** **

**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 June 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 Act of1934 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 August 8, 2003, therewere issued and outstanding 15,774,507 shares of common stock, par value $.01per share.

 

 

----

 

**ProCyteCorporation**

 

**Index**

 
| **Part I - Financial  Information**                                                         |
|---------------------------------------------------------------------------------------------|
| Item  1. Condensed Consolidated Financial Statements (unaudited)                            |
| Balance Sheets - as of June 30, 2003  and December 31, 2002 (unaudited)                     |
| Statements of Operations -  Three & Six Months Ended June 30, 2003 and 2002 (unaudited) |
| Statements of Cash Flows – Six  Months Ended June 30, 2003 and 2002 (unaudited)        |
| Statements of  Stockholders’ Equity – Six Months Ended June 30, 2003 (unaudited)  |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                           |
| 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)**

 

**BalanceSheets****- as ofJune 30, 2003 and December 31, 2002 (unaudited)**

**(in thousands)**

** **

** **
|                                                            |   | **June 30,  2003** |   | **December  31, 2002** |   |
|-----------------------------------------------------------------|--------|--------------------|--------|------------------------|--------|
| **ASSETS**                                                      |   |               |   |                   |   |
| Cash and cash equivalents                                       |   | $                  | 4,482  |                   | $      | 4,556 |   |
| Accounts receivable, net of allowance for  doubtful accounts    |   | 1,176              |   | 1,328                  |   |
| Inventory                                                       |   | 2,103              |   | 1,718                  |   |
| Prepaid expenses                                                |   | 157                |   | 326                    |   |
| Other current assets                                            |   | 105                |   | 3                      |   |
| ***Total current assets***                                      |   | 8,023              |   | 7,931                  |   |
| Property and equipment, net                                     |   | 1,188              |   | 1,286                  |   |
| Intangible  assets, net                                         |   | 2,895              |   | 2,903                  |   |
| Note due from sale of contract  manufacturing operations, net   |   | 1,841              |   | 1,826                  |   |
| Other assets                                                    |   | 40                 |   | 143                    |   |
| **Total Assets**                                                |   | $                  | 13,987 |                   | $      | 14,089 |   |
|                                                            |   |               |   |                   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                   |   |               |   |                   |   |
| Accounts payable, trade                                         |   | $                  | 325    |                   | $      | 277 |   |
| Accrued salaries and benefits                                   |   | 278                |   | 404                    |   |
| Other accrued liabilities                                       |   | 196                |   | 260                    |   |
| Deferred revenue                                                |   | 19                 |   | 21                     |   |
| ***Total  current liabilities***                                |   | 818                |   | 962                    |   |
| Other liabilities                                               |   | 94                 |   | 91                     |   |
| Deferred proceeds on sale of contract  manufacturing operations |   | 1,083              |   | 1,217                  |   |
| **Total Liabilities**                                           |   | 1,995              |   | 2,270                  |   |
| Common stock and additional paid-in-capital                     |   | 85,339             |   | 85,312                 |   |
| Deferred compensation                                           |   | —             |   | (11                    | )      |
| Accumulated deficit                                             |   | (73,347            | )      | (73,483                | )      |
| **Stockholders’ Equity**                                   |   | 11,992             |   | 11,818                 |   |
| **Total Liabilities and Stockholders’ Equity**             |   | $                  | 13,987 |                   | $      | 14,089 |   |

 

*See notes to condensed consolidated financial statements*

 

3

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### **Statements of Operations** - Three & Six Months Ended June 30,2003 and 2002 (unaudited)

**(inthousands, except per share amounts)**

 
|                                        |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|---------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                        |   | **2003**                          |   | **2002**                        |   | **2003** |   | **2002** |   |
| **Revenues**                                |   |                              |   |                            |   |   |   |   |   |
| Product sales                               |   | $                                 | 2,313  |                            | $      | 2,915 |   | $ | 5,195 |   | $ | 5,669 |   |
| Licenses and royalties                      |   | 319                               |   | 348                             |   | 783 |   | 637 |   |
| Total revenues                              |   | 2,632                             |   | 3,263                           |   | 5,978 |   | 6,306 |   |
| Cost of product sales                       |   | 619                               |   | 1,096                           |   | 1,802 |   | 2,023 |   |
| Gross profit                                |   | 2,013                             |   | 2,167                           |   | 4,176 |   | 4,283 |   |
| **Operating Expenses**                      |   |                              |   |                            |   |   |   |   |   |
| Marketing and selling                       |   | 814                               |   | 779                             |   | 2,213 |   | 1,550 |   |
| Research, general, and administrative       |   | 967                               |   | 899                             |   | 1,934 |   | 1,802 |   |
| Total operating expenses                    |   | 1,781                             |   | 1,678                           |   | 4,147 |   | 3,352 |   |
| Operating income                            |   | 232                               |   | 489                             |   | 29 |   | 931 |   |
| Interest and other income                   |   | 37                                |   | 46                              |   | 125 |   | 93 |   |
| Net income before tax                       |   | 269                               |   | 535                             |   | 154 |   | 1,024 |   |
| Provision for income tax                    |   | —                            |   | —                          |   | (18 | ) | — |   |
| Net income                                  |   | $                                 | 269    |                            | $      | 535 |   | $ | 136 |   | $ | 1,024 |   |
| ***Net  earnings per share***               |   |                              |   |                            |   |   |   |   |   |
| Basic                                       |   | $                                 | 0.02   |                            | $      | 0.03 |   | $ | 0.01 |   | $ | 0.07 |   |
| Diluted                                     |   | $                                 | 0.02   |                            | $      | 0.03 |   | $ | 0.01 |   | $ | 0.06 |   |
| ***Shares  used in per share computation*** |   |                              |   |                            |   |   |   |   |   |
| Basic                                       |   | 15,765                            |   | 15,705                          |   | 15,755 |   | 15,694 |   |
| Diluted                                     |   | 16,040                            |   | 16,061                          |   | 15,979 |   | 16,016 |   |

