**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

** **
| **For  the fiscal year ended December 31, 2003** |   | **Commission  file number 0-18044** |
|--------------------------------------------------|--------|-------------------------------------|

 

| **PROCYTE  CORPORATION**                                                                                           |
|--------------------------------------------------------------------------------------------------------------------|
| (exact name of  registrant as 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 19, 2004 was$18,235,517, based upon the average of the closing high and low prices of suchstock as reported on the NASD OTC bulletin board.  The aggregate market value of common stock held by non-affiliatesas of June 30, 2003 was $18,815,000, based upon the average of the closing highand low prices of such stock as reported on the NASD OTC bulletin board.

 

As of March 19, 2004there were issued and outstanding 15,791,190 shares of common stock, par value$.01 per share.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of the ProxyStatement for the Registrant’s 2004 Annual Meeting of Shareholders scheduled tobe held May 19, 2004 are incorporated by reference in Part III of this Form10-K.

 

 

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**PROCYTE CORPORATION**

 

**2003 Form 10-K**

 

**Table of Contents**

 
| **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       |   |
|           | Item 9A. | Controls and Procedures                                                                     |   |
|           |     |                                                                                        |   |
| **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                                             |   |
|           | Item 14. | Principal Accountant Fees and Services                                                      |   |
|           |     |                                                                                        |   |
| **PART IV**    |     |                                                                                        |
|           |     |                                                                                        |   |
|           | Item 15  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                            |   |
|           |     |                                                                                        |   |
| **SIGNATURES** |     |                                                                                        |

 

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# **PART I**

 

## **Item 1.        Business**

 

*ThisAnnual Report on Form 10-K contains forward-looking statements. Thesestatements relate to future events or future financial performance.  In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,”“expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,”“potential,” “propose” or “continue,” the negative of these terms, or otherterminology.  These statements are onlypredictions. Actual events or results may differ materially. In evaluatingthese statements, you should specifically consider various factors describedbelow in the section entitled “Additional Information About the Company’sBusiness; Risk Factors.” These factors may cause our actual results to differmaterially from any forward-looking statement.*

 

*Althoughwe believe the expectations reflected in the forward-looking statements arereasonable, we cannot guarantee future results, levels of activity, productdemand, performance or achievements. You should not place undue reliance on ourforward-looking statements, which speak only as of the date of thisreport.  We undertake no obligation topublicly update any forward-looking statements, whether as a result of newinformation, future events or otherwise.*

 

### **General**

 

ProCyte Corporation(“ProCyte” or the “Company”) is a Washington corporation organized in1986.  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 focus since1996 has been to bring unique products, primarily based upon patentedtechnologies such as GHK and AHK copper peptide technologies, to selected markets.  ProCyte currently sells its productsdirectly to the dermatology, plastic and cosmetic surgery, and spamarkets.  The Company has also expandedthe use of its novel copper peptide technologies into the mass retail marketfor skin and hair care through specifically targeted technology licensing andsupply agreements.    To augment ourtechnology portfolio we obtained the rights to market and sell current andfuture products containing the patent-pending Quadrinone® technologyfrom Cutanix Corporation in June 2003.

 

### **Products**

 

The Company’s productsaddress the growing demand for skin health and hair care products, includingproducts designed to address the effects aging has on the skin and hair and toenhance appearance.  The Company’s productsare formulated, branded for and targeted at specific markets.  The Company’s initial products in this areaaddressed the dermatology, plastic and cosmetic surgery markets for usefollowing various procedures. Anti-aging skin care products were added to expand into a comprehensiveapproach for incorporation into a patients skin care regimen.  Certain of these products incorporated ourpatented technologies, while others complement the product line such as ouradvanced sunscreen products that reduce the effects of sun damage and aging onthe skin.

 

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

 

ProCyte’s products arewell 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 studiespresented at the American Academy of Dermatology and other medical symposiahave confirmed the advantages of products containing copper peptidetechnologies versus materials such as tretinoin, vitamin C, and other popularanti-aging and skin rejuvenation products. The actions of copper peptide-containing wound care gels and creams havebeen documented in the scientific literature for their ability to stimulatecollagen 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 and has a strong desire to look good and feel good.  ProCyte has a series of products tailored tothe needs of these types of procedures, including the GraftCyte®System and the Complex Cu3®

 

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System, and has developeda series of daily use products that contain the Company’s patented copperpeptide compounds to aid in maintaining the quality of the skin and hairfollowing the procedures.

 

ProCyte’s GraftCyte®System was created to address the special tissue repair needs of patientsfollowing hair transplant surgery.  Thissystem continues to be the only complete solution addressing post procedurecare in the hair restoration market. The Company has continued to emphasize its Complex Cu3®Post Laser Lotion, Intensive Repair Creme, Cleanser and Hydrating Gel productsused to treat patients following chemical peels, microdermabrasion and lasertreatments.  The Complex Cu3®products provide a comprehensive approach to post-procedure care and allow theCompany to differentiate its line of skin care products on the basis of itsproprietary copper peptide technologies. Studies have indicated that the skin heals more quickly with the use ofcopper peptide compounds.

 

The Company launched itssuccessful Neova® Therapy line of anti-aging products in response todemand from physician customers for a comprehensive approach to medicallydirected skin care.  The Neova®Therapy line of GHK Copper Peptide Complex® products showcaseelegant moisturizers and serums complemented by supporting cleansers, toners,and masks for an integrated approach to anti-aging skin care. Each year theCompany has added new products to the product line including Neova®Microdermabrasion Scrub and Neova® Therapy Crème de la Copper addedin 2003 and the Neova® Therapy Dual Action Lotion, a combination ofGHK Copper Peptide Complex® + Retinol in March 2004.  The Neova® Therapy line is designedto offer high performance, cosmetically elegant lifestyle products that arepremium priced in the market.

 

The Company’s line ofadvanced sun protection products, marketed under the brand names of Ti-Silc®and Z-Silc®, are recommended by dermatologists and plastic surgeonsto assist in the prevention of sun exposure that can lead to a number ofproblems including age spots, hyperpigmentation, premature aging andmelanoma.  To complement the currentline of sunscreen products the Company will extend the product line with theplanned launch of Ti-Silc® Scalp DefenseTM sunscreen in April 2004.

 

In June 2003, ProCyteincreased its product portfolio by obtaining the rights to market and sellcurrent and future products containing the patent-pending Quadrinone® technologyfrom Cutanix Corporation.  Under termsof the agreement, ProCyte has the distribution rights for the medical and spamarkets within the United States, Canada and Puerto Rico for a two-year periodwith options to extend it up to five years, subject to meeting certainminimums.  The Cutanix Dramatic ReliefTMproduct line incorporates Quadrinone® technology in a variety oftherapeutic moisturizing bases and cleansers. The Quadrinone® technology has demonstrated promising resultsin pre-clinical and initial clinical studies as a safe and effectiveanti-inflammatory, and has been shown in controlled studies to providesymptomatic relief for sufferers of patients with rosacea and eczema proneskin. Rosacea alone affects more than 14 million people in the U.S.  ProCyte sells Dramatic ReliefTM productsprimarily through its direct sales force.

 

#### ***Hair Care***

 

The Company introducedits Tricomin® line of Triamino Copper ComplexTM-containing hair careproducts to physicians’ offices in the third quarter of 1998.  Tricomin® Shampoos, Conditionersand Follicle Therapy Solution are positioned to participate in the rapidlygrowing $20 billion worldwide hair care market as a program for the maintenanceof thinning 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 care for their patients.  The Company also sells Tricomin®products directly via their www.tricomin.com website.  The Company is currently working on the next generation ofproducts to increase the effectiveness of the Triamino Copper NutritionalComplexTM delivery.

 

#### ***Chronic Wound Care***

 

The Company’s chronicwound care product, marketed under the Iamin® name, has met withvarying degrees of market success.  Thewound care market is highly fragmented, with many competitors, priceconstraints, and inadequate Medicare reimbursement.  The wound care market also requires a significant investment insupporting a large sales organization. For these reasons, ProCyte has historically attempted to collaboratewith partners to market its chronic wound care product and will continue to doso.  Additionally, the Company haslooked

 

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for other methods ofdistribution and includes Iamin® as one of the products in theGraftCyte® System used by patients following hair transplantsurgery.  A number of other programshave been initiated in an effort to increase utilization of the Iamin®product; however none have resulted in meaningful revenue increases to date.

 

### **Marketsand Distribution**

 

 The markets for skin care, hair care andwound care products are global.  Thereare numerous distinct markets where we have a presence through our own directsales efforts or through agreements with others.  These include dermatology, plastic and cosmetic surgery, spa,catalog, and direct mail.  The Company sellsits products to its customers utilizing a direct sales force and also generatesrevenues from technology licensing.

 

###### *Direct Sales*

 

The Company’s primarymethod of distribution is to sell its branded products through dermatology,cosmetic and plastic surgery practices that ProCyte services with a directsales force and third party distributors, supported by telemarketing andcustomer mailings.  Domestically, thenational sales force, led by a Director of Sales, consists of two salesRegional Managers and geographically targeted Sales Representatives, all ofwhom are employees of the Company.  Toexpand the commercialization of our technologies beyond the dermatology andcosmetic surgery markets, the Company recently acquired a spa productsdistribution business that will allow for the direct participation in this fastgrowing market.  With the acquisition ofthe spa distribution business, sales representatives are being hired as spaspecialists in the largest potential markets. The Company has primarily utilized independent distributors to marketits products in certain foreign countries and a Director of International Salesis responsible for expanding this market.

 

The Company emphasizeshigh quality products and services, technical knowledge, and responsiveness tocustomer needs in its marketing activities. The Company educates itsdistributors, customers and prospective customers about ProCyte’s productsthrough a series of detailed marketing brochures, technical bulletins andpamphlets, presentations, news releases and direct mail pieces. ProCyte alsoconducts a series of one-day educational symposia around the country to provideproduct updates and marketing ideas to current and potential physiciancustomers.  These activities aresupplemented by advertising in industry publications, technical presentations,and exhibitions at over 30 local, national and international trade shows.  In 2004 the Company plans to participate ineight to twelve spa industry trade shows and expects to conduct separate professionaleducational programs at most of these shows.

 

During the fourth quarterof 2002, ProCyte contracted with a company experienced in the design,development, production and rollout of health and beauty infomercials with theexpectation of creating an infomercial for a line of anti-aging and skin careproducts to be marketed under the new brand VitalCopperTM.  Many of the initial VitalCopperTM productsincluded GHK Copper Peptide compounds. Production and filming were completed in January 2003 and the initialmarket test began in selected markets during March 2003.  Based on the results of the initial markettest a number of changes were made in the infomercial, some of which requiredre-shooting a limited number of segments modifying the theme and testingdifferent price and offer structures. Despite these changes the results of the second market test were similarto those of the first test.  Afterconsultation with several outside experts in the field the decision was made inOctober 2003 to discontinue all further work on the infomercial.  As a result of required accounting practicesfor production and development costs associated with the infomercial, all ofthe infomercial’s development costs were expensed in the first half of2003.  VitalCopperTM continues to be abrand that is being used for direct to consumer marketing and may be found atwww.vitalcopper.com and will be launched internationally in the spring of 2004in a prestige direct to consumer catalog.

 

###### *Technology Licensing*

 

Technology licensinggenerated 32 percent, 39 percent and 33 percent of the Company’s total revenuesin 2003, 2002 and 2001, respectively. We are continuously seeking partners in the prestige, direct toconsumer, specialty retail and home shopping categories.  ProCyte’s strategy is to identify skin caremarkets that would be best served by more established companies and then targeta significant partner in each market to license its technology.

 

In April 2000, ProCyteentered a long-term worldwide license agreement with Neutrogena Corporation, aJohnson & Johnson Company (“Neutrogena”), for worldwide use of theCompany’s patented copper peptide

 

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technology in productsfor 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 newproducts using ProCyte’s patented copper peptide technology.  Neutrogena began expanding the sale of theseproducts into some of its international markets during 2003 and has indicatedplans to continue such expansion. The Company receives royalty payments, basedon product sales by Neutrogena and revenue from the sale of the copper peptidecompound used in Neutrogena’s products.

 

During 2001, the Companycompleted license and supply agreements with Creative Nail Design and AmericanCrew, both of which are part of the Colomer Group based in Barcelona,Spain.  These agreements provide worldwiderights for use of the copper peptide technology in products sold to the salonand spa markets for their respective lines of business.  The Company receives royalties, based onsales of licensed product, and revenue from the sale of the copper peptidecompounds used in such products.  Theinitial products were introduced in mid-year 2002 with generally positivereviews.  Revenues to date have beendisappointing and management has continued to discuss this matter with each ofthe partners and intends to continue to monitor their progress during2004.  Revenue during the first half of2002 was substantially higher than expected as American Crew built inventoriesof copper peptide compound in preparation for the initial product launch.  They experienced unexpected competitivepressures and were forced to re-launch the products in the later part of2002.  American Crew did not place anyorders for the copper peptide in 2003 and we do not anticipate any orders for 2004.  However, American Crew did make the minimumroyalty payment required to maintain its rights to the technology for 2004.

 

### **OtherBusiness Relationships**

 

In addition to licensingothers to make and distribute products based upon copper peptide compounds,ProCyte has from time to time entered into a limited number of private labelmanufacturing agreements. Under such agreements, the Company receives revenuefrom the sale of products that it develops specifically for the customer.  This is a small part of the Company’sbusiness; however, it provides opportunities to increase the profit margin onthe sale and possibly benefit from larger production runs and efficiencies ofscale with our third party manufacturers.

 

ProCyte intends toidentify and enter into distribution or other strategic agreements with partiesthat it believes are capable of penetrating targeted markets and obtaining anyrequired international registrations for the sale of the Company’s copperpeptide-based skin care, hair care and wound care products and technologies.

 

### **ContractManufacturing Services**

 

Prior to July 2001, theCompany provided contract manufacturing services.  In July 2001, the Company sold its pharmaceutical contractmanufacturing operations to Emerald Pharmaceuticals, L.P., a Delaware limitedpartnership.  ProCyte received $250,000in cash, a $2 million senior secured promissory note and an 18.75 percentlimited partner voting interest in the partnership.  Emerald also subleased 19,770 square feet of ProCyte’s current34,532 square foot leased facility.  Inlate January 2004, the General Partner of Emerald Pharmaceutical LP, informedthe Company that Emerald had experienced significant customer imposed delays incurrent and expected contracts and that revenues from its remaining near termcontract manufacturing orders were not going to provide sufficient cash to lastbeyond the March 2004 quarter.  After anextensive review of the options available, including approaching currentcustomers to help provide funding, Emerald decided in early February 2004 tosuspend operations, terminate all employees and seek partners to operate orpurchase the facility.

 

ProCyte is workingdirectly with Emerald’s general and limited partners to ensure that ProCyte’scollateral on the note is protected, to ensure that the facility is properlymaintained and to provide any assistance needed in marketing the facility toprospective partners.  If Emerald isunsuccessful in returning to operations, ProCyte management believes that thefacility has significant value to other contract manufacturing organizationsand biotechnology companies and can be re-leased or re-sold after anappropriate marketing period.  Afterreview of the facts currently available at the time of this filing, managementhas determined that it is probable that certain assets have been impaired.  Therefore, the Company has recorded a chargeto fourth quarter 2003 earnings of $637,000. See also “Significant Events Effecting Operations in 2003” and“Liquidity and Capital Resources” under Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations and “Note 16 of Notes ToConsolidated Financial Statements.”

