|UNITED STATES
                                                  SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

                                                               FORM 10-Q
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ý | Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934

            For the Quarter ended September 30, 2006
|- | ---------------------------------------------------------------------------------------------------------------------------------------------

|o | 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.
|-------------------------------------------------------------------

|A Delaware Corporation | I.R.S Employer Identification No. 04-3128178
|---------------------- | --------------------------------------------

|82 Cambridge Street, Burlington, Massachusetts 01803
Registrant's telephone number, including area code: (781) 993-2300
Securities registered pursuant to Section 12(b) of the Act:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Title of each class
Common Stock, $0.01 par value | Name of each exchange on which registered
NASDAQ - National Market
|------------------------------------------------- | ------------------------------------------------------------------

|Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 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.
  YesýNo
o

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See
definition of accelerated filer and large accelerated filer in Rule 12b(2) of the Exchange Act. (Check one).

  Large accelerated filero
Accelerated filerýNon-accelerated filero


Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act.  Yeso
   Noý


The number of shares of common stock outstanding at November 1, 2006 was 17,682,742.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|Palomar Medical
Technologies, Inc. and Subsidiaries

Table of Contents
|----------------------------------------------------------------------

|                               |                                                                                                                                      |  | Page No.
|------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------ |  | --------
|PART I - Financial Information |                                                                                                                                      |  |         
|                               |                                                                                                                                      |  |         
|Item 1.                        | Financial Statements                                                                                                                 |  |         
|                               | Unaudited Condensed Consolidated Balance Sheets as of
         September 30, 2006 and December 31, 2005                              |  | 2       
|                               | Unaudited Condensed Consolidated Statements of Income for the periods ending
         September 30, 2006 and September 30, 2005      |  | 3       
|                               | Unaudited Condensed Consolidated Statements of Cash Flows for the periods ending
          September 30, 2006 and September 30, 2005 |  | 4       
|                               | Notes to Unaudited Condensed Consolidated Financial Statements                                                                       |  | 5       
|Item 2.                        | Managements Discussion and Analysis of Financial Condition and the
              Results of Operations                              |  | 13      
|                               | Cautionary Statements                                                                                                                |  | 20      
|Item 3.                        | Quantitative and Qualitative Disclosures About Market Risk                                                                           |  | 32      
|Item 4.                        | Controls and Procedures                                                                                                              |  | 32      
|                               |                                                                                                                                      |  |         
|PART II - Other Information    |                                                                                                                                      |  |         
|                               |                                                                                                                                      |  |         
|Item 1.                        | Legal Proceedings                                                                                                                    |  | 32      
|Item 2.                        | Changes in Securities, Use of Proceeds and Issuer Purchases of Securities                                                            |  | 33      
|Item 3.                        | Defaults Upon Senior Securities                                                                                                      |  | 33      
|Item 4.                        | Submission of Matters to a Vote of Security Holders                                                                                  |  | 34      
|Item 5.                        | Other Information                                                                                                                    |  | 34      
|Item 6.                        | Exhibits                                                                                                                             |  | 34      
|SIGNATURES                     |                                                                                                                                      |  | 35      

|Palomar Medical
Technologies, Inc. and Subsidiaries Condensed Consolidated Balance Sheets
(Unaudited)
|-----------------------------------------------------------------------------------------------------

|                                                                        | September 30,
2006 | December 31
2005
|----------------------------------------------------------------------- | ------------------ | ----------------
|Assets                                                                  |                    |                 
|                                                                        |                    |                 
|Current assets                                                          |                    |                 
|Cash and cash equivalents                                               |                    |                 
|Available-for-sale investments, at market value                         |                    |                 
|Accounts receivable, net                                                |                    |                 
|Inventories                                                             |                    |                 
|Other current assets                                                    |                    |                 
|                                                                        |                    |                 
|Total current assets                                                    |                    |                 
|                                                                        |                    |                 
|Property and equipment, net                                             |                    |                 
|                                                                        |                    |                 
|Other assets                                                            |                    |                 
|                                                                        |                    |                 
|Total Assets                                                            |                    |                 
|                                                                        |                    |                 
|Liabilities and Stockholders' Equity                                    |                    |                 
|                                                                        |                    |                 
|Current liabilities                                                     |                    |                 
|Accounts payable                                                        |                    |                 
|Accrued liabilities                                                     |                    |                 
|Deferred revenue                                                        |                    |                 
|                                                                        |                    |                 
|Total current liabilities                                               |                    |                 
|                                                                        |                    |                 
|Commitments and Contingencies                                           |                    |                 
|                                                                        |                    |                 
|Stockholders' equity                                                    |                    |                 
|Preferred stock, $.01 par value-                                        |                    |                 
|Authorized - 1,500,000 shares                                           |                    |                 
|Issued -  none                                                          |                    |                 
|Common stock, $.01 par value-                                           |                    |                 
|Authorized - 45,000,000 shares                                          |                    |                 
|Issued and outstanding - 17,673,859 and 17,126,467 shares, respectively |                    |                 
|Additional paid-in capital                                              |                    |                 
|Accumulated deficit                                                     |                    |                 
|                                                                        |                    |                 
|Total stockholders' equity                                              |                    |                 
|                                                                        |                    |                 
|Total liabilities and stockholders equity                              |                    |                 
|                                                                        |                    |                 

|See accompanying notes to condensed
consolidated financial statements.

2
|-------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries
                                              Condensed Consolidated Statements of Income
                                                              (Unaudited)
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                              | Three Months Ended
September 30, | Nine Months Ended
September 30, |  |                 
|--------------------------------------------- | -------------------------------- | ------------------------------- |  | ----------------
|
|Revenues                                      |                                  |                                 |  |                 
|Product revenues                              |                                  | $23,671,555                     |  | $16,726,018     
|Royalty revenues                              |                                  | 3,642,413                       |  | 1,211,547       
|Funded product development revenues           |                                  | 707,814                         |  | 1,341,108       
|                                              |                                  |                                 |  |                 
|Total revenues                                |                                  | 28,021,782                      |  | 19,278,673      
|                                              |                                  |                                 |  |                 
|Costs and expenses                            |                                 
|Cost of product revenues                      |                                  | 7,036,514                       |  | 5,220,270       
|Cost of royalty revenues                      |                                  | 1,456,969                       |  | 484,619         
|Research and development                      |                                  | 3,537,561                       |  | 3,162,199       
|Selling and marketing                         |                                  | 5,821,573                       |  | 4,335,302       
|General and administrative                    |                                  | 2,362,082                       |  | 1,712,847       
|                                              |                                  |                                 |  |                 
|Total costs and expenses                      |                                  | 20,214,699                      |  | 14,915,237      
|                                              |                                  |                                 |  |                 
|Income from operations                        |                                  | 7,807,083                       |  | 4,363,436       
|                                              |                                  |                                 |  |                 
|Interest income                               |                                  | 1,031,530                       |  | 315,116         
|                                              |                                  |                                 |  |                 
|Income before income taxes                    |                                  | 8,838,613                       |  | 4,678,552       
|                                              |                                  |                                 |  |                 
|Provision for income taxes                    |                                  | 470,948                         |  | 90,677          
|                                              |                                  |                                 |  |                 
|Net income                                    |                                  | $  8,367,665                    |  | $  4,587,875    
|                                              |                                  |                                 |  |                 
|Net income per share                          |                                 
|Basic                                         |                                  | $           0.47                |  | $           0.27
|                                              |                                  |                                 |  |                 
|Diluted                                       |                                  | $           0.41                |  | $           0.24
|                                              |                                  |                                 |  |                 
|Weighted average number of shares outstanding |                                 
|Basic                                         |                                  | 17,642,215                      |  | 16,942,281      
|                                              |                                  |                                 |  |                 
|Diluted                                       |                                  | 20,244,414                      |  | 19,115,171      
|                                              |                                  |                                 |  |                 

|See accompanying notes to condensed
consolidated financial statements.

3
|-------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries   Condensed Consolidated Statements of Cash Flows  (Unaudited)
|------------------------------------------------------------------------------------------------------------------

|                                                                            | Nine Months Ended September 30, | 
|--------------------------------------------------------------------------- | ------------------------------- | 
|
|Cash flows from operating activities                                        |                                 | 
|Net income                                                                  |                                 | 
|                                                                            |                                 | 
|Adjustments to reconcile net income  to net cash from operating activities: |                                 | 
|Depreciation and amortization                                               |                                 | 
|Stock-based compensation expense                                            |                                 | 
|Provision for bad debt                                                      |                                 | 
|Inventory write-offs                                                        |                                 | 
|Changes in assets and liabilities:                                          |                                 | 
|Accounts receivable                                                         |                                 | 
|Inventories                                                                 |                                 | 
|Other current assets                                                        |                                 | 
|Accounts payable                                                            |                                 | 
|Accrued liabilities                                                         |                                 | 
|Deferred revenue                                                            |                                 | 
|                                                                            |                                 | 
|Net cash from operating activities                                          |                                 | 
|                                                                            |                                 | 
|Cash flows used in investing activities                                     |                                 | 
|Purchases of property and equipment                                         |                                 | 
|Purchases of available-for-sale investments                                 |                                 | 
|Proceeds from sale of available-for-sale investments                        |                                 | 
|                                                                            |                                 | 
|Net cash used in investing activities                                       |                                 | 
|                                                                            |                                 | 
|Cash flows from financing activities                                        |                                 | 
|Proceeds from the exercise of stock options                                 |                                 | 
|Tax benefit from the exercise of stock options                              |                                 | 
|Costs incurred related to issuance of common stock                          |                                 | 
|                                                                            |                                 | 
|Net cash from financing activities                                          |                                 | 
|                                                                            |                                 | 
|Net increase in cash and cash equivalents                                   |                                 | 
|Cash and cash equivalents, beginning of the period                          |                                 | 
|                                                                            |                                 | 
|Cash and cash equivalents, end of the period                                |                                 | 
|                                                                            |                                 | 
|Supplemental disclosure of cash flow information                            |                                 | 
|Cash paid for income taxes                                                  |                                 | 
|                                                                            |                                 | 

|See accompanying notes to condensed
consolidated financial statements.

4
|-------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed
Consolidated Financial Statements (Unaudited)


Note 1           Basis of presentation


The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States for interim
information. The consolidated balance sheet at December 31, 2005 has been derived from the
audited balance sheet at that date; however, the accompanying financial statements do not
include all of the information and footnotes required by accounting principles generally
accepted in the United States 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. We believe that the
quarterly information presented includes all adjustments (consisting of normal, recurring
adjustments) necessary for a fair presentation in accordance with accounting principles
generally accepted in the United States. The accompanying condensed consolidated financial
statements and notes should be read in conjunction with our Form 10-K for the year ended
December 31, 2005.



Note 2  Stock
based compensation


In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard SFAS 123 (revised 2004), Share-Based Payment(SFAS
123R). SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the
approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS
123(R) requires share-based payments to employees, including grants of employee stock
options, to be recognized in the income statement based on their fair values at the date
of grant. Pro forma disclosure is no longer an alternative.


On
January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as
permitted under SFAS 123(R). Under this transition method, compensation cost recognized in
2006 includes compensation cost for all share-based payments granted prior to but not yet
vested as of December 31, 2005, based on the grant-date fair value estimated in accordance
with the provisions of SFAS 123. In accordance with the modified prospective method of
adoption, our results of operations and financial position for prior periods have not been
restated.



Our
income before taxes and net income was $94,448 and $436,211 lower for the three months and
nine months ended September 30, 2006, respectively, as a result of stock-based
compensation expense as a result of the adoption of SFAS 123(R). As of September 30, 2006,
there was $60,726 of unrecognized compensation expense related to non-vested market-based
share awards.



Prior
to December 31, 2005, we followed the provisions of SFAS No. 123, Accounting
for Stock-Based Compensation. The provisions of SFAS No. 123 allowed companies to
either expense the estimated fair value of stock options or to continue to follow the
intrinsic value method set forth in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), but disclose
the pro forma effects on net income had the fair value of the options been expensed. We
elected to apply APB 25 in accounting for our stock option incentive plans.


In
accordance with APB 25 and related interpretations, compensation expense for stock options
was recognized in income based on the excess, if any, of the quoted market price of the
stock at the grant date of the award or other measurement date over the amount an employee
must pay to acquire the stock. Generally, the exercise price for stock options granted to
employees was equal to the fair market value of our common stock at the date of grant,
thereby resulting in no recognition of compensation expense by us prior to December 31,
2005.






