** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

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

 

**For the Quarterly Period Ended March31, 2003**

 

**Commission File Number 0-18044**

 

**PROCYTECORPORATION**

(Exact name of theregistrant as specified in its charter)

 

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

 

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

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

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange ActRule 12b-2).

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

 

As of May 8, 2003,there were issued and outstanding 15,764,687 shares of common stock, par value$.01 per share.

 

 

----

 

**ProCyte Corporation**

** **

**Index**

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

 

2

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# **PartI** - FinancialInformation

 

## **Item 1**. Condensed Consolidated Financial Statements(unaudited)

 

### **BalanceSheets** - asof March 31, 2003 and December 31, 2002 (unaudited)

 
|                                                            |   | **March 31,  2003** |       | **December  31, 2002** | ** ** |
|-----------------------------------------------------------------|--------|---------------------|------------|------------------------|------------|
| **Assets**                                                      |   |                |       |                   |       |
| Cash and cash equivalents                                       |   | $                   | 4,387,698  |                   | $          | 4,555,985 |   |
| Accounts receivable, net of allowance for doubtful  accounts    |   | 1,461,829           |       | 1,327,956              |       |
| Inventory                                                       |   | 1,672,743           |       | 1,717,813              |       |
| Prepaid expenses                                                |   | 46,519              |       | 326,386                |       |
| Other current assets                                            |   | 4,067               |       | 3,319                  |       |
| ***Total current assets***                                      |   | 7,572,856           |       | 7,931,459              |       |
| Property and equipment, net                                     |   | 1,214,042           |       | 1,285,776              |       |
| Intangible assets, net                                          |   | 2,898,994           |       | 2,902,996              |       |
| Note due from sale of contract manufacturing  operations, net   |   | 1,833,600           |       | 1,825,800              |       |
| Other assets                                                    |   | 142,781             |       | 142,781                |       |
| **Total  Assets**                                               |   | $                   | 13,662,273 |                   | $          | 14,088,812 |   |
|                                                            |   |                |       |                   |       |
| **Liabilities and Stockholders’ Equity**                   |   |                |       |                   |       |
| Accounts payable, trade                                         |   | $                   | 199,925    |                   | $          | 277,178 |   |
| Accrued salaries and benefits                                   |   | 157,425             |       | 404,282                |       |
| Other accrued liabilities                                       |   | 274,780             |       | 259,880                |       |
| Deferred revenue                                                |   | 75,247              |       | 21,000                 |       |
| ***Total current  liabilities***                                |   | 707,377             |       | 962,340                |       |
| Other liabilities                                               |   | 93,394              |       | 91,258                 |       |
| Deferred proceeds on sale of contract manufacturing  operations |   | 1,149,990           |       | 1,216,891              |       |
| **Total  Liabilities**                                          |   | 1,950,761           |       | 2,270,489              |       |
| Common stock and additional paid-in-capital                     |   | 85,326,776          |       | 85,311,638             |       |
| Deferred compensation                                           |   | —              |       | (10,830                | )          |
| Accumulated deficit                                             |   | (73,615,264         | )          | (73,482,485            | )          |
| **Stockholders’  Equity**                                  |   | 11,711,512          |       | 11,818,323             |       |
| **Total  Liabilities and Stockholders’ Equity**            |   | $                   | 13,662,273 |                   | $          | 14,088,812 |   |

 

*See notes to condensed consolidated financial statements*

 

3

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### **Statements of Operations** - Three Months Ended March 31, 2003 and2002 (unaudited)

 
|                                        |   | **Three  months ended  March 31,** | ** ** |
|---------------------------------------------|--------|------------------------------------|------------|
|                                        |   | **2003**                           |       | **2002** | ** ** |
| **Revenues**                                |   |                               |       |   |   |
| Product sales                               |   | $                                  | 2,881,916  |   | $ | 2,753,400 |   |
| Licenses and royalties                      |   | 464,486                            |       | 289,000 |   |
| Total revenue                               |   | 3,346,402                          |       | 3,042,400 |   |
| Cost of product sales                       |   | 1,183,201                          |       | 926,081 |   |
| Gross profit                                |   | 2,163,201                          |       | 2,116,319 |   |
| **Operating  Expenses**                     |   |                               |       |   |   |
| Marketing and selling                       |   | 1,399,575                          |       | 771,784 |   |
| Research, general, and administrative       |   | 967,028                            |       | 902,456 |   |
| Total operating expenses                    |   | 2,366,603                          |       | 1,674,240 |   |
| Operating income (loss)                     |   | (203,402                           | )          | 442,079 |   |
| Interest and other income                   |   | 88,123                             |       | 46,797 |   |
| Net income (loss) before tax                |   | (115,279                           | )          | 488,876 |   |
| Provision for income tax                    |   | (17,500                            | )          | — |   |
| Net income (loss)                           |   | $                                  | (132,779   | ) | $ | 488,876 |   |
| ***Net earnings (loss)  per share***        |   |                               |       |   |   |
| Basic                                       |   | $                                  | (0.01      | ) | $ | 0.03 |   |
| Diluted                                     |   | $                                  | (0.01      | ) | $ | 0.03 |   |
| ***Shares used in  per share computation*** |   |                               |       |   |   |
| Basic                                       |   | 15,745,696                         |       | 15,682,473 |   |
| Diluted                                     |   | 15,745,696                         |       | 16,000,865 |   |

 

*See notes to condensed consolidatedfinancial statements*

 

4

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### **Statements of Cash Flows** - Three Months Ended March 31, 2003 and2002 (unaudited) 

