**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, 2005**
 
 **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**
    **59-2058100**(State or other jurisdiction of incorporation or
      organization)
    (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 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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act.)
 Yes ý No  ̈
 
 The
number of shares outstanding of the issuer's Common Stock as of May 9, 2005 were
50,843,515 shares.
 
 
   
 PHOTOMEDEX,
INC. AND SUBSIDIARIES
 
 INDEX
 Part
I. Financial Information:  PAGE
 ITEM 1.
Financial Statements:
 
 
 a.
    Consolidated
      Balance Sheets, March 31, 2005 (unaudited) and
 December
      31, 2004 (based on audited statements)
    3
 
 b.
    Consolidated
      Statements of Operations for the three
months
 ended
      March 31, 2005 and 2004 (unaudited)
    4
  c.    
      Consolidated
      Statement of Stockholders’ Equity for the three months
    5
 ended March 31, 2005 (unaudited)
 
 d.
    Consolidated
      Statements of Cash Flows for the three
months
 ended
      March 31, 2005 and 2004 (unaudited)
    6
 
 e.
    Notes
      to Consolidated Financial Statements (unaudited)
    7
 
 ITEM 2. Management’s Discussion and Analysis of Financial Condition
      and
      Results of Operations
    23ITEM 3. Quantitative and Qualitative Disclosure about Market
      Risk
    41ITEM 4. Controls and Procedures
    42Part II. Other Information:ITEM 1. Legal Proceedings
    42ITEM 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
    42ITEM 3. Defaults Upon Senior Securities
    43ITEM 4. Submission of Matters to a Vote of Security
      Holders
    43ITEM 5. Other Information
    43ITEM 6. Exhibits
    44Signatures
    44Certifications
    45
 
 **PART
I - Financial Information**
  **ITEM
1. Financial Statements**
  PHOTOMEDEX,
INC. AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
  March
      31, 2005
    
    December
      31, 2004(Unaudited)
    
    ***ASSETS**Current
      assets:Cash
      and cash equivalents
    
    $
    7,287,916
    
    $
    3,884,817Restricted
      cash
    
    
    11,769
    
    
    112,200Accounts
      receivable, net of allowance for doubtful accounts of $940,351 and
      $736,505, respectively
    
    
    4,945,632
    
    
    4,117,399Inventories
    
    
    8,181,873
    
    
    4,585,631Prepaid
      expenses and other current assets
    
    
    567,497
    
    
    401,989Total
      current assets
    
    
    20,994,687
    
    
    13,102,036Property
      and equipment, net
    
    
    5,727,913
    
    
    4,996,688Goodwill,
      net
    
    
    15,939,350
    
    
    2,944,423Patents
      and licensed technologies, net
    
    
    1,080,164
    
    
    929,434Other
      intangible assets, net
    
    
    5,166,625
    
    
    -Other
      assets
    
    
    289,684
    
    
    989,345Total
      assets
    
    $
    49,198,423
    
    $
    22,961,926**LIABILITIES
      AND STOCKHOLDERS' EQUITY**Current
      liabilities:Current
      portion of notes payable
    
    $
    317,880
    
    $
    69,655Current
      portion of long-term debt
    
    
    886,813
    
    
    873,754Accounts
      payable
    
    
    3,910,246
    
    
    3,515,293Accrued
      compensation and related expenses
    
    
    1,381,065
    
    
    963,070Other
      accrued liabilities
    
    
    1,135,429
    
    
    924,054Deferred
      revenues
    
    
    649,715
    
    
    636,962Total
      current liabilities
    
    
    8,281,148
    
    
    6,982,788Notes
      payable
    
    
    19,888
    
    
    26,736Long-term
      debt
    
    
    1,175,191
    
    
    1,372,119Other
      liabilities
    
    
    29,023
    
    
    -Total
      liabilities
    
    
    9,505,250
    
    
    8,381,643Commitments
      and ContingenciesStockholders’
      equity:Common
      stock, $.01 par value, 75,000,000 shares authorized; 50,724,165 and
      40,075,019 shares issued and outstanding, respectively
    
    
    507,242
    
    
    400,750Additional
      paid-in capital
    
    
    116,690,024
    
    
    90,427,632Accumulated
      deficit
    
    
    (77,374,674
    )
    
    (76,246,562
    )Deferred
      compensation
    
    
    (129,419
    )
    
    (1,537
    )Total
      stockholders' equity
    
    
    39,693,173
    
    
    14,580,283Total
      liabilities and stockholders’ equity
    
    $
    49,198,423
    
    $
    22,961,926
  * The
December 31, 2004 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 31,2005
    
    2004Revenues:Product
      sales
    
    $
    2,225,699
    
    $
    1,792,400Services
    
    
    2,757,633
    
    
    2,232,8304,983,332
    
    
    4,025,230Cost
      of revenues:Product
      cost of revenues
    
    
    892,964
    
    
    832,484Services
      cost of revenues
    
    
    1,739,404
    
    
    1,661,5822,632,368
    
    
    2,494,066Gross
      profit
    
    
    2,350,964
    
    
    1,531,164Operating
      expenses:Selling,
      general and administrative
    
    
    3,220,976
    
    
    2,470,424Engineering
      and product development
    
    
    186,971
    
    
    415,9503,407,947
    
    
    2,886,374Loss
      from operations
    
    
    (1,056,983
    )
    
    (1,355,210
    )Interest
      expense, net
    
    
    71,129
    
    
    7,872Net
      loss
    
    
    ($
      1,128,112
    )
    
    ($
      1,363,082
    )Basic
      and diluted net loss per share
    
    
    ($0.03
    )
    
    ($0.04
    )Shares
      used in computing basic and diluted net loss per share
    
    
    41,755,950
    
    
    37,773,301

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


4
 PHOTOMEDEX,
INC. AND SUBSIDIARIES CONSOLIDATED
STATEMENT OF STOCKHOLDERS’ EQUITY
  (Unaudited)
  AdditionalCommon
      Stock
    
    Paid-In
    
    Accumulated
    
    DeferredShares
    
    Amount
    
    Capital
    
    Deficit
    
    Compensation
    
    TotalBALANCE,
      DECEMBER 31, 2004
    
    
    40,075,019
    
    $
    400,750
    
    $
    90,427,632
    
    
    ($76,246,562
    )
    
    ($
      1,537
    )
    $
    14,580,283Exercise
      of warrants
    
    
    73,530
    
    
    736
    
    
    146,324
    
    
    -
    
    
    -
    
    
    147,060Exercise
      of stock options
    
    
    35,037
    
    
    350
    
    
    52,798
    
    
    -
    
    
    -
    
    
    53,148Acquisition
      of ProCyte
    
    
    10,540579,
    
    
    105,406
    
    
    26,197,732
    
    
    -
    
    
    (132,081
    )
    
    26,171,057Amortization
      of deferred compensation
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    4,199
    
    
    4,199Registration
      expenses
    
    
    -
    
    
    -
    
    
    (134,462
    )
    
    -
    
    
    -
    
    
    (134,462
    )Net
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,128,112
    )
    
    -
    
    
    (1,128,112
    )BALANCE,
      MARCH 31, 2005
    
    
    50,724,165
    
    $
    507,242
    
    $
    116,690,024
    
    
    ($77,374,674
    )
    
    ($129,419
    )
    $
    39,693,173
  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 EndedMarch
      31,2005
    
    2004**Cash
      Flows From Operating Activities**:Net
      loss
    
    
    ($
      1,128,112
    )
    
    ($
      1,363,082
    )Adjustments
      to reconcile net loss to net cash usedin
      operating activities:Depreciation
      and amortization
    
    
    526,396
    
    
    493,745Stock
      options issued to consultants for services
    
    
    -
    
    
    48,192Amortization
      of deferred compensation
    
    
    4,199
    
    
    1,620Provision
      for bad debts
    
    
    167,412
    
    
    -Changes
      in operating assets and liabilities, net of effects of acquired assets and
      liabilities:Accounts
      receivable
    
    
    141,768
    
    
    (273,070
    )Inventories
    
    
    (769,136
    )
    
    19,025Prepaid
      expenses and other assets
    
    
    192,129
    
    
    65,865Accounts
      payable
    
    
    (210,567
    )
    
    119,443Accrued
      compensation and related expenses
    
    
    266,688
    
    
    (134,768
    )Other
      accrued liabilities
    
    
    (781,200
    )
    
    (110,761
    )Cash
      deposits
    
    
    9,000
    
    
    -Deferred
      revenues
    
    
    (82,683
    )
    
    144,757Other
      liabilities
    
    
    (23,860
    )
    
    -Net
      cash used in operating activities
    
    
    (1,687,966
    )
    
    (989,034
    )**Cash
      Flows From Investing Activities:**Purchases
      of property and equipment
    
    
    (56,382
    )
    
    (11,137
    )Lasers
      placed into service
    
    
    (722,509
    )
    
    (481,398
    )Cash
      received from acquisition, net of costs incurred
    
    
    6,014,450
    
    
    -Net
      cash provided by (used in) investing activities
    
    
    5,235,559
    
    
    (492,535
    )**Cash
      Flows From Financing Activities:**Proceeds
      from issuance of common stock, net of direct issuance
costs
    
    
    (134,462
    )
    
    11,199Proceeds
      from exercise of options
    
    
    53,148
    
    
    -Proceeds
      from exercise of warrants
    
    
    147,060
    
    
    814,231Payments
      on long-term debt
    
    
    (70,131
    )
    
    (68,997
    )Payments
      on notes payable
    
    
    (86,225
    )
    
    (82,376
    )Net
      repayments on lease line of credit
    
    
    (154,315
    )
    
    -Decrease
      in restricted cash, cash equivalentsand
      short-term investments
    
    
    100,431
    
    
    -Net
      cash (used in) provided by financing activities
    
    
    (144,494
    )
    
