**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-K**

 

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ý         **Annual Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**For theFiscal Year Ended December 31, 2005**

 

**or**

 

o         **Transition Report Pursuant to Section 13 or 15(d) ofthe Securities Exchange Act of 1934**

 

**CommissionFile No. 001-31257**

 

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**ADVANCEDMEDICAL OPTICS, INC.**

(Exact name of Registrant as Specified in itsCharter)

 
| **Delaware**                                           | ** ** | **33-0986820**                       |
|--------------------------------------------------------|------------|--------------------------------------|
| (State of Incorporation)                               |       | (I.R.S. Employer Identification No.) |
|                                                   |       |                                 |
| **1700  E. St. Andrew Place, Santa Ana, California**   | ** ** | **92705**                            |
| (Address of principal executive offices)               |       | (Zip Code)                           |
|                                                   |       |                                 |
| Registrant’s telephone number:**(714)  247-8200** |

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 
| **Title of each class** | ** ** | **Name of each exchange on which each class registered** |
|----------------------------------------|------------|--------------------------------------------------------------------------------------------------|
| **Common  Stock, $0.01 par value**     | ** ** | **New  York Stock Exchange**                                                                     |
| **Preferred  Stock Purchase Rights**   |       |                                                                                             |

 

Securitiesregistered pursuant to Section 12(g) of the Act:**None**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes  ý    No  o

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15 (d) of the Exchange Act. Yes o   No  ý

 

Note:  Checking the box above will not relieve anyregistrant required to file reports pursuant to Section 13 or 15 (d) of theExchange Act  from their obligationsunder those Sections.

 

Indicateby check mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days     Yes  ý    No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act (checkone):

 

Largeaccelerated filer ý            Acceleratedfiler  o            Non-acceleratedfiler  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act. Yes o    No  ý

 

Theaggregate market value of the registrant’s voting and non-voting common equityheld by non-affiliates is approximately $2.1 billion based upon theclosing price on the New York Stock Exchange as of June 24, 2005.

 

CommonStock outstanding as of February 28, 2006:  68,450,579 shares (including 1,397 shares heldin treasury).

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

PartIII incorporates certain information by reference from the registrant’s proxy statementfor the 2006 annual meeting of stockholders, which proxy statement will befiled no later than 120 days after the close of the registrant’s fiscal yearended December 31, 2005.

 

 

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**TABLE OFCONTENTS**

 
| ** **         |                                                                                                                | **Page** |
|--------------------|---------------------------------------------------------------------------------------------------------------------|----------|
| ** **         |                                                                                                                |     |
| **PART I**         |                                                                                                                |     |
|               |                                                                                                                |     |
| Item 1.            | Business                                                                                                            | 1        |
| Item 1A.           | Risk Factors                                                                                                        | 14       |
| Item 1B.           | Unresolved  Staff Comments                                                                                          | 25       |
| Item 2.            | Properties                                                                                                          | 25       |
| Item 3.            | Legal  Proceedings                                                                                                  | 25       |
| Item 4.            | Submission  of Matters to a Vote of Security Holders                                                                | 26       |
|               |                                                                                                                |     |
| **PART II**        |                                                                                                                |     |
|               |                                                                                                                |     |
| Item 5.            | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 27       |
| Item 6.            | Selected Financial  Data                                                                                            | 28       |
| Item 7.            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 30       |
| Item 7A.      | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 44       |
| Item 8.            | Financial  Statements and Supplementary Data                                                                        | 48       |
| Item 9.            | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 85       |
| Item 9A.      | Controls and  Procedures                                                                                            | 85       |
| Item 9B.      | Other Information                                                                                                   | 85       |
|               |                                                                                                                |     |
| **PART III**       |                                                                                                                |     |
|               |                                                                                                                |     |
| Item 10.      | Directors  and Executive Officers of the Registrant                                                                 | 86       |
| Item 11.      | Executive  Compensation                                                                                             | 86       |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 86       |
| Item 13.      | Certain  Relationships and Related Transactions                                                                     | 86       |
| Item 14.      | Principal  Accountant Fees and Services                                                                             | 86       |
|               |                                                                                                                |     |
| **PART IV**   |                                                                                                                |     |
|               |                                                                                                                |     |
| Item 15.      | Exhibits and  Financial Statement Schedules                                                                         | 87       |
|               |                                                                                                                |     |
| SIGNATURES         |                                                                                                                | S-1      |
| INDEX OF  EXHIBITS | S-3                                                                                                                 |
| SCHEDULE II        |                                                                                                                | S-8      |
| EXHIBITS           | (Attached to this  Report on Form 10-K)                                                                             |

 

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**PART I**

 

**Item1. Business**

 

AMO was incorporated in Delaware in October 2001 as asubsidiary of Allergan, Inc. (Allergan). Allergan spun-off our company to itsstockholders by way of a distribution of all of our shares of common stock onJune 29, 2002. As a result of our spin-off from Allergan, we are an independentpublic company, and Allergan has no continuing stock ownership in us. Unlessthe context requires otherwise, references to “AMO”, the “Company,” “we,” “us”or “our” refer to Allergan’s optical medical device business for the periodsprior to June 29, 2002 and to Advanced Medical Optics, Inc. and itssubsidiaries for the periods on or after such date.

 

**Overview**

 

We are a global leader in the development, manufactureand marketing of medical devices for the eye. We have two major product lines:ophthalmic surgical and eye care. Our ophthalmic surgical product line providesmedical devices for use in the cataract / implant and laser visioncorrection markets. In the cataract and implant market, we focus on the fourkey products required for cataract surgery – foldable intraocular lenses, orIOLs, implantation systems, phacoemulsification systems and viscoelastics. Inthe laser vision correction market, we market laser systems, diagnosticdevices, treatment cards and microkeratomes for use in laser eye surgery. Oureye care product line provides a full range of contact lens care products foruse with most types of contact lenses. These products include single-bottle,multi-purpose cleaning and disinfecting solutions, hydrogen peroxide-baseddisinfecting solutions, daily cleaners, enzymatic cleaners and contact lensrewetting drops. In addition, we sell contact lenses in Europe and Asia. Ourproducts are sold in approximately 60 countries and we have direct operationsin over 20 countries.

 

In June 2004, we completed our acquisition of PfizerInc.’s surgical ophthalmic business, which expanded our viscoelastic and IOLproduct offerings, allowing us to offer a more comprehensive portfolio ofproducts required to perform cataract surgery. We acquired the*Healon* family of viscoelastic productsand the*Tecnis* and*CeeOn* IOL brands. The addition of the*Healon* family, one of the leadingviscoelastic brands, significantly expanded our viscoelastic product line. The*Tecnis* and*CeeOn* IOL brands further strengthened our position in theophthalmic surgery market with the*Tecnis*Multifocal IOL brand further expanding our refractive IOL portfolio. We alsoacquired the*Baerveldt* glaucomashunt, or drainage device, which provided an entry for us into the glaucomamarket.

 

In May 2005, we acquired VISX, Incorporated, theglobal leader in laser vision correction. As a result of the VISX acquisition,we are a leader in the design and development of proprietary technologies andsystems for laser vision correction of refractive vision disorders. Ourproducts include the *VISX S**TAR* Excimer Laser System, which is a fully integratedophthalmic medical device incorporating an excimer laser and a computer drivenworkstation; the *VISX**WaveScan*System, which is a diagnostic device that useslaser beam technology to measure comprehensive refractive errors of the eye andderive comprehensive refractive information about a patient’s individualoptical system; and *VISX*treatmentcards, which provide the user with specific access to proprietary software andare required to operate the *VISX S**TAR* Excimer Laser System.

 

**Industry**

 

***Vision and VisionImpairment.***

 

•            *How Vision Works.* Vision is enabled by thecornea and the lens, which work together to focus light, and the iris, whichregulates the amount of light that passes through the cornea onto the retina.The retina contains light-sensitive receptors that transmit the image throughthe optic nerve to the brain.

 

•            *Cataracts.* Cataracts are an irreversibleprogressive ophthalmic condition in which the eye’s natural lens loses itsusual transparency and becomes clouded and opaque. This clouding obstructs thepassage of light to the retina and can eventually lead to blindness.

 

•            *Refractive Disorders.* Refractivedisorders, such as myopia, hyperopia, astigmatism and presbyopia, occur whenthe lens system is unable to properly focus images on the retina. For example,with myopia (nearsightedness), light rays focus in front of the retina becausethe curvature of the cornea is too steep. With hyperopia (farsightedness),light rays focus behind the retina because the curvature of the cornea is tooflat. Astigmatism makes it difficult for a person to focus on any objectbecause the otherwise uniform curvature of the cornea or lens is somehow disruptedor becomes uneven. Presbyopia is the progressive loss of flexibility of thelens and its ability to change shape to focus on near or far objects, and ispresumably caused by aging of the eye’s lens and the muscles that control theshape of the lens.

 

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*OphthalmicSurgical Products Market.* Ophthalmic surgical productsgenerally are designed to correct impaired vision through minimally invasivesurgical procedures. As the eye ages, the prevalence of cataracts andrefractive disorders generally increases. We believe that an aging population,introduction of new technologies and increasing market acceptance presentopportunities for growth in the ophthalmic surgical market.

 

*CataractTreatment.*The largest segment of the ophthalmic surgicalproducts market is the treatment of cataracts. Cataract extraction followed byIOL implantation is one of the most common surgical procedures performed in theUnited States and most other developed nations. As estimated by MarketScope,approximately 2.8 million cataract procedures were performed in the UnitedStates and over 13.3 million cataract procedures were performed worldwide in2005. MarketScope estimates that the global cataract surgery market, whichincludes sales of IOLs, phacoemulsification equipment, viscoelastics and otherrelated products, was approximately $3.1 billion in 2005 and is projected togrow at a compound annual growth rate of approximately 9% from 2005 to 2010.The data in this report attributed to MarketScope is used with the permissionof MarketScope.

 

During cataract surgery, patients are often treatedusing phacoemulsification, a process that uses ultrasound waves to break thenatural lens into tiny fragments that can be removed from the eye.Viscoelastics are used during cataract surgery to protect the inner layer ofthe cornea, provide lubrication and maintain space in the anterior chamber ofthe eye and the capsular bag in the posterior chamber (which houses the lens),allowing the eye to maintain its shape.