 
|                                                                                                       |   | **Three  months ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                                                       |   | **2003**                          |       | **2002** | ** ** |
| **Operating  Activities**                                                                                  |   |                              |       |   |   |
| Net income (loss)                                                                                          |   | $                                 | (132,779   | ) | $ | 488,876 |   |
| ***Adjustments to  reconcile net income (loss) to net cash provided by (used) in operating  activities:*** |   |                              |       |   |   |
| Depreciation and amortization                                                                              |   | 75,737                            |       | 78,085 |   |
| Amortization of deferred proceeds                                                                          |   | (66,900                           | )          | (66,901 | ) |
| Non-cash expense related to stock-based compensation                                                       |   | 12,000                            |       | 12,000 |   |
| Amortization of promissory note discount                                                                   |   | (7,800                            | )          | (7,800 | ) |
| Amortization of deferred compensation                                                                      |   | 3,654                             |       | — |   |
| ***Change in  operating assets and liabilities:***                                                         |   |                              |       |   |   |
| Accounts receivable                                                                                        |   | (133,873                          | )          | (703,312 | ) |
| Inventory                                                                                                  |   | 45,070                            |       | (237,247 | ) |
| Prepaid expenses                                                                                           |   | 279,867                           |       | 58,001 |   |
| Other current assets                                                                                       |   | (748                              | )          | (1,184 | ) |
| Accounts payable, trade                                                                                    |   | (77,253                           | )          | (259,406 | ) |
| Accrued salaries and benefits                                                                              |   | (246,856                          | )          | (71,059 | ) |
| Other accrued liabilities                                                                                  |   | 14,898                            |       | 82,050 |   |
| Deferred revenue                                                                                           |   | 54,247                            |       | 24,000 |   |
| Other liabilities                                                                                          |   | 2,135                             |       | (6,337 | ) |
| ***Net cash used in  operating activities***                                                               |   | (178,601                          | )          | (610,234 | ) |
| **Financing  Activities**                                                                                  |   |                              |       |   |   |
| Proceeds from issuance of common stock                                                                     |   | 10,314                            |       | 6,180 |   |
| **Investing Activities**                                                                                   |   |                              |       |   |   |
| Purchase of property and equipment                                                                         |   | —                            |       | (8,734 | ) |
| Decrease in other assets                                                                                   |   | —                            |       | 45,000 |   |
| ***Net cash provided  by investing activities***                                                           |   | —                            |       | 36,266 |   |
| ***Net decrease in  cash and cash equivalents***                                                           |   | (168,287                          | )          | (567,788 | ) |
| **Cash  and Cash Equivalents**                                                                             |   |                              |       |   |   |
| At beginning of period                                                                                     |   | 4,555,985                         |       | 3,002,579 |   |
| At end of period                                                                                           |   | $                                 | 4,387,698  |   | $ | 2,434,791 |   |

 

*See notes to condensed consolidated financial statements*

 

5

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### **Statements of Stockholders’ Equity** - Three Months Ended March 31, 2003 and2002 (unaudited)

 
|                                                      |   | **Common Stock** |   | **Additional  Paid-in  Capital** |    | **Deferred  Compen-  sation** |   | **Accumulated  Deficit** |   | **Total** |    |
|-----------------------------------------------------------|--------|------------------|--------|----------------------------------|---------|-------------------------------|--------|--------------------------|--------|-----------|---------|
| **Shares**                                                |   | **Par Value**    |
| Balance – December 31, 2001                          |   | 15,653,542       |   | $                                | 156,535 |                          | $      | 85,062,476               |   | $         | —  |   | $ | (75,151,338 | ) | $ | 10,067,673 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Shares issued under non-employee director stock plan      |   | 8,604            |   | 86                               |    | 11,914                        |   | —                   |   | —    |    | 12,000 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Shares issued upon exercise of warrant issued in  1999    |   | 18,549           |   | 185                              |    | (185                          | )      | —                   |   | —    |    | — |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Shares issued upon exercise of options                    |   | 8,002            |   | 81                               |    | 6,099                         |   | —                   |   | —    |    | 6,180 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Net income for three months ended March 31, 2002          |   | —           |   | —                           |    | —                        |   | —                   |   | 488,876   |    | 488,876 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Balance – March 31, 2002                             |   | 15,688,697       |   | $                                | 156,887 |                          | $      | 85,080,304               |   | $         | —  |   | $ | (74,662,462 | ) | $ | 10,574,729 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Balance – December 31, 2002                          |   | 15,733,911       |   | $                                | 157,339 |                          | $      | 85,154,299               |   | $         | (10,830 | ) | $ | (73,482,485 | ) | $ | 11,818,323 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Shares issued under non-employee director stock plan      |   | 8,644            |   | 86                               |    | 11,914                        |   | —                   |   | —    |    | 12,000 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Shares issued upon exercise of options                    |   | 12,000           |   | 120                              |    | 10,194                        |   | —                   |   | —    |    | 10,314 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Re-measurement of stock options granted to  non-employees |   |             |   |                             |    | (7,176                        | )      | 7,176                    |   | —    |    | — |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Amortization of deferred compensation                     |   |             |   |                             |    |                          |   | 3,654                    |   |      |    | 3,654 |   |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Net loss for three months ended March 31, 2003       |   | —           |   | —                           |    | —                        |   | —                   |   | (132,779  | )       | (132,779 | ) |
|                                                      |   |             |   |                             |    |                          |   |                     |   |      |    |   |   |
| Balance – March 31, 2003                             |   | 15,754,555       |   | $                                | 157,545 |                          | $      | 85,169,231               |   | $         | —  |   | $ | (73,615,264 | ) | $ | 11,711,512 |   |

 

*See notes to condensed consolidatedfinancial statements*

 

6

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**ProCyte CorporationNotes to Condensed Consolidated Financial Statements (unaudited)**

 

**1.**              **Basis ofPresentation**

 

The accompanyingcondensed consolidated financial statements (unaudited) include the accounts ofProCyte Corporation and its wholly-owned, subsidiaries NextDerm, Inc. (aDelaware corporation) and NextDerm, Inc. (a Washington corporation incorporatedFebruary 28, 2003) (collectively “ProCyte” or the “Company”) for thethree-month periods ended March 31, 2003 and 2002 have been prepared by theCompany in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and the instructionsto Form 10-Q and Article 10 of Regulation S-X. Pursuant to such rules and regulations, the consolidated condensedfinancial statements do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for audited financial statements. Accordingly, this financial information should be read in conjunctionwith the complete audited financial statements, including the notes thereto,which are included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2002.  In the opinionof management, all material adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation of the financialstatements have been included.  Interimresults are not necessarily indicative of the results that may be expected forthe year.

 

**2.**              **AccountsReceivable**

 

Two customers eachrepresented greater than 10% of the net accounts receivable balance at March31, 2003 and December 31, 2002 as follows:

 
|       |   | **March 31,  2003** |   | **December  31, 2002** | ** ** |
|------------|--------|---------------------|--------|------------------------|------------|
| Customer A |   | 42                  | %      | 44                     | %          |
| Customer B |   | 11                  | %      | 13                     | %          |

 

The Companyprovided an allowance for uncollectable receivables in the amount of $67,447and $68,029 at March 31, 2003 and December 31, 2002, respectively.  The bad debt expense, net of recoveries of$2,427 in 2003 and $1,601 in 2002, was $9,882 and $5,128 for the three monthsended March 31, 2003 and 2002, respectively. Accounts written off to the allowance amounted to $12,891 and $1,730 forthe three months period ended March 31, 2003 and 2002, respectively.

