**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**Forthe Quarterly Period Ended September 30, 2003**

 

**Commission File Number 0-18044**

 

**PROCYTECORPORATION**

(Exact name of the registrant as specified inits 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**                   |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

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

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

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

 

As of November 7, 2003, there were issued and outstanding15,782,602 shares of common stock, par value $.01 per share.

 

 

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**ProCyteCorporation**

 

**Index**

 
| **Part I - Financial Information** |
|------------------------------------|
|                               |
|                               | Item 1. | Condensed Consolidated Financial Statements  (unaudited) |
|                               | Balance  Sheets - as of September 30, 2003 and December 31, 2002 (unaudited) |
|                               | Statements of Operations - Three & Nine Months Ended  September 30, 2003 and 2002 (unaudited) |
|                               | Statements of Cash Flows – Nine Months Ended September 30, 2003  and 2002 (unaudited) |
|                               | Statements of Stockholders’ Equity – Nine  Months Ended September 30, 2003 (unaudited) |
|                               | Notes to Condensed Consolidated Financial  Statements (unaudited) |
|                               | Item 2. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                               | Item 3. | Quantitative  and Qualitative Disclosures About Market Risk |
|                               | Item 4. | Controls  and Procedures |
|                               |   |   |
| **Part II - Other Information**    |
|                               |
|                               | Item 1. | Legal Proceedings |
|                               | Item 2. | Changes in Securities and Use of Proceeds |
|                               | Item 3. | Defaults Upon Senior Securities |
|                               | Item 4. | Submission of Matters to a Vote of Security  Holders |
|                               | Item 5. | Other Information |
|                               | Item 6. | Exhibits and Reports on Form 8-K |
|                               |   |   |
| **Signatures**                     |

 

2

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**PartI - Financial Information**

 

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

 

### **Balance Sheets**- as of September 30, 2003 and December 31, 2002 (unaudited)

**(in thousands)**

** **
|                                                            |   | **September 30,  2003** |   | **December 31,  2002** |   |
|-----------------------------------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
| **ASSETS**                                                      |   |                         |   |                        |   |
| Cash and cash equivalents                                       |   | $                            | 4,456  |                        | $      | 4,556 |   |
| Accounts receivable, net of allowance for  doubtful accounts    |   | 1,122                        |   | 1,328                       |   |
| Inventory                                                       |   | 2,600                        |   | 1,718                       |   |
| Prepaid expenses                                                |   | 196                          |   | 326                         |   |
| Other current assets                                            |   | 105                          |   | 3                           |   |
| ***Total current assets***                                      |   | 8,479                        |   | 7,931                       |   |
| Property and equipment, net                                     |   | 1,106                        |   | 1,286                       |   |
| Intangible  assets, net                                         |   | 2,891                        |   | 2,903                       |   |
| Note due from sale of contract  manufacturing operations, net   |   | 1,849                        |   | 1,826                       |   |
| Other assets                                                    |   | 40                           |   | 143                         |   |
| **Total Assets**                                                |   | $                            | 14,365 |                        | $      | 14,089 |   |
|                                                            |   |                         |   |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                   |   |                         |   |                        |   |
| Accounts payable, trade                                         |   | $                            | 290    |                        | $      | 277 |   |
| Accrued salaries and benefits                                   |   | 261                          |   | 405                         |   |
| Other accrued liabilities                                       |   | 191                          |   | 260                         |   |
| Deferred revenue                                                |   | 249                          |   | 21                          |   |
| ***Total current  liabilities***                                |   | 991                          |   | 963                         |   |
| Other liabilities                                               |   | 93                           |   | 91                          |   |
| Deferred proceeds on sale of contract  manufacturing operations |   | 1,016                        |   | 1,217                       |   |
| **Total Liabilities**                                           |   | 2,100                        |   | 2,271                       |   |
| Common stock and additional paid-in-capital                     |   | 85,351                       |   | 85,312                      |   |
| Deferred compensation                                           |   | —                       |   | (11                         | )      |
| Accumulated deficit                                             |   | (73,086                      | )      | (73,483                     | )      |
| **Stockholders’ Equity**                                   |   | 12,265                       |   | 11,818                      |   |
| **Total Liabilities and Stockholders’ Equity**             |   | $                            | 14,365 |                        | $      | 14,089 |   |

* *

*See notes tocondensed consolidated financial statements*

 

3

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###  

### **Statements ofOperations**- Three & Nine Months EndedSeptember 30, 2003 and 2002 (unaudited)

**(in thousands, except per share amounts)**

 
|                                        |   | **Three  months ended  September 30,** |   | **Nine  months ended  September 30,** |   |
|---------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                        |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
| **Revenues**                                |   |                                        |   |                                       |   |   |   |   |   |
| Product sales                               |   | $                                           | 2,286  |                                       | $      | 2,735 |   | $ | 7,481 |   | $ | 8,404 |   |
| Licenses and royalties                      |   | 437                                         |   | 391                                        |   | 1,220 |   | 1,028 |   |
| Total revenues                              |   | 2,723                                       |   | 3,126                                      |   | 8,701 |   | 9,432 |   |
| Cost of product sales                       |   | 675                                         |   | 1,285                                      |   | 2,477 |   | 3,308 |   |
| Gross profit                                |   | 2,048                                       |   | 1,841                                      |   | 6,224 |   | 6,124 |   |
|                                        |   |                                        |   |                                       |   |   |   |   |   |
| **Operating Expenses**                      |   |                                        |   |                                       |   |   |   |   |   |
| Marketing and selling                       |   | 1,024                                       |   | 728                                        |   | 3,237 |   | 2,279 |   |
| Research, general, and administrative       |   | 797                                         |   | 840                                        |   | 2,731 |   | 2,642 |   |
| Total operating expenses                    |   | 1,821                                       |   | 1,568                                      |   | 5,968 |   | 4,921 |   |
| Operating income                            |   | 227                                         |   | 273                                        |   | 256 |   | 1,203 |   |
| Interest and other income                   |   | 34                                          |   | 49                                         |   | 159 |   | 142 |   |
| Net income before tax                       |   | 261                                         |   | 322                                        |   | 415 |   | 1,345 |   |
| Provision for income tax                    |   | —                                      |   | —                                     |   | (18 | ) | — |   |
| Net income                                  |   | $                                           | 261    |                                       | $      | 322 |   | $ | 397 |   | $ | 1,345 |   |
|                                        |   |                                        |   |                                       |   |   |   |   |   |
| ***Net earnings per  share***               |   |                                        |   |                                       |   |   |   |   |   |
| Basic                                       |   | $                                           | 0.02   |                                       | $      | 0.02 |   | $ | 0.03 |   | $ | 0.09 |   |
| Diluted                                     |   | $                                           | 0.02   |                                       | $      | 0.02 |   | $ | 0.02 |   | $ | 0.08 |   |
|                                        |   |                                        |   |                                       |   |   |   |   |   |
| ***Shares used in per  share computation*** |   |                                        |   |                                       |   |   |   |   |   |
| Basic                                       |   | 15,774                                      |   | 15,722                                     |   | 15,761 |   | 15,703 |   |
| Diluted                                     |   | 15,974                                      |   | 16,031                                     |   | 15,973 |   | 16,996 |   |

 

*See notes tocondensed consolidated financial statements*

 

4

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### **Statements of CashFlows**– Nine Months Ended September 30, 2003 and2002 (unaudited)