 

*See notes to condensed consolidated financial statements*

 

4

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**Statements of Cash Flows****– Six Months Ended June 30, 2003 and 2002 (unaudited)**

**(in thousands)**

 
|                                                                                                |   | **Six months  ended June 30,** |   |
|-----------------------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                                |   | **2003**                       |   | **2002** |   |
| **Operating Activities**                                                                            |   |                           |   |   |   |
| Net income                                                                                          |   | $                              | 136    |   | $ | 1,024 |   |
| ***Adjustments  to reconcile net income to net cash provided by (used in) operating  activities:*** |   |                           |   |   |   |
| Depreciation and amortization                                                                       |   | 153                            |   | 157 |   |
| Amortization of deferred proceeds                                                                   |   | (134                           | )      | (134 | ) |
| Non-cash expense related to stock-based  compensation                                               |   | 24                             |   | 24 |   |
| Amortization of promissory note discount                                                            |   | (16                            | )      | (16 | ) |
| Amortization of deferred compensation                                                               |   | 4                              |   | 2 |   |
| ***Change  in operating assets and liabilities:***                                                  |   |                           |   |   |   |
| Accounts receivable                                                                                 |   | 152                            |   | (888 | ) |
| Inventory                                                                                           |   | (385                           | )      | 418 |   |
| Prepaid expenses                                                                                    |   | 169                            |   | (61 | ) |
| Other current assets                                                                                |   | 2                              |   | 14 |   |
| Accounts payable, trade                                                                             |   | 48                             |   | (568 | ) |
| Accrued salaries and benefits                                                                       |   | (126                           | )      | 111 |   |
| Other accrued liabilities                                                                           |   | (64                            | )      | 169 |   |
| Deferred revenue                                                                                    |   | (2                             | )      | 560 |   |
| Other liabilities                                                                                   |   | 2                              |   | (12 | ) |
| ***Net  cash provided by (used in) operating activities***                                          |   | (37                            | )      | 800 |   |
| **Financing Activities**                                                                            |   |                           |   |   |   |
| Proceeds from issuance of common stock                                                              |   | 10                             |   | 22 |   |
| **Investing Activities**                                                                            |   |                           |   |   |   |
| Purchase of property and equipment                                                                  |   | (47                            | )      | (10 | ) |
| Decrease in deposits                                                                                |   | —                         |   | 45 |   |
| ***Net  cash provided by (used in) investing activities***                                          |   | (47                            | )      | 35 |   |
| ***Net  increase (decrease) in cash and cash equivalents***                                         |   | (74                            | )      | 857 |   |
| **Cash and Cash Equivalents**                                                                       |   |                           |   |   |   |
| At beginning of period                                                                              |   | 4,556                          |   | 3,003 |   |
| At end of period                                                                                    |   | $                              | 4,482  |   | $ | 3,860 |   |

 

*See notes to condensed consolidated financial statements*

 

5

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### **Statements of Stockholders’ Equity** – Six Months Ended June 30, 2003(unaudited)

**(inthousands)**

 
|                                                      |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Deferred  Compensation** |   | **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     |   | 19                |   | (*                               | )      | 24                         |   | —                   |   | —    |   | 24 |   |
|                                                      |   |              |   |                             |   |                       |   |                     |   |      |   |   |   |
| 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 six months ended June 30,  2003            |   | —            |   | —                           |   | —                     |   | —                   |   | 136       |   | 136 |   |
|                                                      |   |              |   |                             |   |                       |   |                     |   |      |   |   |   |
| Balance – June 30, 2003                              |   | 15,765            |   | $                                | 158    |                       | $      | 85,181                   |   | $         | — |   | $ | (73,347 | ) | $ | 11,992 |   |

 

----

(*) rounds to less than $1,000

 

*See notes to condensed consolidated financial statements*

 

6

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**ProCyte Corporation**

### **Notes to 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 Delawarecorporation) and NextDerm, Inc. (a Washington corporation incorporated February28, 2003) (collectively “ProCyte” or the “Company”) for the three and six monthperiods ended June 30, 2003 and 2002 have been prepared by the Company inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and the instructions to Form 10-Qand Article 10 of Regulation S-X. Pursuant to such rules and regulations, the consolidated condensedfinancial statements do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for audited financial statements. Accordingly, this financial information should be read in conjunctionwith the complete audited financial statements, including the notes thereto,which are included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2002.  In the opinionof management, all material adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation of the financialstatements have been included.  Interimresults are not necessarily indicative of the results that may be expected forthe year.

