** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

 

 

**FORM 10-Q**

 

 

 

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE**

**SECURITIES EXCHANGE ACT OF 1934.**

 

 

**For the Quarterly PeriodEnded September 30, 2004**

 

Commission File Number 0-18044

 

**PROCYTE CORPORATION**

(Exact name of theregistrant as specified in its charter)

 

 

 

 

 

| **Washington**                                                | ** ** | **91-1307460**                        |
|---------------------------------------------------------------|------------|---------------------------------------|
| (State of incorporation)                                      |       | (I.R.S. Employer  Identification No.) |
|                                                          |       |                                  |
| **8511 154th Avenue N.E., Redmond, WA**                       | ** ** | **98052**                             |
| (Address of principal executive offices)                      |       | (Zip code)                            |
|                                                          |       |                                  |
| **Registrant’s telephone number, including area  code:** | ** ** | **(425) 869-1239**                    |

 

 

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 
| Yes  ý |   | No  o |
|-------------|--------|-------|

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2).

 
| Yes  o |   | No  ý |
|--------|--------|------------|

 

Asof November 5, 2004, there were issued and outstanding 15,816,762 shares ofcommon stock, par value $.01 per share.

 

 

 

----

 

**ProCyte Corporation**

 

**Index**

 

 
| **Part I - Financial  Information**                                                                  | **3**  |
|------------------------------------------------------------------------------------------------------|--------|
| Item  1. Condensed Consolidated Financial Statements (unaudited)                                     | 3      |
| Balance  Sheets - as of September 30, 2004 and December 31, 2003 (unaudited)                         | 3      |
| Statements  of Operations - Three and Nine Months Ended September 30, 2004 and 2003  (unaudited)     | 4      |
| Statements  of Cash Flows — Nine Months Ended September 30, 2004 and 2003 (unaudited)           | 5      |
| Statements  of Stockholders’ Equity — Nine Months Ended September 30, 2004 (unaudited)     | 6      |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                    | 7      |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 13     |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                  | 25     |
| Item 4. Controls and  Procedures                                                                     | 25     |
| **Part II - Other Information**                                                                      | **27** |
| Item 6. Exhibits                                                                                     | 27     |
| **Signatures**                                                                                       | **27** |
|                                                                                                 |   |

# ** **

2

----

 

# **Part I—FinancialInformation**

 

## **Item1. Condensed Consolidated Financial Statements (unaudited)**

 

### **BalanceSheets - as of September 30, 2004 and December 31, 2003 (unaudited)**

(in thousands)
| ** **                                                  | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **Assets**                                                  |       |                    |       |                   |       |
| **Current Assets**                                          |       |                    |       |                   |       |
| Cash and cash equivalents                                   |       | $                       | 5,321      |                   | $          | 3,796 |   |
| Accounts receivable, net of allowance for doubtful accounts |       | 1,317                   |       | 1,336                  |       |
| Inventory                                                   |       | 2,977                   |       | 2,942                  |       |
| Assets held for sale                                        |       | 814                     |       | —                 |       |
| Prepaid and other                                           |       | 295                     |       | 289                    |       |
| **Total current assets**                                    |       | 10,724                  |       | 8,363                  |       |
| **Property and equipment**                                  |       |                    |       |                   |       |
| Equipment                                                   |       | 325                     |       | 315                    |       |
| Leasehold improvements                                      |       | 3,141                   |       | 3,520                  |       |
| Less accumulated depreciation and amortization              |       | (3,392                  | )          | (3,294                 | )          |
| **Property and equipment, net**                             |       | 74                      |       | 541                    |       |
| Intangible assets                                           |       | 3,198                   |       | 3,212                  |       |
| Note due from related party, net                            |       | —                  |       | 781                    |       |
| Deferred tax asset                                          |       | 6,938                   |       | 7,068                  |       |
| Other assets                                                |       | 38                      |       | 38                     |       |
| **Total Assets**                                            |       | $                       | 20,972     |                   | $          | 20,003 |   |
|                                                        |       |                    |       |                   |       |
| **Liabilities and Stockholders’ Equity**               |       |                    |       |                   |       |
| **Current Liabilities**                                     |       |                    |       |                   |       |
| Accounts payable, trade                                     |       | $                       | 542        |                   | $          | 147 |   |
| Accrued salaries and benefits                               |       | 293                     |       | 246                    |       |
| Other accrued liabilities                                   |       | 200                     |       | 239                    |       |
| Deferred revenue                                            |       | 381                     |       | 60                     |       |
| **Total current liabilities**                               |       | 1,416                   |       | 692                    |       |
| Other liabilities                                           |       | 75                      |       | 93                     |       |
| **Total Liabilities**                                       |       | 1,491                   |       | 785                    |       |
| **Stockholders’ Equity**                               |       |                    |       |                   |       |
| Common stock and additional paid-in-capital                 |       | 85,443                  |       | 85,419                 |       |
| Deferred compensation                                       |       | (42                     | )          | (59                    | )          |
| Accumulated deficit                                         |       | (65,920                 | )          | (66,142                | )          |
| **Stockholders’ Equity**                               |       | 19,481                  |       | 19,218                 |       |
| **Total Liabilities and Stockholders’ Equity**         |       | $                       | 20,972     |                   | $          | 20,003 |   |
|                                                        |       |                    |       |                   |       |

 

*Seenotes to condensed consolidated financial statements*

 

3

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### **Statementsof Operations—Three and Nine Months Ended September 30, 2004 and 2003**(unaudited)

(inthousands, except per share amounts)

 
| ** **                                 | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                 | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Revenues**                               |       |                                  |       |                                 |       |   |   |   |   |
| Product sales                              |       | $                                     | 2,883      |                                 | $          | 2,286 |   | $ | 9,198 |   | $ | 7,481 |   |
| Licenses and royalties                     |       | 353                                   |       | 437                                  |       | 942 |   | 1,220 |   |
| Total revenues                             |       | 3,236                                 |       | 2,723                                |       | 10,140 |   | 8,701 |   |
| Cost of product sales                      |       | 756                                   |       | 675                                  |       | 2,774 |   | 2,477 |   |
| Gross profit                               |       | 2,480                                 |       | 2,048                                |       | 7,366 |   | 6,224 |   |
| **Operating Expenses**                     |       |                                  |       |                                 |       |   |   |   |   |
| Marketing and selling                      |       | 1,091                                 |       | 1,024                                |       | 3,549 |   | 3,237 |   |
| Research, general, and administrative      |       | 1,055                                 |       | 797                                  |       | 3,203 |   | 2,731 |   |
| Loss on asset impairment                   |       | 25                                    |       | —                               |       | 319 |   | — |   |
| Total operating expenses                   |       | 2,171                                 |       | 1,821                                |       | 7,071 |   | 5,968 |   |
| Operating income                           |       | 309                                   |       | 227                                  |       | 295 |   | 256 |   |
| Interest and other income                  |       | 14                                    |       | 34                                   |       | 64 |   | 159 |   |
| Net income before tax                      |       | 323                                   |       | 261                                  |       | 359 |   | 415 |   |
| Provision (benefit) for income tax         |       | 122                                   |       | —                               |       | 137 |   | (18 | ) |
| Net income                                 |       | $                                     | 201        |                                 | $          | 261 |   | $ | 222 |   | $ | 397 |   |
| ***Net earnings per share***               |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                      |       | $                                     | 0.01       |                                 | $          | 0.02 |   | $ | 0.01 |   | $ | 0.03 |   |
| Diluted                                    |       | $                                     | 0.01       |                                 | $          | 0.02 |   | $ | 0.01 |   | $ | 0.02 |   |
| ***Shares used in per share computation*** |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                      |       | 15,807                                |       | 15,774                               |       | 15,799 |   | 15,761 |   |
| Diluted                                    |       | 15,954                                |       | 15,974                               |       | 16,000 |   | 15,973 |   |

 

*Seenotes to condensed consolidated financial statements*

 

4

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### **Statementsof Cash Flows—Nine Months Ended September 30, 2004 and 2003**(unaudited)

(inthousands)

 
| ** **                                                                                         | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| **Operating Activities**                                                                           |       |                                |       |   |   |
| Net income                                                                                         |       | $                                   | 222        |   | $ | 397 |   |
| ***Adjustments to reconcile net income to net cash  provided by (used in) operating activities:*** |       |                                |       |   |   |
| Depreciation and amortization                                                                      |       | 119                                 |       | 244 |   |
| Amortization of deferred proceeds                                                                  |       | —                              |       | (201 | ) |
| Non-cash expense related to stock-based compensation                                               |       | 41                                  |       | 40 |   |
| Amortization of promissory note discount                                                           |       | —                              |       | (23 | ) |
| Change in deferred tax asset, net of change in valuation allowance                                 |       | 130                                 |       | — |   |
| Loss on asset impairment                                                                           |       | 319                                 |       | — |   |
| ***Change in operating assets and liabilities:***                                                  |       |                                |       |   |   |
| Accounts receivable                                                                                |       | 19                                  |       | 206 |   |
| Inventory                                                                                          |       | (15                                 | )          | (882 | ) |
| Prepaid and other                                                                                  |       | (6                                  | )          | 132 |   |
| Accounts payable, trade                                                                            |       | 395                                 |       | 13 |   |
| Accrued salaries and benefits                                                                      |       | 47                                  |       | (144 | ) |
| Other accrued liabilities                                                                          |       | (39                                 | )          | (69 | ) |
| Deferred revenue                                                                                   |       | 321                                 |       | 228 |   |
| Other liabilities                                                                                  |       | (18                                 | )          | 2 |   |
| ***Net cash provided by (used in) operating  activities***                                         |       | 1,535                               |       | (57 | ) |
| **Financing Activities**                                                                           |       |                                |       |   |   |
| Proceeds from issuance of common stock                                                             |       | —                              |       | 10 |   |
| **Investing Activities**                                                                           |       |                                |       |   |   |
| Purchase of property and equipment                                                                 |       | (10                                 | )          | (53 | ) |
| ***Net increase (decrease) in cash and cash  equivalents***                                        |       | 1,525                               |       | (100 | ) |
| **Cash and Cash Equivalents**                                                                      |       |                                |       |   |   |
| At beginning of period                                                                             |       | 3,796                               |       | 4,556 |   |
| At end of period                                                                                   |       | $                                   | 5,321      |   | $ | 4,456 |   |
| **Supplemental Non-Cash Financing Activities**                                                     |       |                                |       |   |   |
| Assets received in settlement of note receivable                                                   |       | 841                                 |       | — |   |
|                                                                                               |       |                                |       |   |   |

