##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10 - Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from _________ to ___________
 Commission File Number 0-11365
 PHOTOMEDEX, INC.
  Delaware
    
    59-2058100(State or other jurisdiction 
of incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 147 Keystone Drive, Montgomeryville, Pennsylvania 18936
 (215) 619-3600
  o þ
  þ o
  Large accelerated filer o
    
    Accelerated filer þ
    
    Non-accelerated filer o
  o þ
      1




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##### 



Part I. Financial Information:
    
    PAGEITEM 1. Financial Statements:a.
    
    Consolidated Balance Sheets, September 30, 2006 (unaudited) and December 31, 2005
    
    
    3b.
    
    Consolidated Statements of Operations for the three months ended September 30, 2006 and 2005 (unaudited)
    
    
    4c.
    
    Consolidated Statements of Operations for the nine months ended September 30, 2006 and 2005 (unaudited)
    
    
    5d.
    
    Consolidated Statement of Stockholders Equity for the nine months ended September 30, 2006 (unaudited)
    
    
    6e.
    
    Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005 (unaudited)
    
    
    7f.
    
    Notes to Consolidated Financial Statements (unaudited)
    
    
    8ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    29ITEM 3. Quantitative and Qualitative Disclosure about Market Risk
    
    
    45ITEM 4. Controls and Procedures
    
    
    45Part II. Other Information:ITEM 1. Legal Proceedings
    
    
    45ITEM 1A. Risk Factors
    
    
    46ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    46ITEM 3. Defaults Upon Senior Securities
    
    
    46ITEM 4. Submission of Matters to a Vote of Security Holders
    
    
    46ITEM 5. Other Information
    
    
    46ITEM 6. Exhibits
    
    
    47Signatures
    
    
    47CertificationsExhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
   2




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##### Table of Contents



PART I  Financial Information
 
 ITEM 1.
    
    Financial Statements
 
 
 September 30, 2006
    
    
    December 31, 2005(Unaudited)
    
    
    *ASSETSCurrent assets:Cash and cash equivalents
    
    $
    4,281,457
    
    
    $
    5,403,036Restricted cash
    
    
    156,000
    
    
    
    206,931Accounts receivable, net of allowance for
doubtful accounts of $560,685 and $765,440,
respectively
    
    
    4,721,340
    
    
    
    4,651,080Inventories
    
    
    7,525,412
    
    
    
    8,047,444Prepaid expenses and other current assets
    
    
    870,755
    
    
    
    621,372Total current assets
    
    
    17,554,964
    
    
    
    18,929,863Property and equipment, net
    
    
    8,340,585
    
    
    
    7,044,713Goodwill, net
    
    
    16,917,808
    
    
    
    16,375,384Patents and licensed technologies, net
    
    
    1,769,399
    
    
    
    1,577,554Other intangible assets, net
    
    
    3,770,125
    
    
    
    4,467,625Other assets
    
    
    570,984
    
    
    
    280,467Total assets
    
    $
    48,923,865
    
    
    $
    48,675,606LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of notes payable
    
    $
    428,934
    
    
    $
    228,398Current portion of long-term debt
    
    
    2,679,951
    
    
    
    1,749,969Accounts payable
    
    
    3,965,273
    
    
    
    3,572,077Accrued compensation and related expenses
    
    
    1,324,818
    
    
    
    867,427Other accrued liabilities
    
    
    788,871
    
    
    
    936,591Deferred revenues
    
    
    664,790
    
    
    
    466,032Total current liabilities
    
    
    9,852,637
    
    
    
    7,820,494Long-term liabilities:Notes payable
    
    
    144,405
    
    
    
    159,213Long-term debt
    
    
    3,502,858
    
    
    
    2,278,871Total liabilities
    
    
    13,499,900
    
    
    
    10,258,578Commitments and ContingenciesStockholders equity:Common stock, $.01 par value, 75,000,000
shares authorized; 52,765,491 and 51,414,294
shares issued and outstanding, respectively
    
    
    527,655
    
    
    
    514,143Additional paid-in capital
    
    
    120,462,144
    
    
    
    118,140,838Accumulated deficit
    
    
    (85,565,834
    )
    
    
    (80,182,606
    )Deferred compensation
    
    
    
    
    
    
    (55,347
    )Total stockholders equity
    
    
    35,423,965
    
    
    
    38,417,028Total liabilities and stockholders equity
    
    $
    48,923,865
    
    
    $
    48,675,606
 *
    
    The December 31, 2005 balance sheet was derived from the Companys audited financial
statements.
   3




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##### Table of Contents



For the Three Months EndedSeptember 30,2006
    
    
    2005Revenues:Product sales
    
    $
    5,165,901
    
    
    $
    4,537,938Services
    
    
    3,125,646
    
    
    
    3,085,9008,291,547
    
    
    
    7,623,838Cost of revenues:Product cost of revenues
    
    
    2,097,500
    
    
    
    1,956,022Services cost of revenues
    
    
    2,561,436
    
    
    
    2,347,3624,658,936
    
    
    
    4,303,384Gross profit
    
    
    3,632,611
    
    
    
    3,320,454Operating expenses:Selling and marketing
    
    
    2,678,419
    
    
    
    2,444,807General and administrative
    
    
    2,220,985
    
    
    
    2,081,371Engineering and product development
    
    
    267,062
    
    
    
    304,9355,166,466
    
    
    
    4,831,113Loss from operations
    
    
    (1,533,855
    )
    
    
    (1,510,659
    )Other income
    
    
    
    
    
    
    244,988Interest expense, net
    
    
    (159,180
    )
    
    
    (84,229
    )Net loss
    
    
    ($1,693,035
    )
    
    
    ($1,349,900
    )Basic and diluted net loss per share
    
    
    ($0.03
    )
    
    
    ($0.03
    )Shares used in computing basic and diluted net loss per share
    
    
    52,659,132
    
    
    
    51,198,095
   4




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##### Table of Contents



For the Nine Months EndedSeptember 30,2006
    
    
    2005Revenues:Product sales
    
    $
    15,418,727
    
    
    $
    11,718,700Services
    
    
    9,177,725
    
    
    
    8,943,64024,596,452
    
    
    
    20,662,340Cost of revenues:Product cost of revenues
    
    
    6,374,344
    
    
    
    4,856,858Services cost of revenues
    
    
    7,216,680
    
    
    
    6,301,08613,591,024
    
    
    
    11,157,944Gross profit
    
    
    11,005,428
    
    
    
    9,504,396Operating expenses:Selling and marketing
    
    
    8,236,179
    
    
    
    6,242,676General and administrative
    
    
    6,969,862
    
    
    
    5,701,917Engineering and product development
    
    
    764,445
    
    
    
    819,84515,970,486
    
    
    
