | 4,358 |   | $ | 6,329 |   |
| State        |       | 785                                        |       | 1,198 |   | 916 |   |
|         |       | 3,908                                      |       | 5,556 |   | 7,245 |   |
| **Deferred** |       |                                       |       |   |   |   |   |
| Federal      |       | (313                                       | )          | 384 |   | 421 |   |
| State        |       | (137                                       | )          | 103 |   | 19 |   |
|         |       | (450                                       | )          | 487 |   | 440 |   |
|         |       | $                                          | 3,458      |   | $ | 6,043 |   | $ | 7,685 |   |

 

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

| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal statutory  income tax rate        |       |   35.0                           | %          |   35.0 | % |   35.0 | % |
| State income tax,  net of federal benefit |       | 4.4                                        | %          | 5.7 | % | 2.8 | % |
| Research and  development credit          |       | (3.4                                       | )%         | — |   | — |   |
| Other                                     |       | 0.1                                        | %          | (0.4 | )% | (2.4 | )% |
|                                      |       | 36.1                                       | %          | 40.3 | % | 35.4 | % |

 

F-24

----

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

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

| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Deferred  assets**          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Financial statement reserves  |       | $                     | 375        |   | $ | 381 |   |
| State taxes                   |       | —                |       | 170 |   |
| Depreciation and amortization |       | 652                   |       | 996 |   |
| Trademark expenses            |       | 200                   |       | 217 |   |
| Compensation expense          |       | 719                   |       | 498 |   |
| Prepaid royalty               |       | 492                   |       | 487 |   |
| Debt issuance costs           |       | 606                   |       | — |   |
| Foreign operating loss        |       | 56                    |       | 45 |   |
| Other                         |       | 147                   |       | 67 |   |
|                          |       | 3,247                 |       | 2,861 |   |
| **Deferred  liabilities**     | ** ** | ** **            | ** ** | ** ** | ** ** |
| Prepaid expenses              |       | (180                  | )          | (296 | ) |
| State taxes                   |       | (40                   | )          | — |   |
|                          |       | (220                  | )          | (296 | ) |
| Net deferred  assets          |       | 3,027                 |       | 2,565 |   |
| Less valuation  allowance     |       | (56                   | )          | (45 | ) |
|                          |       | $                     | 2,971      |   | $ | 2,520 |   |

 

The Company recorded a deferred tax asset of $56 and$45 related to the net operating loss carryover of its majority ownedsubsidiary, Obagi Singapore, as of December 31, 2006 and 2005,respectively. A full valuation allowance was provided for the loss carryover asthe Company believes that it is more likely than not that this deferred taxasset will not be realized.

The Company was audited bythe Internal Revenue Service (“IRS”). During 2004, as a result of a favorabledetermination made by the IRS, the Company recognized an additional tax benefitof $985 related to federal and California Research and Development credits**.**

**Note 7:    Concentrationsof credit risk and significant customers**

For the years ended December 31, 2006, 2005, and2004, no single customer accounted for 10% or more of the Company’s netrevenues.

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

F-25

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

The Company currently haslimited internal research and development capabilities and primarily outsourcesits product research and development to third-party research labs. Althoughthere are a limited number of third-party research labs, management believesthat other labs could provide similar services on comparable terms. A change inproviders, however, could cause a delay in the Company’s ability to develop anddeliver products on a timely and competitive basis, which could affectoperating results adversely.

**Note 8:   Royalty licensee agreements**

All of the Company’sproducts are marketed under the name “Obagi” and other marketed brands. TheCompany owns the registered trademark and trade name “Obagi.” In December 2002,the Company entered into a new license agreement, replacing a previousagreement, with Dr. Obagi, the Company’s former medical director and boardmember and one of its current principal stockholders (refer to Note 9). Aspart of the new agreement, Dr. Obagi is to receive an annual payment in anamount equal to $200 plus a royalty of 5% of the net sales of twononprescription product line concepts, if and to the extent, that such linesare developed, marketed and sold. The payments and royalties for any year arenot to exceed $500. For the years ended December 31, 2006, 2005 and 2004,no sales of such nonprescription product lines were made; accordingly, noroyalty payments were required. Additionally, the annual payment is expensed asincurred and costs have been included as a component of selling, general andadministrative expenses.  In addition,according to the new agreement, the Company must provide Dr. Obagi withthe ability to purchase products in connection with his own private practice,at a discount equal to the maximum discount that the Company provides toindependent third-party customers. As of December 31, 2006, 2005 and 2004,the Company did not owe Dr. Obagi any amounts due under the agreement. Asof December 2, 2005, this licensing agreement had expired.

Pursuant to the PatentLicense Agreement dated June 26, 2003 with a third party, the Company haslicensed four interlocking method and formulation patents in exchange for anon-refundable fee in the amount of $200 for the first year, and an additional$100 payable on each of the first and second anniversaries of this agreement.The agreement also calls for the Company to pay royalties in the amount of (i) 5%of the net sales of products sold in a territory covered by the licensedpatents and (ii) 3.5% of net sales of products manufactured in a territorycovered by the licensed patents and sold in a territory not covered by thelicensed patents. Such royalties are to be paid on a quarterly basis. For theyears ended December 31, 2006, 2005 and 2004, related royalties of $179,$122 and $31, have been included as a component of cost of sales, respectively.The initial term of this agreement is three years and is renewable annually atthe option of the Company provided the Company makes an annual non-refundablerenewal fee in the amount of $100. The Patent License Agreement may terminateat the licensor’s option upon merger or acquisition of the Company and may becancelled by either party upon default.