 

The following table sets forth the estimated revenuesfor each component of the global cataract surgery market in its variouscomponents for the year 2005 according to MarketScope (in millions):

 

| IOLs                                         |   | $   | 1,284 |
|----------------------------------------------|--------|-----|-------|
| Viscoelastics                                |   | 493 |
| Phacoemulsification machines and accessories |   | 463 |
| Other                                        |   | 825 |
| Total                                        |   | $   | 3,065 |

 

*                RefractiveVision Correction.* Another segment of the ophthalmic surgicalmarket is the surgical treatment of refractive disorders.

 

*LASIK*

 

The most common refractive surgery procedure is lasersurgery, and the most common surgical technique for treating refractivedisorders is laser assisted in-situ keratomileusis, or LASIK. LASIK involvesthe use of an automated cutting device to cut a thin corneal flap, which isthen pulled back to expose the underlying tissue, which is treated using anexcimer laser to achieve vision correction. The most common cutting device iscalled a microkeratome.

 

As a result of the VISX acquisition, we are a leaderin the design and development of proprietary technologies and systems for laservision correction of refractive vision disorders. Laser vision correction (LVC)eliminates or reduces reliance on eyeglasses or contact lenses. It employs acomputerized laser that ablates, or removes, sub-micron layers of tissue fromthe cornea, reshaping the eye and thereby improving vision.

 

Standard LASIK was introduced in the mid 1990’s. Inperforming Standard LASIK, an ophthalmologist conducts a traditional eyeexamination to determine the prescription required to correct the patient’svision. The prescription is then programmed into the laser system, whichcalculates the ablation needed to make a precise corneal correction to treatnearsightedness, farsightedness, and astigmatism. Unlike Custom LASIK (seebelow), Standard LASIK cannot correct higher order aberrations.

 

The most advanced method of performing laser visioncorrection is Custom LASIK. Custom LASIK employs a diagnostic evaluation of theeye that measures refractive errors in the patient’s vision more precisely thanpreviously available technology. The diagnostic device obtains comprehensiveinformation about the imperfections, or refractive errors, of each patient’svision. Refractive errors are displayed by the diagnostic device in the form ofan aberration map that offers a unique pattern for each patient’s eye, similarto a fingerprint. The map displays information about refractive errors thatresult in nearsightedness, farsightedness, and astigmatism, as well asinformation about higher order aberrations that were not previously measurableby any other instrument.

 

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The information from the diagnostic device is used togenerate a personalized treatment plan that is digitally transferred to thelaser system. The ablation derived from this information is thereforecustomized to the individual’s eye.

 

Laser vision correction can also be performed byphotorefractive keratectomy (“PRK”). PRK does not require the use of a microkeratomes,and the epithelial layer (or outer layer) of the cornea is removed beforeablation. Patients may experience discomfort for approximately 24 hours andblurred vision for approximately 48 to 72 hours after the procedure. Drops topromote corneal healing and alleviate discomfort may be prescribed. Althoughmost patients experience significant improvement in uncorrected vision (visionwithout the aid of eyeglasses or contact lenses) within a few days of theprocedure, unlike LASIK it generally takes several months for the final correctionto stabilize and for the full benefit of the procedure to be realized.

 

*IOLs.*Surgicalimplantation of IOLs may be used to treat those patients with refractivedisorders. Phakic IOLs can be implanted in front or in back of the iris andwork in conjunction with the patient’s natural lens to treat refractivedisorders. Multifocal IOLs address near, intermediate and distance vision andare approved for non-cataract procedures outside of the United States. Otherprocedures, such as replacing the patient’s natural lens with an accommodatingIOL for refractive vision correction, are also being developed.

 

*EyeCare Market.* As the use of contact lenses has becomeincreasingly popular, the demand for disinfecting solutions, daily cleaners,enzymatic cleaners and contact lens rewetting drops has increased. We believethat the contact lens market growth is driven by technological advancements inlens materials and designs and broader adoption among younger wearers. Inresponse to increasing popularity of more frequently replaceable lenses andconsumer interest in more convenient lens care regimens, we believe the contactlens care market continues to evolve towards greater use of single-bottle,multi-purpose solutions and away from hydrogen peroxide-based solutions. Thisevolution has had an unfavorable impact on the global hydrogen peroxide market,which is concentrated in Japan and parts of Europe.

 

Overall, we believe that strong demographic trends,new lens materials and specialty lenses are fueling global increases in thenumber of contact lens wearers, especially in China and other Asia Pacificcountries. We believe that this is contributing to overall growth inmulti-purpose solutions. The exception to this positive dynamic is in Japan,where a higher than average percent of the market has moved to daily disposablecontact lenses that use cleaning solutions only occasionally or not at all.

 

Finally, the eye care market includes artificial tearand contact lens rewetter products designed to relieve dryness associated withcontact lens wear, environmental conditions and dry eye disease. We believe theglobal market for artificial tear products exceeds $500 million per year.

 

**Our Products**

 

***Ophthalmic SurgicalProduct Line***

 

Our ophthalmic surgical products business develops,manufactures and markets medical devices for the cataract / implant and laservision correction markets, with a focus on technologically advanced products.

 

*Cataract Surgery*

 

We focus on the four key devices for the cataractsurgery market:

 

•                  *Foldable IOLs –* Foldable IOLs areartificial lenses used to replace the human lens.

 

•                  *Implantation systems –* Implantationsystems are designed and used specifically to implant IOLs during cataractsurgery.

 

•                  *Phacoemulsification systems –*Phacoemulsification systems use ultrasound during small incision cataractsurgery to break apart and remove the cloudy human lens prior to itsreplacement with an IOL.

 

•                  *Viscoelastics –* Viscoelastics provide abarrier of protection for the cornea during phacoemulsification and maintainthe shape of the eye during IOL insertion.

 

*IntraocularLenses.* As a leading provider of IOLs, we offer surgeons achoice of high quality, innovative foldable IOLs in both acrylic and silicone,together with our proprietary implantation systems, for use in minimallyinvasive cataract surgical procedures. We are the only company that offers aselection of IOLs in both silicone and acrylic materials in the United States,and

 

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we offer both monofocaland multifocal designs. Sales of our IOLs represented approximately 28%, 32%and 34% of our net sales in 2005, 2004 and 2003, respectively. Our IOLs primarilyinclude:

 

*MonofocalLenses*

 

•                  *Tecnis –* the only foldable IOL with anaspheric surface and the only IOL to receive FDA approval for claims ofimproved functional vision, which results in quicker recognition of objects inlower-light conditions. The *Tecnis* lens isthe only lens currently designated as a *“*new technologyintraocular lens*”*by the U.S. Center for Medicareand Medicaid Services. With this designation, ambulatory surgery centers canreceive $50 in additional reimbursement when implanting the *Tecnis*IOL.

 

•                  *Sensar* – an acrylic monofocal IOL, withthe patented*OptiEdge* design,intended to reduce post-surgical posterior capsular opacification, in order tolessen the need for subsequent corrective laser procedures, and to reduce thepotential for unwanted glare and reflections following implantation.

 

•                  *ClariFlex –* a silicone monofocal IOL, alsowith the*OptiEdge* design.

 

•                  *PhacoFlex*– a silicone monofocal IOL.

 

*Multifocaland Refractive Lenses*

 

•                  *ReZoom* – an acrylic multifocal IOL with optical zones thatprovide near, intermediate and distance vision, reducing that patient’sdependence on eyeglasses. The*ReZoom*IOL is also approved in Europe for the treatment of presbyopia.

 

•                  *Tecnis Multifocal*– a silicone multifocalIOL with a diffractive, aspheric lens surface is approved in Europe fortreatment of presbyopia.

 

•                  *Verisyse*– a phakic IOL that works inconjunction with the human lens to treat high myopia

 

*ImplantationSystems.* As a companion to our foldable IOLs, we marketinsertion systems for each of our foldable IOL models. The*Unfolder,* our proprietary series ofimplantation systems, which includes the*Emerald*,*SilverT* and*Silver* implantation systems, is used forinsertion of our foldable IOLs. These systems assist the surgeon in achievingcontrolled release of the intraocular lens into the capsular bag through asmall incision in the eye.

 

*PhacoemulsificationSystems.* We are a leading provider of phacoemulsificationsystems, and have a range of systems to meet market needs. Phacoemulsificationsystems use disposable or reusable packs that are necessary to operate theequipment. The majority of our phacoemulsification product sales are from salesof these packs and related accessories. Sales of our phacoemulsificationproducts represented approximately 9%, 10% and 11% of our net sales in 2005,2004 and 2003, respectively.

 

We currently market the following phacoemulsificationsystems:

 

•                  *Sovereign* – our premierphacoemulsification system is designed to reduce procedure times and providethe surgeon with increased control. The*Sovereign* system is available with our proprietary *Occlusion**Mode*and*WhiteStar* technology, whichcreates less heat and turbulence in the ocular environment, giving rise to theterm “cold phaco” and enabling better patient outcomes. Our*WhiteStar* technology also permits thesystem to offer bimanual, micro-incision phaco, a procedure which givessurgeons more operating flexibility over traditional techniques.

 

•                  *Sovereign Compact -*is a mid-sized phacoemulsification system designed to meet surgeons’needs for an advanced phacoemulsification system, with the samefunctionality of the*Sovereign*system, in a smaller, more portable size. The*Sovereign Compact* system is also available with *OcclusionMode* and*WhiteStar*technology.

 

•                  *Diplomax*– is a small-sizedphacoemulsification system designed for surgeons who need a less expensive andmore portable machine. These systemsdo not include WhiteStar technology, but do employ Occlusion Mode technology.

 

*Viscoelastics.*We acquired from Pfizer in June 2004 the*Healon* family of viscoelastics, and as a result are a leadingprovider of viscoelastic products. The*Healon* family is one of the leading brands of viscoelastics and hassignificantly expanded the scale of our existing viscoelastic offering. Thedifferent characteristics associated with each*Healon* product,*Healon, Healon GV*and*Healon5,* provide surgeonswith a range of viscoelastic choices that combine the familiarity of the*Healon* line

 

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with advancedtechnologies to satisfy different surgical needs.*Healon* was the first viscoelastic introduced into theophthalmic surgical product market and is known for its purity and ease of use.*Healon GV* is of a greater viscosity thanthe original*Healon* solution,which is designed for certain ophthalmic surgical procedures.*Healon5* is the first and onlyviscoadaptive agent to exhibit properties of both cohesive and dispersiveviscoelastics.*Healon5* has thehighest viscosity of any viscoelastic currently available and is designed tocreate and maintain a deep anterior chamber during surgery, which facilitatesmanipulation inside the eye. Sales of our viscoelastic products representedapproximately 14%, 10% and 3% of our net sales in 2005, 2004 and 2003,respectively.