 

**3.**              **Inventory**

 

Certainreclassifications have been made to inventory items reported in the prior yearto conform to the current year’s presentation. Inventory consisted of the following:

 
|            |   | **March 31,  2003** |      | **December  31, 2002** | ** ** |
|-----------------|--------|---------------------|-----------|------------------------|------------|
| Finished Goods  |   | $                   | 1,048,936 |                   | $          | 1,254,434 |   |
| Work in process |   | 300,648             |      | 227,080                |       |
| Raw materials   |   | 323,159             |      | 236,299                |       |
| **Total**       |   | $                   | 1,672,743 |                   | $          | 1,717,813 |   |

 

7

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**4.**              **Property andEquipment**

 

Property andequipment consisted of the following:

 
|                                             |   | **March 31,  2003** |      | **December  31, 2002** | ** ** |
|--------------------------------------------------|--------|---------------------|-----------|------------------------|------------|
| Equipment                                        |   | $                   | 332,550   |                   | $          | 332,550 |   |
| Leasehold improvements                           |   | 4,028,807           |      | 4,028,807              |       |
| Less accumulated depreciation & amortization |   | (3,147,315          | )         | (3,075,581             | )          |
| Property and equipment, net                      |   | $                   | 1,214,042 |                   | $          | 1,285,776 |   |

 

**5.**              **IntangibleAssets**

 

Intangible assetsinclude patents of $81,623 and $85,625 at March 31, 2003 and December 31, 2002,respectively.  Patents are shown net ofaccumulated amortization of $209,307 and $205,305, at March 31, 2003 andDecember 31, 2002, respectively. Patents are amortized over the term of the patent and the amortizationexpense related thereto was $4,002 for each of three-month periods ended March31, 2003 and 2002, respectively.  Patentamortization expense is expected to be $16,000 for each of the years endingDecember 31, 2003 through 2007 and $6,000 for the year endingDecember 31, 2008.

 

Intangible assetsalso include goodwill of $2,817,371 at March 31, 2003 and at December 31,2002.  Under the guidance of Statementof Financial Accounting Standards (SFAS) No. 142 “Goodwill and Other IntangibleAssets,” the Company performed an annual test on the value of certainintangibles such as goodwill on March 31, 2003.  The Company tested whether there was an indication of goodwillimpairment, and concluded that goodwill was not impaired.  The Company determined that it has one reportableunit, therefore, all of goodwill is deemed to be associated with ProCyte’soverall business operations.

 

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

** **

No provision wasmade for federal income taxes for the three months ended March 31, 2003 and2002.  At March 31, 2003 and December31, 2002, the Company provided a full valuation allowance for its net deferredtax assets.  The Company believessufficient uncertainty exists regarding the realizability of the deferred taxassets.  The net changes in thevaluation allowance during the three months ended March 31, 2003 and the yearended December 31, 2002, were $(26,300) and $(627,390), respectively.

 

A provision forstate income tax was made for California state income tax in the quarter endedMarch 31, 2003.  The Company has a netoperating loss carry forward for California state income tax of $350,015,however in the fourth quarter of 2002 the State of California temporarilysuspended the use of the net operating loss carry forward deduction for 2002and 2003.  As a result, the Company isrecognizing $17,500 related to state income taxes in the first quarter of 2003.

 

As of March 31,2003, the Company’s U.S. federal net operating loss and general business creditcarry forward for income tax purposes were approximately $68.0 million and $1.6million, respectively.  If not utilized,the federal net operating loss carry forward and tax credits carry forward willexpire between 2004 and 2021.  Changesin ownership, as defined by Section 382 of the IRC, may limit the amount of netoperating loss carry forward used in any one year.

 

8

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**7.**              **Earnings(loss) per share**

 

Basic and dilutedper share results for all periods presented were computed based on the netearnings or loss for the respective periods. The weighted average number of common shares outstanding during theperiod was used in the calculation of basic earnings (loss) 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 fromoperations, as such adjustments would otherwise be anti-dilutive to earningsper share from operations.  For thequarter ended March 31, 2002, 318,392 dilutive stock options were included inthe calculation of average number of common shares outstanding for dilutedcomputations.  As a result of theCorporation recording a loss from operations in the quarter ended March 31,2003, the average number of common shares used in the calculation of thediluted loss per share has not been adjusted for the effects of 169,499dilutive stock options since their impact would be anti-dilutive.

 

**8.**              **Warrants toAcquire Common Stock**

 

The Company issuedthree common stock purchase warrants totaling 100,000 shares on May 26, 1999 inexchange for services.  The threewarrants oblige the Company to issue 33,334 shares at $0.6875 per share, themarket price on the grant date, 33,333 shares at $1.6875 and 33,333 shares at$2.6875.  Each of the warrants has afive-year life and is fully vested. The fair value of these warrants wasdetermined to be $90,117 using the Black-Scholes option-pricing model and wasexpensed in 1999.  The assumptions usedin the model were a risk-free interest rate of 4.08%, an expected life of fiveyears, 98% stock price volatility and no dividends over the expected life.  On January 2, 2002, the first warrant for33,334 shares was exercised in a net exercise, as provided by the terms of thewarrant, resulting in the issuance of 18,549 shares.

 

**9.**              **StockOptions**

 

Informationrelating to stock options granted, exercised, canceled and currentlyexercisable is as follows:

 
|                         |   | **Shares  Subject to Option** |   | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------|--------|-------------------------------|--------|---------------------------------------|------------|
| Outstanding, January 1, 2002 |   | 2,087,002                     |   | $                                     | 1.57       |   |
| Granted                      |   | 28,000                        |   | $                                     | 1.33       |   |
| Exercised                    |   | (8,002                        | )      | $                                     | 0.75       |   |
| Canceled or expired          |   | (31,331                       | )      | $                                     | 1.08       |   |
| Outstanding, March 31, 2002  |   | 2,075,669                     |   | $                                     | 1.58       |   |

 

9

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|                         |   | **Shares  Subject to Option** |   | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------|--------|-------------------------------|--------|---------------------------------------|------------|
| Outstanding, January 1, 2003 |   | 2,185,335                     |   | $                                     | 1.57       |   |
| Granted                      |   | 97,500                        |   | $                                     | 1.31       |   |
| Exercised                    |   | (12,000                       | )      | $                                     | 0.86       |   |
| Canceled or expired          |   | (45,501                       | )      | $                                     | 1.55       |   |
| Outstanding, March 31, 2003  |   | 2,225,334                     |   | $                                     | 1.56       |   |
| Exercisable, March 31, 2003  |   | 1,436,347                     |   | $                                     | 1.61       |   |

