**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10 - Q**




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


**For
      the quarterly period ended March 31, 2006**


**OR**


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





**For
      the transition period from _________ to ___________**





Commission
      File Number 0-11365





**PHOTOMEDEX,
      INC.**


(Exact
      name of registrant as specified in its charter)





Delaware
              (State
                or other jurisdictionof
                incorporation or organization)
            
            59-2058100
              (I.R.S.
                EmployerIdentification
                No.)





147
      Keystone Drive, Montgomeryville, Pennsylvania 18936


(Address
      of principal executive offices, including zip code)





(215)
      619-3600


(Registrant's
      telephone number, including area code)





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


Yes ý No  ̈





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.


Yes  ̈ No ý





Indicate
      by check mark whether the registrant: (i) 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 (ii) has been subject to such filing requirements
      for
      the past 90 days.


Yes ý No  ̈





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of "accelerated
      filer and large accelerated filer" in Rule 12b-2 of the Exchange
      Act.




Large
                accelerated filer ̈
            Accelerated
                filerý
            Non-accelerated
                filer ̈





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act.)


Yes  ̈ No ý





The
      number of shares outstanding of the issuer's Common Stock as of May 9, 2006
      was
      52,622,404 shares.


1





PHOTOMEDEX,
      INC. AND SUBSIDIARIES





INDEX





Part
                I. Financial Information:
            PAGEITEM 1.
            Financial
              Statements:




a.
            Consolidated
                Balance Sheets, March 31, 2006 (unaudited) and December 31,
                2005
            3b.
            Consolidated
                Statements of Operations for the three months ended March 31, 2006
                and
                2005 (unaudited)
            4c.
            Consolidated
                Statement of Stockholders’ Equity for the three months ended March 31,
                2006 (unaudited)
            5e.
            Consolidated
                Statements of Cash Flows for the three months ended March 31, 2006
                and
                2005 (unaudited)
            6f.
            Notes
                to Consolidated Financial Statements (unaudited)
            7




ITEM 2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            26ITEM 3.
            Quantitative
                and Qualitative Disclosure about Market Risk
            38ITEM 4.
            Controls
                and Procedures
            39Part
                II. Other Information:ITEM
                1. Legal Proceedings
            39ITEM
                1A. Risk Factors
            39ITEM
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            40ITEM
              5. Other Information
            40ITEM
                6. Exhibits
            40Signatures
            41Certifications


2


**PART
      I - Financial Information**




**ITEM
      1. Financial Statements**




PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      BALANCE SHEETS




March
                31, 2006
            
            December
                31, 2005(Unaudited)
            
            ***ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,458,312
            
            $
            5,403,036Restricted
                cash
            
            
            207,050
            
            
            206,931Accounts
                receivable, net of allowance for doubtful accounts of $754,197 and
                $765,440, respectively
            
            
            4,737,483
            
            
            4,651,080Inventories
            
            
            7,536,171
            
            
            8,047,444Prepaid
                expenses and other current assets
            
            
            753,435
            
            
            621,372Total
                current assets
            
            
            18,692,451
            
            
            18,929,863Property
                and equipment, net
            
            
            7,407,593
            
            
            7,044,713Goodwill,
                net
            
            
            16,917,808
            
            
            16,375,384Patents
                and licensed technologies, net
            
            
            1,902,449
            
            
            1,577,554Other
                intangible assets, net
            
            
            4,235,125
            
            
            4,467,625Other
                assets
            
            
            541,010
            
            
            280,467Total
                assets
            
            $
            49,696,436
            
            $
            48,675,606**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Current
                portion of notes payable
            
            $
            224,655
            
            $
            228,398Current
                portion of long-term debt
            
            
            2,127,896
            
            
            1,749,969Accounts
                payable
            
            
            4,187,982
            
            
            3,572,077Accrued
                compensation and related expenses
            
            
            1,551,316
            
            
            867,427Other
                accrued liabilities
            
            
            709,144
            
            
            924,968Deferred
                revenues
            
            
            572,124
            
            
            466,032Total
                current liabilities
            
            
            9,373,117
            
            
            7,808,871Long-term
                liabilities:Notes
                payable
            
            
            178,889
            
            
            159,213Long-term
                debt
            
            
            2,722,869
            
            
            2,278,871Other
                liabilities
            
            
            5,818
            
            
            11,623Total
                liabilities
            
            
            12,280,693
            
            
            10,258,578Commitments
                and ContingenciesStockholders’
                equity:Common
                stock, $.01 par value, 75,000,000 shares authorized; 52,620,304 and
                51,414,294 shares issued and outstanding, respectively
            
            
            526,203
            
            
            514,143Additional
                paid-in capital
            
            
            119,422,407
            
            
            118,140,838Accumulated
                deficit
            
            
            (82,532,867
            )
            
            (80,182,606
            )Deferred
                compensation
            
            
            -
            
            
            (55,347
            )Total
                stockholders' equity
            
            
            37,415,743
            
            
            38,417,028Total
                liabilities and stockholders’ equity
            
            $
            49,696,436
            
            $
            48,675,606




*
      The
      December 31, 2005 balance sheet was derived from our audited financial
      statements.




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




PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF OPERATIONS




(Unaudited)




For
                the Three Months Ended
              March
                31,2006
            
            2005Revenues:Product
                sales
            
            $
            5,243,912
            
            $
            2,225,699Services
            
            
            2,837,250
            
            
            2,757,6338,081,162
            
            
            4,983,332Cost
                of revenues:Product
                cost of revenues
            
            
            2,321,669
            
            
            892,964Services
                cost of revenues
            
            
            2,386,229
            
            
            1,739,4044,707,898
            
            
            2,632,368Gross
                profit
            
            
            3,373,264
            
            
            2,350,964Operating
                expenses:Selling
                and marketing
            
            
            2,952,939
            
            
            1,380,591General
                and administrative
            
            
            2,407,239
            
            
            1,840,385Engineering
                and product development
            
            
            242,204
            
            
            186,9715,602,382
            
            
            3,407,947Loss
                from operations
            
            
            (2,229,118
            )
            
            (1,056,983
            )Interest
                expense, net
            
            
            (121,143
            )
            
            (71,129
            )Net
                loss
            
            $
            (2,350,261
            )
            $
            (1,128,112
            )Basic
                and diluted net loss per share
            
            $
            (0.05
            )
            $
            (0.03
            )Shares
                used in computing basic and diluted net loss per share
            
            
            52,173,618
            
            
            41,755,950







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


4


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENT OF STOCKHOLDERS’ EQUITY


FOR
      THE
      THREE MONTHS ENDED MARCH 31, 2006




(Unaudited)









AdditionalCommon
                Stock
            
            Paid-In
            
            Accumulated
            
            DeferredShares
            
            Amount
            
            Capital
            
            Deficit
            
            Compensation
            
            TotalBALANCE,
                DECEMBER 31, 2005
            
            
            51,414,294
            
            $
            514,143
            
            $
            118,140,838
            
            $
            (80,182,606
            )
            $
            (55,347
            )
            $
            38,417,028Adoption
              of SFAS 123R
            
            
            -
            
            
            -
            
            
            (55,347
            )
            
            -
            
            
            55,347
            
            
            0Exercise
                of stock options
            
            
            45,000
            
            
            450
            
            
            67,950
            
            
            -
            
            
            -
            
            
            68,400Stock
                options issued to consultants for services
            
            
            -
            
            
            -
            
            
            76,622
            
            
            -
            
            
            -
            
            
            76,622Stock-based
                compensation expense related to employee options
            
            
            -
            
            
            -
            
            
            311,624
            
            
            -
            
            
            -
            
            
            311,624Stock-based
                compensation expense related to severance agreement
            
            
            -
            
            
            -
            
            
            195,497
            
            
            -
            
            
            -
            
            
            195,497Issuance
                of restricted stock
            
            
            860,000
            
            
            8,600
            
            
            78,544
            
            
            -
            
            
            -
            
            
            87,144Issuance
                of stock for Stern assets acquisition
            
            
            101,010
            
            
            1,010
            
            
            190,725
            
            
            -
            
            
            -
            
            
            191,735Issuance
                of stock for AzurTec agreement
            
            
            200,000
            
            
            2,000
            
            
            381,273
            
            
            -
            
            
            -
            
            
            383,273Amortization
                of deferred compensation
            
            
            -
            
            
            -
            
            
            14,718
            
            
            -
            
            
            -
            
            
            14,718Registration
                expenses
            
            
            -
            
            
            -
            
            
            (7,890
            )
            
            -
            
            
            -
            
            
            (7,890
            )Issuance
                of warrants for draws under line of credit
            
            
            -
            
            
            -
            
            
            27,853
            
            
            -
            
            
            -
            
            
            27,853Net
                loss for the three months ended March 31, 2006
            
            
            -
            
            
            -
            
            
            -
            
            
            (2,350,261
            )
            
            -
            
            
            (2,350,261
            )BALANCE,
                MARCH 31, 2006
            
            
            52,620,304
            
            $
            526,203
            
            $
            119,422,407
            
            $
            (82,532,867
            )
            $
            -
            
            $
            37,415,743













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


5


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF CASH FLOWS


(Unaudited)




For
                the Three Months Ended
              March
                31,2006
            
            2005**Cash
                Flows From Operating Activities**:Net
                loss
            
            $
            (2,350,261
            )
            $
            (1,128,112
            )Adjustments
                to reconcile net loss to net cash usedin
                operating activities:Depreciation
                and amortization
            
            
            1,017,095
            
            
            526,396Stock-based
                compensation expense related to employee options and restricted
                stock
            
            
            390,168
            
            
            -Stock
                options issued to consultants for services
            
            
            76,622
            
            
            -Amortization
                of deferred compensation
            
            
            14,718
            
            
            4,199Provision
                for bad debts
            
            
            58,246
            
            
            167,412Changes
                in operating assets and liabilities, net of effects on acquired assets
                and
                liabilities:Accounts
                receivable
            
            
            (144,649
            )
            
            141,768Inventories
            
            
            528,890
            
            
            (769,136
            )Prepaid
                expenses and other assets
            
            
            93,236
            
            
            192,129Accounts
                payable
            
            
            615,905
            
            
            (210,567
            )Accrued
                compensation and related expenses
            
            
            336,962
            
            
            266,688Other
                accrued liabilities
            
            
            (188,825
            )
            
            (781,200
            )Cash
                deposits
            
            
            (27,000
            )
            
            9,000Deferred
                revenues
            
            
            106,092
            
            
            (82,683
            )Other
                liabilities
            
            
            (5,805
            )
            
            (23,860
            )Net
                cash provided by (used in) operating activities
            
            
            521,394
            
            
            (1,687,966
            )**Cash
                Flows From Investing Activities:**Purchases
                of property and equipment
            
            
            (11,366
            )
            
            (56,382
            )Lasers
                placed into service
            
            
            (1,079,167
            )
            
            (722,509
            )Cash
                received from acquisition, net of costs incurred
            
            
            -
            
            
            6,014,450Net
                cash (used in) provided by investing activities
            
            
            (1,090,533
            )
            
            5,235,559**Cash
                Flows From Financing Activities:**Proceeds
                from issuance of restricted common stock
            
            
            8,600
            
            
            -Costs
                related to issuance of common stock
            
            
            (7,890
            )
            
            (134,462
            )Proceeds
                from exercise of options
            
            
            68,400
            
            
            53,148Proceeds
                from exercise of warrants
            
            
            -
            
            
            147,060Payments
                on long-term debt
            
            
            (58,725
            )
            
            (70,131
            )Payments
                on notes payable
            
            
            (205,718
            )
            
            (86,225
            )Net
                advancements on lease line of credit
            
            
            819,867
            
            
            (154,315
            )(Increase)/decrease
                in restricted cash and cash equivalents
            
            
            (119
            )
            
            100,431Net
                cash provided by (used in) financing activities
            
            
            624,415
            
            
            (144,494
            )Net
                increase in cash and cash equivalents
            
            
            55,276
            
            
            3,403,099Cash
                and cash equivalents, beginning of period
            
            
            5,403,036
            
            
            3,884,817Cash
                and cash equivalents, end of period
            
            $
            5,458,312
            
            $
            7,287,916




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


6


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


NOTES
      TO
      UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




*Note
      1*




**Basis
      of Presentation:**




**The
      Company:**




***Background***


PhotoMedex,
      Inc. (and its subsidiaries) (the “Company”) is a medical device and specialty
      pharmaceutical company focused on facilitating the cost-effective use of
      technologies for doctors, hospitals and surgery centers to enable their patients
      to achieve a higher quality of life. The Company operates in five distinct
      business units, or segments (as described in Note 11): three in Dermatology,
      including Domestic XTRAC®, International Dermatology, and Skin Care (ProCyte®);
      and two in Surgical, including Surgical Services (SIS) and Surgical Products
      and
      other (SLT®). The segments are distinguished by our management structure,
      products and services offered, markets served or types of customers.




The
      Domestic XTRAC segment derives revenues from procedures performed by
      dermatologists in the United States. Our XTRAC laser system is placed in a
      dermatologist’s office without any initial capital cost to the dermatologist and
      then we charge a fee-per-use to treat skin disease. The International
      Dermatology segment was formerly called the International XTRAC segment, but
      with the addition of the VTRACTM lamp-based system in this quarter, we have
      renamed this segment. In comparison to the Domestic XTRAC segment, the
      International Dermatology segment generates revenues from the sale of equipment
      to dermatologists outside the United States through a network of distributors.
      The Skin Care segment generates revenues by selling physician-dispensed skincare
      products worldwide and by earning royalties on licenses for our patented copper
      peptide compound.




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically using our mobile surgical laser equipment delivered and operated
      by a
      technician at hospitals and surgery centers in the United States. The Surgical
      Products segment generates revenues by selling laser products and disposables
      to
      hospitals and surgery centers both domestically and internationally. The
      Surgical Products segment also sells other non-laser products (e.g. the
      ClearESS® II suction-irrigation system).




The
      XTRAC
      laser system is designed and manufactured by us to phototherapeutically treat
      psoriasis, vitiligo, atopic dermatitis and leukoderma. In January 2000, the
      Company received the first Food and Drug Administration (“FDA”) clearance to
      market an excimer laser system, the XTRAC® system, for the treatment of
      psoriasis. It was followed by FDA 510(k) clearance to treat vitiligo in March
      2001, atopic dermatitis in August 2001, and leukoderma in May 2002. The first
      XTRAC phototherapy treatment systems were commercially distributed in the United
      States in August 2000 prior to any of its procedures being approved for medical
      insurance reimbursement. In the last several years, the Company has sought
      to
      obtain reimbursement for psoriasis and other inflammatory skin disorders.
      Obtaining reimbursement for new technologies is a major challenge for any
      company and in the latter part of 2005, the Company received many approvals
      for
      the reimbursement for use of the XTRAC system. The manufacturing facility
      for the XTRAC laser system is located in Carlsbad, California.




The
      Skin
      Care business resulted from the acquisition of ProCyte Corporation (“ProCyte”)
      on March 18, 2005. ProCyte, located in Redmond, Washington, markets products
      for
      skin health, hair care and wound care. Many of these products incorporate
      patented copper peptide technologies. In addition to a diversified product
      line,
      ProCyte has provided a national sales force and increased the Company’s
      marketing department. (see Note 2).




