**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

** **
| **For  the fiscal year ended December 31, 2002** |   | **Commission  file number 0-18044** |
|--------------------------------------------------|--------|-------------------------------------|

 

**PROCYTE CORPORATION**

(exact name of registrantas specified in its charter)

 

| **Washington**                                       |   | **91-1307460**                        |
|------------------------------------------------------|--------|---------------------------------------|
| (State of  incorporation)                            |   | (I.R.S. Employer  Identification No.) |
|                                                 |   |                                  |
| **8511  154th Avenue N.E., Building A, Redmond, WA** |   | **98052-3557**                        |
| (Address of principal  executive offices)            |   | (Zip Code)                            |
|                                                 |   |                                  |

 

| Registrant’s telephone number, including area code: ** (425)  869-1239**                                |
|-------------------------------------------------------------------------------------------------------------------|
|                                                                                                              |
| Securities registered pursuant to Section 12(b) of  the Act:**   None**                                      |
|                                                                                                              |
| Securities registered pursuant to the Section 12(g)  of the Act:**  Common Stock, par value $.01 per share** |

 

Indicate by check markwhether 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 check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.        o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Exchange Act Rule12b-2).

 

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

 

The aggregate marketvalue of common stock held by non-affiliates as of March 21, 2003 was$17,194,855 million, based upon the average of the closing high and low pricesof such stock as reported on the NASD OTC bulletin board.  The aggregate market value of common stockheld by non-affiliates as of June 28, 2002 was $23,306,573 million, based uponthe average of the closing high and low prices of such stock as reported on theNASD OTC bulletin board.

 

As of March 21, 2003there were issued and outstanding 15,754,155 shares of common stock, par value$.01 per share.

 

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DOCUMENTS INCORPORATED BYREFERENCE

 

Portions of the ProxyStatement for the Registrant’s 2003 Annual Meeting of Shareholders scheduled tobe held May 20, 2003 are incorporated by reference in Part III of this Form10-K.

 

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**PROCYTE CORPORATION**

** **

**2002 Form 10-K**

** **

**Table of Contents**

 
| **FORM 10-K**      |
|--------------------|
|               |
| **PART I**         |
|               |   |
| Item  1.           | Business |
|               |   |
| Item  2.           | Properties |
|               |   |
| Item  3.           | Legal Proceedings |
|               |   |
| Item  4.           | Submission of Matters to a Vote of Security  Holders |
|               |   |
| **PART II**        |
|               |   |
| Item  5.           | Market for the Company’s Common Stock and  Related Shareholder Matters |
|               |   |
| Item  6.           | Selected Financial Data |
|               |   |
| Item  7.           | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|               |   |
| Item  7a.          | Quantitative and Qualitative Disclosures about  Market Risk |
|               |   |
| Item  8.           | Consolidated Financial Statements and  Supplementary Data |
|               |   |
| Item  9.           | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure |
|               |   |
| **PART III**       |
|               |   |
| Item  10.          | Directors and Executive Officers of the  Registrant |
|               |   |
| Item  11.          | Executive Compensation |
|               |   |
| Item  12.          | Security Ownership of Certain Beneficial Owners  and Management |
|               |   |
| Item  13.          | Certain Relationships and Related Transactions |
|               |   |
| **PART IV**        |
|               |   |
| Item  14.          | Controls and Procedures |
|               |   |
| Item  15           | Exhibits, Financial Statement Schedules, and  Reports on Form 8-K |
|               |   |
| **SIGNATURES**     |
|               |
| **CERTIFICATIONS** |

 

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**PART I**

 

## **Item 1**.                       Business

 

*This Annual Report on Form 10-K,contains forward-looking statements. These statements relate to future eventsor future financial performance.  Insome cases, you can identify forward-looking statements by terminology such as“may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,”“estimate,” “predict,” “potential,” “propose” or “continue,” the negative ofthese terms, or other terminology. These statements are only predictions. Actual events or results maydiffer materially. In evaluating these statements, you should specificallyconsider various factors described below in the section entitled “ImportantFactors Regarding Forward-Looking Statements.” These factors may cause ouractual results to differ materially from any forward-looking statement.*

 

*Although we believe the expectationsreflected in the forward-looking statements are reasonable, we cannot guaranteefuture results, levels of activity, product demand, performance orachievements. You should not place undue reliance on our forward-lookingstatements, 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.*

 

**General**

 

ProCyteCorporation (“ProCyte” or the “Company”) is a Washington corporation organizedin 1986.  ProCyte is a medical skin carecompany that develops, manufactures and markets products for skin health, haircare and wound care.  Many of theCompany’s products incorporate its patented Copper Peptide technologies.

 

ProCyte’s focussince 1996 has been to bring unique products, primarily based upon its patentedGHK and AHK Copper Peptide technologies, to the dermatology, plastic andcosmetic surgery markets.  The Company’snovel Copper Peptide technology also has expanded into the consumer markets forskin and hair care, and, we believe, may have potential for significant, rapidgrowth following in the steps of AHAs (alpha hydroxy acids) and retinol.  Our goal is to generate profits from thesale of the products that the Company develops, sells and licenses.  To augment the commercialization of ourtechnologies beyond the medical and dermatology markets, the Company hasentered into license and supply agreements to broaden the Company’s reach intothe global consumer markets.  Inaddition, the Company has added a new direct to consumer channel, recentlycompleting the production of an Infomercial that is expected to begin airinglater this year.

 

**Products**

 

The Company’sproducts were initially targeted at the dermatology, plastic and cosmeticsurgery markets for use following procedures, and for reducing the effects ofaging on the skin.  Recently, theCompany’s focus expanded to include a variety of consumer markets for skin careand hair care products.

 

#### *Dermatology, Plastic andCosmetic Surgery and Skin Care*

 

ProCyte’s productsare well suited for use in the medical specialties of dermatology, plastic andcosmetic surgery.  Many of the productsdeveloped by ProCyte incorporate the Company’s clinically tested Copper Peptidetechnologies.  Several recent studieshave confirmed the advantages of products containing the Copper Peptidetechnologies versus materials such as trentinoin, retinol, vitamin C, and otherpopular anti-aging and skin rejuvenation products.  The actions of Copper Peptide-containing wound care gels andcreams have been documented in the scientific literature for their ability tostimulate collagen synthesis, new blood vessel growth and tissue repair.  This has lead to the development of avariety of products designed to treat the skin following certain cosmeticprocedures such as microdermabrasion, laser resurfacing and hairtransplantation.  There are anincreasing number of these cosmetic procedures performed each year as the babyboomer population ages.  ProCyte has aseries of products tailored to the needs of these procedures, including theGraftCyte® System and the Complex Cu3® System.

 

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ProCyte’sGraftCyte® System was created to address the special tissue repair needs ofpatients following hair restoration surgery. This system continues to be the only complete solution addressing postprocedure care in the hair restoration market.   The Company has continued to emphasize its Complex Cu3® Post LaserLotion, Intensive Repair Creme, Cleanser and Hydrating Gel products used totreat patients following chemical peels, microdermabrasion and lasertreatments.  The Complex Cu3® productsprovide a comprehensive approach to post-procedure care and allow the Companyto differentiate its line of skin care products on the basis of its proprietaryCopper Peptide technologies.  Studieshave indicated that the skin heals more quickly with the help of the CopperPeptide.

 

The Companylaunched its successful Neova® Therapy line of anti-aging products in responseto demand from physician customers.  TheNeova® Therapy line of GHK Copper Peptide Complexäproducts showcase elegant moisturizers and serums complemented by supportingcleansers, toners, and masks for an integrated approach to anti-aging skincare.  In addition, there arecomplementary products, including oily-skin, dry-skin and sensitive-skinproducts to treat specific skin conditions.

 

The Company’s lineof advanced sun protection products, marketed under the brand names of Ti-Silc®and Z-Silc®, are recommended by dermatologist and plastic surgeons to assist inthe prevention of sun exposure that can lead to a number of problems includingage spots, hyperpigmentation, premature aging, melanoma and other skindiseases.

 

#### *Hair Care*

 

The Companycommenced shipping its Tricomin® line of Triamino Copper ComplexTM-containinghair care products to physicians’ offices in the third quarter of 1998.  Tricomin® Shampoos, Conditioners andFollicle Therapy Solution are positioned to participate in the rapidly growing$20 billion worldwide hair care market as a program for the maintenance ofthinning hair in men and women.  Hairfollicles require high concentrations of biological copper and the Tricomin®products deliver copper along with amino acids for nourishing and stimulatingthe hair and scalp for improved health, strength and appearance.  These products provide physicians with anon-drug alternative to the problem of thinning hair for their patients.

 

#### *Chronic Wound Care*

 

The Company has achronic wound care product that has met with varying degrees of marketsuccess.  The wound care market ishighly fragmented, with many competitors, price constraints, and inadequateMedicare reimbursement.  The wound caremarket requires a significant investment in supporting a large salesorganization.  For these reasons,ProCyte has historically attempted to collaborate with partners to market itschronic wound care products and will continue to do so.

 

**Markets and Distribution**

 

We believe thatthe Company’s technologies have potential in a variety of consumer markets.  There is an increasing consumer andphysician awareness of the ability to improve skin health and appearance withproducts designed specifically to meet the needs of the aging.  Specific ingredients, such as AHA (alphahydroxy acid) and retinols have played a dominant role in expanding theanti-aging and specialty skin care markets. Specific Copper Peptide compounds may have the same ability to grow theskin care markets and generate a similar presence in the market place.  The worldwide consumer skin care market isestimated to be in excess of $25 billion. ProCyte’s strategy is to identify skin care market segments that wouldbe best served by more established companies and then target a significantpartner in each segment to license its technology.  There are numerous distinct segments that have or are beingtargeted for license or direct sale. These include Mass Retail, Prestige, Direct to Consumer (MLM), HomeShopping TV, Infomercial, Specialty Retail, Spa, Salon, Catalog, and DirectMail.

 

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The Company’sbranded products are currently sold to dermatology, cosmetic and plasticsurgery practices through a direct sales force and third party distributors,supported by telemarketing and customer mailings. Domestically, the nationalsales force, led by a Director of Sales, consists of two sales regionalmanagers and geographically targeted sales representatives, all of whom areemployees of the Company.  For internationalsales, the Company has primarily utilized independent distributors.

 

The Companyemphasizes high quality products and services, technical knowledge, andresponsiveness to customer needs in its marketing activities. The Companyeducates its distributors, customers and prospective customers about itsproducts through a series of detailed marketing brochures, technical bulletinsand pamphlets, presentations, news releases and direct mail pieces. Thesematerials are supplemented by advertising in industry publications, technicalpresentations, and exhibitions at local, national and international tradeshows.

 

In April 2000, ProCyte entered a long-term worldwide license agreementwith Neutrogena Corporation, a Johnson & Johnson Company (“Neutrogena”),for worldwide use of the Company’s patented Copper Peptide technology inproducts for skin health in the mass retail market.  Neutrogena develops, manufactures and markets skin and hair careproducts domestically and internationally. Neutrogena launched its two initial products using our technology underthe brand name of Visibly FirmTM with Active CopperTM in April 2001.  Since that time, it has continued to add newCopper Peptide based products. Neutrogena also began expanding the sale of these products into some ofits international markets during 2002 and has indicated plans to continue suchexpansion. The Company receives royalty payments, based on product sales byNeutrogena and revenue from the sale of the Copper Peptide compound used inNeutrogena’s products.

 

During 2001, theCompany completed license and supply agreements with Creative Nail Design andAmerican Crew, both of which are part of the Colomer Group based in Barcelona,Spain. These agreements provide worldwide rights for use of the Copper Peptidetechnology in products sold to the salon and spa markets for their respectivelines of business.   The Companyreceives royalties, based on sales of licensed product, and revenue from thesale of the Copper Peptide compounds used in such products.   The initial products were introduced in mid-year2002 with generally positive reviews. Revenues to date have not been as anticipated at the onset of theagreements and management intends to continue to monitor the progress of theselicense partners. Revenue during the first half of 2002 was substantiallyhigher than expected as American Crew built inventories of Copper Peptidecompound in preparation for the initial product launch.  They experienced unexpected competitivepressures and were forced to re-launch the products in the later part of 2002.