 

*OtherCataract Surgical Related Products.* In addition to our IOLs,phacoemulsification equipment and viscoelastics, we also provide severalancillary products related to the cataract surgery market, including:

 

•                  *Irrigating Solutions.* We offer irrigatingsolutions for use in cataract surgery to help maintain space in the eye and to aidin removing residual tissue during phacoemulsification. Irrigating solutionsare balanced saline solutions that are compatible with the natural fluid of theanterior segment of the eye.

 

•                  *Custom Eye Trays.* We work with partners inour local markets to offer custom eye trays to our customers. These custom eyetrays typically consist of all of the ancillary items that a surgeon needs touse in a single cataract surgery, such as surgical knives, drapes, gloves andgowns. Our partners typically handle assembly, distribution and billing for theproduct and in most cases we receive a fee per tray from our partners.

 

•                  *Capsular Tension Rings.* In the UnitedStates, we sell the*StabilEyes*capsular tension ring, which is inserted into the capsular bag during cataractsurgery and functions to stabilize the capsular bag during placement of an IOL.We also market and distribute the*Inject-o-Ring* capsular tension ring in Europe. We distribute theseproducts under arrangements with Ophtec B.V. in the United States and Cornealin Europe, respectively.

 

*Other Surgical Products*

 

*GlaucomaImplant.* The*Baerveldt*glaucoma implant is indicated for use in patients with medically uncontrollableglaucoma and a poor surgical prognosis due to severe preexisting conditions.This can include: neovascular glaucoma, aphakic/pseudophakic glaucoma, failedconventional surgery, congenital glaucoma, and secondary glaucoma due touveitis or epithelial down growth.*Baerveldt*glaucoma implants are available in three models, all of which feature a largersurface area plate than competing single-quadrant devices.

 

*Laser Vision Correction*

 

Our laser vision correction products include thefollowing:

 

•                  *VISX STAR Excimer Laser System* – The *VISX STAR* System is a fully integratedophthalmic medical device incorporating an excimer laser and a computer-drivenworkstation.

 

•                  *VISX WaveScan System* – The *WaveScan* System is a diagnostic devicethat uses laser beam technology to measure comprehensive refractive errors ofthe eye and complex mathematical algorithms to derive comprehensive refractiveinformation about the patient’s individual optical system.

 

•                  *VISX Treatment Cards* – Our proprietarytreatment cards control the use of the *VISXSTAR* System.

 

•                  *Microkeratomes*– Surgeons usemicrokeratomes in LASIK procedures to cut a flap of corneal tissue beforetreatment with an excimer laser.

 

*VISXSTAR Excimer Laser System*. The laser ablations produced bythe *VISX STAR* System are theproduct of a variable diameter excimer laser beam scanning system. Seven beams thatrange in size from 0.65 to 6.5 millimeters are homogenized as they converge,scan, and rotate to produce a smooth ablation area on the eye. The *VISX STAR* System centers on the eye andtracks eye movements in three dimensions during the procedure. We also recentlyreleased our Iris Registration technology, the first fully automated method ofaligning and registering wavefront corrections for *CustomVue* treatment. Iris Registration is designed toreplace the current means of registration, which involves manual marking of theeye to assess rotational movement.

 

The *VISX STAR*System performs Standard LASIK, *CustomVue*laser vision correction, and PRK. It also performs specialized procedures knownas Custom-CAP, which treats patients who previously had LVC surgery resultingin symptomatic

 

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decentered ablations (acondition that affects fewer than 4,000 patients per year) and PhotoTherapeuticKeratectomy, or PTK, which treats corneas that are scarred or have irregularitiesfrom prior infection, trauma or underlying corneal disease.

 

*VISXWaveScan System*. The *WaveScan*System displays refractive information about the patient’s individual opticalsystem in the form of an aberration map. This unique map, similar to afingerprint for each patient’s eye, offers objective information aboutrefractive errors associated with nearsightedness, farsightedness andastigmatism, as well as information about higher order aberrations that werepreviously unmeasurable by any other instrument.

 

*VISXTreatment Cards*. Each treatment card provides the user withspecific access to proprietary software and is required to operate the *VISX STAR* System. Because treatment cardsare required to perform procedures, there is a strong correlation betweentreatment card sales and the number of procedures performed on *VISX STAR* Systems. Types of VISX treatmentcards include: *VisionKey*®Cards for performing standard LASIK procedures, which in the United Statescarries a license fee for each procedure that is purchased; *CustomVue* Cards for performing CustomLASIK, which carry a worldwide license fee for each procedure that ispurchased; Custom-CAP Cards for performing laser vision correction with apreviously decentered ablation, which carry a worldwide license fee for eachprocedure that is purchased; and the PTK Card, which is offered to physiciansat a nominal charge to treat certain types of corneal pathologies.

 

*Microkeratomes*.In the refractive surgery market, we are a worldwide distributor of the *Amadeus* and *Amadeus II* microkeratome system and *SurePass* microkeratome blades.

 

***Eye Care Product Line***

 

In the eye care market, we focus on creating productsthat make contact lenses more comfortable, simplify contact lens care andpromote ocular health. Our eye care business develops, manufactures and marketsa full range of contact lens care products for use with most types of contactlenses. Our comprehensive product offering includes single-bottle multi-purposecleaning and disinfecting solutions and hydrogen peroxide-based disinfectingsolutions to destroy harmful microorganisms in and on the surface of contactlenses; daily cleaners to remove undesirable film and deposits from contactlenses; enzymatic cleaners to remove protein deposits from contact lenses; andlens rewetting drops to provide added wearing comfort.

 

*Multi-PurposeSolutions.* We market our*Complete* brand single-bottle multi-purpose solutions, a convenient,one bottle chemical disinfecting system for soft contact lenses, on a worldwidebasis.*Complete MoisturePLUS* isthe first single-bottle, multi-purpose solution with dual demulcents to helpprevent contact lens dryness and discomfort and promote ocular health. Sales ofour multi-purpose solutions represented approximately 17%, 21% and 23% of ournet sales in 2005, 2004 and 2003, respectively. We also offer*Complete Blink-N-Clean,* a uniquein-the-eye lens cleaning solution.

 

*HydrogenPeroxide-Based Solutions.* We offer products that use hydrogenperoxide-based disinfection systems. Our leading hydrogen peroxide brands arethe*Oxysept 1 Step, Ultracare, Consept 1Step and Consept F* solutions*.*Sales of our hydrogen peroxide-based solutions represented approximately 9%, 14%and 16% of our net sales in 2005, 2004 and 2003, respectively.

 

*Lens RewettingSolutions.* We believe that dryness and discomfort are thereasons most often cited for discontinuing contact lens wear. We haveintroduced contact lens rewetting drops designed to provide prolongedlubrication and improved protection against dryness. Our products in thiscategory include*Complete* and*blink* rewetting solutions.

 

*ContactLenses*. In 2004, we entered the contact lens business outsideof the United States with the introduction of the*AquaVision* monthly disposable contact lens.

 

**Research and Development**

 

Our long-term success is dependent on the introductionof new and innovative products in both the ophthalmic surgical and eye carebusinesses. Our research and development strategy is to develop proprietaryproducts for vision correction that are safe and effective and address unmetneeds. As we implement this strategy, we will seek to develop new products withmeasurable benefits such as increased practitioner productivity, better patientoutcomes and reduced costs to health care payors and providers.

 

Research and development activities for our ophthalmicsurgical business are focused on expanding our product portfolio for bothcataract and refractive surgery. Within cataract surgery, we have focused onsix areas of opportunity to provide superior outcomes:

 

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•                  *Small incision surgery –* work with avariety of advanced lens materials to enable small incision surgery whichresults in less induced astigmatism, rapid stabilization of the wound andfaster visual rehabilitation.

 

•                  *Advances in phacoemulsification –*technology providing surgeons with high levels of cutting efficiency but withless heat and turbulence directed into the ocular environment enablingpotential for more effective and safer cataract extraction procedures.

 

•                  *Restoring accommodation following cataract surgery –*following cataract surgery, the eye may lose its ability to accommodate, orshift its field of focus.

 

•                  *Improving quality of vision* – advancementsin optics and optical surface designs.

 

•                  *Reducing posterior capsular opacification, or PCO,following cataract surgery —* PCO is a clouding of the posteriorportion of the intraocular lens that occurs in some patients following cataractsurgery. Currently, treatment of moderate to severe PCO typically requires alaser procedure.

 

•                  *Greater ease of use for practitioners –*development of advanced insertion devices which allow for easier handling inthe operating room and greater surgeon control.

 

•                  *Correcting refractive error*– advancementsin laser assisted intrastromal keratoplasty (LASIK) through both standard andwavefront guided treatments.

 

•                  *Adjunctive technologies for LASIK*–pachymetry and wavefront guided mapping of the cornea for LASIK refractiveerror correction along with microkeratome technologies for creation of thecorneal flap prior to laser ablation.

 

Current projects include expansion of our portfolio ofIOLs with the launch of the *Tecnis*acrylic IOL. Other projects include developing easier to use insertion systemsfor our foldable IOLs that provide for faster and safer procedures, andadvances to our high end phacoemulsification system including our proprietary*WhiteStar* software technology.

 

In addition to cataract surgery products, we areleveraging our expertise in IOL implant technology to the areas of the surgicalcorrection of refractive errors such as the*Verisyse* phakic IOL and two multifocal IOLs, *ReZoom Multifocal*and *Tecnis Multifocal*. These areas represent largelyunmet needs that are not addressed by current surgical procedures. Productsthat are currently under development include *Veriflex*,a foldable phakic IOL.

 

In the area of laser vision correction, our researchand development efforts include expanding treatment applications for customwavefront guided LASIK. For improved laser guided ablation, the *Star S4 IR*iris registration software wasalso launched in 2005. Further new product development includes advances inablation technology, accuracy and reliability in wavefront capture andintraoperative monitoring.

 

Our research and development efforts in the eye carebusiness are aimed at developing proprietary systems that are effective andmore convenient for customers to use, which we believe will result in longer,more comfortable lens wear and a higher rate of compliance with recommendedlens care procedures. Our efforts include seeking formulations that provideprolonged lubrication, improved protection against dryness and enhancedcleaning without irritation and ocular health. Our research and developmentefforts have resulted in the continued development of our flagship*Complete* brand multi-purpose solution and*blink* rewetter solutions, with furtheradvancements currently in development. We are also working to developover-the-counter artificial tear products.