In January 2006, theCompany entered into an Option and Product License Agreement with a third partyto license certain technology, in exchange for a non-refundable fee in theamount of $250, with an additional $250 payable within 15 days ofconfirming successful clinical results. The non-refundable fee of $250 may eitherbe offset against future royalties payable under the agreement or offsetagainst future purchases of inventory. For the first product developed underthis agreement, an additional license payment of $250 is payable upon theproduct becoming commercially available for distribution with another $250 duein the subsequent quarter to that event. For each additional product developed,an additional license payment of $250 is due up to a maximum $1,000 for allproducts developed. The agreement also calls for the Company to pay royaltiesin the amount of (i) 8% of the net sales of products sold in a territorycovered by the licensed patents and (ii) the Company shall pay a minimumannual payment equal of $1,000 in year one, for all subsequent years theCompany is required to pay the greater 

F-26

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

of $500,or 90%, of the prior year royalty payments. Such royalties are to be paid on aquarterly basis. In addition to the royalties, the Company shall also pay onetime milestone payments based upon achieving certain levels of net sales. Theterm of this agreement is for the life of the patent. The patent applicationfor the licensed technology is currently pending. The Option and ProductLicense Agreement may terminate at the licensor’s option upon the Company’sfailure to meet commercially reasonable development benchmarks. Pursuant tothis agreement, the Company recorded the initial payment of $250 in Otherassets as of December 31, 2006. Royalty payments will be expensed asincurred. As of December 31, 2006, no other payments have been made.

In March 2004, aspart of an agreement with a third-party international licensor, the Companyreceived an ongoing, non-exclusive right to market and sell any and allproducts marketed under the “Obagi” brand containing a specific range of Kinetinconcentration, limited to existing channels of trade in Japan. Under the termsof the license agreement with the same party, the Company’s license rights arevalid until the last of the related patents expire in December 2014. Inexchange for this right, the Company paid, on April 2, 2004, an initialpayment of $1,250, net of cash receipts in the amount of $250 from asublicensing arrangement with an international distributor in Japan. Inaddition, 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 thisagreement, the Company recorded the initial net payment as an intangible assetand is amortizing such costs on a straight line basis over the license period.During the years ended December 31, 2006, 2005 and 2004, the Companyrecognized $106, $106 and $122 in amortization expense, respectively. Suchamounts are included as a component of cost of sales. Royalty payments areexpensed as incurred and have amounted to $70, $43 and $7 for the years ended December 31,2006, 2005 and 2004, respectively.

**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 ZeinObagi, M.D., the Company’s former executive medical director and boardmember and one of its current principal stockholders. The employment agreementwas effective until December 2, 2005 or upon triggering of the terminationprovisions of the agreement. Unless either party notified the other in writing,the term of the agreement was automatically extended by successive one-yearterms. Under the agreement, Dr. Obagi was entitled to a base salary of$330 per year subject to an increase as determined by the Company’scompensation committee. In addition, Dr. Obagi was entitled to anincentive bonus of up to $225 as determined by the Company’s compensationcommittee. The compensation committee based its determination on Dr. Obagi’ssuccess of specific activities within his control and other Company-widemeasures. The Company gave Dr. Obagi notice of termination in 2005 asrequired by the agreement. Subsequently, the agreement was extended until June 30,2006.

Under the agreement, if Dr. Obagiwas terminated for cause, he would receive no severance. If Dr. Obagi wasterminated without cause upon 30 days’ prior written notice, then he wouldhave been entitled to his then existing base salary for the entire periodremaining on the term of his employment agreement and certain rights withrespect to his stock. If Dr. Obagi terminated his employment upon90 days’ prior written notice, he would have been entitled to 90 days’salary.

Dr. Obagi is also aprominent physician in the medical community and was granted the right topurchase products from the Company at a discount equal to the maximum discountoffered to the Company’s unrelated customers. In addition to his primarymedical practice in Beverly Hills, California, Dr. Obagi is also a 75%owner of two other dermatology clinics, Chinese Obagi Corporation and 

F-27

----

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

VietnameseObagi Corporation (the “Clinics”), that purchase product from the Company.These Clinics are located in Southern California and cater to the local Chineseand Vietnamese communities. Other than the common ownership interest by Dr. Obagi,the Company is otherwise unrelated to these two corporations.

In 2005, the Company begannegotiations with an affiliate of Dr. Obagi to lease space for a marketingand training center (the “Center”). The space is located in a property owned bythe affiliate of Dr. Obagi. In conjunction with these negotiations whichwere ongoing as of December 31, 2005, the Company began renovations on thespace. As of December 31, 2005, amounts included in Prepaid expenses andother current assets and Other assets totaled $115 and $1,040, respectively.Amounts capitalized as construction in progress totaled $852 as of December 31,2005. On June 29, 2006, the Company entered into a lease agreement and aletter agreement with this affiliate, making an advance to this affiliate onfuture rent. As of December 31, 2006, amounts included in Prepaid expensesand other current assets and Other assets totaled $184 and $659, respectively. Asof December 31, 2006, there was no balance in construction in progressrelated to the Center.