    12,764,438Loss from operations
    
    
    (4,965,058
    )
    
    
    (3,260,042
    )Other income
    
    
    
    
    
    
    333,655Interest expense, net
    
    
    (418,170
    )
    
    
    (212,276
    )Net loss
    
    
    ($5,383,228
    )
    
    
    ($3,138,663
    )Basic and diluted net loss per share
    
    
    ($0.10
    )
    
    
    ($0.07
    )Shares used in computing basic and diluted net loss per share
    
    
    52,486,758
    
    
    
    47,972,456
   5




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##### Table of Contents



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
    )
    
    $
    38,417,028Reversal of deferred compensation
upon adoption of SFAS 123R
    
    
    
    
    
    
    
    
    
    
    (55,347
    )
    
    
    
    
    
    
    55,347
    
    
    
    Exercise of stock options
    
    
    50,187
    
    
    
    502
    
    
    
    75,678
    
    
    
    
    
    
    
    
    
    
    
    76,180Exercise of warrants
    
    
    140,000
    
    
    
    1,400
    
    
    
    166,600
    
    
    
    
    
    
    
    
    
    
    
    168,000Stock options issued to consultants
for services
    
    
    
    
    
    
    
    
    
    
    111,706
    
    
    
    
    
    
    
    
    
    
    
    111,706Stock-based compensation expense
related to employee options
    
    
    
    
    
    
    
    
    
    
    900,773
    
    
    
    
    
    
    
    
    
    
    
    900,773Stock-based compensation expense
related to severance agreement
    
    
    
    
    
    
    
    
    
    
    195,497
    
    
    
    
    
    
    
    
    
    
    
    195,497Issuance of restricted stock
    
    
    860,000
    
    
    
    8,600
    
    
    
    235,632
    
    
    
    
    
    
    
    
    
    
    
    244,232Issuance of stock for Stern
technology 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
    
    
    
    
    
    
    
    
    
    
    44,155
    
    
    
    
    
    
    
    
    
    
    
    44,155Registration expenses
    
    
    
    
    
    
    
    
    
    
    (7,890
    )
    
    
    
    
    
    
    
    
    
    
    (7,890
    )Issuance of warrants for draws under
line of credit
    
    
    
    
    
    
    
    
    
    
    82,504
    
    
    
    
    
    
    
    
    
    
    
    82,504Net loss for the nine months ended
September 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,383,228
    )
    
    
    
    
    
    
    (5,383,228
    )BALANCE, SEPTEMBER 30, 2006
    
    
    52,765,491
    
    
    $
    527,655
    
    
    $
    120,462,144
    
    
    
    ($85,565,834
    )
    
    $
    
    
    
    $
    35,423,965
   6




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##### Table of Contents



For the Nine Months EndedSeptember 30,2006
    
    
    2005Cash Flows From Operating Activities:Net loss
    
    
    ($5,383,228
    )
    
    
    ($3,138,663
    )Adjustments to reconcile net loss to net cash used
in operating activities:Depreciation and amortization
    
    
    3,101,689
    
    
    
    2,216,715Stock options issued to consultants for services
    
    
    111,706
    
    
    
    31,859Stock-based compensation expense related to employee
options and restricted stock
    
    
    1,136,405
    
    
    
    Amortization of deferred compensation
    
    
    44,155
    
    
    
    62,019Nonmonetary exchange of assets
    
    
    
    
    
    
    (88,667
    )Provision for bad debts
    
    
    66,211
    
    
    
    276,124Loss on disposal of assets
    
    
    
    
    
    
    64,937Changes in operating assets and liabilities, net of effects
on acquired assets and liabilities:Accounts receivable
    
    
    (136,471
    )
    
    
    260,265Inventories
    
    
    612,427
    
    
    
    (403,335
    )Prepaid expenses and other assets
    
    
    710,407
    
    
    
    545,943Accounts payable
    
    
    393,196
    
    
    
    (1,110,661
    )Accrued compensation and related expenses
    
    
    110,464
    
    
    
    (157,504
    )Other accrued liabilities
    
    
    (103,306
    )
    
    
    (977,626
    )Cash deposits
    
    
    (27,000
    )
    
    
    8,000Deferred revenues
    
    
    198,758
    
    
    
    (201,070
    )Other liabilities
    
    
    (17,415
    )
    
    
    (4,962
    )Net cash provided by (used in) operating activities
    
    
    817,998
    
    
    
    (2,616,626
    )Cash Flows From Investing Activities:Purchases of property and equipment
    
    
    (60,910
    )
    
    
    (87,488
    )Lasers placed into service
    
    
    (3,485,269
    )
    
    
    (2,548,535
    )Cash received from acquisition, net of costs incurred
    
    
    
    
    
    
    5,578,416Net cash (used in) provided by investing activities
    
    
    (3,546,179
    )
    
    
    2,942,393Cash Flows From Financing Activities:Proceeds from issuance of restricted common stock
    
    
    8,600
    
    
    
    Costs related to issuance of common stock
    
    
    (7,890
    )
    
    
    (169,524
    )Proceeds from exercise of options
    
    
    76,180
    
    
    
    555,685Proceeds from exercise of warrants
    
    
    168,000
    
    
    
    147,060Payments on long-term debt
    
    
    (153,597
    )
    
    
    (202,199
    )Payments on notes payable
    
    
    (656,130
    )
    
    
    (617,799
    )Net advancements on lease line of credit
    
    
    2,120,508
    
    
    
    1,347,945Decrease/(Increase) in restricted cash and cash equivalents
    
    
    50,931
    
    
    
    (94,602
    )Net cash provided by financing activities
    
    
    1,606,602
    
    
    
    966,566Net (decrease) increase in cash and cash equivalents
    
    
    (1,121,579
    )
    
    
    1,292,333Cash and cash equivalents, beginning of period
    
    
    5,403,036
    
    
    
    3,884,817Cash and cash equivalents, end of period
    
    $
    4,281,457
    
    
    $
    5,177,150
   7




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##### Table of Contents



Note 1
 Basis of Presentation:
 The Company:
 Background  ® ® ®
  ®
 ®
    8




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##### Table of Contents



Liquidity and Going Concern
     Summary of Significant Accounting Policies:
 Quarterly Financial Information and Results of Operations
  9




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##### Table of Contents



Principles of Consolidation
 Use of Estimates
  Revenue Recognition
       10




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##### Table of Contents




    
    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 fee for the treatment he or she
purchased from the Company 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 sales of treatments to
a physician can be denied if timely payments are not made, even if a patients appeal
is still in process.
     Impairment of Long-Lived Assets and Intangibles
  11




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##### Table of Contents



Patent Costs and Licensed Technologies
 Impairment of
Long-Lived Assets and Intangibles
 Other Intangible Assets
  Goodwill
  Accrued Warranty Costs
 September 30, 2006Accrual at beginning of period
    