The
      Surgical businesses were acquired on December 27, 2002 as a result of the
      acquisition of Surgical Laser Technologies, Inc. (“SLT”), located in
      Montgomeryville, Pennsylvania. In the Surgical business, the Company
      also develops, manufactures and markets proprietary lasers and delivery systems
      for both contact and non-contact surgery and provide s
      surgical services utilizing these and other manufacturers’ products. The
      Montgomeryville facility also serves as the Company’s corporate
      headquarters.


7


***Liquidity
      and Going Concern***


The
      Company has incurred significant losses and negative cash flows from operations
      since emerging from bankruptcy in May 1995. As of March 31, 2006, the Company
      had an accumulated deficit of $82,532,867. The Company has historically financed
      its activities from operations, the private placement of equity securities
      and
      borrowings under lines of credit. To date, the Company has dedicated most of
      its
      financial resources to research and development, marketing and general and
      administrative expenses.




Cash
      and
      cash equivalents as of March 31, 2006 were $5,665,362, including restricted
      cash
      of $207,050. Management believes that the existing cash balance together with
      its other existing financial resources, including its leasing credit line
      facility with a remaining availability of $770,003 (see Note 9), and any
      revenues from sales, distribution, licensing and manufacturing relationships,
      will be sufficient to meet the Company’s operating and capital requirements
      beyond the second quarter of 2007. The 2006 operating plan reflects anticipated
      growth from an increase in per-treatment fee revenues for use of the XTRAC
      laser
      system based on wider insurance coverage in the United States and continuing
      cost savings from the integration of business operations acquired from ProCyte.
      In addition, the 2006 operating plan calls for increased revenues and profits
      from the Domestic XTRAC business and the continued growth of our skin care
      products. However, depending upon the Company’s rate of growth and other
      operating factors, the Company may require additional equity or debt financing
      to meet its working capital requirements or capital expenditure needs for the
      balance of 2006. There can be no assurance that additional financing, if needed,
      will be available when required or, if available, can be obtained on terms
      satisfactory to the Company.




Since
      2002, the Company has made significant progress in obtaining more extensive
      reimbursement approval from the Centers for Medicare and Medicaid Services
      and
      various private health plans for the treatment of skin disorders using the
      XTRAC
      system.




The
      Company plans to continue to focus on securing reimbursement from more private
      insurers and to concentrate sales and marketing efforts where such
      reimbursement has become available. As approvals for reimbursements are
      obtained, the Company will increase spending on the marketing of its psoriasis,
      vitiligo, atopic dermatitis and leukoderma treatment products and, if necessary,
      expansion of its manufacturing facilities. Notwithstanding the approval for
      reimbursement by Centers for Medicare and Medicaid Services and recent approvals
      by certain private insurers, the Company may continue to face resistance from
      remaining private healthcare insurers to adopt the excimer-laser-based therapy
      as an approved procedure or to provide adequate levels of reimbursement.
      Management cannot provide assurance that the Company will market the product
      successfully or operate profitably in the future, or that it will not require
      significant additional financing in order to accomplish its business plan
      objectives.




The
      Company’s future success also depends in part upon increased patient acceptance
      of its excimer-laser-based systems for the treatment of a variety of skin
      disorders. The Company’s ability to introduce successful new products may be
      adversely affected by a number of factors, such as unforeseen costs and
      expenses, technological change, economic downturns, increased competition,
      other
      factors beyond the Company’s control or excessive costs in order to market the
      product and thus win patient acceptance. The Company is continuing
      implementation of its rollout strategy for the XTRAC laser system in the United
      States in selected areas of the country where reimbursement is widely available.
      The success of the rollout depends on increasing physician and patient demand
      for the treatment.




Management
      cannot provide assurance that the Company will market the product successfully
      or operate profitably in the future, or that it will not require significant
      additional financing in order to accomplish the objectives of its business
      plan.
      Consequently, the Company’s historical operating results cannot be relied on to
      be an indicator of future performance, and management cannot predict whether
      the
      Company will obtain or sustain positive operating cash flow or generate net
      income in the future.




**Summary
      of Significant Accounting Policies:**




***Quarterly
      Financial Information and Results of Operations***


The
      financial statements as of March 31, 2006 and for the three months ended
      March 31, 2006 and 2005, are unaudited and, in the opinion of management,
      include all adjustments (consisting primarily of normal recurring adjustments)
      necessary to present fairly the financial position as of March 31 2006, and
      the
      results of operations and cash flows for the three months ended March 31, 2006
      and 2005. The results for the three months ended March 31, 2006 are not
      necessarily indicative of the results to be expected for the entire year. While
      management of the Company believes that the disclosures presented are adequate
      to make the information not misleading, these consolidated financial statements
      should be read in conjunction with the consolidated financial statements and
      the
      notes included in the Company's Annual Report on Form 10-K for the fiscal year
      ended December 31, 2005.  8


***Principles
      of Consolidation***


The
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiaries. All significant intercompany balances and
      transactions have been eliminated.




***Use
      of Estimates***


The
      preparation of the consolidated financial statements in conformity with
      accounting principles generally accepted in the United States requires
      management to make estimates and assumptions that affect amounts reported in
      the
      financial statements and accompanying notes. Actual results could differ from
      those estimates and be based on events different from those assumptions. Future
      events and their effects cannot be predicted with certainty; estimating,
      therefore, requires the exercise of judgment. Thus, accounting estimates change
      as new events occur, as more experience is acquired, or as additional
      information is obtained.




See
      “Summary of Significant Accounting Policies” in the Company’s 2005 Annual Report
      on Form 10-K for a discussion of the estimates and judgments necessary in the
      Company’s accounting for cash and cash equivalents, accounts receivable,
      inventories, property, equipment and depreciation, product development costs
      and
      fair value of financial instruments.




***Revenue
      Recognition***


The
      Company has two distribution channels for its phototherapy treatment equipment.
      The Company either (i) sells the laser through a distributor or directly to
      a
      physician or (ii) places the lasers in physician’s offices (at no charge to the
      physician) and charges the physician a fee for an agreed upon number of
      treatments. When the Company sells an XTRAC laser to a distributor or directly
      to a physician, revenue is recognized when the following four criteria under
      Staff Accounting Bulletin No. 104 have been met: (i) the product has been
      shipped and the Company has no significant remaining obligations; (ii)
      persuasive evidence of an arrangement exists; (iii) the price to the buyer
      is
      fixed or determinable; (iv) and collection is probable (the “SAB 104 Criteria”).
      At times, units are shipped, but revenue is not recognized until all of the
      criteria are met, and until that time, the unit is carried on the books of
      the
      Company as inventory.




The
      Company ships most of its products FOB shipping point, although from time to
      time certain customers, for example governmental customers, will insist upon
      FOB
      destination. Among the factors the Company takes into account in determining
      the
      proper time at which to recognize revenue are when title to the goods transfers
      and when the risk of loss transfers. Shipments to distributors that do not
      fully
      satisfy the collection criteria are recognized when invoiced amounts are fully
      paid.




Under
      the
      terms of the Company’s distributor agreements, the distributors do not have the
      unilateral right to return any unit that they have purchased. However, the
      Company does allow products to be returned by its distributors for product
      defects or other claims.




When
      the
      Company places a laser in a physician’s office, it recognizes service revenue
      based on the number of patient treatments performed by the physician. Treatments
      in the form of random laser-access codes that are sold to physicians, but not
      yet used, are deferred and recognized as a liability until the physician
      performs the treatment. Unused treatments remain an obligation of the Company
      because the treatments can only be performed on Company-owned equipment. Once
      the treatments are delivered to a patient, this obligation has been satisfied.




The
      Company excludes all sales of treatment codes made within the last two weeks
      of
      the period in determining the amount of procedures performed by its
      physician-customers. Management believes this approach closely approximates
      the
      actual amount of unused treatments that existed at the end of a period. For
      the
      three months ended March 31, 2006 and 2005, the Company deferred an additional
      $421,624 and $311,571, respectively, under this program.




In
      the
      first quarter of 2003, the Company implemented a program to support certain
      physicians in addressing treatments with the XTRAC system that may be denied
      reimbursement by private insurance carriers. The Company recognizes service
      revenue from the sale of treatment codes to physicians participating in this
      program only if and to the extent the physician has been reimbursed for the
      treatments. For the three months ended March 31, 2006, the Company deferred
      an additional $51,080 under this program, as all the SAB 104 Criteria for
      revenue recognition had not been met. At March 31, 2006, the Company had net
      deferred revenues of $101,720 under this program.




9


Under
      this program, the Company may reimburse qualifying doctors for the cost of
      the
      Company’s fee but only if they are ultimately denied reimbursement after appeal
      of their claim with the insurance company. The key components of the program
      are
      as follows:




·
            The
                physician practice must be in an identified location where there
                is an
                insufficiency of insurance companies reimbursing the
                procedure;




·
            The
                program only covers medically necessary treatments of psoriasis as
                determined by the treating
                physician;




·
            The
                patient must have medical insurance and a claim for the treatment
                must be
                timely filed with the patient’s insurance company;




·
            Upon
                denial by the insurance company (generally within 30 days of filing
                a
                claim), a standard insurance form called an EOB (“Explanation of
                Benefits”) must be submitted to the Company’s in-house appeals group, who
                will then prosecute the appeal. The appeal process can take 6 to
                9
                months;




·
            After
                all appeals have been exhausted by the Company and the claim remains
                unpaid, the physician is entitled to receive credit for the treatment
                he
                or she purchased from the Company (our fee only) on behalf of the
                patient;
                and




·
            Physicians
                are still obligated to make timely payments for treatments purchased,
                irrespective of whether reimbursement is paid or denied. Future sale
                of
                treatments to a physician can be denied if timely payments are not
                made,
                even if a patient’s appeal is still in
                process.




The
      Company estimates a contingent liability for potential refunds under this
      program by reviewing the history of denied insurance claims and appeals
      processed. The Company estimates that approximately 4% of the revenues under
      this program for the quarter ended March 31, 2006 are subject to being credited
      or refunded to the physician. The Company estimates that 11% of the revenues
      under this program for the quarter ended March 31, 2005 were subject to being
      credited or refunded to the physician.




The
      Company generates revenues from its skin care business primarily through
      three channels. The first is through product sales for skin health, hair care
      and wound care; the second is through sales of the copper peptide compound,
      primarily to Neutrogena Corporation, a Johnson & Johnson company; and the
      third is through royalties generated by our licenses, principally to Neutrogena.
      The Company recognizes revenues on the products and copper peptide compound
      when
      they are shipped, net of returns and allowances. The Company ships the products
      FOB shipping point. Royalty revenues are based upon sales generated by our
      licensees. The Company recognizes royalty revenue at the applicable royalty
      rate
      applied to shipments reported by our licensee.




The
      Company generates revenues from its surgical businesses primarily from two
      channels. The first is through product sales of laser systems, related
      maintenance service agreements, recurring laser delivery systems and laser
      accessories and the second is through per-procedure surgical services. The
      Company recognizes revenues from surgical laser and other product sales,
      including sales to distributors, when the SAB 104 Criteria have been met.




For
      per-procedure surgical services, the Company recognizes revenue upon the
      completion of the procedure. Revenue from maintenance service agreements is
      deferred and recognized on a straight-line basis over the term of the
      agreements. Revenue from billable services, including repair activity, is
      recognized when the service is provided.




***Impairment
      of Long-Lived Assets and Intangibles***


In
      accordance with SFAS No. 144, “Accounting for the Impairment of Disposal of
      Long-Lived Assets”, long-lived assets, such as property and equipment, and
      purchased intangibles subject to amortization, are reviewed for impairment
      whenever events or changes in circumstances indicate that the carrying amount
      of
      an asset may not be recoverable. Recoverability of assets to be held and used
      is
      measured by a comparison of the carrying amount of an asset to estimated
      undiscounted future cash flows expected to be generated by the asset. If the
      carrying amount of an asset exceeds its estimated future cash flows, an
      impairment charge is recognized by the amount by which the carrying amount
      of
      the asset exceeds the fair value of the asset. Assets to be disposed of would
      be
      separately presented in the balance sheet and reported at the lower of the
      carrying amount or the fair value less costs to sell, and would no longer be
      depreciated. The assets and liabilities of a disposed group would be classified
      as held for sale and would be presented separately in the appropriate asset
      and
      liability sections of the balance sheet. As of March 31, 2006, no such
      impairment existed.


10


***Patent
      Costs and Licensed Technologies***


Costs
      incurred to obtain or defend patents and licensed technologies are capitalized
      and amortized over the shorter of the remaining estimated useful lives or 8
      to
      12 years. Developed technology was recorded in connection with the purchase
      in
      August 2000 of the minority interest of Acculase, a former subsidiary of the
      Company, and is being amortized on a straight-line basis over seven years.
      Developed technology was also recorded in connection with the acquisition of
      ProCyte in March 2005 and is being amortized on a straight-line basis over
      seven
      years.




Management
      evaluates the realizability of intangible assets based on estimates of
      undiscounted future cash flows over the remaining useful life of the asset.
      If
      the amount of such estimated undiscounted future cash flows is less than the
      net
      book value of the asset, the asset is written down to fair value. As of March
      31, 2006, no such write-down was required (See ***Impairment
      of Long-Lived Assets and Intangibles*** ).




***Other
      Intangible Assets***


Other
      intangible assets were recorded in connection with the acquisition of ProCyte
      in
      March 2005. The assets are being amortized on a straight-line basis over 5
      to 10
      years.




Management
      evaluates the recoverability of such other intangible assets based on estimates
      of undiscounted future cash flows over the remaining useful life of the asset.
      If the amount of such estimated undiscounted future cash flows is less than
      the
      net book value of the asset, the asset is written down to fair value. As of
      March 31, 2006, no such write-down was required.




***Goodwill***


Goodwill
      was recorded in connection with the acquisition of ProCyte in March 2005 and
      the
      acquisition of Acculase in August 2000.




Management
      evaluates the recoverability of such goodwill based on estimates of undiscounted
      future cash flows over the remaining useful life of the asset. If the amount
      of
      such estimated undiscounted future cash flows is less than the net book value
      of
      the asset, the asset is written down to fair value. As of March 31, 2006, no
      such write-down was required.




***Accrued
      Warranty Costs***


The
      Company offers a warranty on product sales generally for a one to two-year
      period. The Company provides for the estimated future warranty claims on the
      date the product is sold. The activity in the warranty accrual during the three
      months ended March 31, 2006 is summarized as follows:




March
                31, 2006Accrual
                at beginning of period
            
            $
            204,708Additions
                charged to warranty expense
            
            
            16,250Expiring
                warranties
            
            
            (57,475
            )Claims
                paid
            
            
            (15,284
            )Accrual
                at end of period
            
            $
            148,199




***Income
      Taxes***


The
      Company accounts for income taxes in accordance with SFAS No. 109, “Accounting
      for Income Taxes.” Under SFAS No. 109, the liability method is used for income
      taxes. Under this method, deferred tax assets and liabilities are determined
      based on differences between the financial reporting and tax basis of assets
      and
      liabilities and are measured using enacted tax rates and laws that are expected
      to be in effect when the differences reverse.




