|UNITED STATES
                                                  SECURITIES AND EXCHANGE COMMISSIONWashington, DC 20549


FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the quarterly period ended September 30, 2004.





Commission file number 0-22340

Palomar Medical Technologies, Inc.(Exact name of registrant as specified in its charter)
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                        | 
|--------------------------------------- | 
|Delaware                                | 
|(State
      or other jurisdiction      | 
|of incorporation
      or organization) | 

|82
      Cambridge Street, Burlington, Massachusetts | 01803-4107       | 
|---------------------------------------------------- | ---------------- | 
|(Address
      of principal executive offices)       | (Zip
      code) | 

|Registrants
        telephone number, including area code:(781) 993-2300
|-------------------------------------------------------------------------

|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.    Yes ý No oIndicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Securities Exchange Act of
1934).   Yeso No ý

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             | 
|---------------------------- | 
|Class                        | 
|Common Stock, $.01 par value | 

|
|

|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, 2004
              and December 31, 2003                         |  | 1       
|                               | Unaudited Condensed Consolidated Statements of Income for the three and nine months
              ended September 30, 2004  and 2003 |  | 2       
|                               | Unaudited Condensed Consolidated Statement of Stockholders' Equity                                                                   |  | 3       
|                               | Unaudited Condensed Consolidated Statements of Cash Flows                                                                            |  | 4       
|                               | Notes to Unaudited Condensed Consolidated Financial Statements                                                                       |  | 5       
|Item 2.                        | Managements Discussion and Analysis of Financial Condition and the
   Results of Operations                                         |  | 11      
|                               | Cautionary Statements                                                                                                                |  | 21      
|Item 3.                        | Quantitative and Qualitative Disclosures About Market Risk                                                                           |  | 27      
|Item 4.                        | Controls and Procedures                                                                                                              |  | 27      
|                               |                                                                                                                                      |  |         
|PART II - Other Information    |                                                                                                                                      |  |         
|                               |                                                                                                                                      |  |         
|Item 1.                        | Legal Proceedings                                                                                                                    |  | 28      
|Item 2.                        | Changes in Securities, Use of Proceeds and Issuer Purchases of Securities                                                            |  | 28      
|Item 3.                        | Defaults Upon Senior Securities                                                                                                      |  | 28      
|Item 4.                        | Submission of Matters to a Vote of Security Holders                                                                                  |  | 28      
|Item 5.                        | Other Information                                                                                                                    |  | 28      
|Item 6.                        | Exhibits and Reports on Form 8-K                                                                                                     |  | 28      
|SIGNATURES                     |                                                                                                                                      |  | 30      

|i
|-

|
|

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

|                                                                             | September 30,
2004 | December 31,
2003
|---------------------------------------------------------------------------- | ------------------ | -----------------
|Assets                                                                       |                    |                  
|Current assets:                                                             
|Cash and cash equivalents                                                    | $   19,509,643     | $   10,558,946   
|Accounts receivable, net of allowance of $979,392 and $862,114, respectively | 7,516,800          | 6,637,246        
|Inventories                                                                  | 5,141,970          | 3,385,316        
|Other current assets                                                         | 559,290            | 384,785          
|                                                                             |                    |                  
|Total current assets                                                         | 32,727,703         | 20,966,293       
|                                                                             |                    |                  
|Property and equipment, net                                                  | 894,922            | 582,898          
|                                                                             |                    |                  
|Other assets                                                                 | 111,074            | 111,074          
|                                                                             |                    |                  
|Total Assets                                                                 | $   33,733,699     | $   21,660,265   
|                                                                             |                    |                  
|Liabilities and Stockholders' Equity                                        
|Current liabilities:                                                        
|Accounts payable                                                             | $     1,490,477    | $        655,923 
|Accrued liabilities                                                          | 7,161,935          | 4,979,896        
|Deferred income taxes                                                        | 1,100,000          | 1,100,000        
|Deferred revenue                                                             | 1,191,324          | 560,897          
|                                                                             |                    |                  
|Total current liabilities                                                    | 10,943,736         | 7,296,716        
|                                                                             |                    |                  
|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 -  16,035,991 and 14,554,407 shares, respectively                     | 160,360            | 145,544          
|Additional paid-in capital                                                   | 171,406,452        | 168,267,820      
|Accumulated deficit                                                          | (148,776,849)      | (154,049,815)    
|                                                                             |                    |                  
|Total stockholders' equity                                                   | 22,789,963         | 14,363,549       
|                                                                             |                    |                  
|Total liabilities and stockholders equity                                   | $   33,733,699     | $   21,660,265   
|                                                                             |                    |                  

|The accompanying notes are
an integral part of these consolidated financial statements
-1-
|------------------------------------------------------------------------------------------

|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                               | $ 11,599,737                     | $   8,302,460                   | $ 31,913,625      | $ 22,147,186     
|Royalty revenues                               | 1,254,820                        | 179,659                         | 2,903,325         | 648,445          
|Funded product development revenues            | 1,092,448                        | 700,000                         | 3,194,084         | 1,900,000        
|                                               |                                  |                                 |                   |                  
|Total revenues                                 | 13,947,005                       | 9,182,119                       | 38,011,034        | 24,695,631       
|                                               |                                  |                                 |                   |                  
|                                               |                                  |                                 |                   |                  
|Costs and expenses:                           
|Cost of product revenues                       | 3,991,748                        | 3,510,724                       | 11,232,768        | 9,389,120        
|Cost of royalty revenues                       | 501,928                          | 71,864                          | 1,161,330         | 259,378          
|Research and development                       | 2,532,625                        | 1,595,371                       | 7,561,970         | 4,488,953        
|Selling and marketing                          | 3,034,595                        | 2,394,868                       | 8,840,313         | 6,068,166        
|General and administrative                     | 1,443,626                        | 996,525                         | 3,707,809         | 2,948,094        
|                                               |                                  |                                 |                   |                  
|Total costs and expenses                       | 11,504,522                       | 8,569,352                       | 32,504,190        | 23,153,711       
|                                               |                                  |                                 |                   |                  
|                                               |                                  |                                 |                   |                  
|Income from operations                         | 2,442,483                        | 612,767                         | 5,506,844         | 1,541,920        
|Interest income, net of interest expense       | 78,554                           | 16,724                          | 143,065           | 26,925           
|Other income (expense), net                    | (377,000)                        | --                              | (215,933)         | 58,333           
|                                               |                                  |                                 |                   |                  
|Income from operations before income taxes     | 2,144,037                        | 629,491                         | 5,433,976         | 1,627,178        
|Provision (benefit) from income taxes          | 60,381                           | (275,000)                       | 161,010           | (704,521)        
|                                               |                                  |                                 |                   |                  
|Net income                                     | $   2,083,656                    | $      904,491                  | $   5,272,966     | $   2,331,699    
|                                               |                                  |                                 |                   |                  
|                                               |                                  |                                 |                   |                  
|Net income per share:                         
|Basic                                          | $            0.13                | $            0.07               | $            0.34 | $            0.18
|                                               |                                  |                                 |                   |                  
|Diluted                                        | $            0.12                | $            0.05               | $            0.30 | $            0.15
|                                               |                                  |                                 |                   |                  
|Weighted average number of shares outstanding:
|Basic                                          | 15,878,521                       | 13,859,356                      | 15,547,683        | 13,092,732       
|                                               |                                  |                                 |                   |                  
|Diluted                                        | 17,793,795                       | 16,524,300                      | 17,517,346        | 15,504,757       
|                                               |                                  |                                 |                   |                  

|The accompanying notes are
an integral part of these consolidated financial statements
-2-
|------------------------------------------------------------------------------------------

|Palomar Medical Technologies, Inc. and Subsidiaries
          Condensed Consolidated Statement of Stockholders' Equity
                          (Unaudited)
|------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                 | Common Stock |  |  | Total      | 
|---------------------------------------------------------------- | ------------ |  |  | ---------- | 
|
|
|Balance, December 31, 2003                                       |              |  |  | 14,554,407 | 
|Net income                                                       |              |  |  | --         | 
|Issuance of stock for employee stock purchase plan               |              |  |  | 16,543     | 
|Issuance of stock for 2003 employer 401(k) matching contribution |              |  |  | 38,819     | 
|Costs incurred related to the issuance of common stock           |              |  |  | --         | 
|Tax benefit from the exercise of stock options                   |              |  |  | --         | 
|Exercise of stock options                                        |              |  |  | 1,388,222  | 
|Exercise of warrants                                             |              |  |  | 38,000     | 
|                                                                 |             
|Balance, September 30, 2004                                      |              |  |  | 16,035,991 | 
|                                                                 |             

|The accompanying notes are
an integral part of these consolidated financial statements
-3-
|------------------------------------------------------------------------------------------