    $
    204,708Additions charged to warranty expense
    
    
    75,000Expiring warranties
    
    
    (51,376
    )Claims satisfied
    
    
    (58,514
    )Accrual at end of period
    
    $
    169,818
 Income Taxes
  12




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##### Table of Contents



Net Loss Per Share
  Exchanges of Nonmonetary Assets
 Share-Based Compensation
    13




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##### Table of Contents



Three Months
    
    
    Nine MonthsEnded September
    
    
    Ended September30, 2005
    
    
    30, 2005Net loss:As reported
    
    
    ($1,349,900
    )
    
    
    ($3,138,663
    )Less: stock-based employee
compensation expense included in
reported net loss
    
    
    17,787
    
    
    
    62,019Impact of total stock-based
compensation expense determined
under fair-value-based method for
all grants and awards
    
    
    (483,008
    )
    
    
    (1,264,476
    )Pro-forma
    
    
    ($1,815,121
    )
    
    
    ($4,341,120
    )Net loss per share:As reported
    
    
    ($0.03
    )
    
    
    ($0.07
    )Pro-forma
    
    
    ($0.04
    )
    
    
    ($0.09
    )
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Assumptions for Option Grants
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Risk-free interest rate
    
    
    4.94
    %
    
    
    3.99
    %
    
    
    4.63
    %
    
    
    4.04
    %Volatility
    
    
    91.01
    %
    
    
    94.69
    %
    
    
    93.27
    %
    
    
    97.89
    %Expected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Expected life
    
    7.65 years
    
    5 years
    
    7.39 years
    
    5 yearsEstimated forfeiture rate
    
    
    11
    %
    
    
    N/A
    
    
    
    11
    %
    
    
    N/A
    14




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##### Table of Contents



Nine MonthsEndedSeptember 30,Assumptions for Stock Awards
    
    2006Risk-free interest rate
    
    
    4.32
    %Volatility
    
    
    70
    %Expected dividend yield
    
    
    0
    %Expected Life
    
    4.92 years
    Reclassifications
 Supplemental Cash Flow Information
     15




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##### Table of Contents



Recent Accounting Pronouncements
       16




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##### Table of Contents



Note 2  Acquisitions:
 ProCyte Transaction
   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
   17




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net revenues
    
    $
    8,291,547
    
    
    $
    7,623,838
    
    
    $
    24,596,452
    
    
    $
    23,631,902Net loss
    
    
    ($1,693,035
    )
    
    
    ($1,349,900
    )
    
    
    ($5,383,228
    )
    
    
    ($4,341,120
    )Basic and diluted loss per share
    
    
    ($0.03
    )
    
    
    ($0.03
    )
    
    
    ($0.10
    )
    
    
    ($0.09
    )Shares used in calculating
basic and diluted loss per
share
    
    
    52,659,132
    
    
    
    51,198,095
    
    
    
    52,486,758
    
    
    
    50,906,830
   
    
    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 recognize 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.
  Stern Laser Transaction
  18




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##### Table of Contents



AzurTec Transaction
   Note 3  Inventories:
  September 30, 2006
    
    
    December 31, 2005Raw materials and work in progress
    
    $
    4,607,687
    
    
    $
    4,998,847Finished goods
    
    
    2,917,725
    
    
    
    3,048,597Total inventories
    
    $
    7,525,412
    
    
    $
    8,047,444
   19




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##### Table of Contents



Note 4  Property and Equipment:
  September 30, 2006
    
    
    December 31, 2005Lasers in service
    
    $
    15,432,246
    
    
    $
    12,657,701Computer hardware and software
    
    
    334,490
    
    
    
    334,490Furniture and fixtures
    
    
    322,018
    
    
    
    338,089Machinery and equipment
    
    
    693,553
    
    
    
    755,565Autos and trucks
    
    
    382,690
    
    
    
    382,690Leasehold improvements
    
    
    247,368
    
    
    
    238,27617,412,365
    
    
    
    14,706,811Accumulated depreciation and amortization
    
    
    (9,071,780
    )
    
    
    (7,662,098
    )Property and equipment, net
    
    $
    8,340,585
    
    
    $
    7,044,713
  Note 5  Patents and Licensed Technologies:
  September 30, 2006
    
    
    December 31, 2005Patents, owned and licensed, at
gross costs of $490,468 and
$438,940, net of accumulated
amortization of $222,365 and
$194,660, respectively.
    
    $
    268,103
    
    
    $
    244,280Other licensed or developed
technologies, at gross costs of
$2,432,259 and $2,047,665, net
of accumulated amortization of
$930,963 and $714,391,
respectively.
    
    
    1,501,296
    
    
    
    1,333,274$
    1,769,399
    
    
    $
    1,577,554
   20




---



##### Table of Contents



Note 6  Other Intangible Assets:
  September 30, 2006
    
    
    December 31, 2005Neutrogena Agreement, at gross
cost of $2,400,000 net of
accumulated amortization of
$738,000 and $378,000,
respectively.
    
    $
    1,662,000
    
    
    $
    2,022,000Customer Relationships, at gross
cost of $1,700,000 net of
accumulated amortization of
$522,744 and $267,747,
respectively.
    
    
    1,177,256
    
    
    
    1,432,253Tradename, at gross cost of
$1,100,000 net of accumulated
amortization of $169,131 and
$86,628, respectively.
    
    
    930,869
    
    
    
    1,013,372$
    3,770,125
    
    
    $
    4,467,625
  Note 7  Other Accrued Liabilities:
  September 30, 2006
    
    
    December 31, 2005Accrued warranty
    
    $
    169,818
    
    
    $
    204,708Accrued professional and consulting fees
    
    
    352,443
    
    
    
    437,396Accrued sales taxes
    
    
    215,289
    
    
    
    184,764Other accrued expenses
    
    
    51,321
    
    
    
    109,723Total other accrued liabilities
    
    $
    788,871
    
    
    $
    936,591
  21




---



##### Table of Contents



Note 8  Notes Payable:
  September 30, 2006
    
    
    December 31, 2005Note Payable  secured creditor,
interest at 6%, payable in monthly
principal and interest installments of
$2,880 through June 2012
    
    $
    165,403
    
    
    $
    183,425Note Payable  unsecured creditor,
non-interest bearing, payable in 18
equal monthly installments of $4,326
through October 2007
    
    
    56,244
    
    
    
    Note payable  secured creditor,
interest at 16.47%, payable in monthly
principal and interest installments of
$2,618 through December 2006.
    