 

We plan to supplement our research and developmentactivities with a commitment to identifying and obtaining new technologiesthrough in-licensing, technological collaborations and joint ventures,including the establishment of research relationships with academicinstitutions and individual researchers.

 

We spent approximately $61.6 million in 2005, $45.6million in 2004 and $37.4 million in 2003 on research and development. Totalresearch and development expense in 2005 was $552.4 million, including anon-cash in-process research and development charge of $490.8 million, and in 2004was $73.7 million, including a non-cash in-process research and developmentcharge of $28.1 million. Research and development spending represented 6.7%, 6.1%,and 6.2% of total net sales in 2005, 2004, and 2003, respectively. We believethat the continuing introduction of new products supplied by our research anddevelopment efforts and in-licensing opportunities are critical to our success.There are, however, inherent uncertainties associated with the

 

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research and developmentefforts and the regulatory process and we cannot assure you that any of ourresearch projects will result in new products that we can commercialize.

 

**Customers, Sales and Marketing**

 

*Customers.*Our primary customers for our ophthalmic surgical products include surgeons whoperform cataract surgeries, hospitals and ambulatory surgical centers. Theprimary customers for our eye care products include optometrists, opticians,ophthalmologists, retailers and clinics that sell directly to consumers. Theseretailers include mass merchandisers such as Wal-Mart, drug store chains suchas Walgreen, hospitals, commercial optical chains and food stores. During 2005,no customer accounted for over 10% of our net sales.

 

*Salesand Marketing.* Our sales efforts and promotional activitieswith respect to our ophthalmic surgical products are primarily aimed at eyecare professionals such as ophthalmologists who use our products. Similarly,our sales and promotional efforts in contact lens care are primarily directedtowards optometrists, opticians, optical shops, ophthalmologists and consumers.We often provide samples of our eye care products to practitioners todistribute to their patients to encourage trial use of our solutions. Inaddition, we advertise in professional journals and have a direct mail programof descriptive product literature and scientific information that we provide tospecialists in the eye care field. We have also developed training modules andseminars to update physicians regarding evolving technology. A number of ourmarketing programs include peer-to-peer marketing with practitioners educatingother practitioners about the benefits of our products.

 

Recognizing the importance of our sales force’sexpertise, we invest significant time and expense to provide training in suchareas as product features and benefits. Training for our ophthalmic surgicalproducts sales force focuses on providing sales personnel with technicalknowledge regarding the scope and characteristics of the products they areselling and developing skills in presenting and demonstrating those products.In addition to providing product knowledge for communication to eye carepractitioners, our eye care products sales force focuses on developing thenecessary skills to sell to buyers for mass merchandisers and large drug storechains. This sales force also seeks to develop relationships with eye careprofessionals who may purchase our products and recommend them to theirpatients.

 

Each of our products is marketed under its brand nameand our corporate name. We have a worldwide marketing organization which helpsus to set overall marketing direction, promote consistent global brandpositioning and allocate marketing resources to products and regions offeringthe greatest return. In order to remain sensitive to cultural differences andvarying health care systems throughout the world, tactical execution ofmarketing programs and all sales activities are carried out at the regionallevel.

 

We also use third-party distributors for thedistribution of our products in smaller geographic markets. No individual agentor distributor accounted for more than 10% of our net sales for the year endedDecember 31, 2005.

 

Traditionally, we have realized a seasonal trend inour sales, with the smallest portion of our cataract surgical business salesbeing realized in the first quarter and with sales gradually increasing fromthe second to fourth quarter. This has been driven predominantly by seasonalityin the sales of capital equipment when customers increase spending as theyreach their year end and are able to spend the remainder of their annualbudgeted amounts. In the laser vision correction business, the seasonal trendfavors the highest portion of sales in the first quarter. We expect to realizeless seasonality in future periods as we seek to diversify our salesgeographically and with more products that are less seasonal.

 

**Manufacturing, Operations andFacilities**

 

We manufacture eye care products at our facilities inHangzhou, China, and Madrid, Spain, and we manufacture surgical products at ourfacilities in Santa Clara, California, Añasco, Puerto Rico, Groningen,Netherlands and Uppsala, Sweden. As part of our separation from Allergan, weentered into an agreement with Allergan under which Allergan manufactured eyecare products for us at their facilities in Waco, Texas, Westport, Ireland, andGuarulhos, Brazil. Under this agreement, Allergan also manufactured ourophthalmic surgical product,*Vitrax,*at its Westport, Ireland facility. The manufacturing agreement terminated onJune 29, 2005. We have transitioned products manufactured by Allergan to ourSpain and China plants and to other third-party suppliers

 

As part of the transition from Allergan, in November2003, we entered into an agreement with Nicholas Piramal India Limited for thesupply of neutralizing tablets primarily used with our hydrogen-peroxide lenscare products and unit dose solutions. Nicholas Piramal will be a sole-sourcesupplier of these products. If supply of these products were interrupted, wecannot assure you that we would be able to obtain replacement products, and oureye care product sales may be negatively impacted in a material manner.

 

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We have historically outsourced the manufacture of ourphacoemulsification equipment to third parties, and we depend on single andlimited sources for several key components. Our*Sovereign* system is manufactured by Carl Zeiss Ophthalmic Systems. Ourmanufacturing and supply arrangement will terminate in 2006 when we ceaseproduction of this product. Our*SovereignCompact* system is manufactured by Sanmina-SCI under a manufacturingand supply agreement, which terminates in December 2007. If Carl ZeissOphthalmic Systems or Sanmina-SCI were to cease manufacturing any of thesesystems for any reason, we cannot assure you that we would be able to replacethem on terms favorable to us, or at all.

 

The manufacture of *VISXSTAR* Systems and *WaveScan*Systems is a complex operation involving numerous procedures, and the completedsystems must pass a series of quality control and reliability tests beforeshipment. We buy from various independent suppliers many components that areeither standard or built to our proprietary specifications, and which are thenassembled at our California facility. We also contract with third parties forthe manufacture or assembly of certain components. We depend on single andlimited sources for several key components. Please see our risk factors fordiscussion of the risks related to our reliance on single and limited sourcevendors.

 

**Governmental Regulation**

 

*UnitedStates.* Our products and operations are subject to extensiveand rigorous regulation by the FDA. The FDA regulates the research, testing,manufacturing, safety, labeling, storage, recordkeeping, promotion,distribution and production of medical devices in the United States to providereasonable assurance that medical products distributed domestically are safeand effective for their intended uses. The Federal Trade Commission alsoregulates the advertising of our products.

 

Under the Federal Food, Drug, and Cosmetic Act,medical devices are classified into one of three classes – Class I, Class II orClass III – depending on the degree of risk associated with each medical deviceand the extent of control needed to provide reasonable assurances with respectto safety and effectiveness. Our current products are Class I, II and IIImedical devices, with most being classified as Class II devices and our IOLsbeing classified as Class III devices in the United States, subject to certainexceptions.

 

Class I devices are those for which safety andeffectiveness can be reasonably assured by adherence to a set of guidelines,which include compliance with the applicable portions of the FDA’s QualitySystem Regulation, facility registration and product listing, reporting ofadverse medical events, and appropriate, truthful and non-misleading labeling,advertising, and promotional materials, referred to as the general controls.Some Class I, also called Class I reserved, devices also require premarketclearance by the FDA through the 510(k) premarket notification processdescribed below. Many Class I products are exempt from the premarketnotification requirements.

 

Class II devices are those which are subject to thegeneral controls and may require adherence to certain performance standards orother special controls (as specified by the FDA) and clearance by the FDA:Premarket review and clearance by the FDA for these devices is accomplishedthrough the 510(k) premarket notification procedure. For most Class II devices,the manufacturer must submit to the FDA a premarket notification, demonstratingthat the device is “substantially equivalent” to a legally marketed device.

 

If the FDA agrees that the device is substantiallyequivalent, it will grant clearance to commercially market the device. Byregulation, the FDA is required to complete its review of a 510(k) within 90days of submission of the notification. As a practical matter, clearance oftentakes longer. The FDA may require further information, including clinical data,to make a determination regarding substantial equivalence. If the FDAdetermines that the device, or its intended use, is not “substantiallyequivalent,” the FDA will place the device, or the particular use of thedevice, into Class III, and the device sponsor must then fulfill much morerigorous premarketing requirements, known as premarket approval.

 

A Class III product is a product which has a newintended use or uses advanced technology that is not substantially equivalentto a use or technology with respect to a legally marketed device, or for whichthere is not sufficient information to establish performance standards orspecial controls to provide reasonable assurance of the device’s safety andeffectiveness and the product is represented to be for use in supporting orsustaining human life or for a use that is of substantial importance inpreventing impairment of human health or presents a potential unreasonable riskof illness or injury. The safety and effectiveness of Class III devices cannotbe reasonably assured solely by the general controls and the other requirementsdescribed above. Therefore, these devices almost always require formal clinicalstudies to demonstrate safety and effectiveness.

 

FDA approval of a premarket approval application isrequired before marketing a Class III product. The premarket approvalapplication process is much more demanding than the 510(k) premarketnotification process. A premarket approval application, which is intended toprovide reasonable assurance that the device is safe and effective, must be supportedby extensive data, including data from preclinical studies and human clinicaltrials and existing research material, and must contain a full description 

 

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of the device and itscomponents, a full description of the methods, facilities and controls used formanufacturing, and proposed labeling. Following receipt of a premarket approvalapplication, once the FDA determines that the application is sufficientlycomplete to permit a substantive review, the FDA will accept the applicationfor review. The FDA, by statute and by regulation, has 180 days to review afiled premarket approval application, although the review of an applicationmore often occurs over a significantly longer period of time, up to severalyears.

 

In approving a premarket approval application orclearing a 510(k) notification, the FDA may also require some form ofpostmarket surveillance, whereby the manufacturer follows certain patientgroups for a number of years and makes periodic reports to the FDA on theclinical status of those patients when necessary to protect the public healthor to provide additional safety and effectiveness data for the device.

 

When FDA approval of a device requires human clinicaltrials, and if the clinical trial presents a “significant risk” (as defined bythe FDA) to human health, the device sponsor is required to file aninvestigational device exemption, or IDE, application with the FDA and obtaininvestigational device exemption approval prior to commencing the humanclinical trial. If the clinical trial is considered a “nonsignificant risk,”investigational device exemption submission to the FDA is not required.Instead, only approval from the Institutional Review Board overseeing theclinical trial is required, although the study is still subject to FDAoversight under other provisions of the IDE regulation. Human clinical studiesare generally required in connection with approval of Class III devices and toa much lesser extent for Class I and II devices. Clinical trials conductedabroad must also comply with local regulations.

