**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-Q**

 

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

**SECURITIES EXCHANGE ACT OF 1934.**

 

**For the QuarterlyPeriod Ended March 31, 2004**

 

**Commission FileNumber 0-18044**

 

**PROCYTE CORPORATION**

(Exact name of the registrant 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 check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

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

 

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

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

 

As of April 30, 2004, therewere issued and outstanding 15,798,747 shares of common stock, par value $.01per share.

 

 

----

 

**ProCyte Corporation**

 

**Index**

** **
| **Part I - Financial  Information** |                                                                                                 |
|-------------------------------------|------------------------------------------------------------------------------------------------------|
|                                | Item  1. Condensed Consolidated Financial Statements (unaudited)                                     |   |
|                                |                                                                                                 | Balance Sheets -  as of March 31, 2004 and December 31, 2003 (unaudited) |   |
|                                |                                                                                                 | Statements of  Operations - Three Months Ended March 31, 2004 and 2003 (unaudited) |   |
|                                |                                                                                                 | Statements  of Cash Flows – Three Months Ended March 31, 2004 and 2003 (unaudited) |   |
|                                |                                                                                                 | Statements of  Stockholders’ Equity – Three Months Ended March 31, 2004 (unaudited) |   |
|                                |                                                                                                 | Notes  to Condensed Consolidated Financial Statements (unaudited) |   |
|                                | Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations |   |
|                                | Item  3. Quantitative and Qualitative Disclosures About Market Risk                                  |   |
|                                | Item 4. Controls and Procedures                                                                      |   |
| **Part II - Other Information**     |                                                                                                 |
|                                | Item 1. Legal Proceedings                                                                            |   |
|                                | Item 2. Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities            |   |
|                                | Item 3.  Defaults Upon Senior Securities                                                             |   |
|                                | Item  4. Submission of Matters to a Vote of Security Holders                                         |   |
|                                | Item 5. Other Information                                                                            |   |
|                                | Item 6.  Exhibits and Reports on Form 8-K                                                            |   |
| **Signatures**                      |                                                                                                 |

 

2

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# **Part I - FinancialInformation**

# ** **

## **Item 1. CondensedConsolidated Financial** Statements (unaudited)

## ** **

### **Balance Sheets** - as of March 31, 2004 and December 31,2003 (unaudited)

**(in thousands)**

** **
|                                                         |   | **March 31,  2004** |   | **December  31,  2003** |   |
|--------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| **ASSETS**                                                   |   |                |   |                    |   |
| **Current Assets**                                           |   |                |   |                    |   |
| Cash and cash equivalents                                    |   | $                   | 4,371  |                    | $      | 3,796 |   |
| Accounts receivable, net of allowance for  doubtful accounts |   | 1,516               |   | 1,336                   |   |
| Inventory                                                    |   | 2,594               |   | 2,942                   |   |
| Prepaid and Other                                            |   | 230                 |   | 289                     |   |
| **Total current assets**                                     |   | 8,711               |   | 8,363                   |   |
|                                                         |   |                |   |                    |   |
| **Property and equipment**                                   |   |                |   |                    |   |
| Equipment                                                    |   | 322                 |   | 315                     |   |
| Leasehold improvements                                       |   | 3,520               |   | 3,520                   |   |
| Less accumulated depreciation and  amortization              |   | (3,337              | )      | (3,294                  | )      |
| **Property and equipment, net**                              |   | 505                 |   | 541                     |   |
|                                                         |   |                |   |                    |   |
| Intangible assets                                            |   | 3,212               |   | 3,212                   |   |
| Note due from related party, net                             |   | 781                 |   | 781                     |   |
| Deferred tax asset                                           |   | 7,042               |   | 7,068                   |   |
| Other assets                                                 |   | 38                  |   | 38                      |   |
| **Total Assets**                                             |   | $                   | 20,289 |                    | $      | 20,003 |   |
|                                                         |   |                |   |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                |   |                |   |                    |   |
| **Current Liabilities**                                      |   |                |   |                    |   |
| Accounts payable, trade                                      |   | $                   | 509    |                    | $      | 147 |   |
| Accrued salaries and benefits                                |   | 206                 |   | 246                     |   |
| Other accrued liabilities                                    |   | 182                 |   | 239                     |   |
| Deferred revenue                                             |   | 16                  |   | 60                      |   |
| **Total current liabilities**                                |   | 913                 |   | 692                     |   |
| Other liabilities                                            |   | 93                  |   | 93                      |   |
| **Total Liabilities**                                        |   | 1,006               |   | 785                     |   |
| **Stockholders’ Equity**                                |   |                |   |                    |   |
| Common stock and additional paid-in-capital                  |   | 85,434              |   | 85,419                  |   |
| Deferred compensation                                        |   | (59                 | )      | (59                     | )      |
| Accumulated deficit                                          |   | (66,092             | )      | (66,142                 | )      |
| **Stockholders’ Equity**                                |   | 19,283              |   | 19,218                  |   |
| **Total Liabilities and Stockholders’ Equity**          |   | $                   | 20,289 |                    | $      | 20,003 |   |

 

*See notes tocondensed consolidated financial statements*

 

3

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### **Statements ofOperations - Thre**e Months Ended March 31, 2004 and 2003 (unaudited)

**(in thousands, exceptper share amounts)**

 
|                                        |   | **Three  months ended March 31,** |   |
|---------------------------------------------|--------|-----------------------------------|--------|
|                                        |   | **2004**                          |   | **2003** |   |
| **Revenues**                                |   |                              |   |   |   |
| Product sales                               |   | $                                 | 2,861  |   | $ | 2,882 |   |
| Licenses and royalties                      |   | 359                               |   | 464 |   |
| Total revenues                              |   | 3,220                             |   | 3,346 |   |
| Cost of product sales                       |   | 861                               |   | 1,183 |   |
| Gross profit                                |   | 2,359                             |   | 2,163 |   |
|                                        |   |                              |   |   |   |
| **Operating Expenses**                      |   |                              |   |   |   |
| Marketing and selling                       |   | 1,198                             |   | 1,400 |   |
| Research, general, and administrative       |   | 1,091                             |   | 966 |   |
| Total operating expenses                    |   | 2,289                             |   | 2,366 |   |
|                                        |   |                              |   |   |   |
| Operating income (loss)                     |   | 70                                |   | (203 | ) |
| Interest and other income                   |   | 7                                 |   | 88 |   |
|                                        |   |                              |   |   |   |
| Net income before tax                       |   | 77                                |   | (115 | ) |
| Provision for income tax                    |   | (27                               | )      | (18 | ) |
| Net income (loss)                           |   | $                                 | 50     |   | $ | (133 | ) |
|                                        |   |                              |   |   |   |
| ***Net earnings  (loss) per share***        |   |                              |   |   |   |
| Basic                                       |   | $                                 | 0.00   |   | $ | (0.01 | ) |
| Diluted                                     |   | $                                 | 0.00   |   | $ | (0.01 | ) |
|                                        |   |                              |   |   |   |
| ***Shares used in per  share computation*** |   |                              |   |   |   |
| Basic                                       |   | 15,790                            |   | 15,746 |   |
| Diluted                                     |   | 16,048                            |   | 15,746 |   |