    
    5,325
    
    
    
    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
    
    
    32,788
    
    
    
    Note Payable  unsecured creditor,
interest at 5.39%, payable in monthly
principal and interest installments of
$63,563 through February 2007
    
    
    313,579
    
    
    
    573,339
    
    
    
    387,611Less: current maturities
    
    
    (428,934
    )
    
    
    (228,398
    )Notes payable, net of current maturities
    
    $
    144,405
    
    
    $
    159,213
  22




---



##### Table of Contents



Note 9  Long-term Debt:
  September 30, 2006
    
    
    December 31, 2005Borrowings on credit facility:Draw 1  effective interest at 17.79%, payable in
monthly principal and interest installments of $48,156
through June 2007.
    
    $
    413,178
    
    
    $
    792,362Draw 2  effective interest at 17.14%, payable in
monthly principal and interest installments of $9,957
through September 2007.
    
    
    112,678
    
    
    
    189,543Draw 3  effective interest at 17.61%, payable in
monthly principal and interest installments of $4,797
through December 2007.
    
    
    66,760
    
    
    
    102,541Draw 4  effective interest at 12.62%, payable in
monthly principal and interest installments of $34,859
through June 2008.
    
    
    669,151
    
    
    
    922,350Draw 5  effective interest at 12.94%, payable in
monthly principal and interest installments of $28,757
through September 2008.
    
    
    621,486
    
    
    
    823,810Draw 6  effective interest at 13.36%, payable in
monthly principal and interest installments of $28,923
through December 2008.
    
    
    691,441
    
    
    
    895,524Draw 7  effective interest at 13.74%, payable in
monthly principal and interest installments of $40,887
through March 2009.
    
    
    1,067,551
    
    
    
    Draw 8  effective interest at 13.45%, payable in
monthly principal and interest installments of $40,155
through June 2009.
    
    
    1,142,605
    
    
    
    Draw 9  effective interest at 13.10%, payable in
monthly
principal and interest installments of $40,193 through
September 2009.
    
    
    1,248,846
    
    
    
    Total borrowings on credit facility
    
    $
    6,033,696
    
    
    $
    3,726,130Capital lease obligations (see Note 4)
    
    
    149,113
    
    
    
    302,710Less: current portion
    
    
    (2,679,951
    )
    
    
    (1,749,969
    )Total long-term debt
    
    $
    3,502,858
    
    
    $
    2,278,871
 Leasing Credit Facility
   23




---



##### Table of Contents



Draw 7
    
    
    Draw 8
    
    
    Draw 9Date of draw
    
    
    3/29/06
    
    
    
    6/30/06
    
    
    
    9/29/06Amount of draw
    
    $
    1,287,487
    
    
    $
    1,268,362
    
    
    $
    1,276,949Stated interest rate
    
    
    9.45
    %
    
    
    9.22
    %
    
    
    8.80
    %Effective interest rate
    
    
    13.74
    %
    
    
    13.45
    %
    
    
    13.10
    %Number of warrants issued
    
    
    20,545
    
    
    
    24,708
    
    
    
    25,038Exercise price of
warrants per share
    
    $
    2.06
    
    
    $
    1.69
    
    
    $
    1.68Fair value of warrants
    
    $
    27,853
    
    
    $
    26,548
    
    
    $
    28,103
  Warrants granted
    
    
    Warrants granted
    
    
    Warrants grantedunder Draw 7
    
    
    under Draw 8
    
    
    under Draw 9Risk-free interest rate
    
    
    4.79
    %
    
    
    5.18
    %
    
    
    4.59
    %Volatility
    
    
    87.16
    %
    
    
    84.17
    %
    
    
    84.52
    %Expected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Expected warrant life
    
    5 years
    
    5 years
    
    5 years
    24




---



##### Table of Contents



Capital Leases
 Note 10  Employee Stock Benefit Plans
   WeightedWeighted
    
    
    AverageAverage
    
    
    RemainingNumber of
    
    
    Exercise
    
    
    ContractualOptions
    
    
    Price
    
    
    Term (years)Outstanding, January 1, 2006
    
    
    5,077,646
    
    
    $
    2.12
    
    
    
    4.03Granted
    
    
    1,428,000
    
    
    
    2.07Exercised
    
    
    (50,187
    )
    
    
    1.52Cancelled
    
    
    (290,868
    )
    
    
    2.56Outstanding, September 30, 2006
    
    
    6,164,591
    
    
    $
    2.09
    
    
    
    4.80Options excercisable at September 30, 2006
    
    
    3,803,523
    
    
    $
    2.00
  Note 11  Business Segment and Geographic Data:
    25




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##### Table of Contents



Three Months Ended September 30, 2006SURGICALINTERN'L
    
    
    
    
    
    
    
    
    
    
    PRODUCTSDOMESTIC
    
    
    DERM.
    
    
    SKIN
    
    
    SURGICAL
    
    
    ANDXTRAC
    
    
    EQUIPMENT
    
    
    CARE
    
    
    SERVICES
    
    
    OTHER
    
    
    TOTALRevenues
    
    $
    1,601,125
    
    
    $
    616,342
    
    
    $
    3,050,249
    
    
    $
    1,793,088
    
    
    $
    1,230,743
    
    
    $
    8,291,547Costs of revenues
    
    
    1,224,007
    
    
    
    320,502
    
    
    
    913,012
    
    
    
    1,409,453
    
    
    
    791,962
    
    
    
    4,658,936Gross profit
    
    
    377,118
    
    
    
    295,840
    
    
    
    2,137,237
    
    
    
    383,635
    
    
    
    438,781
    
    
    
    3,632,611Gross profit %
    
    
    23.6
    %
    
    
    48.0
    %
    
    
    70.1
    %
    
    
    21.4
    %
    
    
    35.7
    %
    
    
    43.8
    %Allocated Operating
expenses:Selling, general
and administrative
    
    
    987,163
    
    
    
    60,876
    
    
    
    1,300,536
    
    
    
    226,436
    
    
    
    120,908
    
    
    
    2,695,919Engineering and
product
development
    
    
    
    
    
    
    
    
    
    
    144,996
    
    
    
    
    
    
    
    122,066
    
    
    
    267,062Unallocated
Operating expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,203,485987,163
    
    
    
    60,876
    
    
    
    1,445,532
    
    
    
    226,436
    
    
    
    242,974
    
    
    
    5,166,466Income (loss) from
operations
    
    
    (610,045
    )
    
    
    234,964
    
    
    
    691,705
    
    
    
    157,199
    
    
    
    195,808
    
    
    
    (1,533,855
    )Interest expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (159,180
    )Net income (loss)
    
    
    ($610,045
    )
    
    $
    234,964
    
    
    $
    691,705
    
    
    $
    157,199
    
    
    $
    195,808
    
    
    
    ($1,693,035
    )
 Three Months Ended September 30, 2005INTERN'L
    
    
    
    
    
    
    
    
    
    
    SURGICALDOMESTIC
    
    
    DERM.
    