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

|                                                                                               | Nine Months Ended September 30, |              
|---------------------------------------------------------------------------------------------- | ------------------------------- | -------------
|
|Cash flows from operating activities:                                                          |                                 |              
|Net income                                                                                     | $   5,272,966                   | $ 2,331,699  
|                                                                                               |                                 |              
|Adjustments to reconcile net income  to net cash provided (used in)      operating activities:
|Depreciation and amortization                                                                  | 221,228                         | 156,738      
|Increase in accounts receivable allowance                                                      | 117,278                         | 323,912      
|Tax benefit from the exercise of stock options                                                 | 108,511                         | 32,500       
|Changes in assets and liabilities,                                                            
|Accounts receivable                                                                            | (996,832)                       | (2,674,326)  
|Inventories                                                                                    | (1,756,654)                     | 397,574      
|Other current assets                                                                           | (174,505)                       | 126,089      
|Accounts payable                                                                               | 834,554                         | (925,034)    
|Accrued liabilities                                                                            | 2,395,942                       | (168)        
|Deferred income taxes                                                                          | --                              | (300,000)    
|Deferred revenue                                                                               | 630,427                         | 934,342      
|                                                                                               |                                 |              
|Net cash provided by operating activities                                                      | 6,652,915                       | 403,326      
|                                                                                               |                                 |              
|Cash flows from investing activities:                                                         
|Purchases of property and equipment                                                            | (533,252)                       | (180,780)    
|Decrease in other assets                                                                       | --                              | 7,194        
|                                                                                               |                                 |              
|Net cash used in investing activities                                                          | (533,252)                       | (173,586)    
|                                                                                               |                                 |              
|Cash flows from financing activities:                                                         
|Proceeds from the exercise of stock options, warrants and employee                            
|stock purchase plan                                                                            | 2,892,522                       | 1,309,233    
|Costs incurred related to issuance of common stock                                             | (61,488)                        | (180,625)    
|Proceeds from sale of common stock                                                             | --                              | 3,410,000    
|                                                                                               |                                 |              
|Net cash provided by financing activities                                                      | 2,831,034                       | 4,538,608    
|                                                                                               |                                 |              
|Net increase in cash and cash equivalents                                                      | 8,950,697                       | 4,768,348    
|Cash and cash equivalents, beginning of the period                                             | 10,558,946                      | 4,450,076    
|                                                                                               |                                 |              
|Cash and cash equivalents, end of the period                                                   | $ 19,509,643                    | $ 9,218,424  
|                                                                                               |                                 |              
|Supplemental disclosure of cash flow information:                                             
|                                                                                               |                                 |              
|Cash paid for interest                                                                         | $          3,551                | $      26,819
|                                                                                               |                                 |              
|Supplemental disclosure of noncash financing and investing activities:                        
|                                                                                               |                                 |              
|Issuance of stock for employer 401(k) matching contribution                                    | $      213,903                  | $    195,711 
|                                                                                               |                                 |              
|Exchange of note payable for common stock                                                      | $               --              | $ 1,000,000  
|                                                                                               |                                 |              

|The accompanying notes are
an integral part of these consolidated financial statements
-4-
|------------------------------------------------------------------------------------------

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


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. Accordingly, they 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. Palomar Medical Technologies, Inc. and its subsidiaries (
Palomar) believes 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 Palomars Form 10-K for the year ended December 31, 2003.
Certain prior-period amounts have been reclassified to conform with the current-period
presentation.


Note 2  Stock
based compensation


Palomar
follows the intrinsic value method in accordance with Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees (APB 25) and related
interpretations, in accounting for its stock-based compensation plans, rather than the
alternative fair value accounting method provided for under SFAS No. 123, Accounting
for Stock-Based Compensation. Under APB 25, when the exercise price of options granted
under these plans equals the market price of the underlying stock on the date of grant, no
compensation expense is required. In accordance with EITF 96-18, Palomar records
compensation expense equal to the fair value of options and warrants granted to
non-employees over the vesting period, which is generally the period of service.


The
following table illustrates the effect on net income and earnings per share if Palomar had
applied the fair value recognition provisions of SFAS No. 123 to stock-based employee
compensation. Palomar has computed the pro forma disclosures required under SFAS No. 123
for all stock options granted to employees of Palomar for the three and nine months ended
September 30, 2004 and 2003, respectively, using the Black-Scholes option-pricing model
prescribed by SFAS No. 123.


Pro forma disclosure


The
pro forma effect on Palomar of applying SFAS No. 123 for all options to purchase common
stock of Palomar would be as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                      |  | Three Months Ended
September 30, | Nine Months Ended
September 30, |                |  
|------------------------------------- |  | -------------------------------- | ------------------------------- | -------------- | -
|
|Net income as reported                |  |                                  |                                 | $    2,083,656 |  
|                                      |  |                                  |                                 |                |  
|Less:  Total stock-based employee     | 
|compensation expense determined under | 
|fair value based method for all       | 
|awards, net of tax                    |  |                                  |                                 | (766,981       | )
|                                      |  |                                  |                                 |                |  
|Pro forma net income (loss)           |  |                                  |                                 | $    1,316,675 |  
|                                      |  |                                  |                                 |                |  
|Net income (loss) per share:          | 
|Basic - as reported                   |  |                                  |                                 | $         0.13 |  
|                                      |  |                                  |                                 |                |  
|Basic - pro forma                     |  |                                  |                                 | $         0.08 |  
|                                      |  |                                  |                                 |                |  
|Diluted - as reported                 |  |                                  |                                 | $         0.12 |  
|                                      |  |                                  |                                 |                |  
|Diluted - pro forma                   |  |                                  |                                 | $         0.07 |  
|                                      |  |                                  |                                 |                |  

|-5-


Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial
Statements


Note 3  Cash
equivalents


Cash
equivalents consist of short-term, highly liquid investments which are readily convertible
into cash with maturities of three months or less when purchased.


Note 4  Inventories


Inventories
are stated at lower of cost (first-in, first-out) or market. At September 30, 2004 and
December 31, 2003, inventories consisted of the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                | September 30,
2004 | December 31, 2003
|--------------- | ------------------ | -----------------
|Raw materials   | $                  | 2,989,242        
|Work-in-process |                    | 509,982          
|Finished goods  |                    | 1,642,746        
|                |                    |                  
|                | $                  | 5,141,970        
|                |                    |                  

|Note 5  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
the estimated useful lives. At September 30, 2004 and December 31, 2003, property and
equipment consisted of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | September 30,
2004 | December 31, 2003
|---------------------------------- | ------------------ | -----------------
|Machinery and equipment            |                    | $1,327,844       
|Furniture and fixtures             |                    | 1,899,392        
|Leasehold improvements             |                    | 293,555          
|                                   |                    |                  
|                                   |                    | 3,520,791        
|Less: accumulated depreciation and |                    |                  
|amortization                       |                    | 2,625,869        
|                                   |                    |                  
|                                   |                    | $   894,922      
|                                   |                    |                  

|Note 6  Warranty
costs


Palomars
products generally carry a standard one-year warranty, with pulsed light handpieces
carrying a warranty of the earlier of the period of two-years or 100,000 shots fired.
Palomar provides a reserve based on anticipated warranty claims at the time product
revenue is recognized. In anticipation of actual warranty claims, Palomar amortizes the
reserve ratably over the life of the warranty thereby offsetting actual warranty claims
incurred. Actual warranty claims incurred and charged to product costs of sale during an
interim period may be more or less than the amount of amortized warranty reserve allocated
against them. Factors that affect Palomars product warranty liability include the
number of installed units, the anticipated cost of warranty repairs and historical and
anticipated rates of warranty claims.