    674,057Net
      increase (decrease) in cash and cash equivalents
    
    
    3,403,099
    
    
    (807,512
    )Cash
      and cash equivalents, beginning of period
    
    
    3,884,817
    
    
    6,633,468Cash
      and cash equivalents, end of period
    
    $
    7,287,916
    
    $
    5,825,956
  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*
  **The
Company and Summary of Significant Accounting Policies:**
  **The
Company:**
  ***Background***
 PhotoMedex,
Inc. and 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 develops, manufactures and
markets excimer-laser-based instrumentation designed 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. In March 2001, the Company received FDA clearance to treat vitiligo;
in August 2001, the Company received FDA clearance to treat atopic dermatitis;
and in May 2002, the FDA granted 510(k) clearance to market the XTRAC system for
the treatment of leukoderma. The Company launched the XTRAC phototherapy
treatment system commercially in the United States in August 2000.
  Beginning
with the acquisition of Surgical Laser Technologies, Inc. (“SLT”) on December
27, 2002, the Company also develops, manufactures and markets proprietary lasers
and delivery systems for both contact and non-contact surgery and provides
surgical services utilizing these and other manufacturers’ products.
  Through
the acquisition of ProCyte Corporation (“ProCyte”) on March 18, 2005, the
Company also 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.
  ***Liquidity
and Going Concern***
 The
Company has incurred significant losses and has had negative cash flows from
operations since emerging from bankruptcy in May 1995. As of March 31,
2005, the Company had an accumulated deficit of $77,374,674. However, the
Company was successful in reducing its net loss for the three months ended
March 31, 2005 by $234,970 compared to the three months ended
March 31, 2004. The Company has historically financed its activities from
operations and the private placement of equity securities. To date, the Company
has dedicated most of its financial resources to research and development,
marketing and general and administrative expenses.
  To
increase patient acceptance of targeted UVB therapy for skin disorders using the
XTRAC, the Company needed to obtain newly established current procedural
terminology (“CPT”) codes from the American Medical Association, which occurred
in the latter part of 2002. By early 2003, the Centers for Medicare and Medicaid
Services (“CMS”) had approved rates of reimbursement for the newly established
CPT codes. The Company further required adoption by private health insurance
carriers of a medical policy to reimburse patients for the treatment. During the
first quarter of 2003, the Company re-launched the marketing of its XTRAC system
in the United States following the issuance of CPT codes and associated
reimbursement rates by the CMS. At the same time, the Company has focused its
efforts on securing approval by various private health plans to reimburse for
treatments of psoriasis using the XTRAC.
  The
Company plans to continue to focus on securing reimbursement from more private
insurers and to devote sales and marketing efforts in the areas where such
reimbursement has become available. As favorable momentum is achieved, the
Company will spend substantial amounts on the marketing of its psoriasis,
vitiligo, atopic dermatitis and leukoderma treatment products and expansion of
its manufacturing operations. Notwithstanding the approval by CMS for Medicare
and Medicaid reimbursement and recent approvals by certain private insurers, the
Company may continue to face resistance from private healthcare insurers to
adopt the excimer-laser-based therapy as an approved procedure. Management
cannot provide assurance that the Company will market the product successfully,
operate profitably in the future, or that it will not require significant
additional financing in order to accomplish its business plan.
  The
Company’s future revenues and success depend upon increased patient acceptance
of its excimer-laser-based systems for the treatment of a variety of skin
disorders. The Company’s excimer-laser-based system for the treatment of
psoriasis, vitiligo, atopic dermatitis and leukoderma is currently generating
revenues in both the United States and abroad. The Company’s ability to
introduce successful new products based on its business focus and the expected
benefits to be obtained from these products may be adversely affected by a
number of factors, such as unforeseen costs and expenses, technological change,
economic downturns, competitive factors or other events beyond the Company’s
control. Consequently, the Company’s historical operating results cannot be
relied upon, as indicators 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.
  7
 Cash and
cash equivalents were $7,299,685, including restricted cash of $11,769, as of
March 31, 2005. Management believes that the existing cash balance together
with its existing financial resources, including the leasing credit line
facility (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 through the second quarter of 2006. The 2005 operating
plan reflects anticipated growth from an increase in per-treatment fee revenues
for use of the XTRAC system based on wider insurance coverage in the United
States and continuing costs savings from the integration of the combined
companies. In addition, the 2005 operating plan calls for increased revenues and
profits from its newly acquired business, ProCyte, and the continued growth of
its 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 2005. There can be no assurance that additional financing, if
needed, will be available when required or, if available, could be obtained on
terms satisfactory to the Company.
  **Summary
of Significant Accounting Policies:**
  ***Quarterly
Financial Information and Results of Operations***
 The
financial statements as of March 31, 2005 and for the three months ended
March 31, 2005 and 2004, are unaudited and, in the opinion of management,
include all adjustments (consisting only of normal recurring adjustments)
necessary to present fairly the financial position as of March 31, 2005,
and the results of operations and cash flows for the three months ended
March 31, 2005 and 2004. The results for the three months ended
March 31, 2005 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, 2004.
  ***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 perceived 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 ***Revenue
Recognition*** for
discussion of updates and changes in estimates for XTRAC domestic revenues in
accordance with Staff Accounting Bulletin Nos. 101 and 104 and Statement of
Financial Accounting Standards (“SFAS”) No. 48.
  ***Cash
and Cash Equivalents***
 The
Company invests its excess cash in highly liquid, short-term investments. The
Company considers short-term investments that are purchased with an original
maturity of three months or less to be cash equivalents. Cash and cash
equivalents consisted of cash and money market accounts at March 31, 2005
and December 31, 2004 . Cash
that is pledged to secure obligations is disclosed separately as restricted
cash. The Company maintains its cash and cash equivalents in accounts in several
banks, the balances which at times may exceed federally insured
limits.
  ***Accounts
Receivable***
 The
majority of the Company’s accounts receivables are due from distributors
(domestic and international), hospitals, universities and physicians and other
entities in the medical field. Credit is extended based on evaluation of a
customer’s financial condition and, generally, collateral is not required.
Accounts receivable are most often due within 30 to 90 days and are stated at
amounts due from customers net of an allowance for doubtful accounts. Accounts
outstanding longer than the contractual payment terms are considered past due.
The Company determines its allowance by considering a number of factors,
including the length of time trade accounts receivable are past due, the
customer’s previous loss history, the customer’s current ability to pay its
obligation to the Company, and the condition of the general economy and the
industry as a whole. The Company writes-off accounts receivable when they become
uncollectible, and payments subsequently received on such receivables are
credited to the allowance for doubtful accounts. The Company does not accrue
interest on accounts receivable that are past due.
  8
 ***Inventories***
 Inventories
are stated at the lower of cost (first-in, first-out basis) or market. Cost is
determined to be purchased cost for raw materials and the production cost
(materials, labor and indirect manufacturing cost) for work-in-process and
finished goods. Throughout the laser manufacturing process, the related
production costs are recorded within the cost of inventory. Work-in-process is
immaterial, given the typically short manufacturing cycle, and therefore is
disclosed in conjunction with raw materials. The Company performs full physical
inventory counts for XTRAC and cycle counts on the other inventory to maintain
controls and obtain accurate data.
  The
Company's skin disorder treatment equipment will either (i) be sold to
distributors or physicians directly or (ii) be placed in a physician's office
and remain the property of the Company. The cost to build a laser, whether for
sale or for placement, is accumulated in inventory. When a laser is placed in a
physician’s office, the cost is transferred from inventory to “lasers in
service” within property and equipment. At times, units are shipped to
distributors, but revenue is not recognized until all of the criteria of Staff
Accounting Bulletin No. 104 have been met, and until that time, the unit is
carried on the books of the Company as inventory. Revenue is not recognized from
these distributors until payment is either assured or paid in full. Until this
time, the cost of these shipments continues to be recorded as finished goods
inventory.
  Reserves
for slow moving and obsolete inventories are provided based on historical
experience and product demand. Management evaluates the adequacy of these
reserves periodically based on forecasted sales and market trend.
  ***Property,
Equipment and Depreciation***
 Property
and equipment are recorded at cost. Excimer lasers-in-service are depreciated on
a straight-line basis over the estimated useful life of three years. Surgical
lasers-in-service are depreciated on a straight-line basis over an estimated
useful life of seven years if new, and five years or less if used equipment. The
straight-line depreciation basis for lasers-in-service is reflective of the
pattern of use. For other property and equipment, depreciation is calculated on
a straight-line basis over the estimated useful lives of the assets, primarily
three to seven years for computer hardware and software, furniture and fixtures,
automobiles, and machinery and equipment. Leasehold improvements are amortized
over the lesser of the useful lives or lease terms. Expenditures for major
renewals and betterments to property and equipment are capitalized, while
expenditures for maintenance and repairs are charged to operations as incurred.
Upon retirement or disposition, the applicable property amounts are deducted
from the accounts and any gain or loss is recorded in the consolidated
statements of operations.
  Laser
units and laser accessories located at medical facilities for sales evaluation
and demonstration purposes or those units/accessories used for development and
medical training are included in property and equipment under the caption
“machinery and equipment.” These units and accessories are being depreciated
over a period of up to five years. Laser units utilized in the provision of
surgical services or in the treatment of skin disorders are included, as
discussed above, in property and equipment under the caption “lasers in
service.”
  Management
evaluates the realizability of property and equipment 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 its net realizable value.
As of March 31, 2005, no such write-down was required (see ***Impairment
of Long-Lived Assets*** below).
  ***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 recorded in connection with the acquisition of ProCyte
in March 2005 and is being amortized on a straight-line basis over seven
years.
  9
 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, 2005, no such write-down was required (see ***Impairment
of Long-Lived Assets*** below).
  ***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 five to
ten 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, 2005, no such write-down was required (see ***Impairment
of Long-Lived Assets*** below).
  ***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, 2005 is summarized as follows:
  March
      31, 2005Accrual
      at beginning of period
    
    $
    196,890Additions
      charged to warranty expense
    
    
    21,000Claims
      paid and expiring warranties
    
    
    (33,429
    )Accrual
      at end of period
    
    $
    184,461
  ***Revenue
Recognition***
 The
Company has two distribution channels for its phototherapy treatment equipment.
The Company will either (i) sell the laser through a distributor or directly to
a physician or (ii) place the laser in a physician’s office (at no charge to the
physician) and charge 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: the product has been shipped
and the Company has no significant remaining obligations; persuasive evidence of
an arrangement exists; the price to the buyer is fixed or determinable; and
collection is probable (the “SAB 104 Criteria”). At times, units are shipped but
revenue is not recognized until all of the criteria have been 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.
  Under the
terms of the distributor agreements, the distributors do not have the right to
return any unit which they have purchased. However, the Company does allow
products to be returned by its distributors in redress of product defects or
other claims.
  When the
Company places the laser in a physician’s office, it recognizes service revenue
based on the number of patient treatments used 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 inasmuch as the
treatments can only be performed on Company-owned equipment. Once the treatments
are delivered to a patient, this obligation has been satisfied.
  10
 Until the
fourth quarter of 2004, unused treatments had been based upon an estimate that
at the end of each accounting period, 15 unused treatments existed at each laser
location. This was based upon the reasoning that the Company generally sells
treatments in packages of 30 treatments. Fifteen treatments generally represents
about one-half the purchased quantity by a physician or approximately a one-week
supply for 6-8 patients. This policy had been used on a consistent basis. The
Company believed this approach to have been reasonable and systematic given
that: physicians have little motivation to purchase quantities (which they are
obligated to pay for irrespective of actual use and are unable to seek a credit
or refund for unused treatments) that will not be used in a relatively short
period of time, particularly since in most cases they can obtain incremental
treatments instantaneously over the phone; and senior management regularly
reviews purchase patterns by physicians to identify unusual buildup of unused
treatment codes at a laser site. Moreover, the Company continually looks at its
estimation model based upon data received from our customers.
  In the
fourth quarter of 2004, the Company updated the calculations for the estimated
amount of unused treatments to reflect recent purchasing patterns by physicians
near year-end. The Company has estimated the amount of unused treatments at
December 31, 2004 to include all sales of treatment codes made within the last
two weeks of the period. Management believes this approach more closely
approximates the actual amount of unused treatments that existed at that date
than the previous approach. Accounting Principles Board (“APB”) Opinion No. 20
provides that accounting estimates change as new events occur, as more
experience is acquired, or as additional information is obtained and that the
effect of the change in accounting estimate should be accounted for in the
current period and the future periods that it affects. The Company accounted for
this change in the estimate of unused treatments in accordance with APB No. 20
and SFAS No. 48. Accordingly, the Company’s change in accounting estimate was
reported in revenues for the fourth quarter of 2004, and was not accounted for
by restating amounts reported in financial statements of prior periods or by
reporting proforma amounts for prior periods.
  The
Company has continued this approach or method for estimating the amount of
unused treatments at March 31, 2005. Under the current method of estimation, the
amount of unused treatments at March 31, 2005 is estimated to approximate
$442,000. Had the prior method of estimation been used to calculate unused
treatments at March 31, 2005, the amount of unused treatments would have
approximated $187,000. Due to the change in approach, XTRAC domestic revenues
were thus reduced by an additional $255,000 for the quarter ended March 31,
2005.
  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. The Company must estimate the extent to which a physician
participating in the program has been reimbursed. For the three months ended
March 31, 2005, the Company recognized revenues of $19,150, net from
previously deferred revenues under this program as all the criteria for revenue
recognition were met.
  Under
this program, qualifying doctors can be reimbursed for the cost of the Company’s
fee 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 qualify to be in the program (i.e. it must be in
      an identified location where there is still 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 the
      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 6-9
      months;
  ·
    After
      all appeals have been exhausted by the Company, if the claim remains
      unpaid, then the physician is entitled to receive credit for the treatment
      he or she purchased from the Company (the Company’s fee only) on behalf of
      the patient; and
  11
 ·
    Physicians
      are still obligated to make timely payments for treatments purchased,
      irrespective of whether reimbursement is paid or denied. Future sale of
      treatments to the physician can be denied if timely payments are not made,
      even if a patient’s appeal is still in
process.
  Historically,
the Company estimated this contingent liability for potential refund by
estimating when the physician was paid for the insurance claim. In the absence
of a two-year historical trend and a large pool of homogeneous transactions to
reliably predict the estimated claims for refund as required by Staff Accounting
Bulletin Nos. 101 and 104, the Company previously deferred revenue recognition
of 100% of the current quarter revenues from the program to allow for the actual
denied claims to be identified after processing with the insurance companies.
After more than 91,000 treatments in the last two years and detailed record
keeping of denied insurance claims and appeals processed, the Company can
reliably estimate that approximately 11% of a current quarter’s revenues under
this program are subject to being credited or refunded to the physician.
  As of
December 31, 2004, the Company updated its estimation procedure to reflect this
level of estimated refunds. This change from the past process of deferring 100%
of the current quarter revenues from the program represents a change in
accounting estimate and we have recorded this change in accordance with the
relevant provisions of SFAS No. 48 and APB No. 20. These requirements state that
the effect of a change in accounting estimate should be accounted for in the
current period and the future periods that it affects. A change in accounting
estimate should not be accounted for by restating amounts reported in financial
statements of prior periods or by reporting proforma amounts for prior
periods.
  Due to
this updated approach in estimates, XTRAC domestic revenues were reduced by
$102,000 for the quarter ended March 31, 2005 as compared to the prior method of
estimation.
 The net
impact on revenue recognized for the XTRAC domestic segment as a result of the
above two changes in accounting estimate was to decrease revenues by
approximately $357,000 for the quarter ended March 31, 2005.
  Through
its surgical businesses, the Company generates revenues primarily from two
channels. The first is through product sales of laser systems, related
maintenance service agreements, recurring laser delivery systems and laser
accessories; 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 following 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.
  Through
its acquisition of ProCyte, the Company generates revenues 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; 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. 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.
  ***Product
Development Costs***
 Costs of
research, new product development and product redesign are charged to expense as
incurred.
  ***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.
  12
 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.
  ***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 number 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 8,249,605 and 8,671,340 as of March 31, 2005 and 2004,
respectively, were excluded from the calculation of fully diluted earnings per
share since their inclusion would have been anti-dilutive.
  ***Fair
Value of Financial Instruments***
 The
estimated fair values for financial instruments under SFAS No. 107, “Disclosures
about Fair Value of Financial Instruments,” are determined at discrete points in
time based on relevant market information. These estimates involve uncertainties
and cannot be determined with precision. The fair value of cash is based on its
demand value, which is equal to its carrying value. The fair value of notes
payable is based on borrowing rates that are available to the Company for loans
with similar terms, collateral and maturity. The estimated fair value of notes
payable approximate the carrying values. Additionally, the carrying value of all
other monetary assets and liabilities is equal to its fair value due to the
short-term nature of these instruments.
  ***Impairment
of Long-Lived Assets***
 In
accordance with SFAS No. 144, “Accounting for the Impairment or 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 fair value less costs to sell, and would no longer be
depreciated. The assets and liabilities of a disposed group classified as held
for sale would be presented separately in the appropriate asset and liability
sections of the balance sheet. As of March 31, 2005, no such impairment
existed.
  ***Stock
Options***
 The
Company applies the intrinsic-value-based method of accounting prescribed by APB
Opinion No. 25, “Accounting for Stock Issued to Employees,” and related
interpretations, to account for its fixed-plan stock options. Under this method,
compensation expense is recorded on the date of grant only if the current market
price of the underlying stock exceeds the exercise price. Under the provisions
of SFAS No. 123 (revised 2004), “Share Based Payment,” the Company will,
starting January 1, 2006, discontinue intrinsic-value-based accounting and
recognize compensation expense for stock options under the fair-value-based
accounting.
  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 compensation of $132,081 was recorded and will be amortized over the
remaining vesting period, which is an average of two years.
  Had stock
compensation cost for the Company’s common stock options been determined based
upon the fair value of the options at the date of grant, as prescribed under
SFAS No. 123, the Company’s net loss and net loss per share would have been
increased to the following pro-forma amounts:
  13
 Three
      Months Ended March 31,2005
    