 

During the fourthquarter of 2002, ProCyte initiated work on an Infomercial, a form of direct toconsumer distribution, which will sell a new brand of anti-aging and skin careproducts called VitalCopperTM.  Many ofthe initial VitalCopperTM products include GHK Copper Peptide compounds. ProCytecontracted with a company experienced in the design, development, productionand rollout of health and beauty Infomercials. Production and filming were completed in January 2003 and the initialmarket test began in selected markets during March 2003.  Continuation of the market test was placedon hold with the initiation of the Iraq conflict.  Pending the results of the market test, once restarted, thenational rollout is expected to begin mid year.  However, the actual timing will depend on the duration of the conflict.  As a result of required accounting practices for production anddevelopment costs associated with the Infomercial, all of the Infomercial’sdevelopment cost will be expensed in the first quarter of 2003.  We believe this one time charge will resultin a reported net loss for that quarterly period.

 

#### ***Other Business Relationships***

 

In addition tolicensing others to make and distribute products based upon Copper Peptidecompounds, ProCyte has also entered into private label manufacturingagreements. Under such agreements, the Company receives revenue from the saleof the related products.  This is asmaller part of the Company’s business;

 

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however, it provides opportunities to benefit from larger productionruns and efficiencies of scale with our third party manufacturers.

 

ProCyte intends toidentify and enter into distribution or other strategic agreements with partiesthat are capable of quickly penetrating a targeted market and obtaining anyrequired international registrations for the sale of the Company’s copper-basedskin care, hair care and wound care products and technologies.

 

**Contract Manufacturing Services**

 

In July 2001, theCompany sold its pharmaceutical contract manufacturing operations to EmeraldPharmaceuticals, L.P., a Delaware limited partnership.  ProCyte received $250,000 in cash, a $2million promissory note and an 18.75 percent limited partner voting interest inthe partnership.  Also, as part of thedeal, Emerald subleases 19,770 square feet of ProCyte’s current 34,532 squarefoot leased facility.  Emerald hascontinued to supply certain contract services and product for ProCyte.

 

**Employees**

 

At December 31,2002, the Company had 41 full-time employees, of whom one holds a Ph.D.degree.  At year-end 28 were engaged inmarketing and sales, one in product development, five in operations and sevenin finance and administration.  TheCompany does not expect to significantly increase its staff in 2003.  The Company believes that it has goodrelations with its employees.

 

**Important Factors Regarding Forward-Looking Statements**

 

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

 

Although the Company’s customer base is made up of a large number ofcustomers, our top 10 customers comprised approximately 52 percent of netrevenues during 2002, one of which accounted for approximately 30 percent ofthe Company’s net revenue during 2002. Any decrease in or loss of revenues from these customers could have anadverse effect on our net revenues and results of operations or impair ourability to increase net revenues.  Weexpect that we will continue to depend on revenue from larger customers,generally under multi-year license or supply agreements.  Such agreements can be terminated undercertain circumstances, such as our inability to supply product within requiredtime frames among others.  Any downturnin the business from these customers or the inability to renew or replaceagreements with new customers as they expire could significantly decrease salesto such customers, which could adversely affect our net revenues and results ofoperations.

 

Furthermore, we do not have a substantial non-cancelable backlog oforders; our customers can generally cancel or reschedule orders upon shortnotice.  Variations in the timing ofthese orders can cause significant fluctuations in our quarterly operatingresults, and the cancellation or deferral of product orders or overproductiondue to the failure of anticipated orders to materialize could result in usholding excess or obsolete inventory, which has resulted and could again in thefuture result in write-downs of inventory that would have a material adverseeffect on our operating results.

 

*Dependence on and Management of Existing and FutureCorporate Alliances*

 

The successful commercialization of the Company’s existing and futureproducts in the consumer and wound care markets will depend upon ProCyte’sability to enter into and effectively manage corporate alliances.  There can be no assurance that the Companywill be successful in establishing corporate alliances in the future, or thatit will be successful in performing and maintaining existing or any futurecorporate alliances.  Moreover, therecan be no assurance that the interests and motivations of any corporatepartner, distributor or licensee would be or remain consistent with those ofthe Company, or that the Company and such partners, distributors or licenseeswill successfully perform the necessary technology transfer, clinicaldevelopment, regulatory

 

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compliance,manufacturing, marketing, commercialization and other obligations under theiragreements. Any of these failures could have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

*Recent profitability; No Assurance of Achieving ConsistentProfitable Earnings*

 

The Company has been launching products based on its proprietary CopperPeptide technology since 1996.  Inaddition to sales of products based on its proprietary Copper Peptidetechnology, the Company’s revenues have historically included sales ofnon-proprietary products, license fees and royalties, revenue from contractmanufacturing and interest income.  Thecontract manufacturing operation was sold in July 2001.  During 2002, the Company reported netprofits and positive cash flow from operations for the first time in itsoperating history.  There can be noassurance 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 successful licensing the Company’s products andtechnology.  Payments under corporatepartnerships and licensing arrangements may be subject to fluctuations in bothtiming and amounts and therefore the level of profitability may varysignificantly from quarter to quarter.

 

*We Rely On Third Party Manufacturers For Our Products*

 

We use third party manufacturers to make products. In many cases, thirdparty manufacturers are not obligated under contracts that fix the term oftheir commitments and they may discontinue production upon little or no advancenotice. Manufacturers also may experience problems with product quality ortimeliness of product delivery. We rely on these manufacturers to comply withapplicable current quality system regulations (“QSR”). The loss of a contractmanufacturer may force us to shift production to in-house facilities andpossibly cause manufacturing delays, disrupt our ability to fill orders, orrequire us to suspend production until we find another third partymanufacturer. We are not able to control the manufacturing efforts of thesethird party manufacturers as closely as we control our business. Should any ofthese manufacturers fail to meet the applicable standards, we or ourthird-party manufacturer could face various enforcement actions which wouldhave an adverse effect on our net revenues and results of operations.

 

*Need for Additional Capital*

 

The Company generated positive cash flow from operations in 2002 andcurrently expects that it will generate positive cash flow from operations in2003.  As of December 31, 2002, theCompany had cash, and cash equivalents of $4.6 million.  The Company estimates that, at its plannedrate of spending, its existing cash and cash equivalents and the interestincome thereon will be sufficient to meet its operating and capitalrequirements for at least the next two years. There can be no assurance, however, that our underlying assumed levelsof revenue and expense will prove accurate. Whether or not these assumptions prove to be accurate, the Company mayneed to raise additional capital. Furthermore, the Company may require additional funds to expand orenhance its sales and marketing activities, to accelerate product development,acquire a product line or company.  TheCompany may be required to seek this additional funding through public orprivate financing, 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 be availablewhen needed or may not be available on terms favorable to the Company.  If we issue equity securities to raiseadditional 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.

 

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*Uncertainty of Patent Position and Proprietary Rights*

 

The patent positions of biotechnology, medical device and healthcareproducts companies are often uncertain and involve complex legal and factualquestions, and the breadth of claims allowed in such patents cannot bepredicted.  The Company’s success willdepend on its ability to obtain patents and licenses to patent rights, tomaintain trade secrets, and to operate without infringing on the proprietaryrights of others, both in the United States and in other countries.  The failure of the Company or its licensorsto obtain, maintain and enforce patent protection for the Company’s technologycould have a material adverse effect on the Company.

 

ProCyte’s success depends, in part, upon its ability to protect its productsand technology under intellectual property laws in the United States andabroad.  As of March 21, 2003, theCompany had 21 issued US patents expiring between 2005 and 2017 and numerousissued foreign patents and patent registrations.  The patents relate to use of the Company’s copper-basedtechnology for a variety of healthcare applications, and to the composition ofcertain biologically active, synthesized compounds.  The Company’s strategy has been to apply for patent protectionfor certain compounds and their discovered uses that are believed to havepotential commercial value in countries that offer significant marketpotential.  There can be no assurancethat patent applications relating to the technology used by the Company willresult in patents being issued.  Nor canthere be any assurance that any patent issued to the Company will not besubjected to further proceedings limiting the scope of the rights under thepatent or that such patent will provide a competitive advantage, will affordprotection against competitors with similar technology, or will not besuccessfully challenged, invalidated or circumvented by competitors.

 

The Company’s processes and potential products may conflict withpatents that have been or may be granted to competitors and others.  As the biotechnology, medical device andhealthcare industries expand and more patents are issued, the risk increasesthat the Company’s processes and potential products may give rise to claimsthat they infringe the patents of others. Such other persons could bring legal actions against the Companyclaiming damages and seeking to enjoin clinical testing, manufacturing andmarketing of the affected product or use of the affected process.  Litigation may be necessary to enforcepatents issued to the Company, to protect trade secrets or know-how owned bythe Company or to determine the enforceability, scope and validity ofproprietary rights of others.  If theCompany becomes involved in such litigation, it could result in substantialexpense to the Company and significant diversion of effort by the Company’stechnical and management personnel.  Inaddition to any potential liability for significant damages, the Company couldbe required to obtain a license to continue to manufacture or market theaffected product or use the affected process. Costs associated with any licensing arrangement may be substantial andcould include ongoing royalties.  Therecan be no assurance that any license required under any such patent would bemade available to the Company on acceptable terms, if at all.  If such licenses could not be obtained onacceptable terms, the Company could be prevented from manufacturing andmarketing existing or potential products. Accordingly, an adverse determination in such litigation could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.  The Company isnot aware of any conflicts at this time.

 

The Company also relies upon non-patented proprietary technology.  There can be no assurance that the Companycan meaningfully protect its rights to such non-patented technology, that anyobligation to maintain the confidentiality of such proprietary technology willnot be breached by employees, consultants, collaborators or others or thatothers will not independently develop or acquire substantially equivalenttechnology.  To the extent thatcorporate partners or consultants apply Company technological informationindependently developed by them or by others to Company projects or apply Companytechnology or know-how to other projects, disputes may arise as to theownership of proprietary rights to such information.  Any failure to protect non-patented proprietary technology or anybreach of obligations designed to protect such technology or development ofequivalent technology may have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

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*Uncertainty of Government Regulatory Requirements*

 

The Federal Food, Drug and Cosmetic Act, and the regulationspromulgated thereunder, and other federal and state statutes govern, amongother things, the testing, manufacture, safety, labeling, storage,record-keeping, advertising and promotion of cosmetic products and medicaldevices.  The Company’s products andproduct candidates may be regulated by any of a number of divisions of the FDAand in other 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.  Regulatoryrequirements ultimately imposed could also adversely affect the ability of theCompany to clinically test, manufacture or market products.

 

In the United States, products that do not seek to make effectivenessclaims based on human clinical evaluation may be subject to review andregulation under the FDA’s cosmetic, drug or 510(k) medical deviceguidelines.  Similar guidelines existfor such products in other countries. Such 510(k) products, which include wound care dressings and certainointments and gels, must show safety and substantial equivalency with predicateproducts already cleared by the FDA to be marketed.  There can be no assurance that product applications submitted tothe FDA or similar agencies in other countries will receive clearance to bemarketed, or that the labeling claims sought will be approved, or that, ifcleared, such products will be commercially successful or free from third partyclaims relating to the effectiveness or safety of such products.

 

The Company also is or may become subject to various other federal,state, local and foreign laws, regulations and policies relating to, amongother things, safe working conditions, good laboratory practices, and the useand disposal of hazardous or potentially hazardous substances used inconnection with research and development.

 

Failure to obtain regulatory approvals where appropriate for itsproduct candidates or to attain or maintain compliance with QSR or othermanufacturing requirements would have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

*Intense Competition*

 

Competition in the wound care, skin health and hair care markets isintense.  The Company’s competitorsinclude well-established pharmaceutical, cosmetic and healthcare companies suchas Johnson 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 to its reputation, withdrawalof clinical trial volunteers and loss of revenues.  As a result, regardless of whether the Company is insured, aproduct liability claim or product recall may result in losses that could bematerial to ProCyte.