5



Had
compensation cost for our stock option plans been determined based on the fair value
method set forth in SFAS No. 123 during the prior year, our net income and basic and
diluted net income per common share would have been changed to the pro forma amounts
indicated below:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                      | Three months ended
September 30, 2005 | Nine months ended
September 30, 2005
|----------------------------------------------------- | ------------------------------------- | ------------------------------------
|Net income, as reported                               |                                       |                                     
|Less: Total stock-based employee compensation expense |                                       |                                     
|determined under fair value based method for all      |                                       |                                     
|awards, net of tax                                    |                                       |                                     
|                                                      |                                       |                                     
|Pro forma net income                                  |                                       |                                     
|                                                      |                                       |                                     
|Net income per share:                                 |                                       |                                     
|Basic - as reported                                   |                                       |                                     
|Basic - pro forma                                     |                                       |                                     
|                                                      |                                       |                                     
|Diluted - as reported                                 |                                       |                                     
|Diluted - pro forma                                   |                                       |                                     
|                                                      |                                       |                                     

|There
were no options granted during the nine months ended September 30, 2006. On May 11, 2005,
we granted 645,000 options that were fully vested as of date of grant to employees and
directors with exercise prices equal to fair market value on the date of grant, or $24.63
per share, and expire ten years from the date of grant.


We
use the Black-Scholes option pricing model to calculate the grant-date fair value of an
award. Key input assumptions used to estimate the fair value of stock options include the
exercise price of the award, the expected option term, the expected volatility of our
stock over the options expected term, the risk-free interest rate over the
options expected term and our expected annual dividend yield. Expected volatilities
are based on historical volatilities of our common stock and other factors; the expected
life represents the weighted average period of time that options granted are expected to
be outstanding giving consideration to vesting schedules and our historical exercise
patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at
the time of grant for periods corresponding with the expected life of the option. The fair
value of each option was estimated on the grant date using the Black-Scholes
option-pricing model with the following assumptions:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                         | Nine months ended
September 30, 2005
| | ----------------------- | ------------------------------------
| | Risk-free interest rate | 3.57%                               
| | Expected dividend yield | --                                  
| | Expected lives          | 2 years                             
| | Expected volatility     | 86%                                 

|The
following table summarizes all of our stock option activity since December 31, 2005:




6
|----------------------------------------------------------------------------------------------

|                                | Number of
Shares | Exercise Price | Weighted
Average
Exercise
Price | Weighted
Average
Remaining
Contractual
Term | Aggregate
Intrinsic Value
|------------------------------- | ---------------- | -------------- | ------------------------------- | ------------------------------------------- | -------------------------
|Outstanding, December 31, 2005  |                  |                |                                 | 4,749,965                                   |                          
|                                |                  |                |                                 |                                             |                          
|Granted                         |                  |                |                                 | --                                          |                          
|Exercised                       |                  |                |                                 | (492,378                                    | )                        
|Canceled                        |                  |                |                                 | (31,998                                     | )                        
|                                |                  |                |                                 |                                             |                          
|Outstanding, September 30, 2006 |                  |                |                                 | 4,225,589                                   |                          
|                                |                  |                |                                 |                                             |                          
|                                |                  |                |                                 |                                             |                          
|Exercisable, September 30, 2006 |                  |                |                                 | 2,815,929                                   |                          
|                                |                  |                |                                 |                                             |                          
|                                |                  |               

|The total intrinsic value for options
exercised during the nine months ended September 30, 2006 and 2005 was $14,600,328 and
$15,181,218, respectively.


The
following table summarizes information about stock options outstanding as of September 30,
2006:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |              |           |             
|------------------- | ------------------- | ---------- | ------------ | --------- | ------------
|
|$0.90-$1.00         | 250,861             | 4.89 years | $       0.97 | 250,861   | $       0.97
|1.51-2.19           | 62,233              | 3.62 years | 1.97         | 62,233    | 1.97        
|2.68-3.19           | 145,092             | 2.72 years | 3.18         | 145,092   | 3.18        
|4.08-5.22           | 189,774             | 6.78 years | 4.95         | 189,774   | 4.95        
|6.22-8.23           | 38,432              | 7.01 years | 6.58         | 30,933    | 6.37        
|9.93-14.31          | 36,297              | 7.51 years | 12.10        | 22,134    | 12.62       
|16.00-23.61         | 2,807,900           | 7.61 years | 16.55        | 1,419,902 | 16.56       
|24.06-26.00         | 695,000             | 8.58 years | 24.67        | 695,000   | 24.67       
|                    |                     |            |              |           |             
|$0.90-$26.00        | 4,225,589           | 7.34 years | $15.64       | 2,815,929 | $    15.24  
|                    |                     |            |              |           |             

|Prior
to the adoption of SFAS 123(R), we presented all tax benefits of deductions from the
exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS
123(R) requires the cash flows resulting from the tax benefits resulting from tax
deductions in excess of compensation cost recognized for those options to be classified as
financing cash flows.



Note 3  Inventories


Inventories
are valued at the lower of cost (first in, first-out method) or market, and includes
material, labor and manufacturing overhead. Inventories consisted of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                | September 30,
2006 | December 31,
2005
|--------------- | ------------------ | -----------------
|Raw materials   |                    | $  4,775,916     
|Work in process |                    | 1,661,398        
|Finished goods  |                    | 3,745,737        
|                |                    |                  
|Total           |                    | $10,183,051      
|                |                    |                  

|Note 4  Property
and equipment


Property
and equipment are recorded at cost. Repairs and maintenance costs are expensed as
incurred. Depreciation and amortization are provided using the straight-line method over
their estimated useful lives. Property and equipment consisted of the following:





7
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                         | September 30,
 2006 | December 31,
    2005 | Estimated
useful life                            
|------------------------ | ------------------- | --------------------- | -------------------------------------------------
|Machinery and equipment  | $      1,735,668    | $      1,536,879      | 3-8 years                                        
|Furniture and fixtures   | 2,342,905           | 2,146,247             | 5 years                                          
|Leasehold improvements   | 353,180             | 293,555               | Shorter of estimated useful life or term of lease
|                         |                    
|                         | 4,431,753           | 3,976,681            
|Accumulated depreciation | (3,412,578)         | (3,067,005)           |                                                  
|                         |                    
|Total                    | $    1,019,175      | $    909,676         
|                         |                    

|Note 5  Warranty
costs


We
typically offer a one-year warranty for all of our products. We provide for the estimated
cost of product warranties at the time product revenue is recognized. Factors that affect
our warranty reserves include the number of units sold, historical and anticipated rates
of warranty repairs and the cost per repair. We assess the adequacy of the warranty
provision and may adjust this provision if necessary.


The
following table provides the detail of the change in our product warranty accrual, which
is a component of accrued liabilities on the condensed consolidated balance sheets for the
three and nine months ended September 30, 2006 and 2005:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                    | Three Months Ended
September 30, | Nine Months Ended
September 30, |   |          
|--------------------------------------------------- | -------------------------------- | ------------------------------- | - | ---------
|
|Warranty accrual, beginning of period               |                                  |                                 | $ | 972,135  
|                                                    |                                  |                                 |   |          
|Charges to costs and expenses relating to new sales |                                  |                                 |   | 561,738  
|Costs of product warranty claims                    |                                  |                                 |   | (484,050 
|                                                    |                                  |                                 |   |          
|Warranty accrual, end of period                     |                                  |                                 | $ | 1,049,823
|                                                    |                                  |                                 |   |          

|Note 6  Geographic
information


Product
revenue from international sources was $6.8 million and $5.0 million for the three months
ended September 30, 2006 and 2005, respectively, and $15.3 million and $14.8 million for
the nine months ended September 30, 2006 and 2005. The following table represents the
percentage of product revenue by geographic region from customers for the three and nine
months ended September 30, 2006 and 2005:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Three Months Ended
September 30, | Nine Months Ended
September 30, |    
|-------------------------------- | -------------------------------- | ------------------------------- | ---
|
|United States                    |                                  | 71                              | .5%
|Canada                           |                                  | 11                              | .2%
|Japan                            |                                  | 3                               | .8%
|Asia / Pacific Rim / Middle East |                                  | 5                               | .9%
|Europe                           |                                  | 5                               | .6%
|Australia                        |                                  | 1                               | .0%
|South and Central America        |                                  | 1                               | .0%
|                                 |                                 
|Total                            |                                  | 100                             | .0%
|                                 |                                 

|8



Note 7  Net income
per common share



Basic
net income per share was determined by dividing net income by the weighted average common
shares outstanding during the period. Diluted net income per share was determined by
dividing net income by diluted weighted average shares outstanding. Diluted weighted
average shares reflect the dilutive effect, if any, of common stock options and warrants
based on the treasury stock method.


A
reconciliation of basic and diluted shares is as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | Three Months Ended
September 30, | Nine Months Ended
September 30, |            |            | 
|----------------------------------- | -------------------------------- | ------------------------------- | ---------- | ---------- | 
|
|Basic weighted average number of    |                                  |                                 |            |           
|shares outstanding                  | 17,642,215                       | 16,942,280                      | 17,438,247 | 16,815,519
|Potential common shares pursuant to
|stock options and warrants          | 2,602,199                        | 2,172,891                       | 2,671,688  | 2,228,487 
|                                    |                                 
|Diluted weighted average number of 
|shares outstanding                  | 20,244,414                       | 19,115,171                      | 20,109,935 | 19,044,006

|Diluted
weighted average shares outstanding do not include options and warrants outstanding to
purchase 50,000 common equivalent shares for the nine months ended September 30, 2005, as
their effect would have been antidilutive.



Note 8 
Arrangements with Massachusetts General Hospital


Under
the terms of a research agreement with the Massachusetts General Hospital Corporation,
Massachusetts General Hospital conducts clinical and non-clinical research in the field of
photo thermal removal or reduction of hair, using light (hereinafter referred to as
hair removal). The Research Agreement has a term of three years, until August
2007, and we will provide Massachusetts General Hospital at least $230,000 on an annual
basis to cover the direct and indirect costs of the research. We have the right to
exclusively license, on royalty terms to be negotiated, Palomar-funded inventions that are
discovered during this research.


We
are a party to a license agreement, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital on the sale of
certain products as well as 40% of royalties received from third parties. During the three
months ended March 31, 2006, the license was amended resulting in approximately $762,000
reduction in accrued royalties. The reduction in accrued royalties was recorded as a
reduction in cost of product revenues in the three months ended March 31, 2006.



Note 9 
Development and License Agreement with Gillette


Effective
as of February 14, 2003, we entered into a Development and License Agreement with Gillette
to complete the development and commercialize a home-use, light based hair removal device
for women. The agreement provided for up to $7 million in support of research and
development to be paid by Gillette over approximately 30 months. Effective as of June 28,
2004, we completed the initial phase of the agreement with Gillette and both parties
decided to move onto the next phase. Accompanying this decision, we amended the original
agreement with Gillette, whereby, Gillette provided $2.1 million in additional development
funding to further technical innovations over a 9-month extension of the development
phase, which was completed on August 31, 2006 (the Development Phase).


On September 29, 2006, in response to a first decision point in the Agreement, Gillette decided to continue with the
project. Consequently, after over-the-counter clearance is obtained from the United States Food and Drug Administration for the
device, Gillette will be obligated to make a development completion payment to us of $2.5 million.


After Gillette makes the development completion payment to us of $2.5 million, Gillette will conduct approximately 12 months of
commercial assessment tests with respect to the device. Based on the commercial assessment tests, Gillette will then decide at a
second decision point whether or not to continue with the project. Upon deciding to continue, Gillette will be obligated to make a
development completion payment to us of $10 million. If Gillette decides not to continue
to commercialize the device, we may proceed to commercialize the device on our own or with
a different party.






9


Commencing
12 months after the $10 million development completion payment, Gillette will be obligated
to pay us annual collaboration payments of $10 million for as long as Gillette elects to
have us work exclusively with them.


After
launch of the first device for females, Gillette will pay us up to 6 percent of net sales
of the device, subject in certain instances to various reductions and offsets. Again, for
as long as Gillette elects to have us work exclusively with them, Gillette will continue
to be obligated to pay us annual collaboration payments of $10 million, which will be
offset against the net sales percentage payments.


In
addition to the amounts to be paid by Gillette to us in connection with jointly developed
products, Gillette is required to make certain lump sum and net sales based payments to us
in the event that Gillette launches independent light based female hair removal products.
Gillette also receives the right to enter into a separate agreement with us for the
development and commercialization of home-use, light based hair removal devices for men.