***2006 Services Agreement.******  ***OnJune 29, 2006, the Company entered into an agreement with Zein E.Obagi, MD Inc. (“Obagi, Inc.”), Dr. Obagi, Samar Obagi, the Zeinand Samar Obagi Family Trust and Skin Health Properties, Inc (“SHP, Inc.”).The agreement provides that Dr. Obagi (and his affiliates that enteredinto the agreement, including Obagi, Inc.) and/or SHP, Inc. (anentity controlled by Dr. Obagi and his affiliates) will promote andprovide services to support the marketing of the Company’s products, includingoversight of the property the Company is leasing in Beverly Hills, California.Additionally, Dr. Obagi (and his affiliates that entered into theagreement) will be available to advise and assist the Company in theformulation and clinical testing of new products on a retainer basis, and hewill also provide training and/or education seminars on a fee basis andparticipate in at least one clinical study per year. The Company has agreed topay Obagi, Inc. an annual retainer of $570 for the advising andformulating services and the marketing and support services described above, aswell as for Dr. Obagi’s agreement to chair an annual Obagi Skin HealthAlumni Symposium and up to two clinical advisory meetings per year. Inaddition, 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 Prodermproducts, a line of skincare products. At the end of the two years, the Companyhas an option to continue sell Proderm products, in which case the Company willpay Obagi, Inc. an annual royalty payment of the greater of $200, or 5%,of the Company’s net Proderm revenues. During the year ended December 31,2006, the Company recorded the $200 annual payment as research and developmentexpense as the research of new products in the Proderm line is still inprogress. The Company will also pay Obagi, Inc. royalty fees fordeveloping other products identified in the agreement equal to 5% of theCompany’s net revenues from sales of those products. As there were no productscommercialized under the agreement, the Company did not pay any royaltiespursuant to the agreement during the year ended December 31, 2006. TheCompany has agreed to pay additional fees and expenses for training andeducational services under the agreement. In addition, the Company has agreedto reimburse up to 50% of all invoiced commercially reasonable marketing designand development expenses associated with the opening of the property in BeverlyHills, not to exceed $100. As of December 31, 2006, the Company recorded apayable to Dr. Obagi for $80 related to reimbursable expenses for theopening of the Center.

The Company has alsoagreed to indemnify Dr. Obagi and his affiliates for any claims againstthe Company’s products, or any claims arising out of the Company’s acts oromissions or any breach of warranties given by the Company contained in theagreement.

F-28

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

Under the agreement, theCompany has been granted a perpetual, royalty-free, non-exclusive license toall accounts, customer lists and other customer information and data (subjectto federal and state privacy laws) regarding Obagi, Inc.’s patients, aswell as a non-exclusive license to use and reproduce the marketing materialsproduced 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 useof certain of the Company’s trademarks, as well as a non-exclusive license touse and reproduce the marketing materials designated by the Company from timeto time for the promotion and marketing services being provided under theagreement.

Under the agreement, themaximum discount that the Company provides to independent third-partyphysicians in the United States will apply to all products distributed by theCompany that are supplied by the Company to Obagi, Inc. and/or SHP, Inc.in connection with the promotion and marketing services under the agreement, aswell as those supplied to Obagi, Inc. in connection with Dr. Obagi’spractice within the United States.

Unless otherwise terminatedin accordance with its terms, the agreement’s initial term is five years, andit may be renewed for additional terms upon the mutual consent of the partiesupon six months’ written notice prior to the end of the initial term.

***2006 Separation and release agreement.******  ***In connection with the2006 Services Agreement with Dr. Obagi described above, the Companyentered into a separation and release agreement, which contains non-competitionprovisions, with Dr. Obagi effective as of June 29, 2006. Under theagreement, Dr. Obagi agreed not to directly or indirectly compete with theCompany for a five year period. In connection with the agreement, the Companypaid Dr. Obagi $368.

***2006 Lease agreement and letter agreement.******  ***In connection with the2006 Services Agreement with Dr. Obagi described above, the Companyentered into a lease agreement for the Beverly Hills property described aboveand 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 canbe extended or terminated earlier under the terms of the lease. The base rentunder the lease is $87 per year, and will be raised at a rate of 3.5% per yearthereafter. During the year ended December 31, 2006, the Company recorded$77 in rent expense related to the lease agreement.

The Company also enteredinto a letter agreement in connection with the lease with SHP, Inc., datedJune 29, 2006, that relates to leasehold improvements and prepayment ofrent. Under the letter agreement, SHP, Inc. acknowledges that the Companyhas paid $2,197 in respect of leasehold improvements and prepayment of rentunder the lease, and the Company will not be required to pay any additionalamounts.

**Cellogique Corporation**

Dr. Obagi is also a58% beneficial shareholder in Cellogique Corporation (“Cellogique”), one of theCompany’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 withinthe Middle East. The agreement includes discounts off of the distributors’ baseprice based on volume purchases, and certain advertising and promotional activities.Such discounts may at times exceed 58% 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 inperpetuity.

Prior to the November 2005agreement, Cellogique was under a Product Distribution Agreement, which had aterm of 30 months and was renewable each two years thereafter. Under thissuperseded 

F-29

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

agreement,Cellogique received product discounts off of United States doctor list pricesbased on volume purchases. The agreement granted Cellogique the exclusive rightto promote, market, sell, distribute and sub-distribute certain specifiedproducts 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 31,2006 and 2005, and for the years ended December 31, 2005, 2004 and 2003are included in the Company’s consolidated statements of operations and are asfollows:

| ** **               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales, net of  discounts |       | $                                          | 3,214      |   | $ | 2,569 |   | $ | 2,531 |   |
| Costs of sales           |       | 569                                        |       | 551 |   | 523 |   |
|                          |            |                                            |            |  |  |  |  |  |  |  |

 

**Austin T. McNamara**

On September 1, 2001,the Company entered into an employment agreement with Austin T. McNamara,former chairman of the board, president and chief executive officer. Theagreement was for an initial period of three years and automatically renewedfor successive one-year periods. Under the agreement, Mr. McNamara wasentitled to a base salary of not less than $500 per year. In addition, Mr. McNamarawas entitled to an annual bonus as determined by the compensation committee,with a target of 100% of his base salary based on the achievement ofperformance-based milestones.

