** **

**UNITED STATES****SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934.**

 

**For the Quarterly Period EndedSeptember 30, 2002**

 

**CommissionFile Number 0-18044**

 

**PROCYTECORPORATION**

(Exact name of theregistrant as specified in its charter)

 

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

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý   No  o

 

As of November 5,2002, there were issued and outstanding 15,732,244 shares of common stock, parvalue $.01 per share.

 

 

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**ProCyte Corporation**

 

**Index**

 
| **Part I - Financial Information**                                                                             |
|----------------------------------------------------------------------------------------------------------------|
| Item  1. Condensed Consolidated Financial Statements (unaudited)                                               |
| Balance Sheets - as of September 30,  2002 and December 31, 2001                                               |
| Statements of Operations -  Three & Nine Months Ended September 30, 2002 and 2001                          |
| Statements of Cash Flows -  Nine Months Ended September 30, 2002 and 2001                                      |
| Statements of Stockholders’  Equity - Nine Months Ended September 30, 2002 and 2001                       |
| Notes  to Condensed Consolidated Financial Statements (unaudited)                                              |
| Item 2.   Management’s Discussion & Analysis of Financial Condition &  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**                                                                                                 |
| **Certifications**                                                                                             |
| **Exhibit Index**                                                                                              |

 

2

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**Part I****- Financial Information**

 

## **Item1.** CondensedConsolidated Financial Statements (unaudited)

 

### **Balance Sheets** - as of September 30, 2002 and December31, 2001

 
|                                                            |   | **September  30, 2002** |       | **December  31, 2001** |   |
|-----------------------------------------------------------------|--------|-------------------------|------------|------------------------|--------|
| **Assets**                                                      |   |                    |       |                   |   |
| Cash and cash equivalents                                       |   | $                       | 3,845,507  |                   | $      | 3,002,579 |   |
| Accounts receivable, net of allowance for doubtful  accounts    |   | 1,457,752               |       | 956,024                |   |
| Inventory                                                       |   | 1,869,916               |       | 2,218,556              |   |
| Other current assets                                            |   | 270,777                 |       | 328,666                |   |
| ***Total current assets***                                      |   | 7,443,952               |       | 6,505,825              |   |
| Property and equipment, net                                     |   | 1,346,625               |       | 1,554,387              |   |
| Intangible assets, net                                          |   | 2,906,998               |       | 2,919,004              |   |
| Note due from sale of contract manufacturing  operations, net   |   | 1,818,000               |       | 1,794,600              |   |
| Other assets                                                    |   | 140,286                 |       | 36,782                 |   |
| **Total  Assets**                                               |   | $                       | 13,655,861 |                   | $      | 12,810,598 |   |
|                                                            |   |                    |       |                   |   |
| **Liabilities and Stockholders’ Equity**                   |   |                    |       |                   |   |
| Accounts payable and other accrued liabilities                  |   | $                       | 772,418    |                   | $      | 1,084,338 |   |
| Deferred revenue                                                |   | 22,000                  |       | 62,728                 |   |
| ***Total current  liabilities***                                |   | 794,418                 |       | 1,147,066              |   |
| Other liabilities                                               |   | 89,081                  |       | 101,753                |   |
| Deferred proceeds on sale of contract manufacturing  operations |   | 1,293,405               |       | 1,494,106              |   |
| **Total  Liabilities**                                          |   | 2,176,904               |       | 2,742,925              |   |
| Common stock and additional paid-in-capital                     |   | 85,285,019              |       | 85,219,011             |   |
| Accumulated deficit                                             |   | (73,806,062             | )          | (75,151,338            | )      |
| **Stockholders’  Equity**                                  |   | 11,478,957              |       | 10,067,673             |   |
| **Total  Liabilities and Stockholders’ Equity**            |   | $                       | 13,655,861 |                   | $      | 12,810,598 |   |

 

*See notes to condensed consolidated financial statements*

 

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**Statements of Operations****- Three & NineMonths Ended September 30, 2002 and 2001**

 
|                                              |   | **Three  months ended  September 30,** |      | **Nine  months ended  September 30,** |   |
|---------------------------------------------------|--------|----------------------------------------|-----------|---------------------------------------|--------|
|                                              |   | **2002**                               |      | **2001**                              |   | **2002** |   | **2001** |   |
| **Revenues**                                      |   |                                   |      |                                  |   |   |   |   |   |
| Product sales                                     |   | $                                      | 2,735,068 |                                  | $      | 1,756,609 |   | $ | 8,403,713 |   | $ | 6,170,913 |   |
| Licenses and royalties                            |   | 391,427                                |      | 577,852                               |   | 1,028,376 |   | 924,363 |   |
| Contract manufacturing                            |   | —                                 |      | —                                |   | — |   | 195,620 |   |
| Total revenue                                     |   | 3,126,495                              |      | 2,334,461                             |   | 9,432,089 |   | 7,290,896 |   |
| Cost of product sales                             |   | 1,285,907                              |      | 703,061                               |   | 3,308,490 |   | 2,649,887 |   |
| ***Gross profit***                                |   | 1,840,588                              |      | 1,631,400                             |   | 6,123,599 |   | 4,641,009 |   |
| **Operating  Expenses**                           |   |                                   |      |                                  |   |   |   |   |   |
| Marketing and selling                             |   | 728,094                                |      | 719,634                               |   | 2,278,591 |   | 2,326,750 |   |
| General, research and administrative              |   | 840,121                                |      | 958,876                               |   | 2,642,052 |   | 3,186,033 |   |
| Loss on sale of contract manufacturing operations |   | —                                 |      | 9,955                                 |   | — |   | 109,594 |   |
| Total operating expenses                          |   | 1,568,215                              |      | 1,688,465                             |   | 4,920,643 |   | 5,622,377 |   |
| Operating income (loss)                           |   | 272,373                                |      | (57,065                               | )      | 1,202,956 |   | (981,368 | ) |
| Interest and other income                         |   | 49,357                                 |      | 44,996                                |   | 142,320 |   | 102,993 |   |
| Net income (loss)                                 |   | $                                      | 321,730   |                                  | $      | (12,069 | ) | $ | 1,345,276 |   | $ | (878,375 | ) |
| ***Net earnings  (loss) per share***              |   |                                   |      |                                  |   |   |   |   |   |
| Basic                                             |   | $                                      | 0.02      |                                  | $      | (0.00 | ) | $ | 0.09 |   | $ | (0.06 | ) |
| Diluted                                           |   | $                                      | 0.02      |                                  | $      | (0.00 | ) | $ | 0.08 |   | $ | (0.06 | ) |
| ***Shares used in  per share computation***       |   |                                   |      |                                  |   |   |   |   |   |
| Basic                                             |   | 15,721,705                             |      | 15,595,502                            |   | 15,703,200 |   | 15,563,318 |   |
| Diluted                                           |   | 16,031,445                             |      | 15,595,502                            |   | 15,995,866 |   | 15,563,318 |   |