### ***See notes to condensed consolidated financial statements***

 

5

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### **Statementsof Stockholders’ Equity—Nine Months Ended September 30, 2004**(unaudited)

(inthousands)

 
| ** **                                               | ** ** | **Common Stock** | ** ** | ** **    | ** ** | ** **                     | ** ** | ** **                  | ** ** | ** **              | ** ** |
|----------------------------------------------------------|------------|------------------|------------|---------------|------------|--------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                               | ** ** | **Shares**       | ** ** | **Par Value** | ** ** | **Additional Paid-in Capital** | ** ** | **Deferred Compen- sation** | ** ** | **Accumulated Deficit** | ** ** | **Total** | ** ** |
| Balance, December 31, 2003                               |       | 15,783           |       | $             | 158        |                           | $          | 85,261                      |       | $                       | (59        | ) | $ | (66,142 | ) | $ | 19,218 |   |
| Shares issued under non-employee director stock plan     |       | 24               |       | (*            | )          | 27                             |       | —                      |       | —                  |       | 27 |   |
| Re-measurement of stock options granted to non-employees |       | —           |       | —        |       | (3                             | )          | 3                           |       | —                  |       | — |   |
| Amortization of deferred compensation                    |       | —           |       | —        |       | —                         |       | 14                          |       | —                  |       | 14 |   |
| Net income                                               |       | —           |       | —        |       | —                         |       | —                      |       | 222                     |       | 222 |   |
| Balance, September 30, 2004                              |       | 15,807           |       | $             | 158        |                           | $          | 85,285                      |       | $                       | (42        | ) | $ | (65,920 | ) | $ | 19,481 |   |

 

 

                Thisstatement contains rounding, and (*) is placed where the number rounds to lessthan $1,000.

 

*Seenotes to condensed consolidated financial statements*

* *

 

6

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**ProCyte Corporation**

### **Notesto Condensed Consolidated Financial Statements (unaudited)**

 

 

**1.****             ****Basisof Presentation**

 

The accompanying condensed consolidatedfinancial statements include the accounts of ProCyte Corporation and itswholly-owned subsidiaries, NextDerm, Inc. (a Delaware corporation) andNextDerm, Inc. (a Washington corporation) (collectively “ProCyte” or the “Company”),for the three and nine month periods ended September 30, 2004 and 2003, andhave been prepared by the Company in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and the instructions to Form 10-Q and Article 10 of RegulationS-X.  Pursuant to such rules andregulations, the condensed consolidated financial statements do not include allof the information and footnotes required by accounting principles generallyaccepted in the United States of America for audited financial statements.  Accordingly, this financial informationshould be read in conjunction with the complete audited financial statements,including the notes thereto, which are included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2003.  In the opinion of management, all materialadjustments (consisting of normal recurring accruals) considered necessary fora fair presentation of the financial statements have been included.  Interim results are not necessarilyindicative of the results that may be expected for the year.

 

###### *Useof Estimates in Financial Statements*

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of revenues and expenses during the reporting period and the reportedamounts of assets and liabilities and disclosure of contingent liabilities atthe date of the financial statements, particularly with respect to thevaluation of inventory, assets held for sale, goodwill, leasehold improvementsand deferred tax assets.  Actual resultscould differ from those estimates.

 

*Stock Based Compensation*

The Company follows the intrinsic value basedaccounting method for stock options contained in APB Opinion No. 25, Accountingfor Stock Issued to Employees, as permitted by SFAS No. 123, Accounting forStock-Based Compensation.  Under thismethod, no compensation expense has been recognized for employee incentivestock options, as the exercise price of options granted equaled the fair valueon the date of grant.

 

The following tablerepresents what the Company’s pro forma amounts of net income and net incomeper share would have been for the three and nine months ended September 30,2004 and 2003, had compensation expense for the Company’s stock options grantedunder the incentive compensation plan been recognized based upon the fair valueof the awards granted.

 
| ** **                                                                        | ** ** | **Three months ended September 30,**         | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                     | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                        | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net income, as reported                                                           |       | $                                            | 201        |                                | $          | 261 |   | $ | 222 |   | $ | 397 |   |
| Stock option-based compensation expense determined under fair  value-based method |       | (58                                          | )          | (97                                 | )          | (47 | ) | (224 | ) |
| Pro forma net income                                                              |       | $                                            | 143        |                                | $          | 164 |   | $ | 175 |   | $ | 173 |   |

 

 

7

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| ** **          | ** ** | **Three months ended September 30,**         | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------|------------|----------------------------------------------|------------|-------------------------------------|------------|
| ** **          | ** ** | **2004**                                     | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **          | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Earnings per share: |       |                                         |       |                                |       |   |   |   |   |
| As reported basic   |       | $                                            | 0.01       |                                | $          | 0.02 |   | $ | 0.01 |   | $ | 0.03 |   |
| As reported diluted |       | $                                            | 0.01       |                                | $          | 0.02 |   | $ | 0.01 |   | $ | 0.02 |   |
| Pro forma basic     |       | $                                            | 0.01       |                                | $          | 0.01 |   | $ | 0.01 |   | $ | 0.01 |   |
| Pro forma diluted   |       | $                                            | 0.01       |                                | $          | 0.01 |   | $ | 0.01 |   | $ | 0.01 |   |
|                     |            |                                              |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

TheCompany determined the fair value of stock options granted during the three andnine months ended September 30, 2004 and 2003 using the Black-Scholes optionpricing model and the following assumptions:

 
| ** **                   | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Options Granted**          | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Risk-free interest rate      |       | 3.26                                 | %          | 2.35                                | %          | 2.44-3.26 | % | 2.35-2.81 | % |
| Expected option life (years) |       | 6.00                                 |       | 6.00                                |       | 6.00 |   | 6.00 |   |
| Dividend yield               |       | 0.00                                 |       | 0.00                                |       | 0.00 |   | 0.00 |   |
| Expected volatility          |       | 59                                   | %          | 60                                  | %          | 59-63 | % | 59-62 | % |

 

**2.****             ****AccountsReceivable**

 

Three customers represented greater than 10% of thenet accounts receivable balance at September 30, 2004 and two of such customersrepresented greater than 10% of the net accounts receivable balance at December31, 2003 as follows:

 
| ** ** | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------|------------|------------------------|------------|-----------------------|------------|
| Customer A |       | 27                     | %          | 46                    | %          |
| Customer B |       | 17                     | %          | 5                     | %          |
| Customer C |       | 12                     | %          | 12                    | %          |

 

The Company provided an allowance foruncollectible receivables in the amount of $18,000 and $102,000 at September30, 2004 and December 31, 2003, respective1y. The bad debt expense, net of recoveries of $38,000 in 2004 and $1,000 in2003, was a benefit of $29,000 and an expense of $15,000 for the three monthsended September 30, 2004 and 2003, respectively.  The bad debt expense, net of recoveries of$172,000 in 2004 and $6,000 in 2003, was a benefit of $240,000 and an expenseof $44,000 for the nine months ended September 30, 2004 and 2003,respectively.  Accounts written off tothe allowance amounted to $2,000 and $1,000 for the three-month periods endedSeptember 30, 2004 and 2003, respectively. Accounts written off to the allowance account amounted to $16,000 and$14,000 for the nine-month periods ended September 30, 2004 and 2003,respectively.

 

 

8

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**3.****             ****Inventory**

 

Inventory consisted of the following:

 
| ** **      | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------|------------|------------------------|------------|-----------------------|------------|
| ** **      | ** ** | **(in thousands)**     | ** ** |
| Finished Goods  |       | $                      | 2,153      |                  | $          | 2,235 |   |
| Work in process |       | 416                    |       | 406                   |       |
| Raw materials   |       | 408                    |       | 301                   |       |
| **Total**       |       | $                      | 2,977      |                  | $          | 2,942 |   |

 

**4.****             ****IntangibleAssets**

 

Intangible assets consisted of the following:

 
| ** **                             | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **(in thousands)**     | ** ** |
| Patents, net of amortization           |       | $                      | 57         |                  | $          | 70 |   |
| Other intangibles, net of amortization |       | 27                     |       | 36                    |       |
| Goodwill                               |       | 3,114                  |       | 3,106                 |       |
| **Intangible Assets, net**             |       | $                      | 3,198      |                  | $          | 3,212 |   |

 

Patents are shown net of accumulatedamortization of $233,000 and $221,000, at September 30, 2004 and December 31,2003, respectively.  Patents areamortized over the term of the patent and the amortization expense relatedthereto was $4,000 for each of the three-month periods ended September 30, 2004and 2003, respectively and $12,000 for each of the nine-month periods endedSeptember 30, 2004 and 2003, respectively. Patent amortization expense is expected to be $16,000 for each of theyears ending December 31, 2004 through 2007 and $6,000 for the year endingDecember 31, 2008.