 

The Companyfollows the intrinsic value-based accounting method for stock options containedin APB Opinion No. 25, Accounting forStock Issued to Employees, as permitted by SFAS No. 123, Accounting forStock-Based Compensation.  Underthis method, the Company measures stock-based compensation for option grants toemployees assuming that options granted at market price at the date of granthave no intrinsic value.  Nocompensation expense has been recognized for employee and director stockoption-based incentive compensation plans. Had compensation expense for the Company’s stock options under theincentive compensation plan been recognized based upon the fair value forawards granted, the Company’s net earnings or losses would have been changed tothe following pro forma amounts for the quarters ended March 31, 2003 and 2002:

 
|                                                                              |   | **2003** |     | **2002** | ** ** |
|-----------------------------------------------------------------------------------|--------|----------|----------|----------|------------|
| Net earnings (loss), as reported                                                  |   | $        | (132,779 | )        | $          | 488,876 |   |
| Stock option-based compensation expense determined  under fair value-based method |   | 127,064  |     | 68,327   |       |
| Pro forma net earnings (loss)                                                     |   | $        | (259,843 | )        | $          | 420,549 |   |
| Earnings per share:                                                               |   |     |     |     |       |
| As reported basic                                                                 |   | $        | (0.01    | )        | $          | 0.03 |   |
| As reported diluted                                                               |   | $        | (0.01    | )        | $          | 0.03 |   |
| Pro forma basic                                                                   |   | $        | (0.02    | )        | $          | 0.03 |   |
| Pro forma diluted                                                                 |   | $        | (0.02    | )        | $          | 0.03 |   |

 

The Companydetermined the fair value of stock options granted during the quarters endedMarch 31, 2003 and 2002 using the Black-Scholes option pricing model and thefollowing assumptions: 

 
| **Options Granted**          |   | **2003** |   | **2002** |   |
|------------------------------|--------|----------|--------|----------|--------|
| Risk-free interest rate      |   | 2.81     | %      | 3.84     | %      |
| Expected option life (years) |   | 6.00     |   | 6.00     |   |
| Dividend yield               |   | 0.00     |   | 0.00     |   |
| Expected volatility          |   | 62       | %      | 67       | %      |

 

The weightedaverage fair value of options granted during the quarters ended March 31, 2003and 2002 was approximately $0.79 and $0.85, respectively.

 

The Companygranted 10,000 stock options on February 21, 2002 and 10,000 stock options onMay 20, 2002 in exchange for advisory services from two non-employeeconsultants.  The February and Maygrants, respectively, oblige the Company to issue 10,000 common stock shares at$1.33 and $1.83, the

 

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market price onthe dates of grant.  Both grants becamefully vested one year after their date of issuance.  The re-measured fair value of the February and May grants on thefinal measurement date was determined to be $4,325 and $5,951, respectively,using the Black-Scholes option-pricing model. The options were re-measured on February 28, 2003, the date the serviceswere considered completed.  Theassumptions, used in the model for re-measuring the February and May grants,were a risk-free interest rate of 2.81%, 62% stock price volatility, and nodividends over a one-year expected life.

 

**10.**       **RelatedParty Disclosure**

 

The Company holdsa promissory note in the principal amount of $2,000,000 from EmeraldPharmaceutical L.P., which it received as partial consideration for the sale ofits contract manufacturing operations in 2001. The note is secured by the manufacturing assets sold and bears interestequal to the effective yield on the 10 Year U.S. Treasury Note, which isadjusted quarterly.  The yield for thequarter ended March 31, 2003 was 3.82%. Emerald will begin making annual principal payments of $285,714 in July2005.  The Company also received aminority limited partnership interest in Emerald as part of considerationreceived in the sale.  As part of theagreement, ProCyte leases 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 $1,627,906 has been determined to represent consideration for useof Emerald’s use of the leasehold improvements, and is being recognized over theterm of the lease.  ProCyte engages EmeraldPharmaceutical L.P. to do certain manufacturing and other quality andanalytical services.  Emerald billedProCyte a total of $769,353 and $132,660 for the quarters ended March 31, 2003and 2002, respectively, for such services. ProCyte had trade payables to Emerald of $30,127 and $92,404 on March31, 2003 and December 31, 2002, respectively.

 

One of theCompany’s Directors also serves as Chairman and Chief Executive Officer of oneof ProCyte’s customers.  ProCyte’s netsales to the customer were $187,764 and $217,442 for the three months endedMarch 31, 2003 and 2002, respectively. The customer’s trade receivable balances were $119,390 and $172,145 onMarch 31, 2003 and December 31, 2002, respectively. 

 

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

 

This QuarterlyReport Form 10-Q contains forward-looking statements. These statements relateto future events or future financial performance.  In some cases you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,”“anticipate,” “believe,” “estimate,” “predict,” “potential,” “propose” or“continue,” the negative of these terms, or other terminology.  These statements are only predictions.  Actual events or results may differmaterially.  In evaluating thesestatements, you should specifically consider various factors described below inthe section entitled “Important Factors Regarding Forward-Looking Statements.”These factors may cause our actual results to differ materially from anyforward-looking statement. 

 

Although webelieve the expectations reflected in the forward-looking statements arereasonable, we cannot guarantee future results, levels of activity, productdemand, performance or achievements. You should not place undue reliance on our forward-looking statements,which speak only as of the date of this report. We undertake no obligation to publiclyupdate any forward-looking statements, whether as a result of new information,future events or otherwise. 

 

*Critical Accounting Policies andEstimates*

 

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

 

Product 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.

 

Approximately 21%of ProCyte’s assets as of March 31, 2003 consisted of goodwill, most of whichwas acquired in business combinations and recorded based on the fair value ofthe common stock issued to effect those business combinations.  Under theguidance of SFAS 142 “Goodwill and Other Intangible Assets,” we analyze whetherthe fair value of recorded goodwill is impaired on an annual basis.  Ouranalysis of whether the fair value of recorded goodwill is impaired involved asubstantial amount of judgment, as does establishing and monitoring estimatedlives of amortizable intangible assets.  Future charges related tointangible assets could be material depending on future developments andchanges in technology and our business.

 

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We maintain anallowance for doubtful accounts for estimated losses resulting from thepotential inability of our customers or other debtors to make requiredpayments.  We believe such allowancesare adequate as of March 31, 2003; however, if the financial condition of ourcustomers or other debtors were to deteriorate, resulting in an impairment oftheir ability to make payments to us, additional allowances may be required.