 

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*Potential Volatility of Stock Price; Bulletin Board Listing*

 

The market prices for securities of healthcare, pharmaceutical andbiotechnology companies are subject to volatility, and the market has from timeto time experienced significant fluctuations that are unrelated to theoperations of the Company.  ProCyte’smarket price has fluctuated over a wide range since the Company’s initialpublic offering in 1989, and since March 25, 1999, the Company’s common stockhas traded on the NASD OTC bulletin board. Because real-time price information may not be easily available forbulletin board securities, an investor is likely to find it more difficult todispose of, or to obtain accurate quotations on the market value of, theCompany’s securities than if they were listed on a the Nasdaq or a nationalexchange.  In addition, purchases andsales of the Company’s securities may become subject to Rule 15g-9 of theExchange Act, which imposes various sales practice requirements onbroker-dealers, or to the “penny stock” rules, either of which would likelyreduce the level of trading activity in the secondary market for the Company’ssecurities and make selling the securities more difficult for an investor.

 

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

 

## **Item 2**.                       Properties

 

As of December 31,2002, the Company leased approximately 34,532 square feet in which ProCyteoccupied 14,762 square feet of warehouse and office space and subleased 19,770square feet to Emerald Pharmaceutical L.P. at it’s facility in Redmond,Washington under a ten-year lease, which expires on June 30, 2007.  The Company believes that its facilitieshave adequate capacity for its present needs.

 

## **Item 3**.                       Legal Proceedings

 

Not applicable.

 

## **Item 4**.                       Submission of Matters to a Voteof Security Holders

 

Not applicable.

 

# **PARTII**

 

## **Item 5**.                       Market for the Company’s CommonStock and Related Shareholder Matters

 

The Company’scommon stock is traded on the NASD over the counter bulletin board under thesymbol “PRCY.”  The following table setsforth the high and low bid prices for the Company’s common stock for theperiods indicated.  Such prices reflectinter-dealer prices, without retail mark-up, markdown or commission, and maynot necessarily represent actual transactions.

 

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|             |   | **High** |   | **Low** |   |
|------------------|--------|----------|--------|---------|--------|
| **2001**         |   |     |   |    |   |
| First quarter    |   | $        | 1.53   |    | $      | 0.64 |   |
| Second quarter   |   | 1.27     |   | 0.80    |   |
| Third quarter    |   | 1.47     |   | 0.93    |   |
| Fourth quarter   |   | 1.60     |   | 0.94    |   |
|             |   |     |   |    |   |
| **2002**         |   |     |   |    |   |
| First quarter    |   | $        | 2.01   |    | $      | 1.24 |   |
| Second quarter   |   | 2.17     |   | 1.32    |   |
| Third quarter    |   | 1.65     |   | 1.25    |   |
| Fourth quarter   |   | 1.47     |   | 0.95    |   |
|             |   |     |   |    |   |
| **2003**         |   |     |   |    |   |
| Through March 21 |   | $        | 1.39   |    | $      | 1.10 |   |

 

At the close ofbusiness on March 21, 2003, there were 387 holders of record of the Company’scommon stock.  This does not include thenumber of persons, whose stock is in nominee or “street name” accounts throughbrokers.  ProCyte has not paid any cashdividends on its common stock and does not intend to pay cash dividends in theforeseeable future.

 

*Sale of Unregistered Securities*

 

In connection with consulting services received, the Company, on May 26,1999, issued three five-year warrants. The first warrant gives the holder the right to purchase 33,334 sharesof Common Stock at an exercise price of $0.6875 per share (“Warrant No.1”).  The second warrant gives theholder the right to purchase 33,333 shares of Common Stock at a purchase priceof $1.6875 per share (“Warrant No. 2”). The third warrant gives the holder the right to purchase 33,333 sharesof Common Stock at a purchase price of $2.6875 per share (“Warrant No.3”).  Warrants No.1, No.2 and WarrantNo. 3 were issuedin reliance on Section 4(2) of the Securities Act of 1933.  The purchaser represented, in connectionwith the purchase of the warrant, that it was an accredited investor as definedin Regulation D under the Securities Act.  On January 4, 2002, the purchaser, by cashless exercise of Warrant No.1, exchanged Warrant No. 1 for 18,594 shares of common stock.  The shares issued upon exercise of WarrantNo. 1 were issued in reliance on the Section 4(2) and Rule 144 privateplacement exemptions under the Securities Act.

 

12

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## **Item 6**.                       Selected Financial Data

 
|                                          |   | **Selected Quarterly Financial Data (unaudited)****Quarter Ended** |      |
|-----------------------------------------------|--------|--------------------------------------------------------------------|-----------|
|                                          |   | **March 31**                                                       |      | **June 30** |   | **September 30** |   | **December 31** |   |
| **2002**                                      |   |                                                               |      |   |   |   |   |   |   |
| Revenue                                       |   | $                                                                  | 3,042,400 |   | $ | 3,263,194 |   | $ | 3,126,495 |   | $ | 3,305,133 |   |
| Cost and expenses                             |   | 2,600,321                                                          |      | 2,774,690 |   | 2,854,122 |   | 3,038,135 |   |
| Interest and other income                     |   | 46,797                                                             |      | 46,166 |   | 49,357 |   | 56,579 |   |
| Net income                                    |   | $                                                                  | 488,876   |   | $ | 534,670 |   | $ | 321,730 |   | $ | 323,577 |   |
| Net earnings per share                        |   |                                                               |      |   |   |   |   |   |   |
| Basic                                         |   | $                                                                  | 0.03      |   | $ | 0.03 |   | $ | 0.02 |   | $ | 0.02 |   |
| Diluted                                       |   | $                                                                  | 0.03      |   | $ | 0.03 |   | $ | 0.02 |   | $ | 0.02 |   |
| Shares used in per share computation          |   |                                                               |      |   |   |   |   |   |   |
| Basic                                         |   | 15,682,473                                                         |      | 15,704,841 |   | 15,721,705 |   | 15,732,151 |   |
| Diluted                                       |   | 16,000,865                                                         |      | 16,061,406 |   | 16,031,445 |   | 16,019,351 |   |
| **2001**                                      |   |                                                               |      |   |   |   |   |   |   |
| Revenue                                       |   | $                                                                  | 2,541,561 |   | $ | 2,414,874 |   | $ | 2,334,461 |   | $ | 2,421,215 |   |
| Cost and expenses                             |   | 3,081,141                                                          |      | 2,799,597 |   | 2,391,526 |   | 2,499,786 |   |
| Interest and other income                     |   | 37,915                                                             |      | 20,082 |   | 44,996 |   | 49,752 |   |
| Net loss                                      |   | $                                                                  | (501,665  | ) | $ | (364,641 | ) | $ | (12,069 | ) | $ | (28,819 | ) |
| Net loss per common share,  basic and diluted |   | $                                                                  | (0.03     | ) | $ | (0.02 | ) | $ | (0.00 | ) | $ | (0.00 | ) |
| Shares used in per share  computation         |   | 15,538,405                                                         |      | 15,555,420 |   | 15,595,502 |   | 15,653,423 |   |

 

13

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|                                               |   | **Selected Annual Financial Data****Year Ended December 31,** |       |
|----------------------------------------------------|--------|---------------------------------------------------------------|------------|
|                                               |   | **2002**                                                      |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Revenue                                            |   | $                                                             | 12,737,222 |   | $ | 9,712,111 |   | $ | 6,615,383 |   | $ | 4,694,966 |   | $ | 2,720,444 |   |
| Cost and expenses                                  |   | 11,267,268                                                    |       | 10,772,050 |   | 8,980,386 |   | 10,259,357 |   | 7,726,233 |   |
| Interest and other income                          |   | 198,899                                                       |       | 152,745 |   | 222,251 |   | 248,929 |   | 538,842 |   |
| Net income (loss)                                  |   | 1,668,853                                                     |       | $ | (907,194 | ) | $ | (2,142,752 | ) | $ | (5,315,462 | ) | $ | (4,466,947 | ) |
| Net earnings (loss) per share                      |   |                                                          |       |   |   |   |   |   |   |   |   |
| Basic                                              |   | $                                                             | 0.11       |   | $ | (0.06 | ) | $ | (0.14 | ) | $ | (0.35 | ) | $ | (0.32 | ) |
| Diluted                                            |   | $                                                             | 0.10       |   | $ | (0.06 | ) | $ | (0.14 | ) | $ | (0.35 | ) | $ | (0.32 | ) |
| Shares used in per share computation               |   |                                                          |       |   |   |   |   |   |   |   |   |
| Basic                                              |   | 15,710,498                                                    |       | 15,609,777 |   | 15,481,007 |   | 14,999,496 |   | 14,117,485 |   |
| Diluted                                            |   | 16,179,017                                                    |       | 15,609,777 |   | 15,481,007 |   | 14,999,496 |   | 14,117,485 |   |
| Cash, cash equivalents and  short term investments |   | $                                                             | 4,555,985  |   | $ | 3,002,579 |   | $ | 2,773,474 |   | $ | 3,883,187 |   | $ | 6,938,981 |   |
| Total assets                                       |   | 14,088,812                                                    |       | 12,810,598 |   | 12,185,426 |   | 13,446,628 |   | 18,302,378 |   |
| Total liabilities                                  |   | 2,270,489                                                     |       | 2,742,925 |   | 1,324,405 |   | 558,091 |   | 622,828 |   |
| Stockholders’ equity                          |   | $                                                             | 11,818,323 |   | $ | 10,067,673 |   | $ | 10,861,021 |   | $ | 12,888,537 |   | $ | 17,679,550 |   |

 

## **Item 7**.                       Management’s Discussion andAnalysis of Financial Condition and Results of Operations

 

*Critical Accounting Policies and Estimates*

 

The “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”, aswell as disclosures included elsewhere in this Form 10-K, 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 forinventory.  We base our estimates onhistorical experience, current conditions and on various other assumptions thatare believed to be reasonable under the circumstances, the results of whichform the 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 the preparationof the consolidated financial statements.

 

Product revenuesare recognized when products are shipped, contract manufacturing revenues arerecognized when services are performed, 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 20% ofProCyte’s assets as of December 31, 2002 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

 

14

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establishing and monitoring estimated lives of amortizable intangibleassets.  Future charges related to intangible assets could be materialdepending on future developments and changes in technology and our business.

 

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 December 31, 2002; however, if the financial condition ofour customers or other debtors were to deteriorate, resulting in an impairmentof their 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 recordsadjustments to the value of inventory based upon its forecasted plans to sellits inventories.  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.

 

*General*

 

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.  Through December 31,2002, we have experienced continued revenue growth.  This growth is a result of our focus in recent years to expandproduct offerings as well as develop additional markets and distributionchannels through strategic partners. ProCyte receives revenue from the sale of products via its US salesforce, from royalties and the sale of Copper Peptide compounds under licenseand supply agreements and from the manufacture and sale of private labelproducts containing our technologies. The Company also received revenue in the past from its contractmanufacturing operation, which was sold to Emerald Pharmaceutical L.P in July2001.

 

As a result ofthese initiatives and the reduction in overhead costs resulting from the saleof the contract manufacturing operation and others, we have experienced thefirst full year of net income and earnings per share since our inception.

 

*Revenue*

 

The Company’srevenue for the year ended December 31, 2002 increased 31% to $12.7 millionfrom $9.7 million reported in the year-earlier period.  Comparable revenuewas $6.6 million for the year ended December 31, 2000.  Revenue, excluding contract manufacturingrevenue related to the manufacturing operations sold in 2001, increased 34% in2002 as compared to 2001 and 72% in 2001 as compared to 2000.

