UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION





Washington,
D.C. 20549





FORM 10-Q





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





For the
quarterly period ended April 2, 2005





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





For the
Transition period from  to





Commission
File Number: 0-27598





**IRIDEX
CORPORATION**


(Exact
name of registrant as specified in its charter)




Delaware
    
    77-0210467(State
      or other jurisdiction of
      incorporation
      or organization)
    
    (I.R.S.
      employer
      identification
      No.)





**1212
Terra Bella Avenue**


**Mountain
View, California 94043-1824**


(Address
of principal executive offices, including zip code)





**(650)
940-4700**


(Registrant’s
telephone number, including area code)





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 x No o




Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes o Nox






APPLICABLE
TO CORPORATE ISSUERS:





The
number of shares of common stock, $.01 par value, issued and outstanding as of
May 10, 2005 was 7,433,298.











**IRIDEX Corporation**





**Table
of Contents**





Page**PART
      I.**
    
    **FINANCIAL INFORMATION****Item
      1.**
    
    **Condensed
      Consolidated Financial Statements**(unaudited)Condensed Consolidated Balance Sheets as of April 2, 2005 and
      January 1, 2005
    3Condensed Consolidated Statements of Operations for the three
      months ended
      April 2, 2005 and April 3, 2004
    4Condensed Consolidated Statements of Cash Flows for the three
      months ended
      April 2, 2005 and April 3, 2004
    5Condensed Consolidated Statements of Comprehensive Loss for
      the three months ended April 2, 2005 and April 3, 2004
    6Notes to Unaudited Condensed Consolidated Financial
      Statements
    7**Item
      2.**
    
    **Management’s Discussion and Analysis of Financial Condition
      **and
      Results of Operations****
    12**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 and Use of
      Proceeds**
    28**Item
      3.**
    
    **Defaults Upon Senior
    Securities**
    28**Item
      4.**
    
    **Submission of Matters to Vote of Security
      Holders**
    28**Item
      5.**
    
    **Other Information**
    28**Item
      6.**
    
    **Exhibits and Reports on Form
    8-K**
    28**Signature**
    
    
    29**CERTIFICATIONS**
    30Exhibit
      31.1
    
    Certification
      of Chief Executive Officer pursuant to Securities Exchange Act Rules
      13a-14(a) and 15d-14(a)Exhibit
      31.2
    
    Certification
      of Chief Financial Officer pursuant to Securities Exchange Act Rules
      13a-14(a) and 15d-14(a)Exhibit
      32.1
    
    Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002




2
 *Table of Contents*


****


**Part I. FINANCIAL INFORMATION**





Item 1. Condensed Consolidated Financial
Statements








**IRIDEX Corporation**


**Condensed
Consolidated Balance Sheets**


**(in
thousands)**


**(unaudited)**




**April
      2,**
      **2005**
    
    **January
      1,**
      **2005****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    6,202
    
    $
    10,381Available-for-sale
      securities
    
    
    8,907
    
    
    3,323Accounts
      receivable, net
    
    
    6,848
    
    
    7,404Inventories
    
    
    9,511
    
    
    8,922Prepaids
      and other current assets
    
    
    1,078
    
    
    814Current
      deferred income taxes
    
    
    1,808
    
    
    1,808Total
      current assets
    
    
    34,354
    
    
    32,652Long
      term portion of available-for-sale securities
    
    
    1,535
    
    
    4,324Property
      and equipment, net
    
    
    854
    
    
    852Deferred
      income taxes
    
    
    1,265
    
    
    1,265Total
      assets
    
    $
    38,008
    
    $
    39,093**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    1,179
    
    $
    1,233Accrued
      expenses
    
    
    4,058
    
    
    5,167Deferred
      revenue
    
    
    962
    
    
    910Total
      liabilities
    
    
    6,199
    
    
    7,310Stockholders’
      equity:Common
      stock
    
    
    74
    
    
    74Additional
      paid-in capital
    
    
    25,352
    
    
    25,281Accumulated
      other comprehensive loss
    
    
    (60
    )
    
    (35
    )Treasury
      stock
    
    
    (430
    )
    
    (430
    )Retained
      earnings
    
    
    6,873
    
    
    6,893Total
      stockholders’ equity
    
    
    31,809
    
    
    31,783Total
      liabilities and stockholders’ equity
    
    $
    38,008
    
    $
    39,093







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




3
 *Table of Contents*





**IRIDEX Corporation**


**Condensed
Consolidated Statements of Operations**


**(in
thousands, except per share data)**


**(unaudited)**




**Three
      Months Ended****April
      2,**
      **2005**
    
    **April
      3,**
      **2004**Sales
    
    $
    8,145
    
    $
    7,392Cost
      of sales
    
    
    4,467
    
    
    4,177Gross
      profit
    
    
    3,678
    
    
    3,215Operating
      expenses:Research
      and development
    
    
    1,039
    
    
    1,107Sales,
      general and administrative
    
    
    2,797
    
    
    2,193Total
      operating expenses
    
    
    3,836
    
    
    3,300Loss
      from operations
    
    
    (158
    )
    
    (85
    )Interest
      and other income, net
    
    
    126
    
    
    60Loss
      before income taxes
    
    
    (32
    )
    
    (25
    )Benefit
      from income taxes
    
    
    12
    
    
    8Net
      loss
    
    $
    (20
    )
    $
    (17
    )Net
      loss per share - basic and diluted
    
    $
    (
      0.00
    )
    $
    (
      0.00
    )Shares
      used in computing net loss per share - basic and diluted
    
    
    7,317
    
    
    7,076




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





4
 *Table of Contents*


****


**IRIDEXCorporation**


**Condensed
Consolidated Statements of Cash Flows**


**(in
thousands)**


**(unaudited)**





**Three
      Months Ended****April
      2,**
    
    **April
      3,****2005**
    
    **2004**Cash
      flows from operating activities:Net
      loss
    
    $
    (20
    )
    $
    (17
    )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
    
    
    113
    
    
    137Provision
      for inventories
    
    
    57
    
    
    11Provision
      for doubtful account
    
    
    (5
    )
    
    (4
    )Changes
      in operating assets and liabilities:Accounts
      receivable
    
    
    561
    
    
    727Inventories
    
    
    (646
    )
    
    240Prepaids
      and other current assets
    
    
    (264
    )
    
    (440
    )Accounts
      payable
    
    
    (54
    )
    
    (321
    )Accrued
      expenses
    
    
    (1,109
    )
    
    (375
    )Deferred
      revenue
    
    
    52
    
    
    49Net
      cash provided by (used in) operating activities
    
    
    (1,315
    )
    
    7Cash
      flows from investing activities:Purchases
      of available-for-sale securities
    
    
    (7,151
    )
    
    (3,539
    )Proceeds
      from maturity of available-for-sale securities
    
    
    4,331
    
    
    1,845Acquisition
      of property and equipment
    
    
    (115
    )
    
    (83
    )Net
      cash used in investing activities
    
    
    (2,935
    )
    
    (1,777
    )Cash
      flows from financing activities:Issuance
      of common stock
    
    
    71
    
    
    706Net
      cash provided by financing activities
    
    
    71
    
    
    706Net
      decrease in cash and cash equivalents
    
    
    (4,179
    )
    
    (1,064
    )Cash
      and cash equivalents at beginning of period
    
    
    10,381
    
    
    10,541Cash
      and cash equivalents at end of period
    
    $
    6,202
    
    $
    9,477




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





5
 *Table of Contents*




**IRIDEX Corporation**


**Condensed
Consolidated Statements of Comprehensive Loss**


**(in
thousands)**


**(unaudited)**








**Three
      Months Ended****April
      2,**
    
    **April
      3,****2005**
    
    **2004**Net
      loss
    
    $
    (20
    )
    $
    (17
    )Other
      comprehensive loss:Change
      in unrealized loss onavailable-for-sale
      securities, net of tax
    
    
    (16
    )
    
    (5
    )Comprehensive
      loss
    
    $
    (36
    )
    $
    (22
    )




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





6
 *Table of Contents*


****


**IRIDEX Corporation**


**Notes
to Unaudited Condensed Consolidated Financial Statements**





**1.**
    **Basis
      of Presentation**





The
accompanying unaudited condensed consolidated financial statements of IRIDEX
Corporation (“the Company”) have been prepared in accordance with generally
accepted accounting principles in the United States of America for interim
financial information and pursuant to the instructions to Form 10-Q and Article
10-01 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements. In the opinion of
management, all adjustments, consisting of normal recurring adjustments,
considered necessary for a fair statement of the financial statements have been
included.