For
the three months ended September 30, 2006 and 2005, we recognized $50,000 and $700,000 of
funded product development revenues from Gillette, respectively. For the nine months ended
September 30, 2006 and 2005, we recognized $900,000 and approximately $2.1 million of
funded product development revenues from Gillette, respectively.



Note 10  Joint Development
and License Agreement with Johnson & Johnson Consumer Companies, a Johnson &
Johnson company



Effective as of September 1, 2004, we entered into a Joint Development and License Agreement with Johnson & Johnson Consumer
Companies, Inc., a Johnson & Johnson company, to develop and commercialize home-use, light based devices in the fields of (i)
reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.
Under the agreement Johnson & Johnson funds our research and clinical studies during an initial proof-of-principle phase. At the end
of the proof-of-principle phase, Johnson & Johnson will decide whether or not to continue with one or more of the devices in one or
more of the fields into a development phase. Upon Johnson & Johnson deciding to continue, Johnson & Johnson will be obligated to fund
the development of the selected devices.  If Johnson & Johnson decides not to continue, we may proceed in fields not selected by
Johnson & Johnson to develop and commercialize these and other devices on our own or with a different party.


At
the end of the development phase, Johnson & Johnson will decide whether or not to
commercialize one or more of the devices in one or more fields. Upon Johnson & Johnson
deciding to commercialize one or more of the devices, Johnson & Johnson will make
payments to us for each selected field. Upon commercial launch of the first device in each
selected field, Johnson & Johnson will make a payment to us, and for all devices sold
for use in each selected field, Johnson & Johnson shall pay us a percentage of sales
of such devices and certain topical compounds. If Johnson & Johnson decides not to
commercialize or fails to launch a device, we may proceed in fields not selected by
Johnson & Johnson to develop and commercialize these and other devices on our own or
with a different party.


For
the three months ended September 30, 2006 and 2005, we recognized $340,000 and $375,000 of
funded product development revenues from Johnson & Johnson, respectively. For the nine
months ended September 30, 2006 and 2005, we recognized $1.1 million of funded product
development revenues from Johnson & Johnson for each period. As of September 30, 2006,
$340,000 of advance payments received from Johnson & Johnson for which services were
not yet provided were included in deferred revenue.







10


Note 11  Research
contract with the United States Department of the Army




In
the first quarter of 2004, we began providing services under a $2.5 million research
contract with the United States Department of the Army to develop a light based
self-treatment device for Pseudofolliculitis Barbae or PFB. On October 25, 2005, we
announced that we had been awarded additional funding of $888,000 for a total of $3.4
million and a twelve month extension. On September 1, 2006, we were awarded additional funding of $440,000 for a total of $3.8 million and an additional five month extension until April
30, 2007. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB
research plus an 8% fee.  This revenue is included in funded product development revenue in the accompanying statements of income.
Our revenue from the contract is subject to government audit.  We are unaware of any specific adjustments or open items that could
result from any such audit.



For
the three months ended September 30, 2006 and 2005, we recognized approximately $318,000
and $266,000 of funded product development revenues under this agreement, respectively.
For the nine months ended September 30, 2006 and 2005, we recognized approximately $1.0
million and $795,000 of funded product development revenues under this agreement,
respectively.



Note 12 
Settlement of Lumenis Litigation


On June 22, 2004, we announced that we had reached a settlement with Lumenis Ltd. resolving our on-going litigation
concerning both patent infringement and contractual matters. Pursuant to the settlement, the parties dismissed with prejudice both
the federal action in the Northern District of California as well as the state court action in Massachusetts.  Palomar and Lumenis
executed a Settlement Agreement and a Patent License Agreement.  Under the Patent License Agreement, Palomar granted Lumenis a
non-exclusive, royalty bearing license to the Anderson Patents (U.S. Patent Nos. 5,595,568 & 5,735,844) in the professional field,
excluding the consumer field which is exclusively licensed to the Gillette Company.


Under the terms of the Settlement Agreement and Patent License Agreement, Lumenis paid $868,000 in the second quarter of
2004 for back-owed royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay $3.225 million over the next
six quarters, or $537,500 per quarter, for back-owed royalties due on sales of the LightSheer made between July 1, 2002 and December
31, 2003.  Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the LightSheer and other professional
laser hair removal devices and modules.


In addition, Lumenis granted us a paid up license to a variety of Lumenis' patents for our light based devices.  We granted
Lumenis a paid up license to the Anderson Patents for Lumenis' lamp based devices.  Both parties have agreed to the validity and
enforceability of each others patents and not to challenge such validity and enforceability in the future.



For the three and nine months ended September 30, 2006, Lumenis made payments of approximately $426,000 and $1.3 million,
respectively, relating to the 5% royalty. For the three and nine months ended September 30, 2005, Lumenis made payments of
approximately $519,000 and $1.7 million, respectively, relating to the 5% royalty and $537,500 and $1.6 million, respectively, for
back-owed royalties recorded as royalty revenue.

For more information, please see the Settlement Agreement and the Patent License Agreement filed as Exhibits 99.1 and 99.2
to a Current Report on Form 8-K filed June 22, 2004.



Note 13 
Settlement of Cutera Litigation



On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc. through the execution of a
Settlement Agreement and a License Agreement.  Under the License Agreement, Palomar granted Cutera a non-exclusive, royalty bearing
license to the Anderson Patents (U.S. Patent Nos. 5,595,568 & 5,735,844) in the professional field, excluding the consumer field
which is exclusively licensed to the Gillette Company. Cutera admitted that their products infringe the Anderson Patents and that
these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of
the Anderson Patents in the future. Cutera paid us $22 million as an estimated payment for royalties of 8.5% due on past sales of
their laser- and lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and
reimbursement of our legal costs. Cutera subsequently informed us that they believed the actual liability for past royalties,
interest and legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as
deferred revenue at June 30, 2006 to be applied against future amounts owed.
The final amounts due to us are subject to audit by an independent accounting firm which is scheduled to be completed by the
end of the fourth quarter. Following the audit, the amounts owed may be higher or lower than the estimated $19.6 million. Under our
license agreement with the General Hospital Corporation, we pay to the General Hospital Corporation 40% of all royalty and interest
payments from Cutera. In connection with the settlement, during the three and six months ended June 30, 2006, we recorded $13.6
million of royalty revenue and $5.4 million in cost of royalties.  We also recorded, net of amounts owed to the General Hospital,
$3.8 million as a reduction in general and administrative expense and $1.2 million in interest income.  Beginning April 1, 2006,
Cutera will pay us a 7.5% royalty on future sales of its existing and any new light-based hair removal systems later developed.


11






For the three and nine months ended September 30, 2006, we recognized $943,000 and $14.6 million of royalty revenues from
Cutera, respectively. As of September 30, 2006, $1.5 million has been recorded as deferred revenue to be applied against future
amounts owed.


For more information, please see the Settlement Agreement, the License Agreement, the Consent Judgments and Stipulations of
Dismissal filed as Exhibits 99.1, 99.2, 99.3 and 99.4 to a Current Report on Form 8-K filed June 5, 2006.



Note 14 
Laserscope Agreement



As
a result of a royalty audit of Laserscopes product sales from January 1, 2001
through June 30, 2006, there was an increase in the third quarter royalty revenue of $2.2
million for back-owed royalties, cost of royalty revenue of $864,000 and net income of
$1.2 million.



On
October 18, 2006, we entered into a new license agreement with Laserscope and terminated
the prior license agreement. Under the new license agreement, Laserscope will pay Palomar
a 7.5% royalty on sales of its current light-based hair removal products, including the
Lyra and Gemini Laser Systems and the Solix IPL System, as well as on sales of new
light-based hair removal systems developed in the future.



For more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit 99.2 to a Current Report on Form 8-K
filed October 26, 2006.







Note 15  Income
Taxes


Our
effective tax rate for the nine months ended September 30, 2006 and 2005 was 4.4% and
2.0%, respectively.  The primary components of this provision, in both 2006 and 2005,
were minimum federal and state taxes.  However, our cash tax liabilities were
partially offset with the tax benefit from the exercise of stock options.  We have
fully reserved our otherwise recognizable deferred tax asset which is principally
comprised of net operating loss carryforwards, as its realization is uncertain.


12




Item
2.        Managements Discussion and
Analysis of Financial Condition and Results of Operations



Forward-looking
statements


This
Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All statements other than historical or
current facts, including, without limitation, statements about our business strategy,
plans and objectives of management and our future prospects, are forward-looking
statements. Although we believe that the expectations reflected in such forward-looking
statements are reasonable, such forward-looking statements are subject to risks and
uncertainties that could cause actual results to differ materially from these
expectations. Such risks and uncertainties include, without limitation, the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | financing of future operations, manufacturing risks, variations in our quarterly results,
the occurrence of unanticipated events and circumstances and general economic
conditions, including stock market volatility, results of future operations,
technological difficulties in developing or introducing new products, the results of
future research, lack of product demand and market acceptance for current and
future products, challenges in managing joint ventures, government contracts and
research with third parties, the impact of competitive products and pricing, governmental regulations with respect to medical devices, including whether FDA clearance will
be obtained for future products, the results of litigation, difficulties in
collecting royalties, potential infringement of third-party intellectual property
rights;
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | we
expect to face increased competition that could result in price reductions and reduced
margins, as well as loss of market share; and
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | other risks are indicated below under the caption Cautionary Statements.
| |  |  | - |  | --------------------------------------------------------------------------

|These
risks and uncertainties are beyond our control and, in many cases; we cannot predict the
risks and uncertainties that could cause our actual results to differ materially from
those indicated by the forward-looking statements. When used in this document, the words
assumptions, believes, plans, expects,
anticipates, intends, continue, may,
will, could, should, future,
potential, estimate, or the negative of such terms and similar
expressions as they relate to us or our management are intended to identify
forward-looking statements. We undertake no obligation to release publicly the
result 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
following discussion should be read in conjunction with, and is qualified in its entirety
by, the condensed consolidated financial statements and notes thereto included in Item 1
of this Quarterly Report and the condensed consolidated financial statements and notes
thereto and Managements Discussion and Analysis of Financial Condition and Results
of Operations in our Form 10-K filed with the SEC on March 6, 2006. Historical results and
percentage relationships among any amounts in the financial statements are not necessarily
indicative of trends in operating results for any future periods.


Critical accounting policies


The
discussion and analysis of our financial condition and results of operations are based
upon our consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation of these
financial statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our estimates,
including those related to revenue recognition, bad debts, inventories, warranty
obligations, contingencies and income taxes. We base our estimates on historical
experience and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying
value of assets and liabilities that are not readily apparent from other sources. Actual
results may differ from these estimates under different assumptions or conditions. A
discussion of our critical accounting policies and the related judgments and estimates
affecting the preparation of our consolidated financial statements is included in the
Annual Report on our Form 10-K fiscal year 2005 There have been no material changes to our
critical accounting policies as of September 30 , 2006 except as noted below:



13






Effective
January 1, 2006, we adopted Financial Accounting Standards Board
(FASB) Statement No. 123 (revised), Share-Based Payment
(SFAS 123(R)). With the adoption of SFAS 123(R), we have added
Share-Based Compensation as a critical accounting policy.



Share-Based Compensation


Among
its provisions, SFAS 123(R) requires us to recognize compensation expense for equity
awards over the vesting period based on their grant-date fair value. The compensation
expense is recognized only for share-based payments expected to vest and we estimate
forfeitures at the date of grant based on our historical experience and
future expectations.


We use the Black-Scholes-Merton option-valuation model to value stock options, which
requires the input of subjective assumptions. These assumptions include the length of time
employees will retain their vested stock options before exercising them (expected
term), the estimated volatility of our stock price, risk-free
interest rate, the expected dividend yield and stock price. The expected term of the
options is based on historical experience of similar awards, giving consideration to the
contractual terms, vesting schedules and expectations of future employee behavior. The
expected term determines the period for which the risk-free interest rate and volatility
must be applied. The risk-free interest rate is based on the expected U.S. Treasury rate
over the expected term. Expected stock price volatility is based on a combination of
historical volatility of our stock price and other factors.