**(in thousands)**

 
|                                                                                               |   | **Nine  months ended September 30,** |   |
|----------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                               |   | **2003**                                  |   | **2002** |   |
| **Operating Activities**                                                                           |   |                                      |   |   |   |
| Net income                                                                                         |   | $                                         | 397    |   | $ | 1,345 |   |
| ***Adjustments to  reconcile net income to net cash provided by (used in) operating activities:*** |   |                                      |   |   |   |
| Depreciation and amortization                                                                      |   | 244                                       |   | 236 |   |
| Amortization of deferred proceeds                                                                  |   | (201                                      | )      | (201 | ) |
| Non-cash expense related to stock-based  compensation                                              |   | 36                                        |   | 36 |   |
| Amortization of promissory note discount                                                           |   | (23                                       | )      | (23 | ) |
| Amortization of deferred compensation                                                              |   | 4                                         |   | 4 |   |
| ***Change in  operating assets and liabilities:***                                                 |   |                                      |   |   |   |
| Accounts receivable                                                                                |   | 206                                       |   | (502 | ) |
| Inventory                                                                                          |   | (882                                      | )      | 349 |   |
| Prepaid expenses                                                                                   |   | 130                                       |   | (103 | ) |
| Other current assets                                                                               |   | 2                                         |   | 12 |   |
| Accounts payable, trade                                                                            |   | 13                                        |   | (427 | ) |
| Accrued salaries and benefits                                                                      |   | (144                                      | )      | (218 | ) |
| Other accrued liabilities                                                                          |   | (69                                       | )      | 334 |   |
| Deferred revenue                                                                                   |   | 228                                       |   | (41 | ) |
| Other liabilities                                                                                  |   | 2                                         |   | (13 | ) |
| ***Net cash provided  by (used in) operating activities***                                         |   | (57                                       | )      | 788 |   |
| **Financing Activities**                                                                           |   |                                      |   |   |   |
| Proceeds from issuance of common stock                                                             |   | 10                                        |   | 26 |   |
| **Investing Activities**                                                                           |   |                                      |   |   |   |
| Purchase of property and equipment                                                                 |   | (53                                       | )      | (16 | ) |
| Decrease in other assets                                                                           |   | —                                    |   | 45 |   |
| ***Net cash provided  by (used in) investing activities***                                         |   | (53                                       | )      | 29 |   |
| ***Net increase  (decrease) in cash and cash equivalents***                                        |   | (100                                      | )      | 843 |   |
| **Cash and Cash Equivalents**                                                                      |   |                                      |   |   |   |
| At beginning of period                                                                             |   | 4,556                                     |   | 3,003 |   |
| At end of period                                                                                   |   | $                                         | 4,456  |   | $ | 3,846 |   |

 

*See notes to condensed consolidated financial statements*

 

5

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### **Statements ofStockholders’ Equity**– Nine Months EndedSeptember 30, 2003 (unaudited)

**(in thousands)**

 
|                                                      |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Deferred  Compen-  sation** |   | **Accumulated  Deficit** |   | **Total** |   |
|-----------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|-------------------------------|--------|--------------------------|--------|-----------|--------|
| **Shares**                                                |   | **Par Value**     |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Balance – December 31, 2002                     |   | 15,734            |   | $                                | 158    |                          | $      | 85,154                   |   | $         | (11    | ) | $ | (73,483 | ) | $ | 11,818 |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Shares issued under non-employee director  stock plan     |   | 29                |   | (*                               | )      | 36                            |   | —                   |   | —    |   | 36 |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Shares issued upon exercise of options                    |   | 12                |   | (*                               | )      | 10                            |   | —                   |   | —    |   | 10 |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Re-measurement of stock options granted to  non-employees |   | —            |   | —                           |   | (7                            | )      | 7                        |   | —    |   | — |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Amortization of deferred compensation                     |   | —            |   | —                           |   | —                        |   | 4                        |   | —    |   | 4 |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Net income for nine months ended  September 30, 2003 |   | —            |   | —                           |   | —                        |   | —                   |   | 397       |   | 397 |   |
|                                                      |   |              |   |                             |   |                          |   |                     |   |      |   |   |   |
| Balance – September 30, 2003                    |   | 15,775            |   | $                                | 158    |                          | $      | 85,193                   |   | $         | — |   | $ | (73,086 | ) | $ | 12,265 |   |

 

----

(*) rounds to less than $1,000

 

*See notes to condensed consolidated financial statements*

 

6

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**ProCyte Corporation**

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

 

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

 

The accompanying condensedconsolidated financial statements (unaudited) include the accounts of ProCyteCorporation and its wholly-owned, subsidiaries NextDerm, Inc. (a Delaware corporation)and NextDerm, Inc. (a Washington corporation incorporated February 28,2003) (collectively “ProCyte” or the “Company”), for the three and nine monthperiods ended September 30, 2003 and 2002 have been prepared by theCompany in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and the instructionsto Form 10-Q and Article 10 of Regulation S-X.  Pursuant to such rules and regulations, the consolidatedcondensed financial statements do not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates of America for audited financial statements.  Accordingly, this financial information should be read inconjunction with the complete audited financial statements, including the notesthereto, which are included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2002.  Inthe opinion of management, all material adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation of thefinancial statements have been included. Interim results are not necessarily indicative of the results that maybe expected for the year.

 

*Stock Based Compensation*

 

The Company follows the intrinsicvalue-based accounting method for stock options contained in APB Opinion No.25, Accounting for Stock Issued toEmployees, as permitted by SFAS No. 123, Accounting for Stock-BasedCompensation.  Under this method, nocompensation expense has been recognized as the exercise price of optionsgranted equals the fair value on the date of grant.  Had compensation expense for the Company’s stock optionsunder the incentive compensation plan been recognized based upon the fair valuefor awards granted, the Company’s net earnings would have been changed to thefollowing pro forma amounts for the three and nine months endedSeptember 30, 2003 and 2002:

 
|                                                                              |   | **(in  thousands, except per share amounts)** |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                              |   | **Three  months ended  September 30,**   |   | **Nine  months ended  September 30,** |   |
|                                                                              |   | **2003**                                      |   | **2002** |   | **2003** |   | **2002** |   |
| Net income, as reported                                                           |   | $                                             | 261    |   | $ | 322 |   | $ | 397 |   | $ | 1,345 |   |
| Stock option-based compensation expense  determined under fair value-based method |   | (97                                           | )      | (115 | ) | (224 | ) | (184 | ) |
| Pro forma net income                                                              |   | $                                             | 164    |   | $ | 207 |   | $ | 173 |   | $ | 1,161 |   |
| Earnings per share:                                                               |   |                                          |   |   |   |   |   |   |   |
| As reported basic                                                                 |   | $                                             | 0.02   |   | $ | 0.02 |   | $ | 0.03 |   | $ | 0.09 |   |
| As reported diluted                                                               |   | $                                             | 0.02   |   | $ | 0.02 |   | $ | 0.02 |   | $ | 0.08 |   |
| Pro forma basic                                                                   |   | $                                             | 0.01   |   | $ | 0.01 |   | $ | 0.01 |   | $ | 0.07 |   |
| Pro forma diluted                                                                 |   | $                                             | 0.01   |   | $ | 0.01 |   | $ | 0.01 |   | $ | 0.07 |   |

 