The
condensed consolidated financial statements should be read in conjunction with
the audited financial statements and notes thereto, together with management’s
discussion and analysis of financial condition and results of operations,
contained in our Annual Report on Form 10-K, which was filed with the Securities
and Exchange Commission on April 1, 2005. The results of operations for the
three month period ended April 2, 2005 are not necessarily indicative of the
results for the year ending December 31, 2005 or any future interim
period.





**2.**
    **Summary
      of Significant Accounting Policies**





The
Company’s significant accounting policies are disclosed in our Annual Report on
Form 10-K for the year ended January 1, 2005 which was filed with the Securities
and Exchange Commission on April  1, 2005.
The Company’s significant accounting policies have not materially changed as of
April 2, 2005. ****





Deferred
Revenue





Deferred
revenue related to warranty contracts is recognized on a straight line basis
over the period of the applicable contract. Cost is recognized as incurred. A
reconciliation of changes in the Company’s deferred revenue balances for the
three months ending April 2, 2005 and April 3, 2004 follows (in
thousands):








Three
      Months EndedApril
      2, 2005
    
    April
      3, 2004Balance,
      beginning of period
    
    $
    910
    
    $
    596Additions
      to deferral
    
    
    397
    
    
    223Revenue
      recognized
    
    
    (345
    )
    
    (174
    )Balance,
      end of period
    
    $
    962
    
    $
    645




7
 *Table of Contents*





Warranty





The
Company accrues for an estimated warranty cost upon shipment of products in
accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5,
“Accounting for Contingencies.” Actual warranty costs incurred have not
materially differed from those accrued. The Company’s warranty policy is
effective for shipped products which are considered defective or fail to meet
the product specifications. Warranty costs are reflected in the statement of
operations as a cost of sales. A reconciliation of the changes in the Company’s
warranty liability for the three months ending April 2, 2005 and April 3, 2004
follows (in thousands):




Three
      Months EndedApril
      2, 2005
    
    April
      3, 2004Balance,
      beginning of period
    
    $
    933
    
    $
    801Accruals
      for warranties issued during the period
    
    
    167
    
    
    182Settlements
      made in kind during the period
    
    
    (144
    )
    
    (138
    )Balance,
      end of period
    
    $
    956
    
    $
    845


Accounting
for Stock-Based Compensation





The
Company accounts for stock-based compensation arrangements in accordance with
provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting
for Stock Issued to Employees” and complies with the disclosure provisions of
SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No.
148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an
Amendment of FASB Statement No. 123.”





Under APB
25, compensation expense for stock option grants to employees is based on the
difference, if any, on the date of the grant, between the fair value of the
Company’s stock and the option’s exercise price. SFAS 123 defines a “fair value”
based method of accounting for an employee stock option or similar equity
investment. The pro forma disclosure of the difference between compensation
expense included in net loss and the related cost measured by the fair value
method is presented below.





The
following table provides a reconciliation of net loss to pro forma net loss as
if the fair value method had been applied to all employee awards (in thousands,
except per share data):




8
 *Table of Contents*




Three
      Months EndedApril
      2, 2005
    
    April
      3, 2004Net
      loss, as reported
    
    $
    (20
    )
    $
    (17
    )Add:
      Total stock based compensation expense, net of tax, determined under fair
      value based method for all awards to employees
    
    
    (125
    )
    
    (144
    )Pro
      forma net loss
    
    $
    (145
    )
    $
    (161
    )Basic
      and diluted net loss per share:As
      reported
    
    $
    (0.00
    )
    
    ($0.00
    )Pro
      forma
    
    $
    (0.02
    )
    
    ($0.02
    )


The
determination of fair value of all options granted by the Company is computed
based on the following assumptions:




Employee
      Stock Option Plan
    
    Employee
      Stock Purchase PlanThree
      Months Ended
    
    Three
      Months EndedApril
      2, 2005
    
    April
      3, 2004
    
    April
      2, 2005
    
    April
      3, 2004Average
      risk free interest rate
    
    
    3.38
    %
    
    1.88
    %
    
    2.50
    %
    
    1.00
    %Expected
      life (in years)
    
    
    3
      yrs
    
    
    2
      yrs.
    
    
    0.5
      yrs
    
    
    0.5
      yrs.Dividend
      yield
    
    
    --
    
    
    --
    
    
    --
    
    
    --Average
      volatility
    
    
    86.0
    %
    
    87.0
    %
    
    85.0
    %
    
    87.0
    %


9
 *Table of Contents*




**3.**
    **Inventories**





Inventories
are stated at the lower of cost or market. Cost is based on actual sales
computed on a first in, first out basis. The components of inventories consist
of the following (in thousands):





**April
      2,**
      **2005**
    
    **January
      2,**
      **2005**Raw
      materials and work in progress
    
    $
    5,405
    
    $
    5,460Finished
      goods
    
    
    4,106
    
    
    3,462Total
      inventories
    
    $
    9,511
    
    $
    8,922





**4.**
    **Computations
      of Net Loss Per Common Share**





Basic and
diluted net loss per share are computed by dividing net loss for the period by
the weighted average number of shares of common stock outstanding during the
period. The calculation of diluted net loss per share includes the dilutive
effect of potentially dilutive common stock provided the inclusion of such
potential common stock is not antidilutive. Potentially dilutive common stock
consists of incremental common shares issuable upon the exercise of stock
options.





During
the three months ended April 2, 2005, options to purchase 1,898,249 shares of
common stock at a weighted average exercise price of $5.33 per share and
approximately 10,276 shares issuable to our employee stock
purchase plan were outstanding, but were not included in the computations
of diluted net loss per common share because their effect was antidilutive.
During the three months ended April 3, 2004, options to purchase 1,853,016
shares at a weighted average exercise price of $5.44 and 16,713 shares issuable
to our employee stock purchase plan were outstanding, but were not included in
the computations of diluted net loss per share because their effect was
antidilutive. These options could dilute earnings per share in future
periods.





**5.**
    **Business
      Segments**





We
operate in two reportable segments: the ophthalmology medical device segment and
the dermatology medical device segment. In both segments, we develop,
manufacture and market medical devices. Our revenues arise from the sale of
consoles, delivery devices, disposables and service and support
activities.





Information
on reportable segments for the three months ended April 2, 2005 and April 3,
2004 is as follows (in thousands):




Three
      Months Ended April 2, 2005
    
    Three
      Months Ended April 3, 2004Ophthalmology
      Medical
      Devices
    
    Dermatology
      Medical
      Devices
    
    Total
    
    Ophthalmology
      Medical
      Devices
    
    Dermatology
      Medical
      Devices
    
    TotalSales
    
    $
    6,193
    
    $
    1,952
    
    $
    8,145
    
    $
    6,243
    
    $
    1,149
    
    $
    7,392Direct
      Cost of Goods Sold
    
    
    2,099
    
    
    996
    
    
    3,095
    
    
    2,241
    
    
    648
    
    
    2,889Direct
      Gross Margin
    
    
    4,094
    
    
    956
    
    
    5,050
    
    
    4,002
    
    
    501
    
    
    4,503Total
      Unallocated Costs
    
    
    
    
    
    
    
    
    (5,082
    )
    
    
    
    
    
    
    
    (4,528
    )Pre-tax
      loss
    
    
    
    
    
    
    
    $
    (32
    )
    
    
    
    
    
    
    $
    (25
    )


10
 *Table of Contents*





Indirect
costs of manufacturing, research and development, and selling, general and
administrative costs are not allocated to the segments.





The
Company’s assets and liabilities are not evaluated on a segment basis.
Accordingly, no disclosure of segment assets and liabilities is
provided.





**6.**
    **Recent
      Accounting Pronouncements**





In
December 2004, the Financial Accounting Standards Board (“FASB”) issued (“SFAS”)
No. 123 (R), “Share-Based Payments” (revised 2004). The provisions of SFAS 123
(R) will require the Company to measure all stock-based compensation awards
using a fair value method and record such expense in the consolidated financial
statements, including grants of employee stock options. In addition, the
adoption of SFAS 123(R) will require additional accounting related to the income
tax effects and additional disclosure regarding the cash flow effects resulting
from share-based payment arrangements. SFAS 123 (R) is effective for all public
companies for fiscal years beginning after June 15, 2005. The Company will adopt
SFAS 123 (R) effective January 1, 2006. The Company has not yet determined
whether the adoption of FAS 123(R) will result in amounts that are similar to
the current pro forma disclosures under SFAS 123. The Company is evaluating the
requirements for FAS 123 (R) and expects the adoption to have a significant
adverse impact on the statement of operations and net loss per
share.