    
    SKIN
    
    
    SURGICAL
    
    
    PRODUCTSXTRAC
    
    
    EQUIPMENT
    
    
    CARE
    
    
    SERVICES
    
    
    AND OTHER
    
    
    TOTALRevenues
    
    $
    1,019,184
    
    
    $
    299,176
    
    
    $
    2,928,681
    
    
    $
    1,903,336
    
    
    $
    1,473,461
    
    
    $
    7,623,838Costs of revenues
    
    
    859,061
    
    
    
    244,065
    
    
    
    869,405
    
    
    
    1,465,502
    
    
    
    865,351
    
    
    
    4,303,384Gross profit
    
    
    160,123
    
    
    
    55,111
    
    
    
    2,059,276
    
    
    
    437,834
    
    
    
    608,110
    
    
    
    3,320,454Gross profit %
    
    
    15.7
    %
    
    
    18.4
    %
    
    
    70.3
    %
    
    
    23.0
    %
    
    
    41.3
    %
    
    
    43.6
    %Allocated Operating
expenses:Selling, general
and administrative
    
    
    703,924
    
    
    
    46,407
    
    
    
    1,574,059
    
    
    
    308,701
    
    
    
    157,269
    
    
    
    2,790,360Engineering and
product
development
    
    
    
    
    
    
    
    
    
    
    142,948
    
    
    
    
    
    
    
    161,987
    
    
    
    304,935Unallocated
Operating expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,735,818703,924
    
    
    
    46,407
    
    
    
    1,717,007
    
    
    
    308,701
    
    
    
    319,256
    
    
    
    4,831,113Income (loss) from
operations
    
    
    (543,801
    )
    
    
    8,704
    
    
    
    342,269
    
    
    
    129,133
    
    
    
    288,854
    
    
    
    (1,510,659
    )Other income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    244,988Interest expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (84,229
    )Net income (loss)
    
    
    ($543,801
    )
    
    $
    8,704
    
    
    $
    342,269
    
    
    $
    129,133
    
    
    $
    288,854
    
    
    
    ($1,349,900
    )
  26




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##### Table of Contents



Nine Months Ended September 30, 2006SURGICALINTERN'L
    
    
    
    
    
    
    
    
    
    
    PRODUCTSDOMESTIC
    
    
    DERM.
    
    
    SKIN
    
    
    SURGICAL
    
    
    ANDXTRAC
    
    
    EQUIPMENT
    
    
    CARE
    
    
    SERVICES
    
    
    OTHER
    
    
    TOTALRevenues
    
    $
    3,988,970
    
    
    $
    1,438,023
    
    
    $
    9,580,637
    
    
    $
    5,158,437
    
    
    $
    4,430,385
    
    
    $
    24,596,452Costs of revenues
    
    
    3,050,083
    
    
    
    772,861
    
    
    
    2,905,252
    
    
    
    4,187,792
    
    
    
    2,675,036
    
    
    
    13,591,024Gross profit
    
    
    938,887
    
    
    
    665,162
    
    
    
    6,675,385
    
    
    
    970,645
    
    
    
    1,755,349
    
    
    
    11,005,428Gross profit %
    
    
    23.5
    %
    
    
    46.3
    %
    
    
    69.7
    %
    
    
    18.8
    %
    
    
    39.6
    %
    
    
    44.7
    %Allocated Operating
expenses:Selling, general
and administrative
    
    
    3,092,163
    
    
    
    122,443
    
    
    
    3,942,482
    
    
    
    732,085
    
    
    
    399,506
    
    
    
    8,288,679Engineering and
product
development
    
    
    
    
    
    
    
    
    
    
    377,251
    
    
    
    
    
    
    
    387,194
    
    
    
    764,445Unallocated
Operating expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,917,3623,092,163
    
    
    
    122,443
    
    
    
    4,319,733
    
    
    
    732,085
    
    
    
    786,700
    
    
    
    15,970,486Income (loss) from
operations
    
    
    (2,153,276
    )
    
    
    542,719
    
    
    
    2,355,652
    
    
    
    238,560
    
    
    
    968,649
    
    
    
    (4,965,058
    )Interest expense, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (418,170
    )Net income (loss)
    
    
    ($2,153,276
    )
    
    $
    542,719
    
    
    $
    2,355,652
    
    
    $
    238,560
    
    
    $
    968,649
    
    
    
    ($5,383,228
    )
 Nine Months Ended September 30, 2005SURGICALINTERN'L
    
    
    
    
    
    
    
    
    
    
    PRODUCTSDOMESTIC
    
    
    DERM.
    
    
    SKIN
    
    
    SURGICAL
    
    
    ANDXTRAC
    
    
    EQUIPMENT
    
    
    CARE
    
    
    SERVICES
    
    
    OTHER
    
    
    TOTALRevenues
    
    $
    2,542,373
    
    
    $
    901,561
    
    
    
    7,074,196
    
    
    $
    5,977,366
    
    
    $
    4,166,844
    
    
    $
    20,662,340Costs of revenues
    
    
    1,952,232
    
    
    
    637,815
    
    
    
    2,154,700
    
    
    
    4,283,181
    
    
    
    2,130,016
    
    
    
    11,157,944Gross profit
    
    
    590,141
    
    
    
    263,746
    
    
    
    4,919,496
    
    
    
    1,694,185
    
    
    
    2,036,828
    
    
    
    9,504,396Gross profit %
    
    
    23.2
    %
    
    
    29.3
    %
    
    
    69.5
    %
    
    
    28.3
    %
    
    
    48.9
    %
    
    
    46.0
    %Allocated Operating
expenses:Selling, general
and
administrative
    
    
    1909,846
    
    
    
    200,034
    
    
    
    3,735,087
    
    
    
    930,000
    
    
    
    460,665
    
    
    
    7,235,632Engineering and
product
development
    
    
    
    
    
    
    
    
    
    
    310,661
    
    
    
    
    
    
    
    509,184
    
    
    
    819,845Unallocated
Operating expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,708,9611,909,846
    
    
    
    200,034
    
    
    
    4,045,748
    
    
    
    930,000
    
    
    
    969,849
    
    
    
    12,764,438Income (loss) from
operations
    
    
    (1,319,705
    )
    
    
    63,712
    
    
    
    873,748
    
    
    
    764,185
    
    
    
    1,066,982
    
    
    
    (3,260,042
    )Other income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    333,655Interest expense
(income), net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (212,276
    )Net income (loss)
    
    
    ($1,319,705
    )
    
    $
    63,712
    
    
    
    873,748
    
    
    $
    764,185
    
    
    $
    1,066,982
    
    
    