11


The
      Company’s deferred tax asset has been fully reserved under a valuation
      allowance, reflecting the uncertainties as to realizability evidenced by the
      Company’s historical results and restrictions on the usage of the net operating
      loss carryforwards. When under the rules of SFAS No. 109 the Company may
      recognize some of the deferred tax asset, the recognized portion may reduce
      goodwill, increase stockholder’s equity directly and/or benefit the statement of
      operations. Consistent with the rules of purchase accounting, the historical
      deferred tax asset of ProCyte was written off when the Company acquired ProCyte.
      If and when components of that asset are realized in the future, the acquired
      goodwill of ProCyte will be reduced.




***Net
      Loss Per Share***


The
      Company computes net loss per share in accordance with SFAS No. 128, “Earnings
      per Share.” In accordance with SFAS No. 128, basic net loss per share is
      calculated by dividing net loss available to common stockholders by the weighted
      average of common shares outstanding for the period. Diluted net loss per share
      reflects the potential dilution from the conversion or exercise into common
      stock of securities such as stock options and warrants.




In
      these
      consolidated financial statements, diluted net loss per share is the same as
      basic net loss per share. No additional shares for the potential dilution from
      the conversion or exercise of securities into common stock are included in
      the
      denominator, since the result would be anti-dilutive. Common stock options
      and
      warrants of 8,373,000 and 8,249,605 as of March 31, 2006 and 2005, respectively,
      were excluded from the calculation of fully diluted earnings per share since
      their inclusion would have been anti-dilutive.




***Exchanges
      of Nonmonetary Assets***


Exchanges
      under SFAS No. 153, “Exchanges of Nonmonetary Assets,” are measured based on the
      fair value of the assets exchanged. Further, SFAS No. 153 eliminates the
      previous narrow exception for nonmonetary exchanges of similar productive assets
      and replaces it with a broader exception for exchanges of nonmonetary assets
      that do not have “commercial substance.” Although SFAS No. 153 is generally
      effective for financial statements for fiscal years beginning after June 15,
      2005, the Company elected to early adopt this Statement. For the three months
      ended March 31, 2006 and 2005, the Company has not recognized any income or
      expense in accordance with this Statement.




***Share-Based
      Compensation***


On
      January 1, 2006, The Company adopted SFAS No. 123R, “Share-Based Payment,” which
      requires all companies to measure and recognize compensation expense at fair
      value for all stock-based payments to employees and directors. SFAS No. 123R
      is
      being applied on the modified prospective bases. Prior to the adoption of SFAS
      No. 123R, the Company accounted for its stock-based compensation plans for
      employees and directors under the recognition and measurement principles of
      Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued
      to Employees”, and related interpretations, and accordingly, the Company
      recognized no compensation expense related to the stock-based plans for grants
      to employees or directors. Grants to consultants under the plans were recorded
      under SFAS No. 123.




Under
      the
      modified prospective approach, SFAS No. 123R applies to new grants of options
      and awards of stock as well as to grants of options that were outstanding on
      January 1, 2006 and that may subsequently be repurchased, cancelled or
      materially modified. Under the modified prospective approach, compensation
      cost
      recognized for the first quarter of fiscal 2006 includes compensation cost
      for
      all share-based payments granted prior to, but not yet vested on, January 1,
      2006, based on fair value as of the prior grant-date and estimated in accordance
      with the provisions of SFAS No. 123R. Prior periods were not restated to reflect
      the impact of adopting the new standard.




SFAS
      No.
      123R also requires companies to calculate an initial "pool" of excess tax
      benefits available at the adoption date to absorb any tax deficiencies that
      may
      be recognized under SFAS No. 123R. The pool includes the net excess tax benefits
      that would have been recognized if the Company had adopted SFAS No. 123 for
      recognition purposes on its effective date.




12


The
      Company has elected to calculate the pool of excess tax benefits under the
      alternative transition method described in FASB Staff Position ("FSP") No.
      FAS
      123(R)-3, "Transition Election Related to Accounting for Tax Effects of
      Share-Based Payment Awards," which also specifies the method we must use to
      calculate excess tax benefits reported on the statement of cash flows. The
      Company is in a net operating loss position; therefore, no excess tax benefits
      from share-based payment arrangements have been recognized for the three months
      ended March 31, 2006.




The
      proforma information presented in the following table illustrates the effect
      on
      net income and net income per share if the Company had applied the fair value
      recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based
      Compensation,” as amended by FASB Statement No. 148, “Accounting for Stock-Based
      Compensation – Transition and Disclosure,” to stock-based employee
      compensation for the three months ended March 31, 2005:





Three
                Months
              Ended
                March 31,
              2005Net
                loss:As
                reported
            
            $
            (1,128,112
            )Less:
                stock-based employee compensation expense included in reported net
                loss
            
            
            4,199Impact
                of total stock-based compensation expense determined under
                fair-value-based method for all grants and awards
            
            
            (278,872
            )Pro-forma
            
            $
            (1,402,785
            )Net
                loss per share:As
                reported
            
            $
            (0.03
            )Pro-forma
            
            $
            (0.03
            )




The
      Company uses the Black-Scholes option-pricing model to estimate fair value
      of
      grants of stock options with the following weighted average
      assumptions:




Assumptions
                for Option Grants
            Three
                Months Ended March 31,2006
            
            2005Risk-free
                interest rate
            4.58%
            
            4.02%Volatility
            93.51%
            
            98.27%Expected
                dividend yield
            0%
            
            0%Expected
                life
            7.44
                years
            
            5
                yearsEstimated
                forfeiture rate
            11%
            
            N/A




The
      Company calculates expected volatility for a share-based grant based on
      historic, daily stock price observations of our common stock during the period
      immediately preceding the grant that is equal in length to the expected term
      of
      the grant. For estimating the expected term of share-based grants made in the
      three months ended March 31, 2006, the Company has adopted the simplified method
      authorized in Staff Accounting Bulletin No. 107. SFAS No. 123R also requires
      that estimated forfeitures be included as a part of the estimate of expense
      as
      of the grant date. The Company has used historical data to estimate expected
      employee behaviors related to option exercises and forfeitures. Prior to our
      adoption of SFAS No. 123R, the Company reduced pro-forma share-based
      compensation expense, presented in the notes to its financial statements, for
      actual forfeitures as they occurred.




With
      respect to both grants of options and awards of restricted stock, the risk
      free
      rate of interest is based on the U.S. Treasury rates appropriate for the
      expected term of the grant or award.




With
      respect to awards of restricted stock, the Company uses the Monte-Carlo pricing
      model to estimate fair value of restricted stock awards made in the first
      quarter 2006 with the following weighted average assumptions:




13







Assumptions
                for Stock Awards
            Three
                Months
              Ended
              March31,
                2006Risk-free
                interest rate
            4.32%Volatility
            70%Expected
                dividend yield
            0%Expected
                Life
            4.92
                years




The
      Company calculated expected volatility for restricted stock based on historic,
      daily stock price observations of our common stock during the three-year period
      immediately preceding the grant.




Options
      that were assumed from ProCyte and that were unvested as of March 18, 2005
      were
      re-measured as of March 18, 2005 under intrinsic-value-based accounting.
      Unearned or deferred compensation of $132,081 was recorded and is being
      amortized over the remaining vesting period, which is an average of two years.
      The Company recognized $14,718 and $4,199 of such expense in the three months
      ended March 31, 2006 and 2005, respectively.




There
      was
      $311,624 and $78,544 of compensation expense related to stock options granted
      and restricted stock awarded, respectively, in the three months ended March
      31,
      2006. This expense is recognized in the operating results in selling, general
      and administrative expenses. For stock options granted to consultants during
      the
      three months ended March 31, 2006, an additional selling, general, and
      administrative expense in the amount of $76,622 was recognized. There was no
      comparable expense for grants to consultants in the three months ended March
      31,
      2005.




***Supplemental
      Cash Flow Information***


During
      the three months ended March 31, 2006, the Company financed insurance policies
      through notes payable for $143,775, financed certain credit facility costs
      for
      $41,563, financed a license agreement with a note payable of $77,876 and issued
      warrants to a leasing credit facility which are valued at $27,853, and which
      offset the carrying value of debt. During the three months ended March 31,
      2006,
      the Company issued 101,010 shares of its restricted common stock to Stern Laser
      srl (“Stern”) due under another milestones under the Master Purchase Agreement;
      the cost associated with this issuance is included in the license from Stern,
      which is found in patents and licensed technologies. The Company also issued
      200,000 shares of its restricted common stock to AzurTec, Inc. (“AzurTec”) as
      part of an investment in the capital stock of AzurTec as well as for a license
      agreement on AzurTec technology, both existing and to be developed in the
      future.




In
      connection with the purchase of ProCyte in March 2005, the Company issued
      10,540,579 shares of common stock and assumed options to purchase 1,354,973
      shares of its own common stock (see Note 2).




During
      the three months ended March 31, 2005, the Company financed insurance policies
      through note payables for $327,604, financed vehicle purchases of $30,205 under
      capital leases, financed certain credit facility costs for $11,871 and issued
      warrants to a leasing credit facility which are valued at $5,946, and which
      offset the carrying value of the related debt.




For
      the
      three months ended March 31, 2006 and 2005, the Company paid interest of
      $138,144 and $83,329, respectively. Income taxes paid in the three months ended
      March 31, 2006 and 2005 were immaterial.




***Recent
      Accounting Pronouncements***


In
      May
      2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154,
“Accounting Changes and Error Corrections – replacement of APB Opinion No.
      20 and FASB Statement No. 3”. SFAS No. 154 changes the accounting for and
      reporting of a change in accounting principle by requiring retrospective
      application to prior periods’ financial statements of changes in accounting
      principle unless impracticable. SFAS No. 154 is effective for accounting changes
      made in fiscal years beginning after December 15, 2005.




On
      December 16, 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” which
      is a revision of SFAS No. 123 and supersedes APB Opinion No. 25. In March 2005
      the SEC issued Staff Accounting Bulletin No. 107 (“SAB No. 107”). SAB No. 107
      expresses views of the SEC staff regarding the interaction between SFAS No.
      123R
      and certain SEC rules. SFAS No. 123R requires that the compensation cost
      relating to share-based payment transactions be recognized in financial
      statements. The cost is to be measured based on the fair value of the equity
      or
      liability instruments issued. The Company adopted SFAS No. 123R on January
      1,
      2006 using the modified prospective method. The impact of adopting this Standard
      is discussed in Note 1, “Stock-Based Compensation”.




14


On
      November 24, 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which is an
      amendment to Accounting Research Bulletin (ARB) No. 43, Chapter 4. It clarifies
      the accounting for abnormal amounts of idle facility expense, freight, handling
      costs, and wasted material (spoilage). Under this Statement, such costs should
      be expensed as incurred and not included in overhead. Further, SFAS No. 151
      requires that allocation of fixed production overheads to conversion costs
      should be based on normal capacity of the production facilities. SFAS No. 151
      is
      effective for inventory costs incurred during fiscal years beginning after
      June
      15, 2005. The adoption of this Statement did not have a material effect on
      the
      consolidated financial statements.




*Note
      2*


**Acquisitions:**




***ProCyte
      Transaction***


On
      March
      18, 2005, the Company completed the acquisition of ProCyte Corporation, which
      was organized in 1986. ProCyte develops, manufactures and markets products
      for
      skin health, hair care and wound care.  Many of the Company’s products
      incorporate its patented copper peptide technologies.  ProCyte’s
      focus since 1996 has been to provide unique products primarily based upon
      patented technologies for selected applications in the dermatology, plastic
      and
      cosmetic surgery and spa markets. ProCyte also expanded the use of its novel
      copper peptide technologies into the mass retail market for skin and hair care
      through targeted technology licensing and supply agreements.




The
      aggregate purchase price of $28,086,208 consisted of the issuance of 10,540,579
      shares of the Company’s common stock valued at $2.29 per share, the assumption
      of 1,354,973 common stock options valued at $2,033,132 net of deferred
      compensation of $132,081, and the incurrence of $1,915,150 of transaction costs.
      The merger consideration was based on a fixed exchange ratio of 0.6622 shares
      of
      PhotoMedex common stock for each share of ProCyte common stock. As the exchange
      ratio was fixed, the fair value of PhotoMedex common stock for accounting
      purposes was based on a stock price of $2.29 per share, which is the average
      of
      the closing prices on the date of the announcement of the planned merger and
      the
      two days prior and afterwards.




Based
      on
      the purchase price allocation, the following table summarizes the estimated
      fair
      value of the assets acquired and liabilities assumed at the date of acquisition:




Cash
                and cash equivalents
            
            $
            6,272,540Accounts
                receivable
            
            
            1,137,413Inventories
            
            
            2,845,698Prepaid
                expenses and other current assets
            
            
            134,574Property
                and equipment
            
            
            340,531Patents
                and licensed technologies
            
            
            200,000Other
                intangible assets
            
            
            5,200,000Other
                assets
            
            
            38,277Total
                assets acquired
            
            
            16,169,033Accounts
                payable
            
            
            (605,520
            )Accrued
                compensation and related expenses
            
            
            (158,610
            )Other
                accrued liabilities
            
            
            (1,143,761
            )Deferred
                revenues
            
            
            (95,436
            )Other
                liabilities
            
            
            (52,883
            )Total
                liabilities assumed
            
            
            (2,056,210
            )Net
                assets acquired
            
            $
            14,112,823




15




The
      purchase price exceeded the fair value of the net assets acquired by
      $13,973,385, which was recorded as goodwill. The increase in goodwill recognized
      in the quarter ended March 31, 2006 reflects Management’s best estimate of
      pre-acquisition contingencies based upon plans entered into prior to March
      18,
      2006.




The
      accompanying consolidated financial statements do not include any revenues
      or
      expenses related to the acquisition on or prior to March 18, 2005, the closing
      date. Following are the Company’s unaudited pro-forma results for the three
      months ended March 31, 2006 and 2005, assuming the acquisition had occurred
      on
      January 1, 2005:




Three
                Months Ended March 31,2006
            
            2005Net
                revenues
            
            $
            8,081,162
            
            $
            7,952,894Net
                loss
            
            $
            (2,350,261
            )
            $
            (1,230,164
            )Basic
                and diluted loss per share
            
            $
            (0.05
            )
            $
            (0.02
            )Shares
                used in calculating basic and diluted loss per share
            
            
            52,173,618
            
            
            50,656,883




These
      unaudited pro-forma results have been prepared for comparative purposes only
      and
      do not purport to be indicative of the results of operations which would have
      actually resulted had the acquisition occurred on January 1, 2005, nor to be
      indicative of future results of operations.