7

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The Company determined the fairvalue of stock options granted during the three and nine months endedSeptember 30, 2003 and 2002 using the Black-Scholes option pricing modeland the following assumptions:

 
|                         |   | **Three  months ended September 30,** |   | **Nine  months ended September 30,** |   |
|------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                         |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
| **Options Granted**          |   |                                  |   |                                 |   |   |   |   |   |
| Risk-free interest rate      |   | 2.35                                  | %      | 3.30                                 | %      | 2.35%-2.81 | % | 3.30%-3.92 | % |
| Expected option life (years) |   | 6.00                                  |   | 6.00                                 |   | 6.00 |   | 6.00 |   |
| Dividend yield               |   | 0.00                                  |   | 0.00                                 |   | 0.00 |   | 0.00 |   |
| Expected volatility          |   | 60                                    | %      | 64                                   | %      | 59%-62 | % | 61%-67 | % |

 

*Recent accounting pronouncements*

 

In April 2003, the FASBissued Statement of Financial Accounting Standards No. 149, Amendment ofStatement 133 on Derivative Instruments and Hedging Activities (SFAS No. 149).SFAS No. 149 amends and clarifies financial reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts and for hedging activities under SFAS No. 133, Accounting forDerivative Instruments and Hedging Activities. This statement is effective forcontracts entered into or modified after June 30, 2003, and for hedgingrelationships designated after June 30, 2003. The Company believesadoption of SFAS No. 149 will not have a material effect on the financialcondition, results of operations, or liquidity of the Company.

 

In May 2003, the FASBissued Statement of Financial Accounting Standards No. 150, Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity (SFAS No. 150). SFAS No. 150 establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity, and is effective for financial instruments enteredinto after May 31, 2003. The Company believes it does not have anyfinancial instruments with characteristics of both liabilities and equity andthat adoption of SFAS No. 150 will not have a material effect on the financialcondition, results of operations, or liquidity of the Company.

 

**2.****              AccountsReceivable**

 

Customers, which representedgreater than 10% of the net accounts receivable balance at September 30,2003 and December 31, 2002, are as follows:

 
|       |   | **September 30,  2003** |   | **December 31,  2002** |   |
|------------|--------|------------------------------|--------|-----------------------------|--------|
| Customer A |   | 30                           | %      | 44                          | %      |
|       |   |                         |   |                        |   |
| Customer B |   | 14                           | %      | 13                          | %      |
|       |   |                         |   |                        |   |
| Customer C |   | 10                           | %      | —                      |   |

 

The Company provided anallowance for uncollectable receivables in the amount of $104,000 and $68,000at September 30, 2003 and December 31, 2002, respectively.  The bad debt expense, net of recoveries of$1,000 in 2003 and $1,000 in 2002, was $15,000 and $12,000 for the three monthsended September 30, 2003 and 2002, respectively.  The bad debt expense, net of recoveries of $6,000 in 2003 and$28,000 in 2002, was $44,000 and $5,000 for the nine months endedSeptember 30, 2003 and 2002, respectively.  Accounts written off to the allowance account amounted to $1,000and $6,000 for the three months period ended September 30, 2003 and 2002,respectively.  Accounts written off tothe allowance

 

8

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account amounted to $14,000 and$186,000 for the nine month periods ended September 30, 2003 and 2002,respectively.

 

**3.****              Inventory**

 

Inventory consisted of thefollowing:

 
|            |   | **(in  thousands)**          |   |
|-----------------|--------|------------------------------|--------|
|            |   | **September 30,  2003** |   | **December 31,  2002** |   |
| Finished Goods  |   | $                            | 2,077  |   | $ | 1,254 |   |
|            |   |                         |   |   |   |   |   |
| Work in process |   | 375                          |   | 228 |   |
|            |   |                         |   |   |   |
| Raw materials   |   | 148                          |   | 236 |   |
|            |   |                         |   |   |   |
| **Total**       |   | $                            | 2,600  |   | $ | 1,718 |   |

 

**4.****              Propertyand Equipment**

 

Property and equipmentconsisted of the following:

 
|                                              |   | **(in  thousands)**          |   |
|---------------------------------------------------|--------|------------------------------|--------|
|                                              |   | **September 30,  2003** |   | **December 31,  2002** |   |
| Equipment                                         |   | $                            | 385    |   | $ | 333 |   |
|                                              |   |                         |   |   |   |   |   |
| Leasehold improvements                            |   | 4,029                        |   | 4,029 |   |
|                                              |   |                         |   |   |   |
| Less accumulated depreciation &  amortization |   | (3,308                       | )      | (3,076 | ) |
|                                              |   |                         |   |   |   |
| Property and equipment, net                       |   | $                            | 1,106  |   | $ | 1,286 |   |

 

**5.****              IntangibleAssets**

 

Intangible assets includepatents of $74,000 and $86,000 at September 30, 2003 and December 31,2002, respectively.  Patents are shownnet of accumulated amortization of $217,000 and $205,000, at September 30,2003 and December 31, 2002, respectively. Patents are amortized over the term of the patent and the amortizationexpense related thereto was $4,000 for each of three-month periods endedSeptember 30, 2003 and 2002, respectively, and $12,000 for each of thenine-month periods ended September 30, 2003 and 2002, respectively.  Patent amortization expense is expected tobe $16,000 for each of the years ending December 31, 2003 through 2007 and$6,000 for the year ending December 31, 2008.

 

Intangible assets also includegoodwill of $2.8 million at September 30, 2003 and at December 31,2002.  Under the guidance of Statementof Financial Accounting Standards (SFAS) No. 142 “Goodwill and Other IntangibleAssets,” the Company performed an annual impairment test on the value ofcertain intangibles such as goodwill on March 31, 2003, and concluded thatgoodwill was not impaired.  There wereno events since March 31, 2003, which would cause the Company to changeits valuation as of September 30, 2003. The Company determined that it has one reportable unit, therefore, allof goodwill is deemed to be associated with ProCyte’s overall businessoperations.

 

9

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**6.****              Federaland State Income Taxes**

 

No provision was made forfederal income taxes for the three and nine months ended September 30,2003 and 2002.  At September 30,2003 and December 31, 2002, the Company provided a full valuationallowance for its net deferred tax assets. The Company believes sufficient uncertainty exists regarding therealizability of the deferred tax assets. The net changes in the valuation allowance during the nine months endedSeptember 30, 2003 and the year ended December 31, 2002, dueprimarily to short term timing differences, were a reduction of $206,000 and$627,000, respectively.

 

A provision for stateincome tax was made for California state income tax in the quarter endedMarch 31, 2003.  The Company has anet operating loss carry forward for California state income tax of $350,000,however in the fourth quarter of 2002 the State of California temporarilysuspended the use of the net operating loss carry forward deduction for 2002and 2003.  As a result, the Companyrecognized $18,000 related to state income taxes in the first quarter of 2003.

 

As of September 30,2003, the Company’s U.S. federal net operating loss and general business creditcarry forward for income tax purposes were approximately $68.0 million and $1.6million, respectively.  If not utilized,the federal net operating loss carry forward and tax credits carry forward willexpire between 2004 and 2021.  Changesin ownership, as defined by Section 382 of the IRC, may limit the amountof net operating loss carry forward used in any one year.