 

*ContinuingFood and Drug Administration Regulation.* After the FDApermits a device to enter commercial distribution, numerous regulatoryrequirements apply. These include:

 

•                  the registrationand listing regulation, which requires manufacturers to register allmanufacturing facilities and list all medical devices placed into commercialdistribution;

 

•                  the QualitySystem Regulation, which requires manufacturers to follow elaborate design,testing, control, documentation and other quality assurance procedures duringthe manufacturing process;

 

•                  labelingregulations;

 

•                  the FDA’sgeneral prohibition against promoting products for unapproved or “off-label”uses; and the Medical Device Reporting regulation, which requires thatmanufacturers report to the FDA if their device may have caused or contributedto a death or serious injury or malfunctioned in a way that would likely causeor contribute to a death or serious injury if it were to reoccur;

 

•                  Medical DeviceReporting and recall requirements;

 

•                  Device trackingrequirements; and

 

•                  Post Marketsurveillance requirements.

 

Failure to comply with the applicable U.S. medicaldevice regulatory requirements could result in, among other things, warningletters, fines, injunctions, civil penalties, repairs, replacements, refunds,recalls or seizures of products, total or partial suspension of production, theFDA’s refusal to grant future premarket clearances or approvals, withdrawals orsuspensions of current product applications, and criminal prosecution.

 

*GovernmentalReimbursement.* In the United States, a significant percentageof the patients who receive our IOLs are covered by the federal Medicareprogram. When a cataract extraction with IOL implantation is performed in anambulatory surgical center, Medicare provides the ambulatory surgical centerwith a fixed facility fee that includes a recommended $150 allowance to coverthe cost of the IOL. After the Centers for Medicare and Medicaid Services (CMS)(formerly the Health Care Financing Administration), awarded “new technologyintraocular lens” status to our***Tecnis*IOL in 2006, the reimbursement rate for *Tecnis*IOLs implanted in ambulatorysurgical centers increased to $200 until February 2011. When the procedure isperformed in a hospital outpatient department, the hospital’s reimbursement isbased on a prospective payment that includes payment for the IOL. The allowanceis the same for all IOLs.

 

At the end of 2003, Congress enacted the MedicarePrescription Drug Improvement and Modernization Act of 2003. Among otherthings, this 1egislation requires CMS to establish a new Medicare paymentsystem for services performed in

 

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ambulatory surgicalcenters. This payment system is to be effective no sooner than January 1, 2006,and no later than January 1, 2008. At this time, it is not possible todetermine how this new payment system could affect our revenues or financialcondition.

 

In addition, if implemented, price controls or othercost-containment measures could materially and adversely affect our revenuesand financial condition.

 

We cannot predict the likelihood or pace of any othersignificant legislative or regulatory action in these areas, nor can we predictwhether or in what form health care legislation being formulated by variousgovernments will be passed. Medicare reimbursement rates are subject to changeat any time. We also cannot predict with precision what effect such governmentalmeasures would have if they were ultimately enacted into law. In general,however, we believe that legislative and regulatory initiatives will likelycontinue, and the adoption of new payment or coverage policies can have someimpact on our business.

 

*InternationalRegulation.* Internationally, the regulation of medicaldevices is also complex. In Europe, our products are subject to extensiveregulatory requirements. The regulatory regime in the European Union formedical devices became mandatory in June 1998. It requires that medical devicesmay only be placed on the market if they do not compromise safety and healthwhen properly installed, maintained and used in accordance with their intendedpurpose. National laws conforming to the European Union’s legislation regulateour IOLs and eye care products under the medical devices regulatory system,rather than the more variable national requirements under which they wereformerly regulated. The European Union medical device laws requiremanufacturers to declare that their products conform to the essentialregulatory requirements after which the products may be placed on the marketbearing the CE marking. The manufacturers’ quality systems for products in allbut the lowest risk classification are also subject to certification and auditby an independent notified body. In Europe, particular emphasis is being placedon more sophisticated and faster procedures for the reporting of adverse eventsto the competent authorities.

 

In Japan, premarketing approval and clinical studiesare required, as is governmental pricing approval for medical devices. Clinicalstudies are subject to a stringent “Good Clinical Practices” standard. Approvaltime frames from the Japanese Ministry, Health, Labor and Welfare (MHLW) vary fromsimple notifications to review periods of one or more years, depending on thecomplexity and risk level of the device. In addition, importation into Japan ofmedical devices is subject to “Good Import Practices” regulations. As with anyhighly regulated market, significant changes in the regulatory environmentcould adversely affect future sales.

 

In many of the other foreign countries in which wemarket our products, we may be subject to regulations affecting, among otherthings:

 

•                  productstandards;

 

•                  packagingrequirements;

 

•                  labelingrequirements;

 

•                  quality systemrequirements;

 

•                  importrestrictions;

 

•                  tariffregulations;

 

•                  duties; and

 

•                  taxrequirements.

 

Many of the regulations applicable to our devices andproducts in these countries are similar to those of the FDA. In many countries,the national health or social security organizations require our products to bequalified before they can be marketed with the benefit of reimbursementeligibility.

 

*Fraudand Abuse.* We are subject to various federal and state lawspertaining to health care fraud and abuse, including anti-kickback laws,physician self-referral laws, and false claims laws. Violations of these lawsare punishable by criminal and/or civil sanctions, including, in some instances,imprisonment and exclusion from participation in federal and state health careprograms, including Medicare, Medicaid, Veterans Administration (VA) healthprograms and TRICARE. Although we believe that our operations are in materialcompliance with such laws, we can give no assurances as these laws arefar-reaching and their

 

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interpretation is subjectto change. As a result, we could be required to alter one or more of ourpractices to remain in compliance with these laws. The occurrence of one ormore violations of these laws could result in a material adverse effect on ourfinancial condition and results of operations.

 

*Anti-KickbackLaws.* Our operations are subject to federal and stateanti-kickback laws. Provisions of the Social Security Act, commonly known asthe “Anti-Kickback Law,” prohibit entities, such as our company, from knowinglyand willfully offering, paying, soliciting or receiving any form ofremuneration in return for, or to induce:

 

•                  the referral ofpersons eligible for benefits under a federal health care program, includingMedicare, Medicaid, the VA health programs and TRICARE, or a state healthprogram; or

 

•                  therecommendation, purchase, lease or order of items or services that are covered,in whole or in part, by a federal health care program or state health programs.

 

The Anti-Kickback Law may be violated when even onepurpose, as opposed to a primary or sole purpose, of a payment is to inducereferrals or other business. Federal regulations create a small number of “safeharbors.” Practices which meet all the criteria of an applicable safe harborwill not be deemed to violate the statute; practices that do not satisfy allelements of a safe harbor do not necessarily violate the statute, although suchpractices may be subject to scrutiny by enforcement agencies.

 

Violation of the Anti-Kickback Law is a felony,punishable by substantial fines and (for individuals) imprisonment. Inaddition, the Department of Health and Human Services may impose civilpenalties and exclude violators from participation in federal or state healthcare programs (including Medicare, Medicaid, VA health programs, and TRICARE);if a manufacturer is excluded, its products are not eligible for reimbursementby these programs. Many states have adopted similar anti-kickback laws, whichvary in scope and may extend to payments intended to induce the recommendation,purchase, or order of products reimbursed by private payors as well as federalor state health care programs.

 

**Employee Relations**

 

At December 31, 2005, we employed approximately 3,440 personsthroughout the world, including approximately 900 in the United States. None ofour U.S.-based employees are represented by unions. We consider our relationswith our employees to be, in general, very good.

 

**Global Sales**

 

Net sales in the United States were approximately $302.5million, $186.9 million and $153.5 million for the years ended December 31, 2005,2004 and 2003, respectively. Our international sales represented approximately $618.2million,  $555.2 million and $448.0million for the years ended December 31, 2005, 2004 and 2003, respectively, or 67%,75%, and 74% of total sales, respectively. Sales in Japan were approximately $174.3million, $191.5 million and $164.1 million for the years ended December 31, 2005,2004 and 2003, respectively. Our products are sold in over 60 countries. Salesare attributed to the country where the customer resides. Marketing activitiesare coordinated on a worldwide basis, and resident management teams provideleadership and infrastructure for introduction of new products in the localmarkets. For additional information relating to our geographic operatingsegments, see Note 14 of Notes to Consolidated Financial Statements.

 

**Raw Materials**

 

We use a diverse and broad range of raw materials inthe design, development and manufacture of our products. While we do fabricateor formulate some of our materials at our manufacturing facilities, we purchasemost of the materials and components used in manufacturing our products fromexternal suppliers. In addition, we purchase some supplies from single sourcesfor reasons of quality assurance, sole source availability, cost effectivenessor constraints resulting from regulatory requirements. Several of our materialsare sole sourced, including the source of hyaluronic acid used in manufacturingour*Healon* family of products.However, we work closely with our suppliers to assure continuity of supplywhile maintaining high quality and reliability. Where we buy a material fromone source and other sources are available, alternative supplier options aregenerally considered and identified, although we do not typically pursueregulatory qualification of alternative sources due to the strength of ourexisting supplier relationships and the time and expense associated with theregulatory process. A change in suppliers could require significant effort orinvestment by us in circumstances where the items supplied are integral to theperformance of our products or incorporate unique technology.

 

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**Environmental Matters**

 

Our facilities and operations are subject to federal,state and local environmental and occupational health and safety requirementsof the United States and foreign countries, including those relating todischarges of substances to the air, water and land, the handling, storage anddisposal of wastes and the cleanup of properties affected by pollutants. Webelieve we are currently in material compliance with such requirements and donot currently anticipate any material adverse effect on our business orfinancial condition as a result of our efforts to comply with suchrequirements.

 

In the future, federal, state or local governments inthe United States or foreign countries could enact new or more stringent lawsor issue new or more stringent regulations concerning environmental and workerhealth and safety matters that could affect our operations. Also, in thefuture, contamination may be found to exist at our current or former facilitiesor off-site locations where we have sent wastes. We could be held liable forsuch newly-discovered contamination which could have a material adverse effecton our business or financial condition. In addition, changes in environmentaland worker health and safety requirements could have a material effect on ourbusiness or financial condition.