 

Other intangible assets are shown net ofaccumulated amortization of $9,000 at September 30, 2004.  The assets consist of trademarks and acustomer list acquired from Annette Hanson, Inc. on December 30, 2003.  The trademarks and customer list are beingamortized over their expected lives and the amortization expense relatedthereto was $3,000 and $9,000 for the three and nine months periods endedSeptember 30, 2004, respectively. The amortization expense is expected to be$12,000 for each of the years ending December 31, 2004 through 2006.

 

Intangible assetsalso include goodwill of $3.1 million at September 30, 2004 and December 31,2003.  The Company determined that it hasone reporting unit, therefore, all of the goodwill is deemed to be associatedwith ProCyte’s overall business operations.

 

**5.****             ****Federaland State Income Taxes**

 

Deferred incometaxes reflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. As of September 30, 2004 and December 31,2003, a partial valuation reserve for tax benefits of net operating losses anda full valuation reserve for research and development tax credit carry forwardsremains in place due to the uncertainty of realizing the full tax benefits ofthe net operating losses and tax credits as a result of their expiration.  The net changes in the valuation allowanceduring the nine months

 

 

9

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ended September30, 2004, and the year ended December 31, 2003, were a reduction of $33,000 and$7.1 million, respectively.

 

As of September30, 2004, the Company’s U.S. federal net operating loss and general businesscredit carry forward for income tax purposes were approximately $67.4 millionand $1.6 million, respectively.  If notutilized, the federal net operating loss carry forward and tax credit carryforwards will expire between 2005 and 2021 as follows:

 
| ** ** | ** ** | **Net operating loss** | ** ** | **General business credits** | ** ** |
|------------|------------|------------------------|------------|------------------------------|------------|
| ** ** | ** ** | **(in thousands)**     | ** ** |
| 2005       |       | $                      | 2,002      |                         | $          | 178 |   |
| 2006       |       | 3,928                  |       | 133                          |       |
| 2007       |       | 5,173                  |       | 158                          |       |
| 2008       |       | 7,912                  |       | 242                          |       |
| Thereafter |       | 48,422                 |       | 865                          |       |
| Total      |       | $                      | 67,437     |                         | $          | 1,576 |   |

 

Future changes inownership, as defined by Section 382 of the IRC, may limit the amount of netoperating loss carry forward used in any one year.

 

**6.****             ****Earningsper share**

 

Basic and diluted per share results for allperiods presented were computed based on the net earnings for the respectiveperiods.  The weighted average number ofcommon shares outstanding during the period was used in the calculation ofbasic earnings per share.  In accordancewith FAS 128, “Earnings Per Share,” the weighted average number of commonshares used in the calculation of diluted per share amounts is adjusted for thedilutive effects of stock options based on the treasury stock method only if anentity records earnings from operations, as such adjustments would otherwise beanti-dilutive to earnings per share from operations.  For the three months ended September 30, 2004and 2003, 146,830 and 200,823 dilutive stock options were included in thecalculation of the average number of common shares outstanding for dilutedcomputations, respectively.  For thethree month periods ended September 30, 2004 and 2003, options and warrants topurchase 1,924,180 shares and 1,043,007 shares of common stock, respectively,were not included in the computation of diluted earnings per share because theeffect would have been anti-dilutive because the exercise prices were greaterthan the average fair market value of the Company’s common stock for the periodof $0.98 and $1.16, respectively.  Forthe nine months ended September 30, 2004 and 2003, 201,176 and 211,601 dilutivestock options, respectively, were included in the calculation of the averagenumber of common shares outstanding for diluted computations. For the ninemonths ended September 30, 2004 and 2003, options to purchase 1,826,580 sharesand 981,342 shares, respectively, of common stock with exercise prices greaterthan the average fair market value of the Company’s common stock for the periodof $1.08 and $1.19, respectively, were not included in the computation ofdiluted earnings per share because the effect would have been anti-dilutive.

 

**7.****             ****StockOptions**

 

The Company hasstock option plans for directors, officers, employees and consultants thatprovide for grants of nonqualified and incentive stock options.  Options generally are granted at fair marketvalue, expire between five and ten years from grant date and vest over one tothree years.

 

 

10

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The following table summarizes information about stockoption activity in nine-month periods ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004**              | ** ** | **2003**                     | ** ** |
|--------------------------------|------------|-----------------------|------------|------------------------------|------------|
| **Items**                      | ** ** | **Number of Options** | ** ** | **Wtd. Avg. Exercise Price** | ** ** | **Number of Options** | ** ** | **Wtd. Avg. Exercise Price** | ** ** |
| Outstanding, beginning of year |       | 2,570,167             |       | $                            | 1.41       |   | 2,185,335 |   | $ | 1.57 |   |
| Granted                        |       | 162,000               |       | 1.10                         |       | 169,500 |   | 1.29 |   |
| Exercised                      |       | —                |       | —                       |       | (12,000 | ) | 0.86 |   |
| Canceled or expired            |       | (136,167              | )          | 1.57                         |       | (149,835 | ) | 2.74 |   |
| Outstanding, September 30,     |       | 2,596,000             |       | $                            | 1.38       |   | 2,193,000 |   | $ | 1.47 |   |
| Exercisable, September 30,     |       | 1,861,348             |       | $                            | 1.47       |   | 1,633,179 |   | $ | 1.51 |   |

 

Theoptions outstanding at September 30, 2004 consisted of the following:

 
| **Range of exercise prices** | ** ** | **Number of Options Outstanding** | ** ** | **Wtd. Avg. Remaining Life** | ** ** | **Wtd. Avg. Exercise Price** | ** ** | **Number of Options Exercisable** | ** ** | **Wtd. Avg. Exercise Price** | ** ** |
|------------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| $ 0.49 - $0.77          |       | 564,000                           |       | 5.32                         |       | $                            | 0.74       |                              | 564,000    |                         | $          | 0.74 |   |
| $ 0.77 - $1.09          |       | 536,000                           |       | 8.09                         |       | 1.02                         |       | 135,667                           |       | 0.94                         |       |
| $ 1.11 - $1.30          |       | 576,000                           |       | 7.14                         |       | 1.23                         |       | 360,171                           |       | 1.25                         |       |
| $ 1.31 - $1.83          |       | 536,500                           |       | 6.55                         |       | 1.57                         |       | 418,010                           |       | 1.59                         |       |
| $ 2.16 - $3.44          |       | 383,500                           |       | 1.39                         |       | 2.78                         |       | 383,500                           |       | 2.78                         |       |
| $ 0.49 - $3.44          |       | 2,596,000                         |       | 5.97                         |       | $                            | 1.38       |                              | 1,861,348  |                         | $          | 1.47 |   |

 

The weightedaverage fair value of options granted during the three-month periods endedSeptember 30, 2004 and 2003 was approximately $0.43 and $0.51,respectively.  The weighted average fairvalue of options granted during the nine months ended September 30, 2004 and2003 were approximately $0.49 and $0.76, respectively.

 

On April 12, 2004, the Board of Directors adopted theProCyte Corporation 2004 Stock Option Plan subject to stockholder approval,which approval was obtained on May 19, 2004. 2,000,000 shares of common stock have been reserved for the plan, whichprovides for the grant of nonqualified and incentive stock options.  At September 30, 2004 there were 41,662shares reserved for issuance under the Company’s 1996 Stock Option Plan.

 

**8.****             ****RelatedParty Disclosures**

 

InJuly 2001 the Company sold its contract manufacturing operations to EmeraldPharmaceutical L.P. (“Emerald”) and received a promissory note in the principalamount of $2 million as part of the consideration.  The note was secured by a security agreementcovering substantially all of the assets of Emerald and requires Emerald tomake monthly interest-only payments equal to the effective yield on the 10 YearUS Treasury Note, adjusted quarterly.  Aspart of the agreement, ProCyte subleased a portion of its leased facility,including existing leasehold improvements, to Emerald.  The Company also received a minority limitedpartnership interest in Emerald as part of the consideration received in thesale.

 

Emerald suspendedoperations in February 2004 and until that time ProCyte had engaged Emerald tomanufacture copper peptide compounds, and to perform incoming quality testingand other analytical

 

 

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services.  Emerald billed ProCyte a total of $415,000for the three-month period ended September 30, 2003, and $19,000 and $1.6million for the nine months ended September 30, 2004 and 2003, respectively,for such products and services.  Emeraldprovided no products or services during the three months ended September 30,2004. ProCyte has other sources for these products and services at prices thatdo not materially differ from those charged by Emerald.  ProCyte had no trade payables to Emerald atSeptember 30, 2004 and December 31, 2003.

 

One of the Company’sDirectors also serves as Chairman and Chief Executive Officer of one of ProCyte’scustomers.  ProCyte’s sales to thecustomer were $235,000 and $248,000 for the three month periods ended September30, 2004 and 2003, respectively and $632,000 and $593,000 for the nine monthperiods ended September 30, 2004 and 2003, respectively.  The customer’s trade receivable balances were$158,000 and $165,000 on September 30, 2004 and December 31, 2003,respectively.