 

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### **AdditionalInformation about the Company’s Business; Risk Factors**

 

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

 

Although the Company’scustomer base is made up of a large number of customers, Neutrogena accountedfor approximately 31 percent of the Company’s net revenue during 2003 and ourtop 10 customers comprised approximately 46 percent of net revenues during2003.  Any decrease in or loss ofrevenues from these customers could have an adverse effect on our net revenuesand results of operations or impair our ability to increase net revenues.  The Neutrogena technology license agreementexpires in April 2010, however the royalty payments related to each territorycontinue for a period not less than a five-years from the date products werefirst sold in each territory, which may extend the royalty period beyond 2010for certain territories.  Royaltyrevenue from the Neutrogena license agreement accounted for 14 percent, 10percent and 11 percent of the Company’s total revenues in 2003, 2002 and 2001,respectively.  The patent related to theNeutrogena license agreement expires February 5, 2005, the effect of which willbe a reduction in the percentage paid as royalty during the remaining royaltyperiod as set forth in the agreement. Revenues from sale of copper peptide compound to Neutrogena pursuant toa related supply agreement, accounted for 17 percent, 20 percent and 22 percentof total revenues in 2003, 2002, and 2001, respectively. The supply agreementexpires in April 2005, with extensions for additional two-year terms by mutualconsent of the parties up to April 2010. Their can be no assurance that this agreement will be extended beyondApril 2005, or if extended, that it will be extended to April 2010.  Also, the timing of copper peptide compound shipments are driven by Neutrogena’spurchasing patterns, which can vary based upon production cycles, adjustmentsin safety stock and other factors beyond our control, causing the revenue fromcopper peptide compound sales to fluctuate from quarter to quarter.

 

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

 

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

 

###### *Dependence on andManagement of Existing and Future Corporate Alliances*

 

The successfulcommercialization of the Company’s existing and future products in the massretail, prestige, specialty retail, and home shopping categories and wound caremarkets will depend upon ProCyte’s ability to enter into and effectively managecorporate alliances.  There can be noassurance that the Company will be successful in establishing corporatealliances in the future, or that it will be successful in performing andmaintaining existing or any future corporate alliances.  Moreover, there can be no assurance that theinterests and motivations of any corporate partner, distributor or licenseewould be or remain consistent with those of the Company, or that the Companyand such partners, distributors or licensees will successfully perform thenecessary technology transfer, clinical development, regulatory compliance,manufacturing, marketing, commercialization and other obligations under theiragreements. Any of these failures could have a material adverse effect on theCompany’s business, financial condition and results of operations.

### ** **

###### *Recent Profitability; ProfitabilityMay Fluctuate in Future Periods*

 

The Company has beenmarketing products based on its proprietary copper peptide technology since1996.  In addition to sales of productsbased on its proprietary copper peptide technology, the Company’s revenues havehistorically included sales of non-proprietary products, license fees androyalties, revenue from contract manufacturing and interest income.  The contract manufacturing operation wassold in July 2001.  During 2002, theCompany reported net profits and positive cash flow from operations for thefirst time in its operating history. During 2003, the Company reported net income before tax benefit andbreak even cash flow from operations.

 

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Attaining consistent profitability is dependent upon a wide variety offactors, including successfully manufacturing and marketing of the Company’sproducts, entering into and maintaining agreements with corporate partners forcommercialization of the Company’s products, successfully licensing theCompany’s products and technology and general economic conditions, includingthose which affect demand for the services of our dermatologist, plastic andcosmetic surgery customers.  Paymentsunder corporate partnerships and licensing arrangements may be subject tofluctuations in both timing and amounts and therefore the level ofprofitability may vary significantly from quarter to quarter.

### ** **

###### *We Rely On Third PartyManufacturers For Our Products*

 

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

 

###### *Need for AdditionalCapital*

 

The Company generated abreak even cash flow from operations in 2003 and had a decrease in cashbalances as the Company used $713,000 in cash for the acquisition of the spaproducts distribution business.  TheCompany currently expects that it will generate positive cash flow fromoperations in 2004.  As of December 31,2003, the Company had cash, and cash equivalents of $3.8 million.  The Company estimates that, at its plannedrate of spending, its existing cash and cash equivalents and the interestincome thereon will be sufficient to meet its operating and capitalrequirements for at least the next two years. There can be no assurance, however, that our underlying assumed levelsof revenue and expense will prove accurate. Whether or not these assumptions prove to be accurate, the Company mayneed to raise additional capital. Furthermore, the Company may require additional funds to expand orenhance its sales and marketing activities, to accelerate product development,or acquire a product line or company. The Company may be required to seek this additional funding throughpublic or private financing, including equity financing, or throughcollaborative arrangements.  Adequatefunds for these purposes, whether obtained through financial markets or fromcollaborative or other arrangements with corporate partners or other sources,may not be available when needed or may not be available on terms favorable tothe Company.  If we issue equity securitiesto raise additional funds, dilution to existing shareholders will result.  If funding is insufficient at any time inthe future, the Company may be required to: delay, scale back or eliminate someor all of its marketing and research and development programs; or license tothird parties the rights to commercialize products or technologies that theCompany would otherwise seek to develop on its own.  Furthermore, the terms of any such license agreements or assetsales might be less favorable than if the Company were negotiating from a strongerposition.

### ** **

###### *Uncertainty of PatentPosition and Proprietary Rights*

 

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

 

ProCyte’s successdepends, in part, upon its ability to protect its products, technology andtrademarks under intellectual property laws in the United States andabroad.  The Company receives asignificant amount of its revenue from technology licensing agreements, whichare dependent upon patents, and expects to continue licensing its technologyfor certain markets.  Royalty revenuefrom the Neutrogena license agreement accounted for 14 percent, 10 percent and11 percent of the Company’s total revenues in 2003, 2002 and 2001, respectivelyand is based upon Neutrogena’s applicable sales, as set forth in the agreement,multiplied by specified royalty percentages.

 

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The patent related to the Neutrogena license agreement expires February5, 2005.  Upon expiration of thispatent, the agreement specifies that lower royalty percentages be used for theremaining term, the impact of which is a reduction in the average effectiveroyalty rate of approximately 32 percent. The actual amount of royalty income recognized in future periods isdependent upon the royalty percentages in effect during the period and theactual applicable sales reported by Neutrogena, which can vary from quarter toquarter.    The expiration of the patentwould also allow others, including Neutrogena, to manufacture thecompound.  The supply agreement expiresin April 2005, with extensions for additional two-year terms by mutual consentof the parties up to April 2010.  Therecan be no assurance that this agreement will be extended beyond April 2005, orif extended, that it will be extended to April 2010.

 

As of March 19, 2004, theCompany had 21 issued US patents expiring between 2005 and 2017, numerousissued foreign patents and patent registrations, and 10 patents applied for ofwhich 3 were published and pending action by the United States Patent &Trademark Office.  The patents relate touse of the Company’s copper peptide-based technology for a variety ofhealthcare applications, and to the composition of certain biologically active,synthesized compounds.  The Company’sstrategy has been to apply for patent protection for certain compounds andtheir discovered uses that are believed to have potential commercial value incountries that offer significant market potential.  There can be no assurance that patent applications relating tothe technology used by the Company will result in patents being issued.  Nor can there be any assurance that anypatent issued to the Company will not be subject to further proceedingslimiting the scope of the rights under the patent or that such patent willprovide a competitive advantage, will afford protection against competitorswith similar technology, or will not be successfully challenged, invalidated orcircumvented by competitors.

 

The Company’s processesand potential products may conflict with patents that have been or may begranted to competitors and others.  Asthe biotechnology, medical device and healthcare industries expand and morepatents are issued, the risk increases that the Company’s processes andpotential products may give rise to claims that they infringe the patents ofothers.  Such other persons could bringlegal actions against the Company claiming damages and seeking to enjoinclinical testing, manufacturing and marketing of the affected product or use ofthe affected process.  Litigation may benecessary to enforce patents issued to the Company, to protect trade secrets orknow-how owned by the Company or to determine the enforceability, scope andvalidity of proprietary rights of others. If the Company becomes involved in such litigation, it could result insubstantial expense to the Company and significant diversion of effort by theCompany’s technical and management personnel. In addition to any potential liability for significant damages, theCompany could be required to obtain a license to continue to manufacture ormarket the affected product or use the affected process.  Costs associated with any licensingarrangement may be substantial and could include ongoing royalties.  There can be no assurance that any licenserequired under any such patent would be made available to the Company onacceptable terms, if at all.  If suchlicenses could not be obtained on acceptable terms, the Company could beprevented from manufacturing and marketing existing or potential products.  Accordingly, an adverse determination insuch litigation could have a material adverse effect on the Company’s business,financial condition and results of operations. The Company is not aware of any conflicts at this time.

 

The Company also reliesupon non-patented proprietary technology. There can be no assurance that the Company can meaningfully protect itsrights to such non-patented technology, that any obligation to maintain the confidentialityof such proprietary technology will not be breached by employees, consultants,collaborators or others or that others will not independently develop oracquire substantially equivalent technology. To the extent that corporate partners or consultants apply Companytechnological information independently developed by them or by others toCompany projects or apply Company technology or know-how to other projects,disputes may arise as to the ownership of proprietary rights to suchinformation.  Any failure to protectnon-patented proprietary technology or any breach of obligations designed toprotect such technology or development of equivalent technology may have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

###### *Uncertainty of GovernmentRegulatory Requirements*

 

The Federal Food, Drugand Cosmetic Act, and the regulations promulgated thereunder, and other federaland state statutes govern, among other things, the testing, manufacture,safety, labeling, storage, record-keeping, advertising and promotion ofcosmetic products and medical devices. The Company’s products and product candidates may be regulated by any ofa number of divisions of the FDA and in other countries by similar health and

 

9

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regulatory authorities.  Theprocess of obtaining and maintaining regulatory approvals for the manufacturingor marketing of the Company’s existing and potential products is costly andtime-consuming and is subject to unanticipated delays.  Regulatory requirements ultimately imposedcould also adversely affect the ability of the Company to clinically test,manufacture or market products.

 

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

 

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

 

Failureto obtain regulatory approvals where appropriate for its product candidates orto attain or maintain compliance with QSR or other manufacturing requirementswould have a material adverse effect on the Company’s business, financialcondition and results of operations.

### ** **

###### *Intense Competition*

 

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

 

###### *Product Liability Claims*

 

The testing,manufacturing, marketing and sale of our products may subject the Company toproduct liability claims.  ProCytemaintains insurance coverage against product liability risks up to an aggregateannual limit of $10 million.  However,continuing insurance coverage may not be available at an acceptable cost, if atall.  The Company may not be able toobtain insurance coverage that will be adequate to satisfy any liability thatmay arise.  Regardless of merit oreventual outcome, product liability claims may result in decreased demand for aproduct, injury to its reputation, withdrawal of clinical trial volunteers andloss of revenues.  As a result,regardless of whether the Company is insured, a product liability claim orproduct recall may result in losses that could be material to ProCyte.

#### *** ***

###### *Potential Volatility ofStock Price; Bulletin Board Listing*

 

The market prices forsecurities of healthcare, pharmaceutical and biotechnology companies aresubject to volatility, and the market has from time to time experiencedsignificant fluctuations that are unrelated to the operations of theCompany.  ProCyte’s market price hasfluctuated over a wide range since the Company’s initial public offering in1989, and since March 25, 1999, the Company’s common stock has traded on theNASD OTC bulletin board.  Becausereal-time price information may not be easily available for bulletin boardsecurities, an investor is likely to find it more difficult to dispose of, orto obtain accurate quotations on the market value of, the Company’s securitiesthan if they were listed on a the Nasdaq or a national exchange.  In addition, purchases and

 

10

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sales of the Company’s securities may become subject to Rule 15g-9 ofthe Securities Exchange Act of 1934, which imposes various sales practicerequirements on broker-dealers, or to the “penny stock” rules, either of whichwould likely reduce the level of trading activity in the secondary market forthe Company’s securities and make selling the securities more difficult for aninvestor.

 

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

 

### **Employees**

 

At December 31, 2003, theCompany had 43 full-time employees, of whom one holds a Ph.D. degree.  At year-end 29 were engaged in marketing andsales, one in product development, five in operations and eight in finance andadministration.  The Company plans toemploye additional sales representatives specializing in spa sales, andotherwise does not expect to significantly increase its staff in 2004.  The Company believes that it has goodrelations with its employees.

 

### **Where You Can Find More Information**

 

ProCyte files annual,quarterly and current reports, as well as registration and proxy statements andother information, with the Securities and Exchange Commission.  These documents may be read and copied atthe SEC’s public reference rooms in Washington, DC, New York, NY and Chicago,IL.  Please call the SEC at1-800-SEC-0330 for further information on the public reference rooms. Our SECfilings also are available to the public at the Internet website maintained bythe SEC at *www.sec.gov*.  The Company’s Form 10-Ks and Form 10-Qs andamendments thereto filed with the SEC after January 1, 2002, also areavailable on our website, *www.procyte.com*.  The information contained in our web site does not constitutepart of, nor is it incorporated by reference into, this Annual Report.  We will provide paper copies of our Form10-Ks, Form 10-Qs, Form 8-Ks and other SEC filings free of charge upon request.

 

## **Item 2.        Properties**

 

As of December 31, 2003,the Company leased approximately 34,532 square feet in Redmond, Washington inwhich ProCyte occupied 14,762 square feet of warehouse and office space andsubleased 19,770 square feet to Emerald Pharmaceutical L.P. at its facility inRedmond, Washington under a ten-year lease, which expires on June 30,2007.  Effective January 1, 2004, aspart of the purchase of the spa products distribution business, the Companyassumed the lease for a 2,500 square foot warehouse located in Keyport, NewJersey that expires on February 28, 2006. The Company expects to fulfill spa orders from this location.  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 Vote ofSecurity Holders**

 

Not applicable.

 

# **PART II**

 

## **Item 5.        Market for the Company’s Common Stockand Related Shareholder Matters**

 

The Company’s commonstock is traded on the NASD over the counter bulletin board under the symbol“PRCY.”  The following table sets forththe high and low bid prices for the Company’s common stock for the

 

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periods indicated.  Such pricesreflect inter-dealer prices, without retail mark-up, markdown or commission,and may not necessarily represent actual transactions.

 

|             |   | **High** |   | **Low** |   |
|------------------|--------|----------|--------|---------|--------|
| **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**         |   |     |   |    |   |
| First quarter    |   | $        | 1.39   |    | $      | 1.05 |   |
| Second quarter   |   | 1.40     |   | 0.95    |   |
| Third quarter    |   | 1.60     |   | 1.00    |   |
| Fourth quarter   |   | 1.25     |   | 0.98    |   |
|             |   |     |   |    |   |
| **2004**         |   |     |   |    |   |
| Through March 19 |   | $        | 1.36   |    | $      | 1.02 |   |

 

At the close of business on March 19, 2004, there were385 holders of record of the Company’s common stock.  This does not include the number of persons, whose stock is innominee or “street name” accounts through brokers.  ProCyte has not paid any cash dividends on its common stock anddoes not intend to pay cash dividends in the foreseeable future.