The following table reflects the changes in Palomar's accrued warranty during the nine months ended September 30, 2004:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            | Total
(in thousands)
|------------------------------------------- | --------------------
|Warranty accrual as of December 31, 2003    | $ 585               
|Plus accruals related to new sales          | 904                 
|Less: amortization of prior period accruals | (768)               
|                                            |                     
|Warranty accrual as of September 30, 2004   | $ 721               

|-6-


Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial
Statements


Note 7  Segment
information


Product
revenue from international sources were $5.4 million and $4.0 million for the three months
ended September 30, 2004 and 2003, respectively, and $13.4 million and $11.6 million for
nine months ended September 30, 2004 and 2003, respectively. The following table
represents the percentage of product revenue by geographic region from customers for the
three and nine months ended September 30, 2004 and 2003:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             | Three Months Ended
September 30, | Nine Months Ended
September 30, |        |       
|---------------------------- | -------------------------------- | ------------------------------- | ------ | ------
|
|United States                | 53.7%                            | 52.4%                           | 58.1%  | 46.5% 
|Japan                        | 11.0%                            | 23.8%                           | 11.7%  | 25.7% 
|Canada                       | 13.6%                            | 7.6%                            | 11.3%  | 8.4%  
|Europe                       | 9.0%                             | 6.5%                            | 7.8%   | 7.7%  
|Asia / Pacific / Middle East | 6.1%                             | 5.4%                            | 6.8%   | 4.8%  
|Australia                    | 5.2%                             | 2.3%                            | 3.1%   | 4.3%  
|South and Central America    | 1.4%                             | 2.0%                            | 1.2%   | 2.6%  
|                             |                                  |                                 |        |       
|Total                        | 100.0%                           | 100.0%                          | 100.0% | 100.0%

|Note 8  Net income
per common share


Basic
net income per share was determined by dividing net income attributable to common
stockholders by the weighted average common shares outstanding during the period. Diluted
net income per share was determined by dividing net income attributable to common
stockholders 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 for the three and nine months ended September
30, 2004 and 2003 is as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                        | Three Months Ended
September 30, | Nine Months Ended
September 30, |            |           
|--------------------------------------- | -------------------------------- | ------------------------------- | ---------- | ----------
|
|Basic weighted average number of shares |                                  |                                 |            |           
|outstanding                             | 15,878,521                       | 13,859,356                      | 15,547,683 | 13,092,732
|Weighted average common equivalent     
|shares pursuant to options and         
|warrants to purchase common stock       | 1,915,274                        | 2,664,944                       | 1,969,663  | 2,412,025 
|                                        |                                  |                                 |            |           
|Diluted weighted average number of      |                                  |                                 |            |           
|shares outstanding                      | 17,793,795                       | 16,524,300                      | 17,517,346 | 15,504,757

|Diluted
weighted average shares outstanding do not include options outstanding to
purchase 7,826 and 1,711,100 common equivalent shares for the three and nine months ended
September 30, 2004, respectively, and 107,991 and 650,901 common equivalent shares for the
three months and nine months ended September 30, 2003, respectively, as their effect would
have been antidilutive.

-7-


Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial
Statements




Note 9  Research
and development arrangement with Massachusetts General Hospital


In
August 1995, Palomar entered into an agreement with The Massachusetts General Hospital
Corporation whereby Massachusetts General Hospital agreed to conduct clinical trials on a
laser treatment for hair removal/reduction developed at Wellman Laboratories of
Photomedicine. In July 1999, Palomar further amended this agreement to extend the research
agreement for an additional five years, with Palomar agreeing to pay Massachusetts General
Hospital $475,000 on an annual basis, and to expand the research beyond photothermal hair
removal into the fields of fat removal and acne treatment. Palomar has the right to
exclusively license, on royalty terms to be negotiated, Palomar-funded inventions in the
relevant fields. Palomar is in discussions with Massachusetts General Hospital for an
extension of this agreement for clinical research beyond August 2004. Palomar signed an
extension for clinical research to support three additional months of funding and is in
discussions with Massachusetts General Hospital to extend this agreement for clinical
research beyond October 2004.


Note 10 
Development and license agreement with Gillette


Effective
as of February 14, 2003, Palomar 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 provides for up to $7 million in support of
research and development to be paid by Gillette over approximately 30 months.


At
the end of the 30-month period, or such later date as regulatory clearance is obtained for
the device, Gillette will decide whether or not to continue with the project based on all
the information known at that time. Upon Gillette deciding to continue, Gillette will be
obligated to make a development completion payment to Palomar of $2.5 million. If Gillette
decides not to continue, Palomar may proceed to develop and commercialize the device on
its own or with a different party.


After
Gillette makes the development completion payment to Palomar 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 whether or not
to continue with the project. Upon deciding to continue, Gillette will be obligated to
make a development completion payment to Palomar of $10 million. If Gillette decides not
to continue to commercialize the device, Palomar may proceed to commercialize the device
on its own or with a different party.


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


After
launch of the first device for females, Gillette will pay Palomar a percentage of net
sales of the device, subject in certain instances to various reductions and offsets.
Again, for as long as Gillette elects to have Palomar work exclusively with Gillette,
Gillette will continue to be obligated to pay Palomar 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 Palomar in connection with jointly
developed products, Gillette is required to make certain lump sum and net sales based
payments to Palomar 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 Palomar for the development and commercialization of home-use, light-based hair
removal devices for men.


Effective
as of June 28, 2004, Palomar and Gillette completed the initial phase of the agreement and
both parties decided to move onto the next phase. Accompanying this decision, Palomar and
Gillette amended the original agreement, whereby, Gillette will provide $2.1 million in
additional development funding to further technical innovations over a 9-month extension
of the development phase, which is now planned to be completed by August 31, 2006.


-8-


Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial
Statements



Palomar
has recognized $796,000 and $2.3 million of funded product development revenues from
Gillette during the three months and nine months ended September 30, 2004, respectively.


Note 11  Joint Development
and License agreement with Johnson & Johnson Consumer Companies (JJCC), a
Johnson & Johnson company


Effective
as of September 1, 2004, Palomar entered into a Joint Development and License Agreement
with Johnson & Johnson Consumer Companies, Inc. (JJCC), 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.


The
agreement provides for JJCC to fund Palomars research and clinical studies during an
initial proof-of-principle phase. At the end of the proof-of-principle phase, JJCC 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 JJCC deciding to continue, JJCC will be obligated to
fund the development of the selected devices.  If JJCC decides not to continue,
Palomar may proceed in fields not selected by JJCC to develop and commercialize these and
other devices on its own or with a different party.


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


There
was no revenue recognized under the JJCC development and license agreement during the
three and nine months ended September 30, 2004.


Note 12  Research
contract with the Department of the Army


In
the first quarter of 2004, Palomar began providing services under a $2.5 million research
contract with the 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
Palomar is 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. This revenue is included in funded product development revenue in the
accompanying statements of operations. Palomar has recognized $296,000 and $939,000 of
funded product development revenues from the Department of the Army during the three
months and nine months ended September 30, 2004, respectively.