 

**9.****             ****Loss onAsset Impairment ; Assets Held For Sale**

 

In February 2004, the General Partner of Emeraldinformed the Company that Emerald had suspended operations and terminated allemployees in an effort to conserve remaining capital while it sought other entitiesto operate or purchase the facility. Emerald was ultimately not successful in returning to operations and,therefore, ProCyte terminated the facility sublease effective June 25, 2004.  In addition, effective July 16, 2004,ProCyte, as a secured party, completed a strict foreclosure process ofaccepting substantially all of Emerald’s assets in satisfaction of Emerald’sobligations under the $2 million promissory note.  Based upon the information known at the time,ProCyte recorded a $294,000 impairment charge in the period ended June 30,2004. The fair value of assets received upon completion of the strictforeclosure in July 2004 was estimated to be $841,000.  Assets received that related to the contractmanufacturing operation were made available for immediate sale and theestimated fair value of such assets was recorded as assets held for sale.  As a result of the sale of the assetsdescribed in note 10, management concluded that the carrying value of the assetsshould be reduced an additional $25,000, which was recorded as a loss on assetimpairment in the third quarter ended September 30, 2004.

 

**10.****      ****Subsequent Event**

 

On October 22, 2004, ProCyte entered into a definitiveagreement to sell substantially all of the assets described in footnote 9 andsimultaneously closed the sale transaction contemplated by the agreement.  The sale agreement contained customaryrepresentations, warranties and covenants, including a covenant from ProCyte todefend, indemnify and hold harmless the buyer and its affiliates, successorsand assigns from and against any loss, liability, claim, damage or expensearising out of our related to any breach by ProCyte of its representations,warranties or covenants under the agreement, including a warranty of good andvalid title to the assets transferred by the agreement.  Net proceeds, after deducting costs relatedto the sale incurred in October, were $814,000, which was equal to the netcarrying value of the assets sold recorded on the balance sheet at September30, 2004.

 

In connection with the agreement, ProCytealso entered into an amendment to its current facilities lease dated October 1,1993, as amended (the “Lease”).  Theamendment removes 20,600 square feet from ProCyte’s existing facility lease,reducing ProCyte’s future operating lease obligation immediately after the saleby approximately $16,000 per month.  Thetotal reduction in the future lease obligation as a result of this amendment isapproximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of itscontingent obligation to reimburse the landlord for certain facilityrestoration work provided for in the lease. Other principle terms of the lease, including the expiration dates(December 2005 for 1,727 square feet and June 2007 for the remaining 12,182square feet), were not modified by the amendment.

 

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## **Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

This Quarterly Report on Form 10-Q containsforward-looking statements. These statements relate to future events or futurefinancial performance.  In some cases youcan identify forward-looking statements by terminology such as “may,” “will,” “should,”“expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,”“propose” or “continue,” the negative of these terms, or otherterminology.  These statements are onlypredictions.  Actual events or resultsmay differ materially.  In evaluatingthese statements, you should specifically consider various factors describedbelow in the section entitled “Additional Information About the Company’sBusiness; Risk Factors.” These factors may cause our actual results to differmaterially from any forward-looking statement.

 

Although we believe the expectationsreflected in the forward-looking statements are reasonable, we cannot guaranteefuture results, levels of activity, product demand, performance orachievements.  You should not place unduereliance on our forward-looking statements, which speak only as of the date ofthis report. We undertake no obligation to publicly update any forward-lookingstatements, whether as a result of new information, future events or otherwise.

 

*Recent Events*

 

On July 16, 2004, the Company, as a secured party,completed the strict foreclosure process of accepting substantially all ofEmerald’s assets in satisfaction of Emerald’s obligations under the $2 millionpromissory note.  Based upon theinformation known at the time, including management’s assessment of theestimated fair value of the assets received, ProCyte recorded an impairmentcharge of $294,000 at June 30, 2004.  Assets received that related to the contractmanufacturing operation were made available for immediate sale and the estimatedfair value of such assets was recorded as assets held for sale.  At September 30, 2004, management reviewed the costestimates related to the selling activity for these assets and concluded thatthe carrying value of the assets should be reduced an additional $25,000, whichwas recorded as a loss on asset impairment in the third quarter ended September30, 2004.

 

On October 22, 2004, ProCyte entered into a definitiveagreement to sell the above described assets and simultaneously closed the saletransaction contemplated by the agreement. The sale agreement contained customary representations, warranties andcovenants, including a covenant from ProCyte to defend, indemnify and holdharmless the buyer and its affiliates, successors and assigns from and againstany loss, liability, claim, damage or expense arising out of our related to anybreach by ProCyte of its representations, warranties or covenants under theagreement, including a warranty of good and valid title to the assetstransferred by the agreement.  Netproceeds, after deducting costs incurred in October related to the sale were$814,000, the net carrying value on the balance sheet of the assets sold.

 

In connection with the agreement, ProCytealso entered into an amendment to its current facilities lease dated October 1,1993, as amended (the “Lease”).  Theamendment removes 20,600 square feet from ProCyte’s existing facility lease,reducing ProCyte’s future operating lease obligation immediately after the saleby approximately $16,000 per month, a benefit that increases in June 2005 whenthere is a scheduled rate increase.  Thetotal reduction in the future lease obligation as a result of this amendment isapproximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of itscontingent obligation to reimburse the landlord for certain facilityrestoration work provided for in the lease. Other principle terms of the lease, including the expiration dates(December 2005 for 1,727 square feet and June 2007 for the remaining 12,182square feet), were not modified by the amendment.

 

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*CriticalAccounting Policies and Estimates*

 

The “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” as well as disclosures includedelsewhere in this Form 10-Q, are based upon our condensed consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  The preparation of these consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingencies.  On anongoing basis, we evaluate the estimates used, including those related toimpairment and useful lives of intangible assets, allowances for accountsreceivable and assets held for sale, and for excess and obsoleteinventory.  We base our estimates onhistorical experience, current conditions and on various other assumptions thatare believed to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources as well asidentifying and assessing our accounting treatment with respect to commitmentsand contingencies.  Actual results maydiffer from these estimates under different assumptions or conditions.  We believe the following critical accountingpolicies involve the more significant judgments and estimates used in thepreparation of the consolidated financial statements.

 

Under the guidance of SFAS 109, “Accountingfor Income Taxes,” we review our net deferred tax assets to determine whichamounts, if any, are “more likely than not” to be utilized in futureperiods.  Our analysis of whether thesetax assets will be utilized involved a substantial amount of judgment relatedto our ability to generate taxable net income in future periods, includingrevenue trends, product mix, and estimated margins, the amount and timing ofwhich impacts the amount of net operating tax losses that could be utilizedprior to their expiration.

 

Product revenues are recognized when products areshipped, license fees are recognized over the term of the license agreement,and royalties are recognized when earned. On occasion, we will receive advance deposits with customer purchaseorders.  These deposits are reported as adeferred revenue liability, until the product is shipped to the customer.

 

Under the guidanceof SFAS 142, “Goodwill and Other Intangible Assets,” we analyze whether thefair value of recorded goodwill is impaired on an annual basis.  Application of the goodwill impairment testrequires judgment, including the identification of reporting units anddetermining the fair value of each reporting unit.  Significant judgments required to estimatethe fair value of the reporting unit include estimating future cash flows,determining appropriate discount rates and other assumptions. Changes in theseestimates and assumptions could materially affect the determination of fairvalue.

 

We maintain an allowance for doubtful accounts forestimated losses resulting from the potential inability of our customers orother debtors to make required payments. The allowance is based upon historical experience and a review ofindividual customer balances.  If thefinancial condition of our customers or other debtors were to deteriorate,resulting in an impairment of their ability to make payments to us, additionalallowances may be required.

 

Inventories are stated at the lower of cost or marketvalue.  Cost is principally determined bythe first-in, first-out method.  Werecord adjustments to the value of inventory based upon forecasted plans tosell our inventories.  The physicalcondition (e.g., age and quality) of the inventories is also considered inestablishing its valuation.  Theseadjustments are estimates, which could vary significantly, either favorably orunfavorably, from the amounts that we may ultimately realize upon thedisposition of inventories, if future economic conditions, customer inventorylevels, product discontinuances or competitive conditions differ from ourestimates and expectations.

 

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We recordimpairment losses on long-lived assets used in operations when events andcircumstances indicate that assets might be impaired and the undiscounted cashflows estimated to be generated by those assets are less than the carryingamount of those assets.  Estimation offuture values for the long-lived assets requires a significant amount ofjudgment related to assessing the possible outcomes and the timing related toeach outcome.  The adjustments areestimates, which could vary significantly, either favorably or unfavorably,from the amounts that we may ultimately realize for these assets if the actualevents differ significantly from our estimates and expectations.

 

Assets acquired insettlement of debt and held for sale are valued at their estimated fair valueas of the date of foreclosure. Management evaluates the value of foreclosed assets held for saleperiodically and decreases the carrying value of the assets for any subsequentdeclines in fair value.  Changes in thevaluation of and gains/losses on sales of foreclosed assets are included inloss on asset impairment.