If Mr. McNamara wasterminated without cause or due to change in control, then he would have beenentitled to either 12 months of his base salary or any unpaid base salaryfor the entire remaining term of his employment agreement, whichever isgreater. In addition, all of his unvested options would have immediately vestedin full. Change of control was defined to occur if any institution, other thanStonington Capital Appreciation 1994 Fund, L.P. (“Stonington Fund”), aprincipal stockholder, or its affiliates, acquired greater than 50% of theCompany’s voting stock, or greater than 30% of the Company’s voting stock andStonington Fund did not own at least 30% of the stock. Mr. McNamara isalso subject to a confidentiality covenant, a covenant not to solicit anyemployee to leave the Company’s employment during the term of the agreement andone year thereafter, and a covenant not-to-compete with the Company during thesame time period.

On December 2, 1997,the Company entered into a Management Services Agreement with MandarinManagement Partners, Inc. (“Mandarin Partners”). The agreement providedfor Mandarin Partners to provide management consulting and business advisoryservices to the Company. As compensation for those services, the Company paidMandarin Partners, and then Lighthouse Venture Group (“LVG”), to whom theagreement was assigned on December 31, 2001, a monthly fee equal to twopercent of the Company’s adjusted gross sales. Under an oral agreement betweenLVG and the Company, LVG paid 50% of Mr. McNamara’s salary and bonusthrough December 2005, and to the extent the Company’s fees to LVGexceeded the amounts paid by LVG to Mr. McNamara for his salary and bonus,LVG remitted the additional amounts back to the Company, except for amounts tocover expenses. For the years ended December 31, 2005 and 2004, theCompany made payments to LVG in the amounts of $300 and $556, respectively,which are included in selling, general and administrative expenses. The oraland written agreements with LVG terminated as of December 31, 2005. LVG iscontrolled by Mr. McNamara.

In April 2002, theCompany entered into an Investor’s Rights Agreement with its former Chairmanand Chief Executive Officer, Austin McNamara. Subsequently, trusts establishedby Mr. McNamara became the owners of the 1,875,001 shares of the Company’scommon stock owned by Mr. McNamara and parties to the Investor’s RightsAgreement. Mr. McNamara resigned as a member of the Company’s board 

F-30

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

ofdirectors and as an employee in May 2006 and died in December 2006.The Investor’s Rights Agreement contained a repurchase obligation under whichthe Company was required to repurchase the shares of the Company held by thetrusts upon the exercise of a repurchase right. Subsequent to Mr. McNamara’sresignation, the trusts exercised this repurchase right. Pursuant to proceduresset forth in the Investor’s Rights Agreement, three valuation firms wereretained to prepare valuations of the stock held by the trusts and the totalpurchase price was to have been $ 28,201.

Any obligation the Companywould have to repurchase the trusts’ shares was to have been subordinated toits Credit Agreement, which restricts payments on such obligation to a maximumof $1,500 in any fiscal year, not to exceed $5,000 while the Credit Agreementis in place. The Investor’s Rights Agreement contains subordination provisionsand the trusts signed an additional subordination agreement in connection withthe Credit Agreement pursuant to which they agreed to be subordinated to theloans under the Credit Agreement. On November 17, 2006, the Companytendered promissory notes in the aggregate principal amount of $28,201 and acash payment of $1,500 as partial prepayment of the notes, to the trusts inorder to close on the Company’s repurchase of the shares held by the trustspursuant to the terms of the Investor’s Rights Agreement. The trusts refused toaccept the Company’s tender of these payments and refused to tender theirshares and close on the repurchase of the shares they hold. As a result, theCompany believes the trusts are in material breach of their obligations underthe Investor’s Rights Agreement. Based upon this material breach by the trusts,as well as for other reasons, the Company believes it is no longer obligated torepurchase the shares held by the trusts pursuant to the Investor’s RightsAgreement and the right of the trusts to require the Company to repurchase theshares has expired and can no longer be enforced against the Company.

The trusts have taken theposition that they did not breach their obligations under the Investor’s RightsAgreement and that instead the Company has breached its obligation torepurchase the trusts’ shares under the Investor’s Rights Agreement. While theCompany believes the trusts’ claims to be without merit, there can be noassurance the Company would prevail if the trusts were to seek to enforce theirclaims through litigation. To the Company’s knowledge, as of March 14,2007, the trusts had not commenced litigation against the Company.

On May 18, 2006, thetrusts’ exercised the repurchase right contained in the Investor’s RightsAgreement to require the Company to repurchase the shares owned by the trusts.Subsequently, the Company reported a liability of approximately $28,201 for theestimated amount it would be required to pay to fulfill the repurchaseobligation. As discussed above, on November 17, 2006, the trusts refused toaccept the consideration tendered by the Company to satisfy the repurchaseobligation and in doing so, the Company believes breached the terms of theInvestor’s Rights Agreement and nullified any obligation of the Company torepurchase the trusts’ shares. As a result of this breach, and for otherreasons, the Company reversed the liability it had previously recorded toreflect the Company’s conclusion that the shares held by the trusts are nolonger subject to repurchase by the Company pursuant to the Investor’s RightsAgreement and the right of the trusts to require the Company to repurchase theshares pursuant to the Investor’s Rights Agreement has expired.

Also as discussed above,the trusts have taken the position that they did not breach their obligationsunder the Investor’s Rights Agreement and that instead, the Company hasbreached its obligation to repurchase the trusts’ shares. However, no relatedclaims had been asserted against the Company as of March 14, 2007. As such,there is not a potential liability that would be probable or estimable, andtherefore, the Company did not record a liability for these unasserted claimsas of December 31, 2006.