 

Product sales forthe year ended December 31, 2002, increased 35% to $11,355,796, from $8,400,964reported in the year earlier period. Product sales for the year ended December 31, 2001 grew 66% from the$5,055,030 reported for the year ended December 31, 2000.  Product salesto physicians and distributors grew 24% over each of the comparable prior yearsin 2002 and 2001.  The Company experienced continued strong results fromUS product sales in 2002 and 2001.  In2001, the Company experienced rapid growth in its physician sales, as itincreased the number of US sales representatives.  The Company’s Neova®, GraftCyte® and sun protection product linescontinued to experience consistent growth in 2002 as compared to 2001.  Copper Peptide compound sales to ProCyte’slicensing partners were up 67% in 2002 over 2001 and were up 1,172% in 2001over 2000.  The 2002 increase was due toincreased purchases by Neutrogena, which expanded its GHK Copper PeptideComplexä based skin care products into international markets along withAmerican Crew’s inventory build in preparation for its initial productlaunch.  The 2001 increase in CopperPeptide compound sales was due to purchases by Neutrogena to support theinitial launch of its GHK Copper Peptide ComplexTM based skincare products.

 

15

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The Company soldits contract manufacturing operations to Emerald Pharmaceutical L.P. in July2001.  Revenue from contractmanufacturing services through July 2001 was $195,620 as compared to $1,085,750during the year ended December 31, 2000.

 

ProCyte’s royaltyand licensing revenue for the year ended December 31, 2002 increased 24% to$1,381,426 from $1,115,527 reported for the comparable period in 2001. Royalty and licensing revenue in 2001 increased 135% in 2001 as compared to thecomparable revenues for 2000 of $474,603. The Company’s increases in 2002 and 2001 were principally due toNeutrogena, which launched its GHK Copper Peptide ComplexTM based skincare products in 2001 and expanded into international markets during 2002.  Royalty revenues will fluctuate from quarterto quarter, due to the licensees’ timing of new market launches, specialpromotions and other factors beyond the Company’s control.

 

*Costs and Expenses*

 

                For the year 2002,gross profit increased 31% to $8,030,912 as compared to $6,128,546 reported for2001.   Gross profit for the year ended December 31, 2000 was$6,615,383.  Gross margin was 63% foreach of the years ended 2002 and 2001 and was 77% for the year ended 2000.  Gross margin for the years ended 2002 and2001 were the same because an improvement in Copper Peptide compound margins in2002 was offset by changes in the mix of products which reduced net productmargins.  Gross margin decreased in 2001from 2000 due to the change in overall revenue mix resulting from thesignificant increase in Copper Peptide compound sales in 2001, which have lowermargins, being partially offset by royalty revenue which increased 72% from2000 to 2001.

 

Research anddevelopment expenses were $126,227 for the year ended December 31, 2002, down83% from $745,373 reported for the comparable 2001 period and $1,275,294 forthe comparable period in 2000.  The Companyreduced a majority of its research and development expenses when it sold itscontract manufacturing operations in July 2001.  As a result of the sale, the Company subleased its research labfacility to Emerald Pharmaceutical L.P. and realized expense reductions indirect research labor and fixed facility expenses.

 

Marketing andselling expenses were $3,089,859 for the year ended December 31, 2002,relatively unchanged from the $3,133,640 incurred in the comparable 2001 periodand the $3,077,678 incurred in the comparable 2000 period.  Marketing and selling expenses remainconsistent with the prior years, as the Company continues to leverage morerevenue out of its existing expenditure level.

 

General andadministrative expenses were $3,344,872 for the year ended December 31, 2002,an increase of 7% from the $3,115,878 incurred in the comparable 2001period.  General and administrativeexpenses for the year ended December 31, 2000 were $3,128,328, making the 2001period relatively unchanged from 2000.  The Company realized a decline in certain expenses from the yearended 2002 as compared to 2001 as a result of the sale of the contractmanufacturing operations during 2001 and certain write downs of inventory and reservesfor doubtful accounts related to contract terminations in the amount of$255,000 taken in 2001.  These savingswere offset by increased legal and professional fees related to increasedefforts to file new patents and other corporate activities.  The Company also experienced higher compensationcosts related to hiring new talent into the Company, and in paying higherincentive bonuses to the management team for meeting objectives and helping theCompany achieve its first profitable year.

 

The Companyrecognized a loss of $193,594 on the disposition of the contract manufacturingoperation in 2001.  In 1999, the Companyrecognized a $1.9 million impairment related to the facility and assets used inits contract manufacturing operations.

 

Interest and otherincome for the year ended December 31, 2002 increased 30% to $198,899 ascompared to $152,745 earned in 2001. The Company reported $222,251 of interestand other income for the

 

16

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year ended December 31,2000.  Interest and other income increasedin 2002 primarily due to the interest payments collected on its $2,000,000promissory note from Emerald Pharmaceutical L.P.  For the year endedDecember 31, 2002, ProCyte received interest payments of $93,917 from EmeraldPharmaceutical L.P. as compared to $44,760 in 2001.  The Company realizeddecreasing market yields on its cash reserves in 2002 and 2001 as compared toeach of the comparable prior periods. In addition, the average cash balances were lower during 2001 ascompared to 2000.

 

*Net income (loss)*

 

The Companyreported net income of $1,668,853 for the year ended December 31, 2002 ascompared to the net losses of $907,194 and $2,142,752 reported for years endedDecember 31, 2001 and 2000, respectively. For the first time in its history, the Company has reported net earningsper share for four consecutive quarters, mainly due to continued revenue growthin all four quarters and general operating expense reductions.  Prior to 2002, the Company had incurredoperating losses each year since its inception due to the costs of supportingresearch, development, clinical studies and establishing a sales force for itsproprietary technology.  Since 1997,these losses have gradually decreased as the focus of the Company has shiftedfrom research to selling and marketing. As of December 31, 2002, the Company’s accumulated deficit wasapproximately $73.5 million.  TheCompany sold its contract manufacturing operations in July 2001, which hashelped it reduce related annual operating expenses by approximately $1 million.

 

As of December 31,2002 the Company’s U.S. federal net operating loss and general business taxcredit carry forwards for income tax purposes were approximately $67.8 millionand $1.7 million, respectively.  TheCompany has not yet recognized the benefit of these tax expense savings forfuture period earnings.  The Company hashad net operating losses since inception and reported net income for the firsttime in 2002.  Thus, sufficientuncertainty still exists regarding the realizability of using the deferred taxassets in future periods.  If notutilized, the federal net operating loss carry forward and tax credit carryforwards will expire between 2004 and 2021.

 

*Liquidity and Capital Resources*

 

The Company hasrelied primarily on equity financing, revenue, interest income and corporatepartnerships to fund its operations and capital expenditures.  At December31, 2002, the Company had approximately $4.6 million in cash and cashequivalents, compared to $3.0 million at December 31, 2001.  The netchange in cash and cash equivalents during the year ended December 31, 2002reflects a net positive cash flow of $1,553,406, which is primarily fromoperating activities.  We expect to see fluctuations in cash flows fromoperations over the next several years as our strategic partners continue toinitiate 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 no assurance that the underlying assumedlevels of revenue and expense will prove accurate. 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, assetredeployment, interest income, equity financing, and funding from corporatepartnerships to meet its future capital needs. See “Additional Factors That May Affect Results– Need for AdditionalCapital”.

 

17

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## **Item 7a**.                 Quantitative and QualitativeDisclosures about Market Risk

 

ProCyte did notown any derivative financial instruments as of December 31, 2002.  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 December 31, 2002, 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 LP.  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 8**.                       Consolidated FinancialStatements and Supplementary Data

 
| **Index to Consolidated Financial Statements and Schedules**                                  |
|-----------------------------------------------------------------------------------------------|
|                                                                                          |
| Balance Sheets as of  December 31, 2002 and 2001                                              |
|                                                                                          |
| Statements of  Operations for the years ended December 31, 2002, 2001 and 2000                |
|                                                                                          |
| Statements of  Cash Flows for the years ended December 31, 2002, 2001 and 2000                |
|                                                                                          |
| Statements  of Stockholders’ Equity for the years ended December 31, 2002, 2001 and 2000 |
|                                                                                          |
| Notes to  Consolidated Financial Statements                                                   |
|                                                                                          |
| Report of Independent  Auditors                                                               |

 
| **Note:**      All schedules have been omitted because  of the absence of conditions under which they are required or because the  required information is included in the Financial Statements or notes  thereto. |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

18

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**ProCyte CorporationConsolidated Balance Sheets**

 
|                                                                                                                                                             |   | **December  31,  2002** |           | **December  31,  2001** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------------|-------------------------|------------|
| **Assets**                                                                                                                                                       |   |                    |           |                    |       |
| **Current  Assets**                                                                                                                                              |   |                    |           |                    |       |
| Cash and cash equivalents                                                                                                                                        |   | $                       | 4,555,985      |                    | $          | 3,002,579 |   |
| Accounts receivable, net of allowance for doubtful  accounts                                                                                                     |   | 1,327,956               |           | 956,024                 |       |
| Note due from officer                                                                                                                                            |   | 2,319                   |           | 117,904                 |       |
| Inventory                                                                                                                                                        |   | 1,717,813               |           | 2,218,556               |       |
| Other                                                                                                                                                            |   | 327,386                 |           | 210,762                 |       |
| **Total current assets**                                                                                                                                         |   | **7,931,459**           | ** **     | **6,505,825**           | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| **Property  and Equipment**                                                                                                                                      |   |                    |           |                    |       |
| Equipment                                                                                                                                                        |   | 332,550                 |           | 310,082                 |       |
| Leasehold improvements                                                                                                                                           |   | 4,028,807               |           | 4,028,807               |       |
| Less accumulated depreciation and amortization                                                                                                                   |   | (3,075,581              | )              | (2,784,502              | )          |
| **Property and equipment, net**                                                                                                                                  |   | **1,285,776**           | ** **     | **1,554,387**           | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| **Intangible Assets**                                                                                                                                            |   |                    |           |                    |       |
| Patents                                                                                                                                                          |   | 290,930                 |           | 290,930                 |       |
| Goodwill                                                                                                                                                         |   | 3,675,512               |           | 3,675,512               |       |
| Less accumulated amortization                                                                                                                                    |   | (1,063,446              | )              | (1,047,438              | )          |
| **Intangible  assets, net**                                                                                                                                      |   | **2,902,996**           | ** **     | **2,919,004**           | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| Note due from sale of contract manufacturing  operations, net                                                                                                    |   | 1,825,800               |           | 1,794,600               |       |
| Note due from officer                                                                                                                                            |   | 103,504                 |           | —                  |       |
| Other assets                                                                                                                                                     |   | 39,277                  |           | 36,782                  |       |
| **Total  Assets**                                                                                                                                                |   | **$**                   | **14,088,812** | ** **              | **$**      | **12,810,598** | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| **Liabilities and stockholders’ equity**                                                                                                                    |   |                    |           |                    |       |
| **Current  Liabilities**                                                                                                                                         |   |                    |           |                    |       |
| Accounts payable, trade                                                                                                                                          |   | $                       | 277,178        |                    | $          | 650,160 |   |
| Accrued salaries and benefits                                                                                                                                    |   | 404,282                 |           | 218,102                 |       |
| Other accrued liabilities                                                                                                                                        |   | 259,880                 |           | 216,076                 |       |
| Deferred revenue                                                                                                                                                 |   | 21,000                  |           | 62,728                  |       |
| **Total current liabilities**                                                                                                                                    |   | **962,340**             | ** **     | **1,147,066**           | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| Other liabilities                                                                                                                                                |   | 91,258                  |           | 101,753                 |       |
| Deferred proceeds on sale of contract manufacturing  operations                                                                                                  |   | 1,216,891               |           | 1,494,106               |       |
| **Total Liabilities**                                                                                                                                            |   | **2,270,489**           | ** **     | **2,742,925**           | ** ** |
| **Commitments (Note 14)**                                                                                                                                        |   |                    | ** **     |                    | ** ** |
|                                                                                                                                                             |   |                    |           |                    |       |
| **Stockholders’  Equity**                                                                                                                                   |   |                    |           |                    |       |
| Preferred stock $.01 par value: 2,000,000 shares  authorized; no shares issued or outstanding                                                                    |   | —                  |           | —                  |       |
| Common stock $.01 par value: 30,000,000 shares  authorized; 15,733,911 and 15,653,542 shares issued and outstanding at  December 31, 2002 and 2001, respectively |   | 157,339                 |           | 156,535                 |       |
| Additional paid-in capital                                                                                                                                       |   | 85,154,299              |           | 85,062,476              |       |
| Deferred compensation                                                                                                                                            |   | (10,830                 | )              | —                  |       |
| Accumulated deficit                                                                                                                                              |   | (73,482,485             | )              | (75,151,338             | )          |
| Total stockholders’ equity                                                                                                                                  |   | 11,818,323              |           | 10,067,673              |       |
| **Total  Liabilities and Stockholders’ Equity**                                                                                                             |   | **$**                   | **14,088,812** | ** **              | **$**      | **12,810,598** | ** ** |