Note 13  Product
upgrade options


During
the quarter ended March 31, 2004, Palomar introduced the StarLux Pulsed Light and Laser
System. Palomar began commercially shipping StarLux products at the end of the second
quarter of 2004. In connection with this product introduction, Palomar offered certain
customers an upgrade option to trade-in existing products for a new StarLux system for an
upgrade fee. In connection with the upgrade right and in accordance with the Emerging
Issues Task Force issue No. 00-21 and SEC Staff Accounting Bulletin No. 104, Palomar
deferred approximately $1.5 million of revenue during the first two quarters of 2004.
During the three and nine months ended September 30, 2004, Palomar has recognized
approximately $1.2 million of product revenues relating to this up-grade option. The
remaining $266,000 is expected to be recognized during the fourth quarter of 2004.


Note 14 
Settlement of Litigation


-9-


Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial
Statements


On
June 22, 2004, Palomar and Lumenis Ltd. announced that both parties reached a settlement
resolving their 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.



Under
the terms of the settlement, Lumenis paid $868,000 in the second quarter 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 Palomar a 5% royalty on sales of the LightSheer and
other professional laser hair removal devices and modules.


In
addition, Lumenis granted Palomar a paid up license to a variety of Lumenis patents
for Palomars light based devices. Palomar granted Lumenis a paid up license to the
568 and 844 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, 2004, Lumenis made payments of approximately
$523,000 and $980,000, respectively, relating to the 5% royalty and approximately $537,500
and $1.4 million, respectively, for back-owed royalties recorded as royalty revenue.

-10-





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 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
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.
Palomar undertakes 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 17, 2004. 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 the Companys financial condition and results of
operations are based upon the Companys 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 the Company 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, the Company evaluates its estimates, including those related to revenue
recognition, bad debts, inventories, warranty obligations, contingencies, restructurings
and income taxes. The Company bases its estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the

-11-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 the
Companys critical accounting policies and the related judgments and estimates
affecting the preparation of the Companys consolidated financial statements is
included in the Annual Report on Form 10-K of the Company for fiscal year 2003. There have
been no material changes to our critical accounting policies as of September 30, 2004.



Overview


We
are a leading researcher and developer of proprietary laser and lamp
(light-based) systems for cosmetic treatments. We are uniquely focused on
developing proprietary light-based technology that can be introduced to the mass markets.
Clinical results indicate that our technology can provide superior consumer benefits that
cannot be achieved with currently available technology or products. We are a pioneer in
laser hair removal and are the first company to obtain clearance using laser systems from
the FDA for permanent hair reduction. Our hair removal systems have been
installed in physician practices worldwide, where, to date, millions of treatments have
been performed. Through our research partnerships, we are testing new and exciting
indications to further advance the hair removal market and other cosmetic applications,
including fat reduction, acne treatment and skin rejuvenation.


We
have an agreement with The Gillette Company (NYSE:G) to develop and potentially
commercialize a patented home-use, light-based hair removal device for women, and an
agreement with Johnson & Johnson Consumer Companies to develop and potentially
commercialize home-use, light-based devices for reducing or reshaping body fat including
cellulite, reducing the appearance of skin aging, and reducing or preventing acne. In
addition, we have been awarded a $2.5 million research contract by the U.S. Department of
the Army to develop a light-based self-treatment device for the dermatologic disease
Pseudofolliculitis Barbae or PFB.


This
Managements Discussion and Analysis of Financial Condition and Results of Operations
provide information that our management believes to be necessary to achieve a clear
understanding of our financial statements and results of operations.


Our
management monitors and analyzes a number of key performance indicators in order to manage
our business and evaluate our financial and operating performance.  Those indicators
include but are not limited to the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Revenues.  We derive revenues from products and services relating to our
products, from royalty revenue and from funded product development.  Revenues from
our products and services vary based on such factors as demand for our products, the
number and size of transactions within the reporting period and the impact of changes in
our sales prices.  In addition to monitoring the amount of our product and service
revenues and total revenues, we also consider revenue concentration by customer and by
geographic region to be possible indicators of current and future trends in our business.
Royalty revenues vary based on the amount of sales completed by our sublicensees. Funded
product development revenues from Gillette and JJCC are at a fixed rate; however, funded
product development revenues provided from the United Sates Army are on a reimbursement
basis and fluctuate in accordance with work performed.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Cost of revenues and gross margins. We strive to control our cost of
revenues.  The major items impacting cost of product and service revenues are
material costs, personnel, overhead expenses and royalties collected.  With regard to
the cost of royalty revenue, under our license agreement with Massachusetts General
Hospital (MGH), we pay MGH 40% of royalties we receive from third parties for
sublicenses to United States Patents 5,595,568 and 5,735,844 and foreign counterparts.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Operating expenses.  Operating expenses are substantially driven by personnel,
commissions and overhead expenses. Other significant operating expenses that we monitor
include research and
development, travel and entertainment, professional fees and facilities and other sales
and marketing expenses.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-12-
|----

| |  | Liquidity and cash flows. In recent periods, the primary source of our
liquidity is our net income and proceeds from the exercise of stock options.  From
period to period, we see fluctuations in various items, including our working capital
accounts, capital expenditures, purchases of property and equipment and proceeds from the
exercise of employee stock options.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Balance sheet.  We view cash, working capital, inventory, inventory turns,
accounts receivable balances and days sales outstanding as important indicators of our
financial health.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our
total revenues increased 52% for the third quarter of 2004 to $13.9 million, up from $9.2
million in the third quarter of 2003. Gross margin from product sales increased to $7.6
million (66 percent of product revenues), up from $4.8 million (58 percent of product
revenues) in the year-earlier quarter. We reported net income of $2.1 million, or $0.12
per diluted share, for the third quarter of this year, versus net income of $904,000, or
$0.05 per diluted share, for the third quarter of last year. These increases in gross
margins and net income are due to a higher margin product mix, improved manufacturing
efficiencies across all of our product lines and the effects of increased sales volumes.
Increases in royalty revenues are attributed to Palomar and Lumenis reaching a settlement
resolving on-going litigation concerning both patent infringement and contractual matters
in the second quarter of 2004. As a result of this settlement, our royalty revenues
increased by $1.1 million or 597% for the three months ended September 30, 2004 in
comparison to the same period in 2003. Funded product development revenue increased by 56%
for the third quarter of 2004 to $1.1 million, up from $700,000 in the third quarter in
2003. This increase is related primarily from payments made by the United States Army in connection with a contract for PFB research.
 We also strengthened our balance sheet since the end of last year, including
increasing our cash position by 85% and increasing stockholders equity by 59%.


Over
the last two years, most of our product revenue has been from the Lux family of products
with their complementary handpieces, which offer a suite of applications to the end user
at a lower cost than other competing systems. Customers can invest in their first Lux
system with one handpiece then purchase additional handpieces as their practice grows and
upgrade into a more powerful Lux system when ready. Additionally, the Lux platform enables
us to custom tailor products to fit almost any professional medical office or spa location
and provides our customers with the comfort that the system can grow with their practice.
We have kept a commitment to continually provide value to customers who invest in our Lux
system platform. We believe the Lux family of products are the most affordable and
versatile cosmetic light-based systems on the market.


Our
quarterly product revenue has increased as compared to the same period in 2003 as a result
of the increased product demand for our Lux family of products. Looking forward, we would
expect as our installed base of Lux family of products continues to increase that the
demand for replacement handpieces will increase resulting in additional product revenue.


In
February 2004, we introduced the newest addition to the Lux family of products: the
StarLux Pulsed Light and Laser System. In comparison to other Lux products, the
StarLux has increased power, a computer controlled touch screen, instant handpiece
recognition, integrated cooling, the ability to operate the Lux Y, LuxG, LuxR, LuxRs, LuxV
and the Lux1064 handpieces. We began commercially shipping StarLux systems at the
end of the second quarter of 2004.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-13-
|----

|On
February 18, 2004, we were awarded a $2.5 million research contract by the Department of
the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or
PFB. The project is scheduled to last for nineteen months. As of September 30, 2004, we
have recognized approximately $939,000 to funded product development revenues.