 

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

 

Thefollowing tables show selected financial data. It is important to read this selected financial data along with the“Consolidated Financial Statements and Supplementary Data” and the“Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

 
|                                                          |   | **Selected  Quarterly Financial Data (unaudited)  Quarter Ended** |   |
|---------------------------------------------------------------|--------|-------------------------------------------------------------------|--------|
|                                                          |   | **(in  thousands, except per share amounts)**                     |   |
| **Year ended December 31**                                    |   | **March 31**                                                      |   | **June 30** |   | **September  30** |   | **December  31** |   |
| **2003**                                                      |   |                                                              |   |   |   |   |   |   |   |
| Revenue                                                       |   | $                                                                 | 3,346  |   | $ | 2,632 |   | $ | 2,723 |   | $ | 2,837 |   |
| Gross profit                                                  |   | 2,163                                                             |   | 2,013 |   | 2,048 |   | 2,113 |   |
| Operating  expenses                                           |   | 2,366                                                             |   | 1,781 |   | 1,821 |   | 2,304 |   |
| Income (loss)  from operations                                |   | (203                                                              | )      | 232 |   | 227 |   | (191 | ) |
| Interest and  other income                                    |   | 88                                                                |   | 37 |   | 34 |   | 35 |   |
| Income tax  (expense) benefit                                 |   | (18                                                               | )      | — |   | — |   | 7,100 |   |
| Net income  (loss)                                            |   | $                                                                 | (133   | ) | $ | 269 |   | $ | 261 |   | $ | 6,944 |   |
| Net earnings  (loss) per common share                         |   |                                                              |   |   |   |   |   |   |   |
| Basic                                                         |   | $                                                                 | (0.01  | ) | $ | 0.02 |   | $ | 0.02 |   | $ | 0.44 |   |
| Diluted(a)                                                    |   | $                                                                 | (0.01  | ) | $ | 0.02 |   | $ | 0.02 |   | $ | 0.43 |   |
| Weighted average  common shares used in per share computation |   |                                                              |   |   |   |   |   |   |   |
| Basic                                                         |   | 15,746                                                            |   | 15,765 |   | 15,774 |   | 15,783 |   |
| Diluted                                                       |   | 15,746                                                            |   | 16,040 |   | 15,974 |   | 15,975 |   |
|                                                          |   |                                                              |   |   |   |   |   |   |   |
| **2002**                                                      |   |                                                              |   |   |   |   |   |   |   |
| Revenue                                                       |   | $                                                                 | 3,043  |   | $ | 3,263 |   | $ | 3,126 |   | $ | 3,305 |   |
| Gross profit                                                  |   | 2,116                                                             |   | 2,167 |   | 1,841 |   | 1,907 |   |
| Operating  expenses                                           |   | 1,675                                                             |   | 1,678 |   | 1,568 |   | 1,640 |   |
| Income from  operations                                       |   | 441                                                               |   | 489 |   | 273 |   | 267 |   |
| Interest and  other income                                    |   | 47                                                                |   | 46 |   | 49 |   | 57 |   |
| Provision for  income taxes                                   |   | —                                                            |   | — |   | — |   | — |   |
| Net income                                                    |   | $                                                                 | 488    |   | $ | 535 |   | $ | 322 |   | $ | 324 |   |
| Net earnings per  share                                       |   |                                                              |   |   |   |   |   |   |   |
| Basic                                                         |   | $                                                                 | 0.03   |   | $ | 0.03 |   | $ | 0.02 |   | $ | 0.02 |   |
| Diluted(a)                                                    |   | $                                                                 | 0.03   |   | $ | 0.03 |   | $ | 0.02 |   | $ | 0.02 |   |
| Shares used in  per share computation                         |   |                                                              |   |   |   |   |   |   |   |
| Basic                                                         |   | 15,682                                                            |   | 15,705 |   | 15,722 |   | 15,732 |   |
| Diluted                                                       |   | 16,001                                                            |   | 16,061 |   | 16,031 |   | 16,019 |   |

 

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(a)           Netincome per diluted share of common stock for the twelve months is determined bycomputing a year-to-date weighted average of the number of incremental sharesincluded in each quarterly diluted net income per share calculation. As aresult, the sum of net income per share for the four quarterly periods may notequal the net income per share for the years ended December 31, 2003 and2002.

 

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|                                  |   | **Selected  Annual Financial Data  Year Ended December 31,** |   |
|---------------------------------------|--------|--------------------------------------------------------------|--------|
|                                  |   | **(in  thousands, except per share amounts)**                |   |
|                                  |   | **2003**                                                     |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Revenue                               |   | $                                                            | 11,538 |   | $ | 12,737 |   | $ | 9,712 |   | $ | 6,615 |   | $ | 4,695 |   |
| Gross profit                          |   | 8,337                                                        |   | 8,031 |   | 6,128 |   | 5,116 |   | 3,319 |   |
| Operating expenses                    |   | 8,272                                                        |   | 6,561 |   | 7,188 |   | 7,481 |   | 8,883 |   |
| Income (loss) from operations         |   | 65                                                           |   | 1,470 |   | (1,060 | ) | (2,365 | ) | (5,564 | ) |
| Interest and other income             |   | 194                                                          |   | 199 |   | 153 |   | 222 |   | 249 |   |
| Income tax benefit                    |   | 7,082                                                        |   | — |   | — |   | — |   | — |   |
| Net income (loss)                     |   | $                                                            | 7,341  |   | $ | 1,669 |   | $ | (907 | ) | $ | (2,143 | ) | $ | (5,315 | ) |
| Net earnings  (loss) per share        |   |                                                         |   |   |   |   |   |   |   |   |   |
| Basic                                 |   | $                                                            | 0.47   |   | $ | 0.11 |   | $ | (0.06 | ) | $ | (0.14 | ) | $ | (0.35 | ) |
| Diluted                               |   | $                                                            | 0.46   |   | $ | 0.10 |   | $ | (0.06 | ) | $ | (0.14 | ) | $ | (0.35 | ) |
| Shares used in  per share computation |   |                                                         |   |   |   |   |   |   |   |   |   |
| Basic                                 |   | 15,767                                                       |   | 15,710 |   | 15,610 |   | 15,481 |   | 14,999 |   |
| Diluted                               |   | 15,997                                                       |   | 16,179 |   | 15,610 |   | 15,481 |   | 14,999 |   |
|                                  |   |                                                         |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents             |   | $                                                            | 3,796  |   | $ | 4,556 |   | $ | 3,003 |   | $ | 2,773 |   | $ | 3,883 |   |
| Current assets                        |   | 8,363                                                        |   | 7,931 |   | 6,506 |   | 6,451 |   | 5,454 |   |
| Total assets                          |   | 20,003                                                       |   | 14,089 |   | 12,811 |   | 12,185 |   | 13,447 |   |
| Current liabilities                   |   | 692                                                          |   | 963 |   | 1,147 |   | 1,179 |   | 416 |   |
| Total liabilities                     |   | 785                                                          |   | 2,271 |   | 2,743 |   | 1,324 |   | 558 |   |
| Stockholders’ equity             |   | $                                                            | 19,218 |   | $ | 11,818 |   | $ | 10,068 |   | $ | 10,861 |   | $ | 12,889 |   |

 

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## **Item 7.        Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

#### ***General Overview***

 

ProCyte develops,manufactures and markets products for skin health, hair care and wound care,many of which incorporate its clinically tested and patented copper peptidetechnologies.  Our primary products aretargeted at reducing the impact that age and exposure have on the appearance ofskin and hair.  ProCyte generatesrevenue from two primary sources: the sale of products it makes or acquiresfrom others and amounts earned from licensing agreements.  Our products are sold primarily via our USsales force directly to the dermatology, plastic and cosmetic surgery and spamarkets.  License agreements with largepersonal care product companies provide revenue from the supply of our patentedcompounds and royalties based upon the sales revenue generated by theselicensees.  The Company also receivedrevenue in the past from its contract manufacturing operation, which was soldto Emerald Pharmaceuticals L.P. in July 2001.

 

As demonstrated by growthin product revenues in 2001 and 2002, ProCyte products are sold into marketsthat are normally recession resistant; however, the combination of thedeepening post 9-11 and Enron recession, concern over SARs, the initiation ofthe Iraq war, and unusually severe winter weather in first half of 2003 causeda slowdown in patient traffic for dermatologists, plastic surgeons and hairtransplant clinics.  As theseprofessional practices are the principle customer for our products, ProCyteexperienced a decrease in product revenue for the first six months of 2003 ascompared to 2002.  However, thesecustomers reported increasing traffic in the latter half of 2003 and by the endof 2003, we reported increases in product sales that were enough to offset thedecreases of the first half and bring product sales for 2003 back even with2002.

 

Improvement in productsales can come from new product introductions, a net increase in the customerbase, expansion of the sales force and expansion into new domestic andinternational markets.  Between July2003 and March 2004, we introduced 3 new products and will introduce one morein April 2004.  We have additionalproducts undergoing testing and expect to introduce approximately 2 to 3 morenew skin care products later this year. To expand our markets, we acquired a spa products distribution businesson December 30, 2003 that included two existing brands and a customerbase.  We believe this acquisition willprovide additional revenue opportunities for 2004 and beyond.  We also realigned some of our salesterritories and will expand the number of territories only when the revenuepotential supports such investment.

 

Our growth strategy alsoincludes the acquisition, licensing, and/or distribution of products that webelieve have a demonstrated market.  Wehave acquired, and intend to continue seeking to acquire, rights to manufactureand/or market products that studies have shown to be effective, but which arenot actively promoted and where the surrounding competitive environment appearsconducive to our entry.  Additionally,our growth strategy includes continuing the introduction of new productsdeveloped through our efforts.

 

The other significantrevenue source is from licensing agreements, of which ProCyte currently hasthree, provide the licensees with exclusive rights to specified markets for theterm of the agreements.  The agreementswith American Crew and Creative Nail Design were not significant contributorsin 2003 and the company does not expect significant improvement in 2004.  The third licensee, Neutrogena, hascontinued to add new products and expand them into new territories, as definedin the license agreement, increasing the related royalties.  This license agreement expires in 2010,however the royalty streams related to each territory continue for not lessthan a five-year period from the date product was first sold therein, which mayextend the royalty period beyond 2010 for certain territories.  Royalty revenue from the Neutrogena licenseagreement accounted for 14 percent, 10 percent and 11 percent of the Company’stotal revenues in 2003, 2002 and 2001, respectively.  The patent related to the Neutrogena license agreement expiresFebruary 5, 2005, the effect of which will be a reduction in the percentagepaid as royalty during the remaining royalty period as set forth in theagreement.  Revenues from sale of copperpeptide compound to Neutrogena pursuant to a related supply agreement,accounted for 17 percent, 20 percent and 22 percent of total revenues in 2003,2002, and 2001, respectively. The supply agreement expires in April 2005, withextensions for additional two-year terms by mutual consent of the parties up toApril 2010.  The can be no assurancethat this agreement will be extended beyond April 2005, or if extended, that itwill be extended to April 2010.

 

14

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#### ***Significant eventseffecting operations in 2003***

 

During the fourth quarterof 2002, ProCyte initiated work on an infomercial, a form of direct-to-consumerdistribution, with a new brand of anti-aging and skin care products calledVitalCopperTM.  Many of the initialVitalCopperTM products include GHK Copper Peptide compounds. First productionand filming were completed in January 2003, and the initial market test beganin selected markets during March 2003. Continuation of the market test was placed on hold as public and mediaattention focused on the Iraq conflict. During this hold period, based upon expert feedback, a number of changeswere made to content, style and approach and a new multi-week market test programwas initiated at the end of July 2003. The new market test results indicated that additional modification andtesting cycles would be required.  Whilethis test, modify and retest methodology in not unusual for infomercials,management believes that additional investment would not produce as much returnas other opportunities available to the Company.  Therefore all activities related to the infomercial weresuspended in October 2003.  ProCyte willcontinue to market the VitalCopperTM brand products through the VitalCopperTM website, selected print advertising catalog sales and specialty retail.  As a result of required accounting practicesfor an infomercial, development and production costs totaling $770,000 wereexpensed and included under marketing and selling for the full 2003 year.

 

On December 30, 2003ProCyte completed the purchase of the principal assets of Annette Hanson, Inc.,for approximately $772,000 in cash and forgiveness of receivable.  Ms. Hanson’s business, focused on the spaand salon markets, has sold products containing ProCyte’s technology under theSimple Solutions® brand since April 2002.  Included in the purchase were receivables, inventory, selectedequipment, brand names, trademarks, the customer list and the assumption of afacility lease.  ProCyte believes thatthe acquisition will enable the Company to leverage its copper peptidetechnology and sales and marketing expertise into the spa products market.  Based on the historical annualized revenuesof Ms. Hanson’s spa products distribution business before the acquisition andassuming that expected product synergies occur as a result of the acquisition,ProCyte believes the acquisition will be accretive by the second half of 2004.

 

Untilthe fourth quarter of 2003, ProCyte provided a full valuation allowanceoffsetting its deferred tax assets for timing differences and net operating taxloss carry forwards.  Based upon areview of historical operating performance and ProCyte’s expectation that itcan generate sustainable consolidated net income for the foreseeable future,the Company now believes it is more likely than not that a portion of thesedeferred tax assets will be utilized. ProCyte has therefore recognized an income tax benefit related to areduction in its deferred tax asset valuation allowance, resulting in anon-cash increase in net income of approximately $7.1 million.  As a result of this reduction of thevaluation allowance, ProCyte will begin to reflect income tax expense forfinancial reporting purposes in future periods.  As of December 31, 2003, a partial valuation reserve for taxbenefits of net operating losses and research and development tax credit carryforwards totalling $19.1 million remains in place due to the uncertainty ofrealizing the full tax benefits of the related assets before the net operatingloss and tax benefits expire.

 

In February 2004, theGeneral Partner of Emerald Pharmaceutical LP (“Emerald”) informed the Companythat Emerald had suspended operations and terminated all employees in an effortto conserve remaining capital while it sought other entities to operate orpurchase the facility.  After review ofthe facts currently available, management has determined that it is probablethat certain assets have been impaired. Therefore, the Company recorded a charge to 2003 earnings of$637,000.  The charge is based uponestimates, which could vary significantly, either favorably or unfavorably,from the amounts that the Company may ultimately realize for these assets ifthe actual events differ significantly from our estimates and expectations.  See “Note 16 of Notes to ConsolidatedFinancial Statements” for additional information.

 

15

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#### ***Results ofOperations***

 

#### ***Years Ended December 31, 2003 and 2002***

 

###### *Revenue*

 
|                     |   | **Year Ended  December 31,** |   |     |   |
|--------------------------|--------|------------------------------|--------|----------|--------|
|                     |   | **2003**                     |   | **2002** |   | **% Change** |   |
| Products                 |   | $                            | 7,870  |     | $      | 7,825 |   | 1 | % |
| Copper peptide  compound |   | 1,993                        |   | 3,531    |   | (44 | )% |
| Royalties                |   | 1,675                        |   | 1,381    |   | 21 | % |
|                     |   | $                            | 11,538 |     | $      | 12,737 |   | (9 | )% |

 

*Product*revenues for the first half of 2003 were lower than the first half of 2002 dueto the slowdown in patient traffic experienced by our dermatology, plastic andcosmetic surgery customers at the beginning of the year.  Product revenues began recovering during thethird quarter, in part reflecting actions taken late in the second quarterincluding changing our hiring profile, increasing sales training and expandingcustomer education programs. Product revenues continued to improve in thefourth quarter bringing total product revenue for 2003 back even with 2002.

 

*Copperpeptide compound* shipments are driven by the purchasingpatterns of our largest licensing partner, Neutrogena, which can vary basedupon production cycles, adjustments in safety stock and other factors beyondour control.  Neutrogena ordered morecopper peptide compound in the fourth quarter of 2002 and first quarter of 2003than in any other quarter during the agreement.  Except for the first quarter, Neutrogena’s shipments were lowerin 2003 bringing its total for the 2003 year below that of 2002.  Adding to this reduction was a continuinglack of orders from the other licensing partners, which had collectivelypurchased $1.0 million of compound during 2002.  The 2002 shipments were related to these other licensingpartners’ inventory build up for their initial market launches.  The Company has been advised that follow-onsales to consumers were much slower than these other licensing partnersanticipated, thereby eliminating their need for material in 2003, and reducingthe related royalty revenue earned by the Company as noted below.  The Company continues to explorealternatives with these licensees however we expect these agreements will notbe renewed when they expire at the end of this year.

 

*Royaltyrevenue*is based upon sales generated by our licensees.  Royalty revenues may fluctuate from quarterto quarter, due to the licensees’ timing of new market launches, specialpromotions and other factors beyond the Company’s control.  Royalties received from Neutrogena in 2003grew 25 percent over the 2002 year, which was partially offset by the decreasein royalties received from the other licensees.  The Neutrogena increase is primarily attributable to growth inNeutrogena’s sales of the licensed technology in international markets.  Upon the expiration of the underlying patentin February 2005, the agreement specifies that lower royalty percentages beused for the remaining term, the impact of which is a reduction in the averageeffective royalty rate of approximately 32 percent. The actual amount ofroyalty income recognized in future periods is dependent upon the royaltypercentages in effect during the period and the actual applicable salesreported by Neutrogena, which can vary from quarter to quarter.  Therefore the historical growth in royaltyrevenue may not be an indication of future results.

 

###### *Gross Profit*

 

While revenues for 2003were less than 2002, gross profit for 2003 increased by $300,000, or 4 percent,to $8.3 million.  The related grossmargin for the 2003 year was 72 percent as compared to 63 percent in 2002.  The increase in gross profit dollars wasprimarily attributable to lower cost of manufactured products and compounds in2003.  The increase in gross margin isdue both to the improved margins on lowered costs and the change in revenue mixin favor of having greater product sales and royalty income versus copperpeptide compound sales.  Total grossmargin is sensitive to the revenue mix of packaged products, copper peptidecompound and royalty revenue and will vary from period to period as a result.

