FORM 10-Q

                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   (Mark one)

          [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                  For quarterly period ended September 30, 1998

                                       OR

          [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

               For the transition period from ________ to ________

                         Commission file number: 0-22340

                       PALOMAR MEDICAL TECHNOLOGIES, INC.
                ------------------------------------------------
               (Exact name of issuer as specified in its charter)
<TABLE>
<S>                          <C>                                                     <C>           <C>


                             Delaware                                                              04-3128178
--------------------------------------------------------------------                 ---------------------------------------
(State or other jurisdiction of incorporation or organization)                        (I.R.S. Employer Identification No.)
</TABLE>

               45 Hartwell Avenue, Lexington, Massachusetts 02421
               --------------------------------------------------
                    (Address of principal executive offices)

                                 (781) 676-7300
                 -----------------------------------------------
                (Issuer's telephone number, including area code)

     Check  whether  the issuer:  (1) filed all reports  required to be filed by
Section 13 or 15(d) of the  Exchange  Act during the past 12 months (or for such
shorter period that the  registrant was required to file such reports),  and (2)
has been subject to such filing requirements for the past 90 days. Yes X  No
                                                                       --    --

     As of October 30, 1998,  70,402,163  shares of Common Stock, $.01 par value
per share, were outstanding.

     Transitional Small Business Disclosure Format (check one): Yes    No  X
                                                                   ---    ---

                                                                    Page 1 of 21
<PAGE>

               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                                      INDEX

PART I - FINANCIAL INFORMATION

         ITEM 1.  CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
<TABLE>
<S>      <C>                                                                                              <C>   

         Consolidated Condensed Balance Sheets - December 31, 1997 and September 30, 1998                 P.  3

         Consolidated Statements of Operations - For the Three and Nine Months Ended
                  September 30, 1997 and 1998                                                             P.  4

         Consolidated Statement of Stockholders' Deficit - For the Nine Months Ended
                  September 30, 1998                                                                      P.  5

         Consolidated Statements of Cash Flows - For the Nine Months Ended
                  September 30, 1997 and 1998                                                             P.  6

         Notes to Consolidated Financial Statements                                                       P.  7

         ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                           P. 13

PART II - OTHER INFORMATION

         ITEM 1.  LEGAL PROCEEDINGS                                                                       P. 19

         ITEM 2.  CHANGES IN SECURITIES                                                                   P. 19

         ITEM 3.  DEFAULTS UPON SENIOR SECURITIES                                                         P. 20

         ITEM 4.  SUBMISSION OF MATTERS TO A VOTE
                  OF SECURITY HOLDERS                                                                     P. 20

         ITEM 5.  OTHER INFORMATION                                                                       P. 20

         ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                                        P. 20

SIGNATURES                                                                                                P. 21

</TABLE>

                                       2
<PAGE>

                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                      CONSOLIDATED CONDENSED BALANCE SHEETS
                                   (Unaudited)

<TABLE>
<S>      <C>    <C>                                           <C>                       <C>    <C>    <C>

                                                              December 31,              September 30,
                                                                  1997                      1998
                                                              ------------              -------------

ASSETS

Current Assets:
         Cash and cash equivalents                             $3,003,300                 $2,665,686
         Marketable securities                                  1,449,326                     15,944
         Accounts receivable, net                               2,248,680                  5,901,131
         Inventories                                            4,711,474                  4,117,425
         Other current assets                                   2,153,941                  1,358,886
                                                              ------------              -------------
                  Total current assets                         13,566,721                 14,059,072
                                                              ------------              -------------

Net Assets of Discontinued Operations                           5,825,602                        ---
                                                              ------------              -------------

Property and Equipment, at Cost, Net                            6,455,586                  3,517,716
                                                              ------------              -------------

Other Assets:
         Cost in excess of net assets acquired, net             2,302,348                  1,850,574
         Deferred financing costs                                 591,609                     99,167
         Other noncurrent assets                                  225,706                    160,642
                                                              ------------              -------------
                  Total other assets                            3,119,663                  2,110,383
                                                              ------------              -------------
                                                              $28,967,572                $19,687,171
                                                              ============              =============

LIABILITIES AND STOCKHOLDERS' DEFICIT

Current Liabilities:
         Current portion of long-term debt                     $1,640,465                 $5,765,486
         Accounts payable                                       4,150,982                  3,009,978
         Accrued liabilities                                   13,759,854                 10,652,657
         Current portion of deferred revenue                    1,284,395                  1,181,213
                                                              ------------               ------------
                  Total current liabilities                    20,835,696                 20,609,334
                                                              ------------               ------------

Net Liabilities of Discontinued Operations                            ---                  1,687,079
                                                              ------------               ------------

Long-Term Debt, Net of Current Portion                         12,445,563                  3,173,542
                                                              ------------               ------------

Deferred Revenue, Net of Current Portion                        1,870,000                  1,120,000
                                                              ------------               ------------

Stockholders' Deficit:
         Preferred stock, $.01 par value-
                  Authorized - 5,000,000 shares
                  Issued and outstanding -
                  16,397 shares and 7,549 shares
                  at December 31, 1997 and
                  September 30, 1998, respectively                    164                         75
         Common stock, $.01 par value-
                  Authorized - 120,000,000 shares  
                  Issued and outstanding- 
                  45,792,585 shares and 69,349,440 
                  shares at December 31, 1997
                  and September 30, 1998, respectively            457,926                    693,493
         Additional paid-in capital                           147,356,579                160,634,871
         Accumulated deficit                                 (152,359,497)              (166,592,364)
         Less: Treasury stock - (345,000 shares at cost)       (1,638,859)                (1,638,859)
                                                              ------------              -------------
                  Total stockholders' deficit                  (6,183,687)                (6,902,784)
                                                              ------------              -------------

                                                              $28,967,572                $19,687,171
                                                              ============              =============

</TABLE>

                   The accompanying notes are an integral part
                  of these consolidated financial statements.


                                       3
<PAGE>


               PALOMAR MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (Unaudited)
<TABLE>
<S>                                     <C>                 <C>                   <C>                <C>

                                              Three Months Ended                        Nine Months Ended
                                                 September 30,                             September 30,
                                            1997                1998                  1997               1998
                                        -------------       -------------         -------------      ------------- 

Revenues                                  $5,846,413         $13,810,307            15,698,468         $29,968,108

Cost of Revenues                           4,928,809           5,721,860            14,369,646          16,870,561
                                        -------------       -------------         -------------      --------------
         Gross Margin                        917,604           8,088,447             1,328,822          13,097,547
                                        -------------       -------------         -------------      --------------

Operating Expenses
     Research and development              2,931,942           1,544,543             7,805,844           5,653,066
     Sales and marketing                   1,694,077           4,438,962             4,301,242          10,468,847
     General and administrative            3,647,358           1,777,036            13,303,288           6,980,037
     Restructuring and
         asset write-off costs             3,325,000                  --             3,325,000                  --
     Settlement and litigation costs         597,181                  --             3,199,000                  --
                                        -------------       -------------         -------------      --------------
         Total operating expenses         12,195,558           7,760,541            31,934,374          23,101,950
                                        -------------       -------------         -------------      --------------

         (Loss) income from operations    11,277,954)            327,906           (30,605,552)        (10,004,403)

Interest Expense                            (728,155)           (184,295)           (3,260,549)         (1,013,630)

Asset Write-off                           (9,657,759)                 --            (9,657,759)                 --

Other (Expense) Income                      (375,391)            396,272                 2,845             750,781
                                        -------------       -------------         -------------     ---------------

         Net (Loss) Income from
         Continuing Operations           (22,039,259)            539,883           (43,521,015)        (10,267,252)

Loss from Discontinued Operations (Note 7)

         Loss from operations            (14,950,310)                 --           (23,646,687)         (1,090,885)
         Loss on disposition                      --                  --                    --          (1,533,295)
                                        -------------       -------------         -------------      --------------

         Net Loss from 
               Discontinued Operations   (14,950,310)                 --           (23,646,687)         (2,624,180)
                                        -------------       -------------         -------------      --------------

         Net (Loss) Income              $(36,989,569)           $539,883          $(67,167,702)       $(12,891,432)
                                        =============       =============         =============      ==============

Basic and Diluted Net (Loss) Income Per Common Share:

         Continuing operations                $(0.68)              $0.01                $(1.43)             $(0.19)
         Discontinued operations               (0.43)                 --                 (0.72)              (0.04)
                                        -------------       -------------         -------------      --------------

               Total Basic and Diluted 
               Net (Loss) Income 
               Per Common Share               $(1.11)              $0.01                $(2.15)             $(0.23)
                                        =============       =============         =============      ==============

Weighted Average Number of
    Common Shares Outstanding             34,498,657          67,248,694            32,758,019           60,880,311
                                        =============       =============         =============      ==============
</TABLE>


                   The accompanying notes are an integral part
                  of these consolidated financial statements.