    2004Net
      loss:As
      reported
    
    
    ($
      1,128,112
    )
    
    ($
      1,363,082
    )Less:
      stock-based employee compensation expense included in reported net
      loss
    
    
    4,199
    
    
    1,620Impact
      of total stock-based compensation expense determined under
      fair-value-based method for all grants and awards
    
    
    (278,872
    )
    
    (444,720
    )Pro-forma
    
    
    ($
      1,402,785
    )
    
    ($
      1,806,182
    )Net
      loss per share:As
      reported
    
    
    ($
      0.03
    )
    
    ($
      0.04
    )Pro-forma
    
    
    ($0.03
    )
    
    ($
      0.05
    )
  The above
pro-forma amounts may not be indicative of future pro-forma amounts because
future options are expected to be granted.
  The fair
value of the options granted is estimated using the Black-Scholes option-pricing
model with the following weighted average assumptions applicable to options
granted in the three-month periods:
  For
      the Three Months Ended March 31,2005
    
    2004Risk-free
      interest rate
    
    
    4.02
    %
    
    3.07
    %Volatility
    
    
    98.27
    %
    
    99.9
    %Expected
      dividend yield
    
    
    0
    %
    
    0
    %Expected
      option life
    
    
    5
      years
    
    
    5
      years
  ***Supplemental
Cash Flow Information***
 During
the three months ended March 31, 2005, the Company financed insurance
policies through notes payable for $327,604 and financed vehicle purchases of
$30,205 under capital leases. In connection with the purchase of ProCyte in
March 2005, the Company issued 10,540,579 shares of common stock and assumed
options of 1,354,973 shares of common stock (see Note 2).
  During
the three months ended March 31, 2004, the Company financed an insurance
policy through a note payable for $126,881.
  For the
three months ended March 31, 2005 and 2004, the Company paid interest of $83,329
and $20,307, respectively. Income taxes paid in the three months ended March 31,
2005 and 2004 were immaterial.
  ***Recent
Accounting Pronouncements***
 On
December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123 and
supersedes APB Opinion 25. SFAS No. 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be valued at fair
value on the date of grant, and to be expensed over the applicable vesting
period. Pro-forma disclosure of the income statement effects of share-based
payments will no longer be an alternative. SFAS No. 123(R) is effective for all
stock-based awards granted on or after January 1, 2006. In addition, companies
must also recognize compensation expense related to any awards that are not
fully vested as of the effective date. Compensation expense for the unvested
awards will be measured based on the fair value of the awards previously
calculated in developing the pro-forma disclosures in accordance with the
provisions of SFAS No. 123.
  The
Company plans to adopt SFAS No. 123(R) on January 1, 2006. The Company has not
completed the calculation of the impact of applying SFAS No. 123(R). The Company
currently accounts for share-based payments to its employees using the intrinsic
value method; consequently the results of operations have not included the
recognition of compensation expense for the issuance of stock option awards.
  14
 On
December 16, 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary
Assets,” which is an amendment to APB Opinion No. 29. It states that the
exchanges of nonmonetary assets should be measured based on the fair value of
the assets exchanged. Further, SFAS No. 153 eliminates the 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.” SFAS No. 153 is effective for financial statements for
fiscal years beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges incurred during fiscal years beginning after the
date that this statement is issued. Management believes the adoption of this
Statement will not have a material effect on the consolidated financial
statements.
  On
November 24, 2004, FASB issued SFAS No. 151, “Inventory Costs,” which is an
amendment to ARB No. 43, Chapter 4. It clarifies the accounting for abnormal
amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage). The FASB states that these 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. Management
believes the adoption of this Statement will not have an effect on the
consolidated financial statements.
  In
December 2003, the FASB issued FASB Interpretation No. 46 (revised December
2003), “Consolidation of Variable Interest Entities,” (“VIEs”) (“FIN 46R”) which
addresses how a business enterprise should evaluate whether it has a controlling
financial interest in an entity through means other than voting rights and
accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation
No. 46, “Consolidation of Variable Interest Entities,” which was issued in
January 2003. The Company has adopted FIN 46R as of March 31, 2004 for variable
interests in VIEs. For any VIEs that must be consolidated under FIN 46R that
were created before January 1, 2004, the assets, liabilities and noncontrolling
interests of the VIE initially would be measured at their carrying amounts with
any difference between the net amount added to the balance sheet and any
previously recognized interest being recognized as the cumulative effect of an
accounting change. If determining the carrying amounts is not practicable, fair
value at the date FIN 46R first applies may be used to measure the assets,
liabilities and noncontrolling interest of the VIE. The adoption of FIN 46R did
not have an effect on the consolidated financial statements inasmuch as the
Company has no interests in any VIEs.
  *Note
2*
 **Acquisitions:**
  ***ProCyte
Transaction***
 ProCyte
is a Washington corporation organized in 1986. ProCyte is a medical skin care
company that 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 bring unique products, primarily based upon
patented technologies such as GHK and AHK copper peptide technologies, to
selected markets. ProCyte currently sells its products directly to the
dermatology, plastic and cosmetic surgery and spa markets. The Company has also
expanded the use of its novel copper peptide technologies into the mass retail
market for skin and hair care through specifically targeted technology licensing
and supply agreements.
 
 ProCyte’s
products address the growing demand for skin health and hair care products,
including products designed to address the effects aging has on the skin and
hair and to enhance appearance. ProCyte’s products are formulated, branded for
and targeted at specific markets. ProCyte’s initial products in this area
addressed the dermatology, plastic and cosmetic surgery markets for use
following various procedures. Anti-aging skin care products were added to expand
into a comprehensive approach for incorporation into a patients skin care
regimen. Certain of these products incorporated their patented technologies,
while others complement the product line such as ProCyte’s advanced sunscreen
products that reduce the effects of sun damage and aging on the
skin.
 
 The
aggregate purchase price was $27,160,293 and was paid through the issuance of
10,540,579 shares of 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 $989,235 of transaction costs.
The merger consideration resulted in the equivalent of a fixed 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 upon a five-day average stock price of $2.29 per
share. The five-day average included the closing prices on the date of the
planned merger announcement and the two days prior and afterwards.
  15
 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
    
    
    187,117Property
      and equipment
    
    
    340,531Patents
      and licensed technologies
    
    
    200,000Other
      intangibles
    
    
    5,200,000Other
      assets
    
    
    38,277Total
      assets acquired
    
    
    16,221,576Accounts
      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
    
    $
    14,165,366
  The
purchase price exceeded the fair value of the net assets acquired by
$12,994,927, resulting in goodwill in the same amount.
  The
accompanying consolidated financial statements include revenues and expenses
related to the acquisition only for the nine business days from March 19, 2005,
and 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 quarters ended March 31, 2005 and 2004, assuming the
acquisition had occurred on January 1, 2004.
  Three
      Months Ended March 31,2005
    
    2004Net
      revenues
    
    $
    7,952,894
    
    $
    7,244,990Net
      loss
    
    
    (1,230,164
    )
    
    (1,503,302
    )Basic
      and diluted loss per share
    
    
    (0.02
    )
    
    (0.03
    )Shares
      used in calculating basic and diluted loss per share
    
    
    50,656,883
    
    
    48,313,880
 
 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, 2004, or of future
results of operations.
 
 **Stern
Laser Transaction**
 On
September 7, 2004, the Company closed the transactions set forth in a Master
Asset Purchase Agreement, or the Master Agreement, with Stern Laser srl
(“Stern”). As of March 31, 2005, the Company has issued to Stern 113,877 shares
of its restricted common stock in connection with the execution of the Master
Agreement. The Company also agreed to pay Stern up to an additional $1,150,000
based on the achievement of certain remaining milestones relating to the
development and commercialization of certain licensed technology and the
licensed products which may be developed under such arrangement and may have
certain other obligations to Stern under these arrangements. The Company retains
the right to pay all of these conditional sums in cash or in shares of its
common stock, in its discretion. To secure the latter alternative, the Company
has reserved for issuance, and placed into escrow, 586,123 shares of its
unregistered stock. The per-share price of any future issued shares will be
based on the closing price of the Company’s common stock during the 10 trading
days ending on the achievement of a particular milestone under the terms of the
Master Agreement. Stern also has served as the distributor of the Company’s
XTRAC laser system in South Africa and Italy since 2000.
  16
 The
Company assigned $340,569 as the fair value of the license it acquired from
Stern. Amortization of this intangible is on a straight-line basis over 10
years, which began in January 2005. As Stern completes further milestones under
the Master Agreement, the Company expects to increase the carrying value of the
license.
  *Note
3*
 **Inventories:**
  Set forth
below is a detailed listing of inventories.
  March 31, 2005
    
    December 31, 2004Raw
      materials and work in progress
    
    $
    4,581,599
    
    $
    2,968,728Finished
      goods
    
    
    3,600,274
    
    
    1,616,903Total
      inventories
    
    $
    8,181,873
    
    $
    4,585,631
  Work-in-process
is immaterial, given the typically short manufacturing cycle, and therefore is
disclosed in conjunction with raw materials. Finished goods includes $34,080 and
$84,000 as of March 31, 2005 and December 31, 2004, respectively, for laser
systems shipped to distributors, but not recognized as revenue until all the
criteria of Staff Accounting Bulletin No. 104 have been met.
  *Note
4*
 **Property
and Equipment:**
  Set forth
below is a detailed listing of property and equipment.
  March
      31, 2005
    
    December
      31, 2004Lasers
      in service
    
    $
    10,068,293
    
    $
    9,333,591Computer
      hardware and software
    
    
    393,266
    
    
    256,340Furniture
      and fixtures
    
    
    304,884
    
    
    239,520Machinery
      and equipment
    
    
    714,310
    
    
    522,643Autos
      and trucks
    
    
    412,932
    
    
    400,570Leasehold
      improvements
    
    
    110,441
    
    
    110,44112,004,126
    
    
    10,863,105Accumulated
      depreciation and amortization
    
    
    (6,276,213
    )
    
    (5,866,417
    )Property
      and equipment, net
    
    $
    5,727,913
    
    $
    4,996,688
  Depreciation
expense was $436,994 and $449,737 for the three months ended March 31, 2005
and 2004, respectively. At March 31, 2005 and December 31, 2004, net
property and equipment included $694,038 and $666,326, respectively, of assets
recorded under capitalized lease arrangements, of which $525,322 and $565,245
was included in long-term debt at March 31, 2005 and December 31, 2004,
respectively (see Note 9).
  17
 *Note
5*
  **Patents
and Licensed Technologies:**
  Set forth
below is a detailed listing of patents and licensed technologies.
  March
      31, 2005
    
    December
      31, 2004Patents,
      owned and licensed, at gross costs of $409,780 and $403,023, net of
      accumulated amortization of $166,747 and$155,522
      respectively
    
    $
    243,033
    
    $
    247,501Other
      licensed or developed technologies, at gross costs of $1,377,569 and
      $1,177,568, net of accumulated amortization of $540,439 and $495,635
      respectively
    
    
    837,131
    
    
    681,933$
    1,080,164
    
    $
    929,434
  Related
amortization expense was $56,028 and $44,008 for the three months ended
March 31, 2005 and 2004, respectively. Included in other licensed and
developed technologies is $200,000 in Developed Technologies acquired from
ProCyte.
  *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, 2005Neutrogena
      Agreement, at gross costs of $2,400,000 net of accumulated amortization of
      $17,250.
    
    $
    2,382,750Customer
      Relationships, at gross costs of $1,700,000 net of accumulated
      amortization of $12,000.
    
    
    1,688,000Tradename,
      at gross costs of $1,100,000 net of accumulated amortization of
      $4,125.
    
    
    1,095,875$
    5,166,625
  Related
amortization expense was $33,375 for the three months ended March 31, 2005.
Under the Neutrogena Agreement, the Company has licensed to Neutrogena rights to
its copper peptide technology and for which the Company receives royalties.
Customer Relationships embody the value to the Company of relationships which
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, 2005
    
    December
      31, 2004Accrued
      warranty
    
    $
    184,461
    
    $
    196,890Accrued
      liability from matured notes
    
    
    245,849
    
    
    245,849Accrued
      professional and consulting fees
    
    
    376,141
    
    
    412,019Accrued
      sales taxes
    
    
    131,678
    
    
    61,142Other
      accrued expenses
    
    
    197,300
    
    
    8,154Total
      other accrued liabilities
    
    $
    1,135,429
    
    $
    924,054
  During
2002, SLT resumed direct control of $223,000 of funds previously set aside for
the payment of SLT’s subordinated notes, which matured and ceased to bear
interest on July 30, 1999, and $31,000 of funds set aside to pay related accrued
interest. As of March 31, 2005 and December 31, 2004, the matured principal
and related interest was $245,849.
  18
 *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, 2005
    
    December
      31, 2004Note
      payable - secured creditor, interest at 16.47%, payable in monthly
      principal and interest installments of $2,618 through December
      2006.
    