11
 *Table of Contents*





**Item**
    **2.**





**MANAGEMENT’S
DISCUSSION AND ANALYSIS OF**


**FINANCIAL
CONDITION AND RESULTS OF OPERATIONS**





*This
Quarterly Report on Form 10-Q contains trend analysis and other 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,
such as statements relating to levels of future sales and operating results,
actual order rate and market acceptance of our products; expectations for future
sales growth, generally, including expectations of additional sales from our new
products and new applications of our existing products; the potential for
production cost decreases and higher gross margins; our ability to develop and
introduce new products through strategic alliances; favorable Center for
Medicare and Medicaid coverage decisions regarding procedures that use our
products; results of clinical studies and risks associated with bringing new
products to market; general economic conditions; levels of international sales;
determinations regarding deferred tax assets; and the sufficiency of our cash,
cash equivalents and available-for-sale securities together with cash generated
from operations and our credit facility to meet our anticipated cash
requirements for the next 12 months. In some cases, forward-looking statements
can be identified by terminology, such as “may,” “will,” “should,” “expects,”
“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,”
“potential,” “continue,” or the negative of such terms or other comparable
terminology. These statements involve known and unknown risks, uncertainties and
other factors which may cause our actual results, performance or achievements to
differ materially from those expressed or implied by such forward-looking
statements, including as a result of the factors set forth under “Factors That
May Affect Future Operating Results” below. The reader is cautioned not to
place undue reliance on these forward-looking statements, which reflect
management’s analysis only as of the date of this Form 10-Q. We undertake no
obligation to update such forward-looking statements to reflect events or
circumstances occurring after the date of this report.*





**Results
of Operations**





The
following table sets forth certain operating data as a percentage of sales for
the periods indicated.





**Three
      Months Ended****April
      2,**
    
    **April
      3,****2005**
    
    **2004**Sales
    
    
    100.0
    %
    
    100.0
    %Cost
      of sales
    
    
    54.8
    
    
    56.5Gross
      profit
    
    
    45.2
    
    
    43.5Operating
      expenses:Research
      and development
    
    
    12.8
    
    
    15.0Sales,
      general and administrative
    
    
    34.3
    
    
    29.6Total
      operating expenses
    
    
    47.1
    
    
    44.6Loss
      from operations
    
    
    (1.9
    )
    
    (1.1
    )Interest
      and other income, net
    
    
    1.5
    
    
    0.8Loss
      before income taxes
    
    
    (0.4
    )
    
    (0.3
    )Benefit
      from income taxes
    
    
    0.2
    
    
    0.1Net
      loss
    
    
    (0.2
    )%
    
    (0.2
    )%





The
following table sets forth for the periods indicated the amount of sales for our
operating segments and sales as a percentage of total sales.





12
 *Table of Contents*




Three
      Months EndedApril
      2, 2005
    
    April
      3, 2004Amount
    
    Percentage
      of total sales
    
    Amount
    
    Percentage
      of total salesDomestic
    
    $
    4,925
    
    
    60.5
    %
    $
    4,156
    
    
    56.2
    %International
    
    
    3,220
    
    
    39.5
    %
    
    3,236
    
    
    43.8
    %Total
    
    $
    8,145
    
    
    100.0
    %
    $
    7,392
    
    
    100.0
    %Ophthalmology:Domestic
    
    $
    3,413
    
    
    41.9
    %
    $
    3,366
    
    
    45.5
    %International
    
    
    2,780
    
    
    34.1
    %
    
    2,877
    
    
    38.9
    %Total
    
    $
    6,193
    
    
    76.0
    %
    $
    6,243
    
    
    84.4
    %Dermatology:Domestic
    
    $
    1,512
    
    
    18.6
    %
    $
    790
    
    
    10.7
    %International
    
    
    440
    
    
    5.4
    %
    
    359
    
    
    4.9
    %Total
    
    $
    1,952
    
    
    24.0
    %
    $
    1,149
    
    
    15.6
    %


*Ophthalmology
Sales*





Ophthalmology
sales of $6.2 million remained relatively constant for the three month periods
ending April 2, 2005 and April 3, 2004. For the three month period ended April
2, 2005 and April 3, 2004, domestic ophthalmology sales remained relatively
level at $3.4 million. Likewise, within domestic ophthalmology, the dollar mix
of laser consoles and delivery devices were both relatively constant for this
time period. International ophthalmology sales decreased 3.4% to $2.8 million
for the three months ended April 2, 2005 from $2.9 million for the three months
ended April 3, 2004. The decrease in international ophthalmology sales during
this period was due to a $0.1 million decrease in unit sales of ophthalmology
laser consoles, while sales of laser delivery devices remained relatively level.





*Dermatology
Sales*





Dermatology
sales increased 69.8% to $2.0 million for the three months ended April 2, 2005
from $1.1 million for the three months ended April 3, 2004. Domestic dermatology
sales increased 91.4% to $1.5 million for the three month period ended April 2,
2005 from $0.8 million for the comparable three month period in 2004 due
primarily to unit sales of the new VariLite laser system. International
dermatology sales increased 22.6% to $0.4 million for the three months ended
April 2, 2005 from $0.36 million for the three  months
ended April 3, 2004 due primarily to unit sales of the new VariLite laser
system.





13
 *Table of Contents*





*Gross
Profit* . Our
gross profit increased by $0.5 million to $3.7 million for the three month
period ended April 2, 2005 compared to $3.2 million for the three months ended
April 3, 2004. Gross profit as a percentage
of sales for the three months ended April 2, 2005 increased to 45.2% from 43.5%
for the comparable prior year three month period. The total 1.7% increase in
gross profit as a percentage of sales during this period resulted primarily
from 3.1% due to reduced overhead spending, offset by 1.2% for increased
product costs including inventory and warranty reserves and 0.2% due to
decreased average selling prices. Although increasing competition has continued
to result in a downward trend in average selling prices for some products, we
intend to continue our efforts to reduce the cost of components and
manufacturing and thereby mitigate the impact of price reductions on our gross
profit. In addition, as we evaluate gross margins on each of our product lines,
we may choose to place greater focus on product lines with better margins. See
“-Factors That May Affect Future Results - If We Cannot Increase Our Sales
Volumes, Reduce Our Costs or Introduce Higher Margin Products to Offset
Anticipated Reductions in the Average Unit Selling Price of our Products, Our
Operating Results May Suffer.” We expect our gross profit margins to continue to
fluctuate due to changes in the relative proportions of domestic and
international sales, mix of sales of existing products, pricing, product costs
and a variety of other factors. See “-Factors That May Affect Future Results -
Our Operating Results May Fluctuate from Quarter to Quarter and Year to
Year.”





*Research
and Development* . Our
research and development expenses decreased by 6.1% to $1.03 million for the
three months ended April 2, 2005 from $1.1 million for the three months ended
April 3, 2004. Research and development expenses decreased as a percentage of
sales to 12.8% for the three months ended April 2, 2005 from 15.0% for the
comparable prior year three month period. The decrease in research and
development expense in absolute dollars and as a percentage of sales for the
three month period ended April 2, 2005 was due primarily to $0.07 million in
decreased research and development project spending.  Overall, we expect
the level of research and development spending for fiscal year 2005 in absolute
dollars to be roughly equivalent to fiscal year 2004.





S *ales,
General and Administrative* . Our
sales, general and administrative expenses increased by 27.5% to $2.8 million
for the three months ended April 2, 2005 from $2.2 million for the three months
ended April 3, 2004.
As a percentage of sales, sales, general and administrative expenses increased
to 34.3% for the three months ended April 2, 2005 from 29.6% for the comparable
prior year three month period. The increase in sales, general and administrative
expense in absolute dollars and as a percentage of sales for the three month
period ended April 2, 2005 was due primarily to a $0.2 million increase in
selling costs related to increased headcount, $0.1 million due to increased
marketing spending and $0.3 million in general and administrative spending
related to increased consulting fees, public company costs and legal fees. 
For fiscal year 2005, we expect the level of sales, general and administrative
spending in absolute dollars to exceed that of fiscal 2004 primarily due to
increased sales expense associated with the hiring of additional dermatology
headcount, public company expenses, costs associated with hiring and perhaps
relocating a new Chief Executive Officer for the Company and marketing expenses
associated with recently introduced products.





*Interest
and Other Income, net.* For the
three months ended April 2, 2005, we had net other income of $126,000
as compared with net other income of $60,000 for the three months ended April 3,
2004. The change in net other income for the three month period was due
primarily to an increase in interest income associated with increased cash, cash
equivalents and available for sale securities.