 

*See notes to consolidated financial statements*

 

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**ProCyte CorporationConsolidated Statements of Operations**

 
|                                                       |   | **Twelve  Months Ended December 31,** |       |
|------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                       |   | **2002**                              |       | **2001** |   | **2000** |   |
| **Revenues**                                               |   |                                  |       |   |   |   |   |
| Product sales                                              |   | $                                     | 11,355,796 |   | $ | 8,400,964 |   | $ | 5,055,030 |   |
| Licenses and royalties                                     |   | 1,381,426                             |       | 1,115,527 |   | 474,603 |   |
| Contract manufacturing                                     |   | —                                |       | 195,620 |   | 1,085,750 |   |
| Total revenues                                             |   | 12,737,222                            |       | 9,712,111 |   | 6,615,383 |   |
| **Cost of product sales**                                  |   | 4,706,310                             |       | 3,583,565 |   | 1,499,086 |   |
| **Gross profit**                                           |   | 8,030,912                             |       | 6,128,546 |   | 5,116,297 |   |
|                                                       |   |                                  |       |   |   |   |   |
| **Operating  Expenses**                                    |   |                                  |       |   |   |   |   |
| Research and development                                   |   | 126,227                               |       | 745,373 |   | 1,275,294 |   |
| Marketing and selling                                      |   | 3,089,859                             |       | 3,133,640 |   | 3,077,678 |   |
| General and administrative                                 |   | 3,344,872                             |       | 3,115,878 |   | 3,128,328 |   |
| Loss on sale of contract manufacturing operations          |   | —                                |       | 193,594 |   | — |   |
| Total operating expenses.                                  |   | 6,560,958                             |       | 7,188,485 |   | 7,481,300 |   |
|                                                       |   |                                  |       |   |   |   |   |
| **Operating  income (loss) from operations**               |   | 1,469,954                             |       | (1,059,939 | ) | (2,365,003 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| **Interest  and other income**                             |   | 198,899                               |       | 152,745 |   | 222,251 |   |
|                                                       |   |                                  |       |   |   |   |   |
| **Net  income (loss)**                                     |   | $                                     | 1,668,853  |   | $ | (907,194 | ) | $ | (2,142,752 | ) |
|                                                       |   |                                  |       |   |   |   |   |
| ***Earnings (loss)  per common share (note 9)***           |   |                                  |       |   |   |   |   |
| Basic                                                      |   | $                                     | 0.11       |   | $ | (0.06 | ) | $ | (0.14 | ) |
| Diluted                                                    |   | $                                     | 0.10       |   | $ | (0.06 | ) | $ | (0.14 | ) |
| ***Weighted average  common shares outstanding (note 9)*** |   |                                  |       |   |   |   |   |
| Basic                                                      |   | 15,710,498                            |       | 15,609,777 |   | 15,481,007 |   |
| Diluted                                                    |   | 16,179,017                            |       | 15,609,777 |   | 15,481,007 |   |

 

*See notes to consolidated financial statements*

 

20

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**ProCyte Corporation****Consolidated Statements of Cash Flows**

 
|                                                                                                  |   | **Twelve  Months Ended December 31,** |      |
|-------------------------------------------------------------------------------------------------------|--------|---------------------------------------|-----------|
|                                                                                                  |   | **2002**                              |      | **2001** |   | **2000** |   |
| **Operating  Activities**                                                                             |   |                                  |      |   |   |   |   |
| Net income (loss)                                                                                     |   | $                                     | 1,668,853 |   | $ | (907,194 | ) | $ | (2,142,752 | ) |
| *Adjustments to reconcile net income (loss) to net  cash provided by (used) in operating activities:* |   |                                  |      |   |   |   |   |
| Depreciation and amortization                                                                         |   | 307,087                               |      | 386,458 |   | 439,196 |   |
| Amortization of goodwill                                                                              |   | —                                |      | 245,034 |   | 245,034 |   |
| Amortization of deferred proceeds                                                                     |   | (277,215                              | )         | (133,800 | ) | — |   |
| Non-cash expense related to stock-based compensation                                                  |   | 48,000                                |      | 48,000 |   | 100,998 |   |
| Amortization of promissory note discount                                                              |   | (31,200                               | )         | (13,000 | ) | — |   |
| Amortization of deferred compensation                                                                 |   | 6,623                                 |      | — |   | — |   |
| Loss on sale of contract manufacturing operations                                                     |   | —                                |      | 193,594 |   | — |   |
| ***Change in  operating assets and liabilities:***                                                    |   |                                  |      |   |   |   |   |
| Accounts receivable                                                                                   |   | (371,932                              | )         | 283,153 |   | (506,467 | ) |
| Inventory                                                                                             |   | 500,743                               |      | 18,354 |   | (3,169 | ) |
| Other current assets                                                                                  |   | (161,625                              | )         | 5,749 |   | (23,957 | ) |
| Note due from employee                                                                                |   | 12,082                                |      | (4,735 | ) | (4,734 | ) |
| Accounts payable, trade                                                                               |   | (372,982                              | )         | 427,000 |   | 126,594 |   |
| Accrued salaries and benefits                                                                         |   | 186,180                               |      | 88,976 |   | 78,518 |   |
| Other accrued liabilities                                                                             |   | 43,804                                |      | (10,865 | ) | (41,939 | ) |
| Deferred revenue                                                                                      |   | (41,728                               | )         | (537,272 | ) | 600,000 |   |
| Other liabilities                                                                                     |   | (10,495                               | )         | (43,425 | ) | 3,143 |   |
| *Net cash provided by (used in)  operating activities*                                                |   | 1,506,195                             |      | 46,027 |   | (1,129,535 | ) |
| **Financing  Activities**                                                                             |   |                                  |      |   |   |   |   |
| Proceeds from issuance of common stock                                                                |   | 27,174                                |      | 65,846 |   | 14,234 |   |
| **Investing  Activities**                                                                             |   |                                  |      |   |   |   |   |
| Purchase of property and equipment                                                                    |   | (22,468                               | )         | (28,628 | ) | (18,804 | ) |
| Proceeds from sale of property and equipment                                                          |   | —                                |      | 128,243 |   | — |   |
| Investment in Emerald Pharmaceutical LLP                                                              |   | —                                |      | (1,000 | ) | — |   |
| Decrease in other assets                                                                              |   | 42,505                                |      | 18,617 |   | 24,392 |   |
| *Net cash provided by investing activities*                                                           |   | 20,037                                |      | 117,232 |   | 5,588 |   |
| **Net increase (decrease) in cash and cash  equivalents**                                             |   | 1,553,406                             |      | 229,105 |   | (1,109,713 | ) |
| **Cash  and Cash Equivalents:**                                                                       |   |                                  |      |   |   |   |   |
| At beginning of period                                                                                |   | 3,002,579                             |      | 2,773,474 |   | 3,883,187 |   |
| At end of period                                                                                      |   | $                                     | 4,555,985 |   | $ | 3,002,579 |   | $ | 2,773,474 |   |
| **Supplemental  Non-Cash Financing Activities**                                                       |   |                                  |      |   |   |   |   |
| Promissory note received from sale of contract  manufacturing operations                              |   | —                                |      | $ | 2,000,000 |   | — |   |
| Stock options granted to non-employees                                                                |   | $                                     | 17,453    |   | — |   | — |   |

 

*See notes to consolidated financial statements*

 

21

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**ProCyte CorporationConsolidated Statements ofStockholders’ Equity**

 
|                                                                                                 |   | **Common Stock** | ** ** | **Additiona  Paid-in  Capital** |       | **Deferred  Compen  sation** |   | **Accumulated  Deficit** |   | **Total**  |    |
|------------------------------------------------------------------------------------------------------|--------|------------------|------------|---------------------------------|------------|------------------------------|--------|--------------------------|--------|------------|---------|
|                                                                                                 |   | **Shares**       | ** ** | **Par Value**                   | ** ** |                         |   |                     |   |
| Balance, December 31, 1999                                                                           |   | 15,418,722       |       | $                               | 154,187    |                         | $      | 84,835,742               |   | $          | —  |   | $ | (72,101,392 | ) | $ | 12,888,537 |   |
| Shares issued at $1.50 per  share to settle contingent obligation to sellers of HumaTech Corporation |   | 37,333           |       | 373                             |       | 55,627                       |   | —                   |   | —     |    | 56,000 |   |
| Shares issued upon exercise  of options.                                                             |   | 16,334           |       | 165                             |       | 14,069                       |   | —                   |   | —     |    | 14,234 |   |
| Shares issued under  non-employee director stock plan                                                |   | 42,311           |       | 422                             |       | 44,580                       |   | —                   |   | —     |    | 45,002 |   |
| Net loss                                                                                             |   | —           |       | —                          |       | —                       |   | —                   |   | (2,142,752 | )       | (2,142,752 | ) |
| Balance, December 31, 2000                                                                           |   | 15,514,700       |       | $                               | 155,147    |                         | $      | 84,950,018               |   | $          | —  |   | $ | (74,244,144 | ) | $ | 10,861,021 |   |
| Shares issued under  non-employee director stock plan                                                |   | 50,840           |       | 508                             |       | 47,492                       |   | —                   |   | —     |    | 48,000 |   |
| Shares issued upon exercise  of options                                                              |   | 88,002           |       | 880                             |       | 64,966                       |   | —                   |   | —     |    | 65,846 |   |
| Net loss                                                                                             |   | —           |       | —                          |       | —                       |   | —                   |   | (907,194   | )       | (907,194 | ) |
| 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                                                |   | 31,316           |       | 313                             |       | 47,687                       |   | —                   |   | —     |    | 48,000 |   |
| Shares issued upon exercise  of warrant issued in 1999                                               |   | 18,549           |       | 185                             |       | (185                         | )      | —                   |   | —     |    | — |   |
| Shares issued upon exercise  of options                                                              |   | 30,504           |       | 306                             |       | 26,868                       |   | —                   |   | —     |    | 27,174 |   |
| Stock options granted to  non-employees                                                              |   | —           |       | —                          |       | 17,453                       |   | (17,453                  | )      | —     |    | — |   |
| Amortization of deferred  compensation                                                               |   | —           |       | —                          |       | —                       |   | 6,623                    |   | —     |    | 6,623 |   |
| Net income                                                                                           |   | —           |       | —                          |       | —                       |   | —                   |   | 1,668,853  |    | 1,668,853 |   |
| Balance, December 31, 2002                                                                           |   | 15,733,911       |       | $                               | 157,339    |                         | $      | 85,154,299               |   | $          | (10,830 | ) | $ | (73,482,485 | ) | $ | 11,818,323 |   |

 

 

*See notes to consolidated financial statements*

 

22

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**ProCyte Corporation**

**Notes to Consolidated Financial Statements**

** **

**Note1.  Description of Business and Summaryof Significant Accounting Policies**

 

**Basis ofPresentation**

 

The accompanyingconsolidated financial statements include the accounts of ProCyte Corporationand its wholly owned, non-operating subsidiary NextDerm, Inc. (collectively“ProCyte” or the “Company”) for the three years ended December 31, 2002.

 

**Summaryof Significant Accounting Policies**

 

*Revenuerecognition*

 

Product revenuesare recognized when products are shipped, license fees are recognized over theterm of the license agreement, and royalties are recognized when earned.  Under certain agreements, the Company mayreceive advance deposits with customer purchase orders.  These deposits are reported as a deferredrevenue liability, until the product is shipped to the customer. Contractmanufacturing revenues, included in operations until the manufacturingoperations were sold in June 2001, were recognized when services wereperformed.