 

**7.****              Earningsper share**

 

Basic and diluted per shareresults for all periods presented were computed based on the net earnings forthe respective periods.  The weightedaverage number of common shares outstanding during the period was used in thecalculation of basic earnings per share. In accordance with FAS 128, “Earnings Per Share,” the weighted averagenumber of common shares used in the calculation of diluted per share amounts isadjusted for the dilutive effects of stock options based on the treasury stockmethod only if an entity records earnings from operations, as such adjustmentswould otherwise be anti-dilutive to earnings per share from operations.  For the three months endedSeptember 30, 2003 and 2002, 200,823 and 309,740 dilutive stock options,respectively, were included in the calculation of average number of commonshares outstanding for diluted computations. For the three months ended September 30, 2003 and 2002, options andwarrants to purchase 1,043,007 shares and 487,500 shares, respectively, ofcommon stock with exercise prices greater than the average fair market value ofour stock for the period of $1.16 and $1.49, respectively, were not included inthe computation of diluted earnings per share because the effect would havebeen antidilutive.  For the nine monthsended September 30, 2003 and 2002, 203,565 and 292,666 dilutive stockoptions, respectively, were included in the calculation of average number ofcommon shares outstanding for diluted computations. For the nine months endedSeptember 30, 2003 and 2002, options to purchase 981,342 shares and487,500 shares, respectively, of common stock with exercise prices greater thanthe average fair market value of our stock for the period of $1.19 and $1.62,respectively, were not included in the computation of diluted earnings pershare because the effect would have been antidilutive.

 

10

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**8.****              StockOptions**

 

Information relating to stockoptions granted, exercised, canceled and currently exercisable is as follows:

 
|                                 |   | **Shares  Subject to Option** |   | **Weighted  Average  Exercise Price** |   |
|--------------------------------------|--------|-------------------------------|--------|---------------------------------------|--------|
| Outstanding, January 1, 2002    |   | 2,087,002                     |   | $                                     | 1.57   |   |
| Granted                              |   | 294,500                       |   | $                                     | 1.77   |   |
| Exercised                            |   | (28,837                       | )      | $                                     | 0.89   |   |
| Canceled or expired                  |   | (323,164                      | )      | $                                     | 1.84   |   |
| Outstanding, September 30, 2002 |   | 2,029,501                     |   | $                                     | 1.57   |   |

 
|                                 |   | **Shares  Subject to Option** |   | **Weighted  Average  Exercise Price** |   |
|--------------------------------------|--------|-------------------------------|--------|---------------------------------------|--------|
| Outstanding, January 1, 2003    |   | 2,185,335                     |   | $                                     | 1.57   |   |
| Granted                              |   | 169,500                       |   | $                                     | 1.29   |   |
| Exercised                            |   | (12,000                       | )      | $                                     | 0.86   |   |
| Canceled or expired                  |   | (149,835                      | )      | $                                     | 2.74   |   |
| Outstanding, September 30, 2003 |   | 2,193,000                     |   | $                                     | 1.47   |   |
| Exercisable, September 30, 2003 |   | 1,633,179                     |   | $                                     | 1.51   |   |

 

The weighted average fair valueof options granted during the three months ended September 30, 2003 and2002 were approximately $0.51 and $1.14, respectively.  The weighted average fair value of optionsgranted during the nine months ended September 30, 2003 and 2002 wereapproximately $0.76 and $1.32, respectively.

 

**9.****              RelatedParty Disclosure**

 

The Company holds a promissorynote in the principal amount of $2.0 million from Emerald Pharmaceutical L.P.,which it received as partial consideration for the sale of its contractmanufacturing operations in 2001.  Thenote is secured by the manufacturing assets sold and bears interest equal tothe effective yield on the 10 Year U.S. Treasury Note, which is adjustedquarterly.  The yield for the quarterended September 30, 2003 was 3.51%. Emerald will begin making annual principal payments of $286,000 in July 2005.  The Company also received a minority limitedpartnership interest in Emerald as part of consideration received in thesale.  As part of the agreement, ProCyteleases a portion of its current 34,532 square foot leased facility, includingexisting leasehold improvements, to Emerald. A portion of the proceeds from the sale in the amount of $1.7 millionhas been determined to represent consideration for Emerald’s use of theleasehold improvements, and is being recognized over the term of thelease.  ProCyte engages EmeraldPharmaceutical L.P. to do certain manufacturing and other quality andanalytical services.  Emerald billedProCyte for such services a total of $415,000 and $643,000 for the three monthsended September 30, 2003 and 2002, respectively, and $1.6 million and$837,000 for the nine months ended September 30, 2003 and 2002, respectively.  ProCyte had trade payables to Emerald of$20,000 and $18,000 on September 30, 2003 and December 31, 2002,respectively.

 

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One of the Company’s Directorsalso serves as Chairman and Chief Executive Officer of one of ProCyte’scustomers.  ProCyte’s net sales to thecustomer were $248,000 and $298,000 for the three months endedSeptember 30, 2003 and 2002, respectively and $593,000 and $607,000 forthe nine months ended September 30, 2003 and 2002, respectively.  The customer’s trade receivable balanceswere $158,000 and $274,000 on September 30, 2003 and December 31,2002, respectively.

 

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## **Item2**.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations

 

This Quarterly Report on Form10-Q contains forward-looking statements. These statements relate to futureevents or future financial performance. In some cases you can identify forward-looking statements by terminologysuch as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,”“believe,” “estimate,” “predict,” “potential,” “propose” or “continue,” thenegative of these terms, or other terminology. These statements are only predictions. Actual events or results may differ materially.  In evaluating these statements, you shouldspecifically consider various factors described below in thesection entitled “Important Factors Regarding Forward-Looking Statements.”These factors may cause our actual results to differ materially from anyforward-looking statement.

 

Although we believe theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, product demand,performance or achievements.  You shouldnot place undue reliance on our forward-looking statements, which speak only asof the date of this report. We undertake no obligation to publicly update anyforward-looking statements, whether as a result of new information, futureevents or otherwise.

 

*Critical Accounting Policies and Estimates*

 

The “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” as well asdisclosures included elsewhere in this Form 10-Q, are based upon our condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles 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 notes receivable, and for excess and obsolete inventory.  We base our estimates on historicalexperience, current conditions and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe 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.

 

Product revenues are recognizedwhen products are shipped, license fees are recognized over the term of thelicense agreement, and royalties are recognized when earned.  On occasion, the Company will receiveadvance deposits with customer purchase orders.  These deposits are reported as a deferred revenue liability,until the product is shipped to the customer.

 

Approximately 20% of ProCyte’sassets as of September 30, 2003 consisted of goodwill, most of which wasacquired in business combinations and recorded based on the fair value of thecommon stock issued to effect those business combinations.  Under theguidance of SFAS 142 “Goodwill and Other Intangible Assets,” we analyze whetherthe fair value of recorded goodwill is impaired on an annual basis.  Ouranalysis of whether the fair value of recorded goodwill is impaired involves asubstantial amount of judgment, as does establishing and monitoring estimatedlives of amortizable intangible assets.  Future charges related tointangible assets could be material depending on future developments andchanges in technology and our business.

 

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We maintain an allowance fordoubtful accounts for estimated losses resulting from the potential inabilityof our customers or other debtors to make required payments.  We believe such allowances are adequate asof September 30, 2003; however, if the financial condition of ourcustomers or other debtors were to deteriorate, resulting in an impairment oftheir ability to make payments to us, additional allowances may be required.