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


Recent developments


Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson Consumer Companies, Inc. (JJCC), 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.


The
agreement provides for JJCC to fund our research and clinical studies during an initial
proof-of-principle phase. At the end of the proof-of-principle phase, JJCC 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 JJCC deciding to continue, JJCC will be obligated to fund
the development of the selected devices.  If JJCC decides not to continue, Palomar
may proceed in fields not selected by JJCC to develop and commercialize these and other
devices on its own or with a different party.


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


Results of operations


The
following tables contain selected statements of income information, which serve as the
basis of the discussion of our results of operations for the three and nine months ended
September 30, 2004 and 2003, respectively (in thousands, except for percentages):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | Three Months Ended
September 30, | Change |         |      |          |       
|------------------------------------ | -------------------------------- | ------ | ------- | ---- | -------- | ------
|
|
|Revenues:                            |                                  |        |         |      |          |       
|Product revenues                     | $ 11,600                         | 83%    | $8,302  | 90%  | $ 3,298  | 40%   
|Royalty revenues                     | 1,255                            | 9%     | 180     | 2%   | 1,075    | 597%  
|Funded product development revenues  | 1,092                            | 8%     | 700     | 8%   | 392      | 56%   
|                                     |                                  |        |         |      |          |       
|Total revenues                       | $ 13,947                         | 100%   | $9,182  | 100% | $ 4,765  | 52%   
|                                     |                                  |        |         |      |          |       
|Cost and expenses:                  
|Cost of product revenues             | $   3,992                        | 29%    | $3,511  | 38%  | $    481 | 14%   
|Cost of royalty revenues             | 502                              | 4%     | 72      | 1%   | 430      | 597%  
|Research & development               | 2,533                            | 18%    | 1,595   | 17%  | 938      | 59%   
|Selling & marketing                  | 3,035                            | 22%    | 2,394   | 26%  | 641      | 27%   
|General & administrative             | 1,443                            | 10%    | 997     | 11%  | 446      | 45%   
|                                     |                                  |        |         |      |          |       
|Total costs & expenses               | $ 11,505                         | 82%    | $8,569  | 93%  | $ 2,936  | 34%   
|                                     |                                  |        |         |      |          |       
|Income from operations               | $   2,442                        | 18%    | $   613 | 7%   | $ 1,829  | 298%  
|Interest income, net of interest     | 79                               | 1%     | 16      | -%   | 63       | 394%  
|expense                             
|Other income (expense), net          | (377)                            | (3)%   | --      | -%   | (377)    | *     
|                                     |                                  |        |         |      |          |       
|Income before income taxes           | $   2,144                        | 15%    | $   629 | 7%   | $ 1,515  | 241%  
|(Provision) benefit for income taxes | (60)                             | -%     | 275     | 3%   | (335)    | (122)%
|                                     |                                  |        |         |      |          |       
|Net income                           | $   2,084                        | 15%    | $   904 | 10%  | $ 1,180  | 131%  
|                                     |                                  |        |         |      |          |       

|___________________
* These percentages are not meaningful to the understanding of our financial condition and results of operations.
|-------------------------------------------------------------------------------------------------------------------------------------

|-14-
|----

|                                     | Nine Months Ended
     September 30, | Change |          |      |           |       
|------------------------------------ | ------------------------------------ | ------ | -------- | ---- | --------- | ------
|
|
|Revenues:                            |                                      |        |          |      |           |       
|Product revenues                     | $ 31,914                             | 84%    | $22,148  | 90%  | $   9,766 | 44%   
|Royalty revenues                     | 2,903                                | 8%     | 648      | 2%   | 2,255     | 348%  
|Funded product development revenues  | 3,194                                | 8%     | 1,900    | 8%   | 1,294     | 68%   
|                                     |                                      |        |          |      |           |       
|Total revenues                       | $ 38,011                             | 100%   | $24,696  | 100% | $ 13,315  | 54%   
|                                     |                                      |        |          |      |           |       
|Cost and expenses:                  
|Cost of product revenues             | $ 11,233                             | 30%    | $  9,389 | 38%  | $   1,844 | 20%   
|Cost of royalty revenues             | 1,161                                | 3%     | 259      | 1%   | 902       | 348%  
|Research & development               | 7,562                                | 20%    | 4,489    | 18%  | 3,073     | 68%   
|Selling & marketing                  | 8,840                                | 23%    | 6,068    | 25%  | 2,772     | 46%   
|General & administrative             | 3,708                                | 10%    | 2,949    | 12%  | 759       | 26%   
|                                     |                                      |        |          |      |           |       
|Total costs & expenses               | $ 32,504                             | 86%    | $23,154  | 94%  | $   9,350 | 40%   
|                                     |                                      |        |          |      |           |       
|Income from operations               | $   5,507                            | 14%    | $  1,542 | 6%   | $   3,965 | 257%  
|Interest income, net of interest     | 143                                  | -%     | 27       | -%   | 116       | 430%  
|expense                             
|Other income (expense), net          | (216)                                | (1)%   | 58       | -%   | (274)     | (472)%
|                                     |                                      |        |          |      |           |       
|Income before income taxes           | $   5,434                            | 14%    | $  1,627 | 7%   | $   3,807 | 234%  
|(Provision) benefit for income taxes | (161)                                | -%     | 705      | 3%   | (866)     | (123)%
|                                     |                                      |        |          |      |           |       
|Net income                           | $   5,273                            | 14%    | $  2,332 | 9%   | $   2,941 | 126%  
|                                     |                                      |        |          |      |           |       

|Product
revenues. Increases in unit sales from the Lux family of
products were the leading contributor to the increase in product revenues. Sales from the
Lux family of products, consisting of the StarLux, MediLux, EsteLux, NeoLux
and related additional handpieces, increased by $2.5 million and $9.7 million for both the
third quarter and nine months ended September 30, 2004, respectively, in comparison
to the same periods in 2003. Product revenues were unfavorably impacted by a decrease of
$325,000 and $1.0 million of sales related to our legacy products, the RD-1200 and
SLP1000, during the third quarter and nine months ended, September 30, 2004, respectively,
in comparison to the same periods
in 2003.  Market acceptance of the "Lux" family of products has been increasing since its introduction in September 2001.

-15-


International
product revenue was 46% of total product revenue for the quarter ended September 30, 2004
in comparison to 48% for the same period in 2003. For the nine months ended September 30,
2004, international revenue was 42% versus 54% for the same period in 2003. For the
quarter and nine months ended September 30, 2004, these decreases as a percentage of
revenues in international sales are directly attributed to the increase in domestic
product sales and a decrease in sales made in Japan in comparison to the same periods in
2003.


During
the quarter ended March 31, 2004, we introduced the StarLux Pulsed Light and Laser System.
We began commercially shipping StarLux products at the end of the second quarter of 2004.
In connection with this product introduction, we offered certain customers an upgrade
option to trade-in existing products for a new StarLux system for an upgrade fee. In
connection with the upgrade right and in accordance with the Emerging Issues Task Force
issue No. 00-21 and SEC Staff Accounting Bulletin No. 104, we deferred approximately $1.5
million of revenue during the first two quarters of 2004. During the three and nine months
ended September 30, 2004, we recognized approximately $1.2 million of product revenues
relating to this up-grade option. The remaining $266,000 will be recognized during the
fourth quarter of 2004.


Royalty
revenues. The increase in royalty revenue for the quarter ended and nine
months ended September 30, 2004, in comparison to the same period in 2003, is attributed
to the settlement agreement between Palomar and Lumenis. Under the terms of the
settlement, 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 Palomar a 5% royalty on sales of the LightSheer and other
professional laser hair removal devices and modules. In addition, Lumenis granted Palomar
a paid up license to a variety of Lumenis patents for Palomars light based
devices. Palomar granted Lumenis a paid up license to the 568 and 844 patents
for Lumenis professional 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, 2004,
Lumenis made payments of approximately $523,000 and $980,000, respectively, relating to
the 5% royalty and approximately $537,500 and $1.4 million, respectively, for back-owed
royalties recorded as royalty revenue.