 

16

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###### *Operating Expenses*

 
|                        |   | **Year Ended  December 31,** |   |     |   |
|-----------------------------|--------|------------------------------|--------|----------|--------|
|                        |   | **2003**                     |   | **2002** |   | **% Change** |   |
| Research and  Development   |   | $                            | 191    |     | $      | 126 |   | 52 | % |
| Marketing and  selling      |   | 4,139                        |   | 3,090    |   | 34 | % |
| General and  administrative |   | 3,305                        |   | 3,345    |   | (1 | )% |
| Loss on asset  impairment   |   | 637                          |   | —   |   | — |   |
| Total operating  expenses   |   | $                            | 8,272  |     | $      | 6,561 |   | 28 | % |

 

*Researchand Development* is primarily development work on newformulations and studies related to new product introductions.  The slight increase in development expensesrelates to additional efforts in developing new product combinations and thepatent filings related to them.  Theseefforts resulted in two new product introductions in 2003 and contributed totwo more new products being introduced within the first four months of 2004.

 

*Marketingand selling* expenses for 2003 increased due to $770,000 incosts related to the development of an infomercial, increases in salary andbenefit costs due to higher headcount and increased compensation.  Additionally, advertising and sales supportexpenses increased in the second half of 2003 as more resources were investedin these areas.  These increases werepartially offset by lower sales incentive and compensation expense in the firsthalf of 2003.

 

*Generaland administrative* expenses were materially the same in 2003and 2002.  This resulted from areduction in legal, consulting and recruiting services during the 2003 yearand, as a result of lower revenues and net income performance, significantlylower incentive compensation expense. This decline in expenses was generally offset by an increase in salaryand benefits related to the addition of the Chief Financial Officer in October2002, outside professional services and increased audit fees incurred for compliancewith new corporate governance and reporting standards.

 

*Loss onasset impairment* relates to Emerald Pharmaceutical LP(“Emerald”), which purchased our manufacturing facility in 2001.  In February 2004, the General Partner ofEmerald informed us that Emerald had suspended operations and terminated allemployees in an effort to conserve remaining capital while it sought otherentities to operate or purchase the facility. As a result of Emerald’s action and a review of the facts currentlyavailable, it is probable that ProCyte will not be able to collect all amountscontractually due under its $2.0 million secured note receivable from Emeraldand that certain assets have been impaired resulting in a charge to fourthquarter and full year earnings of $637,000. Emerald has not made a rental payment since January 2004 and has notpaid interest due on the note receivable since December 2003 that are due underits agreements and it is uncertain as to when, if ever, Emerald will be able toresume such payments.  Therefore, untilsuch time as Emerald can resume making payments or the matter is otherwiseresolved through sale or replacement sub lessee, 2004 expenses are expected toincrease by $50,000 per month beginning in February 2004.  In addition, if Emerald should liquidate,ProCyte will incur additional operating expenses for electrical, maintenanceand security costs associated with the portion of the facility it subleases toEmerald, which management currently estimates could be approximately $5,000 permonth.  ProCyte may also be required totake back the facility to protect the Company’s collateral and otherinterests.  If this action becomesnecessary, ProCyte may, based on information currently available, incuradditional expenses between $35,000 and $115,000.  See “Note 16 of Notes to Consolidated Financial Statements” foradditional information.

 

###### *Interest and other income*

 

Interest and other incomeearned during 2003 decreased 2 percent to $194,000 primarily due to decliningshort-term interest rates, which was partially offset by a one-time terminationsettlement of $50,000 received from Merck KGaA.

 

###### *Income Taxes.*

 

Until the fourth quarterof 2003, ProCyte provided a full valuation allowance against its deferred taxassets. Based upon a recent review of historical operating performance andProCyte’s expectation that it can generate

 

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sustainable consolidated net income for the foreseeable future, theCompany now believes it is more likely than not that a portion of thesedeferred tax assets will be utilized. ProCyte has recognized an income tax benefit related to a reversal of aportion of its valuation allowance to properly reflect its deferred tax assetrelated to the estimated future benefit of net operating tax loss carryforwards more likely than not to be utilized, resulting in a non-cash increasein net income of approximately $7.1 million. The deferred tax assets primarilyrepresent the estimated future income tax benefit of net operating losses(NOL’s) that the Company has incurred since inception.  Accordingly, ProCyte will reflect income taxexpense for financial reporting purposes in future reporting periods.

 

###### *Net Income*

 

For the year endedDecember 31, 2003, ProCyte reported net income of $7.3 million as compared tonet income of $1.7 million for 2002. This increase was primarily due to the $7.1 million income tax benefitrecognized upon partial reversal of the deferred tax asset valuation allowance,which was partially offset by the $770,000 infomercial related expenses and$637,000 Emerald related charge recognized in 2003.

 

#### ***Years EndedDecember 31, 2002 and 2001***

 

###### *Revenues*

 

|                     |   | **Year Ended  December 31,** |   |     |   |
|--------------------------|--------|------------------------------|--------|----------|--------|
|                     |   | **2002**                     |   | **2001** |   | **% Change** |   |
| Products                 |   | $                            | 7,825  |     | $      | 6,289 |   | 24 | % |
| Copper peptide  compound |   | 3,531                        |   | 2,112    |   | 67 | % |
| Royalties                |   | 1,381                        |   | 1,115    |   | 24 | % |
|                     |   | 12,737                       |   | 9,516    |   | 34 | % |
| Contract  Manufacturing  |   | —                       |   | 196      |   | — |   |
|                     |   | $                            | 12,737 |     | $      | 9,712 |   | 31 | % |

 

*Productrevenue* increased in 2002 at a rate consistent with that of2001. The 2002 increase was generally due to additional penetration by the USsales force into the physician customer base, the addition of a distributor forhair products and the addition of an international distributor. These resultsreflect the continued market acceptance and success of the Company’s Neova®,GraftCyte®, Tricomin® and sun protection product lines.

 

*Copperpeptide compound* sales to ProCyte’s licensing partnersincreased primarily due to increased purchases by Neutrogena, which expandedits products containing ProCyte’s patented copper peptide compound intointernational markets and American Crew’s inventory build in the first half of2002 in preparation for its initial product launch.

 

*Royaltyrevenue* increased principally due to Neutrogena, whichexpanded its products containing ProCyte’s patented copper peptide compoundinto international markets during 2002. Royalty revenues will fluctuate from quarter to quarter, due to thelicensees’ timing of new market launches, special promotions and other factorsbeyond the Company’s control.

 

*Contractmanufacturing* revenue represents contract fees earned in 2001prior to the sale of the Company’s contract manufacturing operations to EmeraldPharmaceutical L.P. in July 2001.

 

###### *Gross Profit*

 

For the 2002 year, grossprofit increased $1.9 million to $8.0 million, a 31 percent increase over 2001while the corresponding gross margins were 63percent for both 2002 and2001.  While gross margins for the yearsended 2002 and 2001 were the same lower cost of manufactured products andcompounds, which improved gross margins in 2002, was offset by a change in themix of revenues resulting from the significant increase in copper peptidecompound sales in 2002.  Total grossmargin is sensitive to the revenue mix of packaged products, copper peptidecompound and royalty revenue and will vary from period to period as a result.

 

18

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###### *Operating Expenses*

 
|                                               |   | **Year Ended  December 31,** |   |     |   |
|----------------------------------------------------|--------|------------------------------|--------|----------|--------|
|                                               |   | **2002**                     |   | **2001** |   | **% Change** |   |
| Research and  Development                          |   | $                            | 126    |     | $      | 745 |   | (83 | )% |
| Marketing and  selling                             |   | 3,090                        |   | 3,133    |   | (1 | )% |
| General and  administrative                        |   | 3,345                        |   | 3,116    |   | 7 | % |
| Loss on sale of  contract manufacturing operations |   | —                       |   | 194      |   | — |   |
| Total operating  expenses                          |   | $                            | 6,561  |     | $      | 7,188 |   | (9 | )% |

 

*Researchand development*expenses decreased in 2002 primarily due to adecrease in fixed overhead expenses and personnel related to the contractmanufacturing operations that was sold 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.

 

*Marketingand selling* expenses for 2002 were relatively unchanged fromthe comparable 2001 period.  Marketingand selling expenses remain consistent with the prior years, as the Companycontinued to leverage more revenue out of its existing expenditure level.

 

*Generaland administrative* expenses decreased in the 2002 year ascertain expenses declined as a result of the sale of the contract manufacturingoperations during 2001 and write downs of inventory and reserves for doubtfulaccounts related to contract terminations in the amount of $255,000 taken in2001.  These savings were offset byincreased legal and professional fees related to increased efforts to file newpatents and other corporate activities. The Company also experienced higher compensation costs in 2002 relatedto hiring new talent into the Company, and in paying higher incentive bonusesto the management team for meeting objectives and helping the Company achieveits first profitable year.

 

*Loss onsale of contract manufacturing operations* was recognized onthe disposition of the contract manufacturing operation completed in July 2001.

 

###### *Interest and Other income*

 

Interest and other incomefor 2002 increased 30 percent to $199,000 primarily due to the interestpayments collected on the Company’s $2,000,000 promissory note from EmeraldPharmaceutical L.P.  For the year ended December 31, 2002, ProCytereceived interest payments of $94,000 from Emerald Pharmaceutical L.P.,representing a full year of interest as compared to $45,000 for a partial yearin 2001.  This was partially offset by decreasing market yields realizedon the Company’s cash reserves in 2002 as compared to 2001 as interest ratesgenerally declined.

 

###### *Net Income (loss)*

 

The Company reported netincome of $1.7 million for the 2002 year as compared to a net loss of $907,000for the 2001 year.  For the first timein its history, the Company reported net earnings per share for four consecutivequarters, mainly due to continued revenue growth in all four quarters andgeneral operating expense reductions. Prior to 2002, the Company had incurred operating losses each year sinceits inception due to the costs of supporting research, development, clinicalstudies and establishing a sales force for its proprietary technology.  The Company sold its contract manufacturingoperations in July 2001, which has helped it reduce related annual operatingexpenses by approximately $1 million.

 

#### ***Liquidity andCapital Resources***

 

The Company has reliedprimarily on cash flow from operations, interest income and equity financing tofund its operations and capital expenditures. At December 31, 2003, the Company had approximately $3.8 million in cashand cash equivalents, compared to $4.6 million at December 31, 2002.  The net change in cash and cash equivalentsduring 2003 reflects a net use of cash of $760,000. The significant componentsof this net use of cash

 

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are disbursements related to the acquisition of certain assets ofAnnette Hanson, Inc, expenditures for an infomercial, an increase in copperpeptide compound inventory, the payment of 2002 management bonuses in 2003 andcapital expenditures primarily related to updating the Company’s computer andnetwork systems.  Positive cashgenerated by operations during the year largely offset these outflows.  We may see fluctuations in cash flows infuture periods as they depend in large part on the timing of deposits receivedfrom our strategic partners and their initiation of new product introductions.

 

ProCyte believes thatthis acquisition will enable the Company to leverage its copper peptidetechnologies and sales and marketing expertise into the spa products market.  Based on the historical annualized revenuesof Ms. Hanson’s spa products distribution business before the acquisition andassuming that expected product synergies occur as a result of the acquisition,ProCyte believes any additional cash needed to ramp the acquired businessoperations will not be material and that the spa products distributionoperations could generate positive cash flow before the end of 2004.

 

As of February 2004,Emerald Pharmaceuticals, L.P. suspended operations and ProCyte has recorded animpairment related to its $2.0 million note receivable due to the uncertaintythat the full amount will be collected. Emerald also leases its facility from ProCyte under an operatingsublease.  ProCyte is not receiving theinterest and rental payments due under its agreements with Emerald and it isuncertain as to when, if ever, Emerald will be able to resume suchpayments.  Therefore, cash flow fromoperations will be reduced by $35,000 per month until such time as Emerald canresume making payments or the matter is otherwise resolved through sale or areplacement sub lessee.  In addition, ifEmerald should liquidate, ProCyte will incur additional operating expenses forelectrical, maintenance and security costs associated with the portion of thefacility it subleases to Emerald, which management currently estimates to be$5,000 per month.  In addition, ProCytemay be required to take back the facility to protect the Company’s collateraland other interests.  If this actionbecomes necessary, ProCyte may, based on information currently available, incuradditional expenses between $35,000 and $115,000.

 

The Company believes thatits existing cash and cash equivalents and interest thereon, will be sufficientto meet its working capital requirements for at least the next two years.  However, there can be no assurance that theunderlying assumed levels of revenue and expense will prove accurate.  The Company’s actual cash requirements willdepend upon numerous factors, including, the levels of resources that theCompany devotes to taking advantage of strategic acquisitions and/orestablishing and maintaining marketing, sales and distribution capabilities,the emergence of competitive products and other adverse market developments,the timing and amount of revenues and expense reimbursements resulting fromrelationships with third parties, the Company’s degree of success incommercializing new products and the cost of preparing, filing, prosecuting,maintaining and enforcing patent claims and intellectual property rights, andactions by regulatory authorities.  TheCompany will depend on product revenues, royalties and license fees, interestincome, equity financing, and funding from corporate partnerships to meet itsfuture capital needs.  See “AdditionalInformation About the Company’s Business; Risk Factors.”

 

#### ***ContractualObligations***

 

The following tableprovides a summary of our contractual obligations, excluding income fromsubleases, as of December 31, 2003 (in thousands):

 

|                        |   | **Payments  due by period** |   |
|-----------------------------|--------|-----------------------------|--------|
|                        |   | **Total**                   |   | **Less  than  1 year** |   | **1 – 3  years** |   | **4 – 5  years** |   | **More than  5 years** |   |
| Operating lease obligations |   | $                           | 1,539  |   | $ | 437 |   | $ | 1,102 |   | $ | — |   | $ | — |   |
| Purchase obligations        |   | 1,500                       |   | 1,200 |   | 300 |   | — |   | — |   |
| Total                       |   | $                           | 3,039  |   | $ | 1,637 |   | $ | 1,402 |   | $ | — |   | $ | — |   |

 

#### ***Critical AccountingPolicies 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

 

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been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these consolidated financial statements requires usto make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure ofcontingencies.  On an ongoing basis, weevaluate the estimates used, including those related to impairment and usefullives of intangible assets, allowances for accounts receivable and notesreceivable, and for excess and obsolete for inventory.  We base our estimates on historicalexperience, current conditions and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources, as well asidentifying and assessing our accounting treatment with respect to commitmentsand contingencies.  Actual results maydiffer from these estimates under different assumptions or conditions.  We believe the following critical accountingpolicies involve the more significant judgments and estimates used in thepreparation of the consolidated financial statements.

 

Under the guidance ofSFAS 109, “Accounting for Income Taxes,” we review the Company’s net deferredtax assets to determine which amounts, if any, are “more likely than not” to beutilized in future periods.  Our analysisof whether these tax assets will be utilized involved a substantial amount ofjudgment related to the Company’s ability to generate taxable net income infuture periods, including revenue trends, product mix, and estimated margins,the amount and timing of which impacts the amount of net operating tax lossesthat could be utilized prior to their expiration.  See “Note 7 of Notes to Consolidated Financial Statements” foradditional information.

 

Product revenues arerecognized when products are shipped, license fees are recognized over the termof the license agreement, and royalties are recognized when earned.  On occasion, the Company will receiveadvance deposits with customer purchase orders.  These deposits are reported as a deferred revenue liability,until the product is shipped to the customer.

 

Approximately 14 percentof ProCyte’s assets as of December 31, 2003 consisted of goodwill, most ofwhich was acquired in business combinations and recorded based on the fairvalue of the common stock issued to effect those business combinations.  Under the guidance of SFAS 142 “Goodwill andOther Intangible Assets,” we analyze whether the fair value of recordedgoodwill is impaired on an annual basis. Application of the goodwill impairment test requires judgment, includingthe identification of reporting units, assigning assets and liabilities toreporting units, assigning goodwill to reporting units, and determining thefair value of each reporting unit. Significant judgments required to estimatethe fair value of reporting units include estimating future cash flows,determining appropriate discount rates and other assumptions. Changes in theseestimates and assumptions could materially affect the determination of fairvalue.