 

Inventories are stated at thelower of cost or market value.  Cost is principally determined by thefirst-in, first-out method.  The Company records adjustments to the valueof inventory based upon its forecasted plans to sell its inventories.  Thephysical condition (e.g., age and quality) of the inventories is alsoconsidered in establishing its valuation.  These adjustments areestimates, which could vary significantly, either favorably or unfavorably,from the amounts that the Company may ultimately realize upon the dispositionof inventories, if future economic conditions, customer inventory levels,product discontinuances or competitive conditions differ from our estimates andexpectations.

 

The Company has provided a fullvaluation reserve for tax benefits of net operating losses and research anddevelopment tax credit carry forwards due the uncertainty of realizing the taxbenefits of the assets.  In evaluatingthe need for a reserve, each quarter we consider all positive and negativeevidence to determine whether it is more likely than not that the deferred taxassets will be utilized.  In doing so weuse judgment in considering the relative impact of negative and positiveevidence and the weight given to this evidence is commensurate with the extentto which it can be objectively verified.

 

*Corporate Overview*

 

ProCyte develops, manufactures,distributes and markets products for skin health, hair care and wound care,many of which incorporate clinically tested technologies such as its patentedCopper Peptide compounds.  ProCytereceives revenue from the sale of products via its U.S. sales force,distributors and international customers, from royalties and the sale of CopperPeptide compounds under license and supply agreements, and from the manufactureand sale of private label products containing our technologies.

 

Our growth strategy includesacquisition, licensing, and/or distribution of products that we believe have ademonstrated market and may require more directed marketing and promotionalattention.  We have acquired, and intendto acquire, rights to manufacture and/or market products that studies haveshown to be effective, but which are not actively promoted and where thesurrounding competitive environment is conducive to our entry.  In addition to acquisitions, our growthstrategy includes the introduction of new products developed through ourresearch and development program.

 

During the fourth quarter of2002, ProCyte initiated work on an infomercial, a form of direct-to-consumerdistribution, with a new brand of anti-aging and skin care products calledVitalCopperTM.  Many of the initialVitalCopperTM products include GHK Copper Peptide compounds. First productionand filming were completed in January 2003, and the initial market testbegan in selected markets during March 2003.  Continuation of the market test was placed on hold as public andmedia attention focused on the Iraq conflict. During this hold period, based upon expert feedback, a number of changeswere made to content, style and approach and a new multi-week market testprogram was initiated at the end of July 2003.  The new market test results indicated that additionalmodification and testing cycles would be required.  While this test, modify and retest methodology in not unusual forinfomercials, management believes that additional investment would not produceas much return as other opportunities available to the Company.  Therefore all activities related to theinfomercial have been suspended. ProCyte will continue to market the VitalCopperTM brand products toconsumers through the VitalCopperTM web site, selected print advertising catalogsales and specialty retail.  As a resultof required accounting practices

 

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for an infomercial, developmentand production costs totaling $540,000 were expensed and included undermarketing and selling in the first quarter of 2003, when the first infomercialtest ran.  For the nine months endedSeptember 30, 2003, expenses included in marketing and selling related tothe infomercial were $770,000, or approximately $0.05 per share.

 

*Revenues*

 

Total revenue for the thirdquarter of 2003 decreased to $2.7 million as compared to $3.1 million reportedin the same quarter of the prior year. Revenues in the first nine months of 2003 decreased to $8.7 million from$9.4 million as compared to the comparable 2002 period.  The revenue decrease for the quarter andfirst nine months is due to lower shipments of ProCyte’s patented CopperPeptide compound to licensed partners during the second and thirdquarters.  The timing and amount ofproduct shipments are dependent on customers’ production schedules and canfluctuate widely from quarter to quarter. However, revenue from Copper Peptide compound is expected to remain at thecurrent period level into the fourth quarter of 2003 and therefore is expectedto remain below the prior comparable period level. Product sales to physiciansand distributors in the 2003 third quarter and nine-month periods were evenwith the prior-year periods. Royalty revenue was higher in the third quarterand nine-month periods of 2003 as compared to the 2002 periods.

 

Product sales, which includethe sale of Copper Peptide compounds under license and supply agreements,decreased 16 percent to $2.3 million in the third quarter as compared to $2.7million reported in the third quarter of 2002. Within this category, physician and distributor sales for the thirdquarter improved 3 percent from the prior year quarter while this same categorywas down 1 percent for the first nine-months of 2003; an improvement from thesecond quarter and first six months of 2003, which were lower than the 2002comparable periods and reflects the action taken late in the second quarter tofocus on the company’s core customer base. Sales of Copper Peptide compounds during the third quarter of 2003 weredown 58 percent as compared to the third quarter of 2002 and were down 35percent for the first nine months. Shipments of the Copper Peptide compounds are driven by the purchasingpatterns of our largest licensing partner, Neutrogena.  While volatile from quarter to quarter, andlower in the second and third quarters, sales to this partner for the firstnine months of 2003 were still 5 percent greater than the same period in 2002.  Offsetting this nine month increase werezero purchases of Copper Peptide compound by the other licensing partners, whohad purchased $1.0 million during the first nine-months of 2002.  These prior period shipments were related tothe other licensing partners’ inventory build up for their initial marketlaunches.  The Company has been advisedthat follow on sales to consumers were much slower than these other licensingpartners anticipated, thereby eliminating their need for material in the firstnine months of 2003, and reducing the related royalty revenue earned by theCompany as noted below.  It is not knownwhen or whether shipments to these others partners will resume, and the Companyis currently evaluating its alternatives with these licensees.

 

For the quarter endedSeptember 30, 2003, licensing and royalties revenue increased 11 percentas compared to the same period in 2002 and 19 percent in the first nine monthsas compared to the same period in 2002. 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.  For thenine months of 2003 as compared to the same period in 2002, the Company’slargest licensing partner represented a 30 percent increase in royalty revenue,which was partially offset by a decline in royalty revenues of 85 percent fromthe other licensing partners noted above.

 

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*Gross Profit*

 

In the third quarter of 2003,gross profit increased 11 percent to $2.0 million as compared to $1.8 millionreported in same quarter in 2002.  Therelated gross margin for the third quarter of 2003 was 75 percent as comparedto 59 percent in the third quarter of 2002. The increase was primarily attributable to the revenue mix havinggreater product sales and royalty income versus Copper Peptide compound salesduring the quarter and from realizing an improved gross profit on the sale ofthe Company’s Copper Peptide compound as compared to the year earlierperiod.  For the first nine months of2003, gross profit was up 2 percent as compared to the comparable year earlierperiod for the same reasons. Gross margin is sensitive to the revenue mix ofpackaged products, licensee purchases of Copper Peptide compounds and royaltyrevenue and will vary from period to period as a result.

 

*Expenses*

 

Total operating expensesincreased 16 percent to $1.8 million in the third quarter of 2003 from $1.6million reported for the same quarter in 2002. For the nine months ended, expenses were up 21 percent to $6.0 millionfrom $4.9 million reported in the same period in 2002.

 

Marketing and selling expensesfor the third quarter increased by $296,000 to $1.0 million as compared to$728,000 for the prior year quarter of which $83,000 related to the additionalmarket testing and modification of the infomercial in the 2003 third quarter.In addition sales training, sales force compensation, selling aids andadvertising expenses increased as more resources were invested in theseareas.  Year to date, marketing andselling expenses were $3.2 million as compared to $2.3 million in the firstnine months of 2002, an increase of $958,000 of which $770,000 were infomercialrelated expenses.  The rest of the increaseresults from the above increased sales and advertising expenses and theaddition of a Director of Business Development in February 2003, whichwere partially offset by lower sales commissions and sales compensation expensein the first half of 2003.