The
      Company’s goals for this acquisition are summarized below:




·
            the
                addition of ProCyte's sales and marketing personnel should enhance
                the
                Company’s ability to market the XTRAC system;




·
            ProCyte's
                presence in the skin health and hair care products market should
                present a
                growth opportunity for PhotoMedex to market its existing products;




·
            the
                addition of ProCyte's cash balances as of the date of acquisition
                and of
                its operations should improve PhotoMedex's operating results and
                strengthen its balance sheet;




·
            the
                combined company may reap short-term cost savings and have the opportunity
                for additional longer-term cost efficiencies; and




·
            the
                combination of the senior management of ProCyte and PhotoMedex should
                allow complementary skills to strengthen the management team.




Since
      the
      acquisition date, the Company has made progress toward the achievement of these
      goals. Financial and administrative functions were transferred from Redmond
      to
      Montgomeryville in June 2005. Integration of and coordination between the sales
      forces of the Skin Care and Domestic XTRAC business units is an ongoing process.
      Mr. Clifford, who has been responsible for domestic sales and marketing of
      the
      dermatologic business segments, will be leaving the Company in the second
      quarter of 2006, but will be available to the Company on a consulting basis.




***Stern
      Laser Transaction***


On
      September 7, 2004, the Company closed the transactions set forth in a Master
      Asset Purchase Agreement (the “Master Agreement”) with Stern Laser srl
      (“Stern”). In March 2006, the Company issued an additional 101,010 shares of its
      restricted common stock to Stern based on a milestone set forth in the Master
      Agreement. As of March 31, 2006, the Company has issued an aggregate 589,854
      shares of its restricted common stock to Stern in connection with the Master
      Agreement. The Company also agreed to pay Stern up to an additional $250,000
      based on the achievement of two remaining milestones. The Company retains the
      right to pay these conditional sums in cash or in shares of its common stock,
      in
      its sole discretion. To provide for the issuance of shares, the Company has
      reserved for issuance, and placed into escrow, 110,136 shares of its
      unregistered stock. The per-share price of any shares issued in the future
      will
      be the average closing price of the Company’s common stock during the 10 trading
      days ending on the date of achievement of a particular milestone. Stern also
      has
      served as the distributor of the Company’s XTRAC laser system in South Africa
      and Italy since 2000. The primary asset acquired from Stern in the transaction
      is a license for Stern’s lamp-based technology, which was carried on the
      Company’s books at $1,107,979, net as of March 31, 2006. Amortization of this
      intangible is on a straight-line basis over 10 years and began in January 2005.
      In the quarter ended March 2006, Stern purchased $28,000 of products from the
      Company.




16


***AzurTec
      Transaction***


On
      March
      30, 2006, the Company closed the transaction set forth in an Investment
      Agreement with AzurTec, Inc. (“AzurTec”). The Company issued 200,000 shares of
      its restricted common stock in exchange for 6,855,141 shares of AzurTec common
      stock and 181,512 shares of AzurTec Class A preferred stock, which represents
      a
      14% interest on a fully diluted basis. In accordance with APB No. 18, and
      related interpretations, the Company will account for its investment in AzurTec
      on the cost basis.


The
        Company also received a license from AzurTec with respect to its existing
        and
        future technology for the MetaSpex Laboratory System. The license gives the
        Company rights to manufacture and market the ex vivo versions of the MetaSpex
        product in exchange for certain royalty obligations. The license also confers
        on
        the Company certain rights on a potential in situ version of the MetaSpex
        product. AzurTec remains responsible for the development and clinical trial
        costs of the MetaSpex products, for which AzurTec is committed to raise
        additional equity capital. AzurTec has contracted with the Company to resume
        development work of the ex vivo versions of the MetaSpex product. The Company
        will resume, and be paid for, such work once AzurTec has raised additional
        equity capital and has its outstanding arrearage to the Company for prior
        development work.




The
      Company assigned $268,291 as the fair value of the investment in AzurTec. It
      also assigned $114,982 as the fair value of the license it acquired from
      AzurTec. Amortization of this intangible is on a straight-line basis over 10
      years, which began April 2006.




*Note
      3*


**Inventories:**




Set
      forth
      below is a detailed listing of inventories:




March 31, 2006
            
            December 31, 2005Raw
                materials and work in progress
            
            $
            4,509,987
            
            $
            4,998,847Finished
                goods
            
            
            3,026,184
            
            
            3,048,597Total
                inventories
            
            $
            7,536,171
            
            $
            8,047,444




Work-in-process
      is immaterial, given the Company’s typically short manufacturing cycle, and
      therefore is disclosed in conjunction with raw materials. Finished goods
      includes $0 and $69,963 as of March 31, 2006 and December 31, 2005,
      respectively, for laser systems shipped to distributors, but not recognized
      as
      revenue until all the SAB 104 Criteria have been met. At times, units are
      shipped but revenue is not recognized until all of the criteria are met, and
      until that time, the unit is carried on the books of the Company as inventory.
      The Company ships most of its products FOB shipping point, although from time
      to
      time certain customers, for example governmental customers, will insist on
      FOB
      destination. Among the factors the Company takes into account in determining
      the
      proper time at which to recognize revenue are when title to the goods transfers
      and when the risk of loss transfers. Shipments to the distributors that do
      not
      fully satisfy the collection criteria are recognized when invoiced amounts
      are
      fully paid. As of March 31, 2006 and December 31, 2005, the Company carried
      specific reserves against its inventories of $952,733 and $931,719,
      respectively.




17


*Note
      4*


**Property
      and Equipment:**




Set
      forth
      below is a detailed listing of property and equipment:




March
                31, 2006
            
            December
                31, 2005Lasers
                in service
            
            $
            13,661,846
            
            $
            12,657,701Computer
                hardware and software
            
            
            334,490
            
            
            334,490Furniture
                and fixtures
            
            
            341,573
            
            
            338,089Machinery
                and equipment
            
            
            737,948
            
            
            755,565Autos
                and trucks
            
            
            382,690
            
            
            382,690Leasehold
                improvements
            
            
            246,158
            
            
            238,27615,704,705
            
            
            14,706,811Accumulated
                depreciation and amortization
            
            
            (8,297,112
            )
            
            (7,662,098
            )Property
                and equipment, net
            
            $
            7,407,593
            
            $
            7,044,713




Depreciation
      expense was $710,036 and $436,994 for the three months ended March 31, 2006
      and 2005, respectively. At March 31, 2006 and December 31, 2005, net
      property and equipment included $496,292 and $530,191, respectively, of assets
      recorded under capitalized lease arrangements, of which $243,984 and $302,710
      was included in long-term debt at March 31, 2006 and December 31, 2005,
      respectively (see Note 9).




*Note
      5*


**Patents
      and Licensed Technologies:**




Set
      forth
      below is a detailed listing of patents and licensed technologies:




March
                31, 2006
            
            December
                31, 2005Patents,
                owned and licensed, at gross costs of $453,801 and $438,940, net
                of
                accumulated amortization of $203,895 and $194,660,
                respectively
            
            $
            249,906
            
            $
            244,280Other
                licensed or developed technologies, at gross costs of $2,432,258
                and
                $2,047,665, net of accumulated amortization of $779,715 and $714,391,
                respectively
            
            
            1,652,543
            
            
            1,333,274$
            1,902,449
            
            $
            1,577,554




Related
      amortization expense was $74,559 and $56,028 for the three months ended
      March 31, 2006 and 2005, respectively. Included in other licensed and
      developed technologies is $200,000 in developed technologies acquired from
      ProCyte and $114,982 for the license with AzurTec (see Note 2). On March 31,
      2006, the Company closed the transaction set forth in a License Agreement with
      Mount Sinai School of Medicine of New York University (“Mount Sinai”). The
      Company will reimburse to Mount Sinai, over the first 18 months of the license
      term and at no interest for $77,876 of extant patent prosecution costs incurred
      to date. The Company is also obligated, beginning April 1, 2006, to pay Mount
      Sinai a royalty on a combined base of domestic sales of XTRAC treatment codes
      used for psoriasis as well as for vitiligo. In the first four years of the
      license, however, Mount Sinai may elect to be paid royalties on an alternate
      base, comprised simply of treatments for vitiligo, but at a higher royalty
      rate
      than the rate applicable to the combined base. This technology is for the laser
      treatment of vitiligo and is included in other licensed or developed
      technologies.




18


*Note
      6*


**Other
      Intangible Assets:**




Set
      forth
      below is a detailed listing of other intangible assets, all of which were
      acquired from ProCyte and which have been recorded at their appraised fair
      market values:




March
                31, 2006
            
            December
                31, 2005Neutrogena
                Agreement, at gross cost of $2,400,000 net of accumulated amortization
                of
                $498,000 and $378,000, respectively.
            
            $
            1,902,000
            
            $
            2,022,000Customer
                Relationships, at gross cost of $1,700,000 net of accumulated amortization
                of $352,746 and $267,747, respectively.
            
            
            1,347,254
            
            
            1,432,253Tradename,
                at gross cost of $1,100,000 net of accumulated amortization of $114,129
                and $86,628, respectively.
            
            
            985,871
            
            
            1,013,372$
            4,235,125
            
            $
            4,467,625




Related
      amortization expense was $232,500 and $33,375 for the three months ended
      March 31, 2006 and 2005, respectively. Amortization for 2005 was from March
      18 to 31, 2005 due to the closing date of the merger with ProCyte. Under the
      Neutrogena Agreement, the Company licenses to Neutrogena rights to its copper
      peptide technology for which the Company receives royalties. Customer
      Relationships embody the value to the Company of relationships that ProCyte
      had
      formed with its customers. Tradename includes the name of “ProCyte” and various
      other trademarks associated with ProCyte’s products.




*Note
      7*


**Other
      Accrued Liabilities:**




Set
      forth
      below is a detailed listing of other accrued liabilities:




March
                31, 2006
            
            December
                31, 2005Accrued
                professional and consulting fees
            
            $
            351,384
            
            $
            437,396Accrued
                warranty
            
            
            148,199
            
            
            204,708Accrued
                sales taxes
            
            
            176,202
            
            
            184,764Other
                accrued expenses
            
            
            33,359
            
            
            98,100Total
                other accrued liabilities
            
            $
            709,144
            
            $
            924,968







19




*Note
      8*


**Notes
      Payable:**




Set
      forth
      below is a detailed listing of notes payable. The stated interest rate
      approximates the effective cost of funds from the notes:




March
                31, 2006
            
            December
                31, 2005Note
                Payable – secured creditor, interest at 6%, payable in monthly
                principal and interest installments of $2,880 through June 2012
            
            $
            177,508
            
            $
            183,425Note
                Payable – unsecured creditor, non-interest bearing, payable in 18 equal
                monthly installments of $4,326 through October 2007
            
            
            77,876
            
            
            -Note
                payable – secured creditor, interest at 16.47%, payable in monthly
                principal and interest installments of $2,618 through December
                2006.
            
            
            19,888
            
            
            26,736Note
                Payable – unsecured creditor, interest at 7.42%, payable in monthly
                principal and interest installments of $61,493 through March
                2006
            
            
            -
            
            
            177,450Note
                Payable – unsecured creditor, interest at 8.97%, payable in monthly
                principal and interest installments of $16,578 through November
                2006
            
            
            128,272
            
            
            -403,544
            
            
            387,611Less:
                current maturities
            
            
            (224,655
            )
            
            (228,398
            )Notes
                payable, net of current maturities
            
            $
            178,889
            
            $
            159,213







20




*Note
      9*


**Long-term
      Debt:**




Set
      forth
      below is a detailed listing of the Company’s long-term debt:




March
                31, 2006
            
            December
                31, 2005Borrowings
                on credit facility:Draw
                1 – effective interest at 17.79%, payable in monthly principal and
                interest installments of $48,156.46 through June 2007.
            
            $
            669,543
            
            $
            792,362Draw
                2 – effective interest at 17.14%, payable in monthly principal and
                interest installments of $9,957.08 through September 2007.
            
            
            164,605
            
            
            189,543Draw
                3 – effective interest at 17.61%, payable in monthly principal and
                interest installments of $4,796.60 through December 2007.
            
            
            90,944
            
            
            102,541Draw
                4 – effective interest at 12.62%, payable in monthly principal and
                interest installments of $34,859.11 through June 2008.
            
            
            840,022
            
            
            922,350Draw
                5 – effective interest at 12.94%, payable in monthly principal and
                interest installments of $28,756.93 through September
                2008.
            
            
            758,072
            
            
            823,810Draw
                6 – effective interest at 13.36%, payable in monthly principal and
                interest installments of $28,923.11 through December 2008.
            
            
            823,960
            
            
            895,524Draw
                7 – effective interest at 13.74%, payable in monthly principal and
                interest installments of $40,887.14 through March 2009.
            
            
            1,259,635
            
            
            -Total
                borrowings on credit facility
            
            $
            4,606,781
            
            $
            3,726,130Capital
                lease obligations (see Note 4)
            
            
            243,984
            
            
            302,710Less:
                current portion
            
            
            (2,127,896
            )
            
            (1,749,969
            )Total
                long-term debt
            
            $
            2,722,869
            
            $
            2,278,871




*Leasing
      Credit Facility*


The
      Company entered into a leasing credit facility with GE Capital Corporation
      (“GE”) on June 25, 2004. The credit facility has a commitment term of three
      years, expiring on June 25, 2007. For each year of the term, called a “tranche,”
various parameters are set or re-set. The Company accounts for each draw as
      funded indebtedness taking the form of a capital lease, with equitable ownership
      in the lasers remaining with the Company. GE retains title as security for
      the
      borrowings. The Company depreciates the lasers over their remaining useful
      lives, as established when originally placed into service. Each draw against
      the
      credit facility has a self-amortizing repayment period of three years and is
      secured by specified lasers, which the Company has sold to GE and leased back
      for continued deployment in the field.




Under
      the
      first tranche, GE made available $2,500,000 under the line. A draw under that
      tranche is set at an interest rate based on 522 basis points above the
      three-year Treasury note rate. Each such draw is discounted by 7.75%; the first
      monthly payment is applied directly to principal. With each draw, the Company
      agreed to issue warrants to purchase shares of the Company’s common stock equal
      to 5% of the draw. The number of warrants is determined by dividing 5% of the
      draw by the average closing price of the Company’s common stock for the ten days
      preceding the date of the draw. The warrants have a five-year term from the
      date
      of each issuance and bear an exercise price set at 10% over the average closing
      price of the Company’s common stock for the ten days preceding the date of the
      draw.




For
      reporting purposes, the carrying value of the liability is reduced at the time
      of each draw by the value ascribed to the warrants. This reduction will be
      amortized at the effective interest rate to interest expense over the term
      of
      the draw.




21


The
      Company has accounted for these warrants as equity instruments in accordance
      with EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to,
      and Potentially Settled in, a Company's Own Stock" since there is no option
      for
      cash or net-cash settlement when the warrants are exercised. Future exercises
      and forfeitures will reduce the amount of warrants. Exercises will increase
      the
      amount of common stock outstanding and additional paid in capital.




The
      Company obtained a second tranche under the leasing credit facility for
      $5,000,000 on June 28, 2005. The Company accounts for draws under this second
      tranche in the same manner as under the first tranche except that: (i) the
      stated interest rate is set at 477 basis points above the three-year Treasury
      note rate; (ii) each draw is discounted by 3.50%; and (iii) with each draw,
      the
      Company has agreed to issue warrants to purchase shares of the Company’s common
      stock equal to 3% of the draw. The number of warrants is determined by dividing
      3% of the draw by the average closing price of the Company’s common stock for
      the ten trading days preceding the date of the draw. The warrants have a
      five-year term from the date of each issuance and bear an exercise price set
      at
      10% over the average closing price of the Company’s common stock for the ten
      trading days preceding the date of the draw.