 

*See notes to condensed consolidated financial statements*

 

4

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### **Statementsof Cash Flows – Three Months End**ed March 31, 2004 and 2003 (unaudited) 

**(in thousands)**

 
|                                                                                                      |   | **Three  months ended March 31,** |   |
|-----------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                      |   | **2004**                          |   | **2003** |   |
| **Operating Activities**                                                                                  |   |                              |   |   |   |
| Net income (loss)                                                                                         |   | $                                 | 50     |   | $ | (133 | ) |
| ***Adjustments to  reconcile net income to net cash provided by (used in) operating activities:***        |   |                              |   |   |   |
| Depreciation and amortization                                                                             |   | 50                                |   | 76 |   |
| Amortization of deferred proceeds                                                                         |   | —                            |   | (67 | ) |
| Non-cash expense related to stock-based  compensation                                                     |   | 9                                 |   | 12 |   |
| Amortization of promissory note discount                                                                  |   | —                            |   | (8 | ) |
| Change in deferred tax asset, net of change  in valuation allowance                                       |   | 25                                |   | — |   |
| Amortization of deferred compensation                                                                     |   | 6                                 |   | 4 |   |
| ***Change in  operating assets and liabilities net of effects from purchase of spa products  business:*** |   |                              |   |   |   |
| Accounts receivable                                                                                       |   | (180                              | )      | (134 | ) |
| Inventory                                                                                                 |   | 341                               |   | 45 |   |
| Prepaid and other                                                                                         |   | 60                                |   | 280 |   |
| Accounts payable, trade                                                                                   |   | 362                               |   | (77 | ) |
| Accrued salaries and benefits                                                                             |   | (40                               | )      | (247 | ) |
| Other accrued liabilities                                                                                 |   | (57                               | )      | 15 |   |
| Deferred revenue                                                                                          |   | (44                               | )      | 54 |   |
| Other liabilities                                                                                         |   | —                            |   | 2 |   |
| ***Net cash provided  by (used in) operating activities***                                                |   | 582                               |   | (178 | ) |
| **Financing Activities**                                                                                  |   |                              |   |   |   |
| Proceeds from issuance of common stock                                                                    |   | —                            |   | 10 |   |
| **Investing Activities**                                                                                  |   |                              |   |   |   |
| Purchase of property and equipment                                                                        |   | (7                                | )      | — |   |
| Decrease in other assets                                                                                  |   | —                            |   | — |   |
| ***Net cash used in  investing activities***                                                              |   | (7                                | )      | — |   |
| ***Net increase  (decrease) in cash and cash equivalents***                                               |   | 575                               |   | (168 | ) |
| **Cash and Cash Equivalents**                                                                             |   |                              |   |   |   |
| At beginning of period                                                                                    |   | 3,796                             |   | 4,556 |   |
| At end of period                                                                                          |   | $                                 | 4,371  |   | $ | 4,388 |   |

 

*See notes to condensed consolidated financial statements*

 

5

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### **Statements ofStockholders’ Equity** – Three Months Ended March 31, 2004 (unaudited)

**(in thousands)**

 
|                                                      |   |          |   | **Additional  Paid-in  Capital** |   | **Deferred  Compen-  sation** |   | **Accumulated  Deficit** |   | **Total** |   |
|-----------------------------------------------------------|--------|---------------|--------|----------------------------------|--------|-------------------------------|--------|--------------------------|--------|-----------|--------|
| **Common  Stock**                                         |
| **Shares**                                                |   | **Par Value** |
| Balance, December 31, 2003                                |   | 15,783        |   | $                                | 158    |                          | $      | 85,261                   |   | $         | (59    | ) | $ | (66,142 | ) | $ | 19,218 |   |
| Shares issued under non-employee director  stock plan     |   | 8             |   | (*                               | )      | 9                             |   | —                   |   | —    |   | 9 |   |
| Re-measurement of stock options granted to  non-employees |   | —        |   | —                           |   | 6                             |   | (6                       | )      | —    |   | — |   |
| Amortization of deferred compensation                     |   | —        |   | —                           |   | —                        |   | 6                        |   | —    |   | 6 |   |
| Net income                                                |   | —        |   | —                           |   | —                        |   | —                   |   | 50        |   | 50 |   |
| Balance, March 31, 2004                                   |   | 15,791        |   | $                                | 158    |                          | $      | 85,276                   |   | $         | (59    | ) | $ | (66,092 | ) | $ | 19,283 |   |

 

This statement contains rounding, and (*) isplaced where the number rounds to less than $1,000.

 

*See notes to condensed consolidated financial statements*

 

6

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**ProCyte Corporation**

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

### ** **

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

 

The accompanying condensedconsolidated financial statements (unaudited) include the accounts of ProCyteCorporation and its wholly-owned, subsidiaries, NextDerm, Inc. (a Delawarecorporation) and NextDerm, Inc. (a Washington corporation) (collectively“ProCyte” or the “Company”), for the three month periods ended March 31, 2004and 2003, and have been prepared by the Company in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Pursuant to such rulesand regulations, the condensed consolidated financial statements do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for audited financialstatements.  Accordingly, this financialinformation should be read in conjunction with the complete audited financialstatements, including the notes thereto, which are included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.  In the opinion of management, all materialadjustments (consisting of normal recurring accruals) considered necessary fora fair presentation of the financial statements have been included.  Interim results are not necessarilyindicative of the results that may be expected for the year.

 

###### *Goodwill*

In accordance withStatement of Financial Accounting Standards (SFAS) No. 142, Goodwill and OtherIntangible Assets, the Company has elected to perform its annual testing ofgoodwill impairment as of March 31. As of March 31, 2004, the Company completedit’s goodwill impairment test and determined that there was no impairment.

 

###### *Use of estimates in financial statements*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of revenues and expensesduring the reporting period and the reported amounts of assets and liabilitiesand disclosure of contingent liabilities at the date of the financialstatements, particularly with respect to the valuation of inventory, notesreceivable, goodwill, leasehold improvements and deferred tax assets.  Actual results could differ from thoseestimates.

 

*Stock Based Compensation*

The Companyfollows the intrinsic value based accounting method for stock options containedin APB Opinion No. 25, Accounting for Stock Issued to Employees, as permittedby SFAS No. 123, Accounting for Stock-Based Compensation.  Under this method, no compensation expensehas been recognized for employee incentive stock options, as the exercise priceof options granted equaled the fair value on the date of grant.

 

The following tablerepresents what the Company’s pro forma amounts of net income (loss) and netincome (loss) per share would have been for the three months ended March 31,2004 and 2003, had compensation expense for the Company’s stock options grantedunder the incentive compensation plan been recognized based upon the fair valueof the awards granted.