 

We maintain an allowancefor doubtful accounts for estimated losses resulting from the potentialinability of our customers or other debtors to make required payments.  The allowance is based upon historicalexperience and a review of individual customer balances.  If the financial condition of our customersor other debtors were to deteriorate, resulting in an impairment of theirability to make payments to us, additional allowances may be required.

 

Inventories are stated atthe lower of cost or market value.  Costis principally determined by the first-in, first-out method.  The Company records adjustments to the valueof inventory based upon its forecasted plans to sell its inventories.  The physical condition (e.g., age andquality) of the inventories is also considered in establishing its valuation.  These adjustments are estimates, which couldvary significantly, either favorably or unfavorably, from the amounts that theCompany may ultimately realize upon the disposition of inventories, if futureeconomic conditions, customer inventory levels, product discontinuances orcompetitive conditions differ from our estimates and expectations.

 

The Company recordsimpairment losses on long-lived assets used in operations when events andcircumstances indicate that assets might be impaired and the undiscounted cashflows estimated to be generated by those assets are less than the carryingamount of those assets such as assets related to Emerald Pharmaceuticals,LP.  Estimation of future values for thelong-lived assets require a significant amount of judgment related to assessingthe possible outcomes and the timing related to each outcome.  The adjustments are estimates, which couldvary significantly, either favorably or unfavorably, from the amounts that theCompany may ultimately realize for these assets if the actual events differsignificantly from our estimates and expectations.

 

#### ***Recent AccountingPronouncements***

 

In June 2002, the FASBissued SFAS No. 146, Accounting for Costs Associated with Exit or DisposalActivities.  This standard requires companiesto recognize costs associated with exit or disposal activities when they

 

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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.  The Company’s adoption of SFAS No. 146,effective January 1, 2003, did not have a material effect on the financialposition, results of operations or liquidity of the Company in 2003. Theapplication of SFAS No. 146 may result in a 2004 charge related to theCompany’s sublease with Emerald.

 

In April 2003, the FASBissued Statement of Financial Accounting Standards No. 149, Amendment ofStatement 133 on Derivative Instruments and Hedging Activities (SFAS No. 149).SFAS No. 149 amends and clarifies financial reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts and for hedging activities under SFAS No. 133, Accounting forDerivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified afterJune 30, 2003, and for hedging relationships designated after June 30,2003.  The Company does not have anyderivative financial instruments.  TheCompany adoption of SFAS No. 149 did not have a material effect on thefinancial condition, results of operations, or liquidity of the Company.

 

In May 2003, the FASBissued Statement of Financial Accounting Standards No. 150, Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity (SFAS No. 150). SFAS No. 150 establishes standards for how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity, and is effective for financial instruments enteredinto after May 31, 2003.  The Companydoes not have any financial instruments with characteristics of bothliabilities and equity and therefore the adoption of SFAS No. 150 did not havean effect on the financial condition, results of operations, or liquidity ofthe Company.

 

In November 2002, FASBInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”)was issued. FIN 45 elaborates on the disclosures to be made by a guarantor inits interim and annual financial statements about its obligations under certainguarantees that it has issued.  It alsoclarifies that a guarantor is required to recognize, at the inception of aguarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee.  The initialrecognition and initial measurement provisions of this Interpretation areapplicable on a prospective basis to guarantees issued or modified afterDecember 31, 2002.  The requireddisclosures are effective for financial statements of interim or annual periodsending after December 15, 2002.  TheCompany’s adoption of FIN 45 in 2003 did not have a material effect on theCompany’s financial position or results of operations.

 

In January 2003, the FASBissued Interpretation No. 46, “Consolidation of Variable Interest Entities”(“FIN 46”) to clarify the conditions under which assets, liabilities andactivities of another entity should be consolidated into the financialstatements of a company.  FIN 46requires the consolidation of a variable interest entity by a company thatbears the majority of the risk of loss from the variable interest entity’sactivities, is entitled to receive a majority of the variable interest entity’sresidual returns, or both.  Theprovisions of FIN 46 are effective for all variable interest entities createdor acquired after January 31, 2003.  TheCompany currently has no contractual relationship or other businessrelationship with a variable interest entity and therefore the adoption of FIN46 did not have an effect on the Company’s financial position or results ofoperations.

 

## **Item 7a.      Quantitative and Qualitative Disclosuresabout Market Risk**

 

ProCyte did not own anyderivative financial instruments as of December 31, 2003.  The Company isdebt-free and is exposed to interest rate risk to the extent that it has investedidle cash balances and the promissory note receivable described below.  At December 31, 2003, the idle cash balanceswere invested in a money market fund that invests primarily in commercialpaper, bank obligations, short-term debt securities, including instrumentsissued by certain trusts or other special purpose issuers like pass-throughcertificates representing participations in, or instruments backed by, thesecurities and other assets owned by these issuers, short-term taxablemunicipal securities and repurchase agreements secured by first-tiersecurities, U.S. government obligations or U.S. Treasury obligations.  The fund may also invest in other moneymarket funds, consistent with its investment objective and strategies.  When the fund trustee believes marketconditions warrant, the fund may invest more than 25 percent of its assets inU.S. dollar denominated bank obligations, including obligations of U.S. banks,foreign branches of U.S. banks and U.S. branches of foreign banks.  Although the fund tries to maintain a shareprice of $1.00, an investment in the fund may lose money.  At December 31, 2003, $3.6 million wasinvested in the fund.  ProCyte employs

 

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established policies and procedures to manage its exposure to changesin the market risk of its investments. The Company believes that the market risk arising from holdings of itsfinancial instruments is not material.

 

## **Item8.**                       ConsolidatedFinancial Statements and Supplementary Data

 
|   | **Index to  Consolidated Financial Statements and Schedules**                                                                                                                                                                                                                               |   |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | Balance Sheets as of December 31, 2003 and 2002                                                                                                                                                                                                                                             |   |
|   | Statements of Operations for the years  ended December 31, 2003, 2002 and 2001                                                                                                                                                                                                              |   |
|   | Statements of Cash Flows for the years  ended December 31, 2003, 2002 and 2001                                                                                                                                                                                                              |   |
|   | Statements of Stockholders’ Equity for the  years ended December 31, 2003, 2002 and 2001                                                                                                                                                                                               |   |
|   | 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. |   |

 

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**ProCyteCorporationConsolidated Balance Sheets**

(in thousands)

 
|                                                                                                                                                             |   | **December  31,  2003** |       | **December  31,  2002** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|------------|
| **Assets**                                                                                                                                                       |   |                    |       |                    |       |
| **Current Assets**                                                                                                                                               |   |                    |       |                    |       |
| Cash and cash equivalents                                                                                                                                        |   | $                       | 3,796      |                    | $          | 4,556 |   |
| Accounts receivable, net of allowance for  doubtful accounts                                                                                                     |   | 1,336                   |       | 1,328                   |       |
| Note due from officer                                                                                                                                            |   | 105                     |       | 2                       |       |
| Inventory                                                                                                                                                        |   | 2,942                   |       | 1,718                   |       |
| Other                                                                                                                                                            |   | 184                     |       | 327                     |       |
| **Total current assets**                                                                                                                                         |   | **8,363**               | ** ** | **7,931**               |       |
|                                                                                                                                                             |   |                    |       |                    |       |
| **Property and Equipment**                                                                                                                                       |   |                    |       |                    |       |
| Equipment                                                                                                                                                        |   | 315                     |       | 333                     |       |
| Leasehold improvements                                                                                                                                           |   | 3,520                   |       | 4,029                   |       |
| Less accumulated depreciation and  amortization                                                                                                                  |   | (3,294                  | )          | (3,076                  | )          |
| **Property and equipment, net**                                                                                                                                  |   | **541**                 | ** ** | **1,286**               | ** ** |
|                                                                                                                                                             |   |                    |       |                    |       |
| **Intangible  Assets**                                                                                                                                           |   |                    |       |                    |       |
| Patents, net of  amortization                                                                                                                                    |   | 70                      |       | 86                      |       |
| Goodwill                                                                                                                                                         |   | 3142                    |       | 2817                    |       |
| **Intangible assets, net**                                                                                                                                       |   | **3,212**               | ** ** | **2,903**               |       |
|                                                                                                                                                             |   |                    |       |                    |       |
| Note due from sale of contract  manufacturing operations, net of allowance                                                                                       |   | 781                     |       | 1,826                   |       |
| Note due from officer                                                                                                                                            |   | —                  |       | 104                     |       |
| Deferred tax asset                                                                                                                                               |   | 7,068                   |       | —                  |       |
| Other assets                                                                                                                                                     |   | 38                      |       | 39                      |       |
| **Total Assets**                                                                                                                                                 |   | **$**                   | **20,003** | ** **              | **$**      | **14,089** |   |
|                                                                                                                                                             |   |                    |       |                    |       |
| **Liabilities  and stockholders’ equity**                                                                                                                   |   |                    |       |                    |       |
| **Current Liabilities**                                                                                                                                          |   |                    |       |                    |       |
| Accounts payable, trade                                                                                                                                          |   | $                       | 147        |                    | $          | 302 |   |
| Accrued salaries and benefits                                                                                                                                    |   | 246                     |       | 404                     |       |
| Other accrued liabilities                                                                                                                                        |   | 239                     |       | 236                     |       |
| Deferred revenue                                                                                                                                                 |   | 60                      |       | 21                      |       |
| **Total current liabilities**                                                                                                                                    |   | **692**                 | ** ** | **963**                 |       |
|                                                                                                                                                             |   |                    |       |                    |       |
| Other liabilities                                                                                                                                                |   | 93                      |       | 91                      |       |
| Deferred proceeds on sale of contract  manufacturing operations                                                                                                  |   | —                  |       | 1,217                   |       |
| **Total Liabilities**                                                                                                                                            |   | **785**                 | ** ** | **2,271**               |       |
| **Commitments (Note 15)**                                                                                                                                        |   |                    |       |                    |       |
|                                                                                                                                                             |   |                    |       |                    |       |
| **Stockholders’ Equity**                                                                                                                                    |   |                    |       |                    |       |
| Preferred stock $.01 par value: 2,000,000  shares authorized; no shares issued or outstanding                                                                    |   | —                  |       | —                  |       |
| Common stock $.01 par value: 30,000,000  shares authorized; 15,782,601 and 15,733,911 shares issued and outstanding at  December 31, 2003 and 2002, respectively |   | 158                     |       | 158                     |       |
| Additional paid-in capital                                                                                                                                       |   | 85,261                  |       | 85,154                  |       |
| Deferred compensation                                                                                                                                            |   | (59                     | )          | (11                     | )          |
| Accumulated deficit                                                                                                                                              |   | (66,142                 | )          | (73,483                 | )          |
| Total stockholders’ equity                                                                                                                                  |   | 19,218                  |       | 11,818                  |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                              |   | **$**                   | **20,003** | ** **              | **$**      | **14,089** |   |

 

*See notes toconsolidated financial statements*

 

24

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**ProCyteCorporationConsolidated Statements ofOperations**

(in thousands, except per share amounts)

 
|                                                                                          |   | **Twelve  Months Ended December 31,** |   |
|-----------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                          |   | **2003**                              |   | **2002** |   | **2001** |   |
| **Revenues**                                                                                  |   |                                  |   |   |   |   |   |
| Product sales                                                                                 |   | $                                     | 9,863  |   | $ | 11,356 |   | $ | 8,401 |   |
| Licenses and royalties                                                                        |   | 1,675                                 |   | 1,381 |   | 1,115 |   |
| Contract manufacturing                                                                        |   | —                                |   | — |   | 196 |   |
| Total revenues                                                                                |   | 11,538                                |   | 12,737 |   | 9,712 |   |
| **Cost of product sales**                                                                     |   | 3,201                                 |   | 4,706 |   | 3,584 |   |
| **Gross profit**                                                                              |   | 8,337                                 |   | 8,031 |   | 6,128 |   |
|                                                                                          |   |                                  |   |   |   |   |   |
| **Operating Expenses**                                                                        |   |                                  |   |   |   |   |   |
| Research and development                                                                      |   | 191                                   |   | 126 |   | 745 |   |
| Marketing and selling                                                                         |   | 4,139                                 |   | 3,090 |   | 3,133 |   |
| General and administrative                                                                    |   | 3,305                                 |   | 3,345 |   | 3,116 |   |
| Loss on asset impairment (2003) and loss on  sale of contract manufacturing operations (2001) |   | 637                                   |   | — |   | 194 |   |
| Total operating expenses                                                                      |   | 8,272                                 |   | 6,561 |   | 7,188 |   |
|                                                                                          |   |                                  |   |   |   |   |   |
| **Income (loss) from operations**                                                             |   | 65                                    |   | 1,470 |   | (1,060 | ) |
|                                                                                          |   |                                  |   |   |   |   |   |
| Interest and other income                                                                     |   | 194                                   |   | 199 |   | 153 |   |
|                                                                                          |   |                                  |   |   |   |   |   |
| **Net income (loss) before tax**                                                              |   | 259                                   |   | 1,669 |   | (907 | ) |
|                                                                                          |   |                                  |   |   |   |   |   |
| Income tax benefit                                                                            |   | 7,082                                 |   | — |   | — |   |
|                                                                                          |   |                                  |   |   |   |   |   |
| **Net income (loss)**                                                                         |   | $                                     | 7,341  |   | $ | 1,669 |   | $ | (907 | ) |
|                                                                                          |   |                                  |   |   |   |   |   |
| ***Earnings (loss) per common share (note 10)***                                              |   |                                  |   |   |   |   |   |
| Basic                                                                                         |   | $                                     | 0.47   |   | $ | 0.11 |   | $ | (0.06 | ) |
| Diluted                                                                                       |   | $                                     | 0.46   |   | $ | 0.10 |   | $ | (0.06 | ) |
| ***Weighted average common shares outstanding  (note 10)***                                   |   |                                  |   |   |   |   |   |
| Basic                                                                                         |   | 15,767                                |   | 15,710 |   | 15,610 |   |
| Diluted                                                                                       |   | 15,997                                |   | 16,179 |   | 15,610 |   |

 

*See notes toconsolidated financial statements*

 

25

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**ProCyteCorporationConsolidated Statements of Cash Flows**