 

#### ***Results of Operations***

 

***Three Months Ended September 30, 2004 and 2003***

 

###### *Revenue*

 
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | ** ** | ** ** |
|-------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **              | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **% Change** | ** ** |
| ** **              | ** ** | **(in thousands)**                   | ** ** | ** ** | ** ** |
| Products                |       | $                                    | 2,683      |       | $          | 1,918 |   | 40 | % |
| Copper peptide compound |       | 200                                  |       | 368        |       | (46 | )% |
| Royalties               |       | 353                                  |       | 437        |       | (19 | )% |
|                    |       | $                                    | 3,236      |       | $          | 2,723 |   | 19 | % |

 

*Product* revenues forthe third quarter of 2004 increased $765,000, or 40 percent over the thirdquarter of 2003.  The increase wasprimarily due to a $339,000, or 247 percent increase in sales to internationaldistributors, a $187,000 or 12 percent increase in sales to physicians and theadditional sales related to the spa distribution business included in the 2004third quarter.  During 2004, we directedspecific efforts at growing our international business, including the additionof a new international sales director in November 2003.  During the third quarter of 2004, wecompleted the negotiations for a new distribution agreement with our currentKorean distributor and entered into distribution agreements with four newdistributors located in Taiwan, Hong Kong, Malaysia and Australia.  Due to the number of new agreements occurringin a single quarter and the buying patterns of our international distributors,the results of the 2004 third quarter are not necessarily an indication offuture quarterly international sales results for a single quarter.  Sales to physicians have been improving eachquarter, on a comparable quarter basis, since the third quarter of 2003 drivenin part by the introduction of new products in the first and second quarter of2004 and the implementation of new sales and training programs.

 

*Copperpeptide compound*shipments are driven by the purchasing patterns of our largest licensee,Neutrogena, which can vary based upon production cycles, adjustments in safetystock and other factors beyond our control. As a result of these factors, 46% less copper peptide compound wasshipped in the third quarter of 2004 as compared to the comparable 2003quarter.

 

*Royalty*revenue**is based uponsales generated by our licensees, principally Neutrogena.  Royalty revenues may fluctuate from quarterto quarter, due to the licensees’ timing of new market launches,

 

 

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special promotions and other factors beyond theCompany’s control.  Royalties receivedfrom Neutrogena in the third quarter of 2004 were 19 percent lower than thecomparable 2003 quarter.  Royalty revenuevaries from quarter to quarter due to differences in the timing of ourlicensees’ promotions and expansions into new territories and thereforequarterly comparisons are expected to vary as a result.

 

###### *Gross Profit*

 

Gross profit forthe 2004 third quarter increased by $432,000, or 21 percent, over the thirdquarter of 2003 to $2.5 million.  Grossmargin for the 2004 third quarter was 77 percent as compared to 76 percent inthe 2003 third quarter.  The increase ingross profit is primarily from the 40% increase in product revenues for the2004 third quarter, which was partially offset by the decrease in royaltyrevenue for that quarter.

 

###### *OperatingExpenses*

 
| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                           | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(in thousands)**                   | ** ** | ** ** | ** ** |
| Marketing and selling                |       | $                                    | 1,092      |       | $          | 1,024 |   | 7 | % |
| Research, general and administrative |       | 1,055                                |       | 797        |       | 32 | % |
| Loss on asset impairment             |       | 25                                   |       | —     |       | — |   |
| Total operating expenses             |       | $                                    | 2,171      |       | $          | 1,821 |   | 19 | % |

 

*Marketing and selling* expenses for the third quarter of 2004increased primarily due to expenses related to the spa distribution business inthe 2004 quarter.  This is partiallyoffset by $83,000 in costs related to the development and testing of aninfomercial included in the third quarter of 2003 and not repeated in 2004.

 

*Research, general and administrative* expenses for the 2004 third quarterincreased $258,000 over the comparable 2003 period.  This was primarily due to approximately$111,000 in expenses related to Emerald not making rental and other paymentsunder its sublease and other agreements and costs related to supporting themanufacturing facility.  Such paymentspartially offset the Company’s rent expense in the 2003 quarter.  The remaining increase for the 2004 thirdquarter over the comparable 2003 period was from general market increases incompensation and employee benefit expenses, a provision for estimated bonusesincluded in the 2004 third quarter but not in the 2003 third quarter due tolower performance in 2003, legal expense increases due to the timing ofcontract and general corporate work, and additional expenses from the inclusionof spa operations in the 2004 third quarter period.  These increased expenses were partiallyoffset by a $38,000 decrease in bad debt expense due to the receipt of paymentsin the 2004 third quarter from accounts previously written off in priorperiods.

 

*Loss on asset impairment* relates to theassets held for sale.  The Company soldthese assets on October 22, 2004. Considering the proceeds received in October and the remaining costincurred to sell, ProCyte took a loss on asset impairment charge of $25,000 atSeptember 30, 2004.

 

 

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###### *Interest and Other Income*

 

Interest and otherincome earned during the third quarter of 2004 decreased primarily due tointerest income not received on the Emerald note during the 2004 quarter.

 

###### *Net Income*

 

Net income before income taxes was $323,000for the third quarter of 2004, an increase of 24% as compared to $261,000 forthe 2003 period.  As a result of thepartial reversal of our deferred tax asset valuation allowance in the fourthquarter of 2003, ProCyte’s 2004 third quarter reflects a provision for incometax expense while in the comparable 2003 period no income tax expense wasrecorded.  Accordingly, third quarter2004 net income, after a $122,000 provision for income tax expense was $201,000or $0.01 per diluted share as compared to net income of $261,000 or $0.02 perdiluted share in the 2003 third quarter.

 

***Nine Months Ended September 30, 2004 and 2003***

 

###### *Revenue*

 
| ** **              | ** ** | **Nine Months Ended September 30,** | ** ** | ** ** | ** ** |
|-------------------------|------------|-------------------------------------|------------|------------|------------|
| ** **              | ** ** | **2004**                            | ** ** | **2003**   | ** ** | **% Change** | ** ** |
| ** **              | ** ** | **(in thousands)**                  | ** ** | ** ** | ** ** |
| Products                |       | $                                   | 7,834      |       | $          | 5898 |   | 33 | % |
| Copper peptide compound |       | 1,364                               |       | 1,583      |       | (14 | )% |
| Royalties               |       | 942                                 |       | 1,220      |       | (23 | )% |
|                    |       | $                                   | 10,140     |       | $          | 8,701 |   | 17 | % |

 

*Product* revenues forthe first nine months of 2004 increased $1.9 million, or 33 percent, over thefirst nine months of 2003. The increase was primarily due to a $1.1 million or23 percent increase in sales to physicians, a $330,000 or 68 percent increasein sales to international distributors, and $594,000 in sales related to thespa distribution business included in the comparable 2004 period.  Sales to physicians have been improving eachquarter, on a comparable quarter basis, since the third quarter of 2003 drivenin part by the introduction of new products in the first and second quarter of2004 and the implementation of new sales and training programs.

 

*Copperpeptide compound*shipments are driven by the purchasing patterns of our largest licensee,Neutrogena, which can vary based upon production cycles, adjustments in safetystock and other factors beyond our control. Accordingly, the quarterly comparisons can be volatile and inconsistentand they have been so in 2004 as compared to comparable quarters of 2003.  For the first nine months of 2004 Copperpeptide compound revenues were 14 percent lower than the comparable 2003period.

 

*Royalty*revenue**is based uponsales generated by our licensees. Royalty revenues may fluctuate from quarter to quarter, due to thelicensees’ timing of new market launches, special promotions and other factorsbeyond the Company’s control.  Royaltiesearned in the first nine months of 2004 decreased 23 percent as compared to thecorresponding 2003 period, principally due to lower reported sales of licensedproducts by Neutrogena.  In addition,upon the expiration of the underlying ProCyte patent in February 2005, thelicense agreement specifies that lower royalty percentages be used for theremaining term, the impact of which will be a reduction in the averageeffective royalty rate of approximately 34 percent. The actual dollar amount ofroyalty income recognized in future periods is dependent upon both the royalty

 

 

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percentages in effect during the period and the actualapplicable sales reported by Neutrogena, which can vary from quarter toquarter.  Therefore, historic royaltyrevenue is not an indication of future results.

 

 

###### *Gross Profit*

 

Gross profit forthe first nine months of 2004 increased by $1.1 million, or 18 percent, to $7.4million.  Gross margin for the first ninemonths of 2004 was 73 percent as compared to 72 percent in the corresponding2003 period.  The increase in grossprofit during the first nine months of 2004 was primarily due to the 33%increase in product sales, which was partially offset by the decrease in royaltyrevenue when compared to the first nine months of 2003. The increase in grossmargin percentage is due to a slightly different revenue mix in the two periodsbeing compared.

 

###### *OperatingExpenses*

 
| ** **                           | ** ** | **Nine Months Ended September 30,** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-------------------------------------|------------|------------|------------|
| ** **                           | ** ** | **2004**                            | ** ** | **2003**   | ** ** | **% Change** | ** ** |
|                                 | ** ** | **(in  thousands)**                 | ** ** | ** ** | ** ** |
| Marketing and selling                |       | $                                   | 3,549      |       | $          | 3,237 |   | 10 | % |
| Research, general and administrative |       | 3,203                               |       | 2,731      |       | 17 | % |
| Loss on asset impairment             |       | 319                                 |       | —     |       | — |   |
| Total operating expenses             |       | $                                   | 7,071      |       | $          | 5,968 |   | 19 | % |

 

*Marketing and selling* expenses for the first nine months of2004 increased $312,000 primarily due to increased selling activity during theperiod.  Of the net increase,approximately $407,000 was related to higher salary, benefit and travel costsfrom increased headcount supporting selling efforts in the 2004 period, highercommission expense related to the 33% increase in current period product salesand increased legal expenses related to the establishment and defense of theCompany’s trademarks.  In addition, thefirst nine months of 2004 includes expenses related to the spa distributionbusiness not included in the 2003 period. These increases are partially offset by $770,000 in costs related to thedevelopment and testing of an infomercial included in the 2003 period and notrepeated in 2004.