                                       4
<PAGE>




                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                                   (Unaudited)

<TABLE>
<S>                                                            <C>           <C>       <C>         <C>       <C>        <C>

                                                               -------------------------------------------------------------------
                                                                    Preferred Stock        Common Stock         Treasury Stock
                                                               -------------------------------------------------------------------
                                                                 Number        $0.01     Number      $0.01     Number
                                                                of Shares    Par Value  of Shares  Par Value  of Shares    Cost
                                                               -------------------------------------------------------------------

BALANCE, DECEMBER 31, 1997                                        16,397        $164   45,792,585  $457,926  (345,000)  $(1,638,859)

Sale of common stock pursuant to 
     warrants, options and Employee Stock Purchase Plan                -           -      162,582     1,626         -             - 
Conversion of preferred stock                                     (5,532)        (55)   6,269,945    62,699         -             - 
Conversion of convertible debentures                                   -           -    6,512,441    65,124         -             - 
Redemption of preferred stock                                     (3,316)        (34)           -         -         -             - 
Issuance of common stock net of investment banking fees                -           -   10,200,000   102,000         -             - 
Value ascribed to warrants issued to investor                          -           -            -         -         -             - 
Issuance of common stock for 1997 employer 
     401(k) matching contribution                                      -           -      311,887     3,118         -             - 
Common stock issued for advisory services                              -           -      100,000     1,000         -             - 
Costs incurred related to issuance of common stock                     -           -            -         -         -             - 
Preferred stock dividends and interest penalties                       -           -            -         -         -             - 
Net loss                                                               -           -            -         -         -             - 
                                                               ---------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 1998                                        7,549         $75   69,349,440  $693,493  (345,000)  $(1,638,859)
                                                               =====================================================================
</TABLE>


<TABLE>
<S>                                                            <C>                       <C>                   <C>

                                                               -------------------------------------------------------------------
                                                                   Additional                                      Total
                                                                     Paid-in              Accumulated          Stockholders'
                                                                    Capital                 Deficit               Deficit
                                                               -------------------------------------------------------------------

BALANCE, DECEMBER 31, 1997                                       $147,356,579            $(152,359,497)          ($6,183,687)

Sale of common stock pursuant to 
     warrants, options and Employee Stock Purchase Plan                32,856                        -                34,482
Conversion of preferred stock                                         535,467                        -               598,111
Conversion of convertible debentures                                6,011,870                        -             6,076,994
Redemption of preferred stock                                      (3,371,064)                       -            (3,371,098)
Issuance of common stock net of investment banking fees             9,738,000                        -             9,840,000
Value ascribed to warrants issued to investor                         171,000                        -               171,000
Issuance of common stock for 1997 employer 
     401(k) matching contribution                                     251,163                        -               254,281
Common stock issued for advisory services                              99,000                        -               100,000
Costs incurred related to issuance of common stock                   (190,000)                       -              (190,000)
Preferred stock dividends and interest penalties                            -               (1,341,435)           (1,341,435)
Net loss                                                                    -              (12,891,432)          (12,891,432)
                                                               -------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 1998                                      $160,634,871            $(166,592,364)          $(6,902,784)
                                                               ===================================================================
</TABLE>

                 The accompanying notes are an integral part of
                    these consolidated financial statements.


                                       5
<PAGE>




                       PALOMAR MEDICAL TECHNOLOGIES, INC.

                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                   (Unaudited)
<TABLE>
<S>      <C>      <C>                                                              <C>                 <C>

                                                                                        Nine Months Ended Sept 30,
                                                                                        1997                1998
                                                                                   -------------       --------------

Cash Flows from Operating Activities
         Net Loss                                                                   $(67,167,702)      $(12,891,432)
                  Less: Net Loss from Discontinued Operations                        (23,650,687)       $(2,624,180)
                                                                                   -------------       --------------
         Net Loss from Continuing Operations                                         (43,517,015)       (10,267,252)
                                                                                   =============       ==============

         Adjustments to reconcile net loss from continuing operations to net cash
                  used in operating activities-
                  Depreciation and amortization                                        1,844,458          2,189,013
                  Restructuring and asset write-off costs                             12,982,759
                  Settlement and litigation costs                                      2,900,000                 --
                  Write-off of deferred financing costs associated with
                           redemption of convertible debentures                           27,554                 --
                  Valuation allowances for notes and investments                       1,035,912                 --
                  Foreign currency exchange gain                                        (546,316)                --
                  Noncash interest expense related to debt                             2,585,606           171,000
                  Noncash compensation related to common stock and warrants              689,703                 --
                  Realized loss on marketable securities                                (195,706)                --
                  Unrealized gain on marketable securities                              (826,142)         (703,211)
                  Changes in assets and liabilities:
                           Net sale of marketable trading securities                   1,477,640          2,484,572
                           Accounts receivable                                           (82,192)        (3,608,624)
                           Inventories                                                (5,320,234)           434,925
                           Other current assets                                       (1,864,176)           654,227
                           Accounts payable                                            1,258,182           (840,022)
                           Accrued expenses                                             (253,898)           124,140
                                                                                   --------------      --------------
                                    Net cash used in operating activities            (27,803,865)        (9,361,232)

Cash Flows from Investing Activities
         Purchases of property and equipment                                          (5,355,750)         (308,896)
         Increase in other assets                                                       (681,016)          (470,252)
         Increase in notes receivable                                                   (308,712)           (86,818)
         Investment in nonmarketable securities                                       (1,057,631)                --
                                                                                   --------------      --------------
                           Net cash used in investing activities                      (7,403,109)          (865,966)
                                                                                   --------------      --------------

Cash Flows from Financing Activities
         Proceeds from issuance of convertible debentures                             16,715,169                 --
         Redemption of convertible debentures                                           (196,000)         (2,196,667)
         Net proceeds from the issuance of notes
                  payable and advances from distributor                                  657,384           3,138,439
         Proceeds from issuance of common stock                                           27,041           9,840,000
         Proceeds from exercise of warrants, stock options
                  and Employee Stock Purchase Plan                                     1,416,768              34,482
         Guaranteed value associated with Dermascan acquisition                         (216,562)
         Issuance of preferred stock                                                  15,000,000                  --
         Costs incurred related to issuance of common stock                             (427,102)           (190,000)
         Redemption of preferred stock, including
                  accrued dividends of $749,575                                               --          (4,120,673)
                                                                                   --------------      --------------
                           Net cash provided by financing activities                  32,976,698           6,505,581
                                                                                   --------------      --------------
Net (decrease) in cash and cash equivalents                                           (2,230,276)         (3,721,617)
Net cash (used in) provided by discontinued operations                                  (636,862)          3,384,003
Cash and cash equivalents, beginning of the period                                    12,292,406           3,003,300
                                                                                   --------------      --------------
Cash and cash equivalents, end of the period                                          $9,425,268         $2,665,686
                                                                                   ==============      ==============

Supplemental Disclosure of Cash Flow Information
         Cash paid for interest                                                         $359,565         $1,094,759
                                                                                   ==============      ==============

Supplemental Disclosure of Noncash Financing and Investing Activities:
         Conversion of convertible debentures and related accrued
                  interest, net of financing fees                                     $9,026,241         $6,076,994
                                                                                   --------------      --------------

         Conversion of preferred stock                                                  $308,199           $598,111
                                                                                   ==============      ==============

         Issuance of common stock for 1996 and 1997
                  employer 401(k) matching contribution                                 $269,262            $254,281
                                                                                   ==============      ==============
</TABLE>


                 The accompanying notes are an integral part of
                    these consolidated financial statements.