 

Research, general andadministrative expenses declined 5 percent to $797,000 in the third quarter of2003 as compared to $840,000 in the corresponding 2002 period.  The decline was due to a reduction in legaland consulting services during the 2003 quarter and, as a result of lowerrevenues and net income performance, not accruing any estimated bonus expenseduring the 2003 third quarter.  Thisdecline in expenses was partially offset by an increase in salary and benefitsrelated to the addition of the Chief Financial Officer in October 2002 andretainer fees paid to the company’s investment bank in the 2003 quarter.  Expenses for the nine months of 2003increased 3 percent to $2.7 million as compared to $2.6 million in the sameperiod in 2002.  The increase for thenine months is due to increased salaries and benefits related to the additionof a Chief Financial Officer in the 2003 period, increased legal and audit feesincurred for compliance with new corporate governance and reporting standards,and increased legal fees related to actions initiated by ProCyte to enforce itsrights under certain agreements.  Theseincreases were partially offset by decreases in consulting and recruitingexpenses and the aforementioned lower accrual for the management bonus plan.

 

*Interest and Other Income*

 

Interest and other incomeearned during the third quarter of 2003 decreased 31 percent to $34,000 ascompared to $49,000 earned in the same quarter in 2002.  The decline in the quarterly income wasprimarily due to declining short-term interest rates.  For the nine months ended September 30, 2003, the Companyreported a 12 percent increase in interest and other income as compared to thesame nine-month period in 2002, primarily due to receiving a one-timetermination settlement from Merck KGaA for $50,000, which was partially offsetby the lower interest rates.

 

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*Income Taxes*

 

As of September 30, 2003the Company’s U.S. federal net operating loss and general business tax creditcarry forwards for income tax purposes were approximately $68.0 million and$1.6 million, respectively.  The Companyhas not yet recognized the benefit of these tax expense savings for futureperiod earnings.  The Company has hadnet operating losses since inception, with the exception of net income reportedfor the first time in 2002.  Thus,sufficient uncertainty still exists regarding the realizability of using thedeferred tax assets in future periods. If not utilized, the federal net operating loss carry forward and taxcredit carry forwards will expire between 2004 and 2021.

 

A provision for stateincome tax was made for California income tax in the first nine months of theyear.  The Company has a net operatingloss carry forward for California state income tax of $350,000, however in thefourth quarter of 2002 the State of California temporarily suspended the use ofthe net operating loss carry forward deduction for 2002 and 2003.  As a result, the Company recognized $18,000related to state income taxes for the nine months ended September 30,2003.

 

*Net Income*

 

For the quarter endedSeptember 30, 2003, ProCyte reported net income of $261,000 as compared tonet income of $322,000 in the same quarter in 2002.  This decrease was primarily due to the increase in operatingexpenses that were partially offset by the higher gross profit during the thirdquarter of 2003.  For the nine monthsended September 30, 2003, the Company reported net income of $397,000 ascompared to $1.3 million reported for the same period in 2002.  This $948,000 decrease in net income for thenine-month period was primarily due to the aforementioned $770,000 infomercialrelated expenses, increased investment in the Company’s sales activities andadvertising which were partially offset by an improvement in gross profit inthe 2003 period.

 

*Liquidity and Capital Resources*

 

The Company has reliedprimarily on cash flow from operations, interest income and equity financing tofund its operations and capital expenditures.  At September 30, 2003,the Company had approximately $4.5 million in cash and cash equivalents,compared to $4.6 million at December 31, 2002.  The net change incash and cash equivalents during the first nine months of 2003 reflects a netuse of cash of $100,000. The significant components of this net use of cash aredisbursements related to the infomercial, an increase in Copper Peptidecompound inventory which is partially offset by a related customer deposit, thepayment of 2002 management bonuses in 2003 and capital expenditures primarilyrelated to updating the Company’s computer and network systems.  These outflows were mostly offset bypositive cash generated by operations during the nine month period.  We may see fluctuations in cash flows infuture periods as they depend in large part on the timing of deposits receivedfrom our strategic partners and their initiation of new product introductions.

 

Effective October 14, 2003ProCyte entered into non-binding Letter of Intent with Annette Hanson toacquire the principal assets of her product distribution business forapproximately $730,000 in cash.  Ms.Hanson’s business, focused on the spa and salon markets, has sold productscontaining ProCyte’s technology under the Simple Solutions® brandsince April 2002.  Included in theproposed purchase are receivables, inventory, selected equipment, brand namesand trademarks.  Annualized revenues ofthe existing business are approximately $1 million.  If completed, the proposed acquisition is expected to allowProCyte to expand into targeted retail distribution and leverage its CopperPeptide technology and sales and marketing expertise.  ProCyte believes that significant product synergies would alsooccur as a

 

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result of the proposedacquisition.  Based upon suchassumptions and subject to due diligence, ProCyte believes the acquisition willbe accretive in 2004 and, due to the short revenue period remaining in 2003after the closing, may be slightly dilutive in the fourth quarter.

 

Completion of the transactionis subject to the completion of due diligence, negotiation and execution of thedefinitive agreements, including a consulting contract with Ms. Hanson, andsatisfaction of customary conditions of closing and Board approval.  ProCyte currently believes that theserequirements will be successfully satisfied and expects that the proposedacquisition will close in the fourth quarter.

 

The Company believes that itsexisting cash and cash equivalents and interest thereon, will be sufficient tomeet its working capital requirements for at least the next two years.  However, there can be no assurance that theunderlying assumed levels of revenue and expense will prove accurate.  The Company’s actual cash requirements willdepend upon numerous factors, including actions by regulatory authorities, thelevels of resources 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, our degree ofsuccess in commercializing new products and the cost of preparing, filing,prosecuting, maintaining and enforcing patent claims and intellectual propertyrights.  The Company will depend onproduct revenues, royalties and license fees, interest income, equityfinancing, and funding from corporate partnerships to meet its future capitalneeds.  See “Important Factors RegardingForward-Looking Statements – Need for Additional Capital.”

 

**Important Factors Regarding Forward-LookingStatements**

 

*Loss of or Reduction in Orders by SignificantCustomers Could Adversely Affect Our Net Revenues and Results of Operations*

 

Although the Company’s customerbase is made up of a large number of customers, our top three customerscomprised approximately 41 percent of net revenues during the first nine monthsof 2003, one of which accounted for approximately 29 percent of the Company’snet revenue.  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.  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. Any downturn in the business from these customers or the inability torenew or replace agreements with new customers as they expire couldsignificantly decrease sales to such customers, which could adversely affectour net revenues and results of operations.

 

Furthermore, we do not have asubstantial non-cancelable backlog of orders; our customers can generallycancel or reschedule orders upon short notice.  Variations in the timing of these orders can cause significantfluctuations in our quarterly operating results, and the cancellation ordeferral of product orders or overproduction due to the failure of anticipatedorders to materialize could result in the Company holding excess or obsoleteinventory, which has resulted and could again in the future result inwrite-downs of inventory that would have a material adverse effect on ouroperating results.