 

*See notes to condensed consolidated financial statements*

 

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### **Statements of CashFlows** - NineMonths Ended September 30, 2002 and 2001

 
|                                                                                                       |   | **Nine  months ended September 30,** |      |
|------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|-----------|
|                                                                                                       |   | **2002**                             |      | **2001** |   |
| **Operating  Activities**                                                                                  |   |                                 |      |   |   |
| Net income (loss)                                                                                          |   | $                                    | 1,345,276 |   | $ | (878,375 | ) |
| ***Adjustments to  reconcile net income (loss) to net cash provided by (used) in operating  activities:*** |   |                                 |      |   |   |
| Depreciation and amortization                                                                              |   | 235,857                              |      | 478,216 |   |
| Loss on sale of contract manufacturing operations                                                          |   | —                               |      | 109,594 |   |
| Amortization of promissory note discount                                                                   |   | (23,400                              | )         | (5,200 | ) |
| Amortization of deferred gain                                                                              |   | (200,701                             | )         | (66,900 | ) |
| Amortization of deferred compensation                                                                      |   | 4,448                                |      | — |   |
| Stock issued in payment of expenses                                                                        |   | 36,000                               |      | 36,000 |   |
| ***Change in  operating assets and liabilities:***                                                         |   |                                 |      |   |   |
| Accounts receivable                                                                                        |   | (501,728                             | )         | 134,633 |   |
| Inventory                                                                                                  |   | 348,640                              |      | 126,998 |   |
| Other current assets                                                                                       |   | (90,615                              | )         | (87,239 | ) |
| Accounts payable and other accrued liabilities                                                             |   | (311,920                             | )         | (25,585 | ) |
| Deferred revenue                                                                                           |   | (40,728                              | )         | (121,049 | ) |
| Other liabilities                                                                                          |   | (12,672                              | )         | 19,071 |   |
| ***Net cash provided  by (used in) operating activities***                                                 |   | 788,457                              |      | (279,836 | ) |
| **Financing  Activities**                                                                                  |   |                                 |      |   |   |
| Proceeds from issuance of common stock                                                                     |   | 25,560                               |      | 65,847 |   |
| **Investing  Activities**                                                                                  |   |                                 |      |   |   |
| Purchase of property and equipment                                                                         |   | (16,089                              | )         | (29,179 | ) |
| Proceeds from sale of property and equipment                                                               |   | —                               |      | 212,243 |   |
| Investment in Emerald Pharmaceutical LP                                                                    |   | —                               |      | (1,000 | ) |
| Decrease in other assets                                                                                   |   | 45,000                               |      | 18,617 |   |
| ***Net cash provided  by investing activities***                                                           |   | 28,911                               |      | 200,681 |   |
| ***Net increase  (decrease) in cash and cash equivalents***                                                |   | 842,928                              |      | (13,308 | ) |
| **Cash  and Cash Equivalents**                                                                             |   |                                 |      |   |   |
| At beginning of period                                                                                     |   | 3,002,579                            |      | 2,773,474 |   |
| At end of period                                                                                           |   | $                                    | 3,845,507 |   | $ | 2,760,166 |   |
| **Supplemental  Non-Cash Financing Activities**                                                            |   |                                 |      |   |   |
| Promissory note received from sale of contract  manufacturing operations                                   |   | —                               |      | $ | 2,000,000 |   |
| Stock options granted in payment of expenses                                                               |   | $                                    | (17,453   | ) | — |   |

### ** **

*See notes to condensed consolidated financial statements*

 

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### **Statements ofStockholders**’Equity - Nine Months Ended September 30, 2002 and 2001

 
|                                                                                            |   |             |   |          |    | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Deferred  Compen-  sation** |        | **Total** |   |
|-------------------------------------------------------------------------------------------------|--------|------------------|--------|---------------|---------|----------------------------------|--------|--------------------------|--------|-------------------------------|-------------|-----------|--------|
|                                                                                            |   | **Common Stock** |   |
|                                                                                            |   | **Shares**       |   | **Par Value** |    |
| Balance – January 1, 2001                                                                  |   | 15,514,700       |   | $             | 155,147 |                             | $      | 84,950,018               |   | $                             | (74,244,144 | )         | — |   | $ | 10,861,021 |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Shares issued under non-employee director stock plan                                            |   | 39,892           |   | 399           |    | 35,601                           |   | —                   |   | —                        |        | 36,000    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Shares issued upon exercise of options                                                          |   | 88,002           |   | 880           |    | 64,967                           |   | —                   |   | —                        |        | 65,847    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Net loss for Nine months ended September 30, 2001                                               |   | —           |   | —        |    | —                           |   | (878,375                 | )      | —                        |        | (878,375  | )      |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Balance – September 30, 2001                                                               |   | 15,642,594       |   | $             | 156,426 |                             | $      | 85,050,586               |   | $                             | (75,122,519 | )         | — |   | $ | 10,084,493 |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Balance – January 1, 2002                                                                  |   | 15,653,542       |   | $             | 156,535 |                             | $      | 85,062,476               |   | $                             | (75,151,338 | )         | — |   | $ | 10,067,673 |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Shares issued under non-employee director stock plan                                            |   | 22,792           |   | 228           |    | 35,772                           |   | —                   |   | —                        |        | 36,000    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Shares issued at $0.6875 under a stock warrant  issued on May 26, 1999 in exchange for services |   | 18,549           |   | 185           |    | (185                             | )      | —                   |   | —                        |        | —    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Shares issued upon exercise of options                                                          |   | 28,837           |   | 287           |    | 25,273                           |   | —                   |   | —                        |        | 25,560    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Compensatory stock option grants                                                                |   |             |   |          |    | 17,453                           |   |                     |   | (17,453                       | )           | —    |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Amortization of deferred compensation                                                           |   |             |   |          |    |                             |   |                     |   | 4,448                         |        | 4,448     |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Net income for nine months ended September 30, 2002                                             |   | —           |   | —        |    | —                           |   | 1,345,276                |   | —                        |        | 1,345,276 |   |
|                                                                                            |   |             |   |          |    |                             |   |                     |   |                          |        |      |   |
| Balance – September 30, 2002                                                               |   | 15,723,720       |   | $             | 157,235 |                             | $      | 85,140,789               |   | $                             | (73,806,062 | )         | $      | (13,005 | ) | $ | 11,478,957 |   |
|                                                                                                 |        |                  |        |               |         |                                  |        |                          |        |                               |             |           |        |  |  |  |  |  |  |  |  |

 

*Seenotes to condensed financial statements*

 

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**ProCyte Corporation**

### **Notes** to Condensed Consolidated FinancialStatements (unaudited)

 

**1.****             ****Basis of Presentation**

 

The accompanyingcondensed consolidated financial statements (unaudited) include the accounts ofProCyte Corporation and its wholly-owned, non-operating subsidiary NextDerm,Inc. (collectively “ProCyte” or the “Company”) for the three-monthand nine- month periods ended September 30, 2002 and 2001 have beenprepared by the Company in accordance with accounting principles generallyaccepted in the United States of America for interim financial information andthe instructions to Form 10-Q and Article 10 of Regulation S-X.  Pursuant to such rules and regulations, theconsolidated condensed financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for audited financial statements.  Accordingly, this financial informationshould be read in conjunction with the complete audited financial statements,including the notes thereto, which are included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2001.  In the opinion of management, all material adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation ofthe financial statements have been included. Interim results are not necessarily indicative of the results that maybe expected for the year.