 

*Research, general and administrative* expenses for the first nine months of2004 increased $472,000 over the comparable 2003 period.  This was primarily due to approximately$343,000 in expenses related to Emerald not making rental and other payments underits sublease and other agreements and costs related to supporting themanufacturing facility.  Such paymentsfrom Emerald partially offset the Company’s rent expense in the 2003period.  The remaining increase for thenine months of 2004 over the comparable 2003 period was from general marketincreases in compensation and employee benefit expenses, legal expensesincreasing due to the timing of contract and general corporate work, andexpenses from the addition of spa operations in the 2004 period.  These increased expenses were partiallyoffset by a $285,000 decrease in bad debt expense due to the receipt ofpayments in 2004 from accounts previously written off in prior periods and alower accrual for estimated bonuses in the first nine months of 2004 ascompared to the comparable 2003 period.

 

###### *Interest and Other Income*

 

Interest and otherincome earned during the first nine months of 2004 decreased $95,000 to $64,000primarily due to a decrease of $79,000 in interest income not recognized on theEmerald note in the 2004

 

 

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period due toEmerald’s suspension of operations in February 2004 and a terminationsettlement of $50,000 received from Merck KGaA in the first quarter of2003.  This decrease was partially offsetby interest income of $34,000 recognized during the second quarter of 2004 uponthe final settlement of accounts receivable from a former licensee and writtenoff in 2002.

 

###### *Net Income*

 

Net income before income taxes was $359,000 for thefirst nine months of 2004, a decrease of 13% as compared to $414,000 for thecomparable 2003 period.  Net income forthe first nine months of 2004, after a $137,000 provision for income taxexpense was $222,000, or $0.01 per diluted share, compared to net income of$397,000 or $0.02 per diluted share for the same period of 2003, which includedno comparable provision for income tax expense. The decrease in net income isdue to the effect of including the provision for income tax expenses in the2004 period and the expenses and impairment charge related to the manufacturingfacility incurred during the nine month period ended September 30, 2004.

 

***Liquidity and Capital Resources***

 

The Company relies primarily on cash flow fromoperations to fund its operations and capital expenditures.  At September 30, 2004, the Company hadapproximately $5.3 million in cash and cash equivalents, compared to $3.8million at December 31, 2003.  The netchange in cash and cash equivalents during the first nine months of 2004reflects a net increase in cash of $1.5 million.  The significant components of this positivecash increase are an increase in trade payables, the receipt of payment on anote due from an officer and the receipt of a customer deposit under a supplycontract.  Positive cash generated waspartially offset by the reduction in cash flow from Emerald as discussed below,the payment of the 2003 management bonuses in March 2004, an increase inprepaid insurance premiums for several annual policies that renewed in Augustor were extended until August of 2005, and net cash used in support of the spaproducts distribution business.

 

As of February2004, Emerald Pharmaceuticals, L.P. suspended operations and in fiscal 2003ProCyte recorded an impairment related to its $2.0 million note receivable dueto the uncertainty that the full amount would be collected.  Emerald also leased its facility from ProCyteunder an operating sublease.  During thefirst nine months of 2004, except for January rent, ProCyte did not receive theinterest and rental payments due under its agreements with Emerald.  Therefore, cash flow from operations wasreduced by $40,000 per month, from the comparable 2003 period.  ProCyte terminated the sublease on June 25,2004 in order to take back the facility and protect the Company’s collateraland other interests.  Effective thatdate, ProCyte become responsible for facility related operating expenses suchas utilities, insurance and security of approximately $11,000 per month.  In October 2004, ProCyte completed the assetsale described in Item 2. “Management’s Discussion and Analysis of FinancialCondition and Results of Operations — Recent Events,” and received netproceeds, after deducting costs incurred in October related to the sale of$814,000.  As part of the asset sale, theCompany amended its primary facility lease reducing the monthly rent expense by$16,000 per month, or a total of $668,000 over the remaining term of the lease.

 

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Spa sales have developed more slowly than initiallyanticipated at the time we acquired the spa business at the end of 2003, andfor the nine months ended September 30, 2004 spa sales activity had requirednet cash to support operations of $300,000. Based upon recent experience and current plans, ProCyte believes thatadditional cash of up to $150,000 could be required over the next two quartersbefore spa operations provide positive cash flow from operations.

 

We may seefluctuations in operating cash flows in future periods as they depend in largepart on the timing of deposits received from our licensees, of new productintroductions and the timing of shipments to and payments received from ourcustomers.  Additionally, ProCytereceived $900,000 in cash from the completion of the asset sale on October 22,2004 increasing available cash in the fourth quarter of 2004.

 

The Companybelieves that its existing cash and cash equivalents and interest thereon, willbe sufficient to meet its working capital requirements for at least the nexttwo years.  However, there can be noassurance that the underlying forecasts of revenue and expense will prove tohave been accurate.  The Company’s actualcash requirements will depend upon numerous factors, including the levels ofresources that the Company devotes to taking advantage of strategicacquisitions and/or establishing and maintaining marketing, sales anddistribution capabilities, the emergence of competitive products and otheradverse market developments, the timing and amount of revenues and expensereimbursements resulting from relationships with third parties, the Company’sdegree of success in commercializing new products and the cost of preparing,filing, prosecuting, maintaining and enforcing patent claims and intellectualproperty rights, and actions by regulatory authorities.  The Company will depend on product revenues,royalties and license fees, interest income, equity financing, and funding fromcorporate alliances to meet its future capital needs.  See “Additional Information About the Company’sBusiness; Risk Factors.”

 

**AdditionalInformation About the Company’s Business; Risk Factors**

 

###### *Lossof or Reduction in Orders by Significant Customers Could Adversely Affect OurNet Revenues and Results of Operations*

Although the Company’s customer base is madeup of a large number of customers, Neutrogena accounted for approximately 23percent of the Company’s net revenue during the first nine months of 2004 andour top 10 customers comprised approximately 37 percent of such netrevenues.  Any decrease in or loss ofrevenues from these customers could have an adverse effect on our net revenuesand results of operations or impair our ability to increase net revenues.  The Neutrogena technology license agreementexpires in April 2010, however the royalty payments related to each territorycontinue for a period not less than five years from the date products werefirst sold in each territory, which may extend the royalty period beyond 2010for certain territories.  Royalty revenuefrom the Neutrogena license agreement accounted for 9 percent and 14 percent ofthe Company’s net revenues in the first nine months of 2004 and 2003,respectively.  The patent related to theNeutrogena license agreement expires February 5, 2005, the effect of which willbe a reduction in the percentage paid as royalty during the remaining royaltyperiod as set forth in the agreement. Revenues from sale of copper peptide compound to Neutrogena pursuant toa related supply agreement, accounted for 14 percent and 18 percent of netrevenues in the first nine months of 2004 and 2003, respectively. The supplyagreement expires in April 2005, with extensions for additional two-year termsby mutual consent of the parties up to April 2010.  There can be no assurance that this agreementwill be extended beyond April 2005, or if extended, that it will be extended toApril 2010.  Also, the timing of copperpeptide compound shipments are driven by Neutrogena’s purchasing patterns,which can vary based upon production cycles, adjustments in safety

 

 

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stock and other factors beyond our control,causing the revenue from copper peptide compound sales to fluctuate fromquarter to quarter.

 

We expect that we will continue to depend onrevenue from larger customers, generally under multi-year license or supplyagreements.  Such agreements can beterminated under certain circumstances, including our inability to supplyproduct within required time frames.  Anydownturn in the business from these customers or the inability to renew orreplace agreements with new customers as they expire could significantlydecrease sales to such customers, which could adversely affect our net revenuesand results of operations.

 

Furthermore, we ship most orders whenreceived.  Virtually all orders areshipped within 48 hours and therefore we do not have a substantialnon-cancelable backlog of orders. Variations in the timing of orders can cause significant fluctuations inour quarterly operating results, and the cancellation or deferral of productorders or overproduction due to the failure of anticipated orders tomaterialize could result in us holding excess or obsolete inventory, which hasresulted and could again in the future result in write-downs of inventory thatwould have a material adverse effect on our operating results.

 

###### *Dependenceon and Management of Existing and Future Corporate Alliances*

The successful commercialization of theCompany’s existing and future products in the mass retail, prestige, specialtyretail, and home shopping categories and wound care markets will depend uponProCyte’s ability to enter into and effectively manage corporatealliances.  There can be no assurancethat the Company will be successful in establishing corporate alliances in thefuture, or that it will be successful in performing and maintaining existing orany future corporate alliances. Moreover, there can be no assurance that the interests and motivationsof any distributor, licensee or other alliance party would be or remainconsistent with those of the Company, or that the Company and suchdistributors,  licensees or allianceparty will successfully perform the necessary technology transfer, clinicaldevelopment, regulatory compliance, manufacturing, marketing, commercializationand other obligations under their agreements. Any of these failures could havea material adverse effect on the Company’s business, financial condition andresults of operations.

 

###### *Recent Profitability;Profitability May Fluctuate in Future Periods*

The Company has been marketing products basedon its proprietary copper peptide technology since 1996.  In addition to sales of products based on itsproprietary copper peptide technology, the Company’s revenues have historicallyincluded sales of non-proprietary products, license fees and royalties, revenuefrom contract manufacturing and interest income.  The contract manufacturing operation was soldin July 2001.  During fiscal 2002, theCompany reported net profits and positive cash flow from operations for thefirst time in its operating history. During 2003, the Company reported net income before tax benefit andbreak even cash flow from operations. During the first nine months of 2004, the company reported a net profitand positive cash flow from operations. Attaining consistent profitability is dependent upon a wide variety offactors, including successfully manufacturing and marketing of the Company’sproducts, entering into and maintaining agreements with third parties forcommercialization of the Company’s products, successfully licensing the Company’sproducts and technology and general economic conditions, including those whichaffect demand for the services of our dermatologist, plastic and cosmeticsurgery customers.  Payments undercorporate alliances and licensing arrangements may be subject to fluctuationsin both timing and amounts and therefore the level of profitability may varysignificantly from quarter to quarter.