 

*Dependence on and Management of Existing andFuture Corporate Alliances*

 

The successfulcommercialization of the Company’s existing and future products in the consumerand wound care markets will depend upon ProCyte’s ability to enter into andeffectively manage corporate

 

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alliances.  There can be no assurance that the Companywill be successful in establishing corporate alliances in the future, or thatit will be successful in performing and maintaining existing or any futurecorporate alliances.  Moreover, therecan be no assurance that the interests and motivations of any corporatepartner, distributor or licensee would be or will remain consistent with thoseof the Company, or that the Company and such partners, distributors orlicensees 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; No Assurance of AchievingConsistent Profitable Earnings*

 

The Company has been launchingand marketing products based on its proprietary Copper Peptide technology since1996.  In addition to sales of productsbased on its proprietary Copper Peptide technology, the Company’s revenues havehistorically included sales of non-proprietary products, license fees androyalties, revenue from contract manufacturing and interest income.  During 2002, the Company reported net incomeand positive cash flow from operations for the first time in its operatinghistory.  During the nine months endedSeptember 30, 2003, the Company reported a net income and a slight net useof cash from operations.  There can beno assurance that the Company can maintain a consistent, profitable level ofoperations.  Attaining consistentprofitability is dependent upon a wide variety of factors, includingsuccessfully manufacturing and marketing of the Company’s products, enteringinto and maintaining agreements with corporate partners for commercializationof the Company’s products, and successfully licensing the Company’s productsand technology.  Payments undercorporate partnerships and licensing arrangements may be subject tofluctuations in both timing and amounts and therefore the level ofprofitability may vary significantly from quarter to quarter.

 

*We Rely on Third Party Manufacturers for OurProducts*

 

We use third partymanufacturers to make products. In many cases, third party manufacturers arenot obligated under contracts that fix the term of their commitments and theymay discontinue production upon little or no advance notice. Manufacturers alsomay experience problems with product quality or timeliness of product delivery.We rely on these manufacturers to comply with applicable current quality systemregulations (“QSR”). The loss of a contract manufacturer may force us to shiftproduction to in-house facilities and possibly cause manufacturing delays,disrupt our ability to fill orders, or require us to suspend production untilwe find another third party manufacturer. We are not able to control themanufacturing efforts of these third party manufacturers as closely as wecontrol our business. Should any of these manufacturers fail to meet theapplicable standards, we, or our third-party manufacturers, could face variousenforcement actions, which would have an adverse effect on the Company’s netrevenues and results of operations.

 

*Need for Additional Capital*

 

As of September 30, 2003,the Company had cash and cash equivalents of $4.5 million.  The Company estimates that, exclusive ofpossible acquisitions not yet identified and at its planned rate of spending,its existing cash and cash equivalents and the interest income thereon will besufficient to meet its operating and capital requirements for at least the nexttwo years.  There can be no assurance,however, that our underlying assumed levels of revenue and expense will proveaccurate.  Whether or not these assumptionsprove to be accurate, the Company may need to raise additional capital.  Furthermore, the Company may requireadditional funds to expand or enhance its sales and marketing activities, toaccelerate product development, 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

 

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collaborativearrangements.  Adequate funds for thesepurposes, whether obtained through financial markets or from collaborative orother arrangements with corporate partners or other sources, may not beavailable when needed or may not be available on terms favorable to theCompany.  If we issue equity securitiesto raise additional funds, dilution to existing shareholders will result.  In addition, in the event that additionalfunds are obtained through arrangements with collaborative partners, sucharrangements may require the Company to relinquish its rights to certaintechnologies or potential products that it would otherwise seek to develop orcommercialize on its own.  If funding isinsufficient at any time in the future, the Company may be required to: delay,scale back or eliminate some or all of its marketing and research anddevelopment programs; or license to third parties the rights to commercializeproducts or technologies that the Company would otherwise seek to develop onits own.  Furthermore, the terms of anysuch license agreements or asset sales might be less favorable than if the Companywere negotiating from a stronger position.

 

*Uncertainty of Patent Position andProprietary Rights*

 

The patent positions ofbiotechnology, medical device and healthcare products companies are oftenuncertain and involve complex legal and factual questions, and the breadth ofclaims allowed in such patents cannot be predicted.  The Company’s success will depend on its ability to obtainpatents and licenses to patent rights, to maintain trade secrets, and tooperate without infringing on the proprietary rights of others, both in theUnited States and in other countries. The failure of the Company or its licensors to obtain, maintain andenforce patent protection for the Company’s technology could have a materialadverse effect on the Company.

 

ProCyte’s success depends, inpart, upon its ability to protect its products and technology underintellectual property laws in the United States and abroad.  As of September 30, 2003, the Companyhad 21 issued U.S. patents expiring between 2005 and 2017 and numerous issuedforeign patents and patent registrations. The patents relate to use of the Company’s copper-based technology for avariety of healthcare applications, and to the composition of certainbiologically active, synthesized compounds. The Company’s strategy has been to apply for patent protection forcertain compounds and their discovered uses that are believed to have potentialcommercial value in countries that offer significant market potential.  There can be no assurance that patentapplications relating to the technology used by the Company will result inpatents being issued.  Nor can there beany assurance that any patent issued to the Company will not be subjected tofurther proceedings limiting the scope of the rights under the patent or that suchpatent will provide a competitive advantage, will afford protection againstcompetitors with similar technology, or will not be successfully challenged,invalidated or circumvented by competitors.

 

The Company’s processes andpotential products may conflict with patents that have been or may be grantedto competitors 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

 

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acceptable terms, if atall.  If such licenses could not beobtained on acceptable terms, the Company could be prevented from manufacturingand marketing existing 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 alsorelies upon non-patented proprietary technology.  There can be no assurance that the Company can meaningfullyprotect its rights to such non-patented technology, that any obligation tomaintain the confidentiality of such proprietary technology will not bebreached by employees, consultants, collaborators or others or that others willnot independently develop or acquire substantially equivalent technology.  To the extent that corporate partners orconsultants apply Company technological information independently developed bythem or by others to Company projects or apply Company technology or know-howto other projects, disputes may arise as to the ownership of proprietary rightsto such information.  Any failure toprotect non-patented proprietary technology or any breach of obligationsdesigned to protect such technology or development of equivalent technology mayhave a material adverse effect on the Company’s business, financial conditionand results of operations.

 

*Uncertainty of Government RegulatoryRequirements*

 

The Federal Food, Drug andCosmetic Act, and the regulations promulgated thereunder, and other federal andstate statutes govern, among other things, the testing, manufacture, safety,labeling, storage, record-keeping, advertising and promotion of cosmeticproducts and medical devices.  TheCompany’s products and product candidates may be regulated by any of a numberof divisions of the FDA and in other countries by similar health and regulatoryauthorities.  The process of obtainingand maintaining regulatory approvals for the manufacturing or marketing of theCompany’s existing and potential products is costly and time-consuming and issubject to unanticipated delays. Regulatory requirements ultimately imposed could also adversely affectthe ability of the Company to clinically test, manufacture or market products.

 

In the United States, productsthat do not seek to make effectiveness claims based on human clinicalevaluation may be subject to review and regulation under the FDA’s cosmetic,drug or 510(k) medical device guidelines. Similar guidelines exist for such products in other countries.  Such 510(k) products, which include 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 assurancethat product 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 maybecome subject to various other federal, state, local and foreign laws,regulations and policies relating to, among other things, safe workingconditions, good laboratory practices, and the use and disposal of hazardous orpotentially hazardous substances used in connection with research anddevelopment.