Funded
product development revenues.We account for funded product development
revenue under the Gillette agreement ratably over the funding period as payments are
received. For both the quarter and nine months ended September 30, 2004, funded product
development revenues increased. For the quarter ended September 30, 2004, we received from
Gillette $796,000 to fund development. For the nine months ended, we received from
Gillette approximately $2.3 million. Since inception in 2003, we received from Gillette
approximately $4.9 million to fund development. Any amounts received in advance are
recorded as deferred revenue. Payments are not refundable if the development is not
successful.


For
the cost reimbursement contract with a fixed fee awarded by the Department of the Army, we
earn a fixed fee of 8% as costs are incurred or services are provided. The total value of
the contract is $2.5 million. For the third quarter ended September 30, 2004, we billed
the Department of the Army for approximately $274,000 plus a fixed fee of $22,000 totaling
approximately $296,000. For the nine months ended September 30, 2004, we billed the
Department of the Army for approximately $868,000 plus a fixed fee of $71,000 totaling
approximately $939,000.


Cost
of product revenues. The cost of product revenues decreased as a percentage
of product revenue for both the quarter ended and nine months ended September 30, 2004
from the same periods in 2003. These decreases as a percentage of product revenue are
primarily a result of increased sales volumes and higher margin product mix which have improved the absorption of
manufacturing overhead at our manufacturing facility.


-16-


Cost
of royalty revenues. 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 2003.
The increase in the cost of royalty revenues is attributed to the settlement agreement
between Palomar and Lumenis.


Research
and development expense. For the quarter and nine months ended September
30, 2004, research and development expenses increased in comparison to the same periods in
2003. These increases are a direct result of our spending related to the Gillette
agreement, other expenses related to the Department of the Army contract, legal costs
related to our increasing patent portfolio, our continued commitment to introducing new
platforms and enhancing our current family of products. For the third quarter ended
September 30, 2004 expenses relating to the Gillette agreement increased by approximately
$315,000 as compared to the same period in 2003. For the nine months ended September 30,
2004, expenses relating to the Gillette agreement increased by approximately $880,000 as
compared to the same period in 2003. These increases in expenses relating to the Gillette
agreement are directly attributed to Palomar incurring additional payroll and payroll
related expenses as well as additional development costs.


Expenses
relating to the Army contract, which began in February of 2004, totaled approximately
$274,000 for the third quarter ended September 30, 2004 and $867,000 for the nine months
ended September 30, 2004. The project is scheduled to last for nineteen months from its
inception.


For
the third quarter and nine months ended September 30, 2004, legal expenses relating to the
prosecution of new patents increased by approximately $12,000 and $203,000, respectively,
in comparison to the same periods in 2003. We are committed to expanding intellectual
property rights necessary to protect discoveries made through our investment in research
and development.


Expenses
relating to the introduction of new products such as the StarLux, enhancements made to the
Companys current family of products and research and development overhead increased
by approximately $420,000 for the third quarter of 2004 and by $1.4 million for the nine
months ended September 30, 2004, in comparison to the same periods in 2003.


The
spending on research and development reflects our commitment to continuing dermatology
research for a better understanding of various cosmetic and medical conditions and to
continuing research and development of devices and delivery systems to better treat those
various cosmetic and medical conditions. The research and development goals in the fields
of light based hair removal, pigmented and vascular lesion removal and acne treatment are
to design systems that: (1) permit effective treatment and more rapid treatment of large
areas, (2) have high gross margins, and (3) are manufactured at lower costs, to expand our
current markets. Furthermore, we are developing products to address other dermatology and
cosmetic conditions, including the fields of fat reduction and skin rejuvenation.


Selling
and marketing expense. For the quarter ended September 30, 2004, selling
and marketing increased by $486,000 from payroll and payroll related expenses, $221,000
related to tradeshow expenses and other overhead costs, $210,000 related to the write-off
of demo inventory offset by a decrease in commission expense of $277,000 in comparison to
the same period in 2003. Domestic commission expense increased by approximately $51,000,
European commissions increased by approximately $31,000 while Far East commissions
decreased by approximately $359,000 due to a change in our commission structure with one
of our Far East distributors. This change in commission structure was necessitated by the
Shonin regulatory approval obtained by one of our distributors, which allows us to sell
certain products directly to our distributor at a transfer price. Previously, we sold
directly to the end customer and incurred higher commission costs. These increases
directly correlate with our increased revenues, upfront costs associated with both
international and domestic sales force and distribution channel expansion as well as the
introduction of our newest product, the StarLux Pulsed Light and Laser System.


For
the nine months ended September 30, 2004, selling and marketing expenses increased by $1.5
million from payroll and payroll related expenses, approximately $1.1 million relating to
tradeshows, consultants and other sales and marketing infrastructure costs, $210,000
related to the write-off of demo inventory offset by a decrease of approximately $79,000
relating to commission expense in comparison to the same


-17-


period in 2003. Domestic commission
increased by approximately $800,000 correlating with our increased domestic product
revenue, European commissions increased by $72,000, while Far East commissions decreased
by approximately $951,000 due to a change in our commission structure with one of our Far
East distributors as discussed above. These increases directly correlate with our
increased revenues, upfront costs associated with both international and domestic sales
force and distribution channel expansion as well as the introduction of our newest
product, the StarLux Pulsed Light and Laser System.


General
and administrative expense. For both the quarter and nine months ended,
September 30, 2004, general and administrative expenses increased. For the quarter ended
September 30, 2004, this increase is mainly attributed to increases to incentive
compensation of $140,000, related to our incentive compensation plan of 2004, an increase
in payroll and payroll related expenses of approximately $27,000, an increase in costs
related corporate governance caused by Sarbanes-Oxley of $87,000, an increase in our
corporate legal expenses of approximately $228,000, offset by a decrease in infrastructure costs of $35,000 as compared to
the same period in 2003. For the nine months ended, September 30, 2004, this increase is
mainly attributed to increases to incentive compensation of $500,000, related to our
incentive compensation plan of 2004, an increase in payroll and payroll related expenses
of approximately $154,000, an increase in costs related corporate governance caused by
Sarbanes-Oxley of $175,000, an increase in our corporate legal expenses of approximately
$29,000 offset by a decrease of approximately $100,000 in infrastructure costs as compared to the same period in
2003.


Interest
income, net of interest expense.For the quarter and nine months ended
September 30, 2004, interest income, net of interest expense increased, respectively, in
comparison to the same periods in 2003. For both the quarter and nine months ended
September 30, 2004, interest income, net of interest expense increased due to higher
levels of excess cash on hand in comparison to the same periods in 2003.


Other
income (expense), net. For the quarter and nine months ended September 30,
2004, other income (expense), net decreased in comparison to the same period in 2003. This
decrease is attributable to costs of $380,000 related to a non-recurring expense from the
settlement of a previously owned subsidiarys facility lease offset by payments
received from a previously written-off note receivable and equity investment.


Provision
(benefit) for income taxes. We provided approximately a 3% effective tax
rate for anticipated federal alternative minimum taxes and minimum state income taxes due
for 2004. The benefit from income taxes for the three and nine months ended, September 30,
2003 was $225,000 and $705,000, respectively. During the three months ended June 30, 2003,
we recognized a tax benefit of $470,000, which is associated with the recovery of
carryback operating losses paid in prior years pursuant to the Economic Stimulus package
of 2002. During the three months ended, September 30, 2003, we recognized a benefit from
income taxes of $300,000, which is attributed to the reduction in deferred income tax
accruals associated with certain tax deductions taken in the Companys 1999 Federal
Tax return. Offsetting these refund claims, we provided a 4%
effective tax rate for both the three-months and nine-months ended September 30, 2003 for
the anticipated federal alternative minimum taxes and minimum state income taxes due for
2003. Given our limited history of profitability, we have fully reserved our
otherwise recognizable deferred tax asset, as its realization is uncertain.