 

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###### *WeRely On Third Party Manufacturers for Our Products*

We use third party manufacturers to makeproducts. In many cases, third party manufacturers are not obligated undercontracts that fix the term of their commitments and they may discontinueproduction upon little or no advance notice. Manufacturers also may experience problems with product quality ortimeliness of product delivery.  We relyon these manufacturers to comply with applicable current quality systemregulations (“QSR”).  The loss of acontract manufacturer may force us to shift production to in-house facilitiesand possibly cause manufacturing delays, disrupt our ability to fill orders, orrequire us to suspend production until we find another third partymanufacturer.  We are not able to controlthe manufacturing efforts of these third party manufacturers as closely as wecontrol our business.  Should any ofthese manufacturers fail to meet the applicable standards, we or ourthird-party manufacturer could face various enforcement actions, which wouldhave an adverse effect on our net revenues and results of operations.

 

###### *Needfor Additional Capital*

The Company generated positive cash fromoperations in the first nine months ended September 30, 2004 and break evencash flow from operations in 2003.  TheCompany currently expects that it will generate positive cash flow fromoperations in 2004.  As of September 30,2004, the Company had cash and cash equivalents of $5.3 million.  The Company estimates that, at its plannedrate of spending, its existing cash and cash equivalents and the interestincome thereon will be sufficient to meet its operating and capitalrequirements for at least the next two years. There can be no assurance, however, that our underlying assumed levelsof revenue and expense will prove accurate. Whether or not these assumptions prove to be accurate, the Company mayneed to raise additional capital as the Company may require additional funds toexpand or enhance its sales and marketing activities, to accelerate productdevelopment, or to acquire a product line or company.  The Company may be required to seek thisadditional funding through public or private financing, including equityfinancing, or through collaborative arrangements.  Adequate funds for these purposes, whetherobtained through financial markets or from collaborative or other arrangements,may not be available when needed or may not be available on terms favorable tothe Company.  If we issue equitysecurities to raise additional funds, dilution to existing shareholders willresult.  If funding is insufficient atany time in the future, the Company may be required to: delay, scale back oreliminate some or all of its marketing and research and development programs;or license to third parties the rights to commercialize products ortechnologies that the Company would otherwise seek to develop on its own.  Furthermore, the terms of any such licenseagreements or asset sales might be less favorable than if the Company werenegotiating from a stronger position.

 

###### *Uncertaintyof Patent Position and Proprietary Rights*

The patent positions of biotechnology,medical device and healthcare products companies are often uncertain andinvolve complex legal and factual questions, and the breadth of claims allowedin such patents cannot be predicted.  TheCompany’s success will depend on its ability to obtain patents and licenses topatent rights, to maintain trade secrets, and to operate without infringing onthe proprietary rights of others, both in the United States and in othercountries.  The failure of the Company orits licensors to obtain, maintain and enforce patent protection for the Company’stechnology could have a material adverse effect on the Company.

 

ProCyte’s success depends, in part, upon itsability to protect its products, technology and trademarks under intellectualproperty laws in the United States and abroad. The Company receives a significant amount of its revenue from technologylicensing agreements, which are dependent upon patents, and expects to continuelicensing its technology for certain markets. Royalty revenue from the Neutrogena

 

 

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license agreement accounted for 9 percent and14 percent of the Company’s net revenues in the first nine months of 2004 and2003, respectively and is based upon Neutrogena’s applicable sales, as setforth in the agreement, multiplied by specified royalty percentages.  The patent related to the Neutrogena licenseagreement expires February 5, 2005.  Uponexpiration of this patent, the agreement specifies that lower royaltypercentages be used for the remaining term, the impact of which is a reductionin the average effective royalty rate of approximately 34 percent.  The actual amount of royalty incomerecognized in future periods is dependent upon the royalty percentages ineffect during the period and the actual applicable sales reported byNeutrogena, which can vary from quarter to quarter.  The expiration of the patent would also allowothers, including Neutrogena, to manufacture the compound.  The supply agreement expires in April 2005,with extensions for additional two-year terms by mutual consent of the partiesup to April 2010.  There can be noassurance that this agreement will be extended beyond April 2005, or ifextended, that it will be extended to April 2010.

 

As of October 22, 2004, the Company had 19issued US patents expiring between 2005 and 2017 and numerous issued foreignpatents and patent registrations.  Inaddition, the Company has 12 patents applied for of which 9 have been publishedand are pending action by the United States Patent & Trademark Office.  The patents relate to use of the Company’scopper peptide-based technology for a variety of healthcare applications, andto the composition of certain biologically active, synthesized compounds.  The Company’s strategy has been to apply forpatent protection for certain compounds and their discovered uses that arebelieved to have potential commercial value in countries that offer significantmarket potential.  There can be noassurance that patent applications relating to the technology used by theCompany will result in patents being issued. Nor can there be any assurance that any patent issued to the Companywill not be subject to further proceedings limiting the scope of the rights underthe patent or that such patent will provide a competitive advantage, willafford protection against competitors with similar technology, or will not besuccessfully challenged, invalidated or circumvented by competitors.

 

The Company’s processes and potentialproducts may conflict with patents that have been or may be granted tocompetitors and others.  As thebiotechnology, medical device and healthcare industries expand and more patentsare issued, the risk increases that the Company’s processes and potentialproducts may give rise to claims that they infringe the patents of others.  Such other persons could bring legal actionsagainst the Company claiming damages and seeking to enjoin clinical testing,manufacturing and marketing of the affected product or use of the affectedprocess.  Litigation may be necessary toenforce patents issued to the Company, to protect trade secrets or know-howowned by the Company or to determine the enforceability, scope and validity ofproprietary rights of others.  If theCompany becomes involved in such litigation, it could result in substantialexpense to the Company and significant diversion of effort by the Company’stechnical and management personnel.  Inaddition to any potential liability for significant damages, the Company couldbe required to obtain a license to continue to manufacture or market theaffected product or use the affected process. Costs associated with any licensing arrangement may be substantial andcould include ongoing royalties.  Therecan be no assurance that any license required under any such patent would bemade available to the Company on acceptable terms, if at all.  If such licenses could not be obtained onacceptable terms, the Company could be prevented from manufacturing and marketingexisting or potential products. Accordingly, an adverse determination in such litigation could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.  The Company isnot aware of any conflicts at this time.

 

The Company also relies upon non-patentedproprietary technology.  There can be noassurance that the Company can meaningfully protect its rights to suchnon-patented technology, that any obligation to maintain the confidentiality ofsuch proprietary technology will not be breached by employees, consultants,collaborators or others or that others will not independently develop oracquire substantially

 

 

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equivalent technology.  To the extent that licensees or consultantsapply Company technological information independently developed by them or byothers to Company projects or apply Company technology or know-how to otherprojects, disputes may arise as to the ownership of proprietary rights to suchinformation.  Any failure to protectnon-patented proprietary technology or any breach of obligations designed toprotect such technology or development of equivalent technology may have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

###### *Uncertaintyof Government Regulatory Requirements*

The Federal Food, Drug and Cosmetic Act, andthe regulations promulgated thereunder, and other federal and state statutesgovern, among other things, the testing, manufacture, safety, labeling,storage, record-keeping, advertising and promotion of cosmetic products andmedical devices.  The Company’s productsand product candidates may be regulated by any of a number of divisions of theFDA and in other countries by similar health and regulatory authorities.  The process of obtaining and maintainingregulatory approvals for the manufacturing or marketing of the Company’sexisting and potential products is costly and time-consuming and is subject tounanticipated delays.  Regulatoryrequirements ultimately imposed could also adversely affect the ability of theCompany to clinically test, manufacture or market products.

 

In the United States, products that do notseek to make effectiveness claims based on human clinical evaluation may besubject to review and regulation under the FDA’s cosmetic, drug or 510(k)medical device guidelines.  Similarguidelines exist for such products in other countries.  Such 510(k) products, which include woundcare dressings and certain ointments and gels, must show safety and substantialequivalency with predicate products already cleared by the FDA to bemarketed.  There can be no assurance thatproduct applications submitted to the FDA or similar agencies in othercountries will receive clearance to be marketed, or that the labeling claimssought will be approved, or that, if cleared, such products will becommercially successful or free from third party claims relating to theeffectiveness or safety of such products.

 

The Company also is or may become subject tovarious other federal, state, local and foreign laws, regulations and policiesrelating to, among other things, safe working conditions, good laboratorypractices, and the use and disposal of hazardous or potentially hazardoussubstances used in connection with research and development.

 

Failure to obtain regulatory approvals whereappropriate for its product candidates or to attain or maintain compliance withQSR or other manufacturing requirements would have a material adverse effect onthe Company’s business, financial condition and results of operations.