                                       6
<PAGE>


                       PALOMAR MEDICAL TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   BASIS OF PRESENTATION

     The  accompanying  unaudited  consolidated  financial  statements have been
prepared in accordance with generally accepted accounting principles for interim
information.  Accordingly,  they  do not  include  all of  the  information  and
footnotes  required by generally  accepted  accounting  principles  for complete
financial statements. The results of operations for the interim periods shown in
this report are not  necessarily  indicative of expected  results for any future
interim period or for the entire fiscal year. Palomar Medical Technologies, Inc.
and its  subsidiaries  (the "Company" or "Palomar")  believes that the quarterly
information presented includes all adjustments (consisting of normal,  recurring
adjustments)  necessary for a fair  presentation  in accordance  with  generally
accepted accounting principles.  The accompanying financial statements and notes
should be read in  conjunction  with the Company's  Form 10-K, as of and for the
year ended December 31, 1997.

     Some of the  Company's  medical  laser  products  are in various  stages of
development;  the success of future  operations  is hence subject to a number of
risks  similar to those of other  companies  in similar  stages of  development.
Principal among these risks are the successful  development and marketing of the
Company's  products,   obtaining  regulatory  approval,  the  need  to  maintain
profitable   operations,   competition  from  substitute   products  and  larger
companies,  the need to obtain adequate  financing to fund future operations and
dependence on key individuals. The Company is currently in negotiations with its
distributor,  Coherent,  Inc. ("Coherent"),  regarding the sale of the Company's
Star Medical  Technologies,  Inc. ("Star")  subsidiary,  which  manufactures the
Company's LightSheer(TM) diode laser hair removal and leg vein treatment system.
(See Item 2.  "Management's  Discussion and Analysis of Financial  Condition and
Results of Operations.") If this subsidiary is sold, the successful introduction
and  marketing  of new  products  will  become more  critical  to the  Company's
long-term success.

     The Company has incurred  significant  losses since inception.  The Company
has  historically  financed  current  operations  and  expansion of its business
primarily through the private sale of debt and equity securities of the Company.
The Company may require additional  financing throughout the year to continue to
fund operations, working capital and growth. The Company may, from time to time,
be required to raise funds  through  additional  private  sales of the Company's
debt or equity securities. Securities are sold to private investors at market or
a  discount  to the  public  market  for  similar  securities.  It has  been the
Company's  experience that private  investors  require that the Company make its
best effort to register its  securities  for resale to the public at some future
time.

2.   INVENTORIES

     Inventories  are stated at lower of cost  (first-in,  first-out) or market.
Work in process and finished goods  inventories  consist of material,  labor and
manufacturing overhead and consist of the following:

                                              December 31,       September 30,
                                                 1997                1998

                                            ----------------    ----------------
  Raw materials                                $2,928,350          $1,320,712
  Work-in-process and finished goods            1,783,124           2,796,714
                                            ----------------    ----------------
                                               $4,711,474          $4,117,425
                                            ================    ================


                                       7
<PAGE>



3.   PROPERTY AND EQUIPMENT

     Property and equipment consist of the following:

<TABLE>
<S>                         <C>                                    <C>                 <C>
                                                                     December 31,       September 30,
                                                                        1997                1998

                                                                   ----------------    ---------------
                            Machinery and equipment                     $6,328,442         $6,070,637
                            Furniture and fixtures                       1,018,931          1,001,155
                            Leasehold improvements                         480,453            445,613
                                                                   ----------------    ---------------
                                                                         7,827,826          7,517,405
                            Less:  Accumulated depreciation

                                       and amortization                  1,372,240          3,999,689
                                                                   ----------------    ---------------
                                                                        $6,455,586         $3,517,716
                                                                   ================    ===============
</TABLE>

4.   NET LOSS PER COMMON SHARE

     In March 1997, the Financial  Accounting Standards Board (FASB) issued SFAS
No. 128, EARNINGS PER SHARE. This statement  establishes standards for computing
and presenting  earnings per share and applies to entities with publicly  traded
common stock or potential  common stock.  This statement is effective for fiscal
years ending after December 15, 1997. Basic net loss per share was determined by
dividing net income by the weighted  average shares of common stock  outstanding
during the period.  Diluted net loss per share is the same as basic net loss per
share because the Company's  potentially  dilutive  securities,  primarily stock
options,  warrants,  redeemable preferred stock and convertible debentures,  are
antidilutive.

     The Company's net loss per common share from continuing  operations for the
three and nine months ended September 30, 1997 and 1998 is as follows:

<TABLE>
<S>                                          <C>               <C>             <C>               <C>


                                                   Three Months Ended                 Nine Months Ended
                                                      September 30,                     September 30,
                                                  1997              1998            1997              1998
                                             ----------------  --------------  ----------------  ---------------
Net (loss) income from continuing

operations                                     $(22,039,259)       $539,883      $(43,521,015)    $(10,267,252)
Amortization of value ascribed to
       preferred stock conversion discount         (941,176)             --        (1,882,352)         --
Preferred stock dividends                          (500,754)       (195,000)       (1,227,978)      (1,341,435)
                                             ----------------  --------------  ----------------  ---------------
Adjusted net (loss) income                     $(23,418,189)       $344,883      $(46,631,345)    $(11,608,687)
                                             ================  ==============  ================  ===============

Basic and diluted net (loss) income
       per common share from
       continuing operations                         $(0.68)           $0.01           $(1.43)          $(0.19)
                                             ================  ==============  ================  ===============

Weighted average number of
    common shares outstanding                     34,498,657      67,248,694        32,758,019       60,880,311
                                             ================  ==============  ================  ===============
</TABLE>


     As of  September  30, 1997 and 1998,  22,833,270  and  29,394,921  weighted
average common equivalent shares, respectively, were not included in the diluted
weighted average shares outstanding as they were antidilutive.


                                       8
<PAGE>


5.   NOTES PAYABLE

     Notes payable consist of the following:
<TABLE>
<S>                                                                                        <C>              <C>

                                                                                            December 31,    September 30,
                                                                                                1997             1998

                                                                                           ---------------- ---------------
Convertible debentures                                                                        $10,683,440      $2,500,000
Note payable issued in connection with guaranty on behalf of discontinued subsidiary            3,233,000       2,290,042
Short-term notes payable to Coherent, Inc.                                                            ---       4,000,000
Advance from Coherent, Inc.                                                                           ---         148,986
Other notes payable                                                                               169,588             ---
                                                                                           ---------------- ---------------
                                                                                               14,086,028       8,939,028
Less - current maturities                                                                      (1,640,465)     (5,765,486)
                                                                                           ---------------- ---------------
                                                                                              $12,445,563      $3,173,542
                                                                                           ================ ===============
</TABLE>

(a)  Convertible Debentures

     During the first  quarter of 1998,  the Company  converted:  the  remaining
$100,000 of its 4.5% convertible  debentures due October 21, 1999, 2000 and 2001
into 60,809 shares of the Company's  common stock;  the remaining  $3,084,344 of
its 5% convertible  debentures due December 31, 2001, January 13, 2002 and March
10, 2002 into 3,646,092  shares of the Company's  common stock;  and $160,000 of
its 6%, 7% and 8%  convertible  debentures  due  September 30, 2002 into 103,021
shares of the Company's  common stock.  Accrued interest  totaling  $158,685 was
included in the above  conversions.  The Company  amortized  deferred  financing
costs  totaling  $245,878  to  additional   paid-in  capital  related  to  these
conversions.

     During the second quarter of 1998, the Company converted  $2,840,000 of 6%,
7% and 8% convertible debentures due September 30, 2002 into 2,702,519 shares of
the Company's common stock.  Accrued interest  totaling $107,999 was included in
the above  conversions.  The Company amortized deferred financing costs totaling
$128,156 to additional paid-in capital related to this conversion.

     During  the  first  quarter  of  1998,  the  Company  redeemed  $2,000,000,
including  interest and premium,  of 6%, 7% and 8%  convertible  debentures  due
September 30, 2002 for $2,196,667.  Deferred financing cost totaling $95,000 was
charged to interest expense upon this redemption.

(b)  Short-term Notes Payable

     On  May  22  and  June  22,  1998,  the  Company  borrowed  $3,000,000  and
$1,000,000,  respectively,  from the Company's worldwide distributor,  Coherent.
These notes accrue  interest at 8.5% per annum.  The notes are secured by all of
the inventory owned by the Company's Star subsidiary.