In
fiscal year 1999, the Company recorded approximately $1.1 million of tax reserves related
to certain state tax consequences of the gain on the sale of Star Medical.  As of
October 15, 2004, the statute of limitations period for assessing state tax for fiscal
year 1999 has expired.  As such, the Company will reduce the $1.1 million of
aforementioned tax reserves in the fourth quarter ended December 31, 2004.

-18-


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 except in current
ratio calculation):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          | Nine months ended
September 30, | Change
2004 to 2003 |         |       
|------------------------- | ------------------------------- | ------------------- | ------- | ------
|
|Operating cash flows      | $ 6,653                         | $    403            | $ 6,250 | 1,551%
|Investing cash flows      | (533)                           | (174)               | (359)   | (206%)
|Financing cash flows      | 2,831                           | 4,539               | (1,708) | (38%) 
|Capital expenditures, net | 533                             | 181                 | 352     | 194%  

|Additionally,
our cash position, working capital, accounts receivable, inventories, working capital and
current ratio are shown below for the periods indicated.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          | September 30,
2004 | December 31,
2003 | Change
Dollars | Change
%
|------------------------- | ------------------ | ----------------- | -------------- | --------
|Cash and cash equivalents | $19,510            | $10,559           | $8,951         | 85%     
|Accounts receivable, net  | 7,517              | 6,637             | 880            | 13%     
|Inventories, net          | 5,142              | 3,385             | 1,757          | 52%     
|Working capital           | 21,784             | 13,670            | 8,114          | 59%     
|                          |                    |                   |                |         
|Current ratio             | 2.99               | 2.87              | .12            | 4%      

|As
of September 30, 2004, we had $19.5 million in cash and cash equivalents. 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, 2004, we had no long-term
debt.


Operating
cash flows provided cash from operating activities for the nine months ended September 30,
2004. This increase primarily reflects the increase of net profits, payables, liabilities
and deferred revenue offset by increases in accounts receivables, inventories and other
current assets. The primary changes in operating cash flows are from increases in accounts
receivable, which corresponds with the increase in our product revenues, an increase in
inventory versus year end levels, which is attributed to new product activities associated
with the StarLux product line and increases in deferred revenue, which is mainly made up
of deferred revenue relating to our upgrade option to trade-in existing products for a new
StarLux system for an upgrade fee. Net cash used in investing activities for the nine
months ended September 30, 2004 primarily reflect cash used for the purchases of capital
equipment. Cash provided by financing activities for the nine months ended September 30,
2004 were a result of exercises of stock options and purchases of common stock pursuant to
the employee stock purchase plan offset by costs related to the issuance of common stock.


We
anticipate that capital expenditures for the remainder of 2004 will total approximately
$100,000, consisting primarily of machinery, equipment, computers and peripherals. We
expect to finance these expenditures with cash on hand.


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. The agreement provides up to $7 million in initial development support funding to
be paid by Gillette to


-19-


Palomar over approximately the first
30 months of the agreement. On June 28, 2004, Palomar and The Gillette Company announced
that they have completed the initial phase of this agreement, and both parties have moved
into the next phase. The original agreement provided for $7 million in development funding
from Gillette. Under this amendment, Gillette will provide $2.1 million in additional
development funding to further technical innovations over a 9-month extension of the
development phase, which is now planned to be completed by August 31, 2006. We recognized
$2.3 million of funded product development revenues from The Gillette Company during the
nine months ended September 30, 2004. Any amounts received in advance are recorded as
deferred revenue. Payments are not refundable if the development is not successful.


In
the first quarter of 2004, we began providing services under a $2.5 million research
contract with the 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
Palomar is 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. This revenue is included in funded product development revenue in the
accompanying statements of operations. We recognized $939,000 of funded product
development revenues from the Department of the Army during the nine months ended
September 30, 2004.


Contractual obligations


It
is not our usual business practice to enter into off-balance sheet arrangements, except
for off-balance sheet arrangements related to inventory purchase commitments and operating
lease commitments, as disclosed in the table of contractual obligations below. In
addition, it is not our normal policy to issue guarantees to third parties.


In
August 1995, we entered into an agreement with Massachusetts General Hospital whereby
Massachusetts General Hospital agreed to conduct clinical trials on a laser treatment for
hair removal/reduction developed at Wellman Laboratories of Photomedicine. In July 1999,
we further amended this agreement to extend its exclusive research agreement for an
additional five years. In addition to laser hair removal, the agreement has been expanded
to include research and development in the fields of fat removal and acne treatment. We
have the right to exclusively license, on royalty terms to be negotiated, the
Palomar-funded inventions related to this research. Under the terms of this agreement, we
have paid Massachusetts General Hospital $475,000 on an annual basis for clinical research
through August 2004. Palomar signed an extension for clinical research to support three
additional months of funding and is in discussions with Massachusetts General Hospital to
extend this agreement for clinical research beyond October 2004.


We
are a party to a license agreement, as amended, with Massachusetts General Hospital
whereby the Company is obligated to pay royalties to Massachusetts General Hospital for
sales of certain products as well as 40% of royalties received from third parties. Royalty
expense in 2004 totaled approximately $2.0 million.


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,
2004, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (000s omitted):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     | Remainder of
2004 | 2005  | 2006 | 2007  | 2008 | Thereafter
|-------------------- | ----------------- | ----- | ---- | ----- | ---- | ----------
|Purchase commitments | $                 | 3,602 | $    | 229   | $    | --        
|Operating leases     |                   | 240   |      | 949   |      | 949       
|                     |                   |       |      |       |      |           
|Total                | $                 | 3,842 | $    | 1,178 | $    | 949       

|-20-




Cautionary statements


Our future revenue may decrease if
we are unable to successfully develop and market new products.


Light
based technology is rapidly changing and improving. In order to be successful, we must
continue to make significant investments in research and development in order to develop
in a timely and cost-effective manner, new products that meet changing market demands,
enhance existing products, and achieve market acceptance for such products. We have in the
past experienced delays in developing and marketing new products and enhancing existing
products. Furthermore, some of our new products under development are based on unproven
technology and/or technology with which we have no previous experience. In addition, the
market for professional hair removal light based devices may already be saturated. At
present, broader market acceptance of light based hair removal is critical to our success
and we intend to continue our goals of bringing light based hair removal devices to the
mass consumer market. We also intend to continue to diversify our product line by
developing cosmetic light based products for uses other than hair and tattoo removal and
treatment of pigmented and vascular lesions. There can be no assurance that we will be
able to successfully implement such strategy in a timely fashion or at all and our failure
to do so could decrease our future revenue.


Our failure to respond to rapid
changes in technology could make our products obsolete and we may be unable to compete
with companies having superior financial, marketing and other resources.


The
light based cosmetic and dermatology industry is highly competitive and companies
frequently introduce new products. We compete in the development, manufacture, marketing,
sales and servicing of light based devices with numerous other companies, some of which
have substantially greater financial, marketing and other resources than us. Our products
also face competition from medical products and cosmetic procedures, such as electrolysis
and waxing, among others. We may not be able to differentiate our products from the
products of our competitors, and customers may not consider our products to be superior to
competing products or procedures, especially if competitive products and procedures are
offered at lower prices. Our competitors may develop products or new technologies that
make our products obsolete or less competitive. If forecasted demand decreases, we could
have excess inventories which may result in a write-off of some or all of our inventory.


We may need to secure additional
financing and without such additional financing we may be unable to fund ongoing
operations or grow the business.