 

7

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|                                                                                        |   | **(in  thousands, except per share amounts** |   |
|---------------------------------------------------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                        |   | **2004**                                     |   | **2003** |   |
| Net income (loss)                                                                           |   | $                                            | 50     |   | $ | (133 | ) |
| Stock option-based compensation expense  (benefit) determined under fair value based method |   | (74                                          | )      | 127 |   |
| Pro forma net income (loss)                                                                 |   | $                                            | 124    |   | $ | (260 | ) |
| Earnings (loss) per share:                                                                  |   |                                         |   |   |   |
| As reported basic                                                                           |   | $                                            | 0.00   |   | $ | (0.01 | ) |
| As reported diluted                                                                         |   | $                                            | 0.00   |   | $ | (0.01 | ) |
| Pro forma basic                                                                             |   | $                                            | 0.01   |   | $ | (0.02 | ) |
| Pro forma diluted                                                                           |   | $                                            | 0.01   |   | $ | (0.02 | ) |

 

The Company determined the fairvalue of stock options granted during the three months ended March 31, 2004 and2003 using the Black-Scholes option pricing model and the followingassumptions: 

 
|                         |   | **Three  months ended March 31,** |   |
|------------------------------|--------|-----------------------------------|--------|
| **Options Granted**          |   | **2004**                          |   | **2003** |   |
| Risk-free interest rate      |   | 2.44%-2.61                        | %      | 2.81 | % |
| Expected option life (years) |   | 6.00                              |   | 6.00 |   |
| Dividend yield               |   | 0.00                              |   | 0.00 |   |
| Expected volatility          |   | 62%-63                            | %      | 62 | % |

 

The Company determines stockoption-based compensation cost on the best available estimate of the number ofoptions that are expected to vest.  TheCompany reviews that estimate each period to determine if subsequentinformation indicates that actual forfeitures are likely to differ from initialestimates and has revised its estimates during the quarter ended March 31,2004.  The adjustment in the cumulativeexpense related to unvested options resulted in a net reduction in compensationexpense.

 

**2.****              AccountsReceivable**

 

One customerrepresented greater than 10% of the net accounts receivable balance at March31, 2004 and two customers each represented greater than 10% at December 31,2003 as follows:

 
|       |   | **March 31,  2004** |   | **December  31, 2003** |   |
|------------|--------|---------------------|--------|------------------------|--------|
| Customer A |   | 50                  | %      | 46                     | %      |
| Customer B |   | 8                   | %      | 12                     | %      |

 

The Companyprovided an allowance for uncollectible receivables in the amount of $78,000and $102,000 at March 31, 2004 and December 31, 2003, respective1y.  The bad debt expense (recovery), net ofrecoveries of $1,000 in 2004 and $2,000 in 2003, was $(24,000) and $10,000 forthe three months ended March 31, 2004 and 2003, respectively.  Accounts written off to the allowanceamounted to $1,000 and $13,000 for the three month periods ended March 31, 2004and 2003, respectively.

 

8

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**3.****              Inventory**

 

Inventoryconsisted of the following:

 
|            |   | **(in  thousands)** |   |
|-----------------|--------|---------------------|--------|
|            |   | **March 31,  2004** |   | **December  31, 2003** |   |
| Finished Goods  |   | $                   | 1,961  |   | $ | 2,235 |   |
| Work in process |   | 413                 |   | 406 |   |
| Raw materials   |   | 220                 |   | 301 |   |
| **Total**       |   | $                   | 2,594  |   | $ | 2,942 |   |

 

**4.****              IntangibleAssets**

 

Intangiblesconsisted of the following:

 
|                                   |   | **(in  thousands)** |   |
|----------------------------------------|--------|---------------------|--------|
|                                   |   | **March 31,  2004** |   | **December  31, 2003** |   |
| Patents, net of amortization           |   | $                   | 65     |   | $ | 70 |   |
| Other intangibles, net of amortization |   | 33                  |   | 36 |   |
| Goodwill                               |   | 3,114               |   | 3,106 |   |
| **Intangible Assets, net**             |   | $                   | 3,212  |   | $ | 3,212 |   |

 

Patents are shown net ofaccumulated amortization of $225,000 and $221,000, at March 31, 2004 andDecember 31, 2003, respectively. Patents are amortized over the term of the patent and the amortizationexpense related thereto was $4,000 for each of three-month periods ended March31, 2004 and 2003, respectively.  Patentamortization expense is expected to be $16,000 for each of the years endingDecember 31, 2004 through 2007 and $6,000 for the year ending December 31,2008.

 

Other intangible assets areshown net of accumulated amortization of $3,000 at March 31, 2004.  The assets consist of trademarks andcustomer list acquired from Annette Hanson, Inc. on December 30, 2003.  The trademarks and customer list are beingamortized over their expected lives and the amortization expense relatedthereto was $3,000 for the three-month period ended March 31, 2004. Theamortization expense is expected to be $12,000 for each of the years endingDecember 31, 2004 through 2006.

 

Intangible assetsalso include goodwill of $3.1 million at March 31, 2004 and December 31, 2003,respectively (Note 1).  The Companydetermined that it has one reporting unit, therefore, all of goodwill is deemedto be associated with ProCyte’s overall business operations.

 

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

 

Deferred incometaxes reflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. As of March 31, 2004 and December 31,2003, a partial valuation reserve for tax benefits of net operating losses anda full valuation reserve for research and development tax credit carry forwardsremains in place due to the uncertainty of realizing the full tax benefits ofthe net operating losses and tax credits as a result of their expiration.  The net change in the valuation allowanceduring the quarter ended March 31, 2004, was a reduction of $33,000.

 

9

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As of March 31,2004, the Company’s U.S. federal net operating loss and general business creditcarry forward for income tax purposes were approximately $67.4 million and $1.6million, respectively.  If not utilized,the federal net operating loss carry forward and tax credit carry forwards willexpire between 2005 and 2021 as follows:

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

 

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

 

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

 

Basic and dilutedper share results for all periods presented were computed based on the netearnings for the respective periods. The weighted average number of common shares outstanding during theperiod was used in the calculation of basic earnings per share.  In accordance with FAS 128, “Earnings PerShare,” the weighted average number of common shares used in the calculation ofdiluted per share amounts is adjusted for the dilutive effects of stock optionsbased on the treasury stock method only if an entity records earnings from operations,as such adjustments would otherwise be anti-dilutive to earnings per share fromoperations.  For the three months endedMarch 31, 2004, 257,826 dilutive stock options were included in the calculationof average number of common shares outstanding for diluted computations.  For the three month periods ended March 31,2004 and 2003, options and warrants to purchase 1,602,670 shares and 2,270,597shares of common stock, respectively, were not included in the computation ofdiluted earnings per share because the effect would have been anti-dilutiveeither because the exercise prices were greater than the average fair marketvalue of our stock for the period of $1.17 and $1.25, respectively, or therewas a net loss for the period.