 

**2.****             ****Accounts Receivable**

 

Two customers eachrepresented greater than 10% of the net accounts receivable balance atSeptember 30, 2002 and December 31, 2001 as follows:

 
|       |   | **September 30, 2002** |   | **December 31, 2001** |   |
|------------|--------|------------------------|--------|-----------------------|--------|
| Customer A |   | 34                     | %      | 22                    | %      |
| Customer B |   | 19                     | %      | 13                    | %      |

 

The Company provided areserve for uncollectable receivables in the amount of $90,029 at September 30,2002 and $243,213 at December 31, 2001. The bad debt expense, net of recoveries, was $11,799 and $177,664 forthe three months ended September 30, 2002 and 2001, respectively, and$4,889 and $187,875 for the nine months ended in September 30, 2002 and 2001,respectively.

 

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

 

Inventory afterconsideration for excess and obsolete items consisted of the following:

 
|            |   | **September 30, 2002** |      | **December 31, 2001** |   |
|-----------------|--------|------------------------|-----------|-----------------------|--------|
| Finished Goods  |   | $                      | 963,462   |                  | $      | 925,422 |   |
| Work in process |   | 53,282                 |      | 350,969               |   |
| Raw materials   |   | 853,172                |      | 942,165               |   |
| **Total**       |   | $                      | 1,869,916 |                  | $      | 2,218,556 |   |

 

7

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**4.     Propertyand Equipment**

 

Property and equipmentconsisted of the following:

 
|                                             |   | **September 30, 2002** |      | **December 31, 2001** |   |
|--------------------------------------------------|--------|------------------------|-----------|-----------------------|--------|
| Equipment                                        |   | $                      | 326,171   |                  | $      | 310,082 |   |
| Leasehold improvements                           |   | 4,028,807              |      | 4,028,807             |   |
| Less accumulated depreciation & amortization |   | (3,008,353             | )         | (2,784,502            | )      |
| Property and equipment, net                      |   | $                      | 1,346,625 |                  | $      | 1,554,387 |   |

 

**5.****             ****Intangible Assets**

 

Intangible assets includepatents of $89,627 and $101,633 and goodwill of $2,817,371 and $2,817,371 atSeptember 30, 2002 and December 31, 2001, respectively.  Intangible assets are shown net ofaccumulated amortization of $1,059,444 and $1,047,438, at September 30, 2002and December 31, 2001, respectively. Patents are amortized over the term of the patent and the estimatedamortization expense related thereto is $16,000 for each of the years endingDecember 31, 2002 through 2007 and $6,000 for the year ending December 31,2008.

 

On January 1, 2002, theCompany implemented the guidance of Statement of Financial Accounting Standards(SFAS) No. 142 “Goodwill and Other Intangible Assets” in recognizing certainintangibles as goodwill and assessing potential future impairments ofgoodwill.  The Company performed anannual test on the value of its goodwill under the guidance of SFAS 142 onMarch 31, 2002, and did not identify the need to recognize any impairment ofvalue at that time.  There were noevents since March 31, 2002, which would cause the Company to change itsvaluation as of September 30, 2002. This analysis was based on one reportable unit.  All of goodwill is deemed to be associatedwith ProCyte’s overall business operations. The Company’s amortization expense for goodwill was $61,259 and $183,776in the three and nine months ended September 30, 2001, respectively.  The net income (loss) for the three and thenine months then ended would have been $49,190 and $(694,599), or $0.00 and$(0.04) net loss per share, if goodwill had not been amortized.

 

**6.****             ****Federal Income Taxes**

 

No provision was made forincome taxes for the three and nine months ended September 30, 2002 and2001.  At September 30, 2002 andDecember 31, 2001, the Company provided full valuation allowance for its netdeferred tax assets.  The Companybelieves sufficient uncertainty exists regarding the realizability of thedeferred tax assets.  The net changes inthe valuation allowance, during the nine months ended September 30, 2002 andyear ended December 31, 2001, were $(1,205,134) and $600,000, respectively.

 

As of September 30, 2002,the Company’s U.S. federal net operating loss and general business credit carryforward for income tax purposes were approximately $25.9 million.  If not utilized, the federal net operatingloss carry forward and tax credits carry forward will expire between 2004 and2021.  Changes in ownership, as definedby Section 382 of the IRC, may limit the amount of net operating loss carryforward used in any one year.

 

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**7.     Stockholders’Equity**

 

Information relating tostock options granted, exercised, canceled and currently exercisable is asfollows:

 
|                              |   | **Shares Subject to Option** |   | **Weighted Average  Exercise Price** |   |
|-----------------------------------|--------|------------------------------|--------|--------------------------------------|--------|
| Balance – January 1, 2001    |   | 2,081,861                    |   | $                                    | 1.63   |   |
| Granted                           |   | 118,000                      |   | $                                    | 1.21   |   |
| Exercised                         |   | (88,002                      | )      | $                                    | 0.75   |   |
| Canceled                          |   | (293,781                     | )      | $                                    | 1.82   |   |
| Balance – September 30, 2001 |   | 1,818,078                    |   | $                                    | 1.61   |   |

 
|                              |   | **Shares Subject to Option** |   | **Weighted Average  Exercise Price** |   |
|-----------------------------------|--------|------------------------------|--------|--------------------------------------|--------|
| Balance – January 1, 2002    |   | 2,087,002                    |   | $                                    | 1.57   |   |
| Granted                           |   | 294,500                      |   | $                                    | 1.77   |   |
| Exercised                         |   | (28,837                      | )      | $                                    | 0.89   |   |
| Canceled                          |   | (323,164                     | )      | $                                    | 1.84   |   |
| Balance – September 30, 2002 |   | 2,029,501                    |   | $                                    | 1.57   |   |
| Currently Exercisable             |   | 1,305,550                    |   | $                                    | 1.67   |   |

 

At September 30, 2002,the Company’s 1996 Stock Option Plan had 648,328 shares of the Company’s commonstock available, which included the 750,000 shares approved for the plan at theCompany’ annual shareholders meeting on May 21, 2002.