 

###### *IntenseCompetition*

Competition in the wound care, skin healthand hair care markets is intense.  TheCompany’s competitors include well-established pharmaceutical, cosmetic andhealthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia, Decloreand Murad.  These competitors havesubstantially more financial and other resources, larger research anddevelopment staffs, and more experience and capabilities in researching,developing and testing products in clinical trials, in obtaining FDA and otherregulatory approvals and in manufacturing, marketing and distribution than theCompany.  In addition, a number ofsmaller companies are developing or marketing competitive products.  The Company’s competitors may succeed indeveloping and commercializing products or obtaining patent protection or otherregulatory approvals for products more rapidly than the Company.  In addition, competitive products may be manufacturedand marketed more successfully than the Company’s potential products.  Such developments could render the Company’sexisting or potential products less competitive or obsolete and

 

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could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

###### *ProductLiability Claims*

The testing, manufacturing, marketing andsale of our products may subject the Company to product liability claims.  ProCyte maintains insurance coverage againstproduct liability risks up to an aggregate annual limit of $10 million.  However, continuing insurance coverage maynot be available at an acceptable cost, if at all.  The Company may not be able to obtaininsurance coverage that will be adequate to satisfy any liability that mayarise.  Regardless of merit or eventualoutcome, product liability claims may result in decreased demand for a product,injury to its reputation, withdrawal of clinical trial volunteers and loss ofrevenues.  As a result, regardless ofwhether the Company is insured, a product liability claim or product recall mayresult in losses that could be material to ProCyte.

 

###### *PotentialVolatility of Stock Price; Bulletin Board Listing*

The market prices for securities ofhealthcare, pharmaceutical and biotechnology companies are subject tovolatility, and the market has from time to time experienced significantfluctuations that are unrelated to the operations of the Company.  ProCyte’s market price has fluctuated over awide range since the Company’s initial public offering in 1989, and since March25, 1999, the Company’s common stock has traded on the NASD OTC bulletinboard.  Because real-time priceinformation may not be easily available for bulletin board securities, aninvestor is likely to find it more difficult to dispose of, or to obtainaccurate quotations on the market value of, the Company’s securities than ifthey were listed on a the Nasdaq or a national exchange.  In addition, purchases and sales of theCompany’s securities may become subject to Rule 15g-9 of the SecuritiesExchange Act of 1934, which imposes various sales practice requirements onbroker-dealers, or to the “penny stock” rules, either of which would likelyreduce the level of trading activity in the secondary market for the Company’ssecurities and make selling the securities more difficult for an investor.

 

Announcements concerning the Company or itscompetitors, including fluctuations in operating results, research anddevelopment program direction, results of clinical trials, addition ortermination of corporate alliances, technology licenses, clearance or approvalto market products, announcements of technological innovations or new productsby the Company or its competitors, changes in government regulations, healthcarereform, developments in patent or other proprietary rights of the Company orits competitors, litigation concerning business operations or intellectualproperty, or public concern as to safety of products, as well as changes ingeneral market conditions and mergers and acquisitions, may have a significanteffect on the market price of ProCyte’s common stock.

 

## **Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

For a discussion of our market risks, referto the Item 7A, “Quantitative and Qualitative Disclosures About MarketRisk,” in our Annual Report on Form 10-K for the year ended December 31,2003. There have been no material changes to the information provided thatwould require additional information with respect to the nine months endedSeptember 30, 2004.

 

## **Item 4.  Controls and Procedures**

 

Asof the end of the period covered by this report, the Company conducted anevaluation, under the supervision and with the participation of its principalexecutive officer and principal financial officer, of the effectiveness anddesign of its disclosure controls and procedures (as defined in Rules 13a-15(e)and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation,

 

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theprincipal executive officer and principal financial officer concluded thatthese disclosure controls and procedures were effective as of September 30,2004, in ensuring that the information required to be disclosed by the Companyin reports it files or submits under the Exchange Act within the time periodsspecified in the SEC rules and forms.

 

Therewere no changes in the Company’s internal controls over financial reportingduring the third quarter of 2004 that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

*Limitations on the Effectiveness of Controls*

 

TheCompany’s management, including our principal executive officer and principalfinancial officer, does not expect that the Company’s disclosure controls orits internal controls will prevent all error and all fraud.  A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of that control system are met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrol must be considered relative to their costs. Because of the inherentlimitation in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the Company have been detected. These inherent limitations include the reality that judgments indecision-making can be faulty, and breakdowns can occur because of simple erroror mistake.  Additionally, controls canbe circumvented by the individual acts of some persons, by collusion of two ormore persons, or by management override of the control.  The design of any system of controls is alsobased in part upon certain assumptions about the likelihood of future events,and there can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions; over time controls maybecome inadequate because of changes in conditions, of the degree of compliancewith the policies and procedures may deteriorate.  Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

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# **Part II - OtherInformation**

 

 

## **Item 6.  Exhibits**

 

(a) Exhibits

 

See Exhibit Index below.

 

# ** **

# ** **

# ** **

# **Signatures**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 
| ** **              | **ProCyte Corporation** |
|-------------------------|-------------------------|
| ** **              | ** **              | ** ** |
| Date: November 12, 2004 | By:                     | /s/ John F. Clifford |
|                    |                    | John F. Clifford, Chairman  and CEO |
|                    |                    |   |
| Date: November 12, 2004 | By:                     | /s/ Robert W. Benson |
|                    |                    | Robert W. Benson, Chief  Financial Officer |

 

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**Exhibit Index**

 
| **Exhibit** | ** ** | **Description**                                                                                                                       | ** ** | **Note** |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| 3.1         |       | Restated Articles of  Incorporation of the Registrant                                                                                 |       | A        |
| 3.2         |       | Restated Bylaws of the  Registrant                                                                                                    |       | A        |
| 4.1         |       | Rights Agreement between  the Registrant and American Securities Transfer and Trust as of December 7,  1994                           |       | G        |
| 10.1*       |       | 1987 Stock Benefit Plan of  ProCyte Corporation                                                                                       |       | A        |
| 10.2*       |       | ProCyte Corporation 1989  Restated Stock Option Plan                                                                                  |       | B        |
| 10.3*       |       | ProCyte Corporation 1991  Restated Stock Option Plan for Non-employee Directors and amendments thereto                                |       | D        |
| 10.4†  |       | Teachers Insurance &  Annuity Association Lease dated as of October 1, 1993 and second amendment  thereto dated February 28, 1997 |       | D        |
| 10.5*       |       | 1996 Stock Option Plan                                                                                                                |       | D        |
| 10.6*       |       | ProCyte Corporation 1998  Non-employee Director Stock Plan                                                                            |       | F        |
| 10.7*       |       | Change of Control  Agreement for Ms. Robin Carmichael                                                                                 |       | K        |
| 10.8*       |       | Change of Control  Agreement for Mr. John Clifford                                                                                    |       | K        |
| 10.9*       |       | Change of Control  Agreement for Mr. Robert Benson                                                                                    |       | K        |
| 10.10*      |       | Form of Indemnity  Agreement dated February 23, 1995 between the Registrant and each of Dr.  Blake, Mr. Patterson and Mr. Clifford.   |       | C        |
| 10.11*      |       | Form of Indemnity  Agreement between ProCyte Corporation and each of various of its Officers and  Directors                           |       | F        |
| 10.12*      |       | Severance Agreement for  Mr. John Clifford                                                                                            |       | K        |
| 10.13† |       | License Agreement dated  April 19, 2000 between ProCyte Corporation and Neutrogena Corporation                                        |       | I        |
| 10.14*      |       | Indemnity Agreement  between ProCyte Corporation and Robert L. Benson dated June 3, 2004                                              |       | H        |
| 10.15*      |       | ProCyte Corporation 2004  Stock Option Plan                                                                                           |       | K        |
| 10.16       |       | Asset Purchase Agreement  dated as of October 22, 2004, by and between ProCyte Corporation and ICOS  Corporation                      |       | J        |
| 10.17       |       | Fifth Lease Amendment  dated October 20, 2004, between ProCyte Corporation and TIAA Realty, Inc.                                      |       | J        |
| 31.1        |       | Rule 13a-14(a)/15d-14(a)  Certification of Chief Executive Officer                                                                    |       | L        |
| 31.2        |       | Rule 13a-14(a)/15d-14(a)  Certification of Chief Financial Officer                                                                    |       | L        |
| 32.1        |       | Section 1350 Certification  of Chief Executive Officer                                                                                |       | L        |
| 32.2        |       | Section 1350 Certification  of Chief Financial Officer                                                                                |       | L        |

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| *      |   | Management contract or  compensatory plan or arrangement.                                                                                                                     |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| † |   | Confidential treatment has  been granted or requested with respect to portions of this exhibit.                                                                               |
| A      |   | Incorporated by reference  to the Registrant’s Registration Statement of Form S-1 (No. 33-31353).                                                                        |
| B      |   | Incorporated by reference  to the Registrant’s Registration Statement of Form S-1 (No. 33-46364).                                                                        |
| C      |   | Incorporated by reference  to the Registrant’s Annual Report on Form 10-K for the year ended December  31, 1994.                                                         |
| D      |   | Incorporated by reference  to the Registrant’s Annual Report on Form 10-K for the year ended December  31, 1996.                                                         |
| F      |   | Incorporated by reference  to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended June  30, 1998.                                                       |
| G      |   | Incorporated by reference  to the Registrant’s Amended Annual Report on Form 10-K/A dated December 31,  1997.                                                            |
| H      |   | Incorporated by reference  to the Registrant’s Amended Quarterly Report on Form 10-Q/A (Amendment No.1)  for the quarter ended June 30, 2004, filed on August 20, 2004 . |
| I      |   | Incorporated by reference  to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended March  31, 2000.                                                      |
| J      |   | Incorporated by reference  to the Registrant’s Current Report on Form 8-K filed October 22, 2004                                                                         |
| K      |   | Incorporated by reference  to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended June  30, 2004.                                                       |
| L      |   | Filed herewith.                                                                                                                                                               |

 

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