 

*Cost ofproduct sales*

 

Cost of productsales is recognized at the time the product is shipped and the revenue isrecorded.  An automated inventory systemis used and product purchases are recorded as inventory.  A significant portion of the inventory itemsare finished goods purchased from third-party vendors for resale.  Please see “Inventories” discussion below.

 

*Advertisingexpense*

 

The cost of advertising is expensed as incurred.  Advertising expense is included in marketingand selling expense and was $220,405, $211,821 and $266,579 for the years endedDecember 31, 2002, 2001 and 2000, respectively.

 

*Researchand development*

 

Research anddevelopment costs are expensed as incurred. The Company enters into contracts with outside laboratories for certainstudies and recognizes the expenses associated with these contracts when therelated services are performed.

 

*Generaland administrative*

 

General andadministrative includes costs associated with the contract manufacturingactivities, which are not separately segregated.  The contract manufacturing business was sold in July 2001.

 

*Inventories*

 

Finished goods,raw materials and work in process inventories are stated at the lower of cost,as determined by the first in, first out method, or market.  Finished goods and work in process costs includematerial, direct labor and overhead. The Company reduces the value of inventoryfor slow moving, obsolete, non-salable or unusable items based upon a productlevel review.

 

23

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*Depreciation and amortization*

* *

Equipment isdepreciated using the straight-line method over the estimated useful lives ofthe related assets, ranging from 3 to 20 years.  Leasehold improvements are amortized over the term of thefacility lease.   Patent applicationcosts are amortized on a straight-line basis over the estimated useful liveswhich are generally 17 years from the date the patents are issued.

 

*Goodwill*

 

Goodwill arisingfrom acquisitions represent the excess of the purchase price over the estimatedfair value of the net assets acquired. The Company periodically evaluates goodwill for impairment.  On January 1, 2002, the Company implementedthe guidance of Statement of Financial Accounting Standards (SFAS) No. 142“Goodwill and Other Intangible Assets” in recognizing certain intangibles asgoodwill and assessing potential future impairments of goodwill.  Previous to January 1, 2002, the Companyamortized goodwill using the straight-line basis over 15 years.

 

*Long-livedassets*

 

The Companyreviews its long-lived assets for impairment to determine whether any events orcircumstances indicate that the carrying amount of the assets may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to the future undiscounted netcash flows expected to be generated by the asset.  If the carrying value is greater than the future undiscountedcash flows, an impairment loss is recorded to reduce the carrying value to fairvalue.

 

*Federal income taxes*

 

The Company usesthe asset and liability method to account for income taxes as provided for inSFAS 109, *Accountingfor Income Taxes*.  Under thismethod deferred tax assets and liabilities are recorded based on differencesbetween basis for financial and tax reporting using the statutory rate ineffect at the time the differences are expected to reverse.  The Company has provided a full valuationreserve for tax benefits of net operating losses and research and developmenttax credit carry forwards due to the uncertainty of realizing the tax benefitsof the assets.

 

*Cashand Cash equivalents*

 

The Companyconsiders all highly liquid investments purchased with maturities of threemonths or less to be cash equivalents. Cash and cash equivalents are primarily held in a United States Treasurymoney market fund.

 

*Stockbased compensation*

 

The Companyfollows the intrinsic value based accounting method for stock options containedin APB Opinion No. 25, *Accounting for Stock Issued to Employees,*as permitted by SFAS No. 123, *Accounting for Stock-Based Compensation*.  Under this method, the Company measuresstock based compensation for option grants to employees assuming that optionsgranted at market price at the date of grant have no intrinsic value.  No compensation expense has been recognizedfor employee and director stock option-based incentive compensation plans.  Had compensation expense for the Company’sstock options under the incentive compensation plan been recognized based uponthe fair value for awards granted, the Company’s net earnings or losses wouldhave been changed to the following pro forma amounts: 

 

24

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|                                                                                           |   | **2002** |      | **2001** |   | **2000**   |   |
|------------------------------------------------------------------------------------------------|--------|----------|-----------|----------|--------|------------|--------|
| Net earnings (loss), as reported                                                               |   | $        | 1,668,853 |     | $      | (907,194   | )      | $ | (2,142,752 | ) |
| Stock option-based compensation  expense determined under fair value  based method, net of tax |   | 258,049  |      | 230,338  |   | 316,544    |   |
|                                                                                           |   |     |      |     |   |       |   |
| Pro forma net earnings                                                                         |   | $        | 1,410,804 |     | $      | (1,137,532 | )      | $ | (2,459,296 | ) |
|                                                                                           |   |     |      |     |   |       |   |
| Earnings per share:                                                                            |   |     |      |     |   |       |   |
|                                                                                           |   |     |      |     |   |       |   |
| As reported basic                                                                              |   | $        | 0.11      |     | $      | (0.06      | )      | $ | (0.14 | ) |
|                                                                                           |   |     |      |     |   |       |   |
| As reported diluted                                                                            |   | $        | 0.10      |     | $      | (0.06      | )      | $ | (0.14 | ) |
|                                                                                           |   |     |      |     |   |       |   |
| Pro forma basic                                                                                |   | $        | 0.09      |     | $      | (0.08      | )      | $ | (0.17 | ) |
|                                                                                           |   |     |      |     |   |       |   |
| Pro forma diluted                                                                              |   | $        | 0.09      |     | $      | (0.08      | )      | $ | (0.17 | ) |

 

The Companydetermined the fair value of stock options granted during 2002, 2001 and 2000using the Black-Scholes option pricing model and the following assumptions: 

 

| **Options Granted**          |   | **2002**   |   | **2001**   |   | **2000** |   |
|------------------------------|--------|------------|--------|------------|--------|----------|--------|
| Risk-free interest rate      |   | 3.13%-3.92 | %      | 3.37%-4.45 | %      | 5.03     | %      |
| Expected option life (years) |   | 6.00       |   | 5.81       |   | 5.81     |   |
| Dividend yield               |   | 0.00       |   | 0.00       |   | 0.00     |   |
| Expected volatility          |   | 61%-67     | %      | 94-140     | %      | 208      | %      |

* *

*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 and other non-current assets.  Actual results could differ from those estimates.

 

*Reclassifications*

* *

Certainreclassifications have been made to items reported in prior years to conform tothe current year’s presentation.

 

*Recent accounting pronouncements*

 

In July 2001, theFASB issued Statement of Financial Accounting Standards No. 142 (“SFAS 142”),“Goodwill and Other Intangible Assets”, which was effective January 1,2002.  SFAS 142 requires, among otherthings, the discontinuance of goodwill amortization.  In addition, the standard includes provisions for the reclassificationof certain existing recognized intangibles as goodwill, reassessment of theuseful lives of existing recognized intangibles, reclassification of certainintangibles out of previously reported goodwill and the identification ofreporting units for purposes of assessing potential future impairments ofgoodwill.  The Company adopted SFAS 142effective January 1, 2002 and per the requirements set forth therein conducteda transitional goodwill impairment test as of January 1, 2002 which did notidentify the need to recognize any transitional impairment.  The Company’s annual amortization expensefor goodwill was $245,034 for the

 

25

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periods ending December31, 2001 and 2000.  The net loss for2001 and 2000 would have been $662,160 and $1,897,718, or $0.04 and $0.12 netloss per share, respectively, if goodwill had not been amortized.

 

In July 2001, theFinancial Accounting Standards Board published Statement of FinancialAccounting Standards (“SFAS”) No. 143. This Statement applies to all entities and financial accounting and reportingfor obligations associated with the retirement of tangible long-lived assetsand the associated asset retirement costs. The provisions of SFAS No. 143 are required to be applied starting withfiscal years beginning after June15, 2002. The Company does not expect SFAS No. 143 to have a material impact onthe Company’s financial statements.

 

In August 2001,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards (“SFAS”) No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets”.  Thispronouncement supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be Disposed Of” as well asreporting provisions of Accounting Principles Board Opinion No. 30 andAccounting Research Bulleting No. 51. The Company adopted SFAS No. 144 effective January 1, 2002 and suchadoption did not have a material impact on the Company’s financial statements.

 

In April 2002, theFinancial Accounting Standards Board (FASB) issued SFAS No. 145, Rescission ofFASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, andTechnical Corrections.  This Statementrescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt,and an amendment of that statement, SFAS No. 64, Extinguishments of Debt Madeto Satisfy Sinking-Fund Requirements. SFAS No. 145 also rescinds SFAS No. 44,Accounting for Intangible Assets of Motor Carriers. SFAS No. 145 amends SFASNo. 13, Accounting for Leases, to eliminate an inconsistency between therequired accounting for sale-leaseback transactions and the required accountingfor certain lease modifications that have economic effects that are similar tosale-leaseback transactions.  SFAS No. 145also amends other existing authoritative pronouncements to make varioustechnical corrections, clarify meanings, or describe their applicability underchanged conditions.  Certain provisionsof SFAS No. 145 will be adopted by the Company on January 1, 2003.  The Company does not anticipate thatadoption of these provisions will have a material effect on its financialposition or results of operations.  TheCompany has adopted the provisions of SFAS No. 145 that are effective forfinancial statements issued after May 15, 2002.  There was no impact on the Company’s financial position orresults of operations as a result of the adoption of these provisions.

 

In June 2002, theFASB issued SFAS No. 146, Accounting for Costs Associated with Exit or DisposalActivities.  This standard requirescompanies to recognize costs associated with exit or disposal activities whenthey are incurred rather than at the date of a commitment to an exit ordisposal plan.  Examples of costscovered by the standard include lease termination costs and certain employeeseverance costs that are associated with a restructuring, discontinuedoperation, plant closing, or other exit or disposal activity. SFAS No. 146 isto be applied prospectively to exit or disposal activities initiated afterDecember 31, 2002.

 

In December 2002,the FASB issued Statement 148 (FAS 148), Accounting for Stock-BasedCompensation Transition and Disclosure. FAS 148 amends the disclosure and certain transition provisions ofStatement 123, Accounting for Stock-Based Compensation.  Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures are required in financial statements forinterim periods beginning after December 15, 2002.  Other than the additional disclosure requirements, thispronouncement is not expected to have a material impact on the Company’sfinancial position or results of operations.

 

In November 2002,FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN45”) was issued. FIN 45 elaborates on the disclosures to be made by a guarantorin its interim and annual financial statements about its obligations undercertain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at theinception of a guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee. The initial recognition and initial measurement provisions of thisInterpretation are applicable on a prospective basis to guarantees issued ormodified after December 31, 2002.  Therequired disclosures are

 

26

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effective for financialstatements of interim or annual periods ending after December 15, 2002.  The Company’s adoption of FIN 45 in 2003 isnot expected to have a material effect on the Company’s financial position orresults of operations.

 

In January 2003,the FASB issued Interpretation No. 46, “Consolidation of Variable InterestEntities” (“FIN 46”) to clarify the conditions under which assets, liabilitiesand activities of another entity should be consolidated into the financialstatements of a company. FIN 46 requires the consolidation of a variableinterest entity by a company that bears the majority of the risk of loss fromthe variable interest entity’s activities, is entitled to receive a majority ofthe variable interest entity’s residual returns, or both. The provisions of FIN46, required to be adopted in fiscal 2003, are not expected to have a materialimpact on the Company’s financial position or results of operations.

 

**Note 2.  AccountsReceivable**

 

Two customers eachrepresented greater than 10% of the net accounts receivable balance at December31, 2002 and 2001 as follows: 

 

|       |   | **December 31, 2002** |   | **December 31, 2001** |   |
|------------|--------|-----------------------|--------|-----------------------|--------|
| Customer A |   | 44                    | %      | 22                    | %      |
| Customer B |   | 13                    | %      | 13                    | %      |

 

The Company provided an allowance for uncollectable receivables in theamount of $68,029 and $243,213 at December 31, 2002 and 2001,respective1y.  The bad debt expense, netof recoveries of $34,203 in 2002, was $3,126, $187,875 and $46,987 for theyears ended December 31, 2002, 2001 and 2000, respectively.  Accounts written off to the allowanceamounted to $212,510, $36,994 and $20,076 for the years ended December 31,2002, 2001 and 2000, respectively.