 

**7.****              StockOptions**

 

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

 

10

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The followingtable summarizes information about stock option activity in three-month periodsended March 31, 2004 and 2003: 

 
|                           |   | **2004**                |   | **2003**                       |   |
|--------------------------------|--------|-------------------------|--------|--------------------------------|--------|
| **Items**                      |   | **Number  of  Options** |   | **Wtd. Avg.  Exercise  Price** |   | **Number  of  Options** |   | **Wtd. Avg.  Exercise  Price** |   |
| Outstanding, beginning of year |   | 2,570,167               |   | $                              | 1.41   |   | 2,185,335 |   | $ | 1.57 |   |
| Granted                        |   | 66,000                  |   | $                              | 1.11   |   | 97,500 |   | $ | 1.31 |   |
| Exercised                      |   | —                  |   | $                              | — |   | (12,000 | ) | $ | 0.86 |   |
| Canceled or expired            |   | (91,167                 | )      | $                              | 1.59   |   | (45,501 | ) | $ | 1.55 |   |
| Outstanding, March 31,         |   | 2,545,000               |   | $                              | 1.39   |   | 2,225,334 |   | $ | 1.56 |   |
| Exercisable, March 31,         |   | 1,835,681               |   | $                              | 1.47   |   | 1,436,347 |   | $ | 1.61 |   |

 

The options outstanding atMarch 31, 2004 consisted of the following: 

 
| **Range of exercise prices** |   | **Number of  Options  Outstanding** |   | **Wtd. Avg.  Remaining  Life** |   | **Wtd. Avg.  Exercise  Price** |   | **Number of  Options  Exercisable** |      | **Wtd. Avg.  Exercise  Price** |   |
|------------------------------|--------|-------------------------------------|--------|--------------------------------|--------|--------------------------------|--------|-------------------------------------|-----------|--------------------------------|--------|
| $ 0.49 - $0.78               |   | 564,000                             |   | 5.82                           |   | $                              | 0.74   |                                | 564,000   |                           | $      | 0.74 |   |
| $ 0.77 - $1.09               |   | 517,500                             |   | 8.53                           |   | $                              | 1.02   |                                | 135,000   |                           | $      | 0.94 |   |
| $ 1.11 - $1.30               |   | 515,000                             |   | 7.34                           |   | $                              | 1.24   |                                | 319,671   |                           | $      | 1.25 |   |
| $ 1.31 - $1.83               |   | 565,000                             |   | 7.11                           |   | $                              | 1.58   |                                | 433,510   |                           | $      | 1.60 |   |
| $ 2.16 - $3.44               |   | 383,500                             |   | 1.89                           |   | $                              | 2.78   |                                | 383,500   |                           | $      | 2.78 |   |
| $ 0.49 - $3.44               |   | 2,545,000                           |   | 6.37                           |   | $                              | 1.39   |                                | 1,835,681 |                           | $      | 1.47 |   |

 

At March 31, 2004there were 92,662 shares reserved for issuance under the Company’s 1996 StockOption Plan.

 

The weightedaverage fair value of options granted during the three-month periods endedMarch 31, 2004 and 2003 was approximately $0.66 and $0.79, respectively.

 

**8.****              RelatedParty Disclosure**

 

The Company holds a promissorynote in the principal amount of $2 million from Emerald Pharmaceutical L.P.(“Emerald”), which it received as partial consideration for the sale of its contractmanufacturing operations in 2001.  Thenote is secured by a security agreement covering all tangible assets and bearsinterest equal to the effective yield on the 10 Year US Treasury Note, which isadjusted quarterly.  The average yieldfor the quarter ended March 31, 2004 was 3.85%.  Emerald is required to make monthly interest-only payments untilJuly 2005, when it is required to begin making annual principal payments of$286,000.  The Company also received aminority limited partnership interest in Emerald as part of considerationreceived in the sale.  As part of theagreement, ProCyte subleases a portion of its current 34,532 square foot leasedfacility, including existing leasehold improvements, to Emerald.  A portion of the proceeds from the sale inthe amount of $1.6 million was determined to represent consideration forEmerald’s use of the leasehold improvements, and is being recognized over theterm of the sublease.

 

In February 2004,the General Partner of Emerald informed the Company that Emerald suspendedoperations and terminated all employees in an effort to conserve remainingcapital while it sought other

 

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entities tooperate or purchase the facility.  IfEmerald is unsuccessful in returning to operations, ProCyte management believesthat the facility has significant value to other contract manufacturingorganizations and biotechnology companies and can be re-leased or re-sold afteran appropriate marketing period.  As aresult of these developments, management determined that it is probable thatthe $2.0 million promissory note receivable from Emerald ($1.9 million atpre-impairment discounted value), leasehold improvements located in the spacesubleased to Emerald with a $949,000 net book value and the limited partnershipinterest at a cost of $1,000 have been impaired.

 

Managementestimated the impairment of the note receivable based upon probability weightedfair values of expected future cash flows discounted at the loan’s effectiverate compared to the current value of the note after reducing the note by the$949,000 unamortized balance of deferred gain on the original sale.  Management estimated the impairment of theleasehold improvements based upon their expected present values using multiplecash flow scenarios that reflected the range of possible outcomes at a riskfree rate.  Management also determinedthat its partnership interest had no probable value.  The Company recorded the impairment in December 2003.  The adjustment was based upon estimates,which could vary significantly from the amounts that the Company may ultimatelyrealize for these assets if the actual events differ significantly from ourestimates and expectations.

 

Until Emeraldsuspended operations in February 2004, ProCyte engaged Emerald to manufacturingcopper peptide compounds, and to perform incoming quality testing and otheranalytical services.  Emerald billedProCyte a total of $19,000 and $769,000 for the three-month periods ended March31, 2004 and 2003, respectively, for such products and services.  ProCyte has second sources for theseproducts and services at prices that do not materially differ from thosecharged by Emerald.  ProCyte had notrade payables to Emerald at March 31, 2004 and December 31, 2003.

 

One of theCompany’s Directors also serves as Chairman and Chief Executive Officer of oneof ProCyte’s customers.  ProCyte’s salesto the customer were $152,000 and $188,000 for the three-month periods endedMarch 31, 2004 and 2003, respectively.  Thecustomer’s trade receivable balances were $115,000 and $165,000 on March 31,2004 and December 31, 2003, respectively.