 

The Company issued 8,524shares on October 1, 2002, in payment of the Board of Director retainers forthe third quarter.  As of October 2,2002, the Company’s 1998 Non-employee Director Stock Plan had 146,951 shares ofthe Company’s common stock available.

 

The Company granted10,000 stock options on February 21, 2002 and 10,000 stock options on May 20,2002 in exchange 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 become fully vested one year after their date ofissuance.  The fair value of theFebruary and May grants was determined to be $6,448 and $11,005, respectively,using the Black-Scholes option pricing model. The assumptions used in the model for the February and May grants,respectively, were a risk-free interest rate of 3.84% and 3.92%, 67% and 61%stock price volatility, and no dividends over the two year expected lives.  The fair values are reported as deferredcompensation in Stockholders’ Equity, and are being amortized as an operatingexpense over the expected lives.

 

The Company issued threecommon stock purchase warrants for 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

 

9

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$90,117 using theBlack-Scholes option-pricing model and was expensed in 1999.  The assumptions used in the model were arisk-free interest rate of 4.08%, an expected life of five years, 98% stockprice volatility and no dividends over the expected life.  On January 2, 2002, the first warrant for33,334 shares was exercised in a net exercise, as provided by the terms of thewarrant, resulting in the issuance of 18,549 shares.

 

**8.****             ****Related Party Disclosure**

 

The Company owns apromissory note in the principle amount of $2,000,000 from EmeraldPharmaceutical L.P., which it received as partial consideration for the sale ofits contract manufacturing operations in 2001. The note is secured by the manufacturing assets sold and bears interestequal to the effective yield on the 10 Year US Treasury Note, which is adjustedquarterly.  The average yield for thethree and nine months ended September 30, 2002 was 4.80% and 5.07%,respectively.  Emerald will begin makingannual principal payments of $285,714 in July 2005.  The Company also received a minority limited partnership interestin Emerald as part of consideration received in the sale.  As part of the agreement, ProCyte leases aportion of its current 32,750 square foot leased facility, including existingleasehold improvements, to Emerald. Also included in the proceeds is $1,627,906, which is being recognizedover the term of the lease for Emerald’s use of the leaseholdimprovements.  ProCyte engages EmeraldPharmaceutical L.P. to do certain manufacturing and other quality andanalytical services.  Emerald billedProCyte a total of $643,450 and $175,394 for the three months ended September30, 2002 and 2001, respectively, and $836,521 and $175,394 for the nine monthsended September 30, 2002 and 2001, respectively.  Such amounts were mostly related to manufacturing activities thatflows into inventory and then cost of product sales.  ProCyte had trade payables to Emerald of $17,640 and $44,155 onSeptember 30, 2002 and December 31, 2001, respectively.

 

One of the Company’sDirectors also serves as Chairman and Chief Executive Officer of one ofProCyte’s customers.  ProCyte’s sales tothe customer were $298,038 and $127,667 for the three months ended September30, 2002 and 2001, respectively, and $606,582 and $367,502 for the nine monthsended September 30, 2002 and 2001, respectively.  The customer’s trade receivable balances were $273,839 and$122,165 on September 30, 2002 and December 31, 2001, respectively.

 

At September 30, 2002 andDecember 31, 2001, respectively, an Officer owed the Company $105,058 and$117,904, respectively.  The originalpromissory note, dated December 16, 1998, beared interest at 4.28%, compoundedsemi-annually, which was payable at June 30, 2002.  In the first quarter of 2002, the Compensation Committee of theBoard of Directors agreed to extend the note’s due date an additional two yearsto June 30, 2004.  The extendedpromissory note agreement, dated June 30, 2002, bears interest at theapplicable federal short-term rate at June 30, 2002 of 2.91%, which is payableannually.

 

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## **Item 2.  Management’sDiscussion & Analysis of Financial Condition & Results of Operations**

 

This Form 10-Q containsforward-looking statements.  In somecases you can identify forward-looking statements by terminology such as“believe,” “expect,” “intend,” “anticipate,” “estimate,” “predict,”“potential,” “propose” or “continue,” variations of such words and similarexpressions identifying forward looking statements.  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 That May Affect Results.”

 

Although we believe theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, performance orachievements.  You are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date of this report. This report should be read in conjunction with theCompany’s Annual Report on Form 10-K for the year ended December 31, 2001 andother reports of the Company filed with the U.S. Securities and ExchangeCommission (SEC).  The Companyundertakes no obligation to update publicly any forward-looking statements toreflect new information, events or circumstances after the date of this report,or to reflect the occurrence of unanticipated events.

 

*Critical Accounting Policies and Estimates*

 

The “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”, aswell as disclosures included elsewhere in this Form 10-Q, are based upon ourfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingencies.  On an ongoing basis,we evaluate the estimates used, including those related to impairment anduseful lives of intangible assets, allowances for accounts receivable and forexcess and obsolete inventory.  We baseour estimates on historical experience, current conditions and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources, aswell as identifying and assessing our accounting treatment with respect tocommitments and contingencies.  Actualresults may differ from these estimates under different assumptions orconditions.  We believe the followingcritical accounting policies involve the more significant judgments andestimates used in the preparation of the consolidated financial statements.

 

Product revenues arerecognized when products are shipped, license fees are recognized over the termof the license 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 21% ofProCyte’s assets as of September 30, 2002 consist of goodwill, most of whichwas acquired in business combinations and recorded based on the fair value ofthe common stock issued to effect those business combinations.  Under the guidance of SFAS 142 “Goodwill andOther Intangible Assets” we analyze whether the fair value of recorded goodwillis impaired on an annual basis.  Ouranalysis of whether the fair value of recorded goodwill is impaired involved asubstantial amount of judgment, as does establishing and monitoring estimatedlives of amortizable intangible assets. Future charges related to intangible assets could be material dependingon future developments and changes in technology and our business.

 

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We maintain an allowancefor doubtful accounts for estimated losses resulting from the potentialinability of our customers to make required payments.  We believe such allowances are adequate as of September 30, 2002;however, if the financial condition of our customers or other debtors were todeteriorate, resulting in an impairment of their ability to make payments tous, additional allowances may be required.

 

Inventories are stated atthe lower of cost or market value.  Costis principally determined by the first-in, first-out method.  The Company records adjustments to the valueof inventory based upon its forecasted plans to sell its inventories.  The physical condition (e.g., age andquality) of the inventories is also considered in establishing itsvaluation.  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.