 

**Competition**

 

The markets for our ophthalmic surgical device and eyecare products are intensely competitive and are subject to significanttechnological change. Companies within the ophthalmic surgical device marketcompete on technological leadership and innovation, quality and efficacy ofproducts, relationships with eye care professionals and health care providers,breadth and depth of product offering and pricing. We believe we have thesecond largest ophthalmic surgical device business on a global basis behindAlcon, Inc., a subsidiary of Nestle S.A. Other competitors in the ophthalmicsurgical device business include Bausch & Lomb, Staar Surgical, Moria, Nidek,IntraLase, Eyeonics, Hoya, Santen, and Corneal. We believe our competitiveposition is enhanced by our global distribution network, our focus ontechnology and customer relationships and product quality. Our ability tocompete against larger companies may be impeded by having fewer resources todevote to research and development, sales and marketing.

 

Companies within the eye care market compete primarilyon recommendations from eye care professionals, customer brand loyalty, productquality and pricing. We believe we have one of the top three largest contactlens care businesses on a global basis along with Alcon and Bausch & Lomb.Other competitors include CIBA Vision Corporation, a unit of Novartis; Moria,and in the contact lens business, CooperVision, Vistakon, a Johnson and Johnsoncompany, and CIBA Vision Corporation. Our competitive position in the eye carebusiness is enhanced by our strong presence outside the United States and ourknowledge of these foreign markets, as well as technological advancement. Ourlarger competitors have more resources to devote to advertising and promotion,and this may negatively impact our competitive position.

 

Our competitors may develop technologies and productsthat are more effective or less costly than any of our current or futureproducts or that could render our products obsolete or noncompetitive. Some ofthese competitors have substantially more resources and marketing capabilitiesthan we do. Among other things, these consolidated companies can spread theirresearch and development costs over much broader revenue bases than we can andcan influence customer and distributor buying decisions. Our inability toproduce and develop products that compete effectively against those of ourcompetitors could result in a material reduction in sales.

 

**Patents, Trademarks and OtherIntellectual Property**

 

Patents and other proprietary rights are important tothe success of our business. We likewise utilize trade secrets, know-how,continuing technological innovations and licensing opportunities to develop andmaintain our competitive position. We protect our proprietary rights through avariety of methods, including confidentiality agreements and proprietaryinformation agreements with vendors, employees, consultants and others who haveaccess to our proprietary information.

 

We have rights to over 1,400 granted and issuedpatents and approximately 970 pending patent applications relating to aspectsof the technology incorporated in many of our products. The scope and durationof our proprietary protection varies throughout the world by jurisdiction andby individual product. In particular, patents for individual products extendfor varying periods of time according to the date a patent application isfiled, the date a patent is granted and the term of patent protection availablein the jurisdiction granting the patent. Our proprietary protection oftenaffords us the opportunity to enhance our position in the marketplace byprecluding our competitors from using or otherwise exploiting our technology.

 

We believe trademark protection is particularlyimportant to the maintenance of the recognized brand names under which wemarket our products. The scope and duration of our trademark protection variesthroughout the world, with some countries protecting trademarks only as long asthe mark is used, and others requiring registration of the mark and the paymentof

 

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registration fees. We ownor have rights to material trademarks or trade names that we use in conjunctionwith the sale of our products, which include, among others,*Advanced Medical Optics®, AmadeusTM,AMO®,  Array®,** Baerveldt®, blinkTM,Blink-n-Clean®, ClariFlex®, Complete®*,*Complete MoisturePLUSTM, Consept®,Consept 1 StepTM, Custom Vue®,  Healon®, Healon5®,Healon GV®, Injector RingTM, OcupureTM, OptiEdgeTM,Oxysept®, Oxysept 1 StepTM, PhacoFlex®, ReZoom®**, Sensar®, Sovereign®,Sovereign CompactTM, Stabileyes®, Star S4 IRTM,Tecnis®, The Unfolder®, UltraCare®,Ultrazyme®, VerisyseTM, VISX®, WaveScan®,*and*WhiteStar®*.Generally, our products are marketed under one of these trademarks or brandnames. *Amadeus*is a trademark of SIS Ltd.

 

We are also a party to several license agreementsrelating to various of our products; however, we do not believe the loss of anyone license would materially affect our business.

 

We believe that our patents, trademarks and otherproprietary rights are important to the development and conduct of our businessand the marketing of our products. As a result, we aggressively protect ourintellectual property. However, we do not believe that any one of our patentsor trademarks is currently of material importance in relation to our overallsales.

 

**Information Available on our Website**

 

Our Internet address is www.amo-inc.com. We makeavailable on our website, free of charge, our filings made with the SECelectronically, including those on Form 10-K, Form 10-Q, and Form 8-K, and anyamendments to those filings. Copies are available as soon as reasonablypracticable after we have filed or furnished these documents to the SEC. OurCode of Ethics, which applies to all employees, is available on our website.Our Code of Ethics is also available in print to any stockholder who requestsit from our Investor Relations department, (714) 247-8348. Any changes to theCode of Ethics or waivers granted to our chief executive officer, chief financialofficer or controller by our board of directors will be publicized on ourwebsite***.***

 

**Item 1A. Risk Factors**

 

You should carefully consider the following risks andother information. These risks and uncertainties are not the only ones we face.Others that we do not know about now, or that we do not now think areimportant, may also impair our business. The risks described in this section couldcause our actual results to differ materially from those anticipated.

 

**Risks Relating to Our Business**

 

***We may not successfullymake or integrate acquisitions or enter into strategic alliances.***

 

As part of our business strategy, we intend to pursueselected acquisitions and strategic alliances and partnerships. We compete withother ophthalmic surgical products and eye care companies, among others, forthese opportunities and we cannot assure you that we will be able to effectstrategic alliances, partnerships or acquisitions on commercially reasonableterms or at all. Even if we do enter into these transactions, we may experience:

 

•                  delays inrealizing the benefits we anticipate, or we may not realize the benefits weanticipate at all;

 

•                  difficulties inintegrating any acquired companies and products into our existing business;

 

•                  attrition of keypersonnel from acquired businesses;

 

•                  costs orcharges;

 

•                  difficulties ordelays in obtaining regulatory approvals;

 

•                  higher costs ofintegration than we anticipated; or

 

•                  unforeseenoperating difficulties that require significant financial and managerialresources that would otherwise be available for the ongoing development orexpansion of our existing operations.

 

Consummating these transactions could also result inthe incurrence of additional debt and related interest expense, as well asunforeseen contingent liabilities, all of which could have a material adverseeffect on our business, financial condition and results of operations. We mayalso issue additional equity in connection with these transactions, which woulddilute our existing stockholders.

 

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***We conduct asignificant amount of our sales and operations outside of the United States,which subjects us to additional business risks that may cause our profitabilityto decline.***

 

Because we manufacture and sell a significant portionof our products in a number of foreign countries, our business is subject torisks associated with doing business internationally. In particular, ourproducts are sold in over 60 countries, and our manufacturing facilities arelocated outside the continental United States, in Añasco, Puerto Rico; Madrid,Spain; and Hangzhou, China. In connection with the acquisition of Pfizer’s ophthalmicsurgical business, we acquired Pfizer’s ophthalmic surgical products andcertain manufacturing and research and development facilities located inUppsala, Sweden and Groningen, Netherlands. In 2005, on an historical basis, wederived approximately $618.2 million, or 67%, of our net sales, from sales ofour products outside of the United States, including 19% of our net sales inJapan. We intend to continue to pursue growth opportunities in salesinternationally, which could expose us to greater risks associated withinternational sales and operations. Our international operations are, and willcontinue to be, subject to a number of risks and potential costs, including:

 

•                  unexpectedchanges in foreign regulatory requirements;

 

•                  differing localproduct preferences and product requirements;

 

•                  fluctuations inforeign currency exchange rates;

 

•                  political andeconomic instability;

 

•                  changes inforeign medical reimbursement and coverage policies and programs;

 

•                  diminishedprotection of intellectual property in some countries outside of the UnitedStates;

 

•                  trade protectionmeasures and import or export licensing requirements;

 

•                  difficulty instaffing and managing foreign operations;

 

•                  differing laborregulations; and

 

•                  potentiallynegative consequences from changes in tax laws.

 

Any of these factors may, individually or as a group,have a material adverse effect on our business and results of operations. Inaddition, we are particularly susceptible to the occurrence of any of theserisks in Japan, due to our high concentration of sales in Japan.

 

As we expand our existing international operations, wemay encounter new risks. For example, as we focus on building our internationalsales and distribution networks in new geographic regions, we must continue todevelop relationships with qualified local distributors and trading companies.If we are not successful in developing these relationships, we may not be ableto grow sales in these geographic regions. These or other similar risks couldadversely affect our revenue and profitability.

 

***We are exposed toforeign currency risks from our international operations that could adverselyaffect our financial results.***

 

A significant portion of our sales and operating costsare, and from time to time, a portion of our indebtedness may be, denominatedin foreign currencies. We are therefore exposed to fluctuations in the exchangerates between the U.S. dollar and the currencies in which our foreignoperations receive revenues and pay expenses, including debt service. Ourconsolidated financial results are denominated in U.S. dollars and therefore,during times of a strengthening U.S. dollar, our reported international salesand earnings will be reduced because the local currency will translate intofewer U.S. dollars. In addition, the assets and liabilities of our non-U.S.subsidiaries are translated into U.S. dollars at the exchange rates in effectat the balance sheet date. Revenues and expenses are translated into U.S.dollars at the weighted average exchange rate for the period. Translationadjustments arising from the use of differing exchange rates from period toperiod are included in “Accumulated other comprehensive income (loss)” in “Stockholders’equity.” Gains and losses resulting from foreign currency fluctuations andremeasurements relating to foreign operations deemed to be operating in U.S.dollar functional currency are included in “Other, net” in our consolidatedstatements of operations. Accordingly, changes in currency exchange rates willcause our net earnings and stockholders’ equity to fluctuate.

 

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***If we do notintroduce new commercially successful products in a timely manner, our productsmay become obsolete over time, customers may not buy our products and ourrevenue and profitability may decline.***

 

Demand for our products may change in ways we may notanticipate because of:

 

•                  evolvingcustomer needs;

 

•                  the introductionof new products and technologies;

 

•                  evolvingsurgical practices; and

 

•                  evolvingindustry standards.