    $
    45,675
    
    $
    51,489Note
      payable - unsecured creditor, interest at 5.75%, payable in monthly
      principal and interest installments of $44,902 through January
      2005.
    
    
    -
    
    
    44,902Note
      payable - unsecured creditor, interest at 7.42%, payable in monthly
      principal and interest installments of $21,935 through November
      2005
    
    
    170,694
    
    
    -Note
      payable - unsecured creditor, interest at 7.42%, payable in monthly
      principal and interest installments of $15,600 through November
      2005
    
    
    121,399
    
    
    -337,768
    
    
    96,391Less:
      current maturities
    
    
    (317,880
    )
    
    (69,655
    )Notes
      payable, net of current maturities
    
    $
    19,888
    
    $
    26,736
  *Note
9*
 **Long-term
Debt:**
  Set forth
below is a detailed listing of the Company’s long-term debt.
  March
      31, 2005
    
    December
      31, 2004Borrowings
      on credit facility
    
    $
    1,536,682
    
    $
    1,680,627Capital
      lease obligations (see Note 4)
    
    
    525,322
    
    
    565,246Less:
      current portion
    
    
    (886,813
    )
    
    (873,754
    )Total
      long-term debt
    
    $
    1,175,191
    
    $
    1,372,119
  The
Company obtained a $2,500,000 leasing credit facility from GE Capital
Corporation (“GE”) on June 25, 2004. The credit facility has a commitment term
of three years, expiring on June 25, 2007. 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 a form of security
over the lasers. The Company continues to depreciate 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. The draw is set at an
interest rate based on 522 basis points above the three-year Treasury note rate.
Each draw is discounted by 7.75%; the first monthly payment is applied directly
to principal. With each draw, the Company has 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 for the ten
days preceding the date of the draw.
  19
 As of
March 31, 2005, the Company had made three draws against the line.
  Draw
      1
    
    Draw
      2
    
    Draw
      3Date
      of draw
    June
      30, 2004
    
    September
      24, 2004
    
    December
      30, 2004Amount
      of draw
    $1,536,950
    
    $320,000
    
    $153,172Stated
      interest rate
    8.47%
    
    7.97%
    
    8.43%Effective
      interest rate
    17.79%
    
    17.14%
    
    17.61%Number
      of warrants issued
    23,903
    
    6,656
    
    3,102Exercise
      price of warrants per share
    $3.54
    
    $2.64
    
    $2.73Fair
      value of warrants
    $62,032
    
    $13,489
    
    $5,946
  The fair
value of the warrants granted is estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions applicable
to the warrants granted:
  Warrants
      granted under:Draw
      1
    
    Draw
      2
    
    Draw
      3Risk-free
      interest rate
    3.81%
    
    3.70%
    
    3.64%Volatility
    99.9%
    
    100%
    
    99.3%Expected
      dividend yield
    0%
    
    0%
    
    0%Expected
      option life
    5
      years
    
    5
      years
    
    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.
  The
Company is negotiating with GE Capital Corporation to open a second line of
leasing credit for an additional $5,000,000. However the Company cannot assure
you that it will be successful in concluding this second line
  Concurrent
with the SLT acquisition, the Company assumed a $3,000,000 credit facility from
a bank. The credit facility had a commitment term of four years, which expired
May 31, 2004, permitted deferment of principal payments until the end of the
commitment term, and was secured by SLT’s business assets, including
collateralization (until May 13, 2003) of $2,000,000 of SLT’s cash and cash
equivalents and short-term investments. The bank agreed to allow the Company to
apply the cash collateral to a paydown of the facility in 2003. The credit
facility had an interest rate of the 30-day LIBOR plus 2.25%.
  The
obligations under capital leases are at fixed interest rates and are
collateralized by the related property and equipment (see Note 4).
  *Note
10*
 **Warrant
Exercises:**
  In the
three months ended March 31, 2005, the Company received $147,060 from the
exercise of 73,530 warrants. The warrants were issued in connection with a
private placement of securities in June 2002 and bore an exercise price of
$2.00.
  In the
three months ended March 31, 2004, 460,182 warrants on the common stock of the
Company were exercised, resulting in an increase to the Company’s shares
outstanding as of the end of the period by the same amount. Most of these
warrants were exercisable at $1.77 per share and were set to expire on March 31,
2004. The Company received $746,735 in cash proceeds from the exercises and
$67,496 in subscriptions receivable that were paid after the end of the
period.
  20
 *Note
11*
 **Business
Segment and Geographic Data:**
  Segments
are distinguished primarily by the organization of our management structure.
Industry considerations and the business model used to generate revenues also
influence distinctions. The Domestic XTRAC segment is a procedure-based business
model used to date only in the United States with revenues derived from
procedures performed by dermatologists. The International XTRAC segment
presently generates revenues from the sale of equipment to dermatologists
through a network of distributors outside the United States. The Surgical
Services segment generates revenues by providing fee-based procedures generally
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 on both a domestic and international basis. The
Skin Care (ProCyte) segment generates revenues by selling skincare products and
by royalties on licenses for the patented copper peptide compound. For the three
months ended March 31, 2005 and 2004, the Company did not have material net
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 is carried at $2,944,423 at March 31, 2005 and
December 31, 2004 has been allocated to the domestic and international XTRAC
segments based upon its fair value as of the date of the Acculase buy-out in the
amounts of $2,061,096 and $883,327, respectively. Goodwill of $12,994,927 at
March 31, 2005 from the ProCyte acquisition has been allocated to the Skin Care
(ProCyte) segment.
  
 Three
      Months Ended March 31, 2005DOMESTIC
      XTRAC
    
    INTERN’L
      XTRAC
    
    SURGICAL
      SERVICES
    
    SURGICAL
      PRODUCTS
      AND
      OTHER
    
    SKIN
      CARE
    
    TOTALRevenues
    
    $
    634,018
    
    $
    288,202
    
    $
    2,070,650
    
    $
    1,367,161
    
    $
    623,301
    
    $
    4,983,332Costs
      of revenues
    
    
    403,181
    
    
    159,596
    
    
    1,315,460
    
    
    528,174
    
    
    225,957
    
    
    2,632,368Gross
      profit
    
    
    230,837
    
    
    128,606
    
    
    755,190
    
    
    838,987
    
    
    397,344
    
    
    2,350,964Allocated
      Operating expenses:Selling,
      general and administrative
    
    
    530,988
    
    
    61,033
    
    
    291,116
    
    
    158,152
    
    
    356,802
    
    
    1,398,091Engineering
      and product development
    
    
    -
    
    
    -
    
    
    -
    
    
    173,174
    
    
    13,797
    
    
    186,971Unallocated
      Operating expenses
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    1,822,885530,988
    
    
    61,033
    
    
    291,116
    
    
    331,326
    
    
    370,599
    
    
    3,407,947Income
      (loss) from operations
    
    
    (300,151
    )
    
    67,573
    
    
    464,074
    
    
    507,661
    
    
    26,745
    
    
    (1,056,983
    )Interest
      expense (income), net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (4,079
    )
    
    71,129Net
      income (loss)
    
    
    ($300,151
    )
    $
    67,573
    
    $
    464,074
    
    $
    507,661
    
    $
    30,824
    
    
    ($1,128,112
    )
 
 21
 
 Three
      Months Ended March 31, 2004DOMESTIC
      XTRAC
    
    INTERN’L
      XTRAC
    
    SURGICAL
      SERVICES
    
    SURGICAL
      PRODUCTS
      AND
      OTHER
    
    SKIN
      CARE
    
    TOTALRevenues
    
    $
    550,601
    
    $
    580,744
    
    $
    1,639,604
    
    $
    1,254,281
    
    
    -
    
    $
    4,025,230Costs
      of revenues
    
    
    486,286
    
    
    370,380
    
    
    1,138,910
    
    
    498,490
    
    
    -
    
    
    2,494,066Gross
      profit
    
    
    64,315
    
    
    210,364
    
    
    500,694
    
    
    755,791
    
    
    -
    
    
    1,531,164Allocated
      Operating expenses:Selling,
      general and administrative
    
    
    500,740
    
    
    128,101
    
    
    325,991
    
    
    124,454
    
    
    -
    
    
    1,079,286Engineering
      and product development
    
    
    162,794
    
    
    101,911
    
    
    -
    
    
    151,245
    
    
    -
    
    
    415,950Unallocated
      Operating expenses
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    1,391,138663,534
    
    
    230,012
    
    
    325,991
    
    
    275,699
    
    
    -
    
    
    2,886,374Income
      (loss) from operations
    
    
    (599,219
    )
    
    (19,648
    )
    
    174,703
    
    
    480,092
    
    
    -
    
    
    (1,355,210
    )Interest
      expense, net
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    7,872Net
      income (loss)
    
    
    ($599,219
    )
    
    ($19,648
    )
    $
    174,703
    
    $
    480,092
    
    
    -
    
    
    ($1,363,082
    )
 
 
 March
      31, 2005
    
    December
      31, 2004Assets:Total
      assets for reportable segments
    
    $
    46,848,581
    
    $
    18,547,510Other
      unallocated assets
    
    
    2,349,842
    
    
    4,414,416Consolidated
      total
    
    $
    49,198,423
    
    $
    22,961,926
  For the
three months ended March 31, 2005 and 2004, there were no material net
revenues attributed to an individual foreign country. Net revenues by geographic
area were as follows:
  For
      the Three Months Ended March 31,2005
    
    2004Domestic
    
    $
    4,465,666
    
    $
    3,269,746Foreign
    
    
    517,666
    
    
    755,484$
    4,983,332
    
    $
    4,025,230
  *Note
12*
 **Significant
Alliances/Agreements:**
  As of
March 31, 2005, the Company entered into a Sales and Marketing Agreement with
GlobalMed (Asia) Technologies Co. Inc. Under this Agreement, GlobalMed will act
as master distributor in the Pacific Rim for the Company’s XTRAC excimer laser,
including the UltraTM excimer laser, as well as 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.
 