 

*Stock Based Compensation*

 

The Company follows theintrinsic value-based accounting method for stock options contained in APBOpinion No. 25, Accounting for StockIssued to Employees, as permitted by SFAS No. 123, Accounting for Stock-BasedCompensation.  Under this method,no compensation 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 options underthe incentive compensation plan been recognized based upon the fair value forawards granted, the Company’s net earnings or losses would have been changed tothe following pro forma amounts for the three and six months ended June 30,2003 and 2002:

 

|                                                                              |   | **(in  thousands, except per share amounts)** |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                              |   | **Three  months ended June 30,**              |   | **Six months  ended June 30,** |   |
|                                                                              |   | **2003**                                      |   | **2002** |   | **2003** |   | **2002** |   |
| Net income, as reported                                                           |   | $                                             | 269    |   | $ | 535 |   | $ | 136 |   | $ | 1,024 |   |
| Stock option-based compensation expense  determined under fair value-based method |   | 90                                            |   | 115 |   | 217 |   | 184 |   |
| Pro forma net income (loss)                                                       |   | $                                             | 179    |   | $ | 420 |   | $ | (81 | ) | $ | 840 |   |
| Earnings per share:                                                               |   |                                          |   |   |   |   |   |   |   |
| As reported basic                                                                 |   | $                                             | 0.02   |   | $ | 0.03 |   | $ | 0.01 |   | $ | 0.07 |   |
| As reported diluted                                                               |   | $                                             | 0.02   |   | $ | 0.03 |   | $ | 0.01 |   | $ | 0.06 |   |
| Pro forma basic                                                                   |   | $                                             | 0.01   |   | $ | 0.03 |   | $ | (0.01 | ) | $ | 0.05 |   |
| Pro forma diluted                                                                 |   | $                                             | 0.01   |   | $ | 0.03 |   | $ | (0.01 | ) | $ | 0.05 |   |

 

7

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The Company determined the fairvalue of stock options granted during the three and six months ended June 30, 2003and 2002 using the Black-Scholes option pricing model and the followingassumptions:

 

|                         |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
| **Options Granted**          |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Risk-free interest rate      |   | 2.58%-2.69                       | %      | 3.84%-3.92                     | %      | 2.58%-2.81 | % | 3.84%-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          |   | 59%-62                           | %      | 61%-67                         | %      | 59%-62 | % | 61%-67 | % |

 

*Recent accounting pronouncements*

 

In November 2002, the EmergingIssues Task Force (“EITF”) reached a consensus on EITF Issue No. 00-21, RevenueArrangements with Multiple Deliverables. This issue addresses certain aspects of the accounting by a company forarrangements under which it will perform multiple revenue-generating activities.  In applying this issue, generally, separatecontracts with the same customer that are entered into at or near the same timeare presumed to have been negotiated as a package and should, therefore, beevaluated as a single contractual arrangement. This issue also addresses how contract consideration should be measuredand allocated to the separate deliverables in the arrangement.  This issue is applicable to revenuearrangements entered into in fiscal periods beginning after June 15, 2003.  The Company believes current revenuerecognition accounting is consistent with the provisions of EITF Issue No.00-21.  Therefore, the Company does notbelieve that adopting the provisions of EITF Issue No. 00-21 will have a materialeffect on its financial position or results of operations.

 

**2.     AccountsReceivable**

 

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

 
|       |   | **June 30, 2003** |   | **December 31, 2002** |   |
|------------|--------|-------------------|--------|-----------------------|--------|
| Customer A |   | 30                | %      | 44                    | %      |
| Customer B |   | 11                | %      | 13                    | %      |
| Customer C |   | 12                | %      | —                |   |

 

The Company provided anallowance for uncollectable receivables in the amount of $89,000 and $68,000 atJune 30, 2003 and December 31, 2002, respectively.  The bad debt expense, net of recoveries of $3,000 in 2003 and$25,000 in 2002, was $19,000 and $(12,000) for the three months ended June 30,2003 and 2002, respectively.  The baddebt expense, net of recoveries of $5,000 in 2003 and $27,000 in 2002, was$29,000 and $(7,000) for the six months ended June 30, 2003 and 2002,respectively.  Accounts written off tothe allowance account amounted to less than $1,000 and $0 for the three monthsperiod ended June 30, 2003 and 2002, respectively.  Accounts written off to the allowance account amounted to $13,000and $180,000 for the six months period ended June 30, 2003 and 2002,respectively.