 

Without the timely introduction of new commerciallysuccessful products and enhancements, our products may become obsolete overtime, in which case our sales and operating results would suffer. The successof our new product offerings will depend on several factors, including ourability to:

 

•                  properlyidentify and anticipate customer needs;

 

•                  commercializenew products in a cost-effective and timely manner;

 

•                  manufacture anddeliver products in sufficient volumes on time;

 

•                  obtainregulatory approval for such new products;

 

•                  differentiateour offerings from competitors’ offerings;

 

•                  achieve positiveclinical outcomes;

 

•                  satisfy theincreased demands by health care payors, providers and patients for lower-costprocedures;

 

•                  innovate anddevelop new materials, product designs and surgical techniques; and

 

•                  provide adequatemedical and/or consumer education relating to new products and attract keysurgeons to advocate these new products.

 

Moreover, innovations generally will require asubstantial investment in research and development before we can determine thecommercial viability of these innovations and we may not have the financialresources necessary to fund these innovations. In addition, even if we are ableto successfully develop enhancements or new generations of our products, theseenhancements or new generations of products may not produce revenue in excessof the costs of development and they may be quickly rendered obsolete bychanging customer preferences or the introduction by our competitors ofproducts embodying new technologies or features.

 

***We are implementinga product rationalization and repositioning plan, which will requiresignificant financial and personnel resources and may not be successful.***

 

On October 31, 2005, our Board of Directors approved aproduct rationalization and repositioning plan covering the discontinuation ofnon-strategic cataract surgical and eye care products and the elimination orredeployment of resources that support these product lines. The plan includesorganizational changes and potential reductions in force in manufacturing,sales and marketing associated with these product lines, as well asorganizational changes in research and development and other corporatefunctions designed to align the organization with our strategy and strategicbusiness unit organization. The plan further calls for increasing ourinvestment in key growth opportunities, specifically our refractive implantproduct line and international laser vision correction business, andaccelerating the implementation of productivity initiatives.

 

We expect that implementation of the productrationalization and repositioning plan will result in significant pre-taxcharges, a substantial portion of which are expected to be cash expenditures.In addition, because we are in the preliminary stages of effectuating the planand are subject to laws and regulations of several foreign jurisdictions thatwill require consultations and negotiations with works councils, labororganizations and local authorities the effects of which we can not yet fullyevaluate, the final costs of the plan may vary significantly from our initialestimates. Implementation of the plan also will require substantial

 

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personnel resources andmay result in diversion of management’s attention away from other business activitiesthat could be beneficial to our operations. We may not be able to successfullyexecute the plan as, and in the time frame, anticipated. In addition, lostsales of discontinued products may not be sufficiently offset by sales frompromoted or new products, which could decrease our revenues, margins, profitsand cash flows.

 

***We rely on certainsuppliers and manufacturers for raw materials and other products and arevulnerable to fluctuations in the availability and price of such products andservices.***

 

We purchase certain raw materials and other productsfrom third-party suppliers and vendors, sometimes from limited sources. Oursuppliers and vendors may not provide the raw materials or other productsneeded by us in the quantities requested, in a timely manner, or at a price weare willing to pay. In the event any of our third-party suppliers or vendorswere to become unable or unwilling to continue to provide important rawmaterials and third-party products in the required volumes and quality levelsor in a timely manner, we would be required to identify and obtain acceptablereplacement supply sources. We may not be able to obtain alternative suppliersand vendors on a timely basis, or at all, which could result in lost salesbecause of our inability to manufacture products containing such raw materialsor deliver products we sell from certain suppliers. In addition, we also relyon certain manufacturers for some of our products. We have historicallyoutsourced the manufacture of our phacoemulsification equipment to thirdparties. If we were unable to renew our third-party manufacturing agreements,or if the manufacturers were to cease manufacturing any of these products forus for any reason, we may not be able to find alternative manufacturers on termsfavorable to us, in a timely manner, or at all. If any of these events shouldoccur, our business, financial condition and results of operations could bematerially adversely affected.

 

***We face intensecompetition, and our failure to compete effectively could have a materialadverse effect on our profitability and results of operations.***

 

We face intense competition in the markets for ourophthalmic surgical and eye care products and these markets are subject torapid and significant technological change. We have numerous competitors in theUnited States and abroad, including, among others, large companies such asAlcon, Inc., a publicly traded subsidiary of Nestle S.A.; Bausch & Lomb;CIBA Vision Corporation, a unit of Novartis; Moria; Intralase; Eyeonics; Hoya,Santen, Corneal, CooperVision; and Vistakon, a Johnson and Johnson company.Many of our competitors have substantially more resources and a greatermarketing scale than we do. We may not be able to sustain our current levels ofprofitability and growth as competitive pressures, including pricing pressurefrom competitors, increase. In addition, if we are unable to develop andproduce or market our products to effectively compete against our competitors,our operating results will materially suffer. We also compete against a largenumber of providers of alternative vision correction solutions, some of whichmay have greater financial resources than us. New or different methods ofvision correction are continually being introduced. Any of these competitivepressures could result in decreased demand for our products.

 

Because of our leading market position in the laservision correction business, all of our competitors target our market share inorder to grow their own revenues. We can give no assurance that we will be ableto maintain or grow our existing market share and it may, in fact, be requiredto incur considerable expenditures in order to maintain or increase that marketshare. Should our procedure market share decline, it could have a material adverseeffect on our business, financial position, and results of operations.

 

***Trends in thecontact lens care market may negatively impact our eye care business.***

 

Our eye care business is impacted by trends in thecontact lens care market such as more simplified disinfection systems andtechnological and medical advances in surgical techniques for the correction ofvision impairment. Less expensive one-bottle chemical disinfection systems havegained popularity among soft contact lens wearers instead of peroxide-basedlens care products. Also, the growing use and acceptance of daily and extendedwear contact lenses and laser correction procedures, along with the otherfactors above, could have the effect of continuing to reduce demand for lenscare products generally. Our marketing and sales plans may not be appropriateor sufficient to mitigate the effect of these trends on our eye care businessand, as a result, our eye care business may suffer.

 

***If we are unable toprotect our intellectual property rights, our business and prospects may beharmed.***

 

Our ability to compete effectively is dependent uponour ability to protect and preserve the proprietary aspects of the designs,processes, technologies and materials owned by, used by or licensed to us. Wehave numerous U.S. patents and corresponding foreign patents that are expectedto expire by their own terms at various dates and have additional patentapplications pending that may not result in issued patents. Our failure tosecure these patents may limit our ability to protect the intellectual propertyrights that these applications were intended to cover. Although we haveattempted to protect our proprietary property, technologies and processes bothin the United States and in foreign countries through a combination of patentlaw, trade

 

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secrets andnon-disclosure agreements, these may be insufficient. Competitors may be ableto design around our patents to compete effectively with our products. We alsomay not be able to prevent third parties from using our technology without ourauthorization, breaching any non-disclosure agreements with us, orindependently developing technology that is similar to ours. The use of ourtechnology or similar technology by others could reduce or eliminate anycompetitive advantage we have developed, cause us to lose sales or otherwiseharm our business. If it became necessary for us to resort to litigation toprotect these rights, any proceedings could be costly and we may not prevail.Further, we may not be able to obtain patents or other protections on ourfuture innovations. In addition, because of the differences in foreign patentand other laws concerning proprietary rights, our products may not receive thesame degree of protection in foreign countries as they would in the UnitedStates. We cannot assure you that:

 

•                  pending patentapplications will result in issued patents;

 

•                  patents issuedto or licensed by us will not be challenged by third parties; or

 

•                  our patents willbe found to be valid or sufficiently broad to protect our technology or provideus with a competitive advantage.

 

***We may be subjectto intellectual property litigation and infringement claims, which could causeus to incur significant expenses or prevent us from selling our products.***

 

There is a substantial amount of litigation overpatent and other intellectual property rights in the eye care industry and inthe ophthalmic surgical products and contact lens care markets particularly.The fact that we have patents issued to us for our products does not mean thatwe will always be able to successfully defend our patents and proprietaryrights against challenges or claims of infringement by our competitors. Asuccessful claim of patent or other intellectual property infringement ormisappropriation against us could adversely affect our growth andprofitability, in some cases materially. We cannot assure you that our productsdo not and will not infringe issued patents or other intellectual property rightsof third parties. From time to time, in the ordinary course of business, wereceive notices from third parties alleging infringement or misappropriation ofthe patent, trademark and other intellectual property rights of third partiesby us or our consumers in connection with the use of our products. We may beunaware of intellectual property rights of others that may cover some of ourtechnology. If someone claims that our products infringe their intellectualproperty rights, whether or not such claims are meritorious, any resultinglitigation could be costly and time consuming and would divert the attention ofour management and personnel from other business issues. The complexity of thetechnology involved and the uncertainty of intellectual property litigationincrease these risks. Claims of intellectual property infringement also mightrequire us to enter into costly royalty or license agreements (if available onacceptable terms or at all). We also may be subject to significant damages oran injunction preventing us from manufacturing, selling or using some or someaspect of our products. We may also need to redesign some of our products orprocesses to avoid future infringement liability. Any of these adverseconsequences could have a material adverse effect on our business andprofitability.

 

***Our manufacturingcapacity may not be adequate to meet the demands of our business.***

 

If our sales increase substantially, we may need toincrease our production capacity. Any prolonged disruption in the operation ofour manufacturing facilities or those of our third-party manufacturers couldmaterially harm our business. We cannot assure you that if we choose toscale-up our manufacturing operations, we will be able to obtain regulatoryapprovals in a timely fashion, which could affect our ability to meet productdemand or result in additional costs.

 

***We could experiencelosses due to product liability claims, product recalls or corrections.***

 

We have in the past been, and continue to be, subjectto product liability claims. In connection with our spin-off from Allergan, weassumed the defense of any litigation involving claims related to our businessand agreed to indemnify Allergan for all related losses, costs and expenses. Aspart of our risk management policy, we have obtained third-party productliability insurance coverage. Product liability claims against us may exceedthe coverage limits of our insurance policies or cause us to record aself-insured loss. A product liability claim in excess of applicable insurancecould have a material adverse effect on our business, financial condition andresults of operations. Even if any product liability loss is covered by aninsurance policy, these policies have substantial retentions or deductiblesthat provide that we will not receive insurance proceeds until the lossesincurred exceed the amount of those retentions or deductibles. To the extentthat any losses are below these retentions or deductibles, we will beresponsible for paying these losses. The payment of retentions or deductiblesfor a significant amount of claims could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

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In addition, we are subject to medical device reportingregulations that require us to report to the FDA or similar governmentalauthorities in other countries if our products cause or contribute to a deathor serious injury or malfunction in a way that would be reasonably likely tocontribute to death or serious injury if the malfunction were to recur. The FDAand similar governmental authorities in other countries have the authority torequire the recall of our products in the event of material deficiencies ordefects in design or manufacturing. A government mandated or voluntary recallby us could occur as a result of manufacturing errors or design defects,including defects in labeling. We have undertaken voluntary recalls of ourproducts in the past.