(in thousands)

 
|                                                                                                     |   | **Twelve  Months Ended December 31,** |   |
|----------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                                     |   | **2003**                              |   | **2002** |   | **2001** |   |
| **Operating Activities**                                                                                 |   |                                  |   |   |   |   |   |
| Net income (loss)                                                                                        |   | $                                     | 7,341  |   | $ | 1,669 |   | $ | (907 | ) |
| *Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities:*    |   |                                  |   |   |   |   |   |
| Depreciation and amortization                                                                            |   | 336                                   |   | 307 |   | 386 |   |
| Amortization of goodwill                                                                                 |   | —                                |   | — |   | 245 |   |
| Amortization of deferred proceeds                                                                        |   | (268                                  | )      | (277 | ) | (134 | ) |
| Non-cash expense related to stock-based  compensation                                                    |   | 45                                    |   | 48 |   | 48 |   |
| Amortization of promissory note discount                                                                 |   | (31                                   | )      | (31 | ) | (13 | ) |
| Decrease in deferred tax asset valuation  allowance                                                      |   | (7,100                                | )      | — |   | — |   |
| Amortization of deferred compensation                                                                    |   | 4                                     |   | 6 |   | — |   |
| Provision for impairment of assets                                                                       |   | 637                                   |   | — |   | — |   |
| Loss on sale of contract manufacturing  operations                                                       |   | —                                |   | — |   | 194 |   |
| ***Change in operating assets and liabilities  net of effects from purchase of spa products business:*** |   |                                  |   |   |   |   |   |
| Accounts receivable                                                                                      |   | (24                                   | )      | (372 | ) | 283 |   |
| Inventory                                                                                                |   | (849                                  | )      | 501 |   | 18 |   |
| Other current assets                                                                                     |   | 177                                   |   | (162 | ) | 6 |   |
| Note due from employee                                                                                   |   | 1                                     |   | 12 |   | (5 | ) |
| Accounts payable, trade                                                                                  |   | (155                                  | )      | (373 | ) | 427 |   |
| Accrued salaries and benefits                                                                            |   | (158                                  | )      | 186 |   | 89 |   |
| Other accrued liabilities                                                                                |   | 4                                     |   | 44 |   | (11 | ) |
| Deferred revenue                                                                                         |   | 38                                    |   | (42 | ) | (537 | ) |
| Other liabilities                                                                                        |   | 2                                     |   | (10 | ) | (43 | ) |
| *Net cash provided by operating activities*                                                              |   | —                                |   | 1,506 |   | 46 |   |
| **Financing Activities**                                                                                 |   |                                  |   |   |   |   |   |
| Proceeds from issuance of common stock                                                                   |   | 10                                    |   | 27 |   | 66 |   |
| **Investing Activities**                                                                                 |   |                                  |   |   |   |   |   |
| Purchase of property and equipment                                                                       |   | (57                                   | )      | (22 | ) | (28 | ) |
| Proceeds from sale of property and  equipment                                                            |   | —                                |   | — |   | 128 |   |
| Investment in Emerald Pharmaceutical LLP                                                                 |   | —                                |   | — |   | (1 | ) |
| Acquisition of assets of Annette Hanson,  Inc.                                                           |   | (713                                  | )      | — |   | — |   |
| Decrease in other assets                                                                                 |   | —                                |   | 42 |   | 19 |   |
| *Net cash provided by (used in) investing  activities*                                                   |   | (770                                  | )      | 20 |   | 118 |   |
| **Net  increase (decrease) in cash and cash equivalents**                                                |   | (760                                  | )      | 1,553 |   | 230 |   |
| **Cash and Cash Equivalents:**                                                                           |   |                                  |   |   |   |   |   |
| At beginning of period                                                                                   |   | 4,556                                 |   | 3,003 |   | 2,773 |   |
| At end of period                                                                                         |   | $                                     | 3,796  |   | $ | 4,556 |   | $ | 3,003 |   |
|                                                                                                     |   |                                  |   |   |   |   |   |
| **Supplemental Disclosure of Cash Flow  Information**                                                    |   |                                  |   |   |   |   |   |
| Cash paid for income taxes                                                                               |   | $                                     | 18     |   | $ | — |   | $ | — |   |
|                                                                                                     |   |                                  |   |   |   |   |   |
| **Supplemental Non-Cash Financing and  Investing Activities**                                            |   |                                  |   |   |   |   |   |
| Promissory note received from sale of  contract manufacturing operations                                 |   | $                                     | — |   | $ | — |   | $ | 2,000 |   |
| Stock options granted to non-employees                                                                   |   | 52                                    |   | 17 |   | — |   |
| Forgiveness of spa products business  receivable                                                         |   | 59                                    |   | — |   | — |   |

 

*See notes toconsolidated financial statements*

 

26

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**ProCyteCorporationConsolidated Statements ofStockholders’ Equity**

(in thousands)

 
|                                                      |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Deferred  Compen-  sation** |   | **Accumulated  Deficit** |   | **Total** |   |
|-----------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|-------------------------------|--------|--------------------------|--------|-----------|--------|
| **Shares**                                                |   | **Par Value**     |
| Balance, December 31, 2000                                |   | 15,515            |   | $                                | 155    |                          | $      | 84,950                   |   | $         | — |   | $ | (74,245 | ) | $ | 10,860 |   |
| Shares issued under non-employee director  stock plan     |   | 51                |   | 1                                |   | 47                            |   | —                   |   | —    |   | 48 |   |
| Shares issued upon exercise of options                    |   | 88                |   | 1                                |   | 65                            |   | —                   |   | —    |   | 66 |   |
| Net loss                                                  |   | —            |   | —                           |   | —                        |   | —                   |   | (907      | )      | (907 | ) |
| Balance, December 31, 2001                                |   | 15,654            |   | $                                | 157    |                          | $      | 85,062                   |   | $         | — |   | $ | (75,152 | ) | $ | 10,067 |   |
| Shares issued under non-employee director  stock plan     |   | 31                |   |                             | (*)    | 48                            |   | —                   |   | —    |   | 48 |   |
| Shares issued upon exercise of warrant  issued in 1999    |   | 18                |   |                             | (*)    |                          | (*)    | —                   |   | —    |   | — |   |
| Shares issued upon exercise of options                    |   | 31                |   |                             | (*)    | 27                            |   | —                   |   | —    |   | 27 |   |
| Stock options granted to non-employees                    |   | —            |   | —                           |   | 17                            |   | (17                      | )      | —    |   | — |   |
| Amortization of deferred compensation                     |   | —            |   | —                           |   | —                        |   | 6                        |   | —    |   | 6 |   |
| Net income                                                |   | —            |   | —                           |   | —                        |   | —                   |   | 1,669     |   | 1,669 |   |
| Balance, December 31, 2002                                |   | 15,734            |   | $                                | 158    |                          | $      | 85,154                   |   | $         | (11    | ) | $ | (73,483 | ) | $ | 11,818 |   |
| Shares issued under non-employee director  stock plan     |   | 37                |   |                             | (*)    | 45                            |   | —                   |   | —    |   | 45 |   |
| Shares issued upon exercise of options                    |   | 12                |   |                             | (*)    | 10                            |   | —                   |   | —    |   | 10 |   |
| Stock options granted to non-employees                    |   | —            |   | —                           |   | 59                            |   | (59                      | )      | —    |   | — |   |
| Re-measurement of stock options granted to  non-employees |   | —            |   | —                           |   | (7                            | )      | 7                        |   | —    |   | — |   |
| Amortization of deferred compensation                     |   | —            |   | —                           |   | —                        |   | 4                        |   | —    |   | 4 |   |
| Net income                                                |   | —            |   | —                           |   | —                        |   | —                   |   | 7,341     |   | 7,341 |   |
| Balance, December 31, 2003                                |   | 15,783            |   | $                                | 158    |                          | $      | 85,261                   |   | $         | (59    | ) | $ | (66,142 | ) | $ | 19,218 |   |

 

----

(*) rounds to less than $1,000

 

*See notes toconsolidated financial statements*

 

27

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**ProCyteCorporation**

**Notesto Consolidated Financial Statements**

 

**Note 1.  Description of Business and Summary ofSignificant Accounting Policies**

 

**Basis of Presentation**

 

Theaccompanying consolidated financial statements include the accounts of ProCyteCorporation and its wholly owned, non-operating subsidiaries NextDerm, Inc. (aDelaware corporation) and NextDerm, Inc. (a Washington corporation incorporatedFebruary 28, 2003) (collectively “ProCyte” or the “Company”).

 

**Summary ofSignificant Accounting Policies**

 

###### *Revenuerecognition*

 

Productrevenues are recognized when products are shipped, license fees are recognizedover the term of the license agreement, and royalties are recognized whenearned.  Under certain agreements, theCompany may receive 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 July 2001, were recognized when services wereperformed.

 

###### *Cost of productsales*

 

Costof product sales is recognized at the time the product is shipped and therevenue is recorded.  An automatedinventory system is 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*

 

Thecost of advertising is expensed as incurred. Advertising expense is included in marketing and selling expense and was$250,000 in 2003, $249,000 in 2002 and $212,000 in 2001.

 

*Research anddevelopment*

 

Researchand development costs are expensed as incurred.  The Company enters into contracts with outside laboratories forcertain studies and recognizes the expenses associated with these contractswhen the related services are performed.

 

###### *General andadministrative*

 

In2001 General and administrative includes costs of $1.1 million associated withthe contract manufacturing activities, which are not separatelysegregated.  The contract manufacturingbusiness was sold in July 2001.

 

###### *FinancialInstruments*

 

TheCompany’s financial instruments, consisting primarily of cash and cashequivalents, accounts receivable, accounts payable, when valued using marketinterest rates, would not be materially different from the amounts presented inthe consolidated financial statements.

 

###### *Inventories*

 

Finishedgoods, raw materials and work in process inventories are stated at the lower ofcost, as determined by the first in, first out method, or market.  Finished goods and work in process costsinclude material, direct labor and overhead. The Company reduces the value ofinventory for slow moving, obsolete, non-salable or unusable items based upon aproduct level review.

 

28

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###### *Depreciation andamortization*

 

Equipmentis depreciated using the straight-line method over the estimated useful livesof the 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 lives,which are generally 17 years from the date the patents are issued.

 

###### *Goodwill*

 

Goodwillarising from acquisitions represents the excess of the purchase price over theestimated fair value of the net assets acquired.  On January 1, 2002, the Company implemented the guidance ofStatement of Financial Accounting Standards (SFAS) No. 142, Goodwill and OtherIntangible Assets, in recognizing certain intangibles as goodwill and assessingpotential future impairments of goodwill and per the requirements set forththerein conducted a transitional goodwill impairment test as of January 1,2002, which did not identify the need to recognize any transitionalimpairment.  The Company’s annualamortization expense for goodwill was $245,034 for the year ending December 31,2001.  The net loss for 2001 would havebeen $662,160, or $0.04 net loss per share, if goodwill had not been amortized.

 

The Company has electedto perform its annual testing of goodwill impairment as of March 31. As ofMarch 31, 2003 and 2002, the Company updated its testing of goodwill forimpairment and determined that there was no impairment. There were no eventssince March 31, 2003, which would cause the Company to change its valuation asof December 31, 2003.

 

###### *Long-live*d assets

 

TheCompany reviews its long-lived assets for impairment to determine whether anyevents or circumstances indicate that the carrying amount of the assets may notbe recoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to the future undiscounted netcash expected to be generated by the asset. If the carrying value is greater than the future undiscounted cashflows, an impairment loss is recorded to reduce the carrying value to fairvalue (See Note 16).

 

###### *Federal incometaxes*

 

TheCompany uses the asset and liability method to account for income taxes asprovided for in SFAS 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 partial valuationreserve for tax benefits of net operating losses and a full valuation reservefor research and development tax credit carry forwards due to the uncertaintyof realizing the tax benefits of the net operating losses and tax credits as aresult of their expiration.

 

###### *Cash and Cashequivalents*

 

TheCompany considers all highly liquid investments purchased with maturities ofthree months or less to be cash equivalents. Cash and cash equivalents are primarily held in a United States Treasurymoney market fund.

 

###### *Stock basedcompensation*

 

TheCompany follows the intrinsic value based accounting method for stock optionscontained in APB Opinion No. 25, Accountingfor Stock Issued to Employees, as permitted by SFAS No. 123, Accounting forStock-Based Compensation.  Under thismethod, no compensation expense has been recognized for employee incentivestock options, as the exercise price of options granted equaled the fair valueon the date of grant.

 

The following table represents what the Company’s pro forma amounts ofnet income (loss) and net income (loss) per share would have been for the yearsended December 31, 2003, 2002 and 2001, had compensation expense for theCompany’s stock options granted under the incentive compensation plan beenrecognized based upon the fair value of the awards granted.

 

Subsequent to the issuance of the December 31, 2002 consolidatedfinancial statements, the Company determined that it had incorrectly calculatedits previously reported stock compensation amounts for its pro forma

 

29

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disclosure. The incorrectcalculation had no effect on the Company’s previously reported consolidatedbalance sheets as of December 31, 2002 and 2001 and the consolidated statementof operations for the years ended December 31, 2002 and 2001. The followingtable summarizes changes in previously reported footnote information:

 
|                                                                              |   | **(In  thousands, except per share amounts)** |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                              |   |                                          |   | **2002** |   | **2001** |   |
|                                                                              |   | **2003**                                      |   | **As  previously  reported** |   | **As  revised** |   | **As  previously  reported** |   | **As  revised** |   |
| Net income (loss), as reported                                                    |   | $                                             | 7,341  |   | $ | 1,669 |   | $ | 1,669 |   | $ | (907 | ) | $ | (907 | ) |
| Stock option-based compensation expense  determined under fair value based method |   | 362                                           |   | 258 |   | 477 |   | 230 |   | 399 |   |
| Pro forma net income (loss)                                                       |   | $                                             | 6,979  |   | $ | 1,411 |   | $ | 1,192 |   | $ | (1,137 | ) | $ | (1,306 | ) |
| Earnings per share:                                                               |   |                                          |   |   |   |   |   |   |   |   |   |
| As reported basic                                                                 |   | $                                             | 0.47   |   | $ | 0.11 |   | $ | 0.11 |   | $ | (0.06 | ) | $ | (0.06 | ) |
| As reported diluted                                                               |   | $                                             | 0.46   |   | $ | 0.10 |   | $ | 0.10 |   | $ | (0.06 | ) | $ | (0.06 | ) |
| Pro forma basic                                                                   |   | $                                             | 0.44   |   | $ | 0.09 |   | $ | 0.08 |   | $ | (0.08 | ) | $ | (0.08 | ) |
| Pro forma diluted                                                                 |   | $                                             | 0.43   |   | $ | 0.09 |   | $ | 0.07 |   | $ | (0.08 | ) | $ | (0.08 | ) |

 

TheCompany determined the fair value of stock options granted during 2003, 2002and 2001 using the Black-Scholes option pricing model and the followingassumptions:

 

| **Options Granted**          |   | **2003**   |   | **2002**   |   | **2001**   |   |
|------------------------------|--------|------------|--------|------------|--------|------------|--------|
| Risk-free interest rate      |   | 2.35%-2.81 | %      | 3.13%-3.92 | %      | 3.37%-4.45 | %      |
| Expected option life (years) |   | 6.00       |   | 6.00       |   | 5.81       |   |
| Dividend yield               |   | 0.00       |   | 0.00       |   | 0.00       |   |
| Expected volatility          |   | 55%-62     | %      | 61%-67     | %      | 94%-140    | %      |

 

###### *Use of estimatesin financial statements*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of revenues andexpenses during the reporting period and the reported amounts of assets andliabilities and disclosure of contingent liabilities at the date of the financialstatements, particularly with respect to the valuation of inventory, notesreceivable, goodwill, leasehold improvements and deferred tax assets.  Actual results could differ from thoseestimates.

 

###### *Reclassifications*

 

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

 

###### *Recent accountingpronouncements*

 

InJune 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated withExit or Disposal Activities.  Thisstandard requires companies to recognize costs associated with exit or disposalactivities when they are incurred rather than at the date of a commitment to anexit or disposal plan.  Examples ofcosts covered by the standard include lease termination costs and certainemployee severance costs that are associated with a restructuring, discontinuedoperation, plant closing, or other exit or disposal activity.  The Company’s adoption of SFAS No. 146,effective January 1, 2003, did not have a material effect on the financialposition, results of operations or liquidity of the Company.

 

InApril 2003, the FASB issued Statement of Financial Accounting Standards No.149, Amendment of Statement 133 on Derivative Instruments and HedgingActivities (SFAS No. 149). SFAS No. 149 amends and

 

30

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clarifies financial reportingfor derivative instruments, including certain derivative instruments embeddedin other contracts and for hedging activities under SFAS No. 133, Accountingfor Derivative Instruments and Hedging Activities. This statement is effectivefor contracts entered into or modified after June 30, 2003, and for hedgingrelationships designated after June 30, 2003. The Company does not have anyderivative financial instruments.  TheCompany’s adoption of SFAS No. 149 did not have a material effect on thefinancial condition, results of operations, or liquidity of the Company.

 

In May2003, the FASB issued Statement of Financial Accounting Standards No. 150,Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity (SFAS No. 150). SFAS No. 150 establishes standards forhow an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity, and is effective for financialinstruments entered into after May 31, 2003. The Company does not have anyfinancial instruments with characteristics of both liabilities and equity andtherefore the adoption of SFAS No. 150 did not have an effect on the financialcondition, results of operations, or liquidity of the Company.

 

InNovember 2002, FASB Interpretation No. 45, “Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others” (“FIN 45”) was issued. FIN 45 elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it hasissued.  It also clarifies that aguarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee.  The initial recognition andinitial measurement provisions of this Interpretation are applicable on aprospective basis to guarantees issued or modified after December 31,2002.  The required disclosures areeffective for financial statements of interim or annual periods ending afterDecember 15, 2002.  The Company’sadoption of FIN 45 in 2003 did not have a material effect on the Company’sfinancial position or results of operations.