     Under the terms of the Loan Agreement between Coherent and the Company, the
Company agreed to enter into good faith negotiations with Coherent regarding the
sale of Star for a price of no less than $42 million, on terms to be agreed upon
between the Company and Coherent. The negotiations are ongoing, and Coherent and
the Company have  announced  that, if the parties are able to reach a definitive
agreement,  the sale price for Star is expected to be in the range of $60 to $65
million,  payable in cash. However, at this time, the parties have not agreed to
all of the terms of the  transaction.  Because a number  of  significant  issues
regarding  the  terms of the  transaction  remain  unresolved,  there  can be no
assurance that the parties will reach agreement.  Due to the uncertain nature of
transaction  negotiations,  the likelihood  that an agreement will be reached is
indeterminable.  If an agreement  is reached,  consummation  of the  transaction
would be subject to the  approval of the  stockholders  of  Palomar,  as well as
certain regulatory approvals and other standard closing conditions. In the event
that the parties are unable to agree on the terms and conditions for the sale of
Star,  the  $4,000,000 of funds borrowed by the Company from Coherent are due 90
days from the termination of negotiations regarding the proposed sale.


                                       9
<PAGE>
(c)  Advance From Coherent

     Coherent  advanced  funds to the Company  during  1998.  The  advances  are
secured by specific accounts receivable  outstanding at the time of the advance.
Payments against this advance are made as Coherent collects receivables from the
end users of the Company's products.

(d)  Revolving Line Of Credit

     On September 23, 1998 the Company received a commitment  letter from a bank
for a $10,000,000  revolving line of credit.  This line of credit will mature on
March  31,  2000 and will bear  interest  at the  bank's  prime  rate  (8.50% at
September 30, 1998). Borrowings under this line of credit will be limited to 80%
of  domestic  accounts  receivable,  as  defined.  A director of the Company has
personally guaranteed borrowings under this line of credit.

6.   STOCKHOLDERS' DEFICIT

(a)  Issuance Of Common Stock

     During 1998 the Company sold  10,200,000  shares of common stock to a group
of investors for $10,200,000.  In addition, the Company issued callable warrants
to the  investors to purchase  10,200,000  shares of common stock at an exercise
price of $3.00 per share.  The  callable  warrants are not  exercisable  for the
first six months after issuance and, thereafter,  are callable by the Company if
the closing price of the Company's  common stock equals or exceeds $5.00 for ten
consecutive trading days. Under the terms of this private placement, the Company
is obligated to pay the investors a fee of 5% per annum  (payable  quarterly) of
the dollar value  invested in the Company as long as the  investors  continue to
hold their common stock in their name.  Through  September 30, 1998, the Company
has paid  $190,000  related to this fee.  The Company  paid a 5%  commission  of
$360,000  related to this  issuance  which has been netted  against the proceeds
through a reduction in additional paid-in capital.

(b)  Convertible Preferred Stock

     During  the first  quarter of 1998,  the  Company  converted  268 shares of
Series G Preferred  Stock and accrued  dividends  and  interest of $30,255  into
283,507 shares of the Company's common stock.  Also, during the first quarter of
1998,  the Company  converted  3,840 shares of its Series H Preferred  Stock and
accrued  dividends of $359,807 into  4,103,650  shares of the  Company's  common
stock.

     During the first  quarter of 1998,  the Company  redeemed  2,200  shares of
Series H Preferred  Stock including  related accrued  dividends and premiums for
$2,673,850.

     During the second  quarter of 1998,  the  Company  converted  536 shares of
Series G Preferred  Stock and accrued  dividends  and  interest of $66,485  into
616,378 shares of the Company's common stock. During the second quarter of 1998,
the  Company  converted  84  shares  of Series H  Preferred  Stock  and  accrued
dividends of $24,112 into 85,000 shares of the Company's common stock.

     During  the second  quarter of 1998,  the  Company  redeemed  866 shares of
Series H Preferred  Stock including  related accrued  dividends and premiums for
$1,118,039.  During the second quarter of 1998, the Company  converted 84 shares
of Series H Preferred Stock and accrued  dividends of $24,112 into 85,000 shares
of the Company's common stock.

     During  the third  quarter of 1998,  the  Company  converted  804 shares of
Series G Preferred  Stock and accrued  dividends  and interest of $117,451  into
1,181,410 shares of the Company's common stock.

     During the third quarter of 1998, the Company redeemed 250 shares of Series
H Preferred Stock including related accrued dividends and premiums for $328,784.


                                       10
<PAGE>

(c)  Options To Purchase Common Stock

     During the nine months  ended  September  30, 1998,  the Company  cancelled
options to purchase  2,892,400  shares of the Company's common stock at exercise
prices ranging from $1.50 to $8.00 per share.  In addition,  the Company granted
2,234,900  options at above market prices.  No options were exercised during the
nine months ended September 30, 1998.

(d)  Warrants To Purchase Common Stock

     During the nine months  ended  September  30, 1998,  the Company  cancelled
warrants to purchase  2,508,452 shares of the Company's common stock at exercise
prices  ranging  from $2.25 to $6.75 per share and issued  warrants  to purchase
12,385,000  shares of the Company's common stock at exercise prices ranging from
$.01 to $3.25 per share.  During the nine months  ended  September  30,  1998, a
warrant for 125,000 shares was exercised for $1,250. This warrant was held by an
investor.

(e)  Reserved Shares

     As of  September  30, 1998,  the Company had reserved  shares of its common
stock for the following:

                                                                  September 30,
                                                                      1998
                                                                 ---------------
             Convertible debentures                                   3,739,915
             Stock option plans                                       6,707,655
             Warrants                                                19,749,578
             Employee 401(k) plan                                       554,787
             Employee stock purchase plan                               439,272
             Convertible preferred stock                              3,950,631
             Common stock reserved in
               connection with guarantee of note
               payable on behalf of discontinued
               subsidiary                                             3,250,000
                                                                 ===============
                                   Total                             38,391,838
                                                                 ===============

7.   Discontinued Operations

     During  the  fourth  quarter  of 1997,  the  Company's  Board of  Directors
approved a plan to dispose of the Company's electronics business segment. During
the second quarter of 1998,  the Company sold all of the issued and  outstanding
common stock of its wholly owned  subsidiary  Dynaco  Corp.  ("Dynaco")  for net
proceeds of  approximately  $2,381,000.  Due to the delay in the sale of Dynaco,
the Company  recognized a loss from  discontinued  operations  of  approximately
$1,091,000  for the nine months ended  September 30, 1998.  This  represents the
amount in excess of the losses  accrued for at December  31, 1997 related to the
operations of Dynaco  through the date of  disposition.  The Company  recorded a
charge to discontinued  operations of $1,525,000 due to management's decision to
write down the carrying  value of its  investment  in Nexar  Technologies,  Inc.
("Nexar")  during the nine months ended September 30, 1998. For the three months
ended September 30, 1998 there was no effect from discontinued operations.

     Pursuant to Accounting  Principles  Board ("APB") Opinion No. 30, REPORTING
THE RESULTS OF  OPERATIONS - REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A
BUSINESS  AND  EXTRAORDINARY,  UNUSUAL  AND  INFREQUENTLY  OCCURRING  EVENTS AND
TRANSACTIONS,  the  consolidated  financial  statements of the Company have been
reclassified to reflect the disposition of the electronics segment. Accordingly,
the  assets  and  liabilities,  revenues  and  expenses,  and cash  flows of the
electronics  segment  have been  excluded  from the  respective  captions in the
Consolidated Condensed Balance Sheets, Consolidated Statements of Operations and
Consolidated  Statements of Cash Flows.  The net assets /  liabilities  of these
entities  have  been  reported  as "Net  Assets /  Liabilities  of  Discontinued
Operations" in the accompanying  Consolidated  Condensed Balance Sheets; the net
operating  losses  of these  entities  have  been  reported  as "Net  Loss  from
Discontinued   Operations"  in  the  accompanying   Consolidated  Statements  of
Operations; the net cash flows of these entities have been reported as "Net Cash
(Used In) Provided by Discontinued Operations" in the accompanying  Consolidated
Statements of Cash Flows.