*Income
Taxes* . The
effective income tax rates for the three month periods ended April 2, 2005 and
April 3, 2004 were lower for periods where we had pre-tax income and higher for
periods where we had pre-tax loses than the Federal and State combined
statutory rate of 40% primarily because of certain tax benefits associated with
tax credits for research and development activities. Since the Company was
almost at breakeven for the quarter, this tax rate may be adjusted in future
quarters.





In
addition to estimating our quarterly income tax benefit we assess temporary
differences resulting from differing treatment of items for tax and accounting
purposes which result in deferred tax assets and liabilities, which are included
in our balance sheet. Currently, we have determined that no valuation allowance
is required against our deferred tax assets as it is more likely than not that
the deferred tax assets can be realized based on determination of our future
taxable income. A valuation allowance is required to reduce our deferred tax
assets to the amount that is more likely than not to be realized. However, if at
any point in time, we determine that it is more likely than not that we will not
realize all or a portion of our remaining deferred tax assets, we will increase
our valuation allowance with a charge to income tax expense. Significant
management judgment is required in determining our provision for income taxes,
our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. In the event that actual results differ
from these estimates or we adjust these estimates in future periods, we may need
to establish a valuation allowance which could materially impact our financial
position and results of operations. Our ability to utilize our deferred tax
assets and the continuing need for a related valuation allowance are monitored
on an ongoing basis.





14
 *Table of Contents*





**Liquidity
and Capital Resources**





At April
2, 2005, our primary sources of liquidity included cash and cash equivalents and
available-for-sale securities in the aggregate amount of $16.6 million. In
addition, we have available $4 million under our unsecured line of credit which
bears interest at the bank’s prime rate and expires in October 2006. As of April
2, 2005, no borrowings were outstanding under this credit facility.





During
the three months ended April 2, 2005, operating activities used $1.3 million of
cash. The primary uses of cash from operating activities included a decrease in
accrued expenses of $1.1 million, an increase in net inventory of $0.6 million
and an increase of $0.3 million in prepaid expenses offset by sources of cash
which primarily included a $0.6 million decrease in accounts receivable and
depreciation of $0.1 million. The decrease in accrued expenses resulted
primarily from payment of an accrual for a sales tax liability. The accrual for
sales tax represented a reserve resulting from the completion of a comprehensive
review of our sales tax practices. Historically, we had been collecting and
remitting sales tax in only those states where we believed we had nexus. Based
on the independent review, we are now collecting and remitting sales tax from
customers in additional states and have entered into voluntary settlement
agreements with certain states. The Company chose not to retroactively collect
this sales tax from our customers. The increase in inventory related primarily
to purchases connected with the Company’s recent introduction of new products.





Investing
activities used $2.9 million in cash and cash equivalents during the three
months ended April 2, 2005, primarily due to net purchases of available for sale
securities of $2.8 million and purchases of fixed assets of
$0.1 million.





Net cash
provided by financing activities during the three months ended April 2, 2005 was
$0.1 million which consisted of the issuance of common stock under employee
option plans and the employee stock purchase
plan.





We
believe that, based on current estimates, our cash, cash equivalents and
available-for-sale securities together with cash generated from operations and
our credit facility will be sufficient to meet our anticipated cash requirements
for the next 12 months. Our liquidity could be negatively affected by a decline
in demand for our products, the need to invest in new product development or
reductions in spending by our customers as a result of the continuing economic
downturn or other factors. There can be no assurance that additional debt or
equity financing will be available when required or, if available, can be
secured on terms satisfactory to us. See “-Factors That May Affect Future
Results - We May Need Additional Capital, which May Not Be Available, and Our
Ability to Grow May Be Limited as a Result.”





In
December 1998, we instituted a stock repurchase program whereby up to 150,000
shares of our common stock may be repurchased in the open market. We plan to
utilize all of the reacquired shares for reissuance in connection with employee
stock programs. No shares were repurchased during the three months ended April
2, 2005. To date, we have purchased 103,000 shares of our common stock under
this program.





15
 *Table of Contents*





**Critical
Accounting Policies**





The
Company’s significant accounting policies are disclosed in our Annual Report on
Form 10-K for the year ended January 1, 2005 which was filed with the Securities
and Exchange Commission on April 2, 2005.





**Recent
Accounting Pronouncements**





In
December 2004, the Financial Accounting Standards Board (“FASB”) issued (“SFAS”)
No. 123 (R), “Share-Based Payments” (revised 2004). The provisions of SFAS 123
(R) will require the Company to measure all stock-based compensation awards
using a fair value method and record such expense in the consolidated financial
statements, including grants of employee stock options. In addition, the
adoption of SFAS 123(R) will require additional accounting related to the income
tax effects and additional disclosure regarding the cash flow effects resulting
from share-based payment arrangements. SFAS 123 (R) is effective for all public
companies for fiscal years beginning after June 15, 2005. The Company will adopt
SFAS 123 (R) effective January 1, 2006. The Company has not yet determined
whether the adoption of FAS 123(R) will result in amounts that are similar to
the current pro forma disclosures under SFAS 123. The Company is evaluating the
requirements for FAS 123 (R) and expects the adoption to have a significant
adverse impact on the statement of operations and net loss per
share.





**Factors
That May Affect Future Results**





*We
Rely on Continued Market Acceptance of Our Existing Products and Any Decline in
Sales of Our Existing Products Would Adversely Affect Our Business and Results
of Operations.* We
currently market visible and infrared light semiconductor-based photocoagulator
medical laser systems to the ophthalmic market. We also market visible and
infrared light semiconductor-based photocoagulator medical laser systems to the
dermatology market. We believe that continued and increased sales, if any, of
these medical laser systems is dependent upon a number of factors including the
following:





§
    Product
      performance, features, ease of use, scalability and
      durability;




§
    Recommendations
      and opinions by ophthalmologists, dermatologists, other clinicians,
      plastic surgeons and their associated opinion leaders, including study
      outcomes;




§
    Price
      of our products and prices of competing products and
      technologies;




§
    Availability
      of competing products, technologies and alternative
      treatments;




§
    Willingness
      of ophthalmologists and dermatologists to convert to semiconductor-based
      or infrared laser systems from alternative technologies;
    and




§
    Level
      of reimbursement for treatments administered with our
      products.




In
addition, we derive a meaningful portion of our revenues from the sale of
delivery devices. Our ability to increase revenues from the sale of delivery
devices will depend primarily upon the features, ease of use and prices of our
products, including the relationship to prices of competing delivery devices.
The level of service revenues will depend on our quality of care, responsiveness
and the willingness of our customers to request our services rather than
purchase competing products or services. Any significant decline in market
acceptance of our products or our revenues derived from the sales of laser
consoles, delivery devices or services would have a material adverse effect on
our business, results of operations and financial condition.





16
 *Table of Contents*





*We
Face Strong Competition in Our Markets and Expect the Level of Competition to
Grow in the Foreseeable Future.* Competition
in the market for devices used for ophthalmic and dermatology treatment
procedures is intense and is expected to increase. Our competitive position
depends on a number of factors including product performance, characteristics
and functionality, ease of use, scalability, durability and cost. Our principal
competitors in ophthalmology are Lumenis Ltd., Carl Zeiss, Inc., Alcon, Quantel,
Laserex and Nidek, Inc. All of these companies currently offer a competitive
semiconductor-based laser system in ophthalmology. Also within ophthalmology
pharmaceutical alternative treatments for AMD such as Visudyne (Novartis) and
Macugen (Eyetech) compete rigorously with traditional laser procedures. Our
principal competitors in dermatology are Laserscope, Candela Corporation,
Palomar Technologies, Lumenis Ltd. and Cutera, Inc. Some competitors have
substantially greater financial, engineering, product development,
manufacturing, marketing and technical resources than we do. Some companies also
have greater name recognition than we do and long-standing customer
relationships. In addition to other companies that manufacture photocoagulators,
we compete with pharmaceuticals, other technologies and other surgical
techniques. Some medical companies, academic and research institutions, or
others, may develop new technologies or therapies that are more effective in
treating conditions targeted by us or are less expensive than our current or
future products. Any such developments could have a material adverse effect on
our business, financial condition and results of operations.