 

8

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**3.     Inventory**

 

Inventory consisted of thefollowing:

 
|            |   | **(in  thousands)** |   |
|-----------------|--------|---------------------|--------|
|            |   | **June 30,  2003**  |   | **December  31, 2002** |   |
| Finished Goods  |   | $                   | 1,548  |   | $ | 1,254 |   |
| Work in process |   | 292                 |   | 228 |   |
| Raw materials   |   | 263                 |   | 236 |   |
| **Total**       |   | $                   | 2,103  |   | $ | 1,718 |   |

 

**4.     Propertyand Equipment**

 

Property and equipmentconsisted of the following:

 
|                                              |   | **(in  thousands)** |   |
|---------------------------------------------------|--------|---------------------|--------|
|                                              |   | **June 30,  2003**  |   | **December  31, 2002** |   |
| Equipment                                         |   | $                   | 379    |   | $ | 333 |   |
| Leasehold improvements                            |   | 4,029               |   | 4,029 |   |
| Less accumulated depreciation &  amortization |   | (3,220              | )      | (3,076 | ) |
| Property and equipment, net                       |   | $                   | 1,188  |   | $ | 1,286 |   |

 

**5.     IntangibleAssets**

 

Intangible assets includepatents of $78,000 and $86,000 at June 30, 2003 and December 31, 2002,respectively.  Patents are shown net ofaccumulated amortization of $213,000 and $205,000, at June 30, 2003 andDecember 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 ended June30, 2003 and 2002, respectively, and $8,000 for each of the six-month periodsended June 30, 2003, respectively. Patent amortization expense is expected to be $16,000 for each of the yearsending December 31, 2003 through 2007 and $6,000 for the year ending December31, 2008.

 

Intangible assets also includegoodwill of $2.8 million at June 30, 2003 and at December 31, 2002.  Under the guidance of Statement of FinancialAccounting Standards (SFAS) No. 142 “Goodwill and Other Intangible Assets,” theCompany performed an annual test on the value of certain intangibles such asgoodwill on March 31, 2003.  The Companytested whether there was an indication of goodwill impairment, and concludedthat goodwill was not impaired.  Therewere no events since March 31, 2003, which would cause the Company to changeits valuation as of June 30, 2003.  TheCompany determined that it has one reportable unit, therefore, all of goodwillis deemed to be associated with ProCyte’s overall business operations.

 

9

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**6.     Federaland State Income Taxes**

 

No provision was made forfederal income taxes for the three and six months ended June 30, 2003 and2002.  At June 30, 2003 and December 31,2002, the Company provided a full valuation allowance for its net deferred taxassets.  The Company believes sufficientuncertainty exists regarding the realizability of the deferred tax assets.  The net changes in the valuation allowanceduring the six months ended June 30, 2003 and the year ended December 31, 2002,were $(125,000) and $(627,000), respectively.

 

A provision for stateincome tax was made for California state income tax in the quarter ended March31, 2003.  The Company has a netoperating 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 six months of2003.

 

As of June 30, 2003, theCompany’s U.S. federal net operating loss and general business credit carryforward 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 amount of netoperating 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 ended June 30, 2003 and2002, 275,342 and 356,565 dilutive stock options, respectively, were includedin the calculation of average number of common shares outstanding for dilutedcomputations.  For the three monthsended June 30, 2003 and 2002, options and warrants to purchase 982,508 sharesand 454,167 shares, respectively, of common stock with exercise prices greaterthan the average fair market value of our stock for the period of $1.16 and$1.82, respectively, were not included in the computation of diluted earningsper share because the effect would have been antidilutive.  For the six months ended June 30, 2003 and2002, 223,502 and 321,884 dilutive stock options, respectively, were includedin the calculation of average number of common shares outstanding for dilutedcomputations. For the six months ended June 30, 2003 and 2002, options topurchase 982,508 shares and 454,167 shares, respectively, of common stock withexercise prices greater than the average fair market value of our stock for theperiod of $1.21 and $1.69, respectively, were not included in the computationof diluted earnings per share because the effect would have been antidilutive.

 

**8.     Warrantsto Acquire Common Stock**

 

The Company issued three commonstock purchase warrants totaling 100,000 shares on May 26, 1999 in exchange forservices.  The three warrants oblige theCompany to issue 33,334 shares at $0.6875 per share, the market price on thegrant date, 33,333 shares at $1.6875 and 33,333 shares at $2.6875.  Each of the warrants has a five-year lifeand is fully vested. The fair value of these warrants was determined to be$90,000 using the Black-Scholes option-pricing model and was expensed in1999.  The assumptions used in the modelwere a risk-free interest rate of 4.08%, an expected life of five years, 98%stock price volatility

 

10

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and no dividends over theexpected life.  On January 2, 2002, thefirst warrant for 33,334 shares was exercised in a net exercise, as provided bythe terms of the warrant, resulting in the issuance of 18,549 shares.

 

**9.     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                      |   | 286,000                       |   | $                                     | 1.78   |   |
| Exercised                    |   | (24,503                       | )      | $                                     | 0.90   |   |
| Canceled or expired          |   | (294,498                      | )      | $                                     | 1.90   |   |
| Outstanding, June 30, 2002   |   | 2,054,001                     |   | $                                     | 1.56   |   |

 
|                         |   | **Shares  Subject to Option** |   | **Weighted  Average  Exercise Price** |   |
|------------------------------|--------|-------------------------------|--------|---------------------------------------|--------|
| Outstanding, January 1, 2003 |   | 2,185,335                     |   | $                                     | 1.57   |   |
| Granted                      |   | 157,500                       |   | $                                     | 1.30   |   |
| Exercised                    |   | (12,000                       | )      | $                                     | 0.86   |   |
| Canceled or expired          |   | (85,001                       | )      | $                                     | 3.76   |   |
| Outstanding, June 30, 2003   |   | 2,255,834                     |   | $                                     | 1.47   |   |
| Exercisable, June 30, 2003   |   | 1,639,514                     |   | $                                     | 1.52   |   |

 

The weighted average fair valueof options granted during the three months ended June 30, 2003 and 2002 wereapproximately $0.74 and $1.36, respectively. The weighted average fair value of options granted during the six monthsended June 30, 2003 and 2002 were approximately $0.77 and $1.32, respectively.