F-31

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

Combinedamounts due from LVG for reimbursement of certain expenses and Dr. Obagi, Mr. McNamara,Cellogique and the Clinics for product purchases at December 31, 2006 and2005 are reflected in receivables due from related parties in the accompanyingconsolidated Balance Sheets as follows:

| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Due from  Dr. Obagi            |       | $                     | 560        |   | $ | 182 |   |
| Due from  Cellogique                |       | 646                   |       | 609 |   |
| Due from China  Obagi Corporation   |       | 27                    |       | 26 |   |
| Due from Vietnam  Obagi Corporation |       | —                |       | 8 |   |
| Due from Austin  McNamara           |       | —                |       | 52 |   |
| Due from LVG                        |       | 268                   |       | 268 |   |
|                                |       | $                     | 1,501      |   | $ | 1,145 |   |

 

**Stonington CapitalAppreciation 1994 Fund, L.P.**

In December 2002, the Company entered into amanagement services agreement (“Services Agreement”) with Stonington Partners, Inc.(“Stonington”), an affiliate of Stonington Fund, our majority stockholder. Theagreement calls for Stonington to provide management with consulting andbusiness advisory services. As compensation for these services, the Companypays Stonington an annual fee equal to 1.5% of its capital invested in theCompany plus expenses for services provided in the 2003 and 2002 fiscal years,and is renewable annually thereafter.

For the years ended December 31, 2006, 2005 and2004, fees plus expenses totaled approximately $400, $400, and $400, respectively,and are included as a component of selling, general and administrative expenses. This agreement terminated upon thecompletion of the initial public offering. In addition, the Company paid anaffiliate of Stonington two installments of $500, in December 2004 and January 2005,for consulting services associated with obtaining the $80,000 Senior SecuredCredit Facilities. These payments were capitalized as debt issuance costs andare included in Other assets in the accompanying Consolidated Balance Sheets.

Amountspayable to Dr. Obagi for any bonus, annual payment or royalties andinterest, and to other stockholders and their affiliates for management feesand other services as of December 31, 2006 and 2005 are reflected in theaccompanying Consolidated Balance Sheets as amounts due to related parties asfollows:

| ** **     | ** ** | **December 31,**            | ** ** |
|----------------|------------|----------------------------------|------------|
| ** **     | ** ** | **  2006  ** | ** ** | **2005** | ** ** |
| Dr. Obagi |       |                             | $          | 137 |   |   | $ |  205 |   |
| Stonington     |       |                             | 15         |   |   | — |   |
|           |       |                             | $          | 152 |   |   | $ | 205 |   |

 

During February 2005, the Company repurchased allof its outstanding Series A mandatorily redeemable preferred stock forapproximately $11,822 and paid the related accrued dividends of approximately$9,329. Dr. Obagi and Stonington received approximately $3,288 and $17,863for 18,375 and 99,840 shares of Series A preferred stock and the relatedaccrued dividends, respectively.

F-32

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

During February 2005,the Company declared and paid a $3.60 per share common stock dividend, totalingapproximately $63,088, in cash. A substantial portion of the common stockdividend was paid to Stonington, Dr. Obagi, and Mr. McNamara forapproximately $38,924, $15,142, and $6,750, respectively.

In February 2005, oneofficer of the Company issued a note for $15 and LVG issued notes for $1,225and $1,400 to the Company to exercise their vested options. These full-recoursenotes were repaid in full later in February 2005.

**Note 10: Commitments and contingencies**

**Lease commitments**

TheCompany leases some of its facilities and equipment under operating leases.Some of the leases require payment of property taxes and include rentescalation clauses. Future minimum operating lease commitments undernon-cancelable leases are as follows as of December 31, 2005:

| ** **                          | ** ** | **Operating** | ** ** |
|-------------------------------------|------------|---------------|------------|
| ** **                          | ** ** | **Leases**    | ** ** |
| **Years  ending December 31,** | ** ** |          | ** ** | ** ** |   |
| 2007                                |       |          | $          | 1,130 | ** ** |   |
| 2008                                |       |          | 797        | ** ** |   |
| 2009                                |       |          | 182        | ** ** |   |
| Total minimum payments  required    |       |          | $          | 2,109 | ** ** |   |

 

Rent expense for the yearsended December 31, 2006, 2005 and 2004 was approximately $639, $494, and$418, respectively. The Company records sublease rental income as an offset torent expense. Sublease rental income for the year ended December 31, 2004was approximately $520.

**Indemnifications**

The Company is a party toa variety of agreements entered into in the ordinary course of businesspursuant to which it may be obligated to indemnify the other parties forcertain liabilities that arise out of or relate to the subject matter of theagreements. Some of the agreements entered into by the Company require it toindemnify the other party against losses due to property damage includingenvironmental contamination, personal injury, failure to comply with applicablelaws, the Company’s negligence or willful misconduct, or breach ofrepresentations and warranties and covenants.

The Company provides forindemnification of directors, officers and other persons in accordance withlimited liability agreements, certificates of incorporation, bylaws, articlesof association or similar organizational documents, as the case may be. TheCompany maintains directors’ and officers’ insurance which should enable theCompany to recover a portion of any future amounts paid.

While the Company’s futureobligations under certain agreements may contain limitations on liability forindemnification, other agreements do not contain such limitations and undersuch agreements it is not possible to predict the maximum potential amount offuture payments due to the conditional nature of the Company’s obligations andthe 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 directorsand executive officers that provide them with rights to indemnification andexpense advancement to the fullest extent permitted under the Delaware GeneralCorporation Law.

F-33

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

**Employment agreements**

The Company has enteredinto employment agreements with certain of its management employees whichrequire annual gross salary payments which range from $400 to $500 per annum.The employment agreements range from a period of three to five years andinclude a provision for annual bonuses based on specific performance criteria.In the event that such key management employees are terminated without cause,the Company is contractually obligated to pay from 18 months up to theremaining balance due on the employment contracts.

Thefollowing is a schedule of the Company’s future minimum annual payments undersuch employment agreements as of December 31, 2006:

| **Years ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2007                               |       | $          | 400        |   |
| 2008                               |       | 67         |       |
|                               |       | $          | 467        |   |

 

**Severance agreements**

On September 1, 2006,the Company entered into severance agreements with four of our executiveofficers. The severance agreements provide that if one of these officersemployment with us is terminated within 12 months following a change ofcontrol without cause or by the officer with good reason, the officer will beentitled, upon execution of a release in a form acceptable to us, an amountequal to 100% of the officer’s then current annual base salary, payable over 12consecutive months.