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation of VariableInterest Entities” (“FIN 46”) to clarify the conditions under which assets,liabilities and activities of another entity should be consolidated into thefinancial statements of a company.  FIN46 requires the consolidation of a variable interest entity by a company thatbears the majority of the risk of loss from the variable interest entity’sactivities, is entitled to receive a majority of the variable interest entity’sresidual returns, or both.  Theprovisions of FIN 46 are effective for all variable interest entities createdor acquired after January 31, 2003.  TheCompany currently has no contractual relationship or other businessrelationship with a variable interest entity and therefore the adoption of FIN46 did not have any effect on the Company’s financial position or results ofoperations.

 

**Note 2.  Acquisition of Spa Products DistributionBusiness**

 

OnDecember 30, 2003 the Company purchased substantially all of the assets ofAnnette Hanson, Inc., a private distributor of skin care products to the spamarket.  ProCyte made a cash payment of$661,000 and forgave an outstanding receivable balance to Annette Hanson, Inc.of $59,000.  The related acquisitioncosts amounted to approximately $52,000. As part of the purchase, the Company assumed the lease for a 2,500square foot warehouse that expires on February 28, 2006.  Total consideration paid, includingacquisition costs has been allocated among the assets acquired as follows:

 

|                           |   | **(in  thousands)** |   |
|--------------------------------|--------|---------------------|--------|
| Trade receivables              |   | $                   | 44     |   |
| Inventory                      |   | 375                 |   |
| Prepaids                       |   | 2                   |   |
| Equipment                      |   | 26                  |   |
| Goodwill and other intangibles |   | 325                 |   |
|                           |   | $                   | 772    |   |

 

ProCytehas also entered into a multi-year consulting agreement with the principal,Annette Hanson, which includes among other things annual payments of $150,000for the years 2004 thru 2006, options to purchase

 

31

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150,000 shares of common stock(See Note 13), and payments contingent on the amount of growth in spa productrevenue.  The consulting agreement isfor future services and is cancelable for cause.

 

**Note 3.  Product and geographic information**

 

Productrevenue includes the Company’s skin health, hair care and wound care products,which are sold primarily to specialty distributors and physicians, and itspatented copper peptide compound sold to its licensed partners.  One customer accounted for 10% or more ofproduct and total revenue for each period reported, which represented 20%, 23%and 21% of the product revenues in 2003, 2002 and 2001, respectively.  The same customer accounted for 31%, 30% and32% of the Company’s total revenues in 2003, 2002 and 2001, respectively.  The Company has not made significant salesoutside of the United States and does not currently maintain discrete financialinformation to measure operating performance on a segment basis.

 

Productsales consisted of the following:

 

|                                  |   | **(in  thousands)**          |   |
|---------------------------------------|--------|------------------------------|--------|
|                                  |   | **Year Ended  December 31,** |   |
|                                  |   | **2003**                     |   | **2002** |   | **2001** |   |
| Skin Health, Wound Care and Hair Care |   | $                            | 7,870  |   | $ | 7,825 |   | $ | 6,289 |   |
| Copper peptide compound               |   | 1,993                        |   | 3,531 |   | 2,112 |   |
|                                  |   | $                            | 9,863  |   | $ | 11,356 |   | $ | 8,401 |   |

 

**Note 4.  Accounts Receivable**

 

Twocustomers each represented greater than 10% of the net accounts receivablebalance at December 31, 2003 and 2002 as follows:

 

|       |   | **December  31,  2003** |   | **December  31,  2002** |   |
|------------|--------|-------------------------|--------|-------------------------|--------|
| Customer A |   | 46                      | %      | 43                      | %      |
| Customer B |   | 12                      | %      | 13                      | %      |

 

TheCompany provided an allowance for uncollectible receivables in the amount of$102,000 and $68,000 at December 31, 2003 and 2002, respective1y.  The bad debt expense, net of recoveries of$6,000 in 2003, $34,000 in 2002, and no recoveries in 2001, was $35,000, $3,000and $188,000 for the years ended December 31, 2003, 2002 and 2001,respectively.  Accounts written off tothe allowance amounted to $14,000, $213,000 and $37,000 for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

**Note 5.  Inventory**

 

Inventoryconsisted of the following:

 

|            |   | **(in  thousands)**    |   |
|-----------------|--------|------------------------|--------|
|            |   | **December 31,  2003** |   | **December 31,  2002** |   |
| Finished Goods  |   | $                      | 2,235  |   | $ | 1,254 |   |
| Work in process |   | 406                    |   | 228 |   |
| Raw materials   |   | 301                    |   | 236 |   |
| **Total**       |   | $                      | 2,942  |   | $ | 1,718 |   |

 

**Note 6.  Intangible Assets**

 

Intangibleassets include patents of $70,000 and $86,000 at December 31, 2003 and 2002,respectively.  Patents are shown net ofaccumulated amortization of $221,000 and $205,000, at December 31, 2003 and2002, respectively.  Patents areamortized over the term of the patent and the amortization expense relatedthereto was

 

32

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$16,000 for each of the yearsended December 31, 2003, 2002 and 2001. Amortization expense is expected to be $16,000 for each of the yearsending December 31, 2004 through 2007 and $6,000 for the year ending December31, 2008.

 

Intangibleassets also include goodwill of $3.1 million and $2.8 million at December 31,2003 and 2002, respectively (Note 1). The Company determined that it has one reporting unit, therefore, all ofgoodwill is deemed to be associated with ProCyte’s overall business operations.

 

**Note 7.  Federal Income Taxes**

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of theCompany’s deferred tax assets and liabilities are as follows:

 

|                                |   | **(in  thousands)**    |   |
|-------------------------------------|--------|------------------------|--------|
|                                |   | **December 31,  2003** |   | **December 31,  2002** |   |
| **Current deferred tax asset:**     |   |                   |   |   |   |
| Compensation accrual                |   | $                      | 43     |   | $ | 112 |   |
| Bad debt allowance                  |   | 35                     |   | 24 |   |
| Inventory write downs               |   | 40                     |   | 43 |   |
| Current deferred asset              |   | 118                    |   | 179 |   |
| Valuation allowance                 |   | (86                    | )      | (179 | ) |
| Net current deferred tax asset      |   | $                      | 32     |   | $ | — |   |
|                                |   |                   |   |   |   |
| **Non-current deferred tax asset:** |   |                   |   |   |   |
| Net operating loss carry-forward    |   | $                      | 22,929 |   | $ | 23,736 |   |
| Tax credit carry-forward            |   | 1,609                  |   | 1,678 |   |
| Asset impairment write-downs        |   | 829                    |   | 520 |   |
| Depreciation                        |   | 889                    |   | 593 |   |
| Deferred gain                       |   | —                 |   | 426 |   |
| Other                               |   | 2                      |   | 61 |   |
| Total gross deferred tax asset      |   | 26,258                 |   | 27,014 |   |
| Deferred tax liabilities            |   | (127                   | )      | (56 | ) |
| Net deferred tax asset              |   | 26,131                 |   | 26,958 |   |
| Valuation allowance                 |   | (19,063                | )      | (26,958 | ) |
| Net non-current deferred tax asset  |   | $                      | 7,068  |   | $ | — |   |

 

Until the fourth quarter of 2003, the Companyprovided a full valuation allowance offsetting its deferred tax assets fortiming differences and net operating tax loss carry forwards.  Based upon a review of historical operatingperformance and management’s expectation that the Company can generatesustainable consolidated net income for the foreseeable future, the managementnow believes it is more likely than not that a portion of these deferred taxassets will be utilized.  The Companytherefore recognized an income tax benefit related to a reduction in itsdeferred tax asset valuation allowance of approximately $7.1 million.  As of December 31, 2003, a partial valuationreserve for tax benefits of net operating losses and a full valuation reservefor research and development tax credit carry forwards remains in place due tothe uncertainty of realizing the full tax benefits of the net operatinglosses and tax credits as a result of their expiration. The net change in the valuation allowance during the years endedDecember 31, 2003 and 2002, was a reduction of $7.9 million and $627,000,respectively.

 

33

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Theprovision for income taxes differs from the amount computed by applying thestatutory federal income tax rate to the net income or loss from operations.The sources and tax effects of the differences are as follows:

 

|                                                                 |   | **(in thousands)Year ended December 31,** |   |
|----------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                 |   | **2003**                                  |   | **2002** |   | **2001** |   |
| Income tax provision (benefit) at the  Federal statutory rate of 34% |   | $                                         | 88     |   | $ | 584 |   | $ | (318 | ) |
| Permanent tax/book differences                                       |   | 3                                         |   | 20 |   | 12 |   |
| State taxes                                                          |   | 12                                        |   | — |   | — |   |
| Tax provision (benefit) before net operating  loss carry forward     |   | 103                                       |   | 604 |   | (306 | ) |
| Change in valuation allowance                                        |   | (7,100                                    | )      | — |   | 306 |   |
| Net operating loss carry forward benefit                             |   | (85                                       | )      | (604 | ) | — |   |
| Net tax provision (benefit)                                          |   | $                                         | (7,082 | ) | $ | — |   | $ | — |   |

 

Aprovision for state income tax was made for California state income tax in2003.  The Company has a net operatingloss carry forward for California state income tax of $350,000, however in thefourth quarter of 2002 the State of California temporarily suspended the use ofthe net operating loss carry forward deduction for 2002 and 2003.  As a result, the Company recognized $18,000related to state income taxes in 2003.

 

The components of theprovision for income taxes are as follows:

 

|                                |   | **(in  thousands)Year ended December 31,** |   |
|-------------------------------------|--------|--------------------------------------------|--------|
|                                |   | **2003**                                   |   | **2002** |   | **2001** |   |
| Current expense (benefit):          |   |                                       |   |   |   |   |   |
| Federal                             |   | $                                          | 123    |   | $ | 366 |   | $ | 410 |   |
| State                               |   | 18                                         |   | 14 |   | 11 |   |
| Use of operating loss carry forward |   | (123                                       | )      | (380 | ) | (421 | ) |
|                                |   | 18                                         |   | — |   | — |   |
| Deferred expense (benefit)          |   |                                       |   |   |   |   |   |
| Federal                             |   | 888                                        |   | 627 |   | (1,264 | ) |
| State                               |   | —                                     |   | — |   | — |   |
|                                |   | 888                                        |   | 627 |   | (1,264 | ) |
| Valuation allowance                 |   | (7,988                                     | )      | (627 | ) | 1,264 |   |
| Total                               |   | $                                          | (7,082 | ) | $ | — |   | $ | — |   |

 

34

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As ofDecember 31, 2003, the Company’s U.S. federal net operating loss and generalbusiness credit carry forward for income tax purposes were approximately $67.4million and $1.6 million, respectively. If not utilized, the federal net operating loss carry forward and taxcredit carry forwards will expire between 2004 and 2021 as follows:

 

|       |   | **(in  thousands)**     |   |
|------------|--------|-------------------------|--------|
|       |   | **Net operating  loss** |   | **General  business  credits** |   |
| 2004       |   | $                       | — |   | $ | 33 |   |
| 2005       |   | 2,002                   |   | 178 |   |
| 2006       |   | 3,928                   |   | 133 |   |
| 2007       |   | 5,173                   |   | 158 |   |
| 2008       |   | 7,912                   |   | 242 |   |
| Thereafter |   | 48,422                  |   | 865 |   |
| Total      |   | $                       | 67,437 |   | $ | 1,609 |   |

 

Futurechanges in ownership, as defined by Section 382 of the IRC, may limit theamount of net operating loss carry forward used in any one year.

 

**Note 8.  401(k) Plan**

 

TheCompany sponsors the 1991 ProCyte Corporation Profit Sharing and SalaryDeferral 401(k) Plan, which is funded by voluntary employee pretax salarydeferrals to the extent permitted under law and provides for employer matchingcontributions at the discretion of the Board of Directors.  No employer contribution has been made sincethe adoption of the plan.

 

**Note 9.  Note Due from Officer**

 

AtDecember 31, 2003 and 2002, an Officer owed the Company $105,000 and $106,000,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 theapplicable federal short-term rate at June 30, 2002 of 2.91%, which is payableannually.

 

**Note 10.Earnings (loss) per share**

 

Basicand diluted per share results for all periods presented were computed based onthe net earnings for the respective periods. The weighted average number of common shares outstanding during theperiod was used in the calculation of basic earnings per share.  In accordance with FAS 128, “Earnings PerShare,” the weighted average number of common shares used in the calculation ofdiluted per share amounts is adjusted for the dilutive effects of stock optionsbased on the treasury stock method only if an entity records earnings fromoperations, as such adjustments would otherwise be anti-dilutive to earningsper share from operations.  For theyears ended December 31, 2003 and 2002, 230,645 and 468,519 dilutive stockoptions, respectively, were included in the calculation of average number ofcommon shares outstanding for diluted computations.  As a result of reporting a net loss in 2001, the average numberof common shares used in the calculation of the diluted loss per share, has notbeen adjusted for the effects of 182,460 of dilutive stock options since theirimpact would be anti-dilutive.  For theyears ended December 31, 2003, 2002 and 2001, options and warrants to purchase1,914,331 shares, 1,215,821 shares and 1,616,320 shares, respectively, ofcommon stock with exercise prices greater than the average fair market value ofour stock for the period of $1.16, $1.55 and $1.15, respectively, were notincluded in the computation of diluted earnings per share because the effectwould have been anti-dilutive.

 

35

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**Note 11.  Stockholders’ Equity**

 

*Non-employeeDirector Stock Plan*

 

InJune 1998, the shareholders approved the 1998 Non-employee Director Stock Plan,reserving 200,000 shares for issuance to directors.  200,000 additional shares were approved for issuance under theplan at the Company’s annual shareholders meeting on May 23, 2000. Under thisplan, eligible directors receive all or a portion of their quarterly retainerfees in shares of the common stock of the Company.  The number of shares each eligible director receives is based onthe average fair market value of the common stock for the last 20 business daysof the fiscal quarter.  For the yearsended December 31, 2003 and 2002, 36,690 shares and 31,316 shares were issuedunder the Plan, respectively.  Issuanceof shares to non-employee directors are expensed.  After issuing 8,589 shares on January 9, 2004, the plan had101,672 shares available for issuance.

 

*Shareholder Rightsplan*

 

InDecember 1994, the Board of Directors adopted a shareholder rights plandeclaring a dividend of one preferred share purchase right (the “Rights”) foreach outstanding share of common stock of the Company.  Each Right, initially evidenced by andtraded with the shares of common stock, entitles the registered holder topurchase one one-hundredth (1/100) of a share of preferred stock of the Companyat an exercise price of $14.00, subject to adjustment based on the market priceof the Company’s common stock at the time the Rights 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.

 

**Note 12. Warrants to Acquire Common Stock**

 

The Companyissued three common stock purchase warrants for 100,000 shares on May 26, 1999in exchange 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.  Thefair value of these warrants was determined to be $90,117 using theBlack-Scholes option-pricing model and was expensed in 1999.  The assumptions used in the model were arisk-free interest rate of 4.08%, an expected life of five years, 98% stockprice volatility and no dividends over the expected life.  On January 2, 2002, the first warrant for33,334 shares was exercised in a net exercise, as provided by the terms of thewarrant, resulting in the issuance of 18,549 shares.

 

**Note 13.  Stock Options**

 

TheCompany has stock option plans for directors, officers, employees andconsultants that provide for grants of nonqualified and incentive stockoptions.  Options generally are grantedat fair market value, expire between five and ten years from grant date andvest ratably over one to three years.