 

Failure to obtain regulatoryapprovals where appropriate for its product candidates or to attain or maintaincompliance with QSR or other manufacturing requirements would have a materialadverse effect on the Company’s business, financial condition and results of operations.

 

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*Intense Competition*

 

Competition in the wound care,skin health and hair care markets is intense. The Company’s competitors include well-established pharmaceutical,cosmetic and healthcare companies such as Johnson and Johnson, Galderma, Obagi,La Roche Posay, and Allergan. These competitors have substantially more financial and other resources,larger research and development staffs, and more experience and capabilities inresearching, developing and testing products in clinical trials, in obtainingFDA and other regulatory approvals and in manufacturing, marketing anddistribution than the Company.  Inaddition, a number of smaller companies are developing or marketing competitiveproducts.  The Company’s competitors maysucceed in developing and commercializing products or obtaining patentprotection or other regulatory approvals for products more rapidly than theCompany.  In addition, competitiveproducts may be manufactured and marketed more successfully than the Company’spotential products.  Such developmentscould render the Company’s existing or potential products less competitive orobsolete and could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

*Product Liability Claims*

 

The testing, manufacturing,marketing and sale of our products may subject the Company to product liabilityclaims.  ProCyte maintains coverageagainst product liability risks. However, continuing insurance coverage may not be available at anacceptable cost, if at all.  The Companymay not be able to obtain insurance coverage that will be adequate to satisfyany liability that may arise. Regardless of merit or eventual outcome, product liability claims mayresult in decreased demand for a product, injury to its reputation 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.

 

*Potential Volatility of Stock Price; BulletinBoard Listing*

 

The market prices forsecurities of healthcare, pharmaceutical and biotechnology companies aresubject to volatility, and the market has from time to time experiencedsignificant fluctuations that are unrelated to the operations of theCompany.  ProCyte’s market price hasfluctuated over a wide range since the Company’s initial public offering in1989, and since March 25, 1999, the Company’s common stock has traded onthe NASD OTC bulletin board.  Becausereal-time price information may not be easily available for bulletin boardsecurities, an investor is likely to find it more difficult to dispose of, orto obtain accurate quotations on the market value of, the Company’s securitiesthan if they 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 Exchange Act,which imposes various sales practice requirements on broker-dealers, or to the“penny stock” rules, either of which would likely reduce the level of tradingactivity in the secondary market for the Company’s securities and make sellingthe securities more difficult for an investor.

 

Announcements concerning theCompany or its competitors, including fluctuations in operating results,research and development program direction, results of clinical trials,addition or termination of corporate alliances, technology licenses, clearanceor approval to market products, announcements of technological innovations ornew products by the Company or its competitors, changes in governmentregulations, healthcare reform, developments in patent or other proprietaryrights of the Company or its competitors, litigation concerning businessoperations or intellectual property, or public concern as to safety ofproducts, as well as changes in general market conditions and mergers andacquisitions, may have a significant effect on the market price of ProCyte’scommon stock.

 

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## **Item3**.  Quantitativeand Qualitative Disclosures About Market Risk

 

ProCyte did not own anyderivative financial instruments as of September 30, 2003.  TheCompany is debt-free and is exposed to interest rate risk to the extent that ithas invested idle cash balances and the promissory note receivable describedbelow.  At September 30, 2003, the idle cash balances were investedin a United States Treasury money market fund.  ProCyte employsestablished policies and procedures to manage its exposure to changes in themarket risk of its investments.  The Company believes that the market riskarising from holdings of its financial instruments is not material.  TheCompany holds a $2.0 million promissory note as a result of the sale of itscontract manufacturing operation to Emerald Pharmaceutical L.P.  The notehas a variable interest rate, adjusted quarterly, and is guaranteed by asecurity agreement giving ProCyte a first lien position on the assets sold toEmerald.

 

## **Item4**.  Controls andProcedures

 

Under the supervision of andwith the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, the Company has evaluatedthe effectiveness and design and operation of its disclosure controls and proceduresas of the end of the quarter covered by this report, and, based on theirevaluation, the Chief Executive Officer and the Chief Financial Officer haveconcluded that these disclosure controls and procedures are effective inensuring that all material information required to be disclosed in the reportsthat the Company files or submits under the Securities Exchange Act of 1934have been made know to them in a timely fashion.  There were no changes in the Company’s internal controls overfinancial reporting that occurred during the quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrols over financial reporting.

 

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# **Part II**-Other Information

 

## **Item 1.  LegalProceedings**

 

Not applicable.

 

## **Item 2.  Changes in Securities and Use of Proceeds**

 

Not applicable.

 

## **Item 3.  Defaults Upon Senior Securities**

 

Not applicable.

 

## **Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

Not applicable.

 

## **Item 5.  OtherInformation**

 

Not applicable.

 

## **Item 6. Exhibits and Reports on Form 8-K**

 

(a) Exhibits

 

See Exhibit Index below.

 

(b) Reports on Form 8-K

 

Current Report on Form 8-Kfiled on July 24, 2003, reporting the Company’s earnings for the secondquarter of 2003.

 

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# **Signatures**

 

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

 

 
|                               |   |                                      | **ProCyte Corporation (Registrant)** |
|------------------------------------|--------|-------------------------------------------|--------------------------------------|
|                               |   |                                      |
|                               |   |                                      |
| Date:  November 13, 2003 | By:    | /s/ John F. Clifford                      |                                 |
|                               |   |                                      |
|                               |   | John F. Clifford, Chairman and CEO        |
|                               |   |                                      |
|                               |   |                                      |
| Date:  November 13, 2003 | 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                                                                                           |   | F        |
| 10.8*       |   | Change of  Control Agreement for Mr. John Clifford                                                                                              |   | D        |
| 10.13*      |   | Form of  Indemnity Agreement dated February 23, 1995 between the Registrant and  each of Dr. Blake, Mr. Patterson and Mr. Clifford.        |   | C        |
| 10.14*      |   | Form of  Indemnity Agreement between ProCyte Corporation and each of various of its  Officers and Directors                                     |   | F        |
| 10.15*      |   | Form of  Severance Agreement for Mr. John Clifford                                                                                              |   | D        |
| 10.16*      |   | Form of Promissory  Note between ProCyte Corporation and Mr. John Clifford                                                                      |   | H        |
| 10.17† |   | License  Agreement dated April 19, 2000 between ProCyte Corporation and  Neutrogena Corporation                                            |   | I        |
| 31.1        |   | Certification  of President and Chief Executive Officer pursuant to Rule 13a-14a                                                                |   | J        |
| 31.2        |   | Certification  of Chief Financial Officer pursuant to Rule 13a-14a                                                                              |   | J        |
| 32.1        |   | Certification  of President and Chief Executive Officer pursuant to 18 USC Section 1350                                                    |   | J        |
| 32.2        |   | Certification  of Chief Financial Officer pursuant to 18 USC Section 1350                                                                  |   | J        |

 

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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 Annual Report on Form 10-K/A dated  December 31, 1998.       |
| I      |   | Incorporated  by reference to the Registrant’s Quarterly Report on Form 10-Q for the  Quarter ended March 31, 2000. |
| J      |   | Filed  herewith.                                                                                                              |

 

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