Although
we have generated a profit in recent years, we have a history of losses. We may have to
secure additional financing to complete our research and development activities,
commercialize our current and proposed light based products, and fund ongoing operations.
However, there can be no assurance that such financing will be obtained. We may also
determine, depending upon the opportunities available, to seek additional debt or equity
financing to fund the costs of operations or 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 quarterly operating results are and may continue to be volatile, and that may hurt the
price of our common stock. If our operating results fall below the expectations of
investors or public market analysts, the price of our common stock could decline.


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. A
disruption in the delivery of these key components could prevent us from manufacturing
product 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.

-21-


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. 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 U.S. Food and Drug Administration (FDA)
pursuant to the Federal Food, Drug, and Cosmetic Act. The FDAs 510(k) clearance
process 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. 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.


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.


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. 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 were 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.


We may also be subject to state
regulations. State regulations, and changes to state regulations, may prevent sales to
particular end users 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.
As a result, in some states non-physicians may purchase and operate our product. However,
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. Thus, state
regulations and changes to state regulations may decrease revenues or prevent growth of
revenues. The purchase and use of our products by non-physicians may result in their
misuse, which could harm our reputation and expose us to costly product liability
litigation.


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

-22-


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 (QSR), which requires manufacturers to follow
elaborate design, testing, control, documentation, and other quality assurance procedures.
This complexity makes complete compliance difficult to achieve. Also, the determination as
to whether a QSR violation has occurred is often subjective. If the FDA finds that we have
failed to comply with the QSR or other applicable requirements, the agency can institute a
wide variety of enforcement actions, including a public warning letter or other stronger
remedies, such as fines, injunctions, and civil penalties, recall or seizure of our
products, operating restrictions, partial suspension, or total shutdown of our production,
refusing our requests for 510(k) clearance or PMA approval of new products, withdrawing
product approvals already granted or criminal prosecution.


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.


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 have and may continue to issue options and warrants 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 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 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. 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. 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


-23-


to be found invalid and
unenforceable. 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. 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.


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 management of us, 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
(Rights Plan). The Rights Plan is intended to protect shareholders from unfair
or coercive takeover practices. In accordance with the 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.


We may not be able to successfully
collect licensing royalties.


-24-


In
past years and now again following the settlement with Lumenis, material portions of our
revenues consist of royalties from sub-licensing patents licensed to us on an exclusive
basis by Massachusetts General Hospital.


We
have sued Cutera, Inc. (formerly Altus Medical Inc., See Legal Proceedings) for patent
infringement, and we are involved in patent disputes with other third parties. Such other
disputes may also result in litigation. We have incurred, and likely will continue to
incur, legal expenses in connection with such matters. There can be no assurance that such
litigation will result in favorable outcomes for us. Any adverse result in litigation
could weaken the strength of the patents involved, have a material adverse effect on our
business, financial condition and results of operations.


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 less than 150 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.
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.


Disappointing 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.


We face risks associated
with product warranties.


-25-


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 was 49% of total product revenue for the year ended 2003,
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. In particular, longer payment cycles common in
foreign markets, credit risk and delays in obtaining necessary import or foreign
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.


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. We believe that this represents a unique opportunity to bring light based devices
to the mass market. 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 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
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
Pseudofolliculitis Barbae or PFB. We believe this represents a unique opportunity to
address PFB. Although the project is scheduled to last for nineteen months, 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 (JJCC) effectively may divert the
attention of key technical personnel and management from the core business. If JJCC


-26-


ends the relationship our stock
price could fall, and we may be unable 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.


On
September 1, 2004, we entered into a Development and License Agreement with Johnson &
Johnson Consumer Companies, Inc. (JJCC), 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. We believe that this represents a unique opportunity to bring
light based devices to the mass market. 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 JJCC 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, JJCC has the ability to choose not to
continue and may terminate the agreement. If JJCC 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.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.



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


Our
management has evaluated the effectiveness of our disclosure controls and procedures as of
the end of the period covered by this report. Based upon that evaluation, our Chief
Executive Officer and our Chief Financial Officer concluded that our disclosure controls
and procedures were effective to provide reasonable assurance that we record, process,
summarize and report the information we must disclose in reports that we file or submit
under the Securities Exchange Act of 1934, as amended, within the time periods specified
in the SECs rules and forms.


The
effectiveness of a system of disclosure controls and procedures is subject to various
inherent limitations, including cost limitations, judgments used in decision making,
assumptions about the likelihood of future events, the soundness of internal controls, and
the risk of fraud. Because of these limitations, there can be no assurance that any system
of disclosure controls and procedures will be successful in preventing all errors or fraud
or in making all material information known in a timely manner to the appropriate levels
of management.


During
the three months ended September 30, 2004, there were no changes in our internal control
over financial reporting that have affected, or are reasonably likely to affect,
materially our internal control over financial reporting.

-27-




PART II  Other
information


Item 1. Legal proceedings


On
February 15, 2002, Palomar commenced an action for patent infringement in the United
States District Court for the District of Massachusetts against Altus Medical, Inc., now
known as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint
alleges Cuteras CoolGlide and CoolGlide Excel laser systems willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to Palomar by the Massachusetts
General Hospital. The Massachusetts General Hospital has been added as a plaintiff in this
lawsuit. Cutera answered the complaint denying that its products infringe the asserted
patent and filed a counterclaim seeking a declaratory judgment that the asserted patent is
invalid and not infringed. Palomar and the Massachusetts General Hospital filed a reply
denying the material allegations of the counterclaims. Palomar and the Massachusetts
General Hospital have further alleged that Cuteras CoolGlide Vantage and CoolGlide
XEO laser systems also willfully infringe the asserted patent. On June 4, 2003, Cutera
amended their answer and asserted a counter claim alleging that the patent is
unenforceable due to inequitable conduct. Palomar and the Massachusetts General Hospital
believe that this claim is without merit and filed a reply denying the material
allegations of this counterclaim. A claim construction hearing (often referred to as a
Markman hearing) was held on June 12, 2003, and on February 27, 2004 the Judge issued her
ruling. Palomar believes the ruling largely embraced Palomars position and will have
a considerable impact on the case as it proceeds toward trial. Fact discovery is on-going.
A trial date has not yet been set.(See Cautionary
Statements)


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


Not
applicable.


Item 3. Defaults upon
senior securities


Not
applicable.

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


Not applicable.


Item 5. Other
information.


Not
Applicable.


Item 6. Exhibits and
reports on Form 8-K

(a)
 Exhibits
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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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.                                                                     
| | 32.1 | 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.
| | 32.1 | 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.                     

|-28-


(b)               Reports on Form 8-K
|--------------------------------------------

| | During the three months ended September 30, 2004 we furnished the following Form 8-Ks.  Information
         regarding each item
reported on is listed below.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------

|Date filed or
Furnished | Item No. | Description                                                                                                                                                                                                                                                                                                                                                                                            
|----------------------- | -------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|September 7, 2004       | 99.1 *   | Press Release dated September 7, 2004 entitled "Palomar Medical
                                         Signs Agreement with Johnson & Johnson Consumer Companies to
                                         Develop Home-Use, Light-Based Devices for Skin Rejuvenation, Acne
                                         and Cellulite".       *   Filed under application for confidential treatment.
|                        |         
|July 29, 2004           | 99.2     | Press Release dated July 29, 2004 entitled " PALOMAR MEDICAL
                                        REPORTS RECORD REVENUES AND PROFITABILITY FOR SECOND QUARTER 2004
                                        Revenues Increase by 53 Percent; Operating Income More than
                                        Triples;"                                                                           

|-29-




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 5, 2004 | By:/s/ Joseph P. Caruso
      Joseph P. Caruso
      President, Chief Executive Officer and Director
|                        |                                                                                                     

|                        |                                                                                            
|----------------------- | -------------------------------------------------------------------------------------------
|Date:  November 5, 2004 | By:/s/ Paul S. Weiner
      Paul S. Weiner
      Vice President and Chief Financial Officer
|                        |                                                                                            

|-30-
|----