 

Inventories arestated at the lower of cost or market value.  Cost is principallydetermined by the first-in, first-out method.  The Company records adjustmentsto the value of inventory based upon its forecasted plans to sell itsinventories.  The physical condition (e.g., age and quality) of theinventories is also considered in establishing its valuation.  Theseadjustments are estimates, which could vary significantly, either favorably orunfavorably, from the amounts that the Company may ultimately realize upon thedisposition of inventories, if future economic conditions, customer inventorylevels, product discontinuances or competitive conditions differ from ourestimates and expectations.

 

*Corporate Overview*

* *

ProCyte develops,manufactures and markets products for skin health, hair care and wound care,many of which incorporate its clinically tested and patented Copper Peptidetechnologies.  We have experiencedannual revenue growth since 1997.  Thisgrowth is a result of our continued focus to expand product offerings as wellas to develop additional markets and distribution channels through strategicpartners.  ProCyte receives revenue fromthe sale of products via its U.S. sales force, distributors and internationalcustomers, from royalties and the sale of Copper Peptide compounds underlicense and supply agreements, and from the manufacture and sale of privatelabel products containing our technologies.

 

During the fourthquarter of 2002, ProCyte initiated work on an infomercial, a form ofdirect-to-consumer distribution, which will sell a new brand of anti-aging andskin care products called VitalCopperTM. Many of the initial VitalCopperTM products include GHK Copper Peptidecompounds. Production and filming were completed in January 2003, and theinitial market test began in selected markets during March 2003.  Continuation of the market test was placedon hold as public and media attention focused on the Iraq conflict.  We currently expect to restart the markettest in the summer of 2003 and, pending results of the market test, evaluatethe national rollout planned for the later part of 2003.  However, the actual timing of additionaltest marketing and actual release of the infomercial will depend on ourassessment of the ability to capture public attention during the aftermath ofthe conflict and in light of world and national affairs at any given time.  As a result of required accounting practicesfor an infomercial, development and production costs totaling $540,000 wereexpensed and included under marketing and selling upon first run of theinfomercial in the first quarter of 2003.

 

*Revenues*

* *

The Company’stotal revenue for the first quarter of 2003 increased 10% to $3.3 million from$3.0 million reported in the first quarter 2002.  The Company experienced growth in both product sales andlicensing and royalties revenue over the same quarter in the prior year.

 

Product sales,which include the sale of Copper Peptide compounds under license and supplyagreements, increased 5% in the first quarter to $2,881,916, from $2,753,400reported in the same period a year earlier. This increase includes sales to physicians and distributors, whichincreased 4% over the prior year quarter. Within this category, domestic physician and distributor sales were downslightly from the prior year quarter, reflecting the impact that severe winterweather and the soft economy had on our customers; however, the decline wasmore than offset by an increase in international distributor sales.  Sales of Copper Peptide compounds increased6% in the current year quarter as compared to the same

 

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period in theprior year.  Contributing to the growthin 2003 was Neutrogena’s increased demand for our Copper Peptide compound,which more than offset the larger amount of Copper Peptide compound purchasedby American Crew in the first quarter of 2002 to support its initial marketlaunch.

 

Licensing androyalties revenue increased 61% in the first quarter of 2003 over the sameperiod in 2002. This is due to the fact that our license partners were at thevery early stages of product introduction in the 2002 period.  Royalty revenues may fluctuate from quarterto quarter, due to the licensees’ timing of new market launches, specialpromotions and other factors beyond the Company’s control.

 

*Gross Profit*

 

In the firstquarter of 2003, gross profit increased 2% to $2,163,201 as compared to$2,116,319 reported for the same quarter in 2002.  Gross margin was 65% in 2003 as compared to 70% reported in theyear earlier period.  ProCyteexperiences fluctuating gross margins from quarter to quarter based on therevenue mix of packaged products, licensee purchases of Copper Peptidecompounds and royalty revenue.  Thedecrease in gross margin in the first quarter of 2003 was a result of changesin the mix from the prior period.

 

*Expenses*

 

Total operatingexpenses increased 41% in the first quarter of 2003 to $2,366,603 from$1,674,241 reported for the same quarter in 2002.  Certain reclassifications have been made to operating expensesreported in the prior year to conform to the current year’s presentation.  

 

Marketing andselling expenses, which included a $540,000 charge for the development andproduction of an infomercial, increased 81% over the same quarter in 2002.  The infomercial expense represented 86% ofthis increase.  Excluding theaforementioned infomercial expense item, marketing and selling expensesincreased 11% in the 2003 quarter as compared to the 2002 period.  The increase is primarily due to theaddition of a Director of Business Development in the first quarter of 2003,increased advertising expenditures as well as costs to develop a web site forits Vital CopperTM product line in the 2003 period.  

 

Research, generaland administrative expenses increased 7% to $967,028 in the 2003 quarter ascompared to $902,456 in the corresponding 2002 period.  This is due to increased salaries andbenefits related to the inclusion of a Chief Financial Officer in the 2003period, increased legal and audit fees incurred for compliance with newcorporate governance and reporting standards, and increased legal fees relatedto actions initiated by ProCyte to enforce its rights under certainagreements.  These increases werepartially offset by decreases in recruiting expenses.

 

Interest and otherincome for the first quarter of 2003 increased 92% to $88,123 as compared to$46,797 earned in the same quarter in 2002. The Company received a one-time termination settlement from Merck KGaAfor $50,000 in the first quarter of 2003. For the quarter ended March 31, 2003, ProCyte received interest paymentsof $18,828 from Emerald Pharmaceutical L.P. on a $2,000,000 promissory note ascompared to $24,756**received for the comparable quarter in2002.

 

*Income Taxes*

 

As of March 31,2003 the Company’s U.S. federal net operating loss and general business taxcredit carry forwards for income tax purposes were approximately $68.0 millionand $1.6 million, respectively.  TheCompany has not yet recognized the benefit of these tax expense savings forfuture period earnings.  The

 

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Company has hadnet operating losses since inception, with the exception of net income reportedfor the first time in 2002.  Thus,sufficient uncertainty still exists regarding the realizability of using thedeferred tax assets in future periods. If not utilized, the federal net operating loss carry forward and taxcredit carry forwards will expire between 2004 and 2021.

 

A provision forstate income tax was made for California income tax in the quarter ended March31, 2003.  The Company has a netoperating loss carry forward for California state income tax of $350,000,however in the fourth quarter of 2002 the State of California temporarilysuspended the use of the net operating loss carry forward deduction for 2002and 2003.  As a result, the Company isrecognizing $17,500 related to state income taxes in the first quarter of 2003.