*Our
Future Success Depends on Our Ability to Develop and Successfully Introduce New
Products and New Applications* . Our
future success is dependent upon, among other factors, our ability to develop,
obtain regulatory approval or clearance of, manufacture and market new products.
In October 2004, we introduced two new laser products, the IQ810 in
ophthalmology and the VariLite in dermatology. In May 2004, we introduced a new
type of illuminating Endoprobe. In June 2003 we began shipment of two new
products; a 50 micron slit lamp adaptor and a 25 gauge single-use Endoprobe. In
October 2002, we announced the introduction of a number of new products,
specifically the OcuLight Symphony multi-wavelength laser delivery system, an
expanded EndoProbe product line and a 5 mm Large Spot Slit Lamp Adapter. We also
announced the Millennium Endolase module in 2002, which we manufacture to be
included in Bausch & Lomb’s Millennium Microsurgical System. Successful
commercialization of these and other new products and new applications will
require that we effectively transfer production processes from research and
development to manufacturing and effectively coordinate with our suppliers. In
addition, we must successfully sell and achieve market acceptance of new
products and applications and enhanced versions of existing products. The extent
of, and rate at which, market acceptance and penetration are achieved by future
products is a function of many variables, which include, among other things,
price, safety, efficacy, reliability, marketing and sales efforts, the
development of new applications for these products, the availability of
third-party reimbursement of procedures using our new products, the existence of
competing products and general economic conditions affecting purchasing
patterns. Our ability to market and sell new products may also be subject to
government regulation, including approval or clearance by the United States Food
and Drug Administration, or FDA, and foreign government agencies. Any failure in
our ability to successfully develop and introduce new products or enhanced
versions of existing products and achieve market acceptance of new products and
new applications could have a material adverse effect on our operating results
and would cause our net revenues to decline.





*If We
Cannot Increase Our Sales Volumes, Reduce Our Costs or Introduce Higher Margin
Products to Offset Anticipated Reductions in the Average Unit Price of Our
Products, Our Operating Results May Suffer.* We have
experienced declines in the average unit price of our products and expect to
continue to suffer from declines in the future. The average unit price of our
products may decrease in the future in response to changes in product mix,
competitive pricing pressures, new product introductions by our competitors or
other factors. If we are unable to offset the anticipated decrease in our
average selling prices by increasing our sales volumes or through new product
introductions, our net revenues will decline. In addition, to maintain our gross
margins, we must continue to reduce the manufacturing cost of our products. If
we cannot maintain our gross margins, our business could be seriously harmed,
particularly if the average selling price of our products decreases
significantly without a corresponding increase in sales.





17
 *Table of Contents*





*We
Depend on Sales of Our Ophthalmology Products for a Significant Portion of Our
Operating Results* . We
derive, and expect to continue to derive, a large portion of our revenue and
profits from sales of our ophthalmology products. For the three months ended
April 2, 2005 our ophthalmology sales were $6.2 million or 76.0% of total sales.
We anticipate that sales of our ophthalmology products will continue to account
for a significant portion of our revenues in the foreseeable future as we
continue to introduce new ophthalmology products, such as the IQ810 Laser
System.





*We
Depend on International Sales for a Significant Portion of Our Operating
Results* . We
derive, and expect to continue to derive, a large portion of our revenue from
international sales. For the three months ended April 2, 2005, our international
sales were $3.2 million or 39.5% of total sales. We anticipate that
international sales will continue to account for a significant portion of our
revenues in the foreseeable future.
None of our international revenues and costs has been denominated in foreign
currencies. As a result, an increase in the value of the U.S. dollar relative to
foreign currencies makes our products more expensive and thus less competitive
in foreign markets. The factors stated above could have a material adverse
effect on our business, financial condition or results of operations. Our
international operations and sales are subject to a number of other risks
including:




§
    Longer
      accounts receivable collection periods;




§
    Impact
      of recessions in economies outside of the United
States;




§
    Foreign
      certification requirements, including continued ability to use the “CE”
      mark in Europe;




§
    Reduced
      or limited protections of intellectual property rights in jurisdictions
      outside the United States;




§
    Potentially
      adverse tax consequences; and




§
    Multiple
      protectionist, adverse and changing foreign governmental laws and
      regulations.




Any one
or more of these factors stated above could have a material adverse effect on
our business, financial condition or results of operations. For additional
discussion about our foreign currency risks, see Item 3, “Quantitative and
Qualitative Disclosures about Market Risk.”





*We
Rely on Our Direct Sales Force and Network of International Distributors to Sell
Our Products and any Failure to Maintain Our Direct Sales Force and Distributor
Relationships Could Harm Our Business.* Our
ability to sell our products and generate revenue depends upon our direct sales
force within the United States and relationships with independent distributors
outside the United States. As of April 2, 2005 our direct sales force consisted
of 14 employees with 3 additional open positions and we maintained relationships
with 73 independent distributors internationally selling our products into 107
countries. We generally grant our distributors exclusive territories for the
sale of our products in specified countries. The amount and timing of resources
dedicated by our distributors to the sales of our products is not within our
control. Our international sales are entirely dependent on the efforts of these
third parties. If any distributor breaches or fails to generate sales of our
products, we may be forced to replace the distributor and our ability to sell
our products into that exclusive sales territory would be adversely
affected.





18
 *Table of Contents*





We do not
have any long-term employment contracts with the members of our direct sales
force. We may be unable to replace our direct sales force personnel with
individuals of equivalent technical expertise and qualifications or hire
qualified personnel to fill any vacant positions in our direct sales force,
which may limit our revenues and our ability to maintain market share. The loss
of the services of these key personnel would harm our business. Similarly, our
distributorship agreements are generally terminable at will by either party and
distributors may terminate their relationships with us, which would affect our
international sales and results of operations.





*We
are Dependent on the Successful Outcome of Clinical Trials of Our Products and
New Applications Using Our Products.* Our
success will depend in part on the successful outcome of clinical trials of our
products and new applications using our products. Clinical trials are long,
expensive and uncertain processes. We have supported several clinical trials,
including, for example, the TTT4CNV clinical trial. The TTT4CNV clinical trial
is a physician initiated multi-center, prospective, double-masked,
placebo-controlled, randomized trial conducted at 22 centers in the United
States. This is a clinical trial performed within the FDA cleared indications of
the OcuLight SLx and is being conducted to determine whether TTT laser treatment
using our OcuLight SLx infrared laser system and Large Spot Slit Lamp Adapter
can reduce the risk of vision loss for patients with wet AMD compared to a
randomized control, which should reflect the natural history of the disease. In
June 2003, we announced the publication of two additional clinical studies,
which also support the effectiveness of TTT for the treatment of wet age-related
macular degeneration. Both studies were prospective, non-randomized, non-masked
case series that were performed using our OcuLight SLx laser and Large Spot Size
Slit Lamp Adapter. In October 2004, we announced that the preliminary visual
outcome data in the intent-to-treat evaluation showed that TTT, as applied in
the TTT4CNV trial, showed favorable trends but overall did not demonstrate
a significant beneficial effect relative to sham and that further subgroup
analysis would be conducted. Since that time, results of subgroup analysis
have demonstrated a statistically significant benefit in a subgroup of patients
with baseline visual acuity of 20/100 or worse.  Within the
TTT4CNV clinical trial, about 41% of the patients enrolled had baseline
vision of 20/100 or worse. Specifically, at 12 months following treatment 23% of
TTT treated eyes improved vision by one or more lines and 14% of TTT treated
eyes improved vision by three or more lines compared with none of the eyes in
the placebo treated control group. Furthermore, at 18 months, there was a 2 line
benefit in preserving vision in this subgroup when compared to placebo treated
eyes. Specifically, TTT treated eyes on average lost 2 lines of visual acuity
while placebo treated eyes lost 4 lines. Any impact on laser sales related to
these trial results may take a number of years. If the future results of any
clinical trial regarding our products fails to demonstrate improved outcomes of
treatment using our products, our ability to generate revenues from new products
or new applications using our products would be adversely affected.





*We
Face Manufacturing Risks* . The
manufacture of our infrared and visible light photocoagulators and the related
delivery devices is a highly complex and precise process. We assemble critical
subassemblies and all of our final products at our facility in Mountain View,
California. We may experience manufacturing difficulties, quality control issues
or assembly constraints, particularly with regard to new products that we may
introduce. We may not be able to manufacture sufficient quantities of our
products, which may require that we qualify other manufacturers for our
products. Furthermore, we may experience delays, disruptions, capacity
constraints or quality control problems in our manufacturing operations and, as
a result, product shipments to our customers could be delayed, which would
negatively impact our net revenues.