 22
 **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 discussed under the section entitled “Risk
Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2004
and is discussed with respect to risks relevant to the acquisition and business
operations of ProCyte Corporation under the section entitled “Risks Factors” in
Pre-Effective Amendment No. 1 to our Registration Statement No. 333-121864 on
Form S-4 filed with the Commission on January 21, 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
presently view our business as comprised of five business segments:
  ·
    Domestic
      XTRAC,
  ·
    International
      XTRAC,
  ·
    Surgical
      Services,
  ·
    Surgical
      Products, and
  ·
    Skin
      Care (ProCyte).
  These
segments are distinguished primarily by the organization of our management
structure. Distinctions are also influenced by industry considerations and the
business model used to generate revenues.
  ·
    The
      Domestic XTRAC segment is a procedure-based business model used only in
      the United States with revenues derived from procedures performed by
      dermatologists.
  ·
    The
      International XTRAC segment presently generates revenues from the sale of
      equipment to dermatologists through a network of distributors outside the
      United States.
  ·
    The
      Surgical Services segment generates revenues by providing fee-based
      procedures generally 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 (but not as
      fee-per-procedure) laser products and disposables to hospitals and surgery
      centers on both a domestic and international basis.
  ·
    The
      Skin Care (ProCyte) segment generates revenues by selling skincare
      products, by selling bulk copper peptide compound, and by royalties on our
      licenses to both the domestic and international
markets.
  23
 **Domestic
XTRAC**
  We are
engaged in the development, manufacturing and marketing of our proprietary
XTRAC® excimer laser and delivery systems and techniques directed toward the
treatment of inflammatory skin disorders. **** In
connection with our current business plan, the initial medical applications for
our excimer laser technology are intended for the treatment of 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,
relating to the use of our XTRAC system for the treatment of psoriasis. The
510(k) establishes that our XTRAC system has been determined to be substantially
equivalent to currently marketed devices for purposes of treating
psoriasis.
  As part
of our commercialization strategy in the United States, we are providing the
XTRAC 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 system and will increase
market penetration. This strategy has and will continue to require us to
identify and target appropriate dermatologists and to balance the planned
roll-out of our XTRAC lasers during 2005 against uncertainties in acceptance by
physicians, patients and health plans and the constraints on the number of XTRAC
systems we are able to provide. Our marketing force has limited experience in
dealing with such challenges. We also expect that we will face increasing
competition as more private insurance plans adopt favorable policies for
reimbursement for treatment of psoriasis.
  Starting
in March 2003, we had introduced a more reliable version of the XTRAC and, based
on the establishment of CPT codes by the AMA and reimbursement rates from the
CMS, we began efforts to secure such favorable policies. To persuade such plans
to adopt favorable policies, we also commissioned a clinical and economic study
of the use of the XTRAC laser as a second-step therapy for psoriasis. In
December 2003, we deployed the findings of the study through a Data Compendium
and mailed a copy of the Data Compendium to a number of medical insurance plans
in our ongoing marketing efforts to secure favorable reimbursement policies.
  Our
primary focus in 2004 was to secure from private health plans favorable
reimbursement policies for treatment of psoriasis using the XTRAC® excimer
laser. **** We
therefore **** expanded
our deployment of the study. From feedback we have received from the medical
insurers to the Data Compendium, we anticipate that the study, coupled with our
other marketing efforts, will succeed in gaining a place on the agenda of
private plans as they consider their coverage and reimbursement policies. By the
first quarter of 2005 we received approval from four significant plans, Regence,
Wellpoint, Aetna, and Anthem, and we are under consideration by other plans. We
cannot at this time provide assurance that other plans will adopt the favorable
policies that we desire, and if they do not, what further requirements may be
asked of us
  In
October 2004, we received from the FDA concurrence under a 510(k) to market the
new XTRAC UltraTM, a smaller-size dermatology laser with increased functionality
for inflammatory skin disorders. The increased functionality will allow shorter
treatment times. We introduced this product at the American Academy of
Dermatology trade show on February 19-21, 2005 in New Orleans.
  In 2005,
we intend to continue our efforts on securing a wider base of private insurance
coverage for psoriasis patients in the United States. In addition, we intend to
expand our selling efforts for the XTRAC in combination with the increased
dermatology sales force obtained in connection with the ProCyte merger. We have
integrated and cross-trained the sales force and reorganized it to be able to
increase the XTRAC installed base and the procedures performed in that
base.
  **International
XTRAC**
  Our
revenues from International XTRAC sales provided needed working capital in 2004
and have continued to do so in 2005. Unlike the domestic market, we derive
revenues from the XTRAC in the international market by selling the dermatology
laser system to distributors, or in certain countries, directly to physicians.
We have benefited in the international market from our clinical studies and the
physician researchers involved in such studies. Due to the revenue model used
overseas, the international XTRAC operations are more widely influenced by
competition from similar laser technologies from other manufacturers and
non-laser lamp alternatives for treating inflammatory skin disorders. Over time,
competition has also served to reduce the prices we charge international
distributors for our XTRAC products. While the average price per laser system
and parts was relatively equal for the three months ended March 31, 2005
($57,640) as in the same period for 2004 ($58,074), the number of lasers sold
was less in the 2005 period (5) than in the 2004 period (10). In addition, of
the 10 lasers recognized in the three months ended March 31, 2004, four of
those lasers had been shipped in 2003, but not recognized as sales due to the
application of the recognition criteria of Staff Accounting Bulletin No. 104.
The XTRAC laser sales vary from quarter to quarter. We have also benefited in
2004 and into 2005 from the improved reliability and functionality of the
XTRAC.
  24
 Due to
the financial resources required,  we were
reluctant in 2004 to implement an international XTRAC fee-per-use revenue model,
similar to the domestic revenue model, but as reimbursement in the domestic
market has become more widespread, we have recently begun to implement a pilot
version of this model overseas.
  In 2005,
we also expect to expand our product offerings to our international customers as
a result of our recent acquisition of worldwide rights to certain proprietary
technology from Stern. The technology is expected to expand our product
offerings in the treatment of dermatological conditions . We
expect that the introduction of the technology based on these newly acquired
rights could be made by the second half of 2005.
  **Surgical
Services**
  We
experienced revenue growth in Surgical Services in 2004 and are experiencing
continued growth in 2005. Our plan in 2004 was to grow in a controlled fashion
such that capital expenditures necessary for that growth would come from these
operations. Although we intend to increase our investment in this business
segment for 2005, we will continue to be very deliberate and controlled with
capital expenditures to grow this business. In this manner, we intend to
conserve our cash resources for the XTRAC business segments.
  We have
growing, but still limited marketing experience in expanding our surgical
services business. The preponderance of this business is in the southeastern
part of the United States. New procedures and geographies, together with new
customers and different business habits and networks, will likely pose different
challenges than the ones we have encountered in the past. There can be no
assurance that our experience will be sufficient to overcome such challenges.
  **Surgical
Products**
  Although
the surgical product revenues increased by $112,880 in the three months ended
March 31, 2005 when compared to the same period in 2004, we expect that the
surgical laser systems and the related disposable base may 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 an
offset to this erosion through expanding our surgical services segment. There
was an increase in surgical laser sales, but such sales vary from quarter to
quarter. With the introduction of the CO2 and diode surgical lasers in the
second quarter of 2004, we hope to offset any decline in laser sales and have a
further offset to the erosion of disposables revenues.
  In the
second quarter 2004, we received from the FDA concurrence under a 510(k) to
market two new surgical lasers: the LaserPro® Diode Laser System and the
LaserPro® CO2 Laser System. Each system has been designed for rugged use in our
Surgical Services business. Each system will also complement the Surgical
Products business in assisting the Company in finding end-user buyers
domestically and overseas. We are also actively exploring opportunities for
supplying the lasers on an OEM basis or under manufacturing-marketing
collaborations.
  Furthermore,
in July 2004, we entered into a development agreement with AzurTec, Inc. AzurTec
is a development-stage company based outside Philadelphia. AzurTec’s product in
development is a device that seeks to rapidly and accurately detect the presence
of cancerous cells in excised tissue. AzurTec’s target customers are generally
the dermatologist and particularly the MOHS surgeon. We intend to assist in the
development of FDA-compliant prototypes for AzurTec’s product. We have collected
payments under the agreement aggregating $240,000 through March 31, 2005. In the
three months ended March 31, 2005, we recognized $124,000 in other revenue under
this agreement, but we have suspended recognition of $59,730 in revenues due to
the uncertainty of collection. Continuing development of this project requires
additional investment by AzurTec. We will resume development once this
investment has been satisfied.
  25
 **Skin
Care (ProCyte)**
  On March
18, 2005, we completed the acquisition of ProCyte Corporation. We acquired three
revenue streams: one from the sale of skin health, hair care and wound care
products; the second from the sale of copper peptide compound in bulk; and the
third from royalties on license for the patented copper peptide
compound.
  The
operating results of ProCyte for the three months ended March 31, 2005 include
activity from ProCyte from March 19, 2005 through March 31, 2005. Also as a
result of purchase accounting rules, the operating results of ProCyte for prior
periods are not included in the statement of operations for these prior periods.
Proforma operating results are disclosed as part of Note 2, Acquisitions to the
financial statements. See also Item 5. Other
Information for
further information regarding the acquisition.
  We
accounted for the acquisition of ProCyte as a purchase by us under generally
accepted accounting principles. We allocated the purchase price based on the
fair value of ProCyte's acquired assets and assumed liabilities. We consolidated
the operating results of ProCyte with our own operating results, beginning as of
the date the parties completed the merger. The allocation of the purchase price
was as follows: $8,765,366 of acquired assets, net of assumed liabilities,
$5,400,000 of other acquired intangibles and $12,994,927 of
goodwill.
  ProCyte
has been in operation since 1986. ProCyte is a medical skin care company that
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 has been to bring unique products, primarily based upon patented
technologies such as GHK and AHK copper peptide technologies, to selected
markets. ProCyte currently sells its products directly to 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 specifically targeted technology licensing and supply
agreements.
  ProCyte’s
products address the growing demand for skin health and hair care products,
including products designed to address the effects aging has on the skin and
hair and to enhance appearance. ProCyte’s products are formulated, branded for
and targeted at specific markets. ProCyte’s initial products in this area
addressed the dermatology, plastic and cosmetic surgery markets for use
following various procedures. Anti-aging skin care products were added to expand
into a comprehensive approach for incorporation into a patients’ skin care
regimen. Certain of these products incorporated their patented technologies,
while others, such as our advanced sunscreen products that reduce the effects of
sun damage and aging on the skin, complement the product line.
  Our goals
from this acquisition are summarized below:
  ProCyte's
presence in the skin health and hair care products market will present a growth
opportunity for PhotoMedex to market its existing products;
  the
addition of ProCyte's sales and marketing personnel will enhance our ability to
market the XTRAC excimer laser;
  the
addition of ProCyte's operations and existing cash balances will enhance
PhotoMedex's operating results and balance sheet;
  the
combination of the senior management of ProCyte and PhotoMedex will allow
complementary skills to strengthen the overall management team; and
  the
combined company may reap short-term cost savings and have the opportunity for
additional longer-term cost efficiencies, thus providing additional cash flow
for operations.
  We have
begun to realize each of these goals. However, as we gain a deeper understanding
of the dynamics of the Skin Care segment, we expect that we will modify the
amount of emphasis and expenditure that are presently devoted to the components
of this segment.
  26
 ProCyte
has 48 employees, consisting of 20 in sales, 13 in marketing, eight in
warehouse/ research and development and seven in finance and administration. We
are integrating the sales personnel from the Skin Care and the Domestic XTRAC
segments under John Clifford, who will be our Executive Vice President for
Dermatology. We are also in the process of transferring the finance functions to
Montgomeryville, Pennsylvania.
  **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 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 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.
  ***Revenue
Recognition***
  *XTRAC-Related
Operations* **
  We have
two distribution channels for our phototherapy treatment equipment. We will
either (i) sell the laser through a distributor or directly to a physician or
(ii) place the laser in a physician’s office (at no charge to the physician) and
charge the physician a fee for an agreed upon number of treatments. When we sell
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: the product has been shipped and we have no significant
remaining obligations; persuasive evidence of an arrangement exists; the price
to the buyer is fixed or determinable; and collection is probable (“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 our books
as inventory. We ship most of our products FOB shipping point, although from
time to time certain customers, for example governmental customers, will insist
on FOB destination. Among the factors we take 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.
  Under the
terms of the distributor agreements, our distributors do not have the right to
return any unit which they have purchased. However, we do allow products to be
returned by our distributors in redress of product defects or other claims.
  When we
place the laser in a physician’s office, we recognize service revenue based on
the number of patient treatments used by the physician. Treatments in the form
of 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. We
defer this portion of unused treatments even though the physician is not given
the right to seek a refund for unused treatments. Unused treatments remain an
obligation of ours inasmuch as the treatments can only be performed on our owned
equipment. Once the treatments are delivered to a patient, this obligation has
been satisfied.
  The
calculation of unused treatments has historically been based upon an estimate
that at the end of each accounting period, 15 unused treatments existed at each
laser location. This was based upon the reasoning that we generally sell
treatments in packages of 30 treatments. Fifteen treatments generally represents
about one-half the purchase quantity by a physician or approximately a one-week
supply for 6-8 patients. This policy had been used on a consistent basis. We
believed this approach to have been reasonable and systematic given that: (a)
physicians have little motivation to purchase quantities (which they are
obligated to pay for irrespective of actual use and are unable to seek a refund
for unused treatments) that will not be used in a relatively short period of
time, particularly since in most cases they can obtain incremental treatments
instantaneously over the phone; and (b) senior management regularly reviews
purchase patterns by physicians to identify unusual buildup of unused treatment
codes at a laser site. Moreover, we continually look at our estimation model
based upon data received from our customers.
  27
 In the
fourth quarter of 2004, we updated the calculations for the estimated amount of
unused treatments to reflect recent purchasing patterns by physicians near
year-end. We have estimated the amount of unused treatments at December 31, 2004
to include all sales of treatment codes made within the last two weeks of the
period. We believe this approach more closely approximates the actual amount of
unused treatments that existed at that date than the previous approach. APB No.
20 provides that accounting estimates change as new events occur, as more
experience is acquired, or as additional information is obtained and that the
effect of the change in accounting estimate should be accounted for in the
current period and the future periods that it affects. We accounted for this
change in the estimate of unused treatments in accordance with APB No. 20 and
SFAS No. 48. Accordingly, our change in accounting estimate was reported in
revenues for the fourth quarter of 2004 and was not accounted for by restating
amounts reported in financial statements of prior periods or by reporting
proforma amounts for prior periods.
  We have
continued this approach or method for estimating the amount of unused treatments
at March 31, 2005. Under the current method of estimation, the amount of unused
treatments at March 31, 2005 is estimated to approximate $442,000. Had the prior
method of estimation been used to calculate unused treatments at March 31, 2005,
the amount of unused treatments would have approximated $187,000. Due to this
approach, XTRAC domestic revenues were thus reduced by an additional $255,000
for the quarter ended March 31, 2005.
  In the
first quarter of 2003, we implemented a program to support certain physicians in
addressing treatments with the XTRAC system that may be denied reimbursement by
private insurance carriers. We recognize 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. In the three months
ended March 31, 2005, we recognized $19,150 of revenues net of deferrals under
this program. At March 31, 2005, we had net deferred revenues of $121,807 under
this program.
  Under
this program, we may reimburse qualifying doctors for the cost of our 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 qualify to be in the program (i.e. it must be in
      an identified location where there is still 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 the
      claim), a standard insurance form called an EOB (“Explanation of
      Benefits”) must be submitted to our in-house appeals group, who will then
      prosecute the appeal. The appeal process can take 6-9
    months;
  ·
    After
      all appeals have been exhausted by us, if the claim remains unpaid, then
      the physician is entitled to receive credit for the treatment he or she
      purchased from us (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 the physician can be denied if timely payments are not made,
      even if a patient’s appeal is still in
process.
  Historically,
we estimated a contingent liability for potential refunds under this program by
estimating when the physician was paid for the insurance claim. In the absence
of a two-year historical trend and a large pool of homogeneous transactions to
reliably predict the estimated claims for refund as required by Staff Accounting
Bulletin Nos. 101 and 104, we previously deferred revenue recognition of 100% of
the current quarter revenues from the program to allow for the actual denied
claims to be identified after processing with the insurance companies. After
more than 91,000 treatments in the last 2 years and detailed record keeping of
denied insurance claims and appeals processed, we have estimated that
approximately 11% of a current quarter’s revenues under this program are subject
to being credited or refunded to the physician.
  28
 As of
December 31, 2004, we updated our analysis to reflect this level of estimated
refunds. This change from the past process of deferring 100% of the current
quarter revenues from the program represents a change in accounting estimate,
and we recorded this change in accordance with the relevant provisions of SFAS
No. 48 and APB No. 20. These pronouncements state that the effect of a change in
accounting estimate should be accounted for in the current period and the future
periods that it affects. A change in accounting estimate should not be accounted
for by restating amounts reported in financial statements of prior periods or by
reporting proforma amounts for prior periods.
  Due to
this updated approach in estimates, XTRAC domestic revenues were reduced by
$102,000 for the quarter ended March 31, 2005 as compared to the prior method of
estimation.
 The net
impact on revenue recognized for the XTRAC domestic segment as a result of the
above two changes in accounting estimate was to decrease revenues by
approximately $357,000 for the quarter ended March 31, 2005.
  *Surgical
Products and Service Operations*
  Through
our surgical businesses, we generate revenues primarily from two
channels:
  ·
    The
      first is through product sales of laser systems, related maintenance
      service agreements, recurring laser delivery systems and laser
      accessories.
  ·
    The
      second is through per-procedure surgical services.
  We
recognize revenues from surgical lasers and other product sales, including sales
to distributors, when 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 our books of as inventory. We ship most
of our products FOB shipping point, although from time to time certain
customers, for example governmental customers, will insist on FOB destination.
Among the factors we take 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.
  For
per-procedure surgical services, we recognize 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.
  *Skin
Care Operations*
  Through
the acquisition of ProCyte, we generate revenues 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; and the third is through royalties generated by our
licenses, principally to Neutrogena. We recognize revenues on the products and
copper peptide compound when they are shipped. We ship the products FOB shipping
point. Royalty revenues is based upon sales generated by our licensees. We
recognize royalty revenue at the applicable royalty rate applied to shipments
reported by our licensee.
  ***Inventory*** **.** We
account for inventory at the lower of cost (first-in, first-out) or market. Cost
is determined to be the purchased cost for raw materials and the production cost
(materials, labor and indirect manufacturing cost) for work-in-process and
finished goods. Throughout the laser manufacturing process, the related
production costs are recorded within inventory. Work-in-process is immaterial,
given the typically short manufacturing cycle and therefore is disclosed in
conjunction with raw materials. We perform full physical inventory counts for
the XTRAC and cycle counts on the other inventory to maintain controls and
obtain accurate data.
  29
 Our XTRAC
laser will either (i) be sold to distributors or physicians directly or (ii) be
placed in a physician's office and remain our property. The cost to build a
laser, whether for sale or for placement, is accumulated in inventory. When a
laser is placed in a physician’s office, the cost is transferred from inventory
to “lasers in service” within property and equipment. At times, units are
shipped to distributors, but revenue is not recognized until all of the criteria
of Staff Accounting Bulletin No. 104 have been met, and until that time, the
unit is carried on our books as inventory. Revenue is not recognized from these
distributors until payment is either assured or paid in full. Until this time,
the cost of these shipments continues to be recorded as finished goods
inventory.
  Reserves
for slow moving and obsolete inventories are provided based on historical
experience and product demand. Management evaluates the adequacy of these
reserves periodically based on forecasted sales and market trend.
  ***Allowance
for Doubtful Accounts*** **.** Accounts
receivable are reduced by an allowance for amounts that may become uncollectible
in the future. The majority of receivables related to phototherapy sales are due
from various distributors located outside of the United States and from
physicians located inside the United States. The majority of receivables related
to surgical services, surgical products and skin care products are due from
various customers and distributors located inside the United States. From time
to time, our customers dispute the amounts due to us, and, in other cases, our
customers experience financial difficulties and cannot pay on a timely basis. In
certain instances, these factors ultimately result in uncollectible accounts.
The determination of the appropriate reserve needed for uncollectible accounts
involves significant judgment. A change in the factors used to evaluate
collectibility could result in a significant change in the reserve needed. Such
factors include changes in the financial condition of our customers as a result
of industry, economic or customer-specific factors.
  ***Property
and Equipment.*** As of
March 31, 2005 and December 31, 2004, we had net property and equipment of
$5,727,913 and $4,996,688, respectively. The most significant component of these
amounts relates to the XTRAC lasers placed by us in physicians’ offices. We own
the equipment and charge the physician on a per-treatment basis for use of the
equipment. The realizability of the net carrying value of the lasers is
predicated on increasing revenues from the physicians’ use of the lasers. We
believe that such usage will increase in the future based on the approved CPT
codes, recent approvals of private health plans of our XTRAC procedure and
expected increases in insurance reimbursement. XTRAC lasers-in-service are
depreciated on a straight-line basis over the estimated useful life of three
years. Surgical lasers-in-service are depreciated on a straight-line basis over
an estimated useful life of seven years if new, five years or less if used
equipment. The straight-line depreciation basis for lasers-in-service is
reflective of the pattern of use. For other property and equipment, including
property and equipment acquired from ProCyte, depreciation is calculated on a
straight-line basis over the estimated useful lives of the assets, primarily
three to seven years for computer hardware and software, furniture and fixtures,
automobiles, and machinery and equipment. Leasehold improvements are amortized
over the lesser of the useful lives or lease terms. Useful lives are determined
based upon an estimate of either physical or economic obsolescence.
  ***Intangibles*** **.** Our
balance sheet includes goodwill and other intangible assets which affect the
amount of future period amortization expense and possible impairment expense
that we will incur. Management’s judgment regarding the existence of impairment
indicators is based on various factors, including market conditions and
operational performance of its business. As of March 31, 2005 and December 31,
2004, we had $22,186,139 and $3,873,857, respectively, of goodwill and other
intangibles, accounting for 45% and 17% of our total assets at the respective
dates. The determination of the value of such intangible assets requires
management to make estimates and assumptions that affect our consolidated
financial statements. We test our goodwill for impairment, at least annually.
This test is usually conducted in December of each year in connection with the
annual budgeting and forecast process. Also, on a quarterly basis, we evaluate
whether events have occurred that would negatively impact the realizable value
of our intangibles or goodwill. There has been no change to the carrying value
of goodwill that is allocated to the XTRAC domestic segment and the XTRAC
international segment in the amounts of $2,061,096 and $883,327, respectively.
The allocation of goodwill to each segment was based upon the relative fair
values of the two segments as of August 2000, when we bought out the minority
interest in Acculase and thus recognized the goodwill. In connection with the
acquisition of ProCyte on March 18, 2005, we acquired certain intangibles
recorded at fair value as of the date of acquisition and allocated fully to Skin
Care (ProCyte) segment. Included in these acquired intangibles were the
following:
  30
 ProCyte
      Neutrogena Agreement
    