**Litigation**

On March 8, 2006, Austin McNamara, the formerchairman of our board, president and chief executive officer, filed a charge ofdiscrimination against us with the California Department of Fair Employment andHousing (“DFEH”). Mr. McNamara died in December 2006. Mr. McNamaraalleged that we demoted, harassed and otherwise discriminated against him dueto his purported physical disability and medical condition. Mr. McNamararequested an immediate right-to-sue notice. On March 20, 2006, the DFEHclosed its case. The DFEH did not conduct an investigation or make adetermination on the merits of the complaint. Mr. McNamara’s estate hasthe right to file a discrimination lawsuit in a state court action within oneyear of the DFEH’s letter closing its case. While Mr. McNamara did notallege a specific amount of damages, the remedies available under Californialaw include compensatory damages, as well as attorneys’ fees. Mr. McNamaraalso threatened to file a wage claim with the California Labor Commissioner,though we are not aware of either Mr. McNamara or his estate actuallyfiling the claim. Mr. McNamara alleged that we did not pay all wages,bonuses, and severance owed to him. Mr. McNamara served as our chiefexecutive officer from September 2001 until July 2005, and as ourpresident from September 2001 until March 2005. He also served on ourboard of directors and as chairman from September 2001 until May 2006.We cannot determine the outcome of these matters at this time. As discussed inthe risk factor entitled “We may be sued by the Estate of Austin McNamara, ourformer Chairman and Chief Executive Officer, and certain trusts established by Mr. McNamara,”Mr. McNamara’s estate and certain trusts he had established have claimedthat we have materially breached our obligation to repurchase shares of ourcommon stock held by the trust pursuant to an Investor’s Rights Agreement. Wehave not been notified that any legal action has been commenced with regard tothis claim.

F-34

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

From time to time, theCompany is involved in litigation and other legal matters in the normal courseof business. Management does not believe that the outcome of any currentmatters will have a material adverse effect on the Company’s consolidated financialposition, results of operations or cash flows.

**Note 11:   Stockoptions**

The 1997 Stock Option/Stock Issuance Plan (the “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 commonstock that were allowed to be issued over the term of the Plan was not toexceed 750,000 shares of the Company’s common stock. In March 2001,the Board of Directors amended the Plan to discontinue further option grantsunder the Plan. At December 31, 2005, due to the aforementioneddiscontinuance of further option grants under the Plan, 501,225 shares areno longer available for the granting of additional options.

Under the option grant program, the exercise price pershare for ISOs shall be no less than 100% of the fair market value per share asdetermined by the Board of Directors on the grant date. The exercise price pershare for NSOs shall be no less than 85% of the fair market value per share asdetermined by the Board of Directors on the grant date. For ISOs and NSOs, theexercise price per share shall be no less than 110% of the fair market valueper share as determined by the Board of Directors on the grant date for anindividual who, at the time of grant, owns stock representing more than 10% ofthe total combined voting power of all classes of stock of the Company. Theright to exercise ISOs and NSOs vests at a rate in accordance with theindividual stock option agreements. The vesting period of options granted underthis plan typically ranges from one to four years. Options expire within aperiod of not more than ten years from the grant date. ISOs granted to anemployee, who at the time of grant owns stock representing more than 10% of thetotal combined voting power of all classes of stock of the Company, expirewithin a period of not more than five years from the grant date.

In November 2000, the Company adopted the 2000Stock Option/Stock Issuance Plan (the “2000 Plan”). The terms of the 2000 Planare consistent with those of the 1997 Stock Option/Stock Issuance Plan, exceptthat the maximum number of shares of common stock that may be issued over theterm of the 2000 Plan shall not exceed 375,000 shares of the Company’scommon stock. In addition, the maximum number of shares of common stock issuedto any person under the 2000 Plan in any calendar year shall not exceed 150,000shares. In September 2001, the Board of Directors amended the 2000 Plan toincrease the maximum number of shares of common stock that may be issued overthe term of the 2000 Plan to 2,083,334 shares. The vesting period ofoptions granted under this plan typically ranges from one to five years.Options expire within a period of not more than ten years from the grant date.In November 2005, the Board of Directors amended the Plan to discontinuefurther option grants under the Plan. At December 31, 2005 and 2006, dueto the aforementioned discontinuance of further option grants under the Plan,151,795 shares are no longer available for the granting of additionaloptions.

In November 2005, the Company adopted the 2005Stock Incentive Plan (the “2005 Plan”). The 2005 Plan provides for the grant ofISOs and NSOs to employees, consultants and directors. On November 27,2006, the Company’s Board of Directors amended the Company’s 2005 Plan. Theamendments to the 2005 Plan included: (i) increasing the number ofauthorized shares to 1,500,000; (ii) establishing an evergreen clause thatreplenishes the 2005 Plan each year with a share amount equal to the lesser of500,000 or 3% of 

F-35

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

outstanding shares; (iii) andother administrative provisions. The amended 2005 Plan was approved by thestockholders of the Company on November 28, 2006.

Pursuant to the 2005 Plan, the exercise price pershare for both ISOs and NSOs shall not be less than 100% of the fair marketvalue per share of the Company’s common stock on the grant date. The exerciseprice per share for both ISOs and NSOs may not be less than 110% of the fairmarket value of the Company’s common stock on the grant date for an individualwho, at the time of grant, owns stock representing more than 10% of the totalcombined voting power of all classes of the Company’s stock. The right toexercise the ISOs and the NSOs vests at a rate in accordance with theindividual stock option agreements. The vesting period of the options grantedunder this plan typically ranges from one to three years. Options expire withina period of not more than ten years from the grant date. ISOs granted to anemployee, who at the time of grant owns stock representing more than 10% of thetotal combined voting power of all classes of stock of the Company, expirewithin a period of not more than five years from the grant date.