 

*Net Income (Losses)*

* *

ProCyte reported anet loss of $132,779 for the first quarter of 2003 as compared to net income of$488,876 in the same quarter in 2002. The Company’s loss in the first quarter of 2003 was due to theaforementioned $540,000 charge for developing and producing aninfomercial.  At March 31, 2003, theCompany’s accumulated deficit was approximately $73.6 million. 

 

*Liquidity and Capital Resources*

* *

The Company hasrelied primarily on equity financing, revenue, interest income and corporatepartnerships to fund its operations and capital expenditures.  At March31, 2003, the Company had approximately $4.4 million in cash and cashequivalents, compared to $4.6 million at December 31, 2002.  The netchange in cash and cash equivalents during the quarter ended March 31, 2003reflects a net use of cash of $168,000. The significant components of thisdecease are disbursements related to the infomercial and 2002 managementbonuses, which were partially offset by a customer deposit received during thequarter.  We expect to see fluctuationsin cash flows from operations in future periods as they depend in large part onthe timing of deposits received from our strategic partners and theirinitiation of new product introductions.

 

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 actions by regulatoryauthorities, the levels of resources that the Company devotes to takingadvantage of strategic acquisitions and/or establishing and maintainingmarketing, sales and distribution capabilities, the emergence of competitiveproducts and other adverse market developments, the timing and amount ofrevenues and expense reimbursements resulting from relationships with thirdparties, our degree of success in commercializing new products and the cost ofpreparing, filing, prosecuting, maintaining and enforcing patent claims andintellectual property rights.  TheCompany will depend on product revenues, royalties and license fees, interestincome, equity financing, and funding from corporate partnerships to meet itsfuture capital needs.  See “ImportantFactors Regarding Forward-Looking Statements – Need for Additional Capital.”

 

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**Important Factors RegardingForward-Looking Statements**

 

*Loss of or Reduction in Orders bySignificant Customers Could Adversely Affect Our Net Revenues and Results ofOperations*

 

Although theCompany’s customer base is made up of a large number of customers, our topthree customers comprised approximately 51 percent of net revenues during thefirst quarter of 2003, one of which accounted for approximately 41 percent ofthe Company’s net revenue.  Any decreasein or loss of revenues from these customers could have an adverse effect on ournet revenues and results of operations or impair our ability to increase netrevenues.  We expect that we willcontinue to depend on revenue from larger customers, generally under multi-yearlicense or supply agreements.  Suchagreements can be terminated under certain circumstances, such as our inabilityto supply product within required time frames among others.  Any downturn in the business from thesecustomers or the inability to renew or replace agreements with new customers asthey expire could significantly decrease sales to such customers, which couldadversely affect our net revenues and results of operations.

 

Furthermore, we donot have a substantial non-cancelable backlog of orders; our customers cangenerally cancel or reschedule orders upon short notice.  Variations in the timing of these orders cancause significant fluctuations in our quarterly operating results, and thecancellation or deferral of product orders or overproduction due to the failureof anticipated orders to materialize could result in us holding excess orobsolete inventory, which has resulted and could again in the future result inwrite-downs of inventory that would have a material adverse effect on ouroperating results.

 

*Dependence on and Management ofExisting and Future Corporate Alliances*

 

The successfulcommercialization of the Company’s existing and future products in the consumerand wound care markets will depend upon ProCyte’s ability to enter into and effectivelymanage corporate alliances.  There canbe no assurance that the Company will be successful in establishing corporatealliances in the future, or that it will be successful in performing andmaintaining existing or any future corporate alliances.  Moreover, there can be no assurance that theinterests and motivations of any corporate partner, distributor or licenseewould be or will remain consistent with those of the Company, or that theCompany and such partners, distributors or licensees will successfully performthe necessary technology transfer, clinical development, regulatory compliance,manufacturing, marketing, commercialization and other obligations under theiragreements. Any of these failures could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

*Recent Profitability; No Assuranceof Achieving Consistent Profitable Earnings*

 

The Company hasbeen launching products based on its proprietary Copper Peptide technologysince 1996.  In addition to sales ofproducts based on its proprietary Copper Peptide technology, the Company’srevenues have historically included sales of non-proprietary products, licensefees and royalties, revenue from contract manufacturing and interest income.  During 2002, the Company reported netprofits and positive cash flow from operations for the first time in itsoperating history.  During the quarterended March 31, 2003, however, the Company reported a net loss and negativecash flow from operations.  There can beno assurance that the Company can maintain a consistent, profitable level ofoperations.  Attaining consistentprofitability is dependent upon a wide variety of factors, includingsuccessfully manufacturing and marketing of the Company’s products, enteringinto and maintaining agreements with corporate partners for commercializationof the Company’s products, and successfully licensing the Company’s productsand technology.  Payments undercorporate partnerships and licensing

 

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arrangements maybe subject to fluctuations in both timing and amounts and therefore the levelof profitability may vary significantly from quarter to quarter.

 

*We Rely on Third Party Manufacturersfor 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 alsomay experience problems with product quality or timeliness of product delivery.We rely on these manufacturers to comply with applicable current quality systemregulations (“QSR”). The loss of a contract manufacturer may force us to shiftproduction to in-house facilities and possibly cause manufacturing delays,disrupt our ability to fill orders, or require us to suspend production untilwe find another third party manufacturer. We are not able to control themanufacturing efforts of these third party manufacturers as closely as wecontrol our business. Should any of these manufacturers fail to meet theapplicable standards, we or our third-party manufacturers could face variousenforcement actions which would have an adverse effect on the Company’s netrevenues and results of operations.

 

*Need for Additional Capital*

 

The Companygenerated negative cash flows from operations in the first quarter ended March31, 2003, but currently expects that it will generate positive cash flow fromoperations in 2003.  As of March 31, 2003,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 capital requirementsfor at least the next two years.  Therecan be no assurance, however, that our underlying assumed levels of revenue andexpense will prove accurate.  Whether ornot these assumptions prove to be accurate, the Company may need to raiseadditional capital.  Furthermore, theCompany may require additional funds to expand or enhance its sales andmarketing activities, to accelerate product development, or to acquire aproduct line or company.  The Companymay be required to seek this additional funding through public or privatefinancing, including equity financing, or through collaborativearrangements.  Adequate funds for thesepurposes, whether obtained through financial markets or from collaborative orother arrangements with corporate partners or other sources, may not beavailable when needed or may not be available on terms favorable to theCompany.  If we issue equity securitiesto raise additional funds, dilution to existing shareholders will result.  In addition, in the event that additionalfunds are obtained through arrangements with collaborative partners, sucharrangements may require the Company to relinquish its rights to certaintechnologies or potential products that it would otherwise seek to develop orcommercialize on its own.  If funding isinsufficient at any time in the future, the Company may be required to: delay,scale back or eliminate some or all of its marketing and research anddevelopment programs; or license to third parties the rights to commercializeproducts or technologies that the Company would otherwise seek to develop onits own.  Furthermore, the terms of anysuch license agreements or asset sales might be less favorable than if theCompany were negotiating from a stronger position.