On
      March
      29, 2006, the Company made a draw against the second tranche, as follows:




Draw
                7Amount
                of draw
            
            $1,287,487Stated
                interest rate
            
            9.45%Effective
                interest rate
            
            13.74%Number
                of warrants issued
            
            20,545Exercise
                price of warrants per share
            
            $2.06Fair
                value of warrants
            
            $27,853




The
      fair
      value of the warrants granted under the draws is estimated using the
      Black-Scholes option-pricing model with the following weighted average
      assumptions applicable to the warrants granted:




Warrants
                granted
              under
                Draw 7Risk-free
                interest rate
            
            4.79%Volatility
            
            87.16%Expected
                dividend yield
            
            0%Expected
                warrant life
            
            5
                years




For
      reporting purposes, the carrying value of the liability is reduced at the time
      of each draw by the value ascribed to the warrants. This reduction will be
      amortized at the effective interest rate to interest expense over the term
      of
      the draw.




As
      of
      March 31, 2006, the Company had available $770,003 from the second tranche
      of
      the line of credit from which to draw on in the future.




The
      Company has accepted a letter of intent from GE to open a third line of leasing
      credit for $5,000,000. Final approval from GE is expected in the second quarter
      of 2006. If the third tranche is extended to the Company, the remaining
      availability for the second tranche will be retired.




*Capital
      Leases*


The
      obligations under capital leases are at fixed interest rates and are
      collateralized by the related property and equipment (see Note 4).




22


*Note
      10*


**Employee
      Stock Benefit Plans**




The
      Company has stock-based compensation plans available to grant, among other
      things, incentive and non-incentive stock options to employees, directors and
      third-party service-providers as well as restricted stock to key employees.
      Under the 2005 Equity Compensation Plan (the “Plan”), a maximum of 3,160,000
      shares of the Company’s common stock was reserved for issuance. Following the
      approval of the Plan on December 28, 2005, the Company will not grant any new
      awards under any previously existing stock-based compensation plans, except
      the
      Outside Director Plan. At March 31, 2006, 1,214,000 shares were available for
      future grants under the Plan and 403,750 under the Outside Director Plan. No
      grants of options have been made as of March 31, 2006 under the 2005 Investment
      Plan.




Stock
      option activity under the Company’s share-based compensation plans for the three
      months ended March 31, 2006 was as follows:




Number
                of
              Options
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted
              Average
              Remaining
              Contractual
              Term
                (years)Outstanding,
                January 1, 2006
            
            
            5,077,646
            
            $
            2.12
            
            
            4.03Granted
            
            
            1,269,000
            
            
            2.15Exercised
            
            
            (45,000
            )
            
            3.03Cancelled
            
            
            (49,500
            )
            
            4.05Outstanding,
                March 31, 2006
            
            
            6,252,146
            
            $
            2.11
            
            
            5.04Options
                excercisable at March 31, 2006
            
            
            3,560,994
            
            $
            1.73




At
      March
      31, 2006, there was $5,827,144 of total unrecognized compensation cost related
      to non-vested stock option awards that is expected to be recognized over a
      weighted-average period of 3.09 years.




*Note
      11*


**Business
      Segment and Geographic Data:**




Segments
      are distinguished by the Company’s management structure, products and services
      offered, markets served and types of customers. The Domestic XTRAC business
      derives revenues from procedures performed by dermatologists in the United
      States. The International Dermatology Equipment segment, in comparison,
      generates revenues from the sale of equipment, both XTRAC and VTRAC, to
      dermatologists outside the United States through a network of distributors.
      The
      Skin Care (ProCyte) segment generates revenues by selling skincare products
      and
      by earning royalties on licenses for the Company’s patented copper peptide
      compound. The Surgical Services segment generates revenues by providing
      fee-based procedures typically using the Company’s mobile surgical laser
      equipment delivered and operated by a technician at hospitals and surgery
      centers in the United States. The Surgical Products segment generates revenues
      by selling laser products and disposables to hospitals and surgery centers
      on
      both a domestic and international basis. For the three months ended
      March 31, 2006 and 2005, the Company did not have material revenues from
      any individual customer.




Unallocated
      operating expenses include costs incurred for administrative and accounting
      staff, general liability and other insurance, professional fees and other
      similar corporate expenses. Unallocated assets include cash, prepaid expenses
      and deposits. Goodwill that was carried at $2,944,423 at March 31, 2006 and
      December 31, 2005 has been allocated to the domestic XTRAC and international
      dermatology equipment segments based upon its fair value as of the date of
      the
      Acculase acquisition in the amounts of $2,061,096 and $883,327, respectively.
      Goodwill of $13,973,385 at March 31, 2006 from the ProCyte acquisition has
      been
      entirely allocated to the Skin Care segment.




23


The
      following tables reflect results of operations from our business segments for
      the periods indicated below:





Three
                Months Ended March 31, 2006DOMESTIC
              XTRAC
            
            INTERN’L
              DERM.
              EQUIPMENT
            
            SKIN
              CARE
            
            SURGICAL
              SERVICES
            
            SURGICAL
              PRODUCTS
              AND
              OTHER
            
            TOTALRevenues
            
            $
            1,059,630
            
            $
            531,065
            
            $
            3,460,561
            
            $
            1,616,034
            
            $
            1,413,872
            
            $
            8,081,162Costs
                of revenues
            
            
            946,612
            
            
            330,290
            
            
            1,052,444
            
            
            1,414,578
            
            
            963,974
            
            
            4,707,898Gross
                profit
            
            
            113,018
            
            
            200,775
            
            
            2,408,117
            
            
            201,456
            
            
            449,898
            
            
            3,373,264*Gross
                profit %*
            
            
            *10.7%*
            
            
            *37.8%*
            
            
            *69.6%*
            
            
            *12.5%*
            
            
            *31.8%*
            
            
            *41.7%*Allocated
                Operating expenses:Selling,
                general and administrative
            
            
            1,131,951
            
            
            17,431
            
            
            1,428,174
            
            
            252,076
            
            
            140,807
            
            
            2,970,439Engineering
                and product development
            
            
            -
            
            
            -
            
            
            105,735
            
            
            -
            
            
            136,469
            
            
            242,204Unallocated
                Operating expenses
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            2,389,7391,131,951
            
            
            17,431
            
            
            1,533,909
            
            
            252,076
            
            
            277,276
            
            
            5,602,382Income
                (loss) from operations
            
            
            (1,018,933
            )
            
            183,344
            
            
            874,208
            
            
            (50,620
            )
            
            172,622
            
            
            (2,229,118
            )Interest
                expense, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (121,143
            )Net
                income (loss)
            
            $
            (1,018,933
            )
            $
            183,344
            
            $
            874,208
            
            $
            (50,620
            )
            $
            172,622
            
            $
            (2,350,261
            )








Three
                Months Ended March 31, 2005DOMESTIC
              XTRAC
            
            INTERN’L
              DERM.
              EQUIPMENT
            
            SKIN
              CARE
            
            SURGICAL
              SERVICES
            
            SURGICAL
              PRODUCTS
              AND
              OTHER
            
            TOTALRevenues
            
            $
            634,018
            
            $
            288,202
            
            $
            623,301
            
            $
            2,070,650
            
            $
            1,367,161
            
            $
            4,983,332Costs
                of revenues
            
            
            403,181
            
            
            159,596
            
            
            225,957
            
            
            1,315,460
            
            
            528,174
            
            
            2,632,368Gross
                profit
            
            
            230,837
            
            
            128,606
            
            
            397,344
            
            
            755,190
            
            
            838,987
            
            
            2,350,964*Gross
                profit %*
            
            
            *36.4*%**
            
            
            *44.6%*
            
            
            *63.7%*
            
            
            *36.5%*
            
            
            *61.3%*
            
            
            *47.2%*Allocated
                Operating expenses:Selling,
                general and administrative
            
            
            530,988
            
            
            61,033
            
            
            356,802
            
            
            291,116
            
            
            158,152
            
            
            1,398,091Engineering
                and product development
            
            
            -
            
            
            -
            
            
            13,797
            
            
            -
            
            
            173,174
            
            
            186,971Unallocated
                Operating expenses
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,822,885530,988
            
            
            61,033
            
            
            370,599
            
            
            291,116
            
            
            331,326
            
            
            3,407,947Income
                (loss) from operations
            
            
            (300,151
            )
            
            67,573
            
            
            26,745
            
            
            464,074
            
            
            507,661
            
            
            (1,056,983
            )Interest
                expense, net
            
            
            -
            
            
            -
            
            
            4,079
            
            
            -
            
            
            -
            
            
            (71,129
            )Net
                income (loss)
            
            $
            (300,151
            )
            $
            67,573
            
            $
            30,824
            
            $
            464,074
            
            $
            507,661
            
            $
            (1,128,112
            )




24




March
                31, 2006
            
            December
                31, 2005Assets:Total
                assets for reportable segments
            
            $
            43,182,951
            
            $
            42,341,988Other
                unallocated assets
            
            
            6,513,485
            
            
            6,333,618Consolidated
                total
            
            $
            49,696,436
            
            $
            48,675,606




For
      the
      three months ended March 31, 2006 and 2005, there were no material net
      revenues attributed to any individual foreign country. Net revenues by
      geographic area were, as follows:




For
                the Three Months Ended
              March
                31,2006
            
            2005Domestic
            
            $
            6,659,378
            
            $
            4,465,666Foreign
            
            
            1,421,784
            
            
            517,666$
            8,081,162
            
            $
            4,983,332




*Note
      12*


**Significant
      Alliances/Agreements:**




On
      March
      31, 2005, the Company entered into a Sales and Marketing Agreement with
      GlobalMed (Asia) Technologies Co., Inc. (“GlobalMed”). Under this agreement,
      GlobalMed acts as master distributor in the Pacific Rim for the Company’s XTRAC
      excimer laser and for the Company’s LaserPro® diode surgical laser system. The
      Company’s diode laser will be marketed for, among other things, use in a
      gynecological procedure pioneered by David Matlock, MD. The
      Company has engaged Dr. Matlock as a consultant to explore further business
      opportunities for the Company. In connection with this engagement, Dr. Matlock
      received options to purchase up to 25,000 shares of the common stock of the
      Company, granted with an exercise price based on the market value of the
      Company’s common stock on the date of the grant.




On
      July
      27, 2005, the Company entered into a Marketing Agreement with KDS Marketing,
      Inc. (“KDS”). Using money invested by each party, KDS will research market
      opportunities for the Company’s diode laser and related delivery systems, and
      KDS will then market the diode laser, primarily through a website on which
      physicians may access for information about and purchase the lasers. KDS began
      marketing the laser in the first quarter 2006.




On
      March
      30, 2006, the Company entered a strategic relationship with AzurTec, Inc. to
      resume development, and to undertake the manufacture and distribution, of
      AzurTec's MetaSpex Laboratory System, a light-based system designed to detect
      certain cancers of the skin. PhotoMedex also acquired, on a fully diluted basis,
      a 14 percent stake in AzurTec in exchange for 200,000 shares of the Company’s
      restricted common stock. The Company will assist
      in
      the development of FDA-compliant prototypes for AzurTec’s product. Continuing
      development of this project requires additional investment by AzurTec, which
      AzurTec has undertaken to raise. The Company will resume development once the
      additional investment has been raised, and AzurTec has settled its prior
      indebtedness to the Company.




On
      March
      31, 2006, the Mount Sinai School of Medicine of New York University granted
      the
      Company an exclusive license, effective April 1, 2006, to use Mount Sinai's
      patented methodology for utilization of ultraviolet laser light for the
      treatment of vitiligo. The licensed patent is US Patent No. 6,979,327, Treatment
      of Vitiligo. It was issued December 27, 2005, and the inventor is James M.
      Spencer, MD, a member of the Company’s Scientific Advisory Board.




On
      April
      14, 2006, the Company entered into a Clinical Trial Agreement protocol with
      the
      University of California at San Francisco. The agreement covers a protocol
      for a
      phase 4, randomized, double-blinded study to evaluate the safety and efficacy
      of
      the XTRAC laser system in the treatment of moderate to severe psoriasis. John
      Koo, MD, a member of our Scientific Advisory Board, will guide the study using
      our high-powered UltraTM excimer laser.




25


**ITEM
      2.** **Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.**




*Certain
      statements in this Quarterly Report on Form 10-Q, or the Report, are
“forward-looking statements.” These forward-looking statements include, but are
      not limited to, statements about the plans, objectives, expectations and
      intentions of PhotoMedex, Inc., a Delaware corporation (referred to in this
      Report as “we,” “us,” “our” or “registrant”) and other statements contained in
      this Report that are not historical facts. Forward-looking statements in this
      Report or hereafter included in other publicly available documents filed with
      the Securities and Exchange Commission, or the Commission, reports to our
      stockholders and other publicly available statements issued or released by
      us
      involve known and unknown risks, uncertainties and other factors which could
      cause our actual results, performance (financial or operating) or achievements
      to differ from the future results, performance (financial or operating) or
      achievements expressed or implied by such forward-looking statements. Such
      future results are based upon management's best estimates based upon current
      conditions and the most recent results of operations. When used in this Report,
      the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,”
“estimate” and similar expressions are generally intended to identify
      forward-looking statements, because these forward-looking statements involve
      risks and uncertainties. There are important factors that could cause actual
      results to differ materially from those expressed or implied by these
      forward-looking statements, including our plans, objectives, expectations and
      intentions and other factors that are discussed under the section entitled
“Risk
      Factors,” in our Annual Report on Form 10-K for the year ended December 31,
      2005.*




*The
      following discussion and analysis should be read in conjunction with the
      consolidated financial statements and related notes included elsewhere in this
      Report.*




**Introduction,
      Outlook and Overview of Business Operations**




We
      view
      our business as comprised of the following five business segments:




·
            Domestic
                XTRAC,




·
            International
                Dermatology Equipment,




·
            Skin
                Care (ProCyte),




·
            Surgical
                Services, and




·
            Surgical
                Products.




**Domestic
      XTRAC**




The
      Domestic XTRAC segment is a U.S. business with revenues derived from procedures
      performed by dermatologists. We are engaged in the development, manufacturing
      and marketing of our proprietary XTRAC® excimer laser and delivery systems and
      techniques used in the treatment of inflammatory skin disorders, **** including
      psoriasis, vitiligo, atopic dermatitis and leukoderma. In January 2000, we
      received approval of our 510(k) submission from the Food and Drug
      Administration, or FDA, establishing that our XTRAC laser system is
      substantially equivalent to currently marketed devices for the treatment of
      psoriasis.




As
      part
      of our commercialization strategy in the United States, we provide the XTRAC
      laser system to targeted dermatologists at no initial capital cost to them.
      We
      maintain ownership of the laser and earn revenue each time the physician treats
      a patient with the equipment. We believe that this strategy will create
      incentives for these dermatologists to adopt the XTRAC laser system and will
      increase market penetration.