 

*Corporate Overview*

 

ProCyte continues toexecute its strategic plan of expanding the use and consumer acceptance of GHKand AHK Copper Peptide technologies via licensing of such technologies toothers.  During 2002, three additionalconsumer companies launched products containing licensed copper peptidetechnology into the spa and salon markets. Also, Neutrogena is expanding the introduction of its already successfulVisibly Firmä product line into the internationalmarket.

 

In addition, ProCytecontinues to develop and market its own brands of skin health and hair careproducts which are sold through its direct sales force and selecteddistributors.  The Company continues tofocus its direct sales efforts on the specialty skin health and procedure basedsector, marketing its products to dermatologists, and plastic and cosmeticsurgeons.

 

The Neova® anti-agingtherapy products continue to be the primary focus of the Company in thephysician market.  Third party studiespresented at the American Academy of Dermatology in February 2002 clearlyshowed the improvements to skin tone, texture and reductions in fine line andwrinkles with products containing GHK Copper Peptide Complexäversus other materials.  These studiesalso confirmed the importance of the complexed peptide protection of copperversus uncomplexed copper salts.  Theupdated TiSilc® sunscreen product line is also a strong category and has been acontributor to sales growth for the Company.

 

The Company alsocontinues to emphasize its Complex Cu3® Intensive RepairCreme, Lotion, Cleanser and Hydrating Gel products to treat patients followingchemical peels, microdermabrasion and laser treatments.  The Complex Cu3®System allows the Company to differentiate its line of skin care products onthe basis of its proprietary Copper Peptide technology.  Over the past year there have been anincreasing number of independent physician studies supporting the use of theGHK Copper Peptide containing Complex Cu3® products.

 

The GraftCyte®line of wound care products containing GHK Copper Peptide Complexä areused following hair restoration surgery. ProCyte is the only company to provide a comprehensive line of productsthat address the importance of wound repair in the hair transplant procedure.  Sales in this segment continue to show goodgrowth and physician acceptance.

 

The Company markets itsTricomin® line of Triamino Copper ComplexTM containing hair careproducts to physicians and directly to consumers through its web site atwww.tricomin.com.  Tricomin®shampoos,

 

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conditioners, andfollicle therapy solution are positioned to participate in the rapidly growing$1.5 billion worldwide hair care market as a program for the maintenance ofthinning hair for both men and women. Hair follicles require high concentrations of biological copper, and theTricomin® products deliver copper along with amino acids fornourishing and stimulating the hair and scalp for improved health, strength andappearance.

 

*Net Income (Losses)*

 

ProCyte  reported net income for the third quarter of2002 of $321,730 as compared to a net loss of $12,069 in the same quarter in2001.  Through the first nine months of2002, the Company reported net income of $1,345,276 as compared to a net lossof $878,375 reported for the same period last year.  From ProCyte’s inception through December 31, 2001, the Company’srevenues were exceeded by the costs associated with researching and developingits proprietary technology and selling and marketing its products.  Last year the Company achieved important milestonesby increasing product sales, signing strategic licensing agreements and sellingits loss-generating contract manufacturing operations.  At September 30, 2002, the Company’saccumulated deficit was approximately $73.8 million.  The Company’s U.S. Federal net operating loss carry forward andgeneral business tax credit carry forward for income tax purposes totaledapproximately $25.9 million as of September 30, 2002.  The Company has not yet recognized the benefit of these taxexpense savings for future period earnings. The Company’s history of producing net income is still less than oneyear.  Thus, sufficient uncertaintystill exists regarding the realizability of using the deferred tax assets infuture periods.  Also, if not utilized,the federal net operating loss carry forward and tax credits carry forward willexpire between 2004 and 2021.

 

*Revenues*

 

The Company’s totalrevenue for the third quarter of 2002 increased 34% to $3.1 million from $2.3million reported in the year-earlier period. Total revenue for the first nine months increased 29% to $9.4 million ascompared to $7.3 million reported for the same period in 2001.  In July of 2001, the Company sold itscontract manufacturing operations to Emerald Pharmaceutical L.P.  Total revenue, excluding contractmanufacturing revenue, increased 33% for the nine-month period ended September30, 2002, as compared to the same period in the prior year.

 

Product sales for thethird quarter increased 56% to $2,735,068, from $1,756,609 reported in the yearearlier period.  Product sales for the firstnine months increased 36% to $8,403,713 as compared to $6,170,913 reported inthe year-earlier period.  Product salesto physicians and distributors were up 33% and 29% for the three- andnine-month periods in 2002, respectively, as compared to the same periods in2001.  GHK and AHK Copper Peptide salesto ProCyte’s licensing partners are up 143% in the third quarter and 56% fornine months ended 2002, principally due to increased purchases by Neutrogena,which launched its GHK Copper Peptide Complexäbased skin care products in Europe during 2002.

 

ProCyte’s third quarterroyalty revenue decreased 32% to $391,427 from $577,852 reported for the sameperiod in 2001.  For the nine months,royalties increased 11% to $1,028,376, a $104,013 increase as compared to thesame prior-year period.  Royaltyrevenues will fluctuate from quarter to quarter, due to the licensees’ timingof new market launches, special promotions and other factors beyond theCompany’s control.

 

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Interest and other incomefor the third quarter of 2002 increased 10% to $49,357 as compared to $44,996earned in the same quarter in 2001. For the nine months ended September 30,2002, interest and other income increased 38% to $142,320 as compared to$102,993 reported for the same period in 2001. Interest and other income in the third quarter and for the nine monthsincreased primarily due to the Company’s higher average cash balance during the2002 periods as compared to the same periods in 2001.  For the quarter and nine-month periods ended September 30, 2002,ProCyte received interest payments of $24,172 and $75,819, respectively, fromEmerald Pharmaceutical L.P. on a $2,000,000 promissory note as compared to$21,621**receivedfor both the comparable quarter and nine month periods in 2001.  The Company realized lower market yields onits cash reserves in 2002 as compared to 2001.

 

*Expenses*

 

In the third quarter of2002, gross profit increased 13% to $1,840,588 (59% gross margin) as compared to$1,631,400 (70% gross margin) reported for the same quarter in 2001.   Gross profit for the nine months endedSeptember 30, 2002 increased 32% to $6,123,599 (65% gross margin) as comparedto $4,641,009 (64% gross margin) reported for the same period of 2001.   ProCyte experiences fluctuating grossmargins from quarter to quarter based on the revenue mix of products, licenseepurchases of GHK and AHK Copper Peptide for their products and royalty revenue.