    $
    2,400,000ProCyte
      Customer Relationships
    
    
    1,700,000ProCyte
      Tradename
    
    
    1,100,000ProCyte
      Developed Technologies
    
    
    200,000Goodwill
    
    
    12,994,927Total
    
    $
    18,394,927
  ***Deferred
Income Taxes.*** We have a
deferred tax asset that is fully reserved by a valuation account. We have not
recognized the deferred tax asset, given our historical losses and the lack of
certainty of future taxable income. However, if and when we become profitable
and can reasonably foresee continuing profitability, then under SFAS No. 109 we
may recognize some of the deferred tax asset. The recognized portion may go in
some measure to a reduction of acquired goodwill and in some measure to benefit
the statements of operations.
  ***Warranty
Accruals*** **.** We
establish a liability for warranty repairs based on estimated future claims for
XTRAC systems and based on historical analysis of the cost of the repairs for
surgical laser systems. However, future returns on defective laser systems and
related warranty liability could differ significantly from estimates, and
historical patterns, which would adversely affect our operating
results.
  **Results
of Operations**
  ***Revenues***
  We
generated revenues of $4,983,322 during the three months ended March 31, 2005,
of which $3,437,811 was from the surgical laser products and services operations
and $623,301 was from the ProCyte operations. The balance of revenues was from
phototherapy products and services, including $288,202 from XTRAC international
sales of excimer systems and parts and $634,018 from domestic XTRAC procedures.
We generated revenues of $4,025,230 during the three months ended March 31,
2004, of which $2,893,885 were from the surgical product and services
operations. The balance of revenues was from phototherapy products and services,
including $580,744 from XTRAC international sales of excimer systems and parts
and $550,601 from domestic XTRAC procedures.
  The
following table illustrates revenues from our five business segments for the
periods listed below:
  For
      the Three Months Ended March 31,2005
    
    2004XTRAC
      Domestic Services
    
    $
    634,018
    
    $
    550,601XTRAC
      International Products
    
    
    288,202
    
    
    580,744Total
      XTRAC Revenues
    
    $
    922,220
    
    $
    1,131,345Surgical
      Services
    
    $
    2,070,650
    
    $
    1,639,604Surgical
      Products
    
    
    1,367,161
    
    
    1,254,281Total
      Surgical Products
    
    $
    3,437,811
    
    $
    2,893,885Skin
      Care (ProCyte) Revenues
    
    $
    623,301
    
    
    -Total
      Revenues
    
    $
    4,983,332
    
    $
    4,025,230
  31
  ***Domestic
XTRAC Segment***
  Recognized
revenue for the three months ended March 31, 2005 and 2004 for domestic XTRAC
procedures was $634,018 and $550,601, respectively. Total XTRAC procedures for
the same periods were approximately 12,400 and 10,700, respectively, of which
1,114 and 1,090 procedures, respectively, were performed by customers without
billing from us. These procedures were performed in connection with customer
evaluations of the XTRAC laser, as well as for clinical research. The ramp in
procedures in the periods ended March 31, 2005 was 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
the CPT codes with comparable rates by private healthcare insurers.
  In the
first quarter of 2003, we implemented a program to support certain physicians in
addressing treatments with the XTRAC system that may be denied reimbursement by
private insurance carriers. Applying the requirements of Staff Accounting
Bulletin No. 104 to the program, we recognize service revenue during the program
from the sale of XTRAC procedures, or equivalent 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, 2005, we
recognized revenues of $19,150 from revenues (288 procedures), net, which had
been previously deferred under this program but which could be recognized as
revenue for the period as all the criteria for revenue recognition had been met.
For the three months ended March 31, 2004, we deferred revenues of
$143,271, (2,039 procedures) net, under this program.
  In the
first quarter of 2005, recognized revenues for the domestic XTRAC segment
decreased by approximately $102,000 due to a change in accounting estimate for
potential credits or refunds under the reimbursement program. In addition, we
experienced a decrease of approximately $255,000 in revenue due to a change in
accounting estimate for unused physician treatments that existed at March 31,
2005. The net effect of these two changes in accounting estimates, as detailed
in our revenue recognition policy, was to increase revenue for this segment for
the quarter ended March 31, 2005 by approximately $357,000.
  The
following table illustrates the above analysis for the Domestic XTRAC segment
for the periods reflected below:
  For
      the Three Months Ended March 31,2005
    
    2004Recognized
      revenue
    
    $
    634,018
    
    $
    550,601Change
      in deferred program revenue
    
    
    (19,150
    )
    
    143,271Change
      in deferred unused treatments
    
    
    135,500
    
    
    (18,550
    )Net
      billed revenue
    
    $
    750,368
    
    $
    675,322Procedure
      volume total
    
    
    12,418
    
    
    10,700Less:
      Non-billed procedures
    
    
    1,114
    
    
    1,090Net
      billed procedures
    
    
    11,304
    
    
    9,610Avg.
      price of treatments sold
    
    $
    66.38
    
    $
    70.27Change
      in procedures with deferred/(recognized) program revenue,
    net
    
    
    (288
    )
    
    2,039Change
      in procedures with deferred/(recognized) unused treatments,
      net
    
    
    2,041
    
    
    (264
    )
  The
average price for a treatment can vary from quarter to quarter 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. As a percentage of the
psoriasis patient population, there are fewer patients with moderate psoriasis
than there are with mild psoriasis. Due to the amount of treatment time
required, it has not been generally practical to use our therapy to treat severe
psoriasis patients. This may change going forward, as our new product, the XTRAC
Ultra, has shorter treatment times.
  32
 ***International
XTRAC Segment***
  International
XTRAC sales of our excimer laser system and related parts were $288,202 for the
three months ended March 31, 2005 compared to $580,744 for the three months
ended March 31, 2004. We sold five laser systems in the three months ended March
31, 2005 compared to 10 laser systems in the three months ended March 31, 2004.
The international XTRAC operations are more widely influenced by competition
from similar laser technology from other manufacturers and from non-laser lamp
alternatives for treating inflammatory skin disorders. Over time, competition
has also served to reduce the prices we charge international distributors for
our excimer products. In addition, of the 10 lasers recognized in the three
months ended March 31, 2004, four of those lasers had been shipped in 2003,
but not recognized as sales due to the application of the recognition criteria
of Staff Accounting Bulletin No. 104.
  The
following table illustrates the key changes in the International XTRAC segment
for the periods reflected below:
  For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    288,202
    
    $
    580,744Laser
      systems sold
    
    
    5
    
    
    10Average
      revenue per laser
    
    $
    57,640
    
    $
    58,074
  ***Surgical
Services Segment***
  In the
three months ended March 31, 2005 and 2004, surgical services revenues were
$2,070,650 and $1,639,604, respectively. Revenues in surgical services grew for
the three months ended March 31, 2005 from 2004 by 26.3%, primarily due to
growth in urological procedures performed with laser systems purchased from a
third-party manufacturer. Such procedures included a charge for the use of the
laser and the technician to operate it, as well as a charge for the third
party’s proprietary fiber delivery system.
  The
following table illustrates the key changes in the Surgical Services segment for
the periods reflected below:
  For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    2,070,650
    