 

*Uncertainty of Patent Position andProprietary Rights*

 

The patentpositions of biotechnology, medical device and healthcare products companiesare often uncertain and involve complex legal and factual questions, and thebreadth of claims allowed in such patents cannot be predicted.  The Company’s success will depend on itsability to obtain patents and licenses to patent rights, to maintain tradesecrets, and to operate without infringing on the proprietary rights of others,both in the United States and in other countries.  The failure of the Company or its

 

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licensors toobtain, maintain and enforce patent protection for the Company’s technologycould have a material adverse effect on the Company.

 

ProCyte’s successdepends, in part, upon its ability to protect its products and technology underintellectual property laws in the United States and abroad.  As of March 31, 2003, the Company had 21issued U.S. patents expiring between 2005 and 2017 and numerous issued foreignpatents and patent registrations.  Thepatents relate to use of the Company’s copper-based technology for a variety ofhealthcare applications, and to the composition of certain biologically active,synthesized compounds.  The Company’sstrategy has been to apply for patent protection for certain compounds andtheir discovered uses that are believed to have potential commercial value incountries that offer significant market potential.  There can be no assurance that patent applications relating tothe technology used by the Company will result in patents being issued.  Nor can there be any assurance that anypatent issued to the Company will not be subjected 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’sprocesses and potential products may conflict with patents that have been ormay be granted to competitors and others. As the biotechnology, medical device and healthcare industries expandand more patents are issued, the risk increases that the Company’s processesand potential products may give rise to claims that they infringe the patentsof others.  Such other persons couldbring legal actions against the Company claiming damages and seeking to enjoinclinical testing, manufacturing and marketing of the affected product or use ofthe affected process.  Litigation may benecessary to enforce patents issued to the Company, to protect trade secrets orknow-how owned by the Company or to determine the enforceability, scope andvalidity of proprietary rights of others. If the Company becomes involved in such litigation, it could result insubstantial expense to the Company and significant diversion of effort by theCompany’s technical and management personnel. In addition to any potential liability for significant damages, theCompany could be required to obtain a license to continue to manufacture ormarket the affected product or use the affected process.  Costs associated with any licensingarrangement may be substantial and could include ongoing royalties.  There can be no assurance that any licenserequired under any such patent would be made available to the Company onacceptable terms, if at all.  If suchlicenses could not be obtained on acceptable terms, the Company could beprevented from manufacturing and marketing existing or potential products.  Accordingly, an adverse determination insuch litigation could have a material adverse effect on the Company’s business,financial condition and results of operations. The Company is not aware of any conflicts at this time.

 

The Company alsorelies upon non-patented proprietary technology.  There can be no assurance that the Company can meaningfullyprotect its rights to such non-patented technology, that any obligation tomaintain the confidentiality of such proprietary technology will not bebreached by employees, consultants, collaborators or others or that others willnot independently develop or acquire substantially equivalent technology.  To the extent that corporate partners orconsultants apply Company technological information independently developed bythem or by others to Company projects or apply Company technology or know-howto other projects, disputes may arise as to the ownership of proprietary rightsto such information.  Any failure toprotect non-patented proprietary technology or any breach of obligations designedto protect 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 RegulatoryRequirements*

 

The Federal Food,Drug and Cosmetic Act, and the regulations promulgated thereunder, and otherfederal and state statutes govern, among other things, the testing,manufacture, safety, labeling, storage, record-

 

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keeping, advertisingand promotion of cosmetic products and medical devices.  The Company’s products and productcandidates may be regulated by any of a number of divisions of the FDA and inother countries by similar health and regulatory authorities.  The process of obtaining and maintainingregulatory approvals for the manufacturing or marketing of the Company’sexisting and potential products is costly and time-consuming and is subject tounanticipated delays.  Regulatory requirementsultimately imposed could also adversely affect the ability of the Company toclinically test, manufacture or market products.

 

In the UnitedStates, products that do not seek to make effectiveness claims based on humanclinical evaluation may be subject to review and regulation under the FDA’scosmetic, drug or 510(k) medical device guidelines.  Similar guidelines exist for such products in othercountries.  Such 510(k) products, whichinclude wound care dressings and certain ointments and gels, must show safetyand substantial equivalency with predicate products already cleared by the FDAto be marketed.  There can be noassurance that product applications submitted to the FDA or similar agencies inother countries will receive clearance to be marketed, or that the labelingclaims sought will be approved, or that, if cleared, such products will becommercially successful or free from third party claims relating to theeffectiveness or safety of such products.

 

The Company alsois or may become subject to various other federal, state, local and foreignlaws, 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 obtainregulatory approvals where appropriate for its product candidates or to attainor maintain compliance with QSR or other manufacturing requirements would havea material adverse effect on the Company’s business, financial condition andresults of operations.

 

*Intense Competition*

 

Competition in thewound care, skin health and hair care markets is intense.  The Company’s competitors includewell-established pharmaceutical, cosmetic and healthcare companies such asJohnson and Johnson, Galderma, Obagi, La Roche Posay, and Allergan.  These competitors have substantially morefinancial and other resources, larger research and development staffs, and moreexperience and capabilities in researching, developing and testing products inclinical trials, in obtaining FDA and other regulatory approvals and inmanufacturing, marketing and distribution than the Company.  In addition, a number of smaller companiesare developing or marketing competitive products.  The Company’s competitors may succeed in developing andcommercializing products or obtaining patent protection or other regulatoryapprovals for products more rapidly than the Company.  In addition, competitive products may be manufactured andmarketed more successfully than the Company’s potential products.  Such developments could render the Company’sexisting or potential products less competitive or obsolete and could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

*Product Liability Claims*

* *

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

 

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to its reputationand loss of revenues.  As a result,regardless of whether the Company is insured, a product liability claim orproduct recall may result in losses that could be material to ProCyte.