 

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

## ** **

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

 

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

 

*Recent Events*

 

On December 30, 2003 ProCytecompleted the purchase of the principal assets of Annette Hanson, Inc.  Ms. Hanson’s business, focused on the spaand salon markets, has sold products containing ProCyte’s technology under theSimple Solutions® brand since April 2002.  Included in the purchase were receivables, inventory, selectedequipment, brand names, trademarks, the customer list and the assumption of afacility lease.  ProCyte believes thatthe acquisition will enable the Company to leverage its copper peptidetechnology and sales and marketing expertise into the spa products market.  During the first quarter of 2004, ProCytebegan integrating the spa distribution business into the Company’s operationsand hired sales representatives to focus on the spa market.  Based on the historical annualized revenuesof Ms. Hanson’s spa products distribution business before the acquisition andassuming that expected product synergies occur as a result of the acquisition,ProCyte believes the acquisition will be accretive by the second half of 2004.

 

In February 2004, the GeneralPartner of Emerald Pharmaceutical LP (“Emerald”) informed the Company thatEmerald had suspended operations and terminated all employees in an effort toconserve remaining capital while it sought other entities to operate orpurchase the facility.  After review ofthe facts currently available, management determined that it is probable thatcertain assets have been impaired. Therefore, the Company recorded a charge to 2003 earnings of$637,000.  The charge is based uponestimates, which could vary significantly, either favorably or unfavorably,from the amounts that the Company may ultimately realize for these assets ifthe actual events differ significantly from our estimates andexpectations.  

 

*Critical Accounting Policies and Estimates*

 

The “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” as well asdisclosures included elsewhere in this Form 10-Q, are based upon our condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America.  The preparation of these consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingencies.  On anongoing basis, we evaluate the estimates used, including those related toimpairment and useful lives of intangible assets, allowances for accountsreceivable and notes receivable, and for excess and obsolete inventory.  We base our estimates

 

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on historical experience,current conditions and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources as well as identifying and assessingour accounting treatment with respect to commitments and contingencies.  Actual results may differ from theseestimates under different assumptions or conditions.  We believe the following critical accounting policies involve themore significant judgments and estimates used in the preparation of theconsolidated financial statements.

 

Under the guidance of SFAS 109,“Accounting for Income Taxes,” we review the Company’s net deferred tax assetsto determine which amounts, if any, are “more likely than not” to be utilizedin future periods.  Our analysis ofwhether these tax assets will be utilized involved a substantial amount ofjudgment related to the Company’s ability to generate taxable net income infuture periods, including revenue trends, product mix, and estimated margins,the amount and timing of which impacts the amount of net operating tax lossesthat could be utilized prior to their expiration.  

 

Product revenuesare recognized when products are shipped, license fees are recognized over theterm of 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.

 

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

 

We maintain anallowance for doubtful accounts for estimated losses resulting from thepotential inability of our customers or other debtors to make requiredpayments.  The allowance is based uponhistorical experience and a review of individual customer balances.  If the financial condition of our customersor other debtors were to deteriorate, resulting in an impairment of their abilityto make payments to us, additional allowances may be required.

 

Inventories arestated at the lower of cost or market value. Cost is 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.

 

The Companyrecords impairment losses on long-lived assets used in operations when eventsand circumstances indicate that assets might be impaired and the undiscountedcash flows estimated to be generated by those assets are less than the carryingamount of those assets.  Estimation offuture values for the long-lived assets require a significant amount ofjudgment related to assessing the possible outcomes and the timing related toeach outcome.  The adjustments areestimates, which could vary significantly, either favorably or unfavorably,from the amounts that the Company may ultimately realize for these assets ifthe actual events differ significantly from our estimates and expectations.

 

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

####  

***ThreeMonths Ended March 31, 2004 and 2003***

 

###### *Revenue*

###### * *

|                    |   | **Three  Months Ended March 31,** |   |     |   |
|-------------------------|--------|-----------------------------------|--------|----------|--------|
|                    |   | **2004**                          |   | **2003** |   | **% Change** |   |
| Products                |   | $                                 | 2,421  |     | $      | 1,959 |   | 24 | % |
| Copper peptide compound |   | 440                               |   | 923      |   | (52 | )% |
| Royalties               |   | 359                               |   | 464      |   | (23 | )% |
|                    |   | $                                 | 3,220  |     | $      | 3,346 |   | (4 | )% |

 

*Product* revenues for the first quarter of 2004increased $461,000, or 24 percent over the first quarter of 2003.  The increase was primarily due to a 18percent increase in sales to physicians and distributors and the additionalsales related to the spa distribution business included in the 2004quarter.  In addition, product revenuesin the first quarter of 2003 had been impacted by the slowdown in patienttraffic experienced by our dermatology, plastic and cosmetic surgery customersat the beginning of the 2003 year. Product revenues began recovering during the second half of 2003, inpart reflecting certain actions taken such as changing our hiring profile forsales representatives, increasing sales training and expanding customereducation programs. Sales to physicians and distributors increased by 6 percentin the fourth quarter of 2003 over the third quarter and increased 11 percentin the first quarter of 2004 over the fourth quarter of 2003.

 

*Copper peptide compound* shipments are driven by the purchasingpatterns of our largest licensee, Neutrogena, which can vary based uponproduction cycles, adjustments in safety stock and other factors beyond ourcontrol.  Neutrogena ordered more copperpeptide compound in the fourth quarter of 2002 and first quarter of 2003 thanin any other quarter during the agreement. As a result of the unusually high2003 shipments, copper peptide compound sales were 52 percent lower in the 2004quarter. 

 

*Royalty revenue*is based upon sales generated by ourlicensees.  Royalty revenues mayfluctuate from quarter to quarter, due to the licensees’ timing of new marketlaunches, special promotions and other factors beyond the Company’scontrol.  Royalties received fromNeutrogena in the first quarter of 2004 were 23 percent lower than the 2003quarter principally due to a large one-time customer shipment by Neutrogena inthe 2003 first quarter.  Upon theexpiration of the underlying patent in February 2005, the agreement specifiesthat lower royalty percentages be used for the remaining term, the impact of whichis a reduction in the average effective royalty rate of approximately 32percent. The actual amount of royalty income recognized in future periods isdependent upon the royalty percentages in effect during the period and theactual applicable sales reported by Neutrogena, which can vary from quarter toquarter.  Therefore the historicalgrowth in royalty revenue may not be an indication of future results.

 

###### *Gross Profit*

######  

While revenues forthe 2004 first quarter were 4 percent less than 2003 first quarter, grossprofit for 2004 period increased by $196,000, or 9 percent, to $2.4million.  Gross margin for the 2004quarter was 73 percent as compared to 65 percent in the 2003 quarter.  The increase in gross profit dollars andgross margin percentage is primarily due to the change in revenue mix in favorof having greater product sales versus copper peptide compound sales.  Total gross margin is sensitive to therevenue mix of packaged products, copper peptide compound and royalty revenueand will vary from period to period as a result.