*If We
Fail to Accurately Forecast Demand For Our Product and Component Requirements
For the Manufacture of Our Product, We Could Incur Additional Costs or
Experience Manufacturing Delays and May Experience Lost Sales or Significant
Inventory Carrying Costs.* We use
quarterly and annual forecasts based primarily on our anticipated product orders
to plan our manufacturing efforts and determine our requirements for components
and materials. It is very important that we accurately predict both the demand
for our product and the lead times required to obtain the necessary components
and materials. Lead times for components vary significantly and depend on
numerous factors, including the specific supplier, the size of the order,
contract terms and current market demand for such components. If we overestimate
the demand for our product, we may have excess inventory, which would increase
our costs. Over the past several quarters, we have placed a high priority on our
asset management efforts to, among other things, reduce overall inventory levels
and increase our cash position. If we underestimate demand for our product and,
consequently, our component and materials requirements, we may have inadequate
inventory, which could interrupt our manufacturing, delay delivery of our
product to our customers and result in the loss of customer sales. Any of these
occurrences would negatively impact our business and operating
results.





19
 *Table of Contents*





*We
Depend on Sole Source or Limited Source Suppliers.* We rely
on third parties to manufacture substantially all of the components used in our
products, including optics, laser diodes and crystals. We have some long term or
volume purchase agreements with our suppliers and currently purchase components
on a purchase order basis. Some of our suppliers and manufacturers are sole or
limited sources. In addition, some of these suppliers are relatively small
private companies that may discontinue their operations at any time. There are
risks associated with the use of independent manufacturers, including the
following:




§
    Shortages
      or limitations on the ability to obtain supplies of components in the
      quantities that we require;




§
    Delays
      in delivery or failure of suppliers to deliver critical components on the
      dates we require;




§
    Failure
      of suppliers to manufacture components to our specifications, and
      potentially reduced quality; and




§
    Inability
      to obtain components at acceptable prices.





Our
business and operating results may suffer from the lack of alternative sources
of supply for critical ** sole and
limited source components *.* The
process of qualifying suppliers is complex, requires extensive testing with our
products, and may be lengthy, particularly as new products are introduced. New
suppliers would have to be educated in our production processes. In addition,
the use of alternate components may require design alterations to our products
and additional product testing under FDA and relevant foreign regulatory agency
guidelines, which may delay sales and increase product costs. Any failures by
our vendors to adequately supply limited and sole source components may impair
our ability to offer our existing products, delay the submission of new products
for regulatory approval and market introduction, materially harm our business
and financial condition and cause our stock price to decline. Establishing our
own capabilities to manufacture these components would be expensive and could
significantly decrease our profit margins. We do not currently intend to
manufacture any of these components. Our business, results of operations and
financial condition would be adversely affected if we are unable to continue to
obtain components in the quantity and quality desired and at the prices we have
budgeted.





*Our
Operating Results May Fluctuate from Quarter to Quarter and Year to
Year*. Our
sales and operating results may vary significantly from quarter to quarter and
from year to year in the future. Our operating results are affected by a number
of factors, many of which are beyond our control. Factors contributing to these
fluctuations include the following:




20
 *Table of Contents*




·
    General
      economic uncertainties and political
concerns;




·
    The
      timing of the introduction and market acceptance of new products, product
      enhancements and new applications;




·
    Changes
      in demand for our existing line of dermatology and ophthalmic
      products;




·
    The
      cost and availability of components and subassemblies, including the
      ability of our sole or limited source suppliers to deliver components at
      the times and prices that we have planned;





·
    Our
      ability to maintain sales volumes at a level sufficient to cover fixed
      manufacturing and operating costs;




·
    Fluctuations
      in our product mix between dermatology and ophthalmic products and foreign
      and domestic sales;




·
    The
      effect of regulatory approvals and changes in domestic and foreign
      regulatory requirements;




·
    Introduction
      of new products, product enhancements and new applications by our
      competitors, entry of new competitors into our markets, pricing pressures
      and other competitive factors;




·
    Our
      long and highly variable sales cycle;





·
    Changes
      in the prices at which we can sell our
products;




·
    Changes
      in customers’ or potential customers’ budgets as a result of, among other
      things, reimbursement policies of government programs and private insurers
      for treatments that use our products; and




·
    Increased
      product development costs.





In
addition to these factors, our quarterly results have been, and are expected to
continue to be, affected by seasonal factors.





Our
expense levels are based, in part, on expected future sales. If sales levels in
a particular quarter do not meet expectations, we may be unable to adjust
operating expenses quickly enough to compensate for the shortfall of sales, and
our results of operations may be adversely affected. In addition, we have
historically made a significant portion of each quarter’s product shipments near
the end of the quarter. If that pattern continues, any delays in shipment of
products could have a material adverse effect on results of operations for such
quarter. Due to these and other factors, we believe that quarter to quarter and
year to year comparisons of our past operating results may not be meaningful.
You should not rely on our results for any quarter or year as an indication of
our future performance. Our operating results in future quarters and years may
be below expectations, which would likely cause the price of our common stock to
fall.





21
 *Table of Contents*





*We
Depend on Collaborative Relationships to Develop, Introduce and Market New
Products, Product Enhancements and New Applications* . We
depend on both clinical and commercial collaborative relationships. We have
entered into collaborative relationships with academic medical centers and
physicians in connection with the research and development and clinical testing
of our products. Commercially, we currently collaborate with Bausch & Lomb
to design and manufacture a solid-state green wavelength (532 nm) laser
photocoagulator module, called the Millennium Endolase module. The Millennium
Endolase module is designed to be a component of Bausch & Lomb’s ophthalmic
surgical suite product offering and is not expected to be sold as a stand-alone
product. Sales of the Millennium Endolase module are dependent upon the actual
order rate from and shipment rate to Bausch & Lomb, which depends on the
efforts of our partner and is beyond our control. We cannot assure you that our
relationship with Bausch & Lomb will result in further sales of our
Millennium Endolase module. We also collaborated with Miravant Medical
Technologies, a maker of photodynamic drugs, on a device that emits a laser beam
to activate a photodynamic drug developed by Miravant for the treatment of wet
AMD. In January 2002, Miravant announced that the top line results of their
Phase III clinical trial indicated that PHOTREX, the photodynamic
drug developed, did not meet the primary efficacy endpoint in the study
population. As we could not be assured that PHOTREX would be timely or
successfully pursued through clinical trials by Miravant, we charged to expense
in the fourth quarter of 2001, $0.3 million of inventory related to the OcuLight
664, the laser used by Miravant in the Phase III clinical trials. Miravant has
since received an approvable letter from the FDA for PHOTREX with conditions for
final marketing approval which includes a request for an additional confirmatory
clinical trial. We are the exclusive provider of the OcuLight 664 activation
laser used in this application. Successful commercialization of this product
will depend, among other things, on the results of the confirmatory clinical
trial, acceptance of this product and Miravant’s ability to successfully market
and sell this therapy. The failure of any current or future clinical or
commercial collaboration relationships could have a material adverse effect on
our ability to introduce new products or applications and therefore could have a
material adverse effect on our business, results of operations and financial
condition.





*We
Face Risks Associated with our Collaborative Relationships.* Our
collaborators may not pursue further development and commercialization of
products resulting from collaborations with us or may not devote sufficient
resources to the marketing and sale of such products. Our reliance on others for
clinical development, manufacturing and distribution of our products may result
in unforeseen problems. Further, our collaborative partners may develop or
pursue alternative technologies either on their own or in collaboration with
others. If a collaborator elects to terminate its agreement with us, our ability
to develop, introduce, market and sell the product may be significantly impaired
and we may be forced to discontinue altogether the product resulting from the
collaboration. We may not be able to negotiate alternative collaboration
agreements on acceptable terms, if at all. The failure of any current or future
collaboration efforts could have a material adverse effect on our ability to
introduce new products or applications and therefore could have a material
adverse effect on our business, results of operations and financial
condition.





*We
Are Subject To Government Regulation Which May Cause Us to Delay or Withdraw the
Introduction of New Products or New Applications for Our
Products.* The
medical devices that we market and manufacture are subject to extensive
regulation by the FDA and by foreign and state governments. Under the Federal
Food, Drug and Cosmetic Act and the related regulations, the FDA regulates the
design, development, clinical testing, manufacture, labeling, sale, distribution
and promotion of medical devices. Before a new device can be introduced into the
market, the product must undergo rigorous testing and an extensive regulatory
review process implemented by the FDA under federal law. Unless otherwise
exempt, a device manufacturer must obtain market clearance through either the
510(k) premarket notification process or the lengthier premarket approval
application (PMA) process. Depending upon the type, complexity and novelty of
the device and the nature of the disease or disorder to be treated, the FDA
process can take several years, require extensive clinical testing and result in
significant expenditures. Even if regulatory approval is obtained, later
discovery of previously unknown safety issues may result in restrictions on the
product, including withdrawal of the product from the market. Other countries
also have extensive regulations regarding clinical trials and testing prior to
new product introductions. Our failure to obtain government approvals or any
delays in receipt of such approvals would have a material adverse effect on our
business, results of operations and financial condition.