                                       11
<PAGE>

     Summarized  financial  information for the discontinued  operations were as
follows:

<TABLE>
<S>  <C>                                    <C>                   <C>                <C>                  <C>

                                              Three Months Ended September 30,             Nine Months Ended September 30,
                                                  1997                 1998               1997                    1998

                                            ------------------    ----------------   ----------------     ----------------------
     Revenues                                    $12,460,000            --              $47,507,978                 $5,745,750
     Net Loss from Discontinued
            Operations                          $(14,950,310)           --             $(23,646,687)               $(2,624,180)
</TABLE>

8.   RESTRUCTURING

     In the third quarter of 1997, the Company recognized a restructuring charge
of  $2,700,000  based on the decision to  discontinue  and/or  downsize  certain
medical product and service business units and consolidate  others. The majority
of these amounts related to severance  benefits.  All expenses  accounted for as
restructuring charges were in accordance with the criteria set forth in Emerging
Task Force Issue 94-3,  LIABILITY  RECOGNITION FOR CERTAIN EMPLOYEE  TERMINATION
BENEFITS AND OTHER COSTS TO EXIT AN ACTIVITY  (INCLUDING  CERTAIN COSTS INCURRED
IN A  RESTRUCTURING),  and are exclusive of the charges  related to discontinued
operations.  During the nine months ended  September 30, 1998,  the Company paid
out approximately $1,365,000 of severance,  leaving a restructuring liability of
approximately  $617,000 at September  30,  1998.  This  remaining  restructuring
liability is  principally  associated  with  severance  and equipment due to the
Company's former Medical Director.

                     [This space intentionally left blank.]


                                       12
<PAGE>

ITEM 2. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

REVENUE AND GROSS MARGIN:  THREE MONTHS ENDED  SEPTEMBER  30, 1998,  COMPARED TO
THREE MONTHS ENDED SEPTEMBER 30, 1997

     For the three months ended  September 30, 1998, the Company had revenues of
$13.8  million as compared to $5.8 million for the three months ended  September
30, 1997. The increase in the Company's revenue of $8.0 million or 136% from the
quarter ended  September  30, 1997 was mainly due to additional  sales volume of
$13.0 million associated with the introduction of the LightSheer(TM) diode laser
hair removal and leg vein treatment  system  combined with a decrease in revenue
of  approximately  $5.0 million in other cosmetic  product  revenue  principally
related to the Company's EpiLaser(R) ruby laser hair removal system. The Company
obtained  FDA  clearance  to market and sell its  LightSheer(TM)  laser for hair
removal  and leg vein  treatment  in the United  States at the end of 1997.  The
decrease in sales volume associated with the Company's EpiLaser(R) laser was due
to the  Company's  focus on bringing  the  LightSheer(TM)  laser to market while
developing  a new  generation  of ruby hair removal  laser.  Using its core ruby
laser technology,  originally developed for tattoo and pigmented lesion removal,
Palomar  developed its long pulse  EpiLaser(R)  ruby laser that is  specifically
configured to allow the appropriate wavelength,  energy level and pulse duration
to be absorbed  effectively  by the hair follicle  without being absorbed by the
surrounding  tissue.  That,  combined with Company's patented cooling handpiece,
allows safe and effective hair removal. Palomar's new generation long pulse ruby
laser is expected both to permit more rapid treatment of large areas of the body
such as the back,  chest,  abdomen,  legs and arms and to be  manufactured  at a
higher gross margin than the Company's current  EpiLaser(R)  laser. In July 1998
the Company  obtained FDA clearance to market and sell its EpiLaser(R)  laser in
the United States for "permanent hair reduction."

     The  Company  is in  negotiations  with  its  distributor,  Coherent,  Inc.
("Coherent") regarding the sale of the Company's Star Medical Technologies, Inc.
("Star") subsidiary.  This subsidiary manufactures the Company's  LightSheer(TM)
diode laser. The parties have announced that, if the transaction is consummated,
the sale price for Star is  expected  to be in the range of $60 to $65  million,
payable in cash.  However,  at this time,  the parties have not agreed to all of
the terms of the transaction.  Because a number of significant  issues regarding
the terms of the transaction remain  unresolved,  there can be no assurance that
the parties will reach  agreement.  Due to the uncertain  nature of  transaction
negotiations,   the   likelihood   that  an   agreement   will  be   reached  is
indeterminable.  If an agreement  is reached,  consummation  of the  transaction
would be subject to the  approval of the  stockholders  of  Palomar,  as well as
certain  regulatory  approvals and other  standard  closing  conditions.  If the
transaction is consummated, revenue would decline significantly in the near term
and the successful  introduction  and marketing of new products will become more
critical to the Company's long-term success.

     Gross  margin  for  the  three  months   ended   September   30,  1998  was
approximately  $8.1 million (59% of revenues)  versus $918,000 (16% of revenues)
for the three months  ended  September  30,  1997.  The increase in gross margin
dollars  and gross  margin  percentage  was  caused by the  introduction  of the
LightSheer(TM)  laser.  This new laser system has a  significantly  higher gross
margin than the Company's EpiLaser(R) laser.

OPERATING AND OTHER EXPENSES: THREE MONTHS ENDED SEPTEMBER 30, 1998, COMPARED TO
THREE MONTHS ENDED SEPTEMBER 30, 1997

     Research and development costs were $1.5 million for the three months ended
September  30, 1998 and $2.9 million for the three months  ended  September  30,
1997. Research and development  expenses as a percent of revenue totaled 11% for
the three  months  ended  September  30, 1998 and 50% for the three months ended
September  30,  1997.  The decline in spending  is  primarily  the result of the
Company receiving FDA clearance for the LightSheer(TM) diode laser system at the
end of 1997.  The continued  spending on research and  development  reflects the
Company's  commitment  to  research  and  development  for  medical  devices and
delivery systems for cosmetic laser applications and other medical  applications
using a variety of lasers,  while continuing  dermatology research utilizing the
Company's ruby and diode lasers.  Among the Company's  research and  development
goals in hair removal is to design systems  permitting  more rapid  treatment of
large areas, and to produce systems with high gross margins. Management believes
that research and  development  expenditures  will remain constant over the next
year as the  Company  continues  product  development  and  clinical  trials for
additional  applications for its lasers and delivery systems in the cosmetic and
dermatological markets.

                                       13
<PAGE>

     Selling and marketing  expenses increased to $4.4 million (32% of revenues)
for the three months ended September 30, 1998, from  approximately  $1.7 million
(29% of revenues) for the three months ended September 30, 1997. The increase in
selling and marketing  expenses is attributable to the costs associated with the
Company's  exclusive  distribution  arrangement  with Coherent which increase in
direct proportion to sales volume.

     General and  administrative  expenses  decreased  to $1.8  million  (13% of
revenues)  for the three  months  ended  September  30,  1998,  compared to $3.6
million (62% of revenues) for the three months ended  September  30, 1997.  This
decrease  is  attributable  to  the  Company's   successful   restructuring  and
consolidation  of  administrative  functions in the third and fourth quarters of
1997.  In previous  years,  the Company  focused  management  time and allocated
resources to  developing  businesses  outside of the medical and cosmetic  laser
industry and  financing  those  businesses.  Beginning in the fourth  quarter of
1997,  the  Company  focused  its  efforts  on its core  business.  The  Company
anticipates general and administrative  expense will continue to decrease in the
future as the benefits of the third and fourth  quarter 1997  restructuring  are
realized.

     Restructuring and asset write-off costs were approximately $3.3 million for
the three months ended  September 30, 1997. This  non-recurring  charge reflects
the write-off costs for certain  operating assets that the Company believes were
not fully  realizable.  Included  in this charge is a $2.7  million  reserve for
severance  costs  associated  with   consolidating  the  selling,   general  and
administrative functions, including the closing of certain facilities.

     Asset  write-off  costs of $9.7 million  were  incurred in the three months
ended  September 30, 1997.  This one time charge  reflects asset write-off costs
for notes and investments whose value had been permanently impaired.

     Interest expense decreased to $184,000 for the three months ended September
30, 1998,  from $728,000 for the three months ended September 30, 1997. This 75%
decrease  is  primarily  the  result  of a  decrease  in  convertible  debenture
financings  and the Company's  increased use of  conventional  financing.  Also,
operations did not require as much financing in 1998 as compared to 1997.

     Other (expense) income was income of  approximately  $396,000 for the three
months  ended  September  30,  1998.  This amount was  principally  related to a
realized net gain from the Company's  trading  securities.  The Company incurred
other expenses of  approximately  $375,000 for the three months ended  September
30,1997.  This amount  reflects  unrealized  losses from the  Company's  trading
securities.