    ($3,138,663
    )
  27




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##### Table of Contents



September 30, 2006
    
    
    December 31, 2005Assets:Total assets for reportable segments
    
    $
    43,479,161
    
    
    $
    42,341,988Other unallocated assets
    
    
    5,444,704
    
    
    
    6,333,618Consolidated total
    
    $
    48,923,865
    
    
    $
    48,675,606
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Domestic
    
    $
    6,731,703
    
    
    $
    6,986,126
    
    
    $
    20,524,943
    
    
    $
    18,669,378Foreign
    
    
    1,559,844
    
    
    
    637,712
    
    
    
    4,071,509
    
    
    
    1,992,962$
    8,291,547
    
    
    $
    7,623,838
    
    
    $
    24,596,452
    
    
    $
    20,662,340
 Note 12  Significant Alliances/Agreements:
 ®
      28




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##### Table of Contents



Note 13  Subsequent event:
   
 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
  
    
    Domestic XTRAC,
 
    
    International Dermatology Equipment,
 
    
    Skin Care (ProCyte),
 
    
    Surgical Services, and
 
    
    Surgical Products.
  29




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##### Table of Contents



Domestic XTRAC
 ®
    International Dermatology Equipment
    30




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##### Table of Contents



Skin Care (ProCyte)
  Acquisitions,
    Surgical Services
   Surgical Products
 ®
 Critical Accounting Policies
   31




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##### Table of Contents



Results of Operations
 Revenues
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005 *XTRAC Domestic Services
    
    $
    1,601,125
    
    
    $
    1,019,184
    
    
    $
    3,988,970
    
    
    $
    2,542,373International Dermatology
Equipment Products
    
    
    616,342
    
    
    
    299,176
    
    
    
    1,438,023
    
    
    
    901,561Skin Care (ProCyte) Products
    
    
    3,050,249
    
    
    
    2,928,681
    
    
    
    9,580,637
    
    
    
    7,074,196Total Dermatology Revenues
    
    
    5,267,716
    
    
    
    4,247,041
    
    
    
    15,007,630
    
    
    
    10,518,130Surgical Services
    
    
    1,793,088
    
    
    
    1,903,336
    
    
    
    5,158,437
    
    
    
    5,977,366Surgical Products
    
    
    1,230,743
    
    
    
    1,473,461
    
    
    
    4,430,385
    
    
    
    4,166,844Total Surgical Revenues
    
    
    3,023,831
    
    
    
    3,376,797
    
    
    
    9,588,822
    
    
    
    10,144,210Total Revenues
    
    $
    8,291,547
    
    
    $
    7,623,838
    
    
    $
    24,596,452
    
    
    $
    20,662,340
  Domestic XTRAC Segment
    32




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Total revenue
    
    $
    1,601,125
    
    
    $
    1,019,184
    
    
    $
    3,988,970
    
    
    $
    2,542,373Less: laser sales revenue
    
    
    (338,125
    )
    
    
    
    
    
    
    (338,125
    )
    
    
    Recognized treatment revenue
    
    
    1,263,000
    
    
    
    1,019,184
    
    
    
    3,650,845
    
    
    
    2,542,373Change in deferred program
revenue
    
    
    (54,211
    )
    
    
    25,375
    
    
    
    102,257
    
    
    
    58,090Change in deferred unused
treatments
    
    
    114,410
    
    
    
    (128,091
    )
    
    
    200,683
    
    
    
    (32,291
    )Net billed treatment revenue
    
    $
    1,323,199
    
    
    $
    916,468
    
    
    $
    3,953,785
    
    
    $
    2,568,172Procedure volume total
    
    
    22,204
    
    
    
    15,690
    
    
    
    64,981
    
    
    
    43,611Less: Non-billed procedures
    
    
    2,161
    
    
    
    1,814
    
    
    
    4,813
    
    
    
    4,620Net billed procedures
    
    
    20,043
    
    
    
    13,876
    
    
    
    60,168
    
    
    
    38,991Avg. price of treatments billed
    
    $
    66.02
    
    
    $
    66.05
    
    
    $
    65.71
    
    
    $
    65.87Change in procedures with
(recognized)/deferred program
revenue, net
    
    
    (821
    )
    
    
    384
    
    
    
    1,556
    
    
    
    882Change in procedures with
deferred/(recognized) unused
treatments, net
    
    
    1,733
    
    
    
    (1,939
    )
    
    
    3,054
    
    
    
    (490
    )
  International Dermatology Equipment Segment
  
    
    We have begun selling refurbished domestic XTRAC laser systems into
the international market. The selling price for used equipment is substantially
less than new equipment. We sold one and
six of these used lasers at an average price of $35,000 and $28,000 for the three
and nine months ended September 30, 2006, respectively; and
  33




---



##### Table of Contents




    
    We have begun selling the new VTRAC, a lamp-based, alternative UVB
light source that has a wholesale sales price that is substantially below our
competitors international dermatology equipment. In the three and nine months
ended September 30, 2006, we sold six and ten VTRAC systems, respectively.
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    616,342
    
    
    $
    299,176
    
    
    $
    1,438,023
    
    
    $
    901,561Laser systems sold
    
    
    13
    
    
    
    5
    
    
    
    31
    
    
    
    16Average revenue per laser
    
    $
    47,411
    
    
    $
    59,835
    
    
    $
    46,388
    
    
    $
    56,348
 Skin Care (ProCyte) Segment
    Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Product sales
    
    $
    2,901,891
    
    
    $
    2,704,340
    
    
    $
    8,818,267
    
    
    $
    6,164,280Bulk compound sales
    
    
    112,400
    
    
    
    84,000
    
    
    
    496,400
    
    
    
    587,550Royalties
    
    
    35,958
    
    
    
    140,341
    
    
    
    265,970
    
    
    
    322,366Total ProCyte revenues
    
    $
    3,050,249
    
    
    $
    2,928,681
    
    
    $
    9,580,637
    
    
    $
    7,074,196
 Surgical Services Segment
   34




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    1,793,088
    
    
    $
    1,903,336
    
    
    $
    5,158,437
    
    
    $
    5,977,366
 Surgical Products Segment
      Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    1,230,743
    
    
    $
    1,473,461
    
    
    $
    4,430,385
    
    
    $
    4,166,844Laser systems sold
    
    
    16
    
    
    
    15
    
    
    
    61
    
    
    
    32Laser system revenues
    
    $
    305,625
    
    
    $
    452,750
    
    
    $
    1,397,965
    
    
    $
    1,102,445Average revenue per laser
    
    $
    19,102
    
    
    $
    30,183
    
    
    $
    22,917
    
    
    $
    34,451
  35




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##### Table of Contents



Cost of Revenues
       Gross Margin Analysis
   36




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Company Margin Analysis
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    8,291,547
    
    
    $
    7,623,838
    
    
    $
    24,596,452
    
    
    $
    20,662,340Percent increase
    
    
    8.8
    %
    
    
    
    
    
    
    19.0
    %Cost of revenues
    
    
    4,658,936
    
    
    
    4,303,384
    
    
    
    13,591,024
    
    
    
    11,157,944Percent increase
    
    
    8.3
    %
    
    
    
    
    
    
    21.8
    %Gross profit
    
    $
    3,632,611
    
    
    $
    3,320,454
    
    
    $
    11,005,428
    
    
    $
    9,504,396Gross profit percentage
    
    
    43.8
    %
    
    
    43.6
    %
    
    
    44.7
    %
    
    
    46.0
    %
  
    
    Our skin care business has the highest gross profit percentage of any of our
business segments. However, we acquired ProCyte on March 18, 2005, and, as such, the
operating results of ProCyte for the nine months ended September 30, 2005 only included
activity from March 19, 2005 through September 30, 2005.
 