 

**Note 3.  Inventory**

 

Inventory consisted ofthe following: 

 

|            |   | **December 31, 2002** |      | **December 31, 2001** |   |
|-----------------|--------|-----------------------|-----------|-----------------------|--------|
| Finished Goods  |   | $                     | 1,017,633 |                  | $      | 942,165 |   |
| Work in process |   | 463,881               |      | 350,969               |   |
| Raw materials   |   | 236,299               |      | 925,422               |   |
| **Total**       |   | $                     | 1,717,813 |                  | $      | 2,218,556 |   |

 

**Note 4.  Product andgeographic information**

** **

The Company’s skinhealth, hair care and wound care products are sold primarily to specialtydistributors and physicians.  TheCompany sells its patented Copper Peptide in bulk to its licensedpartners.  One customer accounted for22% and 34% of the product revenues in 2002 and 2001, respectively.  The same customer accounted for 30% and 32%of the Company’s total revenues in 2002 and 2001, respectively.  No customers accounted for more than 10% ofproduct revenues or total revenues in 2000. The Company has not made significant sales outside of the United Statesand does not currently maintain discrete financial information to measureoperating performance on a segment basis.

 

27

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Product sales consistedof the following: 

 

|                                  |   | **Year Ended  December 31,** |       |
|---------------------------------------|--------|------------------------------|------------|
|                                  |   | **2002**                     |       | **2001** |   | **2000** |   |
| Skin Health, Wound Care and Hair Care |   | $                            | 7,824,456  |   | $ | 6,288,734 |   | $ | 4,889,030 |   |
|                                  |   |                         |       |   |   |   |   |
| Bulk Product                          |   | 3,531,340                    |       | 2,112,230 |   | 166,000 |   |
|                                  |   | $                            | 11,355,796 |   | $ | 8,400,964 |   | $ | 5,055,030 |   |

 

**Note 5.  IntangibleAssets**

 

Intangible assetsinclude patents of $85,625 and $101,633 and goodwill of $2,817,371 and $2,817,371at December 31, 2002 and 2001, respectively. Intangible assets are shown net of accumulated amortization of$1,063,446 and $1,047,438, at December 31, 2002 and 2001, respectively.  Patents are amortized over the term of thepatent and the amortization expense related thereto was $16,000 for each of theyears in the three year period ended December 31, 2002. Amortization isexpected to be $16,000 for each of the years ending December 31, 2003 through2007 and $6,000 for the year ending December 31, 2008.

 

Effective January1, 2002, the Company implemented the guidance of Statement of FinancialAccounting Standards (SFAS) No. 142 “Goodwill and Other Intangible Assets” inrecognizing certain intangibles such as goodwill and assessing potential futureimpairments of goodwill.  The Companyperformed an annual test on the value of its goodwill under the guidance ofSFAS 142 on March 31, 2002, and did not identify the need to recognize anyimpairment of value at that time.  Therewere no events since March 31, 2002, which would cause the Company to changeits valuation as of December 31, 2002. This analysis was based on one reportable unit.  All of goodwill is deemed to be associatedwith ProCyte’s overall business operations.

 

**Note 6.  FederalIncome Taxes**

 

The provision forincome taxes differs from the amount computed by applying the statutory federalincome tax rate to the net income or loss from operations. The sources and taxeffects of the differences are as follows: 

 

|                                                                  |   | **Years ended December 31,** |     |
|-----------------------------------------------------------------------|--------|------------------------------|----------|
|                                                                  |   | **2002**                     |     | **2001** |   | **2000** |   |
| Income tax (provision) benefit at federal  statutory rate of 35%      |   | $                            | (584,099 | ) | $ | 317,518 |   | $ | 749,963 |   |
| Permanent tax/book differences                                        |   | (19,951                      | )        | (11,869 | ) | (13,565 | ) |
| Tax (provision) benefit before net operating loss  carry forward      |   | (604,050                     | )        | 305,649 |   | 736,398 |   |
|                                                                  |   |                         |     |   |   |   |   |
| Change in valuation allowance                                         |   | —                       |     | (305,649 | ) | (736,398 | ) |
| Net operating loss and general business credit carry  forward benefit |   | 604,050                      |     | — |   | — |   |
|                                                                  |   |                         |     |   |   |   |   |
| Net tax (provision)/benefit                                           |   | $                            | —   |   | $ | — |   | $ | — |   |

 

28

----

 

The tax effect oftemporary differences and net operating loss carry forward that give rise tothe Company’s deferred tax assets and liabilities are as follows: 

 

|                               |   | **December 31,  2002** |    | **December 31,  2001** |   |
|------------------------------------|--------|------------------------|---------|------------------------|--------|
| **Deferred Tax Assets:**           |   |                   |    |                   |   |
| **Current**                        |   |                   |    |                   |   |
| Compensation accrual               |   | $                      | 111,516 |                   | $      | 5,997 |   |
| Bad debt allowance                 |   | 23,810                 |    | 85,125                 |   |
| Inventory allowance                |   | 43,272                 |    | 169,750                |   |
| **Non-Current**                    |   |                   |    |                   |   |
| Net operating loss carry-forward   |   | 23,736,204             |    | 24,117,664             |   |
| Tax credit carry-forward           |   | 1,677,537              |    | 1,701,070              |   |
| Asset impairment write-down        |   | 520,040                |    | 520,040                |   |
| Depreciation                       |   | 593,347                |    | 551,274                |   |
| Deferred gain                      |   | 425,913                |    | 522,937                |   |
| Promissory note discount           |   | 60,970                 |    | 71,890                 |   |
| Amortization of intangible assets  |   | —                 |    | 22,830                 |   |
| Total gross deferred tax assets    |   | 27,192,609             |    | 27,768,577             |   |
| Deferred tax liabilities           |   | 56,383                 |    | 4,961                  |   |
| Net deferred tax asset             |   | 27,136,226             |    | 27,766,616             |   |
| Valuation allowance                |   | (27,136,226            | )       | (27,766,616            | )      |
| **Net Deferred Tax Asset Balance** |   | $                      | —  |                   | $      | — |   |

 

At December 31,2002 and 2001, the Company provided a full valuation allowance for its netdeferred tax assets.  The Companybelieves sufficient uncertainty exists regarding the realizability of thedeferred tax assets.  The net change inthe valuation allowance during the years ended December 31, 2002 and 2001, was$(627,390) and $372,989, respectively.

 

As of December 31,2002, the Company’s U.S. federal net operating loss and general business creditcarry forward for income tax purposes were approximately $67,817,727 and $1,677,537,respectively.  If not utilized, thefederal net operating loss carry forward and tax credits carry forward willexpire between 2004 and 2021 as follows: 

 
|       |   | **Net operating loss** |       | **General business  credits** |   |
|------------|--------|------------------------|------------|-------------------------------|--------|
| 2003       |   | $                      | —     |                          | $      | 68,616 |   |
| 2004       |   | 253,349                |       | 32,766                        |   |
| 2005       |   | 2,129,240              |       | 178,114                       |   |
| 2006       |   | 3,927,855              |       | 132,674                       |   |
| 2007       |   | 5,173,369              |       | 158,106                       |   |
| Thereafter |   | 56,333,914             |       | 1,107,261                     |   |
| Total      |   | $                      | 67,817,727 |                          | $      | 1,677,537 |   |

 

29

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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.

 

**Note 7.  401(k) Plan**

** **

The Companysponsors the 1991 ProCyte Corporation Profit Sharing and Salary Deferral 401(k)Plan, which is funded by voluntary employee pretax salary deferrals to theextent permitted under law and provides for employer matching contributions atthe discretion of the Board of Directors. No employer contribution has been made since the adoption of the plan.

 

**Note 8.  Note Due fromOfficer**

** **

At December 31,2002 and 2001, an Officer owed the Company $105,823 and $117,904,respectively.  The original promissorynote, dated December 16, 1998, bore interest at 4.28%, compoundedsemi-annually, which was payable at June 30, 2002.  In the first quarter of 2002, the Compensation Committee of theBoard of Directors agreed to extend the note’s due date an additional two yearsto June 30, 2004.  The extendedpromissory note agreement, dated June 30, 2002, bears interest at the applicablefederal short-term rate at June 30, 2002 of 2.91%, which is payable annually.

 

**Note 9. 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 the year2002, 468,519 dilutive stock options were included in the calculation ofaverage number of common shares outstanding for diluted computations.   As a result of the Corporation recordinglosses from operations in years 2001 and 2000, the average number of commonshares used in the calculation of the diluted loss per share have not beenadjusted for the effects of 182,460 and 145,266, respectively, of dilutivestock options since their impact would be anti-dilutive.

 

**Note 10.  Stockholders’Equity**

** **

*Non-employee Director Stock Plan*

 

In June 1998, theshareholders approved the 1998 Non-employee Director Stock Plan, reserving200,000 shares for issuance to directors. 200,000 additional shares were approved for issuance under the plan atthe Company’s annual shareholders meeting on May 23, 2000. Under this plan,eligible directors receive all or a portion of their quarterly retainer fees inshares of the common stock of the Company. The number of shares each eligible director receives is based on theaverage fair market value of the common stock for the last 20 business days ofthe fiscal quarter.  As of December 31,2002 and 2001, 31,316 and 50,840 shares have been issued under the Plan.  After issuing 8,644 shares on January 2,2003, the plan had 138,307 shares available for issuance.

 

*Shareholder Rights plan*

 

In December 1994,the Board of Directors adopted a shareholder rights plan declaring a dividendof one preferred share purchase right (the “Rights”) for each outstanding shareof common stock of the Company.  EachRight, initially evidenced by and traded with the shares of common stock,entitles the registered holder to purchase one one-hundredth (1/100) of a shareof preferred stock of the Company at an exercise price of $14.00, subject toadjustment based on the market price of the Company’s common stock at the timethe Rights

 

30

----

 

become exercisable.  The Rights will be exercisable only if aperson or group acquires 15% or more of the Company’s common stock or announcesa tender offer for the Company.  TheRights may be redeemed, at a redemption price of $0.01 per Right, at any timeuntil any person or group has acquired 15% or more of the Company’s commonstock.  The Board of Directors may alsoelect to exchange the Rights for shares of the Company’s common or preferredstock.  In the event the Company isacquired, each outstanding Right will represent the right to acquire shares ofthe surviving entity.  The Rights expireon December 7, 2004.

 

**Note11.  Warrants to Acquire Common Stock**

 

The Company issuedthree common stock purchase warrants for 100,000 shares on May 26, 1999 inexchange for services.  The warrantsoblige the Company to issue 33,334 shares at $0.6875 per share, the marketprice 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.