 

Total operating expensesdecreased 7% in the third quarter of 2002 to $1,568,215 from $1,688,465reported for the same quarter in 2001. For the nine months ended September 30, 2002 expenses decreased 12% to$4,920,643 as compared to $5,622,377 reported for the same period in 2001.  The Company’s operating expenses continue tobe lower than reported in the same periods last year as a result of the sale ofthe Company’s contract manufacturing operations in July 2001.  The Company began presenting marketing andselling expenses separately from general and administrative expenses in2002.  The Company has reclassifiedcertain expenses in both 2002 and 2001 to more clearly present the comparisonbetween the two years.  Marketing and sellingexpenses remain consistent with the prior year, as the Company continues toleverage more revenue out of its existing expenditure level.  General and administrative expenses are down12% in the third quarter and 17% for the first nine months of 2002 as comparedto the same periods in the prior year, primarily due to the sale of thecontract manufacturing operations.

 

*Liquidity and Capital Resources*

 

The Company has reliedprimarily on equity financing, revenue, interest income and corporatepartnerships to fund its operations and capital expenditures.  At September 30, 2002, the Company hadapproximately $3.8 million in cash and cash equivalents, compared to $3.0million at December 31, 2001.  The netchange in cash and cash equivalents during the nine months ended September 30,2002 reflects a net cash flow of $842,928, which is primarily from operatingactivities.  We expect to seefluctuations in accounts receivable, inventory, accounts payable and deferredrevenues over the next several quarters as our strategic partners continue toinitiate product introductions.

 

ProCyte did not own anyderivative financial instruments as of September 30, 2002.  The Company is debt-free and is exposed tointerest rate risk only to the extent that it has invested idle cash balances.  At September 30, 2002, such balances wereinvested in a United States Treasury money market fund.  ProCyte employs established policies andprocedures to manage its exposure to changes in the market risk of itsinvestments.  The Company believes thatthe market risk arising from holdings of its investment is not material.  The Company holds a $2 million promissorynote as a result of the sale of its

 

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contract manufacturingoperation to Emerald Pharmaceutical LP. The note is guaranteed by a security agreement, which gives ProCyte afirst lien position on the assets sold to Emerald.

 

The Company believes thatits existing cash and cash equivalents and interest thereon, will be sufficientto meet its working capital requirements for at least the next twelve months.  However, there can be no assurance that theunderlying assumed levels of revenue and expense will prove accurate. TheCompany will depend on product revenues, royalties and license fees, assetredeployment, interest income, equity financing, and funding from corporatepartnerships to meet its future capital needs. See “Additional Factors That MayAffect Results– Need for Additional Capital”.

 

*Additional Factors That May Affect Results*

 

In addition to the otherinformation contained in this report and our other reports filed with the SEC,the following factors could affect the Company’s actual results and could causeour actual results to differ materially from those achieved in the past orexpressed in our forwarding-looking statements.

 

*History of Operating Losses; Accumulated Deficit;Fluctuations in Future Earnings*

 

The Company has beenlaunching products based on its proprietary Copper Peptide technologies sincemid-1996.  It expects to continue tolaunch new Copper Peptide based products in the future.  To date, the Company has generated increasingrevenues from sales of products based on its proprietary technology andlicensing agreements, but there can be no assurance that the Company cancontinue to generate sufficient revenues to sustain a profitable level ofoperations.  As of September 30, 2002,the Company’s accumulated deficit was approximately $73.8 million.  In addition to sales of products based onits proprietary Copper Peptide technologies, the Company’s revenues havehistorically included sales of non-proprietary products, license fees androyalties, revenue from contract services and interest income.  The contract manufacturing operation wassold in July 2001.  There can be noassurance that the Company can sustain a consistent and profitable level ofoperations.  Sustained profitability isdependent on a wide variety of factors, including the Company’s ability tosuccessfully manufacture and market its products, enter into agreements withcorporate partners for commercialization of the Company’s products, and licensethe Company’s products and technology. Payments under corporate partnerships and licensing arrangements, ifany, may be subject to fluctuations in both timing and amounts.  Moreover, the Company’s level ofprofitability, if any, cannot be predicted and may vary significantly fromquarter to quarter.

 

*Need for Additional Capital*

 

In the first nine monthsof 2002, the Company, for the first time since its inception, generated netincome and cash from operations.  TheCompany may require additional funds to sustain, expand or enhance its salesand marketing activities, continue product development, acquire a product lineor company, or fund additional distribution channels.  The Company’s future capital requirements will depend on numerousfactors, including: its efforts, and the efforts of its collaborative partners,to commercialize its products; the continued progress in the Company’s researchand development programs; the relationships with existing and future corporatecollaborators, if any; the competing technological and market developments; thecosts involved in filing, prosecuting and enforcing patent claims; and the timeand costs of commercialization activities. As of September 30, 2002, the Company had cash and cash equivalents of$3.8 million.  The Company estimatesthat, at its planned rate of spending, its existing cash and cash equivalentsand the interest income thereon will be sufficient to meet its capitalrequirements for at least the next twelve months.  There can be no assurance that the underlying assumed levels ofrevenue and expense will prove accurate. Whether or not these assumptions prove to be

 

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accurate, the Company mayneed to raise additional capital.  TheCompany may be required to seek additional funding through public or privatefinancing, including equity financing, or through 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 issuing equity securitiesraises 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 and developmentprograms; sell assets; 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.

 

*Uncertainties Related to Product Commercialization andDevelopment*

 

From its inception in1986, the Company has dedicated substantially all of its resources to theresearch and development of wound healing, hair growth and other therapeuticpharmaceutical applications of its Copper Peptide compounds. The Companylaunched its first commercial product in 1996. To date, the Company has generated increasing revenue from the sales ofproducts based on its proprietary Copper Peptide technology.  There can be no assurance that the Company’scurrent products or future products, will be successfully commercialized andaccepted for use by physicians, healthcare providers and consumers on a long-termbasis.

 

*Dependence on and Management of Existing and FutureCorporate Alliances*

 

The Company has enteredinto collaborative arrangements or programs with several partners, includingNeutrogena, American Crew, Medical Hair Restoration and Atelier Esthetique. Thelevel of each collaborator’s involvement and support and the amount and timingof resources it will give or the amount of product it will purchase from theCompany under these agreements, arrangements, or programs are not within thecontrol of ProCyte and can significantly impact ProCyte’s ability to achieveits objectives.  There can be noassurance that these collaborators will perform their contractual obligationsor intentions as expected or that the Company will derive revenue from sucharrangements.  Moreover, the agreementsor business could be terminated.  TheCompany expects to rely on these and additional agreements, arrangements, orprograms to develop, commercialize, promote and sell its present and futureproducts.  The Company may not be ableto negotiate acceptable agreements in the future.  Moreover, new agreements or existing agreements may not besuccessful. If any collaborator breaches or terminates its agreement, or failsto conduct its collaborative activities in a timely manner, thecommercialization of existing and future products could be slowed down orblocked completely.  Disputes may arisebetween the Company and its collaborators on a variety of matters, includingfinancial or other obligations under the business relationships andarrangements between the companies. These disputes may be both expensive and time consuming and may resultin delays in the development and commercialization of the Company’s products.