    
    We sold a greater number of treatment procedures for the XTRAC laser systems in 2006
than in 2005. Each incremental treatment procedure carries negligible variable cost.
The increase in procedure volume was a direct result of improving insurance
reimbursement and increased marketing efforts.
 
    
    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 a gross
margin of approximately 36%.
 
    
    We sold XTRAC lasers domestically during the three and nine months ended September
30, 2006. The gross margin on these sales are higher, approximately 72%, since certain
of the lasers were previously being depreciated.
 
    
    Offsetting the above was an increase in depreciation of $126,000 and $556,000
included in the XTRAC domestic cost of sales as a result of increasing the overall
placements of new lasers since the periods ended September 30, 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 cost of goods sold
for the nine months ended September 30, 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.
  37




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,XTRAC Domestic Segment
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    1,601,125
    
    
    $
    1,019,184
    
    
    $
    3,988,970
    
    
    $
    2,542,373Percent increase
    
    
    57.1
    %
    
    
    
    
    
    
    56.9
    %Cost of revenues
    
    
    1,224,007
    
    
    
    859,061
    
    
    
    3,050,083
    
    
    
    1,952,233Percent increase
    
    
    42.5
    %
    
    
    
    
    
    
    56.2
    %Gross profit
    
    $
    377,118
    
    
    $
    160,123
    
    
    $
    938,887
    
    
    $
    590,140Gross profit percentage
    
    
    23.6
    %
    
    
    15.7
    %
    
    
    23.5
    %
    
    
    23.2
    %
  
    
    We sold XTRAC lasers domestically during the three and nine months ended September
30, 2006. The gross margin on these sales are higher, approximately 72%, since certain
of the lasers were previously being depreciated.
 
    
    A key driver in increased revenue in this segment is insurance reimbursement and
increased direct-to-consumer advertising in targeted territories. In 2005, several
private health insurance plans adopted a favorable policy to cover the medically
necessary treatment of psoriasis using our XTRAC laser system (e.g. United Healthcare,
Highmark, Independence Blue Cross, Empire BCBS, Cigna, Premera, Blue Cross of
Michigan). These insurers added to the group of companies that had already adopted a
favorable policy in 2004. In 2006, we increased our level of direct-to-consumer
advertising to recruit patients to dermatologists office to seek treatment with the
XTRAC laser system. While the advertising helped increase revenues, the advertising is
also costly. We continue to analyze and adjust the advertising campaigns for
cost-effectiveness.
 
    
    Procedure volume increased 44% from 13,876 to 20,043 billed procedures in the three
months ended September 30, 2006 compared to the same period in 2005. Procedure volume
increased 54% from 38,991 to 60,168 billed procedures in the nine months ended
September 30, 2006 compared to the same period in 2005. Price per procedure did not
change significantly between the periods.
 
    
    The cost of revenues increased by $364,946 for the three months ended September 30,
2006. This increase is due to the cost of sales for the lasers of $96,000 and to an
increase in depreciation on the lasers in service of $126,000 over the comparable prior
year period. The cost of revenues increased by $1,097,850 for the nine months ended
September 30, 2006. This increase is due to the cost of sales for the lasers of $96,000
and to an increase in depreciation on the lasers in service of $556,000 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.
  38




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedInternational Dermatology
    
    September 30,
    
    
    September 30,Equipment Segment
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    616,342
    
    
    $
    299,176
    
    
    $
    1,438,023
    
    
    $
    901,561Percent increase
    
    
    106.0
    %
    
    
    
    
    
    
    59.5
    %Cost of revenues
    
    
    320,502
    
    
    
    244,065
    
    
    
    772,861
    
    
    
    637,815Percent increase
    
    
    31.3
    %
    
    
    
    
    
    
    21.2
    %Gross profit
    
    $
    295,840
    
    
    $
    55,111
    
    
    $
    665,162
    
    
    $
    263,746Gross profit percentage
    
    
    48.0
    %
    
    
    18.4
    %
    
    
    46.3
    %
    
    
    29.3
    %
  
    
    We sold seven XTRAC laser systems and six VTRAC lamp-based excimer systems during
the three months ended September 30, 2006 and five XTRAC laser systems in the
comparable period in 2005. We sold 21 XTRAC laser systems and 10 VTRAC lamp-based
excimer systems during the nine months ended September 30, 2006 and 16 XTRAC laser
systems in the comparable period in 2005. The VTRAC systems have a higher gross margin
than the XTRAC laser systems.
 
    
    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 $83,000, the average price for lasers sold during this period was
approximately $41,100 in the three months ended September 30, 2006, down from $49,100
in the comparable period in 2005. Contributing to the overall decrease in the average
selling price in the three months ended September 30, 2006 was the sale of certain used
lasers which were previously deployed in U. S. operations and sold at a discount to the
list price for new equipment. We sold one of these used lasers at a price of $35,000.
This laser had a net book value that was less than the cost of a new XTRAC laser
system.
   39




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Skin Care (ProCyte) Segment
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Product revenues
    
    $
    2,901,891
    
    
    $
    2,704,340
    
    
    $
    8,818,267
    
    
    $
    6,164,280Bulk compound revenues
    
    
    112,400
    
    
    
    84,000
    
    
    
    496,400
    
    
    
    587,550Royalties
    
    
    35,958
    
    
    
    140,341
    
    
    
    265,970
    
    
    
    322,366Total revenues
    
    
    3,050,249
    
    
    
    2,928,681
    
    
    
    9,580,637
    
    
    
    7,074,196Percent
Increase
    
    
    4.2
    %
    
    
    
    
    
    
    35.4
    %Product cost of revenues
    
    
    843,253
    
    
    
    817,272
    
    
    
    2,597,174
    
    
    
    1,744,225Bulk compound cost of revenues
    
    
    69,759
    
    
    
    52,133
    
    
    
    308,078
    
    
    
    410,475Total cost of revenues
    
    
    913,012
    
    
    
    869,405
    
    
    
    2,905,252
    
    
    
    2,154,700Percent
Increase
    
    
    5.0
    %
    
    
    
    
    
    
    34.8
    %Gross profit
    
    $
    2,137,237
    
    
    $
    2,059,276
    
    
    $
    6,675,385
    
    
    $
    4,919,496Gross profit percentage
    
    
    70.1
    %
    
    
    70.3
    %
    
    
    69.7
    %
    
    
    69.5
    %
  
    
    Skin Care (ProCyte) business was acquired on March 18, 2005 and, as such, the
operating results of ProCyte for the nine months ended September 30, 2005 only included
activity from March 19, 2005 through September 30, 2005.
 