Recent Accounting
Pronouncements


In
June 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes  an
interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting
for uncertainty in income taxes recognized in an enterprises financial statements in
accordance with Statement of Financial Accounting Standards (SFAS) 109, Accounting
for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or expected to
be taken in a tax return. FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48
is effective for fiscal years beginning after December 15, 2006. We are currently
analyzing FIN 48 and believe the adoption of FIN 48 will not have a material impact on our
financial condition, results of operations or liquidity



Overview


We
are engaged in research, development, manufacturing and distribution of proprietary light
based systems for hair removal and other cosmetic treatments. Since our inception, we have
been able to develop a differentiated product mix of light based systems for cosmetic
treatments through our research and development as well as with our partnerships with
Massachusetts General Hospitals Wellman Laboratories and other centers throughout
the world. We are continually developing and testing new indications to further the
advancement in cosmetic light based treatments.


Our
total revenues for the quarter ended September 30, 2006 were $28 million, up from $19.3
million in the third quarter of 2005, including back-owed royalties as described below.
Product revenues increased to $23.7 million from $16.7 million and gross profit from
product revenues increased to $16.6 million or 70 percent, up from $11.5 million or 69
percent in the year-earlier quarter. We reported net income of $8.4 million, or $0.41 per
diluted share, for the third quarter of this year, versus net income of $4.6 million, or
$0.24 per diluted share, for the third quarter of last year.



14






We
strengthened our balance sheet since the end of last year including increasing our cash,
cash equivalents and available-for-sale investments by 65% and increasing
stockholders equity by 74%. Our current ratio is 5.4x, up from 4.5x at the end of
2005, and we have no debt.


As
a result of a royalty audit of Laserscopes product sales from January 1, 2001
through June 30, 2006, there was an increase in our third quarter royalty revenue of $2.2
million, cost of royalty revenue of $864,000 and net income of $1.2 million. On October
18, 2006, we entered into a new license agreement with Laserscope and terminated
the prior license agreement. Under the new license agreement, Laserscope will pay us a
7.5% royalty on sales of its current light-based hair removal products, including the Lyra
and Gemini Laser Systems and the Solis IPL System, as well as on sales of new
light-based hair removal systems developed in the future.


We
continue to focus on delivering innovative light based systems and products to our
customers in order to drive revenue and earnings growth.



Results of operations


The
following table contains selected income statement information, which serves as the basis
of the discussion of our results of operations for the three and nine months ended
September 30, 2006 and 2005, respectively (in thousands, except for percentages):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | Three Months Ended September 30, |  |   |        |  | 
|----------------------------------- | -------------------------------- |  | - | ------ |  | 
|
|
|Revenues                            |                                  |  |   |        |  | 
|Product revenues                    |                                  |  | $ | 23,672 |  | 
|Royalty revenues                    |                                  |  |   | 3,642  |  | 
|Funded product development revenues |                                  |  |   | 708    |  | 
|                                    |                                 
|Total revenues                      |                                  |  |   | 28,022 |  | 
|                                    |                                 
|Cost and expenses                   |                                  | 
|Cost of product revenues            |                                  |  |   | 7,036  |  | 
|Cost of royalty revenues            |                                  |  |   | 1,457  |  | 
|Research & development              |                                  |  |   | 3,538  |  | 
|Selling & marketing                 |                                  |  |   | 5,822  |  | 
|General & administrative            |                                  |  |   | 2,362  |  | 
|                                    |                                 
|Total cost & expenses               |                                  |  |   | 20,215 |  | 
|                                    |                                 
|Income from operations              |                                  |  |   | 7,807  |  | 
|Interest income                     |                                  |  |   | 1,032  |  | 
|                                    |                                 
|Income before income taxes          |                                  |  |   | 8,839  |  | 
|Provision for income taxes          |                                  |  |   | 471    |  | 
|                                    |                                 
|Net income                          |                                  |  | $ | 8,368  |  | 
|                                    |                                 

|15
|--

|                                    | Nine Months Ended September 30, |  |   |        |  | 
|----------------------------------- | ------------------------------- |  | - | ------ |  | 
|
|
|Revenues                            |                                 |  |   |        |  | 
|Product revenues                    |                                 |  | $ | 65,679 |  | 
|Royalty revenues                    |                                 |  |   | 18,439 |  | 
|Funded product development revenues |                                 |  |   | 3,015  |  | 
|                                    |                                
|Total revenues                      |                                 |  |   | 87,133 |  | 
|                                    |                                
|Cost and expenses                   |                                 | 
|Cost of product revenues            |                                 |  |   | 18,690 |  | 
|Cost of royalty revenues            |                                 |  |   | 7,376  |  | 
|Research & development              |                                 |  |   | 11,021 |  | 
|Selling & marketing                 |                                 |  |   | 17,043 |  | 
|General & administrative            |                                 |  |   | 3,046  |  | 
|                                    |                                
|Total cost & expenses               |                                 |  |   | 57,176 |  | 
|                                    |                                
|Income from operations              |                                 |  |   | 29,957 |  | 
|Interest income                     |                                 |  |   | 3,476  |  | 
|                                    |                                
|Income before income taxes          |                                 |  |   | 33,433 |  | 
|Provision for income taxes          |                                 |  |   | 1,454  |  | 
|                                    |                                
|Net income                          |                                 |  | $ | 31,979 |  | 
|                                    |                                

|Product
revenues. Sales of the StarLux Pulsed Light and Laser System coupled with
its additional handpieces were the leading contributor to our increase in product revenues
for the three and nine months ended September 30, 2006 in comparison to the same periods
in 2005. Favorably impacting product revenues for the three months ended September 30,
2006, was an increase of 45% in sales related to the Lux family of products,
which includes the StarLux, MediLux, EsteLux and additional handpieces as well as an
increase of 55% in customer service revenue. Offsetting these increases was a reduction in
sales of 73% relating to the Q-Yag 5 product line in comparison to the same period in
2005. For the nine months ended September 30, 2006, favorably impacting product revenues
was an increase of 43% in sales related to the Lux family of products, a 54%
increase in sales relating to customer service offset by a decrease of 32% from sales
related to the Q-Yag 5 product line in comparison to the same period in 2005.


Product
revenue for the three and nine months ended September 30, 2006 comprised of 83% and 85%,
respectively, to North American customers where we sell through a direct sales force and
17% and 15%, respectively, outside of North America where we sell through distributors. In
comparison to the same three and nine month periods in 2005, product revenue consisted of
78% and 76%, respectively, to North American customers, and 22% and 24%, respectively,
outside of North America.


Royalty
revenues.  Royalty revenues increased for the three and nine months ended September 30, 2006, in comparison to the same periods in
2005. These increases are attributed to the settlement of our patent infringement lawsuits against Cutera and a royalty audit of
Laserscope providing back-owed royalties from Laserscopes product sales from January 1, 2001 through June 30, 2006, offset by
Lumenis making its final installment for back-owed royalties during the fourth quarter in 2005.


On
October 18, 2006, we entered into a new license agreement with Laserscope and terminated
the prior license agreement. Under the new license agreement, Laserscope will pay us
a 7.5% royalty on sales of its current light-based hair removal products, including the
Lyra and Gemini Laser Systems and the Solix IPL System, as well as on sales of new
light-based hair removal systems developed in the future. During the three and nine months
ended September 30, 2006, we recognized $2.2 million of back-owed royalties from
Laserscopes product sales from January 1, 2001 through June 30, 2006.


16






On
June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera, Inc. Cutera admitted that their products infringe the Anderson Patents (U.S.
Patent No.s 5,595,568 & 5,735,844) and that these patents are valid and enforceable.
In addition, Cutera agreed not to challenge the infringement, validity and enforceability
of the Anderson Patents in the future. Cutera paid us $22 million as an estimated payment
for royalties of 8.5% due on past sales of their laser- and lamp-based hair removal
systems beginning with their initial sales in 2000 through March 31, 2006, interest and
reimbursement of our legal costs. Cutera subsequently informed us that they believed the
actual liability for past royalties, interest and legal costs was $19.6 million, versus
the actual payment of $22 million. We recorded the difference of $2.4 million as deferred
revenue at June 30, 2006 to be applied against future amounts owed. The final amounts due
to us are subject to audit by an independent accounting firm which is scheduled to be
completed by the end of the fourth quarter. Following the audit, the amounts owed may be
higher or lower than the estimated $19.6 million. Beginning April 1, 2006, Cutera will pay
us a 7.5% royalty on future sales of its existing and any new light-based hair removal
systems later developed. During the quarter ended June 30, 2006, we recognized
approximately $13.6 million of back-owed royalties from Cuteras initial product
sales in 2000 through March 31, 2006 and during the quarter ended September 30, 2006, we
recognized $943,000 relating to royalties owed from Cutera for product sales from April 1,
2006 through June 30, 2006. As of September 30, 2006, $1.5 million has been recorded as
deferred revenue to be applied against future amounts owed.



Funded
product development revenues. Funded product development revenue is
generated from the development agreements with Gillette, Johnson & Johnson Consumer
Companies, Inc. and the United States Department of the Army. For both Gillette and
Johnson & Johnson, we have received payments quarterly in accordance with the work
plans that were developed with both Gillette and Johnson & Johnson. Revenue is
recognized under the contracts as costs are incurred and services are rendered. Any
amounts received in advance of costs incurred and services rendered are recorded as
deferred revenue. Payments are not refundable if the development is not
successful.


Funded product development revenue from Gillette decreased due to completion of the original work plan during both the three
and nine months September 30, 2006 in comparison to the same periods in 2005.  For the three months ended September 30, 2006 and
2005, we recognized $50,000 and $700,000 of funded product development revenues from Gillette, respectively. For the nine months
ended September 30, 2006 and 2005, we recognized $900,000 and approximately $2.1 million of funded product development revenues from
Gillette, respectively. The efforts and the funding under the original work plan were completed during the third quarter and on
September 29, 2006, in response to a first decision point in the Agreement, Gillette decided to continue with the project.
Consequently, after over-the-counter clearance is obtained from the United States Food and Drug Administration for the device,
Gillette will be obligated to make a development completion payment to us of $2.5 million.


Funded
product development revenue from Johnson & Johnson decreased slightly during both the
three and nine months September 30, 2006 in comparison to the same periods in 2005. For
the three months ended September 30, 2006 and 2005, we recognized $340,000 and $375,000 of
funded product development revenues from Johnson & Johnson, respectively. For the nine
months ended September 30, 2006 and 2005, we recognized $1.1 million of funded product
development revenues from Johnson & Johnson for each period. As of September 30, 2006,
$340,000 of advance payments received from Johnson & Johnson for which services were
not yet provided were included in deferred revenue.


We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. For the three
months ended September 30, 2006 and 2005, we recognized approximately $318,000 and
$266,000 of funded product development revenues under this agreement, respectively. For
the nine months ended September 30, 2006 and 2005, we recognized approximately $1.0
million and $795,000 of funded product development revenues under this agreement,
respectively.

17






Cost of product revenues. The cost of product revenues increased in
absolute dollars, but decreased as a percentage of total revenue. The decrease as a
percentage of total revenue for the three months ended September 30, 2006 as compared to
the same period in 2005 was attributed to a shift in product mix to the higher priced
StarLux Pulsed Light and Laser System, additional handpieces and a shift in product sales
to North America offset by the write-off of certain customer service
loaner inventory.


The
decrease as a percentage of total revenue for the nine months ended September 30, 2006 as
compared to the same period in 2005 was attributed to a shift in product mix to the higher
priced StarLux Pulsed Light and Laser System, additional handpieces and a shift in product sales
to North America and a net decrease in product royalties owed
to the General Hospital Corporation as a result of an amendment to our license agreement
and the write-off of certain customer service loaner inventory. During the quarter ended
March 31, 2006, we recorded a net decrease of $617,000 in cost of product revenues as a
result of a non-recurring adjustment made to product royalties offset by the write-off of
certain customer service loaner inventory.


Increased
sales volume has improved the absorption of fixed manufacturing overhead at our
manufacturing facility as approximately 70% of our manufacturing overhead costs are fixed
in nature and are spread over higher sales volumes.


Cost
of royalty revenues. The cost of royalty revenues increased for the three and nine months ended September 30, 2006, in comparison to the same periods in
2005. These increases are attributed to the settlement of our patent infringement lawsuits against Cutera and a royalty audit of
Laserscope providing back-owed royalties from Laserscopes product sales from January 1, 2001 through June 30, 2006, offset by
Lumenis making its final installment for back-owed royalties during the fourth quarter in 2005. As a percentage of royalty revenues,
the cost of royalty revenues was consistent at 40% in accordance with our license agreement with Massachusetts General Hospital for
each period in comparison to the same periods in 2005.