     The Company had no loss from  discontinued  operations for the three months
ended September 30, 1998 due to the fact that it has substantially completed the
divestiture of its  discontinued  operations in the second quarter of 1998. This
compares to losses of $15 million  from  discontinued  operations  for the three
months ended September 30, 1997. (See Note 7 of Notes to Consolidated  Financial
Statements.)

REVENUE AND GROSS MARGIN: NINE MONTHS ENDED SEPTEMBER 30, 1998, COMPARED TO NINE
MONTHS ENDED SEPTEMBER 30, 1997

     For the nine months ended  September 30, 1998,  the Company had revenues of
$30 million as compared to $15.7 million for the nine months ended September 30,
1997.  The increase in the  Company's  revenue of $14.3  million or 91% from the
nine months ended  September 30, 1997 was mainly due to additional  sales volume
of $22 million  associated  with the  introduction of the  LightSheer(TM)  diode
laser combined with a decrease in revenue of approximately $7.7 million in other
cosmetic product revenue.  The Company obtained FDA clearance to market and sell
its  LightSheer(TM)  laser for hair removal and leg vein treatment in the United
States at the end of 1997.  The  decrease in sales  volume  associated  with the
Company's  EpiLaser(R) ruby laser was due to the Company's focus on bringing the
LightSheer(TM) laser to market while further developing a new generation of ruby
hair removal laser. Using its core ruby laser technology,  originally  developed
for  tattoo and  pigmented  lesion  removal,  Palomar  developed  its long pulse
EpiLaser(R) ruby laser that is specifically  configured to allow the appropriate
wavelength,  energy level and pulse  duration to be absorbed  effectively by the
hair follicle without being absorbed by the surrounding  tissue.  That, combined
with  Company's  patented  cooling  handpiece,  allows safe and  effective  hair
removal.  Palomar's  new  generation  long pulse ruby laser is expected  both to
permit more rapid treatment of large areas of the body such as the back,  chest,
abdomen,  legs and arms and to be manufactured at a higher gross margin than the
Company's  current  EpiLaser(R)  laser.  In July 1998 the Company  obtained  FDA
clearance  to market and sell its  EpiLaser(R)  laser in the  United  States for
"permanent hair reduction."

                                       14
<PAGE>

     The Company is in  negotiations  with  Coherent  regarding  the sale of the
Company's Star subsidiary, which manufactures the Company's LightSheer(TM) diode
laser.  The parties have announced that, if the transaction is consummated,  the
sale  price  for Star is  expected  to be in the  range  of $60 to $65  million,
payable in cash.  However,  at this time,  the parties have not agreed to all of
the terms of the transaction.  Because a number of significant  issues regarding
the terms of the transaction remain  unresolved,  there can be no assurance that
the parties will reach  agreement.  Due to the uncertain  nature of  transaction
negotiations,   the   likelihood   that  an   agreement   will  be   reached  is

     indeterminable. If an agreement is reached, consummation of the transaction
would be subject to the  approval of the  stockholders  of  Palomar,  as well as
certain  regulatory  approvals and other  standard  closing  conditions.  If the
transaction is consummated, revenue would decline significantly in the near term
and the successful  introduction  and marketing of new products will become more
critical to the Company's long-term success.

     Gross margin for the nine months ended September 30, 1998 was approximately
$13.1  million  (44% of revenues)  versus $1.3 million (8% of revenues)  for the
nine months ended  September  30,  1997.  The increase in gross margin and gross
margin  percentage was caused by the  introduction of the  LightSheer(TM)  diode
laser system. This new laser system has a significantly higher gross margin than
the Company's EpiLaser(R) laser.

OPERATING AND OTHER EXPENSES:  NINE MONTHS ENDED SEPTEMBER 30, 1998, COMPARED TO
NINE MONTHS ENDED SEPTEMBER 30, 1997

     Research and development  costs were $5.7 million for the nine months ended
September  30, 1998 and $7.8  million  for  September  30,  1997.  Research  and
development  expenses  as a percent of revenue  totaled  19% for the nine months
ended  September 30, 1998 and 50% for the nine months ended  September 30, 1997.
The decline in spending is  primarily  the result of the Company  receiving  FDA
approval for the LightSheer(TM) laser at the end of 1997. The continued spending
on research and  development  reflects the Company's  commitment to research and
development  for  medical  devices  and  delivery  systems  for  cosmetic  laser
applications  and other medical  applications  using a variety of lasers,  while
continuing  dermatology  research utilizing the Company's ruby and diode lasers.
Among the Company's  research and development goals in hair removal is to design
systems  permitting more rapid treatment of large areas,  and to produce systems
with high gross  margins.  Management  believes  that  research and  development
expenditures  will remain  constant over the next year as the Company  continues
product  development  and clinical  trials for additional  applications  for its
lasers and delivery systems in the cosmetic and dermatological markets.

     Selling and marketing expenses increased to $10.5 million (35% of revenues)
for the nine months ended  September 30, 1998, from  approximately  $4.3 million
(27% of revenues) for the nine months ended  September 30, 1997. The increase in
selling and marketing  expenses is attributable to the costs associated with the
Company's   distribution  agreement  with  Coherent  which  increase  in  direct
proportion to sales volume.

     General and  administrative  expenses  decreased  to $7.0  million  (23% of
revenues)  for the nine months ended  September  30, 1998,  as compared to $13.3
million (85% of revenues)  for the nine months ended  September  30, 1997.  This
decrease  is  attributable  to  the  Company's   successful   restructuring  and
consolidation  of  administrative  functions in the third and fourth quarters of
1997.  In previous  years,  the Company  used  management's  time and  allocated
resources to  developing  businesses  outside of the medical and cosmetic  laser
industry and financing the non-core businesses.  Beginning in the fourth quarter
of 1997,  the  Company  focused its  efforts on its core  business.  The Company
anticipates general and administrative  expense will continue to decrease in the
future as the benefits of the third and fourth  quarter 1997  restructuring  are
realized.

     For the nine months ended  September  30,  1998,  the Company did not incur
settlement expenses.  Settlement costs of $3.2 million were incurred in the nine
months ended  September  30, 1997.  These  charges  consisted  mainly of a legal
accrual related to a legal settlement with an investment bank.

     Restructuring and asset write-off costs were approximately $3.3 million for
the nine months ended September 30, 1997. This non-recurring charge reflects the
write-off costs for certain  operating assets that the Company believes were not
fully  realizable.  Included  in  this  charge  is a $2.7  million  reserve  for
severance  coasts  associated  with  consolidating  the  selling,   general  and
administrative functions, including the closing of certain facilities.

                                       15
<PAGE>

     Interest  expense  decreased  to $1.0  million  for the nine  months  ended
September  30, 1998,  from $3.3 million for the nine months ended  September 30,
1997.  This 69%  decrease is primarily  the result of a decrease in  convertible
debenture financings and the Company's increased use of conventional  financing.
Also, operations did not require as much financing in 1998 as compared to 1997.

     Asset  write-off  costs of $9.7  million  were  incurred in the nine months
ended  September 30, 1997.  This  non-recurring  charge reflects asset write-off
costs for notes and investments whose value had been permanently impaired.

     The loss from  discontinued  operations for the nine months ended September
30,  1998 was $2.6  million  compared  to a loss of $23.6  million  for the nine
months ended September 30, 1997. The loss from  discontinued  operations in 1998
was due to a delay in the disposition of Dynaco resulting in operating  expenses
of approximately $1.1 million above the estimated operating expenses accrued for
at December 31, 1997. A loss on  disposition  of  discontinued  entities for the
nine months ended September 30, 1998 of $1.5 million was incurred.  The majority
of this charge relates to management's  decision to write-off the carrying value
of its investment in Nexar.

     Other (expense)  income was  approximately  $751,000 of income for the nine
months ended  September  30, 1998.  This amount  primarily  consists of realized
gains on the Company's trading securities.

Liquidity And Capital Resources

     As of  September  30,  1998,  the  Company had $2.7  million in cash,  cash
equivalents and trading  securities.  During the nine months ended September 30,
1998 the Company  generated  $9.9 million and $3.1 million in net proceeds  from
the issuance of common stock and  short-term  notes payable,  respectively.  The
Company's  net cash  used in  operating  activities  for the nine  months  ended
September 30, 1998 was approximately $9.4 million.

     The  Company's  net loss for the  nine  months  ended  September  30,  1998
included  approximately  $2.2 million of non-cash  depreciation and amortization
expense.