 

36

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Thefollowing table summarizes information about stock option activity in 2003,2002 and 2001:

 
|                           |   | **2003**                |   | **2002**                       |   | **2001**                |      |
|--------------------------------|--------|-------------------------|--------|--------------------------------|--------|-------------------------|-----------|
| **Items**                      |   | **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 |   | 2,185,335               |   | $                              | 1.57   |                    | 2,087,002 |   | $ | 1.57 |   | 2,081,861 |   | $ | 1.63 |   |
| Granted                        |   | 550,000                 |   | $                              | 1.12   |                    | 490,500   |   | $ | 1.67 |   | 440,500 |   | $ | 1.27 |   |
| Exercised                      |   | (12,000                 | )      | $                              | 0.86   |                    | (30,504   | ) | $ | 0.89 |   | (88,002 | ) | $ | 0.75 |   |
| Canceled or expired            |   | (153,168                | )      | $                              | 2.71   |                    | (361,663  | ) | $ | 1.80 |   | (347,357 | ) | $ | 1.73 |   |
| Outstanding, end of year       |   | 2,570,167               |   | $                              | 1.41   |                    | 2,185,335 |   | $ | 1.57 |   | 2,087,002 |   | $ | 1.57 |   |
| Exercisable, end of year       |   | 1,832,682               |   | $                              | 1.47   |                    | 1,457,014 |   | $ | 1.61 |   | 1,265,018 |   | $ | 1.89 |   |

 

The options outstanding at December 31, 2003 consisted of thefollowing:

 
| **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 - $0.90               |   | 576,500                             |   | 6.07                           |   | $                              | 0.74   |                                | 576,500   |                           | $      | 0.74 |   |
| $ 0.91 - $1.15               |   | 532,500                             |   | 8.77                           |   | $                              | 1.03   |                                | 146,002   |                           | $      | 0.99 |   |
| $ 1.16 - $1.35               |   | 555,167                             |   | 7.04                           |   | $                              | 1.28   |                                | 375,171   |                           | $      | 1.27 |   |
| $ 1.36 - $1.99               |   | 522,500                             |   | 7.81                           |   | $                              | 1.65   |                                | 351,509   |                           | $      | 1.67 |   |
| $ 2.00 - $3.44               |   | 383,500                             |   | 2.13                           |   | $                              | 2.78   |                                | 383,500   |                           | $      | 2.78 |   |
| $ 0.49 - $3.44               |   | 2,570,167                           |   | 6.61                           |   | $                              | 1.41   |                                | 1,832,682 |                           | $      | 1.47 |   |

 

AtDecember 31, 2003 there were 67,495 shares reserved for issuance under theCompany’s 1996 Stock Option Plan, which included the 750,000 shares approvedfor the plan at the Company’ annual shareholders meeting on May 21, 2002.

 

Theweighted average fair value of options granted during 2003, 2002, and 2001 wasapproximately $0.51, $1.19 and $1.00, respectively.

 

OnDecember 30, 2003 the Company granted options to purchase 150,000 shares ofcommon stock to Annette Hanson as partial consideration for future servicesprovided under a consulting agreement. The options are exercisable at $1.01 per share, the market price on thedate of grant, and vest ratably over three years from date of grant.  The fair value of the grant was determinedto be $59,000 using the Black-Scholes option pricing model.  The assumptions used in the model were arisk-free interest rate of 2.72%, 59% stock price volatility, and no dividendsover the three year expected life.  Theoptions will be re-valued quarterly until the measurement date is reached uponcompletion of the services. The fair value is reported as deferred compensationin Stockholders’ Equity, and is being amortized as an operating expense overthe expected life.

 

TheCompany granted 10,000 stock options on February 21, 2002 and 10,000 stockoptions on May 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 became fully vested one yearafter their date of issuance.  There-measured fair value of the February and May grants on the final measurementdate was determined to be $4,000 and $6,000, respectively, using theBlack-Scholes option-pricing model.  Theoptions were re-measured on February 28, 2003, the date the services wereconsidered completed.  The assumptionsused in the model for the re-measuring the February and May grants, were arisk-free interest rate of 2.81%, 62% stock price volatility, and no dividendsover the one year expected life.

 

37

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**Note 14.**  **Related Party Disclosure**

 

The Company holds a promissory note in the principle amount of $2.0 millionfrom Emerald Pharmaceutical L.P. (“Emerald”), which it received as partialconsideration for the sale of its contract manufacturing operations in 2001.The note is secured by the manufacturing assets sold and bears interest equalto the effective yield on the 10 Year US Treasury Note, which is adjustedquarterly.  The average yield for theyear ended December 31, 2003 was 3.77%. Emerald is required to make annualprincipal payments of $286,000 in July 2005. The Company also received a minority limited partnership interest inEmerald as part of consideration received 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 ofthe proceeds from the sale in the amount of $1.6 million has been determined torepresent consideration for use of Emerald’s use of the leasehold improvements,and is being recognized over the term of the lease.

 

UntilEmerald ceased operations (See Note 16), ProCyte engaged Emerald tomanufacturing copper peptide compounds, and to perform incoming quality testingand other analytical services.  Emeraldbilled ProCyte a total of $1.9 million, $1.6 million and $175,000 for the yearsended December 31, 2003, 2002 and 2001, respectively, for such product andservices.  ProCyte has second sourcesfor these products and services at prices that do not materially differ fromthose charged by Emerald.  ProCyte hadno trade payables to Emerald at December 31, 2003 and $172,000 of tradepayables at December 31, 2002.

 

One ofthe Company’s Directors also serves as Chairman and Chief Executive Officer ofone of ProCyte’s customers.  ProCyte’ssales to the customer were $910,000, $901,000 and $554,000 for the years endedDecember 31, 2003, 2002 and 2001, respectively.  The customer’s trade receivable balances were $165,000 and$172,000 on December 31, 2003 and 2002, respectively.

 

**Note 15.  Commitments**

 

TheCompany presently leases 34,532 square feet of manufacturing, warehouse,laboratory, and administrative space in Redmond, Washington under a leaseexecuted in August 1993.  The leaseincludes 1,782 additional square feet of office space in the same building,which was occupied in December 2002.  Asamended, the lease term for 32,750 square feet extends through June 30, 2007,and contains a renewal option for the Company to extend the term by anadditional five years.  The lease termfor the new 1,782 square feet of office space is through November 2005.  As part of the acquisition agreement withAnnette Hanson, Inc., effective December 30, 2003 the Company assumed a leasefor a 2,500 square foot warehouse located in Keyport, New Jersey expiringFebruary 28, 2006.

 

As apart of the sale of the contract manufacturing business in 2001, 19,770 squarefeet of the Redmond, Washington space was sub-leased to Emerald PharmaceuticalLP.  The sub-lease agreement reducedProCyte’s net lease expense by $270,000, $278,000 and $131,000 in 2003, 2002and 2001, respectively.  ProCyte remainsthe primary lessee and the payment obligation continues to belong toProCyte.  Emerald suspended operationsin February 2004 and has not paid sublease rent since January 2004.  See Note 16, Subsequent Event.

 

Futureminimum annual lease payments, which are not reduced for sublease rent, are asfollows:

 

|      |   | **(in  thousands)**   |   |
|-----------|--------|-----------------------|--------|
|      |   | **Lease  commitment** |   |
| 2004      |   | $                     | 437    |   |
| 2005      |   | 455                   |   |
| 2006      |   | 432                   |   |
| 2007      |   | 215                   |   |
| **Total** |   | $                     | 1,539  |   |

 

Netrent expense under these commitments in 2003, 2002, and 2001 was $149,000,$118,000 and $227,000, respectively.

 

**Note 16.  Subsequent Event - Loss on Impairment of Asset**

 

TheCompany holds a promissory note in the principal amount of $2 million fromEmerald Pharmaceutical L.P. (“Emerald”), which it received as partialconsideration for the sale of its contract manufacturing operations in2001.  The note is secured by a securityagreement covering all tangible assets and bears interest equal to theeffective yield on the 10 Year US Treasury Note, which is adjustedquarterly.  The average yield for theyear ended December 31, 2003 was 3.77%. Emerald is required to make monthly interest-only payments until July2005, when it is required to begin making annual principal payments of$286,000.  The Company also received aminority limited partnership interest in Emerald as part of considerationreceived in the sale.  As part of theagreement, ProCyte subleases a portion of its current 34,532 square foot leasedfacility, including existing leasehold

 

38

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improvements, to Emerald.  A portion of the proceeds from the sale inthe amount of $1.6 million was determined to represent consideration forEmerald’s use of the leasehold improvements, and is being recognized over theterm of the sublease.

 

InFebruary 2004, the General Partner of Emerald informed the Company that Emeraldsuspended operations and terminated all employees in an effort to conserveremaining capital while it sought other entities to operate or purchase thefacility.  If Emerald is unsuccessful inreturning to operations, ProCyte management believes that the facility hassignificant value to other contract manufacturing organizations andbiotechnology companies and can be re-leased or re-sold after an appropriatemarketing period.  As a result of thesedevelopments, management determined that it is probable that the $2.0 millionpromissory note receivable from Emerald ($1.9 million at pre-impairmentdiscounted value), leasehold improvements located in the space subleased toEmerald with a $949,000 net book value and the limited partnership interest ata cost of $1,000 have been impaired.

 

Managementestimated the impairment of the note receivable to be $127,000 based uponprobability weighted fair values of expected future cash flows discounted atthe loan’s effective rate compared to the current value of the note afterreducing the note by the $949,000 unamortized balance of deferred gain on theoriginal sale.  Management estimated theimpairment of the leasehold improvements to be $509,000 based upon theirexpected present values using multiple cash flow scenarios that reflected therange of possible outcomes at a risk free rate.  Management also determined that its partnership interest had noprobable value and wrote off the $1,000 balance.

 

Therefore,the Company has recorded a charge to 2003 earnings of $637,000.  The adjustment is based upon estimates,which could vary significantly from the amounts that the Company may ultimatelyrealize for these assets if the actual events differ significantly from ourestimates and expectations.

 

39

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**ProCyte Corporation**

**IndependentAuditors’ Report**

 

Board of Directors

ProCyte Corporation

Redmond, Washington

 

Wehave audited the accompanying consolidated balance sheets of ProCyteCorporation (the Company) as of December 31, 2003 and 2002, and the relatedconsolidated statements of operations, cash flows, and stockholders’ equity foreach of the three years in the period ended December 31, 2003.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally accepted inthe United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In ouropinion, such consolidated financial statements present fairly, in all materialrespects, the financial position of the Company as of December 31, 2003, and2002, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2003, in conformity withaccounting principles generally accepted in the United States of America.

 

Asdiscussed in Note 1 to the consolidated financial statements, the Companychanged its method of accounting for goodwill upon adoption of Statement ofFinancial Accounting Standards (SFAS) No. 142 “Goodwill and Other IntangibleAssets” for the year ended December 31, 2002.

 

Alsodescribed in Note 1, the Company revised its SFAS No. 148 “Accounting forStock-Based Compensation-Transition and Disclosure” pro-forma calculationdisclosures for the years ended December 31, 2002 and 2001.

 

 
| DELOITTE & TOUCHE LLP     |
|-------------------------------|
|                          |
| /s/ Deloitte & Touche LLP |   |
|                          |
| Seattle, Washington           |
| March 25, 2004                |

 

40

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## **Item9.**                       Changes inand Disagreements With Accountants on Accounting and Financial Disclosure

 

Not applicable.

 

## **Item9A.**              Controls andProcedures

 

As of the end of theperiod covered by this report, the Company conducted an evaluation, under thesupervision and with the participation of its principal executive officer andprincipal financial officer, of the effectiveness and design of its disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation, the principalexecutive officer and principal financial officer concluded that thesedisclosure controls and procedures were effective as of December 31, 2003, inensuring that all material information required to be disclosed in reports thatthe Company files or submits under the Exchange Act have been made known tothem in a timely fashion.

 

There were no changes inthe Company’s internal controls over financial reporting during the fourthquarter of 2003 that have materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

# **PART III**

 

## **Item10.**                Directors andExecutive Officers of the Registrant

 

Theinformation required under this item is included in the Company’s ProxyStatement relating to the Company’s annual meeting of shareholders, and isincorporated herein by reference.  SuchProxy Statement will be filed with the Securities and Exchange Commissionwithin 120 days after the close of the Company’s fiscal year end, December 31,2003.

 

## **Item11.**                ExecutiveCompensation

 

Theinformation required under this item is included in the Company’s ProxyStatement relating to the Company’s annual meeting of shareholders, and isincorporated herein by reference.  SuchProxy Statement will be filed with the Securities and Exchange Commissionwithin 120 days after the close of the Company’s fiscal year end, December 31,2003.

 

## **Item12.**                Security Ownership of CertainBeneficial Owners and Management

 

Theinformation required under this item is included in the Company’s ProxyStatement relating to the Company’s annual meeting of shareholders, and isincorporated herein by reference.  SuchProxy Statement will be filed with the Securities and Exchange Commissionwithin 120 days after the close of the Company’s fiscal year end, December 31,2003.

 

## **Item13.**                CertainRelationships and Related Transactions

 

Theinformation required under this item is included in the Company’s ProxyStatement relating to the Company’s annual meeting of shareholders, and isincorporated herein by reference.  SuchProxy Statement will be filed with the Securities and Exchange Commission within120 days after the close of the Company’s fiscal year end, December 31, 2003.

 

## **Item14.**                PrincipalAccountant Fees and Services

 

Theinformation required under this item is included in the Company’s ProxyStatement relating to the Company’s annual meeting of shareholders, and isincorporated herein by reference.  SuchProxy Statement will be filed with the Securities and Exchange Commissionwithin 120 days after the close of the Company’s fiscal year end, December 31,2003

 

41

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**PART IV**

 
| **Item 15**   Exhibits,  Financial Statement Schedules, and Reports on Form 8-K |
|-------------------------------------------------------------------------------------------|
|                                                                                      |   |   |
| **a.**                                                                                    | **List of documents  filed as part of this report:** |
|                                                                                      |   |   |
|                                                                                      | (1) | Financial Statements and Supplementary Data Reference is made to the  Index to Financial Statements and Schedules under Item 8 in Part II hereof,  where such documents are listed. |
|                                                                                      | (2) | Exhibits – see (c) below |
|                                                                                      |   |   |
| **b.**                                                                                    | **Reports on Form 8-K** |
|                                                                                      |   |   |
|                                                                                      | Form 8-K filed April 24, 2003 announcing the  Company’s earnings for the first quarter ended March 31, 2003. |
|                                                                                      |   |   |
|                                                                                      | Form 8-K filed July 24, 2003 announcing the  Company’s earnings for the second quarter ended June 30, 2003. |
|                                                                                      |   |   |
|                                                                                      | Form 8-K filed October 29, 2003 announcing the  Company’s earnings for the third quarter ended September 30, 2003. |
|                                                                                      |   |   |
| **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        |
| 14.1        |                                                                                                   | Code of Ethics for Senior Financial Officers                                                                                         |   | J        |
| 23.1        |                                                                                                   | Consent of Deloitte & Touche LLP                                                                                                 |   | J        |
| 31.1        |                                                                                                   | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                    |   | J        |
| 31.2        |                                                                                                   | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                    |   | J        |
| 32.1        |                                                                                                   | Section 1350 Certification of Chief Executive Officer                                                                                |   | J        |
| 32.2        |                                                                                                   | Section 1350 Certification of Chief Financial Officer                                                                                |   | J        |
|        |                                                                                                   |                                                                                                                                 |   |     |
|             |
| *           | 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). |
|             |                                                                                                        |                                                                                                                                      |        |          |  |

 

42

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| **Exhibit** |   | **Description**                                                                                                         |   | **Note** |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------|--------|----------|
| 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.                                                                                                         |   |     |

 

43

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# **SIGNATURES**

 

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

 
|   |           |   | PROCYTE CORPORATION                           |
|--------|----------------|--------|-----------------------------------------------|
|   |           |   | (REGISTRANT)                                  |
|   |           |   |                                          |
|   |           | By:    | /s/ John F. Clifford                          |
| Date:  | March 30, 2004 |   | John F. Clifford                              |
|   |           |   | Chairman of the Board of Directors and  Chief |
|   |           |   | Executive Officer                             |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| **Name**                |   | **Title**                            |   | **Date**            |   |
|-------------------------|--------|--------------------------------------|--------|---------------------|--------|
|                    |   |                                 |   |                |   |
| /s/ John F. Clifford    |   | Chairman and Chief Executive Officer |   | March 30, 2004 |   |
| John F. Clifford        |   | (Principal Executive Officer)        |   |                |   |
|                    |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
| /s/ John M. Hammer      |   | Director                             |   | March 30, 2004 |   |
| John Hammer             |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
| /s/ Matt L. Leavitt     |   | Director                             |   | March 30, 2004 |   |
| Matt L. Leavitt         |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
| /s/ Robert E. Patterson |   | Director                             |   | March 30, 2004 |   |
| Robert E. Patterson     |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
|                    |   |                                 |   |                |   |
| /s/ Robert W. Benson    |   | Chief Financial Officer              |   | March 30, 2004 |   |
| Robert W. Benson        |   | (Principal Financial Officer)        |   |                |   |

 

44

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