Research
and development expense. The increase in research and development expense
is a direct result of our spending related to our continued commitment to introducing new
technology and enhancing our current family of products.



For
both the three and nine months ended September 30, 2006 expenses relating to the Gillette
agreement decreased as compared to the same periods in 2005. These decreases are
attributed to the reduction of research and development expenses associated with the end
of the work plan established with Gillette.


Expenses
relating to the Johnson & Johnson agreement decreased during the three months ended
September 30, 2006 by $65,000 and increased during the nine months ended September 30,
2006 by $120,000 as compared to the same periods in 2005.



For
the three and nine months ended September 30, 2006, expenses relating to the United States
Department of the Army increased by approximately $48,000 and $213,000, respectively, in
comparison to the same periods in 2005.



For
the three and nine months ended September 30, 2006, legal expenses relating to the
prosecution of new patents decreased by approximately $88,000 and $564,000, respectively,
in comparison to the same periods in 2005.



Expenses
for internal research and development projects relating to the introduction of new
products, enhancements made to the current family of products and research and development
overhead increased by approximately $1.1 million and $3.2 million, respectively, for the
three and nine months ended September 30, 2006 in comparison to the same periods in 2005.



18






Selling
and marketing expense. For the quarter ended September 30, 2006, selling
and marketing increased by $265,000 from payroll and payroll related expenses, $439,000
related to tradeshow expenses and other costs, $160,000 related to the write-off of
certain demo inventory and $623,000 related to commission expense in comparison to the
same period in 2005. For the nine months ended September 30, 2006, selling and marketing
expenses increased by $1.2 million from payroll and payroll related expenses,
approximately $1.8 million related to tradeshow expenses and other costs and by
approximately $1.4 million relating to commission expense in comparison to the same period
in 2005. These increases directly correlate with our increased revenues and costs
associated with our expansion of our North American sales force and product lines.



General
and administrative expense.          For the three months ended September 30, 2006, general and administrative expenses increased by $653,000 from payroll and
payroll related expenses, $245,000 from legal and patent litigation expenses offset by a decrease of $249,000 in other over-head
expenses as compared to the same period in 2005.  For the nine months ended September 30, 2006, general and administrative expense
increased by $2.1 million from payroll and payroll related expenses offset by a decrease of $787,000 in other over-head expenses and
a decrease of $3.0 million from legal and patent litigation expenses.  These decreases during the nine months ended September 30,
2006, are mainly attributed to the settlement of our patent infringement lawsuits against Cutera where Cutera reimbursed us
approximately $3.8 million (net of payments owed to the General Hospital Corporation) for legal expenses incurred during the patent
infringement lawsuits.


Interest
income.Interest income increased for both the three and nine months ended
September 30, 2006 due to the increase in cash balances and the settlement of our patent
infringement lawsuits against Cutera where Cutera paid us approximately $1.2 million (net
of what was paid to the General Hospital Corporation) in interest in comparison to the
same periods in 2005.


Provision
for income taxes.  Our effective tax rate for the nine months ended
September 30, 2006 and 2005 was 4.4% and 2.0%, respectively.  The primary components
of this provision, in both 2006 and 2005, were minimum federal and state taxes.
 However, our cash tax liabilities were partially offset with the tax benefit from
the exercise of stock options.  We have fully reserved our otherwise recognizable
deferred tax asset which is principally comprised of net operating loss carryforwards, as
its realization is uncertain.



Liquidity and capital
resources


The
following table sets forth, for the periods indicated, a year-over year comparison of key
components of our liquidity and capital resources (000s omitted):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     | Nine months ended,
September 30, | Change |   |        
|-------------------- | -------------------------------- | ------ | - | -------
|
|Operating cash flows |                                  |        | $ | 26,297 
|Investing cash flows |                                  |        |   | (20,458
|Financing cash flows |                                  |        |   | 6,018  
|Capital expenditures |                                  |        | $ | 455    

|Additionally,
our cash, cash equivalents, available-for-sale investments, accounts receivable,
inventories and working capital are shown below for the periods indicated.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | September 30, | December 31, | Change |       
|---------------------------------- | ------------- | ------------ | ------ | ------
|
|Cash and cash equivalents          |               |              | $      | 22,393
|Available-for-sale investments, at |               |             
|market value                       |               |              |        | 58,760
|Accounts receivable, net           |               |              |        | 15,197
|Inventories                        |               |              |        | 10,183
|Working capital                    |               |              |        | 89,169

|19






We
believe that our current cash balances and expected future cash flows will be sufficient
to meet our anticipated cash needs for working capital, capital expenditures and other
activities for at least the next 12 months. As of September 30, 2006, we had no borrowings
or debt.


Operating
cash flows for the nine months ended September 30, 2006, increased compared to the same
period in 2005. This increase in operating cash flows reflects an increase in net profit,
an increase in deferred revenue as a result of the Cutera settlement offset by an increase
in working capital requirements. Cash used in investing activities decreased for the nine
months ended September 30, 2006, compared to the same period in 2005. These amounts
primarily reflect cash used for purchases of property and equipment, purchases of
available-for-sale investments offset by proceeds from the sale of available-for-sale
investments. Cash provided by financing activities increased for the nine month period
ended September 30, 2006, compared to the same period in 2005. This increase was
primarily due to an increase in exercises of stock options.


We
anticipate that capital expenditures for the remainder of 2006 will total approximately
$300,000, consisting primarily of machinery, equipment, computers and peripherals. We
expect to finance these expenditures with cash on hand.



Contractual obligations


On
August 1, 2004, we entered into a new agreement with Massachusetts General Hospital
whereby they agreed to conduct clinical and non-clinical research in the field of photo
thermal removal or reduction of hair, using light. The agreement has a term of three
years, until August 2007, and we will provide Massachusetts General Hospital at least
$230,000 on an annual basis to cover the direct and indirect costs of the research. We
have the right to exclusively license, on royalty terms to be negotiated, the inventions
we fund that are discovered during this research.


We
are a party to a license agreement, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties.


We
are obligated to make future payments under various contracts, including non-cancelable
inventory purchase commitments and our operating lease relating to our Burlington,
Massachusetts manufacturing, research and development and administrative offices.


The
following table summarizes our estimated contractual cash obligations as of September 30,
2006, excluding amounts due Massachusetts General Hospital, royalty and employment
obligations because they are variable and/or subject to uncertain timing (000s
omitted):
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | Payments due by period |        |        |     |    
|---------------------------------- | ---------------------- | ------ | ------ | --- | ---
|
|Operating lease                    | $  3,399               | $1,165 | $2,234 | $-- | $--
|Purchase commitments               | 7,058                  | 7,058  | --     | --  | -- 
|                                   |                       
|Total contractual cash obligations | $10,457                | $8,223 | $2,234 | $-- | $--
|                                   |                       

|Cautionary statements


The
risks and uncertainties described below together with all of the other information
included in this filing, including the financial statements and related notes should be
carefully considered. If any of the following risks actually occurs, our business,
prospects, financial condition and results of operations may be materially harmed. In this
event, the market price of our common stock could decline and you could lose part or all
of your investment.


20






If we do not continue to develop
and commercialize new products and identify new markets for our products and technology,
we may not remain competitive, and our revenues and operating results could suffer.


The
aesthetic laser and light based treatment system industry is subject to continuous
technological development and product innovation. If we do not continue to be innovative
in the development of new products and applications, our competitive position will likely
deteriorate as other companies successfully design and commercialize new products and
applications. We compete in the development, manufacture, marketing, sales and servicing
of light based devices with numerous other companies, some of which have substantially
greater direct worldwide sales capabilities. Our products also face competition from
medical products, prescription drugs and cosmetic procedures, such as electrolysis and
waxing.


Our products are subject to
numerous medical device regulations. Compliance is expensive and time-consuming. Without
necessary clearances, we may be unable to sell products and compete effectively.


All
of our current products are light based devices, which are subject to FDA regulations for
clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new
product or a new use of or claim for an existing product can be marketed in the United
States, we must obtain clearance from the FDA. In the event that we do not obtain FDA
clearances, our ability to market products in the United States and revenue derived there
from may be adversely affected.  The types of medical devices that we seek to market
in the U.S. generally must receive either 510(k) clearance or PMA
approval in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic
Act. The FDAs 510(k) clearance process can be expensive and usually takes from four
to twelve months, but it can last longer. The process of obtaining PMA approval is much
more costly and uncertain and generally takes from one to three years or even longer from
the time the pre-market approval application is submitted to the FDA until an approval is
obtained.


In
order to obtain pre-market approval and, in some cases, a 510(k) clearance, a product
sponsor must conduct well controlled clinical trials designed to test the safety and
effectiveness of the product. Conducting clinical trials generally entails a long,
expensive and uncertain process that is subject to delays and failure at any stage. The
data obtained from clinical trials may be inadequate to support approval or clearance of a
submission. In addition, the occurrence of unexpected findings in connection with clinical
trials may prevent or delay obtaining approval or clearance. If we conduct clinical
trials, they may be delayed or halted, or be inadequate to support approval or clearance,
for numerous reasons, including:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | FDA, other regulatory authorities
or an institutional review board may place a clinical trial on hold;
| |  |  | - |  | ------------------------------------------------------------------------------------------------------

| |  |  |  |  | patients may not
enroll in clinical trials, or patient follow-up may not occur, at the rate we expect; o
patients may not comply with trial protocols;
| |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | institutional review boards and third
party clinical investigators may delay or reject our trial protocol;
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------

| |  |  |  |  | third party
clinical investigators may decline to participate in a trial or may not perform a trial on
our anticipated
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | schedule
or consistent with the clinical trial protocol, good clinical practices, or other FDA
requirements;
| |  |  | - |  | ------------------------------------------------------------------------------------------------------------

| |  |  |  |  | third party organizations may not perform data collection and analysis in
a timely or accurate manner;
| |  |  | - |  | ------------------------------------------------------------------------------------------------------

| |  |  |  |  | regulatory inspections of our clinical trials or
manufacturing facilities may, among other things, require us to undertake corrective
action or suspend or terminate our clinical trials, or invalidate our clinical trials;
| |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|21
|--

| |  |  |  |  | changes in governmental regulations or administrative actions; and
| |  |  | - |  | ------------------------------------------------------------------

| |  |  |  |  | the interim or final
results of the clinical trials may be inconclusive or unfavorable as to safety or
effectiveness.
| |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------

|Medical devices may be marketed
only for the indications for which they are approved or cleared. The FDA may not approve
or clear indications that are necessary or desirable for successful commercialization.
Indeed, the FDA may refuse our requests for 510(k) clearance or pre-market approval of new
products, new intended uses or modifications to existing products. Our clearances can be
revoked if safety or effectiveness problems develop.


To
date, the FDA has deemed our products eligible for the 510(k) clearance process. We
believe that our products in development will receive similar treatment. However, we
cannot be sure that the FDA will not impose the more burdensome PMA approval process upon
one or more of our future products, nor can we be sure that 510(k) clearance or PMA
approval will ever be obtained for any product we propose to market and our failure to do
so could adversely affect our ability to sell our products.


We
often seek FDA clearance for additional indications for use. Clinical trials in support of
such clearances for additional indications may be costly and time-consuming. In the event
that we do not obtain additional FDA clearances, our ability to market products in the
United States and revenue derived there from may be adversely affected. Medical devices
may be marketed only for the indications for which they are approved or cleared and if we
are found to be marketing our products for off-label, or non-approved, uses we might be
subject to FDA enforcement action or have other resulting liability.


Our
products are subject to similar regulations in many international markets. Complying with
these regulations is necessary for our strategy of expanding the markets for sales of our
products into these countries. Compliance with the regulatory clearance process in any
country is expensive and time consuming.  Regulatory clearances may necessitate
clinical testing, limitations on the number of sales and limitations on the type of end
user, among other things.  In certain instances, these constraints can delay planned
shipment schedules as design and engineering modifications are made in response to
regulatory concerns and requests.  We may not be able to obtain clearances in each
country in a timely fashion or at all, and our failure to do so could adversely affect our
ability to sell our products in those countries.


After clearance or approval of our
products, we are subject to continuing regulation by the FDA, and if we fail to comply
with FDA regulations, our business could suffer.