 

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###### *Operating Expenses*

 
|                                 |   | **Three  Months Ended March 31,** |   |     |   |
|--------------------------------------|--------|-----------------------------------|--------|----------|--------|
|                                 |   | **2004**                          |   | **2003** |   | **% Change** |   |
| Marketing and selling                |   | 1,198                             |   | 1,400    |   | (14 | )% |
| Research, general and administrative |   | 1,091                             |   | 966      |   | 13 | % |
| Total operating expenses             |   | $                                 | 2,289  |     | $      | 2,366 |   | (3 | )% |
|                                      |        |                                   |        |          |        |  |  |  |  |

 

*Marketing and selling* expenses for the 2004 quarter decreasedprimarily due to $608,000 in costs related to the development and testing of aninfomercial included in the 2003 quarter and not repeated in 2004.  This decrease was partially offset byincreases in salary and benefit costs due to higher average headcount in the2004 quarter, an increase in commission expense related to the 2004 sales increaseand $135,000 of expenses related to the operation of the spa distributionbusiness in the 2004 quarter.

 

*Research, general and administrative* expenses for the 2004 quarter increased13 percent over the comparable 2003 period. This was primarily due to Emerald not making rental and other paymentsof $91,000 under its sublease and other agreements with ProCyte because ofEmerald’s cessation of business operations in February 2004.  In addition, compensation, employee benefitand recruiting expenses increased due to the addition of personnel and generalmarket increases, operating costs increased due to higher shipping volume andthe addition of spa operations in the first quarter of 2004.  These increased expenses were generallyoffset by a decrease in legal and bad debt expenses.

 

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

######  

Interest and otherincome earned during the first quarter of 2004 decreased $81,000 to $7,000primarily due to a one-time termination settlement of $50,000 received fromMerck KGaA in the first quarter of 2003 and a decrease of $28,000 of interestincome not recognized on the Emerald note due to Emerald’s suspension ofoperations.

 

###### *Net Income*

######  

For the quarterended March 31, 2004, ProCyte reported net income of $50,000 as compared to netloss of $133,000 for the 2003 period. This increase was primarily due to the increase in gross profit from theimprovement in product sales while keeping expenses comparable, as a percentageof total revenue, to the prior year.

 

***Liquidityand Capital Resources***

 

The Company reliesprimarily on cash flow from operations to fund its operations and capitalexpenditures.  At March 31, 2004, theCompany had approximately $4.4 million in cash and cash equivalents, comparedto $3.8 million at December 31, 2003. The net change in cash and cash equivalents during the first quarter of2004 reflects a net increase in cash of $575,000, generated primarily byoperations. The significant components of this positive cash increase are fromthe net reduction of the Company’s copper peptide compound inventory during thequarter and from the increase in trade payables at quarter end related toinventory received in March 2004. Positive cash generated was partially offset by the payment of the 2003management bonuses in March 2004 and the reduction in cash flow from Emerald asdiscussed below.  We may seefluctuations in operating cash flows in future

 

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periods as theydepend in large part on the timing of deposits received from our licensees andtheir initiation of new product introductions and the timing of shipments toand payments received from our customers.

 

As of December 30,2003, the Company completed the acquisition of Annette Hanson, Inc.  ProCyte believes that this acquisition willenable the Company to leverage its copper peptide technologies and sales andmarketing expertise into the spa products market.  The acquisition has not required material cash infusion duringthe first quarter of 2004 and, based on the historical annualized revenues ofMs. Hanson’s spa products distribution business before the acquisition andassuming that expected product synergies occur as a result of the acquisition,ProCyte believes additional cash, if any, needed to ramp up the acquiredbusiness operations will not be material and that the spa products distributionoperations could generate positive cash flow in the second half of 2004.

 

As of February2004, Emerald Pharmaceuticals, L.P. suspended operations and in fiscal 2003ProCyte recorded an impairment related to its $2.0 million note receivable dueto the uncertainty that the full amount will be collected.  Emerald also leases its facility fromProCyte under an operating sublease. ProCyte is not receiving the interest and rental payments due under itsagreements with Emerald and it is uncertain as to when, if ever, Emerald willbe able to resume such payments. Therefore, cash flow from operations has been reduced by $50,000 permonth as compared to the quarter ended March 31, 2003, which will continueuntil such time as Emerald can resume making payments or the matter isotherwise resolved through sale or securing a replacement sub lessee.  In addition, if Emerald should liquidate,ProCyte will incur additional operating expenses for electrical, maintenanceand security costs associated with the portion of the facility it subleases toEmerald, which management currently estimates to be $5,000 per month.  In addition, ProCyte may be required to takeback the facility to protect the Company’s collateral and other interests.  If this action becomes necessary, ProCytemay, based on information currently available, become responsible for facilityrelated obligations left unpaid by Emerald of between $35,000 and $115,000.

 

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

 

**Additional Information About the Company’sBusiness; Risk Factors**

 

###### *Loss of or Reduction in Orders by Significant Customers CouldAdversely Affect Our Net Revenues and Results of Operations*

######  

Although the Company’s customerbase is made up of a large number of customers, Neutrogena accounted forapproximately 25 percent of the Company’s net revenue during the first quarterof 2004 and our top 10 customers comprised approximately 36 percent of such netrevenues.  Any decrease in or

 

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loss of revenues from thesecustomers could have an adverse effect on our net revenues and results ofoperations or impair our ability to increase net revenues.  The Neutrogena technology license agreementexpires in April 2010, however the royalty payments related to each territorycontinue for a period not less than a five-years from the date products werefirst sold in each territory, which may extend the royalty period beyond 2010for certain territories.  Royaltyrevenue from the Neutrogena license agreement accounted for 11 percent and 14percent of the Company’s net revenues in the first quarter of 2004 and 2003,respectively.  The patent related to theNeutrogena license agreement expires February 5, 2005, the effect of which willbe a reduction in the percentage paid as royalty during the remaining royaltyperiod as set forth in the agreement.  Revenues from sale of copper peptide compound to Neutrogenapursuant to a related supply agreement, accounted for 14 percent and 28 percentof net revenues in the first quarter of 2004 and 2003, respectively. The supplyagreement expires in April 2005, with extensions for additional two-year termsby mutual consent of the parties up to April 2010.  There can be no assurance that this agreement will be extendedbeyond April 2005, or if extended, that it will be extended to April 2010.  Also, the timing of copper peptide compoundshipments are driven by Neutrogena’s purchasing patterns, which can vary basedupon production cycles, adjustments in safety stock and other factors beyondour control, causing the revenue from copper peptide compound sales to fluctuatefrom quarter to quarter.

 

We expect that we will continueto depend on revenue from larger customers, generally under multi-year licenseor supply agreements.  Such agreementscan be terminated under certain circumstances, including our inability to supplyproduct within required time frames. Any downturn in the business from these customers or the inability torenew or replace agreements with new customers as they expire couldsignificantly decrease sales to such customers, which could adversely affectour net revenues and results of operations.

 

Furthermore, we ship mostorders when received.  Virtually allorders are shipped within 48 hours and therefore do not have a substantialnon-cancelable backlog of orders.  Variationsin the timing of orders can cause significant fluctuations in our quarterlyoperating results, and the cancellation or deferral of product orders oroverproduction due to the failure of anticipated orders to materialize couldresult in us holding excess or obsolete inventory, which has resulted and couldagain in the future result in write-downs of inventory that would have amaterial adverse effect on our operating results.