 

*Dependenceon small number of customers; loss of a significant customer*

 

The Company’s currentoperations are dependent upon a relatively small number of customers, whichchange from time to time.  The Company’stwo largest customers during the first nine months of 2002 together accountedfor approximately 36% of the Company’s total sales during that period.  The

 

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Company generally doesnot have long-term purchase contracts with its customers, who order products ona purchase order basis.  In certaincircumstances, customer orders may be cancelled, changed or delayed on shortnotice.  There can be no assurance thatthe Company’s current significant customers will continue to buy products attheir current or increased levels.  Lossof a significant Company customer or further reduction of the level of ordersfrom a significant customer could have a material adverse effect on theCompany’s operating results.

 

*Uncertainty of Patent Position and Proprietary 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.  In addition, there is a substantial backlog of patents at the USPatent and Trademark Office that may delay the review and the potentialissuance of patents.  The Company’ssuccess will depend significantly on its ability to obtain patents and licensesto patent rights, to maintain trade secrets, and to operate without infringingon the proprietary rights of others, both in the United States and in othercountries.  The failure of the Companyor its licensors to obtain and maintain patent protection for the Company’stechnology could have a material adverse effect on the Company.

 

ProCyte’s successdepends, in part, upon its ability to protect its products and technology underintellectual property laws in the United States and abroad.  As of September 30, 2002, the Company had 21****issuedUS patents expiring between 2005 and 2017 and numerous issued foreign patentsand patent registrations.  The patentsrelate 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 the Company will result in patents being issued.  There can be no assurance that any patentissued to the Company will not be subjected to further proceedings limiting thescope of the rights under the patent or that such patent will provide acompetitive advantage, will afford protection against competitors with similartechnology, or will not be successfully challenged, invalidated or circumventedby competitors.

 

The Company’s processesand potential 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 affected process.  Litigation may be necessary to enforcepatents issued to the Company, to protect trade secrets or know-how owned bythe Company or to determine the enforceability, scope and validity ofproprietary rights of others.  If theCompany becomes involved in such litigation, it could result in substantialexpense to the Company and significant diversion of effort by the Company’stechnical and management personnel.  Inaddition to any potential liability for significant damages, the Company couldbe required to obtain a license to continue to manufacture or market theaffected product or use the affected process. Costs associated with any licensing arrangement may be substantial andcould include ongoing royalties.  Therecan be no assurance that any license required under any such patent would bemade available to the Company on acceptable terms, if at all.  If such licenses could not be obtained onacceptable terms, the Company could be prevented from manufacturing 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.

 

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The Company also relieson non-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 Regulatory Requirements*

 

The manufacturing andmarketing of ProCyte’s products are subject to extensive regulation in theUnited States by the federal government, principally by the U. S. Food and DrugAdministration (“FDA”), and in other countries by similar health and regulatoryauthorities.  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.  Productdevelopment and approval or clearance within the regulatory framework requiresa number of years and involves the expenditure of substantial resources.

 

The Company’s productsand product candidates may be regulated by any of a number of divisions of theFDA.  The process of obtaining andmaintaining 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,products that do not seek to make effectiveness claims based on human clinicalevaluation may be subject to review and regulation under the FDA’s cosmetic or510(k) medical device guidelines. Similar guidelines exist for such products in other countries.  Such products, 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 such product applications submitted to the FDA or similar agencies inother countries will receive clearance to be marketed, or that the labelingclaims sought 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.

 

In addition to obtainingapproval or clearance from the FDA or foreign regulatory bodies to market aproduct, the prospective manufacturer’s quality control and manufacturingprocedures must conform to current good manufacturing practices (“cGMP”)guidelines, or ISO 9000 standards, when appropriate.  In complying with these regulations, which are subject to changeat any time without notice to the Company, ProCyte must continue to expendtime, effort and financial resources in production and quality control.  In addition, ProCyte’s contractmanufacturers may be subject to the regulations of and inspections by otherforeign, federal, state or local agencies. There can be no assurance that the Company’s contract manufacturers’facilities or operations will meet or continue to meet all appropriateguidelines or to pass inspections by any government agency.

 

The Company also is ormay become subject to various other federal, state, local and foreign laws,regulations and policies relating to, among other things, safe workingconditions, good laboratory

 

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practices, and the useand disposal of hazardous or potentially hazardous substances used inconnection with its research and development.

 

The Company’s failure tocomply with applicable regulatory requirements, including obtaining requiredregulatory approvals and consents, could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

*Intense Competition*

 

Competition in the woundcare, skin health and hair care markets is intense.  The Company’s competitors include well-establishedpharmaceutical, cosmetic and healthcare companies such as Obagi, Senetek,Allergan and Nioxin.  These competitorsmay have more financial and other resources, larger research and developmentstaffs, and more experience and capabilities in researching, developing andtesting products in clinical trials, in obtaining FDA and other regulatoryapprovals and in manufacturing, marketing and distribution than the Company.  In addition, a number of smaller companiesare developing or marketing competitive products.  The Company’s competitors may develop and commercialize productsor obtain patent protection or other regulatory approvals for products more rapidlythan the Company.  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.

 

*Risk ofproduct liability claims*

 

Thetesting, manufacturing, marketing and sale of ProCyte’s products may subjectthe Company to product liability claims. The Company maintains coverage against product liability risks up to a$10,000,000 aggregate limit.  However,continuing insurance coverage may not be available at an acceptable cost, if atall.  ProCyte may not be able to obtaininsurance coverage that will be adequate to satisfy any liability that mayarise.  Regardless of merit or eventualoutcome, product liability claims may result in decreased demand for a product,injury to its reputation, withdrawal of clinical trial volunteers and loss ofrevenues.  As a result, regardless ofwhether the Company is insured, a product liability claim or product recall mayresult in losses that could be material to the Company.

 

*Potential Volatility of Stock Price; Bulletin Board Listing*

 

The market prices forsecurities of healthcare, medical dressings, pharmaceutical and biotechnologycompanies are subject to volatility, and the market has from time to timeexperienced significant fluctuations that are unrelated to the operations ofthe Company.  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 on theNASD 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 national exchange.  In addition, purchases and sales of the Company’s securities maybecome subject to Rule 15g-9 of the Exchange Act, which imposes various salespractice requirements on broker-dealers, or to the “penny stock” rules, eitherof which would likely reduce the level of trading activity in the secondarymarket for the Company’s securities and make selling the securities moredifficult for an investor.