    
    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.
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Surgical Services Segment
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    1,793,088
    
    
    $
    1,903,336
    
    
    $
    5,158,437
    
    
    $
    5,977,366Percent decrease
    
    
    (5.8
    %)
    
    
    
    
    
    
    (13.7
    %)Cost of revenues
    
    
    1,409,453
    
    
    
    1,465,502
    
    
    
    4,187,792
    
    
    
    4,283,181Percent decrease
    
    
    (3.8
    %)
    
    
    
    
    
    
    (2.2
    %)Gross profit
    
    $
    383,635
    
    
    $
    437,834
    
    
    $
    970,645
    
    
    $
    1,694,185Gross profit percentage
    
    
    21.4
    %
    
    
    23.0
    %
    
    
    18.8
    %
    
    
    28.3
    %
  
    
    We have closed six territories 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
and nine months ended September 30, 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.
  40




---



##### Table of Contents




    
    We suffered business interruption due to hurricanes in the New Orleans and Alabama
territories during August and September 2005.
 
    
    Our product cost percentage has increased due to a change in the mix of procedures
performed.
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Surgical Products Segment
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues
    
    $
    1,230,743
    
    
    $
    1,473,461
    
    
    $
    4,430,385
    
    
    $
    4,166,844Percent (decrease) increase
    
    
    (16.5
    %)
    
    
    
    
    
    
    6.3
    %Cost of revenues
    
    
    791,962
    
    
    
    865,351
    
    
    
    2,675,036
    
    
    
    2,130,016Percent (decrease) increase
    
    
    (8.5
    %)
    
    
    
    
    
    
    25.6
    %Gross profit
    
    $
    438,781
    
    
    $
    608,110
    
    
    $
    1,755,349
    
    
    $
    2,036,828Gross profit percentage
    
    
    35.7
    %
    
    
    41.3
    %
    
    
    39.6
    %
    
    
    48.9
    %
  
    
    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 September 30, 2006 decreased by $242,718 from
the three months ended September 30, 2005 while cost of revenues decreased by $73,389
between the same periods. There was one more laser system sold in the three months
ended September 30, 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 September 30, 2006 and 2005 were
sales of $256,625 and $164,000 of diode lasers, respectively, which have substantially
lower list sales prices than the other types of surgical lasers.
 
    
    Revenues for the nine months ended September 30, 2006 increased by $263,541 from the
nine months ended September 30, 2005 while cost of revenues increased by $545,020
between the same periods. There were 29 more laser systems sold in the nine months
ended September 30, 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 nine months ended September 30, 2006 and 2005 were
sales of $897,915 and $378,000 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 nine months ended September
30, 2006.
 
    
    This revenue increase was partly offset by a decrease in AzurTec project revenues of
$157,000 and a decrease in sales of disposables between the periods. The AzurTec
revenues recognized in 2005 had substantially no associated direct costs. Disposables,
which have a higher gross margin as a percent of
revenues than lasers, represented a higher percentage of revenue in the three months
ended September 30, 2006 compared to the same period in 2005.
  41




---



##### Table of Contents



Selling, General and Administrative Expenses
 Stock-Based Compensation
 Stock-Based
Compensation
 Engineering and Product Development
  Other Income
   Interest Expense, Net
  Net Loss
   42




---



##### Table of Contents



For the three months ended September 30,2006
    
    
    2005
    
    
    ChangeNet Loss
    
    $
    1,693,035
    
    
    $
    1,349,900
    
    
    $
    343,135Major Expenses included in net loss:Depreciation and amortization
    
    
    1,047,178
    
    
    
    883,961
    
    
    
    163,217Stock-based compensation
    
    
    349,553
    
    
    
    
    
    
    
    349,553$
    1,396,731
    
    
    $
    883,961
    
    
    $
    512,770
 For the nine months ended September 30,2006
    
    
    2005
    
    
    ChangeNet Loss
    
    $
    5,383,228
    
    
    $
    3,138,663
    
    
    $
    2,244,565Major Expenses included in net loss:Depreciation and amortization
    
    
    3,101,689
    
    
    
    2,216,715
    
    
    
    884,974Stock-based compensation
    
    
    1,248,111
    
    
    
    
    
    
    
    1,248,111$
    4,349,800
    
    
    $
    2,216,715
    
    
    $
    2,133,085
  Liquidity and Capital Resources
     43




---



##### Table of Contents



Unregistered Sales of Equity
Securities and Use of Proceeds
 Long-term Debt
    Commitments and Contingencies
   44




---



##### Table of Contents



Impact of Inflation
  
 ITEM 3.
    
    Quantitative and Qualitative Disclosure about Market Risk
  
 ITEM 4.
    
    Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
  Change in Internal Control Over Financial Reporting
  
 PART II  Other Information
 
 ITEM 1.
    
    Legal Proceedings
 Legal Proceedings
    45




---



##### Table of Contents



ITEM 1A.
    
    Risk Factors
  
 ITEM 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
 Recent Issuances of Unregistered Securities
   
 ITEM 3.
    
    Defaults Upon Senior Securities
  
 ITEM 4.
    
    Submission of Matter to a Vote of Security Holders
  
 ITEM 5.
    
    Other Information
   46




---



##### Table of Contents



ITEM 6.
    
    Exhibits
 31.1
    
    
    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 to
Section 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 to
Section 906 of the Sarbanes-Oxley Act of 2002
 
 SIGNATURES
  PHOTOMEDEX, INC.Date:  November 9, 2006
    By:
    /s/  Jeffrey F. O'DonnellJeffrey F. O'DonnellPresident and Chief Executive OfficerDate:  November 9, 2006
    By:
    /s/  Dennis M. McGrathDennis M. McGrathChief Financial Officer  47




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##### Table of Contents



EXHIBIT INDEX
 ExhibitNo.
    
    Description31.1
    
    
    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 to
Section 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 to
Section 906 of the Sarbanes-Oxley Act of 2002
  48