For
      the
      past six years, we have sought to clear the path of obstacles and barriers
      to a
      smooth and orderly roll-out of the XTRAC laser system in dermatology. In 2000,
      the laser system, which was originally designed for cardiology applications,
      was
      found to have significant therapeutic advantages for psoriasis patients who
      were
      treated with the UVB light emitted from the excimer based laser system. For
      the
      first two years, we invested in establishing the clinical efficacy of the
      product and mechanical reliability of the equipment. In the last three years,
      we
      have pursued widespread reimbursement commencing with obtaining newly created
      CPT reimbursement codes that became effective in 2003. This was followed by
      the
      lengthy process of persuading private medical insurers to adopt a positive
      reimbursement policy for the procedure. Substantive progress on reimbursement
      was achieved in the second half of 2005. We increased our dermatology sales
      force and marketing department as part of the acquisition of ProCyte in March
      2005. We
      now
      have ten sales representatives in the domestic XTRAC segment and 18 sales
      representatives in the Skin care segment. The representatives of each segment
      provide follow-up sales support for each other and share sales leads with each
      other with a view to enhancing opportunities to cross selling. The marketing
      department has been instrumental in expanding the advertising campaign for
      the
      XTRAC laser system. In November 2005, we commenced an advertising
      campaign in selected regions that we believed have reimbursement potential
      in
      order to make consumers aware of the technology and therapeutic benefits of
      targeted UVB laser treatment for psoriasis.




26


**International
      Dermatology Equipment**




In
      the
      international market, we derive revenues by selling the dermatology laser
      systems to distributors and directly to physicians. In this market, we have
      benefited from both our clinical studies and from the improved reliability
      and
      functionality of the XTRAC laser system.  Compared
      to the domestic segment, the sales of laser systems in the international segment
      is influenced to a greater degree by competition from similar laser technologies
      as well as non-laser lamp alternatives. Over time, this competition has reduced
      the prices we charge to international distributors for our XTRAC products.
      In
      2005, as a result of the acquisition of worldwide rights to certain proprietary
      light-based technology from Stern Laser, we also explored new product offerings
      in the treatment of dermatological conditions. We intend to expand the
      international marketing of this product, called the VTRACTM, in 2006. The VTRAC
      is designed to be a best-in-class lamp-based UVB targeted therapy, positioned
      at
      a price point lower than the XTRAC laser system so that it will effectively
      compete with other non-laser based therapies for psoriasis and
      vitiligo.




Due
      to
      the significant financial investment requirements,  we
      were
      previously reluctant to implement an international XTRAC and/or VTRAC
      fee-per-use revenue model, similar to the domestic revenue model. However,
      as
      reimbursement in the domestic market has become more widespread, we have
      recently started to offer a version of this model overseas.




**Skin
      Care (ProCyte)**




On
      March
      18, 2005, we completed the acquisition of ProCyte Corporation. ProCyte generates
      revenues from the sale of skin health, hair care and wound care products; the
      sale of copper peptide compound in bulk; and royalties on licenses for the
      patented copper peptide compound.




The
      operating results of ProCyte for the three months ended March 31, 2005 are
      included from March 19, 2005 through March 31, 2005. Under purchase accounting
      rules, the operating results of ProCyte for prior periods are not included
      in
      our Statement of Operations. A description of transaction and proforma operating
      results are disclosed as part of Note 2, “ *Acquisitions”,* to the
      financial statements.




ProCyte’s
      focus has been to provide unique products, primarily based upon patented
      technologies for selected applications in the dermatology, plastic and cosmetic
      surgery and spa markets. ProCyte has also expanded the use of its novel copper
      peptide technologies into the mass retail market for skin and hair care through
      targeted technology licensing and supply agreements.




ProCyte’s
      products are aimed at the growing demand for skin health and hair care products,
      including products to enhance appearance and address the effects of aging on
      skin and hair. ProCyte’s products are formulated, branded and targeted at
      specific markets. ProCyte’s initial products addressed the dermatology, plastic
      and cosmetic surgery markets for use after various procedures. Anti-aging skin
      care products were added to offer a comprehensive approach for a patient’s skin
      care regimen.




Since
      the
      acquisition date, we have made progress toward the achievement of these goals.
      Financial and administrative functions were transferred from Redmond to
      Montgomeryville in June 2005. Integration of and coordination between the sales
      forces of the Skin Care and Domestic XTRAC business units is
      ongoing.




**Surgical
      Services**




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically using our mobile surgical laser equipment delivered and operated
      by a
      technician at hospitals and surgery centers in the United States. Although
      we
      intend to increase our investment in this business segment in 2006, we will
      continue to pursue a very cautious growth strategy in order to conserve our
      cash
      resources for the XTRAC business segments.




27


We
      have
      limited marketing experience in expanding our surgical services business. The
      majority of this business is in the southeastern part of the United States.
      New
      procedures and geographical expansion, together with new customers and different
      business habits and networks, will likely pose different challenges compared
      to
      those that we have encountered in the past. There can be no assurance that
      we
      will be able to overcome such challenges.




**Surgical
      Products**




The
      Surgical Products segment generates revenues by selling laser products and
      disposables to hospitals and surgery centers both inside and outside of the
      United States. Also included are various non-laser surgical products (e.g.
      the
      ClearEss ® II suction-irrigation system). Although surgical product revenues
      increased in 2006 compared to 2005, we expect that sales of surgical laser
      systems and the related disposable base may begin to erode as hospitals continue
      to seek outsourcing solutions instead of purchasing lasers and related
      disposables for their operating rooms. We are working at offsetting this erosion
      by expanding our surgical services segment and by increasing sales from the
      diode surgical laser introduced in 2004.




**Critical
      Accounting Policies**




The
      discussion and analysis of our financial condition and results of operations
      in
      this Report are based upon our Consolidated Financial Statements, which have
      been prepared in accordance with accounting principles generally accepted in
      the
      United States. The preparation of financial statements requires management
      to
      make estimates and judgments that affect the reported amounts of assets and
      liabilities, revenues and expenses and related disclosures at the date of the
      financial statements. On an on-going basis, we evaluate our estimates,
      including, but not limited to, those related to revenue recognition, accounts
      receivable, inventories, impairment of property and equipment and of
      intangibles, deferred taxes and accruals for warranty claims. We use
      authoritative pronouncements, historical experience and other assumptions as
      the
      basis for making estimates. Actual results could differ from those estimates.
      Management believes that the following critical accounting policies affect
      our
      more significant judgments and estimates in the preparation of our Consolidated
      Financial Statements. These critical accounting policies and the significant
      estimates made in accordance with them have been discussed with our Audit
      Committee. There have been no changes to our critical accounting policies in
      the
      three months ended March 31, 2006. See "Critical Accounting Policies" in our
      "Management’s Discussion and Analysis of Financial Condition and Results of
      Operations" in Item 7 of our Annual Report on Form 10-K for the year ended
      December 31, 2005 for further information.




28


**Results
      of Operations**




***Revenues***




The
      following table presents revenues from our five business segments for the
      periods listed below:




Three
                Months Ended
              March
                31,2006
            
            2005*XTRAC
                Domestic Services
            
            $
            1,059,630
            
            $
            634,018International
                Dermatology Equipment Products
            
            
            531,065
            
            
            288,202Skin
                Care (ProCyte) Products
            
            
            3,460,561
            
            
            623,301Total
                Dermatology Revenues
            
            
            5,051,256
            
            
            1,545,521Surgical
                Services
            
            
            1,616,034
            
            
            2,070,650Surgical
                Products
            
            
            1,413,872
            
            
            1,367,161Total
                Surgical Revenues
            
            
            3,029,906
            
            
            3,437,811Total
                Revenues
            
            $
            8,081,162
            
            $
            4,983,332




*
              Since
                  ProCyte was acquired on March 18, 2005, there are only 14 days
                  of revenues
                  for the three months ended March 31,
                  2005.




***Domestic
      XTRAC Segment***




Recognized
      revenue for the three months ended March 31, 2006 and 2005 for domestic XTRAC
      procedures was $1,059,630 and $634,018, respectively, reflecting billed
      procedures of 18,760 and 11,304, respectively. In addition, 1,173 and 1,114
      procedures were performed in the three months ended March 31, 2006 and 2005,
      respectively, without billing from us, in connection with clinical research
      and
      customer evaluations of the XTRAC laser. The increase in procedures in the
      period ended March 31, 2006 compared to the comparable period in 2005 was
      largely related to our continuing progress in securing favorable reimbursement
      policies from private insurance plans. Increases in these levels are dependent
      upon more widespread adoption of CPT codes with comparable rates by private
      healthcare insurers and on building market acceptance through marketing programs
      with our physician partners and their patients that the XTRAC procedures will
      be
      of clinical benefit and be generally reimbursed.




In
      the
      first quarter of 2003, we implemented a program to support certain physicians
      who may be denied reimbursement by private insurance carriers for XTRAC
      treatments. In accordance with the requirements of Staff Accounting Bulletin
      No.
      104, we recognize service revenue during this program from the sale of XTRAC
      procedures or equivalent treatments to physicians participating in this program
      only to the extent the physician has been reimbursed for the treatments. For
      the
      three months ended March 31, 2006, we deferred net revenues of $51,080 under
      this program compared to $19,150 of net recognized revenue for the three months
      ended March 31, 2005. The change in deferred revenue under this program is
      presented in the table below.


29


The
      following table sets forth the above analysis for the Domestic XTRAC segment
      for
      the periods reflected below:




Three
                Months Ended March 31,2006
            
            2005Recognized
                revenue
            
            $
            1,059,630
            
            $
            634,018Change
                in deferred program revenue
            
            
            51,080
            
            
            (19,150
            )Change
                in deferred unused treatments
            
            
            110,053
            
            
            135,500Net
                billed revenue
            
            $
            1,220,763
            
            $
            750,368Procedure
                volume total
            
            
            19,933
            
            
            12,418Less:
                Non-billed procedures
            
            
            1,173
            
            
            1,114Net
                billed procedures
            
            
            18,760
            
            
            11,304Avg.
                price of treatments billed
            
            $
            65.07
            
            $
            66.38Change
                in procedures with deferred/(recognized) program revenue,
                net
            
            
            785
            
            
            (288
            )Change
                in procedures with deferred unused treatments, net
            
            
            1,691
            
            
            2,041




The
      average price for a treatment varies based upon the mix of mild and moderate
      psoriasis patients treated by our physician partners. We charge a higher price
      per treatment for moderate psoriasis patients due to the increased body surface
      area required to be treated, although there are fewer patients with moderate
      psoriasis than there are with mild psoriasis. Due to the length of treatment
      time required, it has not been generally practical to use our therapy to treat
      severe psoriasis patients, but this may change as our new product, the XTRAC
      Ultra, has shorter treatment times.




***International
      Dermatology Equipment Segment***




International
      sales of our dermatology equipment and related parts were $531,065 for the
      three
      months ended March 31, 2006 compared to $288,202 for the three months ended
      March 31, 2005. We sold 12 and 5 laser systems in the three months ended March
      31, 2006 and 2005, respectively. Compared to the domestic business, the
      international dermatology equipment operations are more influenced by
      competition from similar laser technology from other manufacturers and from
      non-laser lamps. Such competition has reduced the prices we charge to
      international distributors. Furthermore, average selling prices for
      international dermatology equipment are influenced by the following two
      factors:




·
            We
                have begun selling refurbished domestic XTRACs laser systems into
                the
                international market. Such used equipment is sold for substantially
                less
                than new equipment. We sold three of these used lasers at an average
                price
                of $28,000 for the three months ended March 31, 2006;
                and




·
            We
                have begun selling the new VTRAC, a lamp based alternative UVB light
                source that has a wholesale sales price internationally that is
                substantially below other international dermatology equipment. In
                the
                three months ended March 31, 2006, we have sold two VTRAC
                systems.




The
      following table illustrates the key changes in the International Dermatology
      Equipment segment for the periods reflected below:




Three
                Months Ended March 31,2006
            
            2005Revenues
            
            $
            531,065
            
            $
            288,202Laser
                systems sold
            
            
            12
            
            
            5Average
                revenue per laser
            
            $
            44,255
            
            $
            57,640


30




***Skin
      Care (ProCyte) Segment***




For
      the
      three months ended March 31, 2006, ProCyte revenues were $3,460,561 compared
      to
      $623,301 in the three months ended March 31, 2005. Since ProCyte was acquired
      on
      March 18, 2005, there are only 14 days of revenues for the three months ended
      March 31, 2005. ProCyte revenues are generated from the sale of various skin
      and
      hair care products, from the sale of copper peptide compound and from royalties
      on licenses, mainly from Neutrogena. For the full quarter March 31, 2005,
      unaudited Skin Care revenues were approximately $3.59 million.




The
      following table illustrates the key changes in the Skin Care (ProCyte) segment
      for the periods reflected below:




Three
                Months Ended March 31,2006
            
            2005Product
                sales
            
            $
            3,077,561
            
            $
            452,864Bulk
                compound sales
            
            
            256,000
            
            
            156,000Royalties
            
            
            127,000
            
            
            14,437Total
                ProCyte revenues
            
            $
            3,460,561
            
            $
            623,301




***Surgical
      Services Segment***




In
      the
      three months ended March 31, 2006 and 2005, surgical services revenues were
      $1,616,034 and $2,070,650, respectively, representing a 22% decrease from the
      comparable period in 2005. This decrease was primarily due to the six
      territories that we closed since January 1, 2005 and business interruption
      in
      New Orleans and Alabama from the hurricanes. Two of our territories were
      closed on the western side of Florida due to the termination of a customer
      contract. We closed the other four territories for insufficient profitability.
      During the first quarter of 2006, we have begun work with a regional hospital
      system in central Florida, which we expect will generate annual revenue
      exceeding the annual revenue lost in the western part of the state.




The
      following table illustrates the key changes in the Surgical Services segment
      for
      the periods reflected below:




Three
                Months Ended March 31,2006
            
            2005Revenues
            
            $
            1,616,034
            
            $
            2,070,650




***Surgical
      Products Segment***




Surgical
      Products revenues include revenues derived from the sale of surgical laser
      systems together with sales of related laser fibers and laser disposables.
      Sales
      of laser systems create recurring sales of laser fibers and laser disposables
      that are more profitable than laser systems.




For
      the
      three months ended March 31, 2006, surgical products revenues were $1,413,872
      compared to $1,367,161 in the three months ended March 31, 2005. The increase
      was due to $214,000 in additional laser system revenues reflecting the increase
      in the number of systems sold (18 vs. 5), partially offset by a decline in
      the
      average price per laser sold. This increase was offset, in part, by $120,885
      of
      revenues from the AzurTec project in the three months ended March 31, 2005
      for
      which there were no corresponding revenues in the three months ended March
      31,
      2006.




The
      decrease in average price per laser was largely due to the mix of lasers sold.
      Included in laser sales for the three months ended March 31, 2006 were sales
      of
      thirteen diode lasers, which have lower sales prices than our other types of
      lasers. There was only one sale of a diode laser during the three months ended
      March 31, 2005.