A total of 3,583,334 shares have been authorizedfor issuance under the 2000 Plan and the 2005 Plan (the “Plans”). Of the sharesthat have been authorized for issuance, 1,382,532 and 1,373,156 shareshave been issued for options which have been exercised as of December 31,2006 and 2005, respectively, and 1,285,116 and 558,384 shares have beenreserved for options that are outstanding as of December 31, 2006 and2005, respectively. At December 31, 2006, 747,272 shares were availablefor granting of additional options. At December 31, 2005, 833,334 shareswere available for the granting of additional options.

During the year ended December 31, 2005, theCompany granted 514,593 options with exercise prices ranging from $8.40 to$14.40, which was equal to or greater than the fair value of the underlyingcommon stock on the date of each grant.

During the year ended December 31, 2006, theCompany’s Board of Directors granted stock options to the Company’s managementand employees to purchase a total of 750,000 shares of the Company’s commonstock upon the consummation of an initial public offering. The stock optionswere granted at the initial public offering price of $11.00, which was the fairmarket value on the date of grant.

F-36

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

Asummary of the option activity under the Plans is as follows:

| ** **                                 | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** |
|--------------------------------------------|------------|------------|------------|----------------------------------------------------------------|------------|
| **Outstanding  at December 31, 2003** |       | 1,444,003  |       |                                                           | $          | 2.07 |   |   |
| Granted                                    |       | —     |       |                                                           | —     |   |   |
| Exercised                                  |       | (50,500    | )          |                                                           | 1.15       |   |   |
| Canceled                                   |       | (11,250    | )          |                                                           | 2.62       |   |   |
| **Outstanding  at December 31, 2004** |       | 1,382,253  |       |                                                           | $          | 2.10 |   |   |
| Granted                                    |       | 514,593    |       |                                                           | 9.72       |   |   |
| Exercised                                  |       | (1,336,137 | )          |                                                           | 2.05       |   |   |
| Canceled                                   |       | (2,325     | )          |                                                           | 6.07       |   |   |
| **Outstanding  at December 31, 2005** |       | 558,384    |       |                                                           | $          | 9.22 |   |   |
| Granted                                    |       | 750,000    |       |                                                           | 11.00      |   |   |
| Exercised                                  |       | (9,378     | )          |                                                           | 3.40       |   |   |
| Canceled                                   |       | (13,890    | )          |                                                           | 9.12       |   |   |
| **Outstanding  at December 31, 2006** |       | 1,285,116  |       |                                                           | $          | 10.31 |   |   |
| Exercisable at  December 31, 2004     |       | 1,331,124  |       |                                                           | $          | 2.10 |   |   |
| Exercisable at  December 31, 2005     |       | 44,953     |       |                                                           | $          | 7.41 |   |   |
| Exercisable at  December 31, 2006     |       | 214,277    |       |                                                           | $          | 9.05 |   |   |

 

Asummary of options outstanding and exercisable as of December 31, 2006 areas follows:

| ** **                                                 | ** ** | ** ** | ** ** | **Options Outstanding**                                                     | ** ** | **Options Exercisable**                                   | ** ** |
|------------------------------------------------------------|------------|------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Range of Exercise  Price Per Share** | ** ** | ** ** | ** ** | **Number of Shares  Outstanding at  December 31, 2006** | ** ** | **Weighted Average  Per Share  Exercise Price** | ** ** | **Weighted Average  Remaining Life  (Years)** | ** ** | **Number of Shares  Exercisable at  December 31, 2006** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $1.20 to $1.29                                             |       |       | 26,650     |                                                                             |       |                                                           | $          | 1.21 |   |   |   | 4.98 |   |   |   | 14,150 |   |   |   | $ | 1.21 |   |   |
| $8.40 to $10.00                                            |       |       | 289,709    |                                                                             |       |                                                           | $          | 8.46 |   |   |   | 8.02 |   |   |   | 127,209 |   |   |   | $ | 8.53 |   |   |
| $10.80 to $14.40                                           |       |       | 968,757    |                                                                             |       |                                                           | $          | 11.11 |   |   |   | 9.70 |   |   |   | 72,918 |   |   |   | $ | 11.49 |   |   |
|                                                       |       |       | 1,285,116  |                                                                             |       |                                                           | $          | 10.31 |   |   |   | 9.22 |   |   |   | 214,277 |   |   |   | $ | 9.05 |   |   |

 

On December 13, 2006,the Company issued 2,728 shares of restricted common stock under the 2005 Planto one of its outside directors for services to be received during the yearended December 31, 2007. The resulting compensation expense is recognizedon a straight-line basis over the requisite service period, which equals therestricted stock vesting term of one year. The Company determined the fairmarket value of the restricted stock based upon the initial public offeringprice of our stock, which was $11.00.

**Note 12:   Segments**

SFAS No. 131 requires that the Company disclosecertain information about its operating segments where operating segments aredefined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the chief operatingdecision maker in deciding how to allocate resources and in assessingperformance. Generally, financial information is required to be 

F-37

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

reported on the basis thatis used internally for evaluating segment performance and deciding how toallocate resources to segments.

The Company operates its business on the basis of tworeportable segments (i) skin health and (ii) licensing. The skinhealth segment produces a broad range of topical skin health systems andproducts that enable physicians to treat a range of skin conditions, includingpre-mature aging, photo-damage, hyperpigmentation, acne and soft tissuedeficits, such as fine lines and wrinkles. The licensing segment includesrevenues generated from licensing arrangements with international distributorsthat specialize in the distribution and marketing of over-the-counter medicaloriented products in the drug store, retail and aesthetic spa channels.