 

###### *Dependence on and Management of Existing and FutureCorporate Alliances*

######  

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

 

###### *Recent Profitability; Profitability May Fluctuate in FuturePeriods*

######  

The Company has been marketingproducts based on its proprietary copper peptide technology since 1996.  In addition to sales of products based onits proprietary copper peptide technology, the Company’s revenues havehistorically included sales of non-proprietary products, license fees androyalties, revenue

 

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from contract manufacturing andinterest income.  The contract manufacturingoperation was sold in July 2001.  Duringfiscal 2002, the Company reported net profits and positive cash flow fromoperations for the first time in its operating history.  During 2003, the Company reported net incomebefore tax benefit and break even cash flow from operations.  During the first quarter of 2004, thecompany reported net profits and positive cash flow from operations.  Attaining consistent profitability isdependent upon a wide variety of factors, including successfully manufacturingand marketing of the Company’s products, entering into and maintainingagreements with third parties for commercialization of the Company’s products,successfully licensing the Company’s products and technology and generaleconomic conditions, including those which affect demand for the services ofour dermatologist, plastic and cosmetic surgery customers.  Payments under corporate alliances andlicensing arrangements may be subject to fluctuations in both timing andamounts and therefore the level of profitability may vary significantly fromquarter to quarter.

 

###### *We Rely On Third Party Manufacturers for Our Products*

######  

We use third partymanufacturers to make products. In many cases, third party manufacturers arenot obligated under contracts that fix the term of their commitments and theymay discontinue production upon little or no advance notice.  Manufacturers also may experience problemswith product quality or timeliness of product delivery.  We rely on these manufacturers to complywith applicable current quality system regulations (“QSR”).  The loss of a contract manufacturer mayforce us to shift production to in-house facilities and possibly causemanufacturing delays, disrupt our ability to fill orders, or require us tosuspend production until we find another third party manufacturer.  We are not able to control the manufacturingefforts of these third party manufacturers as closely as we control ourbusiness.  Should any of thesemanufacturers fail to meet the applicable standards, we or our third-partymanufacturer could face various enforcement actions, which would have anadverse effect on our net revenues and results of operations.

 

###### *Need for Additional Capital*

######  

The Company generated positivecash from operations in the first quarter ended March 31, 2004 and break evencash flow from operations in 2003.  TheCompany currently expects that it will generate positive cash flow fromoperations in 2004.  As of March 31,2004, the Company had cash, and cash equivalents of $4.4 million.  The Company estimates that, at its plannedrate of spending, its existing cash and cash equivalents and the interestincome thereon will be sufficient to meet its operating and capitalrequirements for at least the next two years. There can be no assurance, however, that our underlying assumed levelsof revenue and expense will prove accurate. Whether or not these assumptions prove to be accurate, the Company mayneed to raise additional capital as the Company may require additional funds toexpand or enhance its sales and marketing activities, to accelerate productdevelopment, or acquire a product line or company.  The Company may be required to seek this additional fundingthrough public or private financing, including equity financing, or throughcollaborative arrangements.  Adequatefunds for these purposes, whether obtained through financial markets or fromcollaborative or other arrangements, may not be available when needed or maynot be available on terms favorable to the Company.  If we issue equity securities to raise additional funds, dilutionto existing shareholders will result. If funding is insufficient at any time in the future, the Company may berequired to: delay, scale back or eliminate some or all of its marketing andresearch and development programs; or license to third parties the rights tocommercialize products or technologies that the Company would otherwise seek todevelop on its own.  Furthermore, theterms of any such license agreements or asset sales might be less favorablethan if the Company were negotiating from a stronger position.

 

 

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*Uncertainty of Patent Position andProprietary Rights*

 

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

 

ProCyte’s success depends, inpart, upon its ability to protect its products, technology and trademarks underintellectual property laws in the United States and abroad.  The Company receives a significant amount ofits revenue from technology licensing agreements, which are dependent uponpatents, and expects to continue licensing its technology for certainmarkets.  Royalty revenue from theNeutrogena license agreement accounted for 11 percent and 14 percent of theCompany’s net revenues in the first quarter of 2004 and 2003, respectively andis based upon Neutrogena’s applicable sales, as set forth in the agreement,multiplied by specified royalty percentages. The patent related to the Neutrogena license agreement expires February5, 2005.  Upon expiration of thispatent, the agreement specifies that lower royalty percentages be used for theremaining term, the impact of which is a reduction in the average effectiveroyalty rate of approximately 32 percent. The actual amount of royalty income recognized in future periods isdependent upon the royalty percentages in effect during the period and theactual applicable sales reported by Neutrogena, which can vary from quarter toquarter.  The expiration of the patentwould also allow others, including Neutrogena, to manufacture thecompound.  The supply agreement expiresin April 2005, with extensions for additional two-year terms by mutual consentof the parties up to April 2010.  Therecan be no assurance that this agreement will be extended beyond April 2005, orif extended, that it will be extended to April 2010.

 

As of April 30, 2004, theCompany had 19 issued US patents expiring between 2005 and 2017, numerousissued foreign patents and patent registrations, and 11 patents applied for ofwhich 4 were published and pending action by the United States Patent &Trademark Office.  The patents relate touse of the Company’s copper peptide-based technology for a variety of healthcareapplications, 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.  Nor can there be any assurance that anypatent issued to the Company will not be subject to further proceedingslimiting the scope of the rights under the patent or that such patent willprovide a competitive advantage, will afford protection against competitorswith similar technology, or will not be successfully challenged, invalidated orcircumvented by competitors.

 

The Company’s processes andpotential products may conflict with patents that have been or may be grantedto competitors and others.  As thebiotechnology, medical device and healthcare industries expand and more patentsare issued, the risk increases that the Company’s processes and potentialproducts may give rise to claims that they infringe the patents of others.  Such other persons could bring legal actionsagainst the Company claiming damages and seeking to enjoin clinical testing, manufacturingand 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

 

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licensing arrangement may besubstantial and could include ongoing royalties.  There can be no assurance that any license required under anysuch patent would be made available to the Company on acceptable terms, if atall.  If such licenses could not beobtained on acceptable terms, the Company could be prevented from manufacturingand marketing existing or potential products. Accordingly, an adverse determination in such litigation could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.  The Company isnot aware of any conflicts at this time.