31


Disposables
      and fiber sales decreased 7% between the comparable three-month periods ended
      March 31, 2006 and 2005. We expect that our disposables base may continue to
      erode over time as hospitals continue to seek outsourcing solutions instead
      of
      purchasing lasers and related disposables for their operating rooms. We have
      continued to seek to offset this erosion through expansion of our surgical
      services. Similarly, we believe there will be continuing pressure on laser
      system sales as hospitals continue to outsource their laser-assisted procedures
      to third parties, such as our surgical services business. We hope to offset
      the
      decline in laser and disposables revenues by sales on CO2 and diode surgical
      lasers.




The
      following table illustrates the key changes in the Surgical Products segment
      for
      the periods reflected below:




Three
                Months Ended March 31,2006
            
            2005Revenues
            
            $
            1,413,872
            
            $
            1,367,161Laser
                systems sold
            
            
            18
            
            
            5Laser
                system revenues
            
            $
            467,600
            
            $
            253,885Average
                revenue per laser
            
            $
            25,978
            
            $
            50,779




***Cost
      of Revenues***




Our
      cost
      of revenues are comprised of product cost of revenues and service cost of
      revenues. Within product cost of revenues are the costs of products sold in
      the
      International Dermatology Equipment segment, the Skin Care segment (with
      royalties being transferred over from the products side to the services side
      of
      the segment), and the Surgical Products segment (with laser maintenance being
      transferred over from the products side to the services side of this segment).
      Within services cost of revenues are the costs associated with the Domestic
      XTRAC segment and the Surgical Services segment, as well as costs associated
      with such royalties and maintenance.




Product
      cost of revenues for the three months ended March 31, 2006 were $2,321,669
      compared to $892,964 for the three months ended March 31, 2005. The $1,428,705
      increase reflected an increase of $826,487 of costs for the ProCyte business
      acquired on March 18, 2005 (entire period vs. 14 days), an increase of $431,524
      for surgical products due to lower production levels that resulted in increased
      unabsorbed overhead costs, and $170,694 associated with the increase in sales
      of
      dermatology laser equipment sold outside the United States.




Services
      cost of revenues was $2,386,229 in the three months ended March 31, 2006
      compared to $1,739,404 in the comparable period in 2005. Contributing to the
      $646,825 increase was a $103,394 increase in the surgical services business
      associated with increased laser repair costs and increased technician costs.
      In
      addition, cost of revenues in the Domestic XTRAC business segment increased
      $543,431 due to increased depreciation on the lasers of $244,000 and abnormal
      gas consumption, which has been corrected by software modifications.




Certain
      allocable XTRAC manufacturing overhead costs are charged against the XTRAC
      service revenues. The manufacturing facility in Carlsbad, California is used
      exclusively for the production of the XTRAC lasers. The unabsorbed costs are
      allocated to the domestic XTRAC and the international dermatology laser system
      segments based on actual production of lasers for each segment. Included in
      these allocated manufacturing costs are unabsorbed labor and direct plant costs.




***Gross
      Margin Analysis***




Gross
      margin increased to $3,373,264 during the three months ended March 31, 2006
      from
      $2,350,964 during the same period in 2005. As a percent of revenues, gross
      margin decreased to 41.7% for the three months ended March 31, 2006 from 47.2%
      for the same period in 2005.


32


The
      following table analyzes changes in our gross margin for the periods reflected
      below:




**Company
                Margin Analysis**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Revenues
            
            $
            8,081,162
            
            $
            4,983,332Percent
                increase
            
            
            62.2%Cost
                of revenues
            
            
            4,707,898
            
            
            2,632,368Percent
                increase
            
            
            78.8%Gross
                profit
            
            $
            3,373,264
            
            $
            2,350,964Gross
                profit percentage
            
            
            41.7%
            
            
            47.2%


The
        primary reasons for changes in gross margin for the three months ended March
        31,
        2006, compared to the same period in 2005 were as follows:
  ·
              Our
                  skin care business has the highest gross profit percentage of any
                  of our
                  business segments. However, we acquired ProCyte on March 18, 2005,
                  so only
                  the activity after that date is recorded in our financial statements.
  ·
              We
                  sold a greater number of treatment procedures for the XTRAC laser.
                  The
                  increase in procedure volume was a direct result of improving insurance
                  reimbursement.
  ·
              We
                  sold a greater number of surgical laser systems due to the increased
                  marketing of the diode laser. These units were primarily sold to
                  our
                  master distributor at approximately 36% gross
                  margin.


·
            Offsetting
                the above was an increase in depreciation of $244,000 included in
                the
                XTRAC domestic cost of sales as a result of increasing the overall
                placements of new lasers since the period ended March 31,
                2005.




·
            In
                the surgical products segment, unabsorbed labor and overhead plant
                costs,
                due to lower production levels, accounted for $387,000 of the increase
                in
                increased cost of goods sold for the three months ended March 31,
                2006.




·
            Surgical
                Services revenues decreased due to lost contracts, while costs related
                to
                laser repairs increased during the period. Some revenues were lost
                due to
                hurricanes. While we believe a portion of the loss will be covered
                by
                insurance, we will not record any expected recovery until we have
                greater
                assurance of such recovery.




The
      following table analyzes our gross margin for our Domestic XTRAC segment for
      the
      periods presented below:




**XTRAC
                Domestic Segment**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Revenues
            
            $
            1,059,630
            
            $
            634,018Percent
                increase
            
            
            67.1%Cost
                of revenues
            
            
            946,612
            
            
            403,181Percent
                increase
            
            
            134.8%Gross
                profit
            
            $
            113,018
            
            $
            230,837Gross
                profit percentage
            
            
            10.7%
            
            
            36.4%




Gross
      margin decreased for this segment for the three months ended March 31, 2006
      from
      the comparable period in 2005 by $117,819. The key factors for the decrease
      were
      as follows:




33





·
              The
                  cost of revenues increased by $543,431 for the three months ended
                  March
                  31, 2006. This increase is due to an increase in depreciation on
                  the
                  lasers in service of $244,000 over the comparable prior year period
                  and
                  abnormal gas consumption, which has been corrected by software
                  modification. The depreciation costs will continue to increase
                  in
                  subsequent periods as the business grows. In addition, there was
                  an
                  increase in certain allocable XTRAC manufacturing overhead costs
                  that are
                  charged against the XTRAC service
                  revenues.
  ·
              Price
                  per procedure did not change significantly between the
                  periods.


·
            A
                key driver in increased revenue in this segment is insurance
                reimbursement. In 2004, we focused on encouraging private health
                insurance
                plans to adopt the XTRAC laser therapy as an approved medical procedure
                for the treatment of psoriasis. Since January 2004, several major
                health
                insurance plans instituted medical policies to pay claims for the
                XTRAC
                therapy, including Regence, Wellpoint, Aetna, Anthem, Cigna, United
                Healthcare and Independence Blue Cross of
                Pennsylvania.




·
            Procedure
                volume increased 66% from 11,304 to 18,760 billed procedures in the
                three
                months ended March 31, 2006 compared to the same period in 2005.




The
      following table analyzes our gross margin for our International Dermatology
      Equipment segment for the periods presented below:




**International
                Dermatology Equipment Segment**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Revenues
            
            $
            531,065
            
            $
            288,202Percent
                increase
            
            
            84.3%Cost
                of revenues
            
            
            330,290
            
            
            159,596Percent
                increase
            
            
            107.0%Gross
                profit
            
            $
            200,775
            
            $
            128,606Gross
                profit percentage
            
            
            37.8%
            
            
            44.6%




Gross
      margin for the three months ended March 31, 2006 increased by $72,169 from
      the
      comparable period in 2005. The key factors for the increase were as
      follows:




·
            We
                sold ten XTRAC laser systems and two VTRAC lamp-based excimer systems
                during the three months ended March 31, 2006 and five XTRAC laser
                systems
                in the comparable period in 2005.




·
            The
                International dermatology equipment operations are influenced by
                competition from similar laser technology from other manufacturers
                and
                from non-laser lamp alternatives for treating inflammatory skin disorders,
                which has served to reduce the prices we charge international distributors
                for our excimer products. Partially
                offsetting the increase in the number of laser systems sold was a
                decrease
                in the average price of the laser systems sold.After adjusting the
                revenue for parts sales of approximately $87,000, the average price
                for
                lasers sold during this period was approximately $37,000 in the three
                months ended March 31, 2006, down from $49,300 in the comparable
                period in
                2005. Contributing to the overall average selling price decrease
                in the
                three months ended March 31, 2006 was the sale of certain used lasers
                which were previously deployed in the US operations and sold at a
                discount
                to the list price for new equipment. We sold 4 of these used lasers
                at an
                average price of $28,000. Each of these lasers had a net book value
                of
                less than the cost of a new XTRAC laser
                system.


34


The
      following table analyzes our gross margin for our SkinCare (ProCyte) segment
      for
      the periods presented below:




**Skin
                Care (ProCyte) Segment**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Product
                revenues
            
            $
            3,077,561
            
            $
            452,864Bulk
                compound revenues
            
            
            256,000
            
            
            156,000Royalties
            
            
            127,000
            
            
            14,437Total
                revenues
            
            
            3,460,561
            
            
            623,301Product
                cost of revenues
            
            
            893,564
            
            
            96,681Bulk
                compound cost of revenues
            
            
            158,880
            
            
            129,276Total
                cost of revenues
            
            
            1,052,444
            
            
            225,957Gross
                profit
            
            $
            2,408,117
            
            $
            397,344Gross
                profit percentage
            
            
            69.6%
            
            
            63.7%




Gross
      margin for the three months ended March 31, 2006 increased by $2,010,773 for
      the
      comparable period in 2005. The key factors in this business segment were as
      follows:


·
              Copper
                  Peptide bulk compound is sold at a substantially lower gross margin
                  than
                  skin care products, while revenues generated from licensees have
                  no
                  significant costs associated with this revenue
                  stream.
  ·
              Product
                  revenues come primarily from U.S.
                  dermatologists.
  ·
              Lesser
                  product revenues come from sales directed to consumers at spas
                  and from
                  marketing directly to the consumer (e.g.
                  infomercials).


The
      following table analyzes our gross margin for our Surgical Services segment
      for
      the periods presented below:




**Surgical
                Services Segment**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Revenues
            
            $
            1,616,034
            
            $
            2,070,650Percent
                decrease
            
            
            (22.0%)Cost
                of revenues
            
            
            1,414,578
            
            
            1,315,460Percent
                increase
            
            
            7.5%Gross
                profit
            
            $
            201,456
            
            $
            755,190Gross
                profit percentage
            
            
            12.5%
            
            
            36.5%




Gross
      margin in the Surgical Services segment for the three months ended March 31,
      2006 decreased by $553,734 from the comparable period in 2005. The key factors
      impacting gross margin for the Surgical Services business were as
      follows:




·
            The
                cost of revenues increased due to laser repair costs of $47,000 for
                laser
                material and parts over the comparable prior year period. Also due
                to an
                increase in product cost percentage on revenue due to a change in
                the mix
                of procedures performed.




·
            We
                have closed seven geographic areas of business due to unacceptable
                operating profit and one territory due to competition. Although closing
                these unprofitable territories will save costs and improve profitability
                over time, the overall costs saved for the three months ended March
                31,
                2006 have not kept pace with the revenues lost. Nevertheless, in
                the case
                of the territory lost to competition, we have opened a new, contiguous
                territory in which we have secured a long-term contract from which we
                anticipate significant procedure volume. For that reason, we have
                relocated our personnel and material from the lost territory to the
                new
                one.




35


·
            We
                have suffered business interruption due to hurricanes in the New
                Orleans
                and Alabama territories.




The
      following table analyzes our gross margin for our Surgical Products segment
      for
      the periods presented below:




**Surgical
                Products Segment**
            
            Three
                Months Ended
              March
                31,2006
            
            2005Revenues
            
            $
            1,413,872
            
            $
            1,367,161Percent
                increase
            
            
            3.4%Cost
                of revenues
            
            
            963,974
            
            
            528,174Percent
                increase
            
            
            82.5%Gross
                profit
            
            $
            449,898
            
            $
            838,987Gross
                profit percentage
            
            
            31.8%
            
            
            61.4%




Gross
      margin for the Surgical Products segment in the three months ended March 31,
      2006 compared to the same period in 2005 decreased by $389,089. The key factors
      in this business segment were as follows:




·
            This
                segment includes product sales of surgical laser systems and laser
                disposables. Disposables are more profitable than laser systems,
                but the
                sale of laser systems generates the subsequent recurring sale of
                laser
                disposables.




·
            Revenues
                for the three months ended March 31, 2006 increased by $46,711 from
                the
                three months ended March 31, 2005 while cost of revenues increased
                by
                $435,799 between the same periods. There were 13 more laser system
                sold in
                the three months ended March 31, 2006 than in the comparable period
                of
                2005. However, the lasers sold in the 2005 period were at higher
                prices
                than in the comparable period in 2006. The decrease in average price
                per
                laser was largely due to the mix of lasers sold. Included in the
                laser
                sales for the three months ended March 31, 2006 and 2005 were sales
                of
                $230,500 and $35,000 of diode lasers, respectively, which have
                substantially lower list sales prices than the other types of surgical
                lasers.




·
            Unabsorbed
                labor and overhead plant costs, due to lower production levels, accounted
                for $387,000 of the increase in cost of goods sold for the three
                months
                ended March 31, 2006.




·
            This
                revenue increase was partly offset by a decrease in AzurTec project
                revenues and a decrease in sales of disposables between the periods.
                The
                AzurTec revenues recognized in 2005 had substantially no direct costs
                associated with these revenues. Disposables, which have a higher
                gross
                margin as a percent of revenues than lasers, represented a lower
                percentage of revenue in the three months ended March 31, 2006 compared
                to
                the same period in 2005.




***Selling,
      General and Administrative Expenses***




For
      the
      three months ended March 31, 2006, selling, general and administrative expenses
      increased $2,139,202 to $5,360,178 from the three months ended March 31, 2005.
      Selling, general and administrative expenses related to the ProCyte business
      accounted for $1,154,000 of the increase with the remaining increase related
      to
      $185,000 in salaries, benefits and travel expenses associated with an increase
      in the sales force, particularly in the domestic XTRAC segment; an increase
      in
      direct-to-consumer advertising of $305,000, an increase in corporate insurance
      of $96,000, $390,000 for stock-based compensation expense following adoption
      of
      SFAS No. 123R (see Note 1, “Stock-Based Compensation”) and $76,622 for stock
      options issued to consultants. Offsetting some of the increases for the three
      months ended March 31, 2006, was a reduction of bad debt expense of $87,000
      compared to the prior year period.




36


***Engineering
      and Product Development***




Engineering
      and product development expenses for the three months ended March 31, 2006
      increased to $242,204 from $186,971 for the three months ended March 31, 2005.
      The increase is mainly due to the engineering and product development expenses
      related to the ProCyte business being included during the entire period, which
      caused a $91,938 net increase. During the 2005 and 2006 periods, the engineers
      at the Carlsbad plant were primarily focused on manufacturing efforts, and
      therefore, their costs have been reflected in cost of goods sold.