     The Company  anticipates that capital  expenditures for the remaining three
months of 1998 will total approximately $250,000. The Company will finance these
expenditures  with cash on hand,  the line of bank credit and equipment  leasing
lines.  However,  there can be no  assurance  that the  Company  will be able to
obtain the necessary financing.

     On September 23, 1998, the Company received a commitment letter from a bank
for a $10,000,000  revolving line of credit.  This line of credit will mature on
March 31, 2000 will bear  interest at the bank's  prime rate (8.00% at September
30,  1998).  Borrowings  under  this line of credit  will be  limited  to 80% of
domestic  accounts  receivable,  as  defined.  A  director  of the  Company  has
personally guaranteed borrowings under this line of credit.

     The  Company  has also  considered  and  expects to  continue  to  consider
intellectual  property licensing  agreements,  the sale of intellectual property
rights  that the  Company  does not  intend to  exploit,  the sale of  operating
subsidiaries,  and  mergers,  acquisitions,  or other  transactions  to  provide
additional financing to fund future products and research and development.

     The Company is in  negotiations  with  Coherent  regarding  the sale of the
Company's Star subsidiary, which manufactures the Company's LightSheer(TM) diode
laser  system.   The  parties  have  announced   that,  if  the  transaction  is
consummated,  the sale price for Star is  expected  to be in the range of $60 to
$65 million, payable in cash. However, at this time, the parties have not agreed
to all of the terms of the transaction.  Because a number of significant  issues
regarding  the  terms of the  transaction  remain  unresolved,  there  can be no
assurance that the parties will reach agreement.  Due to the uncertain nature of
transaction  negotiations,  the likelihood  that an agreement will be reached is
indeterminable.  If an agreement  is reached,  consummation  of the  transaction
would be subject to the  approval of the  stockholders  of  Palomar,  as well as
certain regulatory approvals and other standard closing conditions.

     The  Company's   strategic  plan  is  to  continue  to  fund  research  and
development  for its medical and  cosmetic  laser  products.  This  research and
development  effort entails extensive  clinical trials.  These activities are an
important  part of the Company's  business  plan.  Due to the nature of clinical
trials and research and  development  activities,  it is not possible to predict

                                       16
<PAGE>

with any certainty the timetable for completion of these research  activities or
the total amount of funding  required to commercialize  products  developed as a
result of such research and development.  The rate of research and the number of
research  projects  underway are dependent to some extent upon external funding.
While the Company is regularly  reviewing  potential funding sources in relation
to these ongoing and proposed research projects,  there can be no assurance that
the current  levels of funding or additional  funding will be available,  or, if
available, on terms satisfactory to the Company.

     In connection with the  disposition of Comtel,  Inc.  ("Comtel"),  a former
wholly-owned  subsidiary  in the  electronics  segment,  the Company  guaranteed
$2,500,000  of a $3,300,000  line of credit  extended by a loan  association  to
Biometric  Technologies Corp. ("BTC"),  the buyer of Comtel. The stockholders of
BTC have personally  guaranteed to the Company payment for any amounts  borrowed
under this line of credit in excess of approximately $1,500,000 in the event the
Company is  obligated  to honor this  guaranty.  The amount BTC has  outstanding
under the line of credit at September 30, 1998 was approximately $2,633,000.

     The Company has historically incurred significant losses. While the Company
achieved  profitable  operations for the three months ended  September 30, 1998,
there can be no assurance  that this will continue.  Therefore,  the Company may
need to continue to secure  additional  financing  to complete  its research and
development activities,  commercialize its current and proposed medical products
and services, and fund ongoing operations. There can be no assurance that events
in the future will not require the  Company to seek  additional  financing.  The
Company continues to investigate several financing  alternatives,  including the
sale of  intellectual  property  rights  that the  Company  does not  intend  to
exploit,  the  sale  of  operating  subsidiaries,  strategic  partnerships,  and
mergers, acquisitions, or other transactions. Based on its historical ability to
raise  funds as  necessary  and ongoing  discussions  with  potential  financing
sources, the Company believes that it will be successful in obtaining additional
financing, if required, in order to fund future operations. Although the Company
believes it will be successful in obtaining additional  financing,  there can be
no assurance that any such financing will be available on terms  satisfactory to
the Company.  The report of the  Company's  independent  public  accountants  in
connection with the Company's  Consolidated  Balance Sheets at December 31, 1997
and 1996, and the related Consolidated  Statements of Operations,  Stockholders'
Equity  (Deficit)  and Cash Flows for the three  years ended  December  31, 1997
includes an explanatory  paragraph stating that the Company's  recurring losses,
working capital  deficiency and stockholders'  deficit raises  substantial doubt
about the Company's ability to continue as a going concern.

Material Uncertainties

     Year 2000 Issues
     ----------------

     During 1998, the Company has been actively  engaged in addressing Year 2000
(Y2K) issues,  which result from the use of two-digit,  rather than  four-digit,
year dates in software, a practice which could cause  date-sensitive  systems to
malfunction  or fail because they may not recognize or process date  information
correctly.  

STATE OF  READINESS:  To manage its Y2K  program,  the  Company  has divided its
efforts into four program areas:

                  *   Information  Technology (computer hardware, and software)
                  *   Physical Plant  (manufacturing  equipment and facilities)
                  *   Products   (including   product   development)   Extended
                  *   Enterprise (suppliers and customers)

     For each of these program areas, the Company is using a four-step approach:

                  *   Ownership (creating awareness, assigning tasks)
                  *   Inventory (listing items to be assessed for Y2K readiness)
                  *   Assessment (prioritizing the inventoried items, assessing
                      their  Y2K   readiness,   planning   corrective   actions,
                      developing initial contingency plans)
                  *   Corrective  Action  Deployment  (implementing  corrective
                      actions, verifying implementation, finalizing and
                      executing contingency plans)

     At September 30, 1998, the Ownership,  Inventory and Assessment  steps were
essentially  complete  for all program  areas.  The Company  expects to complete
Corrective Action Deployment by June 1999.

                                       17
<PAGE>

COSTS TO ADDRESS Y2K ISSUES: The Company's estimated aggregate costs for its Y2K
activities from 1998 through 2000 are expected to be less than $100,000. To date
the Company has spent approximately $10,000.

RISKS OF Y2K ISSUES AND CONTINGENCY  PLANS: The Company  continues to assess the
Year 2000 issues  relating to its physical  plant,  products and suppliers.  The
Company intends to develop a contingency planning process to mitigate worst-case
business disruptions such as delays in product delivery, which could potentially
result from events such as supply  chain  disruptions.  The Company  expects its
contingency plans to be complete by June 1999.

     Sale Of Star
     ------------

     Although  Palomar and Coherent have announced that they are in negotiations
regarding the sale of the Company's Star subsidiary, the parties have not agreed
to all the terms of the  transaction.  Because a number  of  significant  issues
regarding  the  terms of the  transaction  remain  unresolved,  there  can be no
assurance that the parties will reach agreement.  Due to the uncertain nature of
transaction  negotiations,  the likelihood  that an agreement will be reached is
indeterminable.  If an agreement  is reached,  consummation  of the  transaction
would be subject to the  approval of the  stockholders  of  Palomar,  as well as
certain regulatory approvals and other standard closing conditions.

     Nasdaq Stock Market Listing
     ---------------------------

     By letter  dated  October 13,  1998,  the Nasdaq  Stock  Market  ("Nasdaq")
brought to the  Company's  attention  Nasdaq's  concern  regarding the continued
listing of the Company's  common stock on the Nasdaq SmallCap  Market,  based on
the fact that the  Company's  common  stock had failed to maintain a closing bid
price  greater  or equal to $1.00 over the  previous  thirty  consecutive  trade
dates.  Nasdaq  informed the Company that it has ninety calendar days (until the
close of  business  on  January  13,  1998) in which to regain  compliance  with
Nasdaq's  $1.00 minimum bid price  requirement.  Although the  Company's  common
stock may be subject to delisting on January 13, 1998,  the Company may stay the
delisting  by  requesting  a hearing  before  such time.  If the Company has not
regained  compliance with the minimum bid price requirement by January 13, 1998,
the Company  intends to appeal a  potential  delisting  to Nasdaq's  Listing and
Hearing Review  Committee and anticipates that delisting of the Company's common
stock  may be  stayed  during  the  pendency  of such  appeal.  There  can be no
assurance, however, that the Company will be able to maintain Nasdaq listing for
the Company's  common stock  (whether as a result of failure to meet the minimum
bid price  requirement,  the  market  value  requirement  or other  requirements
imposed by Nasdaq). The Company's management anticipates that the absence of the
Nasdaq  listing for the Company's  common stock would have an adverse  effect on
the market for, and potentially the market price of, the Company's common stock.
If the Company's common stock is delisted from Nasdaq,  the Company expects that
brokers would continue to make a market in the Company's common stock on the OTC
Bulletin Board.