    $
    1,639,604Percent
      increase
    
    
    26.3
    %Cost
      of revenues
    
    
    1,315,460
    
    
    1,138,910Gross
      profit
    
    $
    755,190
    
    $
    500,694Percent
      of revenue
    
    
    36.5
    %
    
    30.5
    %
  ***Surgical
Products Segment***
  For the
three months ended March 31, 2005 and 2004, surgical products revenues were
$1,367,161 and $1,254,281, respectively. Surgical products revenues include
revenues derived from the sales of surgical laser systems together with sales of
related laser fibers and laser disposables. Sales of disposables and fibers are
more profitable than laser systems. However, sales of laser systems create
recurring sales of laser fibers and laser disposables. We had five sales of
surgical laser systems aggregating approximately $254,000 for the three months
ended March 31, 2005 compared to three surgical laser system sales aggregating
approximately $211,000 for the three months ended March 31, 2004. The decrease
in average price per laser was due to the mix of lasers sold. Included in the
laser sales for the three months ended March 31, 2005 were sales of a CO2 laser
and a diode laser, which have lower sales prices than the other types of lasers.
There were no sales of these lasers for the three months ended March 31, 2004,
since they were introduced in June 2004. Disposable and fiber sales were
relatively level between the comparable three-month periods. The change in the
laser sale product mix contributed to a slightly higher margin in the three
months ended March 31, 2005 compared to the same period in the prior
year.
  33
 Sales of
surgical laser systems vary quarter by quarter. There is significant competition
for the types of surgical laser systems we offer for sale. Additionally, we have
expected that the disposables base might 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 an
offset to this erosion through expanding our surgical services. Similarly, some
of the decrease in laser system sales is related to the trend of hospitals to
outsource their laser-assisted procedures to third parties, such as our surgical
services business. With the introduction of our CO2 and diode surgical lasers in
the second quarter of 2004, we hope to offset the decline in lasers and have a
further offset to the erosion of disposables revenues.
  The
following table illustrates the key changes in the Surgical Products segment for
the periods reflected below:
  For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    1,367,161
    
    $
    1,254,281Percent
      increase
    
    
    9
    %Laser
      systems sold
    
    
    5
    
    
    3Laser
      system revenues
    
    $
    254,000
    
    $
    211,000Average
      revenue per laser
    
    $
    50,800
    
    $
    70,333
  ***Skin
Care (ProCyte) Segment***
  For the
three months ended March 31, 2005, ProCyte revenues were $623,031. Since ProCyte
was acquired on March 18, 2005, there are no corresponding revenues for the
three months ended March 31, 2004. 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.
  The
following table illustrates the key changes in the Skin Care (ProCyte) segment
for the periods reflected below:
  For
      the Three Months Ended March 31,2005
    
    2004Product
      sales
    
    $
    452,864
    
    $
    -Bulk
      compound sales
    
    
    156,000
    
    
    -Royalties
    
    
    14,437Total
      ProCyte revenues
    
    $
    623,301
    
    $
    -
  ***Cost
of Revenues***
  Product
cost of revenues for the three months ended March 31, 2005 were $892,964
compared to $832,484 for the three months ended March 31, 2004. Included in
these costs were $507,411 and $462,103, related to surgical product revenues,
for the three months ended March 31, 2005 and 2004, respectively. Also included
in the costs for the three months ended March 31, 2005 were $225,957 related to
ProCyte revenues. The remaining product cost of revenues during these periods of
$159,596 and $370,381, respectively, related primarily to the production costs
of the XTRAC laser equipment sold outside of the United States.
  The
decrease in the product cost of sales for the three months ended March 31, 2005,
was primarily related to a decrease in the unabsorbed manufacturing costs due to
the manufacturing efficiencies of our newly designed excimer technology. This
decrease was also related to a decrease in product cost of sales for the
international XTRAC revenues for the three months ended March 31,
2005.
  34
 Services
cost of revenues was $1,739,404 and $1,661,582 in the three months ended March
31, 2005 and 2004, respectively. Included in these costs for the same periods
were $1,336,223 and $1,175,297, respectively, related to surgical services
revenues. The remaining services cost of revenues of $403,181 and $486,285
during the periods ended March 31, 2005 and 2004, respectively, were primarily
attributable to manufacturing, depreciation and field service costs on the
lasers in service for XTRAC domestic revenues.
  The
decrease in the service cost of sales, excluding surgical services’ costs,
relate to the manufacturing efficiencies and improved reliability of our newly
designed excimer technology.
  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, which are placed in
physicians’ offices domestically or sold internationally. The unabsorbed costs
are allocated to the domestic XTRAC and the international XTRAC 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 $2,350,964 during the three months ended March 31, 2005 from
$1,531,164 during the same period in 2004, or an increase of $819,800. Revenues
increased during the three months ended March 31, 2005 to $4,983,332 from
$4,025,230 during the same period in 2004, or an increase of $958,102. The cost
to produce those revenues increased during the three months ended March 31, 2005
to $2,632,368 from $2,494,066 during the same period in 2004, or an increase of
$138,302. Overall gross margin increased for the three months ended March 31,
2005 to 47.2% from 38.0% for the same period in 2004.
  The
following table analyzes changes in our gross margin for the periods reflected
below:
  **Company
      Margin Analysis**
    
    For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    4,983,332
    
    $
    4,025,230Percent
      increase
    
    
    23.8
    %Cost
      of revenues
    
    
    2,632,368
    
    
    2,494,066Percent
      increase
    
    
    5.5
    %Gross
      profit
    
    $
    2,350,964
    
    $
    1,531,164Percent
      of revenue
    
    
    47.2
    %
    
    38.0
    %
  The
primary reasons for improvement in gross margin for the three months ended March
31, 2005, compared to the same periods in 2004 were as follows:
  ·
    We
      increased treatment procedures and lowered field service costs for the
      XTRAC laser. The increase in procedure volume was a direct result of
      improving insurance reimbursement. The lower field service costs were a
      direct result of the planned quality upgrades in 2003 and 2004 for all
      lasers-in-service.
  ·
    We
      continued to increase the volume of sales to existing customers and add
      new customers to our existing base.
  ·
    We
      benefited from the manufacturing efficiencies due to the newly designed
      XTRAC Ultra laser, which resulted in less unabsorbed manufacturing
      costs.
  ·
    We
      acquired ProCyte on March 18, 2005, so there were nine business days of
      activity that are reflected in the first quarter of 2005 but none in
      2004.
  The
following table analyzes our gross margin for our Domestic XTRAC segment for the
periods reflected below:
  35
 **XTRAC
      Domestic Segment**
    
    For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    634,018
    
    $
    550,601Percent
      increase
    
    
    15.2
    %Cost
      of revenues
    
    
    403,181
    
    
    486,286Percent
      decrease
    
    
    (17.1
    %)Gross
      profit
    
    $
    230,837
    
    $
    64,315Percent
      of revenue
    
    
    36.4
    %
    
    11.7
    %
  The most
significant improvement for the three months ended March 31, 2005 came from our
Domestic XTRAC segment. We increased the gross margin for this segment for the
three months ended March 31, 2005 over the comparable periods in 2004 by
$166,522, primarily due to increases in revenues and decreases in the costs in
the 2005 periods from the comparable 2004 periods. The key factors were as
follows:
  ·
    A
      key driver in increased revenue in this segment is insurance
      reimbursement. In 2004, we focused on private health insurance plans’
      adopting the XTRAC laser therapy for psoriasis as an approved medical
      procedure. Since March 31, 2004, several major health insurance plans
      instituted medical policies to pay claims for the XTRAC therapy, including
      Regence, Wellpoint, Aetna and Anthem.
  ·
    Procedure
      volume increased 18% from 9,610 to 11,304 billed procedures in the three
      months ended March 31, 2005 compared to the same period in
      2004.
  ·
    Price
      per procedure was not a meaningful component of the revenue change between
      the periods.
  ·
    In
      the first quarter of 2003, we implemented a limited program to support
      certain physicians in addressing treatments with the XTRAC system that may
      be denied reimbursement by private insurance carriers. We recognize
      service revenue under the program for 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, 2005, we recognized revenues of $19,150, net, from
      revenues under the program which had been previously deferred but which
      could be recognized in the current quarter revenues as all the criteria
      for revenue recognition were met. For the three months ended March 31,
      2004, we deferred revenues of $143,271 under this program.
  ·
    The
      cost of revenues decreased by $83,105 for the three months ended March 31,
      2005. An incremental procedure at a physician’s office does not increase
      our operating costs associated with that laser. This combined with the
      improvement in the reliability of the lasers in 2005 and the resulting
      reduction in unabsorbed manufacturing costs served to reduce costs
      associated with the domestic segment.
  The
following table analyzes our gross margin for our International XTRAC segment
for the periods reflected below:
  **XTRAC
      International Segment**
    
    For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    288,202
    
    $
    580,744Percent
      decrease
    
    
    (50.4
    %)Cost
      of revenues
    
    
    159,596
    
    
    370,380Percent
      decrease
    
    
    (56.9
    %)Gross
      profit
    
    $
    128,606
    
    $
    210,364Percent
      of revenue
    
    
    44.6
    %
    
    36.2
    %
  36
 The gross
profit for the three months ended March 31, 2005 decreased by $81,758 from the
comparable period in 2004. The key factors in this business segment were as
follows:
  ·
    We
      sold five XTRAC laser systems during the three months ended March 31, 2005
      and 10 lasers in the comparable period in 2004. In addition, four lasers
      for a total of $310,000, which had been shipped before the first quarter
      of 2004 but not recognized as sales due to the application of the
      recognition criteria of Staff Accounting Bulletin No. 104 were recognized
      in the first quarter of 2004.
  ·
    The
      International XTRAC operations are more widely influenced by competition
      from similar laser technology from other manufacturers and from non-laser
      lamp alternatives for treating inflammatory skin disorders. Over time,
      competition has also served to reduce the prices we charge international
      distributors for our excimer products. After adjusting the revenue for the
      three months ended March 31, 2005 for parts sales of approximately
      $47,000, the average price for lasers sold during this period was
      approximately $48,000. After adjusting the revenue for the three months
      ended March 31, 2004 for part sales of approximately $9,000, the average
      price for lasers sold during this period was approximately
      $57,000.
  ·
    Although
      the individual standard cost per unit was relatively level between the
      comparable periods, increased production levels served to reduce the
      average cost per laser produced. The difference between standard
      manufacturing costs and total cost of goods sold represents unabsorbed
      overhead costs charged to cost of goods sold in the period of the
      sale.
  The
following table analyzes our gross margin for our Surgical Services segment for
the periods reflected below:
  **Surgical
      Services Segment**
    
    For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    2,070,650
    
    $
    1,639,604Percent
      increase
    
    
    26.3
    %Cost
      of revenues
    
    
    1,315,460
    
    
    1,138,910Percent
      increase
    
    
    15.5
    %Gross
      profit
    
    $
    755,190
    
    $
    500,694Percent
      of revenue
    
    
    36.5
    %
    
    30.5
    %
  Gross
margin in the Surgical Services segment for the three months ended March 31,
2005 increased by $254,496, from the comparable period in 2004. The key factors
impacting gross margin for the Surgical Services business were as
follows:
  ·
    Increased
      procedure volume was the primary reason for improvements in this business
      segment. We continue to experience growth in our surgical services
      business, particularly within existing customers and existing
      geographies.
  ·
    A
      significant part of the growth was an increase in urological procedures
      performed with laser systems we purchased from a third party manufacturer.
      Such procedures included a charge for the use of the laser and the
      technician to operate it, as well as a charge for the third party’s
      proprietary fiber delivery system.
  37
  The
following table analyzes our gross margin for our Surgical Products segment for
the periods reflected below:
  **Surgical
      Products Segment**
    
    For
      the Three Months Ended March 31,2005
    
    2004Revenues
    
    $
    1,367,161
    
    $
    1,254,281Percent
      increase
    
    
    9.0
    %Cost
      of revenues
    
    
    528,175
    
    
    498,490Percent
      increase
    
    
    6.0
    %Gross
      profit
    
    $
    838,986
    
    $
    755,791Percent
      of revenue
    
    
    61.4
    %
    
    60.3
    %
  Gross
margin for the Surgical Products segment in the three months ended March 31,
2005 compared to the same periods in 2004 increased by $83,195. 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. However,
      the sale of laser systems generates the subsequent recurring sale of laser
      disposables.
  ·
    Revenues
      for the three months ended March 31, 2005 increased by $112,880 from the
      three months ended March 31, 2004. Cost of revenues increased by $29,685
      between the same periods. There were two more laser system sales in the
      three months ended March 31, 2005 than in the comparable period of 2004.
      However, the lasers sold in the 2004 period were at higher prices than in
      the comparable period in 2005. This revenue increase was partly offset by
      a decrease in disposables between the
periods.
  ·
    Disposables,
      which have a higher gross margin than lasers, represented a lower
      percentage of revenue in the three months March 31, 2005 compared to the
      three months ended March 31, 2004.
  The
following table analyzes our gross margin for our SkinCare (ProCyte) segment for
the periods reflected below:
  **Skin
      Care (ProCyte) Segment**
    