 

The Company also relies uponnon-patented proprietary technology. There can be no assurance that the Company can meaningfully protect itsrights to such non-patented technology, that any obligation to maintain theconfidentiality of such proprietary technology will not be breached byemployees, consultants, collaborators or others or that others will notindependently develop or acquire substantially equivalent technology.  To the extent that licensees or consultantsapply Company technological information independently developed by them or byothers to Company projects or apply Company technology or know-how to otherprojects, disputes may arise as to the ownership of proprietary rights to suchinformation.  Any failure to protectnon-patented proprietary technology or any breach of obligations designed toprotect such technology or development of equivalent technology may have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

###### *Uncertainty of Government Regulatory Requirements*

######  

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

 

In the United States, productsthat do not seek to make effectiveness claims based on human clinicalevaluation may be subject to review and regulation under the FDA’s cosmetic,drug or 510(k) medical device guidelines. Similar guidelines exist for such products in other countries.  Such 510(k) products, which include woundcare dressings and certain ointments and gels, must show safety and substantialequivalency with predicate products already cleared by the FDA to bemarketed.  There can be no assurancethat product applications submitted to the FDA or similar agencies in othercountries will receive clearance to be marketed, or that the labeling claimssought will be approved, or that, if cleared, such products will becommercially successful or free from third party claims relating to theeffectiveness or safety of such products.

 

The Company also is or maybecome subject to various other federal, state, local and foreign laws,regulations and policies relating to, among other things, safe workingconditions, good laboratory practices, and the use and disposal of hazardous orpotentially hazardous substances used in connection with research anddevelopment.

 

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

 

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*Intense Competition*

 

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

 

###### *Product Liability Claims*

######  

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

 

###### *Potential Volatility of Stock Price; Bulletin Board Listing*

######  

The market prices forsecurities of healthcare, pharmaceutical and biotechnology companies aresubject to volatility, and the market has from time to time experiencedsignificant fluctuations that are unrelated to the operations of the Company.  ProCyte’s market price has fluctuated over awide range since the Company’s initial public offering in 1989, and since March25, 1999, the Company’s common stock has traded on the NASD OTC bulletinboard.  Because real-time price informationmay not be easily available for bulletin board securities, an investor islikely to find it more difficult to dispose of, or to obtain accuratequotations on the market value of, the Company’s securities than if they werelisted on a the Nasdaq or a national exchange. In addition, purchases and sales of the Company’s securities may becomesubject to Rule 15g-9 of the Securities Exchange Act of 1934, which imposesvarious sales practice requirements on broker-dealers, or to the “penny stock”rules, either of which would likely reduce the level of trading activity in thesecondary market for the Company’s securities and make selling the securitiesmore difficult for an investor.

 

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

 

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

 

For a discussion of our marketrisks, refer to the Item 7A, “Quantitative and Qualitative DisclosuresAbout Market Risk,” in our Annual Report on Form 10-K for the year endedDecember 31, 2003. There have been no material changes to the informationprovided that would require additional information with respect to the threemonths ended March 31, 2004.

 

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

## ** **

As of the end of the periodcovered by this report, the Company conducted an evaluation, under thesupervision and with the participation of its principal executive officer andprincipal financial officer, of the effectiveness and design of its disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation, the principalexecutive officer and principal financial officer concluded that thesedisclosure controls and procedures were effective as of March 31, 2004, inensuring that all material information required to be disclosed in reports thatthe Company files or submits under the Exchange Act have been made known tothem in a timely fashion.

 

There were no changes in theCompany’s internal controls over financial reporting during the first quarterof 2004 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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# **Part II - OtherInformation**

# ** **

## **Item 1.  LegalProceedings**

## ** **

Not applicable.

 

## **Item 2. Changes**in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

## ** **

Not applicable. 

 

## **Item 3. Defaults Upo**n Senior Securities

## ** **

Not applicable.

 

## **Item 4. Submission of Ma**tters to a Vote of Security Holders

## ** **

Not applicable.

 

## **Item 5.  OtherInformation**

## ** **

Not applicable.

 

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

## ** **

(a) Exhibits

 

See Exhibit Index below.

 

(b) Reports on Form 8-K

 

Form 8-K filed March 4, 2004announcing the Company’s earnings for the fourth quarter and year endedDecember 31, 2003.

 

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# **Signatures**

# ** **

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

 

 
|                | **ProCyte Corporation** |
|---------------------|-------------------------|
|                |                    |
|                |                    |
| Date: May  17, 2004 | By:                     | /s/ John F. Clifford |   |
|                |                    |   |
|                |                    | John F. Clifford, Chairman and CEO |
|                |                    |   |
| Date: May  17, 2004 | By:                     | /s/ Robert W. Benson |   |
|                |                    |   |
|                |                    | Robert W. Benson, Chief Financial Officer |

 

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Exhibit Index

 
| **Exhibit** |      | **Description** |                                                                                                                                 | **Note** |
|-------------|-----------|-----------------|--------------------------------------------------------------------------------------------------------------------------------------|----------|
| 3           | .1        |            | Restated Articles of Incorporation of the Registrant                                                                                 |     | A |
| 3           | .2        |            | Restated Bylaws of the Registrant                                                                                                    |     | A |
| 4           | .1        |            | Rights Agreement between the Registrant and American Securities  Transfer and Trust as of December 7, 1994                           |     | G |
| 10          | .1*       |            | 1987 Stock Benefit Plan of ProCyte Corporation                                                                                       |     | A |
| 10          | .2*       |            | ProCyte Corporation 1989 Restated Stock Option Plan                                                                                  |     | B |
| 10          | .3*       |            | ProCyte Corporation 1991 Restated Stock Option Plan for Non-employee  Directors and amendments thereto                               |     | D |
| 10          | .4†  |            | Teachers Insurance & Annuity Association Lease dated as of  October 1, 1993 and second amendment thereto dated February 28, 1997 |     | D |
| 10          | .5*       |            | 1996 Stock Option Plan                                                                                                               |     | D |
| 10          | .6*       |            | ProCyte Corporation 1998 Non-employee Director Stock Plan                                                                            |     | F |
| 10          | .7*       |            | Change of Control Agreement for Ms. Robin Carmichael                                                                                 |     | F |
| 10          | .8*       |            | Change of Control Agreement for Mr. John Clifford                                                                                    |     | D |
| 10          | .13*      |            | Form of Indemnity Agreement dated February 23, 1995 between the  Registrant and each of Dr. Blake, Mr. Patterson and Mr. Clifford.   |     | C |
| 10          | .14*      |            | Form of Indemnity Agreement between ProCyte Corporation and each of  various of its Officers and Directors                           |     | F |
| 10          | .15*      |            | Form of Severance Agreement for Mr. John Clifford                                                                                    |     | D |
| 10          | .16*      |            | Form of Promissory Note between ProCyte Corporation and Mr. John  Clifford                                                           |     | H |
| 10          | .17† |            | License Agreement dated April 19, 2000 between ProCyte Corporation  and Neutrogena Corporation                                       |     | I |
| 31          | .1        |            | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                    |     | J |
| 31          | .2        |            | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                    |     | J |
| 32          | .1        |            | Section 1350 Certification of Chief Executive Officer                                                                                |     | J |
| 32          | .2        |            | Section 1350 Certification of Chief Financial Officer                                                                                |     | J |

 

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

 

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