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The FDA
imposes additional regulations on manufacturers of approved medical devices. We
are required to comply with the applicable Quality System regulations (QSRs) and
our manufacturing facilities are subject to ongoing periodic inspections by the
FDA and corresponding state agencies, including unannounced inspections, and
must be licensed as part of the product approval process before being utilized
for commercial manufacturing. Noncompliance with the applicable requirements can
result in, among other things, fines, injunctions, civil penalties, recall or
seizure of products, total or partial suspension of production, withdrawal of
marketing approvals, and criminal prosecution. The FDA also has the authority to
request repair, replacement or refund of the cost of any device we manufacture
or distribute. Any of these actions by the FDA would materially and adversely
affect our ability to continue operating our business and the results of our
operations.





In
addition, we are also subject to varying product standards, packaging
requirements, labeling requirements, tariff regulations, duties and tax
requirements. As a result of our sales in Europe, we are required to have all
products “CE” marked, an international symbol affixed to all products
demonstrating compliance with the European Medical Device Directive and all
applicable standards. While currently all of our released products are CE
marked, continued certification is based on the successful review of our quality
system by our European Registrar during their annual audit. Any loss of
certification would have a material adverse effect on our business, results of
operations and financial condition.





*Our
Products Could Be Subject to Recalls Even After Receiving FDA Approval or
Clearance. A Recall Would Harm our Reputation and Adversely Affect our Operating
Results.* The FDA
and similar governmental authorities in other countries in which we market and
sell our products have the authority to require the recall of our products in
the event of material deficiencies or defects in design or manufacture. A
government mandated recall, or a voluntary recall by us, could occur as a result
of component failures, manufacturing errors or design defects, including defects
in labeling. A recall could divert management’s attention, cause us to incur
significant expenses, harm our reputation with customers and negatively affect
our future sales.





If we
modify one of our FDA approved or cleared devices, we may need to seek new
approvals or clearances which, if not granted, would prevent us from selling our
modified products.





Any
modifications to an FDA-approved or cleared device that would significantly
affect its safety or effectiveness or that would constitute a major change in
its intended use would require a new 510(k) clearance or possibly a PMA
approval. We may not be able to obtain additional 510(k) clearances or PMA
approvals for new products or for modifications to, or additional intended uses
or indications for, our existing products in a timely fashion, or at all. Delays
in obtaining future clearances would adversely affect our ability to introduce
new or enhanced products in a timely manner, which in turn would harm our
revenue and future profitability. We have made modifications to our devices and
the labeling of our devices in the past and may make additional modifications in
the future that we believe do not or will not require additional clearances or
approvals. If the FDA disagrees and requires new clearances or approvals for the
modifications, we may be required to recall and stop marketing the modified
devices, which could harm our operating results and require us to redesign or
relabel our products.




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*We
Rely on Patents and Proprietary Rights to Protect our Intellectual Property and
Business* . Our
success and ability to compete is dependent in part upon our proprietary
information. We rely on a combination of patents, trade secrets, copyright and
trademark laws, nondisclosure and other contractual agreements and technical
measures to protect our intellectual property rights. We file patent
applications to protect technology, inventions and improvements that are
significant to the development of our business. We have been issued fifteen
United States patents and five foreign patents on the technologies related to
our products and processes. We have approximately four pending patent
applications in the United States and five foreign pending patent applications
that have been filed. Our patent applications may not be approved. Any patents
granted now or in the future may offer only limited protection against potential
infringement and development by our competitors of competing products. Moreover,
our competitors, many of which have substantial resources and have made
substantial investments in competing technologies, may seek to apply for and
obtain patents that will prevent, limit or interfere with our ability to make,
use or sell our products either in the United States or in international
markets.





In
addition to patents, we rely on trade secrets and proprietary know-how which we
seek to protect, in part, through proprietary information agreements with
employees, consultants and other parties. Our proprietary information agreements
with our employees and consultants contain industry standard provisions
requiring such individuals to assign to us without additional consideration any
inventions conceived or reduced to practice by them while employed or retained
by us, subject to customary exceptions. Proprietary information agreements with
employees, consultants and others may be breached, and we may not have adequate
remedies for any breach. Also, our trade secrets may become known to or
independently developed by competitors.





The laser
and medical device industry is characterized by frequent litigation regarding
patent and other intellectual property rights. Companies in the medical device
industry have employed intellectual property litigation to gain a competitive
advantage. Numerous patents are held by others, including academic institutions
and our competitors. Until recently patent applications were maintained in
secrecy in the United States until the patents issued. Patent applications filed
in the United States after November 2000 generally will be published eighteen
months after the filing date. However, since patent applications continue to be
maintained in secrecy for at least some period of time, both within the United
States and with regards to international patent applications, we cannot assure
you that our technology does not infringe any patents or patent applications
held by third parties. We have, from time to time, been notified of, or have
otherwise been made aware of, claims that we may be infringing upon patents or
other proprietary intellectual property owned by others. If it appears necessary
or desirable, we may seek licenses under such patents or proprietary
intellectual property. Although patent holders commonly offer such licenses,
licenses under such patents or intellectual property may not be offered or the
terms of any offered licenses may not be reasonable.





Any
claims, with or without merit, and regardless of whether we are successful on
the merits, would be time-consuming, result in costly litigation and diversion
of technical and management personnel, cause shipment delays or require us to
develop noninfringing technology or to enter into royalty or licensing
agreements. An adverse determination in a judicial or administrative proceeding
and failure to obtain necessary licenses or develop alternate technologies could
prevent us from manufacturing and selling our products, which would have a
material adverse effect on our business, results of operations and financial
condition.








*Our
Operating Results May be Adversely Affected by Changes in Third Party Coverage
and Reimbursement Policies and any Uncertainty Regarding Healthcare Reform
Measures* . Our
ophthalmology products are typically purchased by doctors, clinics, hospitals
and other users, which bill various third-party payers, such as governmental
programs and private insurance plans, for the health care services provided to
their patients. Third-party payers are increasingly scrutinizing and challenging
the coverage of new products and the level of reimbursement for covered
products. Doctors, clinics, hospitals and other users of our products may not
obtain adequate reimbursement for use of our products from third-party payers.
While we believe that the laser procedures using our products have generally
been reimbursed, payers may deny coverage and reimbursement for our products if
they determine that the device was not reasonable and necessary for the purpose
used, was investigational or was not cost-effective. In addition, third party
payers may not initiate coverage of new procedures using our products for a
significant period. In September 2000, the Center for Medicare and Medicaid
Services, or CMS, advised that claims for reimbursement for certain age related
macular degeneration, or AMD, procedures which use our OcuLight SLx laser
system, could be submitted for reimbursement, with coverage and payment to be
determined by the local medical carriers at their discretion. To date five
carriers representing 17 states have written reimbursement coverage policies on
Transpupillary Thermotherapy, or TTT. The states reimbursing for TTT are Alaska,
Arizona, California, Colorado, Hawaii, Iowa, Idaho, Mississippi, North Carolina,
North Dakota, Nevada, Oregon, Pennsylvania, South Dakota, Tennessee, Washington
and Wyoming. Domestic sales of the infrared laser systems may continue to be
limited until more local medical carriers reimburse for performing such AMD
procedures or until CMS advises that claims for these procedures may be
submitted directly to CMS at the national level.





24
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Changes
in government legislation or regulation or in private third-party payers’
policies toward reimbursement for procedures employing our products may prohibit
adequate reimbursement. There have been a number of legislative and regulatory
proposals to change the healthcare system, reduce the costs of healthcare and
change medical reimbursement policies. Doctors, clinics, hospitals and other
users of our products may decline to purchase our products to the extent there
is uncertainty regarding reimbursement of medical procedures using our products
and any healthcare reform measures. Further proposed legislation, regulation and
policy changes affecting third party reimbursement are likely. We are unable to
predict what legislation or regulation, if any, relating to the health care
industry or third-party coverage and reimbursement may be enacted in the future,
or what effect such legislation or regulation may have on us. However, denial of
coverage and reimbursement of our products would have a material adverse effect
on our business, results of operations and financial condition.





*If
Product Liability Claims are Successfully Asserted Against Us, We may Incur
Substantial Liabilities That May Adversely Affect Our Business or Results of
Operations.* We may
be subject to product liability claims from time to time. Our products are
highly complex and some are used to treat extremely delicate eye tissue and skin
conditions on and near a patient’s face. Although we currently maintain and
intend to continue the Company’s product liability insurance, adequate insurance
may not be available on acceptable terms, if at all, and may not provide
adequate coverage against potential liabilities. Product liability insurance is
expensive. We might not be able to obtain product liability insurance in the
future on acceptable terms or in sufficient amounts to protect us, if at all. A
successful claim brought against us in excess of our insurance coverage could
have a material adverse effect on our business, results of operations and
financial condition.