Even
after clearance or approval of a product, we are subject to continuing regulation by the
FDA, including the requirements that our facility be registered and our devices listed
with the agency. We are subject to Medical Device Reporting regulations, which require us
to report to the FDA if our products may have caused or contributed to a death or serious
injury or malfunction in a way that would likely cause or contribute to a death or serious
injury if the malfunction were to recur. We must report corrections and removals to the
FDA where the correction or removal was initiated to reduce a risk to health posed by the
device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the
device that may present a risk to health, and maintain records of other corrections or
removals. The FDA closely regulates promotion and advertising and our promotional and
advertising activities could come under scrutiny. If the FDA objects to our promotional
and advertising activities or finds that we failed to submit reports under the Medical
Device Reporting regulations, for example, the FDA may allege our activities resulted in
violations.


The
FDA and state authorities have broad enforcement powers. Our failure to comply with
applicable regulatory requirements could result in enforcement action by the FDA or state
agencies, which may include any of the following sanctions:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | untitled letters, warning letters,
fines, injunctions, consent decrees and civil penalties;
| |  |  | - |  | -------------------------------------------------------------------------------------------

| |  |  |  |  | repair, replacement, refunds,
recall or seizure of our products;
| |  |  | - |  | ----------------------------------------------------------------

| |  |  |  |  | operating restrictions or partial suspension or total
shutdown of production;
| |  |  | - |  | -----------------------------------------------------------------------------

|22
|--

| |  |  |  |  | refusing or delaying our requests for 510(k) clearance or
pre-market approval of new products or new intended uses; and
| |  |  | - |  | -----------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | criminal prosecution.
| |  |  | - |  | ---------------------

|If any of these events were to occur,
they could harm our business.


We have modified some of our
products and sold them under prior 510(k) clearances. The FDA could retroactively decide
the modifications required new 510(k) clearances and require us to cease marketing and/or
recall the modified products.


Any
modification to one of our 510(k) cleared devices that could significantly affect its
safety or effectiveness, or that would constitute a major change in its intended use,
requires a new 510(k) clearance. We may be required to submit pre-clinical and clinical
data depending on the nature of the changes. We may not be able to obtain additional
510(k) clearances or pre-market approvals for modifications to, or additional indications
for, our existing products in a timely fashion, or at all. Delays in obtaining future
clearances or approvals would adversely affect our ability to introduce new or enhanced
products in a timely manner, which in turn would harm our revenue and operating results.
The FDA requires every manufacturer to make this determination in the first instance, but
the FDA can review any such decision. We have modified some of our marketed devices, but
we believe that new 510(k) clearances are not required. We cannot be certain that the FDA
would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us
to seek 510(k) clearance for any modification, we also may be required to cease marketing
and/or recall the modified device until we obtain a new 510(k) clearance.


Federal regulatory reforms may
adversely affect our ability to sell our products profitably.


From
time to time, legislation is drafted and introduced in Congress that could significantly
change the statutory provisions governing the clearance or approval, manufacture and
marketing of a device. In addition, FDA regulations and guidance are often revised or
reinterpreted by the agency in ways that may significantly affect our business and our
products. It is impossible to predict whether legislative changes will be enacted or FDA
regulations, guidance or interpretations changed, and what the impact of such changes, if
any, may be.


We may also be subject to state
regulations.   State regulations, and changes to state regulations, may prevent
sales to particular end users or may restrict use of the products to particular end users
or under particular supervision which may decrease revenues or prevent growth of revenues.


Our
products may also be subject to state regulations.   Federal regulation allows
our products to be sold to and used by licensed practitioners as determined on a
state-by-state basis which complicates monitoring compliance. As a result, in some states
non-physicians may purchase and operate our products. In most states, it is within a
physicians discretion who they can supervise in the operation of our products and
the level of supervision. However, some states have specific regulations as to appropriate
supervision and who may be supervised. A state could disagree with our decision to sell to
a particular type of end user or change regulations preventing sales to particular types
of end users or change regulations as to supervision. In several states these regulations
are in flux.  Thus, state regulations and changes to state regulations may decrease
revenues or prevent growth of revenues.


Because we do not require training
for all users of our products, and sell our products to non-physicians, there exists an
increased potential for misuse of our products, which could harm our reputation and our
business.


Federal regulations allow us to sell our products to or on the order of practitioners
licensed by state law. The definition of licensed practitioners varies from
state to state. As a result, our products may be purchased or operated by physicians with
varying levels of training and, in many states, by non-physicians, including nurse
practitioners, chiropractors and technicians. Outside the United States, many
jurisdictions do not require specific qualifications or training for purchasers or
operators of our products. We do not supervise the procedures performed with our products,
nor do we require that direct medical supervision occur. We and our distributors offer
product training sessions, but neither we nor our distributors require purchasers or
operators of our products to attend training sessions. The lack of required training and
the purchase and use of our products by non-physicians may result in product misuse and
adverse treatment outcomes, which could harm our reputation and expose us to costly
product liability litigation.



23






Achieving complete compliance with
FDA regulations is difficult, and if we fail to comply, we could be subject to FDA
enforcement action or our business could suffer.


We
are subject to inspection and market surveillance by the FDA to determine compliance with
regulatory requirements. The FDAs regulatory scheme is complex, especially the
Quality System Regulation, which requires manufacturers to follow elaborate design,
testing, control, documentation, and other quality assurance procedures. Because some of
our products involve the use of lasers, those products also are covered by a performance
standard for lasers set forth in FDA regulations. The laser performance standard imposes
specific record keeping, reporting, product testing and product labeling requirements.
These requirements include affixing warning labels to laser products as well as
incorporating certain safety features in the design of laser products. The FDA enforces
the Quality System Regulation and laser performance standards through periodic unannounced
inspections. We have been, and anticipate in the future being, subject to such
inspections. The complexity of the Quality System Regulation makes complete compliance
difficult to achieve. Also, the determination as to whether a Quality System Regulation
violation has occurred is often subjective. If the FDA finds that we have failed to comply
with the Quality System Regulation or other applicable requirements or take satisfactory
corrective action in response to an adverse Quality System Regulation inspection or comply
with applicable laser performance standards, the agency can institute a wide variety of
enforcement actions, including a public warning letter or other stronger remedies, such as
fines, injunctions, criminal and civil penalties, recall or seizure of our products,
operating  restrictions, partial suspension, or total shutdown of our production,
refusing to permit the import or export of our products, delaying or refusing our requests
for 510(k) clearance or PMA approval of new products, withdrawing product approvals
already granted or criminal prosecution, any of which could cause our business and
operating results to suffer.


Failure to manage our
relationships with third party researchers effectively may limit our access to new
technology, increase the cost of licensing new technology, and divert management attention
from our core business.


We
are dependent upon third-party researchers over whom we do not have absolute control to
satisfactorily conduct and complete research on our behalf.  We are also dependent
upon third-party researchers to grant us licensing terms, which may or may not be
favorable for products and technology which they may develop. At present, our principal
research partner is the Wellman Laboratories of Photomedicine at Massachusetts General
Hospital. We provide research funding, light technology and optics know-how in return for
licensing rights with respect to specific dermatologic and cosmetic applications and
patents. In return for certain exclusive license rights, we are subject to due diligence
obligations in order to maintain such exclusivity.  Our success will be dependent
upon the results of research with our partners and meeting due diligence obligations. We
cannot be sure that third-party researchers will agree with our interpretation of the
terms of our agreements, that we will meet our due diligence obligations, or that such
research agreements will provide us with marketable products in the future or that any of
the products developed under these agreements will be profitable for us.


If our new products do not gain
market acceptance, our revenues and operating results could suffer.


The
commercial success of the products and technology we develop will depend upon the
acceptance of these products by providers of aesthetic procedures and their patients and
clients. It is difficult for us to predict how successful recently introduced products, or
products we are currently developing, will be over the long term. If the products we
develop do not gain market acceptance, our revenues and operating results could suffer.


24






We
expect that many of the products we develop will be based upon new technologies or new
applications of existing technologies. It may be difficult for us to achieve market
acceptance of some of our products, particularly the first products that we introduce to
the market based on new technologies or new applications of existing technologies.


If demand for our aesthetic
treatment systems by non-traditional physician customers and spas does not develop as we
expect, our revenues will suffer and our business will be harmed.


Our
revenues from non-traditional physician customers and spa purchasers of our products
continue to increase. We believe, and our growth expectations assume, that we and other
companies selling lasers and other light-based aesthetic treatment systems have only begun
to penetrate these markets and that our revenues from selling to these markets will
continue to increase. If our expectations as to the size of these markets and our ability
to sell our products to participants in these markets are not correct, our revenues will
suffer and our business will be harmed.


If there is not sufficient demand
for the procedures performed with our products, practitioner demand for our products could
decline, which would adversely affect our operating results.


Most
procedures performed using our aesthetic treatment systems are elective procedures that
are not reimbursable through government or private health insurance. The cost of these
elective procedures must be borne by the client. As a result, the decision to undergo a
procedure that utilizes our products may be influenced by a number of factors, including:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | consumer awareness of procedures and treatments;
| |  |  | - |  | ------------------------------------------------

| |  |  |  |  | the cost, safety and effectiveness of the procedure and of alternative treatments;
| |  |  | - |  | ----------------------------------------------------------------------------------

| |  |  |  |  | the success of our and our
customers sales and marketing efforts to purchasers of these procedures; and
| |  |  | - |  | --------------------------------------------------------------------------------------------------------

| |  |  |  |  | consumer confidence, which may be affected by economic and other conditions.
| |  |  | - |  | ----------------------------------------------------------------------------

|If
there is not sufficient demand for the procedures performed with our products,
practitioner demand for our products would be reduced, which would adversely affect our
operating results.


Our business and operations are
experiencing rapid growth. If we fail to effectively manage our growth, our business and
operating results could be harmed.


We
have experienced significant growth in the scope of our operations and the number of our
employees. This growth has placed significant demands on our management, as well as our
financial and operational resources. If we do not effectively manage our growth, the
efficiency of our operations and the quality of our products could suffer, which could
adversely affect our business and operating results. To effectively manage this growth, we
will need to continue to:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |  |  | implement appropriate operational,
financial and management controls, systems and procedures;
| |  |  | - |  | ---------------------------------------------------------------------------------------------

| |  |  |  |  | expand our manufacturing
capacity and scale of production;
| |  |  | - |  | ----------------------------------------------------------

| |  |  |  |  | expand our sales, marketing and distribution
infrastructure and capabilities; and
| |  |  | - |  | ---------------------------------------------------------------------------------

| |  |  |  |  | provide adequate training and supervision to
maintain high quality standards.
| |  |  | - |  | -----------------------------------------------------------------------------

|Failure to receive shipments of
critical components could reduce revenues and reduced reliability of critical components
could increase expenses.


We develop light based systems that incorporate third-party components. Some of these
items are custom made or otherwise not readily available on the market. We purchase some
of these components from small, specialized vendors that are not well capitalized. We do
not have long-term contracts with some of these third parties for the supply of parts. A
disruption in the delivery of these key components, or our inability to obtain substitute
components or subassemblies from alternate sources at acceptable prices in a timely
manner, or our inability to obtain assembly or testing services could prevent us from
manufacturing products and result in a decrease in revenue.  We depend on an
acceptable level of reliability for purchased components.  Reliability below
expectations for key components could have an adverse affect on inventory and inventory
reserves. Any extended interruption in our supplies of third party components could
materially harm our business.





25






Our proprietary technology has
only limited protections which may not prevent competitors from copying our new
developments.  This may impair our ability to compete effectively, and we may expend
significant resources enforcing our intellectual property rights to prevent such copying.



Our
business could be materially and adversely affected if we are not able to adequately
protect our intellectual property rights. We rely on a combination of patent, copyright,
trademark and trade secret laws, licenses and confidentiality agreements to protect our
proprietary rights. We own and license a variety of patents and patent applications in the
United States and corresponding patents and patent applications in many foreign
jurisdictions. To date, however, our patent estate has not stopped other companies from
competing against us, and though we have licensed certain competitors to certain patents
and are enforcing those same patents against other competitors and intend to enforce
against others, we do not know how successful we will be in asserting our patents against
suspected infringers. Our pending and future patent applications may not issue as patents
or, if issued, may not issue in a form that will be advantageous to us. Even if issued,
patents may be challenged, narrowed, invalidated or circumvented, which could limit our
ability to stop competitors from marketing similar products or limit the length of term of
patent protection we may have for our products. Changes in either patent laws or in
interpretations of patent laws in the United States and other countries may diminish the
value of our intellectual property or narrow the scope of our patent protection. In
addition to patented technology, we rely upon unpatented proprietary technology, processes
and know-how. We generally enter into non-disclosure agreements with our employees and
third parties with whom we work, including but not limited to consultants and vendors, to
restrict access to, and distribution of, our proprietary information. Despite our efforts
to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise
obtain and use our technology, proprietary information and know-how and we may not have
adequate remedies for any such breach. Monitoring unauthorized use of our technology is
difficult and we cannot be certain that the steps we have taken will prevent unauthorized
use of our technology, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as in the United States. If competitors are able to use
our technology, our ability to compete effectively could be harmed and the value of our
technology and products could be adversely affected.  Costly and time consuming
lawsuits may be necessary to enforce and defend patents issued or licensed exclusively to
us, to protect our trade secrets and/or know-how or to determine the enforceability, scope
and validity of others intellectual property rights. Such lawsuits may result in
patents issued or licensed exclusively to us to be found invalid and unenforceable. 
In addition, our trade secrets may otherwise become known or our competitors also may
independently develop technologies that are substantially equivalent or superior to our
technology and which do not infringe our patents.