 

The Company granted 10,000stock options on February 21, 2002 and 10,000 stock options on May 20, 2002 inexchange for advisory services from two non-employee consultants.  The February and May grants, respectively,oblige the Company to issue 10,000 common stock shares at $1.33 and $1.83, themarket price on the dates of grant. Both grants became fully vested one year after their date of issuance.  The re-measured fair value of the Februaryand May grants on the final measurement date was determined to be $4,000 and$6,000, respectively, using the Black-Scholes option-pricing model.  The options were re-measured on February 28,2003, the date the services were considered completed.  The assumptions, used in the model forre-measuring the February and May grants, were a risk-free interest rate of2.81%, 62% stock price volatility, and no dividends over a one-year expectedlife.

 

**10.  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

 

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effective yield on the 10 YearU.S. Treasury Note, which is adjusted quarterly.  The yield for the quarter ended June 30, 2003 was 3.81%.  Emerald will begin making annual principalpayments of $286,000 in July 2005.  TheCompany also received a minority limited partnership interest in Emerald aspart of consideration received in the sale. As part of the agreement, ProCyte leases a portion of its current 34,532square foot leased facility, including existing leasehold improvements, toEmerald.  A portion of the proceeds fromthe sale in the amount of $1.7 million has been determined to representconsideration for Emerald’s use of the leasehold improvements, and is beingrecognized over the term of the lease. ProCyte engages Emerald Pharmaceutical L.P. to do certain manufacturingand other quality and analytical services. Emerald billed ProCyte for such services a total of $382,000 and $61,000for the three months ended June 30, 2003 and 2002, respectively, and $1.2 millionand $194,000 for the six months ended June 30, 2003 and 2002,respectively.  ProCyte had tradepayables to Emerald of $14,000 and $92,000 on June 30, 2003 and December 31,2002, respectively.

 

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 $157,000 and $204,000 for the three months ended June 30, 2003and 2002, respectively and $344,000 and $421,000 for the six months ended June30, 2003 and 2002, respectively.  Thecustomer’s trade receivable balances were $128,000 and $172,000 on June 30,2003 and December 31, 2002, respectively.

 

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**Item2.  Management’s Discussion and Analysisof 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 the section entitled“Important Factors Regarding Forward-Looking Statements.” These factors maycause our actual results to differ materially from any forward-lookingstatement.

 

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 ourconsolidated 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 June 30, 2003 consisted of goodwill, most of which was acquired inbusiness combinations and recorded based on the fair value of the common stockissued to effect those business combinations.  Under the guidance of SFAS142 “Goodwill and Other Intangible Assets,” we analyze whether the fair valueof recorded goodwill is impaired on an annual basis.  Our analysis ofwhether the fair value of recorded goodwill is impaired involves a substantialamount of judgment, as does establishing and monitoring estimated lives ofamortizable intangible assets.  Future charges related to intangibleassets could be material depending on future developments and changes intechnology 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 June 30, 2003; however, if the financial condition of our customers or otherdebtors were to deteriorate, resulting in an impairment of their ability tomake 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 positive evidenceand the weight given to this evidence is commensurate with the extent to whichit 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.  We have experienced annual revenue growthsince we introduced our first skin care products in 1997.  This growth is a result of product lineexpansion, creation and acquisition of additional brands, an expanding customerbase and our development of additional distribution channels for ourtechnologies.

 

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 test beganin selected markets during March 2003. Continuation of the market test was placed on hold as public and mediaattention focused on the Iraq conflict. A new multi-week market test program was initiated at the end of July2003.  We expect it will require severalweeks to completely analyze the test results in order to determine whether theInfomercial is ready to launch, requires additional adjustments, or should beterminated.  

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*Revenues*

 

The Company’s total revenue forthe second quarter of 2003 decreased to $2.6 million as compared to $3.3million reported in the same quarter in the prior year.  Revenues in the first half of 2003 decreasedto $6.0 million from $6.3 million as compared to the first half of 2002.  The revenue decrease for the quarter andfirst half is largely attributable to lower shipments of ProCyte’s patentedCopper Peptide compound to licensed partners during the second quarter.  The timing and amount of product shipmentsare dependent on customers’ production schedules and can fluctuate widely fromquarter to quarter. In addition, product sales to physicians and distributorsin the 2003 second quarter were lower than in the prior-year period, reflectingthe effects of the soft economy, but were greater than the 2003 firstquarter.  Royalty revenue was lower inthe second quarter of 2003 as compared to the second quarter of 2002, but washigher for the first half of 2003 as compared to the same period in the prioryear.