***Interest
      Expense, Net***




Net
      interest expense for the three months ended March 31, 2006 increased to
      $121,144, as compared to $71,129 for the three months ended March 31, 2005.
      The
      increase in net interest expense was the result of the draws on the lease line
      of credit during the second, third and fourth quarters of 2005.




***Net
      Loss***




The
      aforementioned factors resulted in a net loss of $2,350,261 during the three
      months ended March 31, 2006, as compared to a net loss of $1,128,112 during
      the
      three months ended March 31, 2005, an increase of 108%. This increase was
      primarily the result of the increase in cost of sales and resulting decrease
      in
      gross margin, stock option expense of $466,790 due stock-based compensation
      expense following the adoption of SFAS No. 123R and an increase of $490,699
      of
      depreciation and amortization over the comparable prior year period. The
      following table illustrates the impact of these major expenses between the
      periods:


For
                  the three months ended March 31,2006
              
              
              2005
              
              
              ChangeNet
                  Loss
              
              $
              2,350,261
              
              $
              1,128,112
              
              $
              1,222,149Major
                  Expenses:Depreciation
                  and amortization
              
              
              1,017,095
              
              
              526,396
              
              
              490,699Stock-based
                  compensation
              
              
              466,790
              
              
              -
              
              
              466,790$
              1,483,885
              
              $
              526,396
              
              $
              957,489




Income
      taxes were immaterial, given our current period losses and operating loss
      carryforwards.




***Liquidity
      and Capital Resources***




We
      have
      historically financed our operations with cash provided by equity financing
      and
      from lines of credit and, on recent occasions, from positive results from
      operations.




On
      March
      18, 2005, we acquired ProCyte. The skincare products and royalties provided
      by
      ProCyte increased revenues for the three months ended March 31, 2006. We expect
      to realize cost savings from the consolidation of the administrative and
      marketing infrastructure of the combined company. Additionally, once the
      consolidated infrastructure is in place, we expect our revenues to grow without
      proportionately increasing the rate of growth in our fixed costs.




At
      March
      31, 2006, our current ratio was 1.99 compared to 2.42 at December 31,
      2005. As of March 31, 2006, we had $9,319,334 of working capital compared to
      $11,120,992 as of December 31, 2005. Cash and cash equivalents were $5,665,362
      as March 31, 2006, as compared to $5,609,967 as of December 31, 2005. We had
      $207,050 of cash that was classified as restricted as of March 31, 2006 compared
      to $206,931 as of December 31, 2005.




We
      believe that our existing cash balance together with our other existing
      financial resources, including access to lease financing for capital
      expenditures, and revenues from sales, distribution, licensing and manufacturing
      relationships, will be sufficient to meet our operating and capital requirements
      beyond the second quarter of 2007. The 2006 operating plan reflects costs
      savings from the integration of ProCyte as well as increases in per-treatment
      fee revenues for use of the XTRAC system based on wider insurance coverage
      in
      the United States. In addition, the 2006 operating plan calls for increased
      revenues and profits from our newly acquired Skin Care business. We cannot
      give
      assurances that we will be able to execute our business plan, which may require
      us to obtain additional equity or debt financing to meet our working capital
      requirements or capital expenditure needs. Also, if our growth exceeds the
      business plan projections, we may require additional equity or debt financing.
      There can be no assurance that additional financing, if needed, will be
      available when required or, if available, will be on terms satisfactory to
      us.




37


On
      June
      25, 2004, we entered into a leasing credit facility from GE Capital Corporation
      (“GE”). The credit facility has a commitment term of three years, expiring on
      June 25, 2007. We account for each draw as funded indebtedness taking the form
      of a capital lease, with equitable ownership in the lasers remaining with us.
      GE
      retains title as a form of security over the lasers. Each draw against the
      credit facility has a repayment period of three years and is secured by specific
      lasers, which we have sold to GE and leased back for deployment in the field.
      A
      summary of the activity under the GE leasing credit facility is presented in
      Note 9, “Long-term Debt.”




Net
      cash
      provided by operating activities was $521,394 for three months ended March
      31,
      2006, compared to net cash used of $1,687,966 for the same period in 2005.
      The
      change was primarily due to a decrease in inventory and increases in accounts
      payable.




Net
      cash
      used in investing activities was $1,090,533 for the three months ended March
      31,
      2006 compared to cash provided by of $5,235,559 for the three months ended
      March
      31, 2005. During the three months ended March 31, 2005, we received cash of
      $6,014,450, net of acquisition costs, in the ProCyte acquisition and used
      $722,509 for production of our lasers-in-service compared to $1,079,167 for
      the
      same period in 2006.




Net
      cash
      provided by financing activities was $624,415 for the three months ended March
      31, 2006 compared to net cash used of $144,494 for the three months ended March
      31, 2005. In the three months ended March 31, 2006 we made payments of $264,443
      on certain notes payable and capital lease obligations and $7,890 in
      registration costs. These payments were offset, in part, by the advances under
      the lease line of credit, net of payments, of $819,867 and by receipts of
      $68,400 from the exercise of common stock options. In the three months ended
      March 30, 2005, we received $200,208 from the exercise of common stock options
      and warrants and $100,431 of restricted cash that was released from restriction.
      These cash receipts were offset by $156,356 for the payment of certain notes
      payable and capital lease obligations, $154,315 of net payments on the lease
      line of credit and $134,462 of registration costs.




Our
      ability to expand our business operations is currently dependent in significant
      part on financing from external sources. There can be no assurance that changes
      in our manufacturing and marketing, engineering and product development plans
      or
      other changes affecting our operating expenses and business strategy will not
      require financing from external sources before we will be able to develop
      profitable operations. There can be no assurance that additional capital will
      be
      available on terms favorable to us, if at all. To the extent that additional
      capital is raised through the sale of additional equity or convertible debt
      securities, the issuance of such securities could result in additional dilution
      to our stockholders. Moreover, our cash requirements may differ materially
      from
      those now planned because of results of marketing, product testing, changes
      in
      the focus and direction of our marketing programs, competitive and technological
      advances, the level of working capital required to sustain our planned growth,
      litigation, operating results, including the extent and duration of operating
      losses, and other factors. In the event that we experience the need for
      additional capital, and are not able to generate capital from financing sources
      or from future operations, management may be required to modify, suspend or
      discontinue our business plan.




***Commitments
      and Contingencies***




During
      the three months ended March 31, 2006, there were no items that significantly
      impacted our commitments and contingencies as discussed in the notes to our
      2005
      annual financial statements included in our Annual Report on Form 10-K. However,
      a contingency pre-dating the acquisition of ProCyte Corporation materialized
      and
      was resolved in the three months ended March 31, 2006. We have no significant
      off-balance sheet arrangements.




***Impact
      of Inflation***




We
      have
      not operated in a highly inflationary period, and we do not believe that
      inflation has had a material effect on sales or expenses.




**ITEM
      3. Quantitative and Qualitative Disclosure about Market
      Risk**




We
      are
      not currently exposed to market risks due to changes in interest rates and
      foreign currency rates and, therefore, we do not use derivative financial
      instruments to address treasury risk management issues in connection with
      changes in interest rates and foreign currency rates.


38


**ITEM
      4. Controls and Procedures**




***Evaluation
      of Disclosure Controls and Procedures***





Our
      management, with the participation of our Chief Executive Officer and Chief
      Financial Officer, evaluated the effectiveness of our disclosure controls and
      procedures as of the end of the period covered by this report. Based on that
      evaluation, the Chief Executive Officer and Chief Financial Officer concluded
      that our disclosure controls and procedures as of the end of the period covered
      by this report are functioning effectively to provide reasonable that the
      information required to be disclosed by us in reports filed under the Securities
      Exchange Act f 1934 is (i) recorded, processed, summarized and reported within
      the time periods specified in the Securities and Exchange Commission’s rules and
      forms and (ii) accumulated and communicated to our management, including the
      Chief Executive Officer and Chief Financial Officer, as appropriate to allow
      timely decisions regarding disclosure. A control system cannot provide absolute
      assurance, however, the objectives of the control system are met and no
      evaluation of controls can provide absolute assurance that all control issues
      and instances of fraud, if any, within a company have been
      detected.





***Change
      in Internal Control Over Financial Reporting***





No
      change
      in our internal control over financial reporting occurred during the quarter
      ended March 31, 2006 that has materially affected, or is reasonably likely
      to
      materially affect, our internal control over financial reporting.




**PART
      II - Other Information**




**ITEM
      1. Legal Proceedings**




Reference
      is made to Item 3, ***Legal
      Proceedings*** ,
      in our
      Annual Report on Form 10-K for the year ended December 31, 2005 for descriptions
      of our legal proceedings.




In
      the
      matter brought by us against RA Medical Systems, Inc. and Dean Stewart Irwin
      in
      the United States District Court for the Southern District of California, the
      court has denied the defendants’ motion for summary judgment, which was based on
      a theory of res judicata. In view of this denial, the Court has authorized
      for
      discovery in the case to resume. Our motion for partial summary judgment, is
      based on a theory that defendants have competed unfairly against us in that
      RA
      Medical did not have, until January 2006, a license from the State of California
      to manufacture or market their medical devices. Our motion will stand submitted
      for decision on May 30, 2006, after briefing is completed.




In
      the
      matter brought by RA Medical Systems, Inc. and Dean Stewart Irwin against us,
      Jenkens & Gilchrist, LLP (our outside counsel) and Michael R. Matthias, Esq.
      (litigation partner at our outside counsel), the appellate court denied our
      motion to have the action dismissed under California Code of Civil Procedure
      section 425.16. We are appealing this decision.




We
      are
      involved in certain other legal actions and claims arising in the ordinary
      course of business. We believe, based on discussions with legal counsel, that
      such litigation and claims will be resolved without a material effect on our
      consolidated financial position, results of operations or liquidity.




**ITEM
      1A. Risk Factors**




We
        noted
        in Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended
        December 31, 2005, that “we depend on our executive officers and key personnel
        to implement our business strategy and could be harmed by the loss of their
        services.” By way of update to this risk factor, we note that Mr. Clifford, our
        Executive Vice President, Dermatology, will be leaving the Company in the
        second
        quarter 2006. As Mr. Clifford’s responsibilities included domestic sales and
        marketing of our dermatology segments, his departure could adversely affect
        our
        ability to manage our dermatology businesses and to develop and introduce
        new
        products. We intend to mitigate any adverse effects by entering into a
        consulting arrangement with Mr. Clifford and by redistributing Mr. Clifford’s
        responsibilities, to the extent possible, over existing resources. There
        can be
        no assurance, however, that such efforts in mitigation will be
        successful.




39


**ITEM
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds**




***Recent
      Issuances of Unregistered Securities***




On
      January 15, 2006, we issued 860,000 shares of restricted common stock to two
      of
      our executives. The issuance was approved by our stockholders on December 28,
      2005. These shares were subsequently registered as part of the registration
      under Form S-8 in March 2006 of our 2005 Equity Compensation Plan.




On
      March
      17, 2006, we issued 101,010 **** shares
      of
      our restricted common stock to Stern Laser srl. The issuance was related to
      a
      milestone in the Master Agreement. These shares were subsequently registered
      under Form S-3 in March 2006.




On
      March
      29, 2006, we issued to GE Capital Corporation a warrant to purchase 20,545
      shares of our common stock. The warrant was issued in connection with the fourth
      draw under the second tranche of the leasing line of credit. These shares were
      subsequently registered under Form S-3 in March 2006.




On
      March
      30, 2006, we issued 200,000 shares of our restricted common stock in connection
      with the Investment Agreement with AzurTec, Inc.


**ITEM
        5. Other Information**
 We
          entered into a Separation Agreement dated April 30, 2006 (the “Separation
          Agreement”) with John F. Clifford, our Executive Vice President of Dermatology.
          The agreement became effective on May 8, 2006, upon the expiration of the
          seven-day revocation period provided by applicable law. Pursuant
          to the terms of the Separation Agreement, Mr. Clifford's Employment Agreement
          with us, dated March 18, 2005, was terminated.
 
 Pursuant
          to the Separation Agreement, Mr. Clifford will resign as our Executive
          Vice
          President of Dermatology on a date convenient to both parties, but no later
          than
          June 30, 2006. Mr. Clifford will continue to receive his current base salary
          through his resignation date. For a two-year period following his resignation
          date, Mr. Clifford will act as a consultant to us in the dermatology market.
          In
          his first year as our consultant, Mr. Clifford will receive a consulting
          fee
          equal to $300,000. In the second year, Clifford will receive three payments
          of
          $17,500 each on the first day of the first, second and third months of
          such
          year.
  We
        will
        pay for Mr. Clifford’s coverage under our health plan until the later of
        September 30, 2007 or the date upon which Mr. Clifford secures comparable,
        full-time employment with another employer. Mr. Clifford’s participation in all
        our other benefit plans, including our 401(k) plan and auto allowance benefit,
        will terminate as of the date of his resignation.
  Mr.
        Clifford’s outstanding stock options will continue to vest on their regular
        schedule up to his resignation date. On Mr. Clifford’s resignation date,
        one-half of his unvested options shall fully vest and the remaining unvested
        options shall be cancelled. Such vested options will remain exercisable by
        him
        during his consulting period and for a period of 90 days thereafter. Any
        options
        that are not exercised by Mr. Clifford during such period shall be cancelled
        at
        that time.
  As
        a
        condition to receiving the benefits under the Separation Agreement, Mr. Clifford
        has, among other things, released us from any and all past, present and future
        alleged claims, agreed to keep all information relating to our business
        confidential and agreed not to compete with us for a period of one year (two
        years with respect to certain activities) following the date of his resignation.




**ITEM
      6. Exhibits**




10.56
            Investment
                Agreement, dated March 30, 2006, between AzurTec, Inc. and PhotoMedex,
                Inc. (1)10.57
            License
                Agreement, dated March 30, 2006, between AzurTec, Inc. and PhotoMedex,
                Inc. (2)10.58
            License
                Agreement, delivered March 31, 2006 and effective April 1, 2006,
                between
                Mount Sinai School of Medicine and PhotoMedex, Inc. (3)10.59
            Separation
                Agreement, dated April 30, 2006, between PhotoMedex, Inc. and John
                F.
                Clifford31.1
            Rule 13a-14(a)/15d-14(a) Certificate of Chief Executive Officer31.2
            Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer32.1
            Certificate of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 200232.2
            Certificate of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002





(1)
            Incorporated
              by
              reference to Exhibit 10.1 to Form 8-K, filed on April 6, 2006(2)
            Incorporated
                by reference to Exhibit 10.2 to Form 8-K, filed on April 6,
                2006.(3)
            Incorporated
                by reference to Exhibit 10.1 to Form 8-K, filed on April 10, 2006.


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**SIGNATURES**





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




PHOTOMEDEX,
              INC.Date:
              May 10, 2006
            By:
            /s/ Jeffrey
              F. O’DonnellJeffrey
              F. O’DonnellPresident
              and
              Chief Executive Officer




Date: May 10, 2006
            By:
            /s/ Dennis
              M.
              McGrathDennis
              M. McGrathChief
              Financial Officer

















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