Claims by others that our products
infringe their patents or other intellectual property rights could prevent us from
manufacturing and selling some of our products or require us to pay royalties or incur
substantial costs from litigation or development of non-infringing technology.


In recent years, there has been significant litigation in the United States involving
patents and other intellectual property rights.  The light based cosmetic and
dermatology industry in particular is characterized by a large number of patents and
related litigation regarding patents and other intellectual property rights. Because our
resources are limited and patent applications are maintained in secrecy for a period of
time, we can conduct only limited searches to determine whether our technology infringes
any patents or patent applications. Any claims for patent infringement, regardless of
merit, could be time-consuming, result in costly litigation and diversion of technical and
management personnel, cause shipment delays, require us to develop non-infringing
technology or to enter into royalty or licensing agreements. Uncertainties resulting from
the initiation and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. Although patent and
intellectual property disputes in the light based industry have often been settled through
licensing or similar arrangements, costs associated with such arrangements may be
substantial and often require the payment of ongoing royalties, which could have a
negative impact on gross margins. There can be no assurance that necessary licenses would
be available to us on satisfactory terms, or that we could redesign our products or
processes to avoid infringement, if necessary. Accordingly, an adverse determination in a
judicial or administrative proceeding or failure to obtain necessary licenses could
prevent us from manufacturing and selling some of our products. This could have a material
adverse effect on our business, results of operations and financial condition.



26






On
August 10, 2006, Candela Corporation commenced an action for patent infringement in the
United States District Court for the District of Massachusetts against us, seeking both
monetary damages and injunctive relief. The complaint alleges that our StarLux System with
the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne
treatment, that our QYAG5 System willfully infringes U.S. Patent No. 5,312,395 which is
directed to treatment of pigmented lesions, and that our StarLux System with the LuxG
handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle
treatment. On October 25, 2006, Candela filed an amended complaint which did not include
U.S. Patent No. 6,659,999. Consequently, Candela is no longer accusing the StarLux System
with LuxG handpiece of infringement. With regard to the two remaining patents, Candela is
seeking to enjoin us from selling these products in the United States if found to infringe
the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On October 30,
2006 we answered the complaint denying that our products infringe the asserted patents and
filing counterclaims seeking declaratory judgments that the asserted patents are invalid
and not infringed. In addition, with regard to U.S. Patent No. 5,312,395, we filed a
counter claim of inequitable conduct. We are defending the action vigorously and believe
that we have meritorious defenses of non-infringement, invalidity and inequitable conduct.
However, litigation is unpredictable and we may not prevail in successfully defending or
asserting our position. If we do not prevail, we may be ordered to pay substantial damages
for past sales and an ongoing royalty for future sales of products found to infringe in
the United States. We could also be ordered to stop selling any products that are found to
infringe in the United States.


Public
announcements concerning this litigation that are unfavorable to us may in the future
result in significant declines in our stock price. An adverse ruling or judgment in this
matter could cause our stock price to decline significantly.


Litigation
with Candela is expected to be expensive and protracted, and our intellectual property
position may be weakened as a result of an adverse ruling or judgment. Whether or not we
are successful in the pending lawsuit, litigation consumes substantial amounts of our
financial resources and diverts managements attention away from our core business.



We may not be able to
successfully collect licensing royalties.


In past years and following the settlements with Lumenis and Cutera, material portions of
our revenues consist of royalties from sub-licensing patents licensed to us on an
exclusive basis by Massachusetts General Hospital. If we are unable to collect our
licensing royalties, our revenues will decline.



Quarterly revenue or operating
results could cause the price of our common stock to fall.


Our quarterly revenue and operating results are difficult to predict and may swing sharply
from quarter to quarter.  If our quarterly revenue or operating results fall
below the expectations of investors or public market analysts, the price of our common
stock could fall substantially. Our quarterly revenue is difficult to forecast for many
reasons, some of which are outside of our control.  For example, many factors are
related to market supply and demand, including potential increases in the level and
intensity of price competition between our competitors and us, potential decrease in
demand for our products and possible delays in market acceptance of our new
products.  Other factors are related to our customers and include changes in or
extensions of our customers budgeting and purchasing cycles and changes in the
timing of product sales in anticipation of new product introductions or enhancements by us
or our competitors.   Factors related to our operations may also cause quarterly
revenue or operating results to fall below expectations, including absence of significant
product backlogs, our effectiveness in our manufacturing process, unsatisfactory
performance of our distribution channels, service providers, or customer support
organizations, and timing of any acquisitions and related costs.








27


Managing our relationship with
Gillette effectively may divert the attention of key technical personnel and management
from the core business.   If Gillette ends the relationship our stock price
could fall, and we may be unable to bring a home use hair removal device for women to the
market.


On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and
commercialize a home-use, light based hair removal device for women.  On June 28, 2004, we announced that we have completed the
initial phase of our agreement with Gillette and that both parties would move into the next phase. In conjunction with entering this
next phase, the parties amended the agreement to provide for additional development funding to further technical innovations.  On
September 29, 2006, we announced that we have completed the development phase of our agreement with Gillette and that both parties
would move into the next phase.


We
believe that this represents a unique opportunity to bring light based devices to the mass
market. There can be no assurance that we will be able to meet all our development
obligations under the agreement or receive a 510k clearance for an over-the-counter
product that could be sold directly to consumers.  Under the agreement, significant
resources and the attention of key technical personnel and management continue to be
directed to the development of such a device even though such device will not likely be
commercialized for several years, if ever.  In addition, we cannot be sure that
Gillette will agree with our interpretation of the terms of the agreement, that the
agreement will provide us with marketable products in the future or that we will receive
payments for any of the products developed under the agreement.  During the term of
the agreement, Gillette has the ability to choose not to continue and may terminate the
agreement.  If Gillette terminates the agreement, the price of our common stock could
fall significantly, and we will not receive certain payments.  We may proceed to
develop and commercialize the device on our own or with a third party.  However,
there can be no assurance that we will be able to successfully implement such a
strategy.  In addition, after commercialization of such device, Gillette is to pay us
a percentage of net sales of such device. Certain of these percentages of net sales are
only owed if the device is covered by valid patents.  There can be no assurance that
valid patents will cover the device in any or all countries, in which the device will be
manufactured, used or sold.  This could have a material adverse effect on our
business, results of operations and financial condition.


Managing our contract with the
United States Department of the Army effectively may divert the attention of key technical
personnel and management from the core business.   We may be unable to complete
the project within the time period which may impact our ability to receive future
government contracts.



On
February 18, 2004, we announced that we were awarded a $2.5 million research contract by
the Department of the Army to develop a light based self-treatment device for PFB. This
represents a unique opportunity to address PFB.  On October 25, 2005, we announced
that we received additional funding of $888,000 and a twelve month extension of this
contract.  On September 1, 2006, we were awarded additional funding of $440,000 for a
total of $3.8 million and an additional five month extension. We believe we can complete
the project within the extension. However, there can be no assurance that we will be able
to complete the project within that time period which may impact our ability to receive
future government contracts.  Under the agreement, significant resources and the
attention of key technical personnel and management will be directed to the development of
such a device even though such device will not likely be ready for military use for
several years, if ever.



Managing our relationship with
Johnson & Johnson Consumer Companies, Inc. effectively may divert the attention of key
technical personnel and management from the core business.   If Johnson &
Johnson Consumer Companies, Inc. ends the relationship our stock price could fall, and we
may be unable to bring to market home-use, light based devices for (i) reducing or
reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii)
reducing or preventing acne.

28






On
September 1, 2004, we entered into a Development and License Agreement with Johnson &
Johnson Consumer Companies, Inc. to develop and commercialize home-use, light based
devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii)
reducing appearance of skin aging; and (iii) reducing or preventing acne.  We believe
that this represents a unique opportunity to bring light based devices to the mass
market.  There can be no assurance that we will be able to meet all our development
obligations under the agreement or receive a 510k clearance for over-the-counter products
that could be sold directly to consumers.  Under the agreement, significant resources
and the attention of key technical personnel and management will be directed to the
development of such devices even though such devices will not likely be commercialized for
several years, if ever.  In addition, we cannot be sure that Johnson & Johnson
Consumer Companies, Inc. will agree with our interpretation of the terms of the agreement,
that the agreement will provide us with marketable products in the future or that we will
receive payments for any of the products developed under the agreement.During the term of the agreement, Johnson & Johnson Consumer Companies, Inc. has
the ability to choose not to continue and may terminate the agreement.  If Johnson
& Johnson Consumer Companies, Inc. terminates the agreement, the price of our common
stock could fall significantly, and we will not receive certain payments.  We may
proceed to develop and commercialize the devices on our own or with a third party. 
However, there can be no assurance that we will be able to successfully implement such a
strategy.In addition, after commercialization of such device, Johnson &
Johnson Consumer Companies, Inc. is to pay us a percentage of net sales of such device.
Certain of these percentages of net sales are only owed if the device is covered by valid
patents. There can be no assurance that valid patents will cover these devices in any or
all countries, in which the devices will be manufactured, used or sold.  This could
have a material adverse effect on our business, results of operations and financial
condition.


Failure to maintain effective
internal controls over financial reporting could have a material adverse effect on our
business, operating results and stock price.



Beginning
with our annual report for our fiscal year ended December 31, 2004, Section 404 of the
Sarbanes-Oxley Act of 2002 required us to include a report by our management on our
internal controls over financial reporting. Such report must contain an assessment by
management of the effectiveness of our internal controls over financial reporting as of
the end of our fiscal year and a statement as to whether or not such internal controls are
effective. Such report must also contain a statement that our independent auditors have
issued an attestation report on managements assessment of such internal controls.



Our
efforts to comply with Section 404 have resulted in, and are likely to continue to result
in, significant costs, the commitment of time and operational resources and the diversion
of managements attention. If our management identifies one or more material
weaknesses in our internal controls over financial reporting, we will be unable to assert
that such internal controls are effective. If we are unable to assert that our internal
controls over financial reporting are effective our business may be harmed.


We have not paid dividends in the
past and do not expect to pay dividends in the future, and any return on investment may be
limited to the value of our stock.


We
have never paid cash dividends on our common stock and do not anticipate paying cash
dividends on our common stock in the foreseeable future. The payment of dividends on our
common stock will depend on our earnings, financial condition and other business and
economic factors affecting us at such time as our board of directors may consider
relevant. If we do not pay dividends, our stock may be less valuable because a return on
your investment will only occur if our stock price appreciates.


The expense and potential
unavailability of liability insurance coverage for our customers could adversely affect
our ability to sell our products and our financial condition.


Some
of our customers and prospective customers have had difficulty in procuring or maintaining
liability insurance to cover their operation and use of our products. Medical malpractice
carriers are withdrawing coverage in some states or substantially increasing premiums. If
this trend continues or worsens, our customers may discontinue using our products, and
potential customers may elect not to purchase laser and other light-based products.







29






We may be unable to attract and
retain key executives and research and development personnel that we need to succeed.


As a small company with approximately 200 employees, our success depends on the services
of key employees in executive and research and development positions. The loss of the
services of one or more of these employees could have a material adverse effect on our
business.  Our future success will depend in large part upon our ability to attract,
retain, and motivate highly skilled employees. We cannot be certain that we will be able
to do so.


We face a risk of financial
exposure to product liability claims in the event that the use of our products results in
personal injury.