 

Announcements concerningthe Company or its competitors, including fluctuations in operating results,research and development program direction, results of clinical trials,addition or termination of

 

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corporate alliances,technology licenses, clearance or approval to market products, announcements oftechnological innovations or new products by the Company or its competitors,changes in government regulations, healthcare reform, developments in patent orother proprietary rights of the Company or its competitors, litigationconcerning business operations or intellectual property, or public concern asto safety of products, as well as changes in general market conditions andmergers and acquisitions, may have a significant effect on the market price ofProCyte’s common stock.

 

## **Item 3.  Quantitative andQualitative Disclosures about Market Risk**

 

ProCyte did not own anyderivative financial instruments as of September 30, 2002.  The Company is debt-free and is exposed tointerest rate risk only to the extent that it has invested idle cashbalances.  At September 30, 2002, suchbalances were invested in a United States Treasury money market fund.  ProCyte employs established policies andprocedures to manage its exposure to changes in the market risk of itsinvestments.  The Company believes thatthe market risk arising from holdings of its financial instruments is notmaterial.  The Company holds a $2million promissory note as a result of the sale of its contract manufacturingoperation, which is secured by the manufacturing assets sold, and there is noguaranty.

 

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

 

Under the supervision ofand with 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 within 90 days of the filing date of this quarterly report, and,based on their evaluation, the Chief Executive Officer and the Chief FinancialOfficer have concluded that these disclosure controls and procedures areeffective.  There were no significantchanges in our internal controls or in other factors that could significantlyaffect those controls subsequent to the date of their evaluation.

# ** **

20

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# **Part II** - Other Information

## ** **

## **Item 1.  Legal Proceedings**

 

Not applicable.

 

## **Item 2.  Changes in Securitiesand Use of Proceeds**

 

Not applicable.

 

## **Item 3.  Defaults Upon SeniorSecurities**

 

Not applicable.

 

## **Item 4.  Submission of Mattersto a Vote of Security Holders**

 

Not applicable.

 

## **Item 5.  Other Information**

 

RobertW. Benson joined ProCyte as Chief Financial Officer October 21, 2002.  Before joining ProCyte, from 2001, toOctober 2002, he was Chief Financial Officer for Appliant, Inc., a privatesoftware company.  From 1997 to 2000, heserved as Chief Financial Officer, and subsequently Chief Operating Officer, ofData Critical Corporation, a medical device manufacturer that successfullycompleted its IPO in 1999 and was later acquired by GE Medical Systems. Mr.Benson has 24 years experience in developing and guiding the financial strategiesof public and private companies.  Bensonbegan his career with KPMG Peat Marwick and earned his Bachelor of Science inAccounting, cum laude, from California State University, Northridge.

 

## **Item 6.  Exhibits andReports on Form 8-K**

 

(a) Exhibits

 

See Exhibit Index on page26.

 

(b) Reports on Form 8-K

 

None.

 

21

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**Signatures**

 

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

 

 
|                          |                                       | **ProCyte Corporation (Registrant)** |
|-------------------------------|--------------------------------------------|--------------------------------------|
|                          |
| Date:  November 14, 2002 | By:                                        | /s/ John F. Clifford                 |
|                          |                                       |                                 |
|                          | John F. Clifford,  Chairman and CEO        |
|                          |                                       |
| Date:  November 14, 2002 | By:                                        | /s/ Robert W. Benson                 |
|                          |                                       |                                 |
|                          | Robert W. Benson, Chief  Financial Officer |

 

22

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# **C**ertifications

I, John F. Clifford,certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q ofProCyte Corporation;

 

2.             Based on my knowledge, this quarterly report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this quarterly report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this quarterly report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisquarterly report;

 

4.             The registrant’s other certifying officer and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrantand we have:

 

a)             designed such disclosure controls and procedures toensure that material information relating to the registrant, including itsconsolidated subsidiary, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b)            evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the “Evaluation Date”); and

 

c)             presented in this quarterly report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a)             all significant deficiencies in the design or operation ofinternal controls which could adversely affect the registrant’s ability torecord, process, summarize and report financial data and have identified forthe registrant’s auditors any material weaknesses in internal controls; and

 

b)            any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this quarterly report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date:  November 14, 2002 | By:                                                       | /s/ John F. Clifford |
|-------------------------------|-----------------------------------------------------------|----------------------|
|                          |                                                      |                 |
|                          | John F. Clifford,  Chairman and CEO,  ProCyte Corporation |

 

23

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I, Robert W. Benson,certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q ofProCyte Corporation;

 

2.             Based on my knowledge, this quarterly report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this quarterly report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this quarterly report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisquarterly report;

 

4.             The registrant’s other certifying officer and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrantand we have:

 

a)             designed such disclosure controls and procedures toensure that material information relating to the registrant, including itsconsolidated subsidiary, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b)            evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the “Evaluation Date”); and

 

c)             presented in this quarterly report our conclusions aboutthe effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a)             all significant deficiencies in the design or operationof internal controls which could adversely affect the registrant’s ability torecord, process, summarize and report financial data and have identified forthe registrant’s auditors any material weaknesses in internal controls; and

 

b)            any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant’sinternal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this quarterly report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date:  November 14, 2002 | By:                                                              | /s/ Robert W. Benson |
|-------------------------------|------------------------------------------------------------------|----------------------|
|                          |                                                             |                 |
|                          | Robert W. Benson, Chief  Financial Officer,  ProCyte Corporation |

 

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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        |
|        |   |                                                                                                                                  |   |     |
| 99.1        |   | Certification of Periodic Report by Mr. John F.  Clifford                                                                             |   | J        |
|        |   |                                                                                                                                  |   |     |
| 992         |   | Certification of Periodic Report by Mr. Robert W.  Benson                                                                             |   | J        |
|        |   |                                                                                                                                  |   |     |

 

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*           Management contract or compensatory plan orarrangement.

†            Confidential treatment has been granted or requestedwith respect to portions of this exhibit.

A.     Incorporated by reference to the Registrant’s RegistrationStatement of Form S-1 (No. 33-31353).

B.       Incorporated by reference to the Registrant’sRegistration Statement of Form S-1 (No. 33-46364).

C.       Incorporated by reference to the Registrant’s AnnualReport on Form 10-K for the year ended December 31, 1994.

D.      Incorporated by reference to the Registrant’s AnnualReport on Form 10-K for the year ended December 31, 1996.

F.        Incorporated by reference to the Registrant’sQuarterly Report on Form 10-Q for the Quarter ended June 30, 1998.

G.       Incorporated by reference to the Registrant’s AmendedAnnual Report on Form 10-K/A dated December 31, 1997.

H.      Incorporated by reference to the Registrant’s AmendedAnnual Report on Form 10-K/A dated December 31, 1998.

I.           Incorporated by reference to the Registrant’s QuarterlyReport on Form 10-Q for the Quarter ended March 31, 2000.

J.          Submitted herewith

 

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