 

Product sales, which includethe sale of Copper Peptide compounds under license and supply agreements,decreased 21 percent to $2.3 million in the second quarter as compared to $2.9million reported in the 2002 second quarter. Within this category, second quarter physician and distributor sales weredown 9 percent from the prior year quarter while this same category was down 4percent for the first half of 2003; both periods reflecting the impact that thesoft economy had on our customers. Sales of Copper Peptide compounds during the second quarter of 2003 weredown 57 percent as compared to the second quarter of 2002 and were down 22percent for the first six months. Shipments of the Copper Peptide compounds are driven by the purchasingpatterns of our largest licensing partner. While volatile from quarter to quarter, sales to this partner for thefirst half of 2003 were 72 percent greater than the same period in 2002.  Offsetting this increase were zero purchasesof Copper Peptide compound by the other licensing partners, who had purchased$940,000 during the same six-month period in 2002.  These prior period shipments were related to the other licensingpartners’ inventory build up for their initial market launches.  Follow on sales to consumers were muchslower than they anticipated, thereby eliminating their need for material inthe first half of 2003 and reducing the related royalty revenue earned by theCompany as noted below.  It is not knownwhen or if shipments to these others partners will resume and the Company iscurrently evaluating its alternatives with these licensees.

 

For the quarter ended June 30,2003, licensing and royalties revenue decreased 8 percent as compared to thesame period in 2002, but the first half of 2003 reflects a 23 percent increaseas compared to the first half of 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 thefirst six months of 2003 as compared to the same period in 2002, the Company’slargest licensing partner represented a 43% increase in royalty revenue whichwas partially offset by a decline in royalty revenues of 92 percent from theother licensing partners noted above. The Company is currently evaluating itsalternatives with these other licensees.

 

*Gross Profit*

 

In the second quarter of 2003,gross profit decreased 7 percent to $2.0 million as compared to $2.2 millionreported in same quarter in 2002.  Thedecline in gross profit was due to lower revenues, which was mostly offset byhigher gross margin products.  Grossmargin for the second quarter of 2003 was 76.5 percent as compared to 66.4percent in the second quarter of 2002, which is primarily attributable to thehigher ratio of product sales and royalty income versus Copper Peptide compoundsales during the quarter.  For the firsthalf of 2003, gross profit was down 2.5 percent as compared to the comparableyear

 

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earlier period.  This decline was likewise due to the lowerrevenues as compared to the year earlier period, partially offset by thestronger gross margins.  Gross marginsfor the first half of 2003 were 69.9 percent as compared to 67.9 percent reportfor the same six-month period in 2002. Gross margin is sensitive to the revenue mix of packaged products,licensee purchases of Copper Peptide compounds and royalty revenue and willvary from period to period as a result.

 

*Expenses*

 

Total operating expensesincreased 6 percent to $1.8 million in the second quarter of 2003 from $1.7million reported for the same quarter in 2002. Certain reclassifications have been made to operating expenses reportedin the prior year to conform to the current year’s presentation.

 

Marketing and selling expensesfor the quarter, which increased 5 percent to $814,000 as compared to $789,000for the second quarter of 2002, included expenses related to the market testingand post-production work of the infomercial in 2003 along with an increase inadvertising expenses.  The expenses werepartially offset by lower sales commissions and compensation expenses, whichwere primarily due to the lower physician sales.  Year to date, marketing and selling expenses increased $600,000to $2.2 million from $1.6 million in the first half of 2002.  Marketing expenses for the first half of2003 included $687,000 in infomercial related production costs and otherexpenses and an increase in advertising expenses which were partially offset bythe aforementioned lower sales commissions and compensation expense.

 

Research, general andadministrative expenses increased 7 percent to $966,000 in the second quarterof 2003 as compared to $899,000 in the corresponding 2002 period.  The expenses also increased 7 percent to$1.9 million in the first half of 2003 as compared to $1.8 million in the sameperiod in 2002.  This is due toincreased salaries and benefits related to the addition of a Chief FinancialOfficer in the 2003 period, increased legal and audit fees incurred forcompliance with new corporate governance and reporting standards, and increasedlegal fees related to actions initiated by ProCyte to enforce its rights undercertain agreements.  These increaseswere partially offset by decreases in recruiting expenses.

 

*Interest and Other Income*

 

Interest and other incomeearned during the second quarter of 2003 decreased 21 percent to $37,000 ascompared to $46,000 earned in the same quarter in 2002.  The decline in the quarterly income wasprimarily due to declining short term interest rates.  For the six months ended June 30, 2003, theCompany reported a 34 percent increase in interest and other income as comparedto the same six-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.

 

*Income Taxes*

 

As of June 30, 2003 theCompany’s U.S. federal net operating loss and general business tax credit carryforwards for income tax purposes were approximately $68.0 million and $1.6million, respectively.  The Company hasnot yet recognized the benefit of these tax expense savings for future periodearnings.  The Company has had netoperating losses since inception, with the exception of net income reported forthe first time in 2002.  Thus, sufficientuncertainty still exists regarding the realizability of using the deferred taxassets in future periods.  If notutilized, the federal net operating loss carry forward and tax credit carryforwards will expire between 2004 and 2021.

 

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A provision for state incometax was made for California income tax in the first six 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 six months ended June 30, 2003.