 

*Potential Volatility of Stock Price;Bulletin Board Listing*

 

The market pricesfor securities of healthcare, pharmaceutical and biotechnology companies aresubject to volatility, and the market has from time to time experiencedsignificant fluctuations that are unrelated to the operations of theCompany.  ProCyte’s market price hasfluctuated over a wide range since the Company’s initial public offering in1989, and since March 25, 1999, the Company’s common stock has traded on theNASD OTC bulletin board.  Becausereal-time price information may not be easily available for bulletin boardsecurities, an investor is likely to find it more difficult to dispose of, orto obtain accurate quotations on the market value of, the Company’s securitiesthan if they were listed on a the Nasdaq or a national exchange.  In addition, purchases and sales of theCompany’s securities may become subject to Rule 15g-9 of the Exchange Act,which imposes various sales practice requirements on broker-dealers, or to the“penny stock” rules, either of which would likely reduce the level of tradingactivity in the secondary market for the Company’s securities and make sellingthe securities more difficult for an investor.

 

Announcementsconcerning the Company or its competitors, including fluctuations in operatingresults, research and development program direction, results of clinicaltrials, addition or termination of corporate alliances, technology licenses,clearance or approval to market products, announcements of technologicalinnovations or new products by the Company or its competitors, changes ingovernment regulations, healthcare reform, developments in patent or otherproprietary rights of the Company or its competitors, litigation concerningbusiness operations or intellectual property, or public concern as to safety ofproducts, as well as changes in general market conditions and mergers andacquisitions, may have a significant effect on the market price of ProCyte’scommon stock.

 

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

 

ProCyte did notown any derivative financial instruments as of March 31, 2003.  TheCompany is debt-free and is exposed to interest rate risk to the extent that ithas invested idle cash balances and the promissory note receivable describedbelow.  At March 31, 2003, the idle cash balances were invested in aUnited States Treasury money market fund.  ProCyte employs establishedpolicies and procedures to manage its exposure to changes in the market risk ofits investments.  The Company believes that the market risk arising fromholdings of its financial instruments is not material.  The Company holdsa $2 million promissory note as a result of the sale of its contractmanufacturing operation to Emerald Pharmaceutical L.P.  The note has avariable interest rate, adjusted quarterly, and is guaranteed by a securityagreement giving ProCyte a first lien position on the assets sold to Emerald.

 

## **Item 4**.  Controls andProcedures

 

Under thesupervision of and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer,the Company has evaluated the effectiveness and design and operation of itsdisclosure controls and procedures within 90 days of the filing date of this quarterlyreport, and, based on their evaluation, the Chief Executive Officer and theChief Financial Officer have concluded that these disclosure controls andprocedures are effective.  There were nosignificant changes in the Company’s internal controls or in other factors thatcould significantly affect those controls subsequent to the date of theirevaluation.

 

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# **PartII** - OtherInformation

 

## **Item 1.  Legal Proceedings**

 

Not applicable.

 

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

 

Not applicable. 

 

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

 

Not applicable.

 

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

 

Not applicable.

 

## **Item 5.  Other Information**

 

Not applicable.

 

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

 

(a) Exhibits

 

See Exhibit Indexon page 25.

 

(b) Reports onForm 8-K

 

None.

 

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# **Signatures**

 

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

 

 
|                     | **ProCyte  Corporation (Registrant)**                  |
|--------------------------|--------------------------------------------------------|
|                     |                                                   |
|                     |                                                   |
| Date:  May 12, 2003 | By:                                                    |   /s/  John F. Clifford |
|                     |                                                   |
|                     |   John  F. Clifford, Chairman and CEO        |
|                     |                                                   |
|                     |                                                   |
| Date:  May 12, 2003 | By:                                                    |   /s/  Robert W. Benson |
|                     |                                                   |
|                     |   Robert  W. Benson, Chief Financial Officer |
|                          |                                                        |  |  |

 

22

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# **Certifications**

 

I, John F.Clifford, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of ProCyte Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport; 

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report; 

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  May 12, 2003 | By:    | /s/ John F. Clifford                                     |
|--------------------------|--------|----------------------------------------------------------|
|                     |   |                                                     |
|                     |   | John F. Clifford, Chairman and CEO,  ProCyte Corporation |

 

23

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I, Robert W.Benson, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of ProCyte Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport; 

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report; 

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  May 12, 2003 | By:    | /s/ Robert W. Benson                                            |
|--------------------------|--------|-----------------------------------------------------------------|
|                     |   |                                                            |
|                     |   | Robert W. Benson, Chief Financial Officer,  ProCyte Corporation |

 

24

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Exhibit Index

 
| **Exhibit** |   | **Description**                                                                                                                       |   | **Note** |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
| 3.1         |   | Restated  Articles of Incorporation of the Registrant                                                                                 |   | A        |
| 3.2         |   | Restated Bylaws  of the Registrant                                                                                                    |   | A        |
| 4.1         |   | Rights Agreement  between the Registrant and American Securities Transfer and Trust as of  December 7, 1994                           |   | G        |
| 10.1*       |   | 1987 Stock  Benefit Plan of ProCyte Corporation                                                                                       |   | A        |
| 10.2*       |   | ProCyte  Corporation 1989 Restated Stock Option Plan                                                                                  |   | B        |
| 10.3*       |   | ProCyte  Corporation 1991 Restated Stock Option Plan for Non-employee Directors and  amendments thereto                               |   | D        |
| 10.4†  |   | Teachers  Insurance & Annuity Association Lease dated as of October 1, 1993 and  second amendment thereto dated February 28, 1997 |   | D        |
| 10.5*       |   | 1996 Stock  Option Plan                                                                                                               |   | D        |
| 10.6*       |   | ProCyte  Corporation 1998 Non-employee Director Stock Plan                                                                            |   | F        |
| 10.7*       |   | Change of  Control Agreement for Ms. Robin Carmichael                                                                                 |   | F        |
| 10.8*       |   | Change of  Control Agreement for Mr. John Clifford                                                                                    |   | D        |
| 10.13*      |   | Form of  Indemnity Agreement dated February 23, 1995 between the Registrant and each  of Dr. Blake, Mr. Patterson and Mr. Clifford.   |   | C        |
| 10.14*      |   | Form of Indemnity  Agreement between ProCyte Corporation and each of various of its Officers and  Directors                           |   | F        |
| 10.15*      |   | Form of  Severance Agreement for Mr. John Clifford                                                                                    |   | D        |
| 10.16*      |   | Form of  Promissory Note between ProCyte Corporation and Mr. John Clifford                                                            |   | H        |
| 10.17† |   | License  Agreement dated April 19, 2000 between ProCyte Corporation and Neutrogena  Corporation                                       |   | I        |
| 99.1        |   | Certification of  Periodic Report by Mr. John F. Clifford                                                                             |   | J        |
| 99.2        |   | Certification of  Periodic Report by Mr. Robert W. Benson                                                                             |   | 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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