Factors That May Affect Future Results

     From time to time,  information  provided by the Company or statements made
by its  employees  may contain  "forward-looking"  information,  as that term is
defined in the Private  Securities  Litigation  Reform Act of 1995 (the  "Reform
Act").  This  report  may  also  contain   statements  that  are  deemed  to  be
forward-looking information under the Reform Act, including, without limitation,
statements  relating to sale of the Company's  Star  subsidiary;  products under
development;  maintenance  of Nasdaq  listing for the  Company's  common  stock;
financial  projections;  gross margin,  distribution  and product  improvements;
growing  market  demand;  additional  financings;  increases  in  revenues;  and
research and development,  selling and marketing, general and administrative and
capital expenditures. Readers are cautioned not to place undue reliance on these
forward-looking statements,  which speak only as of the date hereof. The Company
undertakes  no  obligation  to release  publicly the results of any revisions to
these  forward-looking  statements  that  may  be  made  to  reflect  events  or
circumstances   after  the  date  hereof  or  to  reflect  the   occurrence   of
unanticipated  events.  The  Company  cautions  investors  that  there can be no
assurance that actual results or business  conditions will not differ materially
from those projected or suggested in such forward-looking statements as a result
of various factors,  including but not limited to the risk factors identified in
the Company's  Annual Report on Form 10-K for the year ended  December 31, 1997,
which  cautionary  statements  are made pursuant to the provisions of the Reform
Act and with the intention of obtaining  the benefits of safe harbor  provisions
of the Reform Act.

                                       18
<PAGE>

                           PART II - OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

     On March 7, 1997, Selvac Acquisition Corp. ("Selvac"), a subsidiary of Mehl
Biophile International,  Inc. ("Mehl"),  filed a complaint for injunctive relief
and damages for patent  infringement  and for unfair  competition  in the United
States District Court for the District of New Jersey against the Company, two of
its subsidiaries and a New Jersey dermatologist. Selvac's complaint alleged that
the  Company's  EpiLaser(R)  ruby laser hair removal  system  infringed a patent
licensed to Selvac (the "Selvac Patent") and that the Company unfairly  competed
by promoting  the  EpiLaser(R)  ruby laser hair removal  system for hair removal
before it had received FDA approval for that  specific  application.  On May 18,
1998 the court granted the Company's  motion for partial summary judgment on the
ground that the Selvac patent is invalid  because prior art  anticipated it. The
court has since  denied  Selvac's  motion  for  reconsideration  of the  summary
judgment  ruling.  On September 25, 1998, the court denied  Selvac's  motion for
reconsideration  of its  prior  order  dismissing  so  much of  Selvac's  unfair
competition  claim as relied on interpreting the Food, Drug and Cosmetics Act or
FDA  regulations,  and  dismissed  without  prejudice the state law remainder of
Selvac's unfair  competition claim. On October 26, 1998, Selvac filed its notice
of appeal to the Court of Appeals for the Federal Circuit.

     On October 16, 1997, the Company  brought a declaratory  judgment action in
United  States  District  Court for the  District of  Massachusetts  against the
holders and the indenture trustee of the Company's 4.5% Subordinated Convertible
Debentures due 2003, denominated in Swiss francs (the "Swiss Franc Debentures").
The  defendants  in this  action are  Banque SCS  Alliance  SA,  Arbuthnot  Fund
Managers,  Ltd.,  Banca  Commerciale  Lugano,  Privatinvest  Bank AG (these four
defendants  being  referred to  collectively  as the "Asserting  Holders"),  CUF
Finance S.A., Fibi Bank (Schweiz) AG, Teawood Nominees, Ltd., JS Gadd & CIE, SA,
Swedbank  (Luxembourg)  SA,  Christiana Bank Luxembourg SA, (now known as Credit
Agricole Indosuez),  Landatina Financiera SA and American Stock Transfer & Trust
Co., as trustee ("Trustee").  Just prior to this suit, the Asserting Holders had
alleged that the Company is in breach of certain protective  covenants under the
indenture.  The Company  believes that it is not in default under any protective
covenants,  and the Company's  action seeks a declaration from the Court to that
effect.  All payments on the Swiss Franc  Debentures were current to the time of
suit. On October 22, 1997, the Asserting Holders sued the Company and all of its
principal  subsidiaries  in the same court;  the October  16th and October  22nd
cases  have  been  assigned  to the same  judge,  and the  dispute  between  the
Asserting Holders and the Company is proceeding under the October 22nd case. The
Asserting  Holders  claim  that the  Company  has  breached  certain  protective
indenture  covenants  and that the  Asserting  Holders are entitled to immediate
payment of their indebtedness under the Swiss Franc Debentures (which amounts to
about  US$5,000,000 at recent exchange rates).  As of November 13, 1997,  acting
under applicable  provisions of the indenture,  the Company notified the holders
of the Swiss Franc  Debentures  that it is causing the  conversion of all of the
Swiss Franc  Debentures  into an  aggregate of 914,028  shares of the  Company's
common stock.  Palomar filed a motion for summary  judgment,  asserting that its
conversion of the  debentures  into Palomar common stock deprives the plaintiffs
of standing to bring a claim. That motion has been denied without prejudice, and
the court also denied the  plaintiffs'  motion for summary  judgment.  By mutual
agreement,  the  Asserting  Holders and the Company  requested  that the case be
removed from the Court's October 1998 trial calendar. The parties have discussed
ways to  resolve  their  dispute,  but  there can be no  assurance  that all the
debentureholders,  including the Asserting Holders,  and Palomar will complete a
proposed settlement.  If the case is returned to the trial calendar, the Company
expects  vigorously  to contest  the  claims of the  Asserting  Holders,  as the
Company  believes  its  position in the  lawsuit is  correct,  and that the debt
cannot properly be accelerated.

ITEM 2.   CHANGES IN SECURITIES

     Pursuant to Section  4(2) of the Act, on July 22,  1998,  the Company  sold
1,800,000  shares and 1,200,000 shares of the Company's common stock to Rockside
Foundation and an individual investor,  respectively, for an aggregate amount of
$3,000,000.  In addition,  for every share  purchased  the  investor  received a
warrant to  purchase  the  Company's  common  stock for $3.00 per  share.  These
warrants expire five years from the closing date and are  exercisable  beginning
six months after the closing date.

                                       19
<PAGE>

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

         Not applicable.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         Not applicable.

ITEM 5.  OTHER INFORMATION

         Not applicable.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

(A)      EXHIBITS

10.1     Letter Agreement between Palomar Medical Technologies, Inc. and 
         Coherent, Inc., dated September 10, 1998.

27.1     Financial Data  Statement,  Restated,  for the period ended  
         September 30, 1997.

27.2     Financial Data Statement, for the period ended September 30, 1998.

(B)      REPORTS ON FORM 8-K.

         None.

                                       20
<PAGE>
                                   SIGNATURES

     Pursuant to the  requirements of the Securities Act of 1934, the Registrant
certifies  that it has  caused  this  Report to be  signed on its  behalf by the
undersigned,  thereunto  duly  authorized,  in  the  Town  of  Lexington  in the
Commonwealth of Massachusetts on November 13, 1998.

                                            PALOMAR MEDICAL TECHNOLOGIES, INC.
                                            ----------------------------------
                                                      (Registrant)

DATE:  November 13, 1998                    By:    /S/ LOUIS P. VALENTE
                                                ------------------------------
                                                   Louis P. Valente
                                                   Chief Executive Officer
                                                   (Principal Executive Officer)

DATE:  November 13, 1998                     By:    /S/ JOSEPH P. CARUSO
                                                ------------------------------
                                                   Joseph P. Caruso 
                                                   Chief Financial Officer and 
                                                   Treasurer
                                                   (Principal Financial Officer
                                                   and Principal  
                                                   Accounting Officer)

                                       21