 

*Net Income*

 

For the quarter ended June 30,2003, ProCyte reported net income of $269,000 as compared to net income of$535,000 in the same quarter in 2002. This decrease was primarily due to the lower revenues and the aforementionedincrease in operating expenses during the second quarter of 2003.  For the six months ended June 30, 2003, theCompany reported net income of $136,000 as compared to $1.0 million reportedfor the same period in 2002.  TheCompany’s decline in net income for the six-month period was due to the lowerrevenues from 2002 to 2003 and the aforementioned $687,000 expense fordeveloping and testing an infomercial and other related expenses.  At June 30, 2003, the Company’s accumulateddeficit was approximately $73.3 million.

 

*Liquidity and Capital Resources*

 

The Company has reliedprimarily on equity financing, cash flow from operations, interest income andcorporate partnerships to fund its operations and capital expenditures. At June 30, 2003, the Company had approximately $4.5 million in cash and cashequivalents, compared to $4.6 million at December 31, 2002.  The netchange in cash and cash equivalents during the first half of 2003 reflects anet use of cash of $74,000. The significant components of this decrease are disbursementsrelated to the infomercial, payment of 2002 management bonuses and the updatingof the Company’s computer and network systems, which were mostly offset bycollections on the first quarter’s receivables.  We expect to see fluctuations in cash flows from operations infuture periods as they depend in large part on the timing of deposits receivedfrom our strategic partners and their initiation of new product introductions.

 

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, equity financing,and funding from corporate partnerships to meet its future capital needs.  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 42 percent of net revenues during the first half of2003, one of

 

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which accounted forapproximately 33 percent of the Company’s net revenue.  Any decrease in or loss of revenues fromthese customers could have an adverse effect on our net revenues and results ofoperations 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 successful commercializationof the Company’s existing and future products in the consumer and wound caremarkets will depend upon ProCyte’s ability to enter into and effectively managecorporate alliances.  There can be noassurance that the Company will be successful in establishing corporatealliances in the future, or that it will be successful in performing andmaintaining existing or any future corporate alliances.  Moreover, there can be no assurance that theinterests and motivations of any corporate partner, distributor or licenseewould be or will remain consistent with those of the Company, or that theCompany and such partners, distributors or licensees will successfully performthe necessary technology transfer, clinical development, regulatory compliance,manufacturing, marketing, commercialization and other obligations under theiragreements. Any of these failures could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

*Recent Profitability; No Assurance of AchievingConsistent Profitable Earnings*

 

The Company has been launchingproducts based on its proprietary Copper Peptide technology since 1996.  In addition to sales of products based onits 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 six months endedJune 30, 2003, however, 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

 

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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 June 30, 2003, theCompany had cash and cash equivalents of $4.5 million.  The Company estimates that, at its plannedrate of spending, its existing cash and cash equivalents and the interestincome thereon will be sufficient to meet its operating and capitalrequirements for at least the next two years. There can be no assurance, however, that our underlying assumed levelsof revenue and expense will prove accurate. Whether or not these assumptions prove to be accurate, the Company mayneed to raise additional capital. Furthermore, the Company may require additional funds to expand orenhance its sales and marketing activities, to accelerate product development,or to acquire a product line or company. The Company may be required to seek this additional funding throughpublic or private financing, including equity financing, or throughcollaborative arrangements.  Adequatefunds for these purposes, whether obtained through financial markets or fromcollaborative or other arrangements with corporate partners or other sources,may not be available when needed or may not be available on terms favorable tothe Company.  If we issue equitysecurities to raise additional funds, dilution to existing shareholders willresult.  In addition, in the event thatadditional funds are obtained through arrangements with collaborative partners,such arrangements 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 theCompany were 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 June 30, 2003, the Company had 21issued U.S. patents expiring between 2005 and 2017 and numerous issued foreignpatents and patent registrations.  Thepatents relate to use of the Company’s copper-based technology for a variety ofhealthcare applications, and to the composition of certain biologically active,synthesized compounds.  The Company’sstrategy has been to apply for patent protection for certain compounds andtheir discovered uses that are believed to have potential commercial value incountries that offer significant market potential.  There can be no assurance that patent applications relating tothe technology used by

 

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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 thatsuch patent will provide a competitive advantage, will afford protectionagainst competitors with similar technology, or will not be successfullychallenged, 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 the affectedproduct or use the affected process. Costs associated with any licensing arrangement may be substantial andcould include ongoing royalties.  Therecan be no assurance that any license required under any such patent would bemade available to the Company on acceptable terms, if at all.  If such licenses could not be obtained onacceptable terms, the Company could be prevented from manufacturing andmarketing 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 also relies uponnon-patented proprietary technology. There can be no assurance that the Company can meaningfully protect itsrights to such non-patented technology, that any obligation to maintain theconfidentiality of such proprietary technology will not be breached byemployees, consultants, collaborators or others or that others will notindependently 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,

 

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which include wound caredressings 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 claims soughtwill be approved, or that, if cleared, such products will be commerciallysuccessful or free from third party claims relating to the effectiveness orsafety 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 ofoperations.