*If We
Fail to Manage Growth Effectively, Our Business Could Be Disrupted Which Could
Harm Our Operating Results.* We have
experienced, and may continue to experience growth in our business. We have made
and expect to continue to make significant investments to enable our future
growth through, among other things, new product development and clinical trials
for new applications and products. We must also be prepared to expand our work
force and to train, motivate and manage additional employees as the need for
additional personnel arises. Our personnel, systems, procedures and controls may
not be adequate to support our future operations. Any failure to effectively
manage future growth could have a material adverse effect on our business,
results of operations and financial condition.





*If
Our Facilities Were To Experience Catastrophic Loss, Our Operations Would Be
Seriously Harmed.* Our
facilities could be subject to catastrophic loss such as fire, flood or
earthquake. All of our research and development activities, manufacturing, our
corporate headquarters and other critical business operations are located near
major earthquake faults in Mountain View, California. Any such loss at any of
our facilities could disrupt our operations, delay production, shipments and
revenue and result in large expense to repair and replace our
facilities.





25
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*We
May Need Additional Capital, which May Not Be Available, and Our Ability to Grow
May be Limited as a Result.* We
believe that our existing cash balances, available-for-sale securities, credit
facilities and cash flow expected to be generated from future operations will be
sufficient to meet our capital requirements at least through the next 12 months.
However, we may be required, or could elect, to seek additional funding prior to
that time. The development and marketing of new products and associated support
personnel requires a significant commitment of resources. If cash from available
sources is insufficient, we may need additional capital, which may not be
available on favorable terms, if at all. If we cannot raise funds on acceptable
terms, we may not be able to develop or enhance our products, take advantage of
future opportunities, fund potential acquisitions or respond to competitive
pressures or unanticipated requirements. Any inability to raise additional
capital when we require it would seriously harm our business.





*Our
Stock Price Has Been and May Continue to be Volatile and an Investment in Our
Common Stock Could Suffer a Decline in Value.* The
trading price of our common stock has been subject to wide fluctuations in
response to a variety of factors, some of which are beyond our control,
including quarterly variations in our operating results, announcements by us or
our competitors of new products or of significant clinical achievements, changes
in market valuations of other similar companies in our industry and general
market conditions. We receive only limited attention by securities analysts and
may experience an imbalance between supply and demand for our common stock
resulting from low trading volumes. In addition, the stock market has
experienced extreme volatility in the last few years that has often been
unrelated to the performance of particular companies. These broad market
fluctuations could have a significant impact on the market price of our common
stock regardless of our performance.





*Changes
in Accounting Rules for Stock-Based Compensation Will Adversely Affect Our
Operating Results, Our Stock Price and Our Competitiveness in the Employee
Marketplace* . We have
a history of using employee stock options and other stock-based compensation to
hire, motivate and retain our workforce. In December 2004, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 123R, “Share-Based Payment,” which will require us, commencing for the
fiscal year ending 2005, to measure compensation costs for all stock-based
compensation (including stock options and our employee stock purchase plan) at
fair value and to recognize these costs as expenses in our statement of
operations. The recognition of these expenses in our statements of operations
will result in lower earnings per share, which could negatively impact our
future stock price. In addition, if we reduced or altered our use of stock-based
compensation to minimize the recognition of these expenses, our ability to
recruit, motivate and retain employees may be impaired, which could put us at a
competitive disadvantage in the employee marketplace.





*Compliance
with Internal Controls Evaluations and Attestation Requirements* .
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we will be required,
beginning in fiscal 2006, to perform an evaluation of our internal controls over
financial reporting and have our auditor publicly attest to such evaluation. We
have prepared an internal plan of action for compliance, which includes a
timeline and scheduled activities, although as of the date of this filing we
have not yet prepared the evaluation. Compliance with these requirements is
expected to be expensive and time-consuming. If we fail to timely complete this
evaluation, or if our registered independent public accounting firm cannot
timely attest to our evaluation, we could be subject to regulatory scrutiny and
a loss of public confidence in our internal controls. In addition, any failure
to implement required new or improved controls, or difficulties encountered in
their implementation, could harm our operating results or cause us to fail to
meet our reporting obligations.





26
 *Table of Contents*





**Item3.**
    **Quantitative
      and Qualitative Disclosure about Market
Risk**





**Quantitative
Disclosures**





We are
exposed to market risks inherent in our operations, primarily related to
interest rate risk and currency risk. These risks arise from transactions and
operations entered into in the normal course of business. We do not use
derivatives to alter the interest characteristics of our marketable securities
or our debt instruments. We have no holdings of derivative or commodity
instruments.





*Interest
Rate Risk* . We are
subject to interest rate risks on cash and cash equivalents, available-for-sale
marketable securities and any future financing requirements. Interest rate risks
related to marketable securities are managed by managing maturities in our
marketable securities portfolio. We have no long-term debt as of April 2,
2005.





The fair
value of our investment portfolio or related income would not be significantly
impacted by changes in interest rates since the marketable securities maturities
do not exceed a term of 12 - 14 months and the interest rates are primarily
fixed.








**Qualitative
Disclosures**





*Interest
Rate Risk* . Our
primary interest rate risk exposures relate to:





§
    The
      risk that available-for-sale securities will fall in value if market
      interest rates increase.





§
    The
      impact of interest rate movements on our ability to obtain adequate
      financing to fund future operations.





We have
the ability to hold at least a portion of the fixed income investments until
maturity and therefore would not expect our operating results or cash flows to
be affected to any significant degree by a sudden change in market interest
rates on our short- and long-term marketable securities portfolio.





Management
evaluates our financial position on an ongoing basis.





*Currency
Rate Risk.*





As all of
our sales transactions are denominated in U.S. currency, we do not hedge any
balance sheet exposures against future movements in foreign exchange rates. The
exposure related to currency rate movements would not have a material impact on
future net income or cash flows.








**Item 4.**
    **Controls
      and Procedures**





**(a) 
Evaluation of Disclosure Controls and Procedures**





Our
management, with the participation of our Chief Executive Officer and our Chief
Financial Officer, evaluated the effectiveness of our disclosure controls and
procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of
1934), as of the end of the period covered by this Quarterly Report on Form
10-Q. Based on that evaluation, our Chief Executive Officer and our Chief
Financial Officer concluded that our disclosure controls and procedures are
effective to ensure that information we are required to disclose in reports that
we file or submit under the Securities Exchange Act of 1934 (i) is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission rules and forms and (ii) is accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.





27
 *Table of Contents*





**(b) 
Changes in Internal Controls**





There
were no changes in our internal controls over financial reporting that occurred
during the period covered by this Quarterly Report on Form 10-Q that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.








**PART II.**  **OTHER
INFORMATION**




**Item 1.**
    **Legal
      Proceedings**
 The Company is not subject to any material legal
      proceedings as of the date of this report.




**Item 2.**
    **Changes
      in Securities and Use of Proceeds**
 None.




**Item 3.**
    **Defaults
      Upon Senior Securities**
 None.





**Item 4.**
    **Submission
      of Matters to Vote of Security
Holders**
 None.




**Item 5.**
    **Other
      Information**
 None.




**Item 6.**
    **Exhibits**




31.1
    Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.


31.2
    Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.


32.1
    Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.





**Trademark
Acknowledgments**





IRIDEX,
the IRIDEX logo, IRIS Medical, OcuLight, SmartKey, EndoProbe and Apex are our
registered trademarks. IRIDERM, G-Probe, DioPexy, DioVet, TruFocus, TrueCW,
UltraView, DioLite 532, Long Pulse, MicroPulse, ScanLite, ColdTip (Handpiece),
VariSpot (Handpiece), TruView and EasyFit product names are our trademarks. All
other trademarks or trade names appearing in the Form 10-Q are the property of
their respective owners.





28
 *Table of Contents*





**SIGNATURE**





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





IRIDEX
      Corporation (Registrant)Date:
      May 17, 2005
    By:
    /s/
      Larry TannenbaumLarry
      TannenbaumChief
      Financial Officer and Vice President, AdministrationPrincipal
      Financial Officer,Chief
      Accounting Officer and Authorized
Signatory)




29
 *Table of Contents*




**Exhibit Index**








31.1
    Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.





31.2
    Certification
      of Chief Financial pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002.





32.1
    Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.




30