Our products are and will continue to be designed and manufactured with numerous safety
features, but it is possible that consumers could be adversely affected by use of one of
our products. Furthermore, in the event that any of our products prove to be defectively
designed and manufactured, we may be required to recall and redesign such products.
Product liability claims could divert managements attention from our core business,
be expensive to defend and result in sizable damage awards against us. Although we have
not experienced any material losses due to product liability claims to date, there can be
no assurance that we will not experience such losses in the future. We maintain general
liability insurance and umbrella coverage; however, there can be no assurance that such
coverage will continue to be available on terms acceptable to us or that such coverage
will be adequate for liabilities actually incurred. In the event we are found liable for
damages in excess of the limits of our insurance coverage or if any claim or product
recall results in significant adverse publicity against us, our business, financial
condition and results of operations could be materially and adversely affected. In
addition, although our products have been and will continue to be designed to operate in a
safe manner, and although we attempt to educate customers with respect to the proper use
of our products, misuse of our products by personnel over whom we cannot exert control may
result in the filing of product liability claims or significant adverse publicity against
us. Any product liability claims brought against us, with or without merit, could increase
our product liability insurance rates or prevent us from securing continuing coverage,
could harm our reputation in the industry and reduce product sales. We would need to pay
any product losses in excess of our insurance coverage out of cash reserves, harming our
financial condition and adversely affecting our operating results.


We face risks associated with
product warranties.


We
could incur substantial costs as a result of product failures for which we are responsible
under warranty obligations.


Because we derive a significant
amount of our revenue from international sales, we are susceptible to currency
fluctuations, long payment cycles, credit risks and other risks associated with conducting
business overseas.


We sell a significant amount of our products and services outside the U.S. 
International product revenue, consisting of sales from our distributors in Japan, Europe,
Australia, Asia\Pacific Rim and South and Central America and sales shipped directly to
international locations from the United States, and we expect that international sales
will continue to be significant.  As a result, a major part of our revenues and
operating results could be adversely affected by risks associated with international
sales, including but not limited to political and economic instability and difficulties in
managing our foreign operations.  In particular, longer payment cycles common in
foreign markets, credit risk and delays in obtaining necessary import or foreign
certification or regulatory approvals for products may occur.  In addition,
significant fluctuations in the exchange rates between the U.S. dollar and foreign
currencies could cause us to lower our prices and thus reduce our profitability, or could
cause prospective customers to push out orders to later dates because of the increased
relative cost of our products in the aftermath of a currency devaluation or currency
fluctuation.

30






We rely on third party
distributors to market and sell a large portion of our products. If these distributors do
not commit the necessary resources to effectively market and sell our products or if our
relationships with these distributors are disrupted, our business and operating results
may be harmed.


In
the United States, we sell our products through our internal sales organization. Outside
of this market, we sell our products through third party distributors. Our sales and
marketing success in these other markets depends on these distributors, in particular
their sales and service expertise and relationships with the customers in the marketplace.
We do not control these distributors, and they may not be successful in marketing our
products. Third party distributors may terminate their relationships with us, or fail to
commit the necessary resources to market and sell our products to the level of our
expectations. If current or future third party distributors do not perform adequately, or
if we fail to maintain our existing relationships with these distributors or fail to
recruit and retain distributors in particular geographic areas, our revenue from
international sales may be adversely affected and our operating results could suffer.



We may seek additional
financing to grow the business.


Although we have generated a profit in recent years, we have a history of losses. We may
not be able to sustain or increase profitability on a quarterly or annual basis. If our
operating results fall below the expectations of investors or public market analysts, the
price of our common stock could decline.


We
may determine, depending upon the opportunities available, to seek additional debt or
equity financing to fund the costs of expansion.  Additionally, if we incur
indebtedness to fund increased levels of accounts receivable, finance the acquisition of
capital equipment, or if we issue debt securities in connection with any acquisition we
will be subject to risks associated with incurring substantial additional indebtedness.


Our common stock could be further
diluted by the conversion of outstanding options and warrants.


In
the past, we have issued and still have outstanding convertible securities in the form of
options and warrants.  We may continue to issue options, warrants and other equity
rights as compensation for services and incentive compensation for our employees,
directors and consultants or others who provide services to us. We have a substantial
number of shares of common stock reserved for issuance upon the conversion and exercise of
these securities. Such a conversion would dilute our stockholders and could adversely
affect the market price of our common stock.


Our charter documents and Delaware
law may discourage potential takeover attempts.


Our Second Restated Certificate of Incorporation and our By-laws contain provisions that
could discourage takeover attempts or make more difficult the acquisition of a substantial
block of our common stock. Our By-laws require a stockholder to provide to our Secretary
advance notice of director nominations and business to be brought by such stockholder
before any annual or special meeting of stockholders, as well as certain information
regarding such nomination and/or business, the stockholder and others known to support
such proposal and any material interest they may have in the proposed business. They also
provide that a special meeting of stockholders may be called only by the affirmative vote
of a majority of the board of directors. These provisions could delay any stockholder
actions that are favored by the holders of a majority of our outstanding stock until the
next stockholders meeting. In addition, the board of directors is authorized to
issue shares of our common stock and preferred stock that, if issued, could dilute and
adversely affect various rights of the holders of common stock and, in addition, could be
used to discourage an unsolicited attempt to acquire control of us.


We
are also subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law, which prohibits us from engaging in a business combination
with an interested stockholder for a period of three years after the date of
the transaction in which the person becomes an interested stockholder, unless the business
combination is approved in a prescribed manner. The application of Section 203 may limit
the ability of stockholders to approve a transaction that they may deem to be in their
best interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers or tender
offers or could delay or prevent certain changes in control or our management, including
transactions in which stockholders might otherwise receive a premium for their shares over
the then current market price. In April 1999, we adopted a shareholder rights plan. This
is intended to protect shareholders from unfair or coercive takeover practices.  In
accordance with the shareholder rights plan, the Board of Directors declared a dividend
distribution of Series A right for each share of common stock outstanding until the rights
become exercisable.

31








Item 3.  Quantitative and qualitative disclosures about market risk

Our
primary market risk exposures are in the areas of interest rate risk. Our investment
portfolio of cash equivalents and debt securities is subject to interest rate
fluctuations, but we believe this risk is immaterial because of the short-term nature of
these investments.



Item 4. Controls and
procedures


Under the
direction of the principal executive officer and principal financial officer, the Company
has evaluated the effectiveness of its disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2006. Based on that
evaluation, the Company has concluded that its disclosure controls and procedures were
effective in providing reasonable assurance that material information required to be
disclosed is included on a timely basis in the reports filed with the Securities and
Exchange Commission.


There
were no significant changes in the Companys internal controls over financial
reporting or in other factors that could significantly affect these controls during the
quarter ended September 30, 2006, including any corrective actions with regard to
significant deficiencies and material weaknesses.


PART II  Other
information



Item
1.    Legal proceedings


On February 15, 2002 and April 7, 2005, we commenced actions for patent infringement in the United States District Court for
the District of Massachusetts against Cutera, Inc. seeking both monetary damages and injunctive relief. The Massachusetts General
Hospital in Boston, Massachusetts was added as a plaintiff in these lawsuits.  In the first suit, Cuteras CoolGlide Laser Systems,
including the CoolGlide CV, Excel, Vantage and Xeo, were accused of infringing U.S. Patent No. 5,735,844. In the second lawsuit,
Cutera's Lamp Systems, including the CoolGlide Xeo and Solera Opus platforms using the PW770 handpiece, were accused of infringing
both the 5,735,844 Patent as well as U.S. Patent No. 5,595,568 (the "Anderson Patents"). We have an exclusive license to these
patents from the General Hospital Corporation.



On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc. through the execution of a
Settlement Agreement and a License Agreement.  Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing
license to the Anderson Patents (U.S. Patent Nos. 5,595,568 & 5,735,844) in the professional field, excluding the consumer field
which is exclusively licensed to the Gillette Company. Cutera admitted that their products infringe the Anderson Patents and that
these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of
the Anderson Patents in the future. Cutera paid us an estimated payment for royalties of 8.5% due on past sales of their laser- and
lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our
legal costs. The final amounts due to us are subject to audit by an independent accounting firm which is scheduled to be completed by
the end of the fourth quarter. Following the audit, the amounts owed may be higher or lower than the estimated amount. Starting on
April 1, 2006, Cutera began paying us a 7.5% royalty on sales of its existing light-based hair removal systems, and Cutera will pay us a 7.5% royalty on sales of its later
developed light-based hair removal systems.





32






For more information, please see the Settlement Agreement, the License Agreement, the Consent Judgments and Stipulations of
Dismissal filed as Exhibits 99.1, 99.2, 99.3 and 99.4 to a Current Report on Form 8-K filed June 5, 2006.


On July 7, 2006, we commenced an action for patent infringement in the United States District Court for the District of
Massachusetts against Alma Lasers, Inc. seeking both monetary damages and injunctive relief. The complaint alleges Almas Harmony,
Soprano and Sonata Systems which use pulsed light and laser technology for hair removal willfully infringe U.S. patent Nos. 5,595,568
and 5,735,844, which are exclusively licensed to Palomar by the Massachusetts General Hospital.  On July 27, 2006, we filed an
amended complaint including an additional claim against Alma for unfair competition due to infringement by Almas Harmony System of
the distinctive trade dress of our products, including the unique, distinctive, and immediately recognizable design of our Palomar
EsteLux, MediLux and StarLux Systems (Palomars Trade Dress).  We are seeking both monetary and injunctive relief on the new
claim.  Alma answered the complaint denying that its products infringe valid claims of the asserted patents and Palomars Trade Dress
and filing a counterclaim seeking a declaratory judgment that the asserted patents are invalid and not infringed.  Palomar filed a
reply denying the material allegations of the counterclaims.


On August 9, 2006, we commenced an action for patent infringement in the United States District Court for the District of
Massachusetts against Candela Corporation, seeking both monetary damages and injunctive relief. The complaint alleges Candelas
GentleYAG and GentleLASE systems which use laser technology for hair removal willfully infringe U.S. patent No. 5,735,844, which is
exclusively licensed to Palomar by the Massachusetts General Hospital.


On August 10, 2006, Candela Corporation commenced an action for patent infringement in the United States District Court for the
District of Massachusetts against us, seeking both monetary damages and injunctive relief.  The complaint alleges that our StarLux
System with the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne treatment, that our QYAG5
System willfully infringes U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions, and that our StarLux System
with the LuxG handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle treatment.  On October 25, 2006,
Candela filed an amended complaint which did not include U.S. Patent No. 6,659,999.  Consequently, Candela is no longer accusing the
StarLux System with LuxG handpiece of infringement. With regard to the two remaining patents, Candela is seeking to enjoin us from
selling these products in the United States if found to infringe the patents, and to obtain compensatory and treble damages,
reasonable costs and attorneys fees, and other relief as the court deems just and proper. On October 30, 2006 we answered the
complaint denying that our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that the
asserted patents are invalid and not infringed.  In addition, with regard to U.S. Patent No. 5,312,395, we filed a counter claim of
inequitable conduct. We are defending the action vigorously and believe that we have meritorious defenses of non-infringement,
invalidity and inequitable conduct. However, litigation is unpredictable and we may not prevail in successfully defending or
asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for
future sales of products found to infringe in the United States. We could also be ordered to stop selling any products in the United
States that are found to infringe.


Item 2. Changes in
securities, use of proceeds and issuer purchases of securities.



None.



Item 3. Defaults upon
senior securities



None.




33







Item 4.  Submission of matters to a vote of security holders




None.



Item
5. Other information



None.



Item 6. Exhibits
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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| | 31.1 | Certification of Joseph P. Caruso, President and Chief Executive Officer of
                             the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
                             2002.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 31.2 | Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the
Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 32 | Certification of Joseph P. Caruso, President and Chief Executive Officer of the
Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 32 | Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the
Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|34


Signatures


Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant certifies that
it has caused this Report to be signed on its behalf by the undersigned, thereunto duly
authorized.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Palomar Medical
Technologies, Inc.(Registrant)
| |  | ----------------------------------------------

|                        |                                                                                                     
|----------------------- | ----------------------------------------------------------------------------------------------------
|Date:  November 3, 2006 | By:/s/ Joseph P. Caruso
      Joseph P. Caruso
      President, Chief Executive Officer and Director
|                        |                                                                                                     

|                        |                                                                                            
|----------------------- | -------------------------------------------------------------------------------------------
|Date:  November 3, 2006 | By:/s/ Paul S. Weiner
      Paul S. Weiner
      Vice President and Chief Financial Officer
|                        |                                                                                            

|35
|--