 

*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.  Thesecompetitors have substantially more financial and other resources, largerresearch 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 for securitiesof healthcare, pharmaceutical and biotechnology companies are subject tovolatility, and the market has from time to time experienced significantfluctuations that are unrelated to the operations of the Company.  ProCyte’s market price has fluctuated over awide range since the Company’s initial public offering in 1989, and since March25, 1999, the Company’s common stock has traded on the NASD OTC bulletinboard.  Because real-time priceinformation may not be easily available for bulletin board securities, aninvestor is likely to find it more difficult to dispose of, or to

 

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obtain accurate quotations onthe market value of, the Company’s securities than if they were listed on a theNasdaq or a national exchange.  Inaddition, purchases and sales of the Company’s securities may become subject toRule 15g-9 of the Exchange Act, which imposes various sales practicerequirements on broker-dealers, or to the “penny stock” rules, either of whichwould likely reduce the level of trading activity in the secondary market forthe Company’s securities and make selling the securities more difficult for aninvestor.

 

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.

 

**Item 3****.  Quantitativeand Qualitative Disclosures about Market Risk**

 

ProCyte did not own anyderivative financial instruments as of June 30, 2003.  The Company isdebt-free and is exposed to interest rate risk to the extent that it hasinvested idle cash balances and the promissory note receivable describedbelow.  At June 30, 2003, the idle cash balances were invested in a UnitedStates Treasury money market fund.  ProCyte employs established policiesand procedures to manage its exposure to changes in the market risk of itsinvestments.  The Company believes that the market risk arising fromholdings of its financial instruments is not material.  The Company holdsa $2.0 million promissory note as a result of the sale of its contractmanufacturing operation to Emerald Pharmaceutical L.P.  The note has avariable interest rate, adjusted quarterly, and is guaranteed by a securityagreement giving ProCyte a first lien position on the assets sold to Emerald.

 

**Item4.  Controls and Procedures**

 

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 andprocedures as of the end of the quarter covered by this report, and, based ontheir evaluation, the Chief Executive Officer and the Chief Financial Officerhave concluded 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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**PartII - Other Information**

 

**Item 1. Legal Proceedings**

 

Not applicable.

 

**Item2.  Changes in Securities and Use of Proceeds**

 

Not applicable.

 

**Item3.  Defaults Upon Senior Securities**

 

Not applicable.

 

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

 

The annual meeting of theshareholders of the Company was held on May 20, 2003.  Two matters were submitted to the shareholders for a vote:  the election of directors and ratifying theappointment of Deloitte & Touche LLP as independent auditors of the Companyfor the year ending December 31, 2003. As of April 8, 2003, the record date, there were 15,764,687 shareseligible to vote at the meeting, of which, 92.45% or 14,574,567 wererepresented at the meeting, constituting a quorum.

 

The five nominees for electionas directors were elected to serve until the 2004 annual meeting of theshareholders, and until the election and qualification of their respectivesuccessors.  The vote for each directorfollows:

 
| **Directors**       |   | **For**    |   | **Withheld** |   |
|---------------------|--------|------------|--------|--------------|--------|
| John F. Clifford    |   | 14,345,929 |   | 228,638      |   |
| Matt L. Leavitt     |   | 14,345,779 |   | 228,788      |   |
| Glenn A. Oclassen   |   | 14,345,929 |   | 228,638      |   |
| Robert E. Patterson |   | 14,345,929 |   | 228,638      |   |
| John M. Hammer      |   | 14,345,929 |   | 228,638      |   |

 

The other proposal was approvedby the shareholders.  The vote was asfollows:

 
| **Proposal**                                                                                                                        |   | **For**    |   | **Against** |   | **Abstain** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|------------|--------|-------------|--------|-------------|--------|
| Ratified the appointment of Deloitte &  Touche LLP as independent auditors of the Company for the year ended December  31, 2003 |   | 14,505,537 |   | 32,875      |   | 36,155      |   |

 

**Item5.  Other Information**

 

Not applicable.

 

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**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 April 24, 2003, reporting the Company’s earnings for the first quarterof 2003.

 

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**Signatures**

 

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

 

 
|                        |   | **ProCyte Corporation (Registrant)**       |
|-----------------------------|--------|--------------------------------------------|
|                        |   |                                       |
|                        |   |                                       |
| Date:  August 13, 2003 | By:    | /s/ John F.  Clifford                      |   |
|                        |   | John F.  Clifford, Chairman and CEO        |
|                        |   |                                       |
|                        |   |                                       |
| Date:  August 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 orcompensatory plan or arrangement.

†        Confidential treatmenthas been granted or requested with respect to portions of this exhibit.

A       Incorporated by referenceto the Registrant’s Registration Statement of Form S-1 (No. 33-31353).

B       Incorporated by referenceto the Registrant’s Registration Statement of Form S-1 (No. 33-46364).

C       Incorporated by referenceto the Registrant’s Annual Report on Form 10-K for the year ended December 31,1994.

D       Incorporated by referenceto the Registrant’s Annual Report on Form 10-K for the year ended December 31,1996.

F        Incorporated by referenceto the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended June30, 1998.

G       Incorporated by referenceto the Registrant’s Amended Annual Report on Form 10-K/A dated December 31,1997.

H       Incorporated by referenceto the Registrant’s Amended Annual Report on Form 10-K/A dated December 31,1998.

I         Incorporated byreference to the Registrant’s Quarterly Report on Form 10-Q for the Quarterended March 31, 2000.

J        Filed herewith.

 

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