 

**Note 12.  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.

 

The followingtable summarizes information about stock option activity in 2002, 2001 and2000: 

 
| **Items**                      |                    | **2002**  |                           | **2001** |                    | **2000** |                           |
|--------------------------------|-------------------------|-----------|--------------------------------|----------|-------------------------|----------|--------------------------------|
|                           | **Number  of  Options** |      | **Wtd. Avg.  Exercise  Price** |     | **Number  of  Options** |     | **Wtd. Avg.  Exercise  Price** |   | **Number  of  Options** |   | **Wtd. Avg.  Exercise  Price** |   |
| Outstanding, beginning of year |                    | 2,087,002 |                           | $        | 1.57                    |     | 2,081,861                      |   | $ | 1.63 |   | 1,861,727 |   | $ | 1.71 |   |
|                           |                    |      |                           |     |                    |     |                           |   |   |   |   |   |   |
| Granted                        |                    | 490,500   |                           | $        | 1.67                    |     | 440,500                        |   | $ | 1.27 |   | 451,500 |   | $ | 0.94 |   |
|                           |                    |      |                           |     |                    |     |                           |   |   |   |   |   |   |
| Exercised                      |                    | (30,504   | )                              | $        | 0.89                    |     | (88,002                        | ) | $ | 0.75 |   | (16,334 | ) | $ | 0.87 |   |
|                           |                    |      |                           |     |                    |     |                           |   |   |   |   |   |   |
| Canceled or expired            |                    | (361,663  | )                              | $        | 1.80                    |     | (347,357                       | ) | $ | 1.73 |   | (215,032 | ) | $ | 0.97 |   |
|                           |                    |      |                           |     |                    |     |                           |   |   |   |   |   |   |
| Outstanding, end of year       |                    | 2,185,335 |                           | $        | 1.57                    |     | 2,087,002                      |   | $ | 1.57 |   | 2,081,861 |   | $ | 1.63 |   |
|                           |                    |      |                           |     |                    |     |                           |   |   |   |   |   |   |
| Exercisable, end of year       |                    | 1,457,014 |                           | $        | 1.61                    |     | 1,265,018                      |   | $ | 1.89 |   | 1,149,878 |   | $ | 2.21 |   |

 

31

----

 

The optionsoutstanding at December 31, 2002 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 - $0.74               |   | 286,667                             |   | 7.48                          |   | $                             | 0.71   |                                | 220,170   |                          | $      | 0.71 |   |
| $  0.75 - $0.99               |   | 407,000                             |   | 6.57                          |   | $                             | 0.81   |                                | 396,835   |                          | $      | 0.81 |   |
| $  1.00 - $1.39               |   | 535,834                             |   | 7.53                          |   | $                             | 1.26   |                                | 339,175   |                          | $      | 1.24 |   |
| $  1.40 - $1.99               |   | 535,000                             |   | 8.93                          |   | $                             | 1.65   |                                | 80,000    |                          | $      | 1.44 |   |
| $  2.00 - $11.88              |   | 420,834                             |   | 3.20                          |   | $                             | 3.16   |                                | 420,834   |                          | $      | 3.16 |   |
| $  0.49 - $11.88              |   | 2,185,335                           |   | 6.85                          |   | $                             | 1.57   |                                | 1,457,014 |                          | $      | 1.61 |   |

 

At December 31,2002 there were 490,827 shares reserved for issuance under the Company’s 1996Stock Option Plan, which included the 750,000 shares approved for the plan atthe Company’ annual shareholders meeting on May 21, 2002.

 

The weightedaverage fair value of options granted during 2002, 2001, and 2000 wasapproximately $1.19, $1.00, and $0.87 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 market price on the dates of grant.  Both grants become fully vested one yearafter their date of issuance.  The fairvalue of the February and May grants was determined to be $6,448 and $11,005,respectively, using the Black-Scholes option pricing model.  The assumptions used in the model for theFebruary and May grants, respectively, were a risk-free interest rate of 3.84%and 3.92%, 67% and 61% stock price volatility, and no dividends over the twoyear expected lives.  The options arebeing re-valued quarterly until the measurement date is reached upon completionof the services.  The fair values arereported as deferred compensation in Stockholders’ Equity, and are beingamortized as an operating expense over the expected lives.

 

**Note 13.**  **Related Party Disclosure**

** **

The Company holdsa promissory note in the principle amount of $2,000,000 from EmeraldPharmaceutical L.P., which it received as partial consideration for the sale ofits contract manufacturing operations in 2001. The note is secured by the manufacturing assets sold and bears interestequal to the effective yield on the 10 Year US Treasury Note, which is adjustedquarterly.  The average yield for theyear ended December 31, 2002 was 4.70%. 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 overthe term of the lease.  ProCyte engagesEmerald Pharmaceutical L.P. to do certain manufacturing and other quality andanalytical services.  Emerald billedProCyte a total of $1,553,837 and $175,394 for the years ended December 31,2002 and 2001, respectively, for such services.  ProCyte had trade payables to Emerald of $92,404 and $44,155 onDecember 31, 2002 and 2001, respectively.

 

One of theCompany’s Directors also serves as Chairman and Chief Executive Officer of oneof ProCyte’s customers.  ProCyte’s salesto the customer were $858,998 and $553,882 for the years ended December 31,2002 and 2001, respectively.  Thecustomer’s trade receivable balances were $172,145 and $122,165 on December 31,2002 and 2001, respectively.

 

 

32

----

 

**Note 14.  Commitments**

 

The Companypresently leases 34,532 square feet of manufacturing, warehouse, laboratory,and administrative space in Redmond, Washington under a lease executed inAugust 1993.  The lease includes 1,782additional square feet of office space in the same building, which was occupiedin December 2002.  As amended, the leaseterm for 32,750 square feet extends through June 30, 2007, and contains arenewal option for the Company to extend the term by an additional fiveyears.  The lease term for the new 1,782square feet of office space is through November 2005.  As a part of the sale of the contract manufacturing business in2001, 19,770 square feet of space was subleased to Emerald PharmaceuticalLP.  The sublease agreement has reducedProCyte’s net lease expense by $278,274 and $130,950 in 2002 and 2001,respectively.  ProCyte remains theprimary lessee and the payment obligation continues to belong to ProCyte.

 

Future minimumannual lease payments and sublessee commitments are as follows: 

 

|      |   | **Lease  commitment** |      | **Sub-lease  commitment** |   |
|-----------|--------|-----------------------|-----------|---------------------------|--------|
| 2003      |   | $                     | 418,444   |                      | $      | 269,611 |   |
| 2004      |   | 420,939               |      | 269,611                   |   |
| 2005      |   | 439,105               |      | 281,748                   |   |
| 2006      |   | 429,384               |      | 293,884                   |   |
| 2007      |   | 250,474               |      | 171,433                   |   |
| **Total** |   | $                     | 1,958,346 |                      | $      | 1,286,287 |   |

 

Net rent expenseunder these commitments in 2002, 2001, and 2000 was $117,816, $226,857, and$404,196, respectively.

 

33

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**ProCyte Corporation**

**Independent Auditors’ Report**

 

Board of Directors

ProCyte Corporation

Redmond, Washington

 

We have audited theaccompanying consolidated balance sheets of ProCyte Corporation (the Company)as of December 31, 2002 and 2001, and the related consolidated statements ofoperations, cash flows, and stockholders’ equity for each of the three years inthe period ended December 31, 2002. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of the Company as of December 31, 2002, and 2001, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2002, in conformity with accounting principles generallyaccepted in the United States of America.

 

The Company changed itsmethod of accounting for goodwill upon adoption of SFAS No. 142 “Goodwill andOther Intangible Assets” for the year ended December 31, 2002, as discussed inNote 1 to the consolidated financial statements.

 
| DELOITTE & TOUCHE LLP     |
|-------------------------------|
|                          |
|                          |
| /s/ Deloitte & Touche LLP |   |
|                          |
| Seattle, Washington           |
| February 21, 2003             |

 

34

----

 

**Item 9****.    Changes in and Disagreements WithAccountants on Accounting and Financial Disclosure**

 

Not applicable.

 

**PART III**

 

**Item 10****. Directors and Executive Officersof the Registrant**

 

The informationrequired under this item is included in the Company’s Proxy Statement relatingto the Company’s annual meeting of shareholders, and is incorporated herein byreference.  Such Proxy Statement will befiled with the Securities and Exchange Commission within 120 days after theclose of the Company’s fiscal year end, December 31, 2002.

 

**Item 11****. Executive Compensation**

 

The informationrequired under this item is included in the Company’s Proxy Statement relatingto the Company’s annual meeting of shareholders, and is incorporated herein byreference.  Such Proxy Statement will befiled with the Securities and Exchange Commission within 120 days after theclose of the Company’s fiscal year end, December 31, 2002.

 

**Item 12****. Security Ownership of CertainBeneficial Owners and Management**

 

The informationrequired under this item is included in the Company’s Proxy Statement relatingto the Company’s annual meeting of shareholders, and is incorporated herein byreference.  Such Proxy Statement will befiled with the Securities and Exchange Commission within 120 days after theclose of the Company’s fiscal year end, December 31, 2002.

 

**Item 13****. Certain Relationships and RelatedTransactions**

 

The informationrequired under this item is included in the Company’s Proxy Statement relatingto the Company’s annual meeting of shareholders, and is incorporated herein byreference.  Such Proxy Statement will befiled with the Securities and Exchange Commission within 120 days after theclose of the Company’s fiscal year end, December 31, 2002.

 

**PART IV**

 

**Item 14****. Controls and Procedures**

 

Under thesupervision of and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, the Companyhas evaluated the effectiveness and design and operation of its disclosurecontrols and procedures within 90 days of the filing date of this annualreport, 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.

 

**Item 15****Exhibits, Financial StatementSchedules, and Reports on Form 8-K**

 

**a.             List ofdocuments filed as part of this report:**

** **

(1)               FinancialStatements and Supplementary Data Reference is made to the Index to FinancialStatements and Schedules under Item 8 in Part II hereof, where such documentsare listed.

(2)               Exhibits– see (c) below

 

35

----

 

**b.             Reportson Form 8-K**

 

None

 

**c.             Exhibits**

 
| **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        |
|        |   |                                                                                                                                  |   |     |
| 23.1        |   | Consent of Deloitte  & Touche LLP                                                                                                 |   | J        |
|        |   |                                                                                                                                  |   |     |
| 99.1        |   | Certification of  Periodic Report by Mr. John F. Clifford                                                                             |   | J        |
|        |   |                                                                                                                                  |   |     |
| 99.2        |   | Certification of  Periodic Report by Mr. Robert W. Benson                                                                             |   | J        |

 

----

| *      | 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.                                                                                                          |

 

36

----

 

**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)        |
|   |           |                |
|   |           | By:                 | /s/ John F. Clifford |
| Date:  | March 28, 2003 |                | John F. Clifford |
|   |           |                | Chairman of the Board  of Directors and Chief |
|   |           |                | Executive Officer |
|   |           |                |
|   |           |                |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated. 

 
| **Name**                |                           | **Title**                             |                | **Date** |
|-------------------------|--------------------------------|---------------------------------------|---------------------|----------|
|                    |                           |                                  |
| /s/ John F. Clifford    |                           | Chairman and Chief  Executive Officer | March 28, 2003 |
| John F. Clifford        | (Principal Executive  Officer) |                                  |
|                    |                           |                                  |
|                    |                           |                                  |
| /s/ John M. Hammer      |                           | Director                              | March 28, 2003 |
| John Hammer             |                           |                                  |
|                    |                           |                                  |
|                    |                           |                                  |
| /s/ Matt L. Leavitt     |                           | Director                              | March 28, 2003 |
| Matt L. Leavitt         |                           |                                  |
|                    |                           |                                  |
|                    |                           |                                  |
| /s/ Glenn A. Oclassen   |                           | Director                              | March 28, 2003 |
| Glenn A. Oclassen       |                           |                                  |
|                    |                           |                                  |
|                    |                           |                                  |
| /s/ Robert E. Patterson |                           | Director                              | March 28, 2003 |
| Robert E. Patterson     |                           |                                  |
|                    |                           |                                  |
|                    |                           |                                  |
| /s/ Robert W. Benson    |                           | Chief Financial Officer               | March 28, 2003 |
| Robert W. Benson        | (Principal Financial  Officer) |                                  |
|                         |                                |                                       |                     |          |  |  |  |  |

 

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CERTIFICATIONS

 

I, John F. Clifford,certify that:

 

1.             I have reviewed this annual report on Form 10-K ofProCyte Corporation;

 

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

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 
| Date:  | March 28, 2003: | By:                                  | /s/ John F. Clifford |   |
|--------|----------------------|--------------------------------------|----------------------|--------|
|   |                 | John F. Clifford,  Chairman and CEO, |
|   |                 | ProCyte Corporation                  |

 

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I, Robert W. Benson,certify that:

 

1.             I have reviewed this annual report on Form 10-K ofProCyte Corporation;

 

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

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 
| Date:  | March 28, 2003 | By:                                         | /s/ Robert W. Benson |   |
|--------|---------------------|---------------------------------------------|----------------------|--------|
|   |                | Robert W. Benson, Chief  Financial Officer, |
|   |                | ProCyte Corporation                         |

 

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