Management evaluates its segments on a revenue andgross profit basis, which is presented below. The United States information ispresented separately as the Company’s headquarters reside in the United States,and United States sales represented 82.0%, 81.4%, and 80.2% of totalconsolidated net sales for the years ended December 31, 2006, 2005,and  2004, respectively. No other countryor single customer generates over 10% of total Company consolidated net sales.

All ofthe Company’s long-lived assets are located in the United States. The Companydoes not disaggregate assets on a segment basis for internal managementreporting and, therefore, such information is not presented.

| ** **                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by segment**    | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Skin health                 |       | $                                          | 73,940     |   | $ | 61,539 |   | $ | 52,772 |   |
| Licensing                   |       | 4,056                                      |       | 3,402 |   | 3,484 |   |
| Net sales                   |       | $                                          | 77,996     |   | $ | 64,941 |   | $ | 56,256 |   |
| **Gross profit by segment** | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Skin health                 |       | $                                          | 60,650     |   | $ | 50,117 |   | $ | 43,417 |   |
| Licensing                   |       | 3,879                                      |       | 3,252 |   | 3,355 |   |
| Gross profit                |       | $                                          | 64,529     |   | $ | 53,369 |   | $ | 46,772 |   |
| **Geographic information**  | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States               |       | $                                          | 63,929     |   | $ | 52,883 |   | $ | 45,129 |   |
| International               |       | 14,067                                     |       | 12,058 |   | 11,127 |   |
| Net sales                   |       | $                                          | 77,996     |   | $ | 64,941 |   | $ | 56,256 |   |

 

F-38

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

 

| ** **                    | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net sales by product line** | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Skin health                   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Nu-Derm                       |       | $                                          | 53,228     |   | $ | 46,609 |   | $ | 40,567 |   |
| Vitamin C                     |       | 9,814                                      |       | 8,438 |   | 6,974 |   |
| Skin laxity                   |       | 2,278                                      |       | — |   | — |   |
| Other                         |       | 8,620                                      |       | 6,492 |   | 5,231 |   |
| Total                         |       | 73,940                                     |       | 61,539 |   | 52,772 |   |
| Licensing                     |       | 4,056                                      |       | 3,402 |   | 3,484 |   |
| Total net sales               |       | $                                          | 77,996     |   | $ | 64,941 |   | $ | 56,256 |   |

 

**Note 13:   401(k) plan**

On February 1, 1999,the Company established an employee savings and retirement plan and a 401(k) definedcontribution retirement plan, covering substantially all full-time employees.The Company matches 25% of employee contributions up to 6% of employeecompensation. The Company may also make, at the discretion of the board ofdirectors, additional contributions subject to statutory limits. Beginning in April 2006,the Company matches 100% of employee contributions up to 2% of employeecompensation. The Company contributed approximately $125, $42, and $51 for theyears ended December 31, 2006, 2005, and 2004, respectively.Administrative expenses paid on behalf of the plan were nominal for each of therespective years.

**Note14:   Quarterly Financial Data (Unaudited)**

Quarterlyfinancial data for the years ended December 31, 2006 and 2005 are asfollows:

| ** **                                      | ** ** | **Quarter Ended**   | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| Net sales                                       |       |                     | $          | 17,204 |   |   | $ | 18,722 |   |   | $ | 19,105 |   |   |   | $ | 22,965 |   |   |
| Gross profit                                    |       |                     | $          | 14,432 |   |   | $ | 15,705 |   |   | $ | 15,762 |   |   |   | $ | 18,630 |   |   |
| Net income                                      |       |                     | $          | 1,496 |   |   | $ | 1,078 |   |   | $ | 1,006 |   |   |   | $ | 2,536 |   |   |
| Net income  attributable to common stockholders |       |                     | $          | 1,496 |   |   | $ | 1,078 |   |   | $ | 1,006 |   |   |   | $ | 2,536 |   |   |
| Net income attributable  to common shares       |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       |                     | $          | 0.08 |   |   | $ | 0.06 |   |   | $ | 0.06 |   |   |   | $ | 0.14 |   |   |
| Diluted                                         |       |                     | $          | 0.08 |   |   | $ | 0.06 |   |   | $ | 0.06 |   |   |   | $ | 0.14 |   |   |

 

F-39

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

 

| ** **                                      | ** ** | **Quarter Ended**   | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| Net sales                                       |       |                     | $          | 14,998 |   |   | $ | 15,989 |   |   | $ | 14,651 |   |   |   | $ | 19,303 |   |   |
| Gross profit                                    |       |                     | $          | 12,311 |   |   | $ | 13,304 |   |   | $ | 12,052 |   |   |   | $ | 15,702 |   |   |
| Net income                                      |       |                     | $          | 2,772 |   |   | $ | 2,692 |   |   | $ | 997 |   |   |   | $ | 2,495 |   |   |
| Net income  attributable to common stockholders |       |                     | $          | 2,646 |   |   | $ | 2,681 |   |   | $ | 994 |   |   |   | $ | 2,495 |   |   |
| Net income attributable  to common shares       |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       |                     | $          | 0.16 |   |   | $ | 0.15 |   |   | $ | 0.06 |   |   |   | $ | 0.14 |   |   |
| Diluted                                         |       |                     | $          | 0.15 |   |   | $ | 0.15 |   |   | $ | 0.06 |   |   |   | $ | 0.14 |   |   |

 

**Note 15:   Subsequentevents**

Pursuant to the 2005 Plan, on January 9, 2007,the Board of Directors replenished the 2005 Plan with 500,000 shares, for atotal of 1,247,272 shares available for granting of additional options.

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