    For
      the Three Months Ended March 31,2005
    
    2004Product
      revenues
    
    $
    452,864
    
    $
    -Bulk
      compound revenues
    
    
    156,000
    
    
    -Royalties
    
    
    14,437
    
    
    -Total
      revenues
    
    
    623,301
    
    
    -Product
      cost of revenues
    
    
    96,681
    
    
    -Bulk
      compound cost of revenues
    
    
    129,276
    
    
    -Total
      cost of revenues
    
    
    225,957
    
    
    -Gross
      profit
    
    $
    397,344
    
    $
    -Percent
      of revenue
    
    
    63.7
    %
  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 costs
      associated with its revenue stream.
  ·
    Product
      revenues come primarily from U.S. customers, who tend to be
      dermatologists.
  38
 ·
    Lesser
      product revenues come from sales directed to consumers at spas and from
      marketing directly to the consumer (e.g.
infomercials).
  ***Selling,
General and Administrative Expenses***
  For the
three months ended March 31, 2005, selling, general and administrative expenses
were $3,220,976 compared to $2,470,424 for the three months ended March 31,
2004, or an increase of 30.4%. $229,100 of these costs were ProCyte-related
selling, general and administrative expenses after the acquisition on March 18,
2005. The remaining increase was related to an increase in our allowance for
doubtful accounts in the amount of $167,000 and an accrual for severance expense
related to the ProCyte acquisition in the amount of $133,000.
  Selling,
general and administrative expenses specifically allocated to the International
XTRAC segment decreased for the three months ended March 31, 2005 compared to
the same periods in 2004 due to a decrease in warranty expenses, which were
driven by improved reliability in our XTRAC laser systems.
  ***Engineering
and Product Development***
  Engineering
and product development expenses for the three months ended March 31, 2005
decreased to $186,971 from $415,950 for the three months ended March 31, 2004.
The decrease is mainly due to the fact that in 2004, our California resources
dedicated their time to engineering and product development for the Ultra. For
the period ended March 31, 2005, the development of the Ultra was completed,
thus allowing these California resources to devote more time to
manufacturing.
  **Interest
Expense, Net**
  Net
interest expense for the three months ended March 31, 2005 increased to $71,129,
as compared to $7,872 for the three months ended March 31, 2004. The increase in
net interest expense was direct result of the draws on the lease line of credit
during the second, third and fourth quarters of 2004.
  ***Net
Loss***
  The
aforementioned factors resulted in a net loss of $1,128,112 during the three
months ended March 31, 2005, as compared to a net loss of $1,363,082 during the
three months ended March 31, 2004, a decrease of 17.2%. These decreases were
primarily the result of the increase in revenues and resulting gross
margin.
  Income
taxes were immaterial, given our current period losses and operating loss
carryforwards.
  ***Liquidity
and Capital Resources***
  We have
historically financed our operations through the use of working capital provided
from equity financing and from lines of credit.
  On March
18, 2005, we acquired ProCyte. The skincare products and royalties provided by
ProCyte increased revenues for the three months ended March 31, 2005 and we
expect the combined companies to cause revenues to increase throughout 2005 as
compared to 2004. We expect to save costs 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. The established revenues from ProCyte will help to absorb the costs
of the infrastructure of the combined company.
  At March
31, 2005, the ratio of current assets to current liabilities was 2.53 to 1.00
compared to 1.88 to 1.00 at December 31, 2004. As of March 31, 2005, we had
$12,713,539 of working capital compared to $6,119,248 as of December 31, 2004.
Cash and cash equivalents were $7,287,916 as March 31, 2005, as compared to
$3,884,817 as of December 31, 2004. These increases were mainly due to the
acquisition of ProCyte. $11,769 of cash was classified as restricted as of March
31, 2005 compared to $112,200 at December 31, 2004.
  39
 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
through the second quarter of 2006. The 2005 operating plan reflects anticipated
growth from an increase in per-treatment fee revenues for use of the XTRAC
system based on wider insurance coverage in the United States and costs savings
from the integration of ProCyte and PhotoMedex. In addition, the 2005 operating
plan calls for increased revenues and profits from our newly acquired business,
ProCyte, and the continued growth of its skin care products. We cannot give
assurances that our business plan will not encounter obstacles which may require
us to obtain additional equity or debt financing to meet our working capital
requirements or capital expenditure needs. Similarly, if our growth outstrips
the business plan, 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.
  We
obtained a $2,500,000 leasing credit facility from GE Capital Corporation (“GE”)
on June 25, 2004. 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. We
continue to depreciate 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. The draw is set at an interest rate based on 522 basis
points above the three-year Treasury note rate. Each draw is discounted by
7.75%; the first monthly payment is applied directly to principal. With each
draw, we have agreed to issue warrants to purchase shares of our 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 our 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 for the ten days preceding the date of the draw.
  As of
March 31, 2005, we had made three draws against the line.
  Draw
      1
    
    Draw
      2
    
    Draw
      3Date
      of draw
    June
      30, 2004
    
    September
      24, 2004
    
    December
      30, 2004Amount
      of draw
    $1,536,950
    
    $320,000
    
    $153,172Stated
      interest rate
    8.47%
    
    7.97%
    
    8.43%Effective
      interest rate
    17.79%
    
    17.14%
    
    17.61%Number
      of warrants issued
    23,903
    
    6,656
    
    3,102Exercise
      price of warrants per share
    $3.54
    
    $2.64
    
    $2.73Fair
      value of warrants
    $62,032
    
    $13,489
    
    $5,946
  The fair
value of the warrants granted is estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions applicable
to the warrants granted:
  Warrants
      granted under:Draw
      1
    
    Draw
      2
    
    Draw
      3Risk-free
      interest rate
    3.81%
    
    3.70%
    
    3.64%Volatility
    99.9%
    
    100%
    
    99.3%Expected
      dividend yield
    0%
    
    0%
    
    0%Expected
      option life
    5
      years
    
    5
      years
    
    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.
  We are
negotiating with GE Capital Corporation to open a second line of leasing credit
for an additional $5,000,000. However, we cannot assure you that we will be
successful in concluding this second line.
  40
 Concurrent
with the SLT acquisition, we assumed a $3,000,000 credit facility from a bank.
The credit facility had a commitment term of four years, which expired May 31,
2004, permitted deferment of principal payments until the end of the commitment
term, and was secured by SLT’s business assets, including collateralization
(until May 13, 2003) of $2,000,000 of SLT’s cash and cash equivalents and
short-term investments. The bank agreed to allow us to apply the cash collateral
to a paydown of the facility in 2003. The credit facility had an interest rate
of the 30-day LIBOR plus 2.25%.
  Operating
cash flow for the three months ended March 31, 2005 compared to the three months
ended March 31, 2004 decreased mostly due to the payment of various previously
recorded costs associated with the acquisition and increases in inventory for
the new products. This resulted in net cash used in operating activities of
$1,687,966 for the three months ended March 31, 2005, compared to $989,034 for
the same period in 2004.
  Net cash
provided by investing activities was $5,235,559 for the three months ended March
31, 2005 compared to cash used of $492,535 for the three months ended March 31,
2004. During the three months ended March 31, 2005, we received cash of
$6,014,450, net of acquisition costs, in the ProCyte acquisition. During the
three months ended March 31, 2005 and 2004, we utilized $722,509 and $481,398,
respectively, for production of our lasers in service.
  Net cash
used in financing activities was $144,494 for the three months ended March 31,
2005 compared to cash provided of $674,057 for the three months ended March 31,
2004. In the three months ended March 31, 2005 we made payments of $156,356 on
certain notes payable and capital lease obligations, $154,315 on the lease line
of credit and $134,462 in registration costs. These payments were offset, in
part, by receipts of $200,208 from the exercise of common stock options and
warrants and $100,431 from the release of restrictions on cash. In the three
months ended March 31, 2004, we received $814,231 from the exercise of common
stock options and warrants. These cash receipts were offset by $151,373 for the
payment of certain notes payable and capital lease obligations.
  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 vary 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, 2005, there were no items that significantly
impacted our commitments and contingencies as discussed in the notes to our 2004
annual financial statements included in our Annual Report on Form 10-K. In
addition, 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.
  41
 **ITEM
4. Controls and Procedures**
 ******
 ***Disclosure
Controls***
 We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our reports filed or submitted pursuant
to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is to
be recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission’s rules and forms.
Disclosure controls and procedures include, without limitations, controls and
procedures designed to ensure that such information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure.
  Our
management, including the Chief Executive Officer and Chief Financial Officer,
conducted an evaluation of the effectiveness of our disclosure controls and
procedures as of March 31, 2005. Based upon the evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls and
procedures were effective as of March 31, 2005.
 
 ***Changes
in Internal Controls***
 There has
been no significant change in our internal controls over financial reporting
that occurred during the first quarter 2005 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting, except for the addition of ProCyte’s internal control structures.
Management intends to process ProCyte transactions through existing ProCyte
internal control structures through the second quarter of this year, and will
process such transactions through existing PhotoMedex internal control
structures beginning with the third quarter of this year. Management will
evaluate in 2005 the ProCyte internal control structures and determine what
structures should be adopted, conformed or eliminated.
 **
 **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, 2004 for descriptions
of our legal proceedings.
  In the
action brought by the Company against Edwards Lifesciences Corporation and
Baxter Healthcare Corporation in the Superior Court for Orange County,
California, the Court deemed Defendants’ motion for summary judgment to be a
motion for judgment on the pleadings and gave the Company ten days to amend its
complaint, including a count for breach of the implied covenant of good faith
and fair dealing. The Company has made this amendment and added, among other
things, a count for unjust enrichment and added a prayer for exemplary damages
based on counts founded upon breach of fiduciary duty and conversion. The Court
has moved the trial date to December 2005.
  In the
matter brought by the Company against RA Medical Systems, Inc. and Dean Stewart
Irwin in the Superior Court for San Diego County, California, the Court of
Appeals denied the Company’s appeal from the grant by the Superior Court of
Defendants’ attorneys’ fees. The Company has petitioned the California Supreme
Court to review the decision of the Court of Appeal.
  In the
matter brought by the Company against RA Medical Systems and Mr. Irwin in the
United States District Court for the Southern District of California, the
Defendants filed a motion for summary judgment, based on a theory of res
judicata. Under this theory, Defendants have argued that the judgment from the
action brought in State court forecloses the causes of action brought by the
Company in Federal Court. The Company has controverted the motion and awaits the
judgment of the Court.
  In the
matter brought by RA Medical Systems, Inc. and Dean Stewart Irwin against
PhotoMedex, Inc., Jeffrey Levatter Ph.D., Jenkens & Gilchrist, LLP and one
of the attorneys in that firm in the Superior Court for San Diego County,
California, the Company’s motion to strike was denied. However, the Court
dismissed Dr. Levatter from the case. The Company and its codefendants have
filed an appeal from the denial of the motion. The Superior Court action is
stayed pending the appeal.
  **ITEM
2. Unregistered Sales of Equity Securities and Use of
Proceeds**
  ***Recent
Issuances of Unregistered Securities***
  None.
 42
 **ITEM
3. Defaults Upon Senior Securities**
  Not
applicable.
  **ITEM
4. Submission of Matter to a Vote of Security Holders**
  The
results of the Special Meeting of Stockholders on March 3, 2005, approving the
issuance of shares of our common stock in the acquisition of ProCyte
Corporation, were reported in our Annual Report on Form 10-K for the year ended
December 31, 2004.
  **ITEM
5. Other Information**
  On March
18, 2005, we completed the acquisition of ProCyte Corporation.
  ProCyte
Corporation (“ProCyte”) is a Washington corporation organized in 1986. ProCyte
is a medical skin care company that 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 bring unique products primarily based upon patented
technologies such as GHK and AHK copper peptide technologies, to selected
markets. ProCyte currently sells its products directly to the dermatology,
plastic and cosmetic surgery, and spa markets. The Company has also expanded the
use of its novel copper peptide technologies into the mass retail market for
skin and hair care through specifically targeted technology licensing and supply
agreements.
  ProCyte’s
products address the growing demand for skin health and hair care products,
including products designed to address the effects aging has on the skin and
hair and to enhance appearance. ProCyte’s products are formulated, branded for
and targeted at specific markets. The Company’s initial products in this area
addressed the dermatology, plastic and cosmetic surgery markets for use
following various procedures. Anti-aging skin care products were added to expand
into a comprehensive approach for incorporation into a patients’ skin care
regimen. Certain of these products incorporated their patented technologies,
while others, such as advanced sunscreen products that reduce the effects of sun
damage and aging on the skin, complement the product line.
  The
aggregate purchase price was $27,160,293 and was paid through the issuance of
10,540,579 shares of 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 $989,235 of transaction costs.
The merger consideration resulted in the equivalent of a fixed 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 upon a five-day average stock price of $2.29 per
share. The five-day average included the closing prices on the date of the
planned merger announcement and the two days prior and afterwards.
  We
accounted for the acquisition of ProCyte as a purchase by us under generally
accepted accounting principles. We allocated the purchase price based on the
fair value of ProCyte's acquired assets and assumed liabilities. We consolidated
the operating results of ProCyte with our own operating results; beginning as of
the date the parties completed the merger. The allocation of the purchase price
is as follows: $8,765,366 of acquired assets, net of assumed liabilities,
$5,400,000 of other acquired intangibles and $12,994,927 of
goodwill.
  As of
March 31, 2005, we had outstanding liabilities amounting to approximately
$1,200,000 which we have incurred and accrued for in connection with the
merger.
  43
  **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 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
 ——————
 
 **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, 2005     By: /s/
Jeffrey F. O’Donnell
 ————————————————
 Jeffrey
F. O’Donnell
 President
and Chief Executive Officer
 
 
 Date: May
10, 2005     By: /s/
Dennis M. McGrath
 ————————————————
 Dennis M.
McGrath
 Chief
Financial Officer
   44