 

Any product liability claim or recall would divertmanagerial and financial resources and could harm our reputation withcustomers. We cannot assure you that we will not have product liability claimsor recalls in the future or that such claims or recalls would not have amaterial adverse effect on our business.

 

***If we fail tomaintain our relationships with health care providers, customers may not buyour products and our revenue and profitability may decline.***

 

We market our products to numerous health careproviders, including eye care professionals, hospitals, ambulatory surgicalcenters, corporate optometry chains and group purchasing organizations. We havedeveloped and strive to maintain close relationships with members of each ofthese groups who assist in product research and development and advise us onhow to satisfy the full range of surgeon and patient needs. We rely on thesegroups to recommend our products to their patients and to other members oftheir organizations. The failure of our existing products and any new productswe may introduce to retain the support of these various groups could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

***We generally do nothave long-term contracts with our customers.***

 

We generally do not enter into long-term contractswith our customers. As a result, we are exposed to volatility in the market forour products and loss of our customers. As a result, we may not be able tomaintain our level of profitability. If we are unable to market our products onterms we find acceptable, our financial condition and results of operationscould suffer materially.

 

***Our business issubject to extensive government regulation.***

 

Our products and operations are subject to extensiveregulation in the United States by the FDA and various other federal and stateregulatory agencies, including with respect to regulatory clearance or approvalof our products, clinical and pre-clinical testing, product marketing, salesand distributions, adverse event reporting, prohibitions on fraud and abuse,submission of false claims, kickbacks and rebates, and relationships withphysicians and other referral sources. Additionally, in many foreign countriesin which we market our products, we are subject to similar regulations.

 

Before a new medical device or new use of, or claimfor, or modification to an existing product can be marketed in the UnitedStates, a company must first apply for and receive either 510(k) clearance,premarket approval or a premarket approval supplement from the FDA, unless an exemptionapplies. Either process can be expensive, lengthy and unpredictable. Also, theidentification or increased frequency of safety or efficacy concerns couldresult in product recall or withdrawal or revocation of our FDA clearance orpremarket approval. Compliance with these regulations is expensive andtime-consuming. We, our subcontractors, and third party manufacturers aresubject to periodic and unannounced inspections by FDA and governmentalauthorities to assess compliance. If we fail to comply, the FDA and state orother regulatory agencies have broad enforcement powers, including any of thefollowing sanctions:

 

•                  warning letters,fines, injunctions, consent decrees, civil penalties and exclusion fromparticipation in federal and state health care programs;

 

•                  repair,replacement, recall or seizure of our products;

 

•                  operatingrestrictions, partial suspension or total shutdown of production;

 

•                  refusing ourrequests for 510(k) clearance or premarket approval of new products, newintended uses or modifications to existing products;

 

•                  withdrawing510(k) clearance or premarket approvals that have already been granted; and

 

•                  criminalprosecution and penalties.

 

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Product sales, introductions or modifications may bedelayed or canceled as a result of U.S. or foreign regulatory processes, whichcould cause our sales to decline. Failure to obtain regulatory clearance orapprovals of new products or product modifications we develop, any limitationsimposed by regulatory agencies on new product uses or the costs of obtainingregulatory clearance or approvals could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

We, our subcontractors, and third-party manufacturersare also subject to similar state requirements and licenses. We, oursubcontractors, and third-party manufacturers must comply with extensiverecordkeeping and reporting requirements and must make available ourmanufacturing facilities and records for unannounced and periodic inspectionsby governmental agencies, including FDA, state authorities and comparableagencies in other countries.

 

Health care initiatives and other cost-containmentpressures could cause us to sell our products at lower prices, resulting inless revenue to us. In the United States, a significant percentage of thepatients who receive our intraocular lenses are covered by the federal Medicareprogram. Changes in coverage or coding policies or reductions in Medicarereimbursement rates and the implementation of other price controls couldadversely affect our revenues and financial condition. In addition, changes inexisting regulatory requirements or adoption of new requirements could hurt ourbusiness, financial condition and results of operations.

 

***The clinical trialprocess required to obtain regulatory approvals is costly and uncertain, andcould result in delays in new product introductions or even an inability torelease a product.***

 

The clinical trials required to obtain regulatoryapprovals for our products are complex and expensive and their outcomes areuncertain. We incur substantial expense for, and devote significant time to,clinical trials but cannot be certain that the trials will ever result in thecommercial sale of a product. We may suffer significant setbacks in clinicaltrials, even after earlier clinical trials showed promising results. Any of ourproducts may produce undesirable side effects that could cause us or regulatoryauthorities to interrupt, delay or halt clinical trials of a product candidate.We, the FDA, or another regulatory authority may suspend or terminate clinicaltrials at any time if they or we believe the trial participants faceunacceptable health risks.

 

***Our business issubject to environmental regulations.***

 

Our facilities and operations are subject to federal,state and local environmental and occupational health and safety requirementsof the United States and foreign countries, including those relating todischarges of substances to the air, water and land, the handling, storage anddisposal of wastes and the cleanup of properties affected by pollutants. Failureto maintain compliance with these regulations could have a material adverseeffect on our business or financial condition. The facilities we obtained inconnection with the acquisition of Pfizer’s ophthalmic surgical business and inconnection with our acquisition of VISX, Incorporated are also subject to suchrequirements and risks.

 

In the future, federal, state or local governments inthe United States or foreign countries could enact new or more stringent lawsor issue new or more stringent regulations concerning environmental and workerhealth and safety matters that could affect our operations. Also, in thefuture, contamination may be found to exist at our current or former facilitiesor off-site locations where we have sent wastes. We could be held liable forsuch newly discovered contamination which could have a material adverse effecton our business or financial condition. In addition, changes in environmentaland worker health and safety requirements could have a material adverse effecton our business or financial condition.

 

***If we fail toattract, hire and retain qualified personnel, we may not be able to design,develop, market or sell our products or successfully manage our business.***

 

Our ability to attract new customers, retain existingcustomers and pursue our strategic objectives depends on the continued servicesof our current management, sales, product development and technical personneland our ability to identify, attract, train and retain similar personnel.Competition for top management personnel is intense and we may not be able torecruit and retain the personnel we need. The loss of any one of our managementpersonnel, or our inability to identify, attract, retain and integrateadditional qualified management personnel, could make it difficult for us tomanage our business successfully and pursue our strategic objectives.Similarly, competition for skilled sales, product development and technicalpersonnel is intense and we may not be able to recruit and retain the personnelwe need. The loss of services of a number of key sales, product development andtechnical personnel, or our inability to hire new personnel with the requisiteskills, could restrict our ability to develop new products or enhance existingproducts in a timely manner, sell products to our customers or manage ourbusiness effectively.

 

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We may not be able to hire or retain qualifiedpersonnel if we are unable to offer competitive salaries and benefits. If ourstock does not perform well, we may have to increase our salaries and benefits,which would increase our expenses and reduce our profitability.

 

***We may be requiredto satisfy certain indemnification obligations to Allergan, and we may not beable to collect on indemnification rights from Allergan.***

 

Under the terms of our contribution and distributionagreement with Allergan, we and Allergan have each agreed to indemnify eachother from and after our spin-off with respect to the debt, liabilities andobligations retained by our respective companies. These indemnificationobligations could be significant. The ability to satisfy these indemnities, ifcalled upon to do so, will depend upon the future financial strength of each ofour respective companies. We cannot determine whether we will have to indemnifyAllergan for any substantial obligations, and we may not have control over thesettlement of certain claims and lawsuits that may require partialindemnification by us. We also cannot assure you that, if Allergan is requiredto indemnify us for any substantial obligations, Allergan will have the abilityto satisfy those obligations.

 

***We may be responsiblefor federal income tax liabilities that relate to the distribution of ourcommon stock by Allergan.***

 

Allergan has received a ruling from the InternalRevenue Service to the effect that the spin-off qualified as a tax-freetransaction. If either us or Allergan breach representations to each other orto the Internal Revenue Service, or if we or Allergan take or fail to take, asthe case may be, actions that result in the spin-off failing to meet therequirements of a tax-free spin-off pursuant to Section 355 of the InternalRevenue Code, the party in breach will indemnify the other party for any andall resulting taxes. If we were required to pay any of the potential taxesdescribed above, the payment would have a material adverse effect on our financialposition.

 

***Recent changes inthe accounting treatment of stock options are expected to have a negativeimpact on our financial statements and could cause our stock price to decline.***

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 123(R), Share-Based Payment,or FAS 123(R), which includes proposed rule changes requiring companies toexpense the fair value of employee stock options and other forms of stock-basedcompensation. Before 2006, we included the fair value of employee stock optionson a pro forma basis in the notes to our annual financial statements inaccordance with accounting principles generally accepted in the United States,but did not record a charge for employee stock option expense in the reportedfinancial statements. We are required to comply with FAS 123(R) as of January1, 2006 and, as a result, our reported earnings are expected to decrease. Sucha decrease may lead to a decline in our stock price.

 

***If laser visioncorrection is not broadly accepted by both doctors and patients, our business,financial position and results of operations would be materially and adverselyimpacted.***

 

Our business depends upon broad market acceptance oflaser vision correction by both doctors and patients in the United States andkey international markets. Our profitability and growth will be largelydependent on increasing levels of market acceptance and procedure growth,especially with regard to our higher-priced *CustomVue*TMprocedure. Potential complications and side effects of laser vision correctioninclude: post-operative discomfort, corneal haze (an increase in the lightscattering properties of the cornea) during healing, glare/halos (undesirablevisual sensations produced by bright lights), decreases in contrastsensitivity, temporary increases in intraocular pressure in reaction toprocedure medication, modest fluctuations in refractive capabilities duringhealing, modest decrease in best corrected vision (i.e., with correctiveeyewear), unintended over- or under-corrections, regression of effect,disorders of corneal healing, corneal scars, corneal ulcers, and inducedastigmatism (which may result in blurred or double vision and/or shadowimages). Some consumers may choose not to undergo laser vision correctionbecause of these complications or more general concerns relating to its safetyand efficacy or a resistance to surgery in general. Alternatively, someconsumers may elect to delay undergoing laser vision correction surgery becausethey believe improved technology or methods of treatment will be available inthe near future. Should either the ophthalmic community or the generalpopulation turn away from laser vision correction as an alternative to existingmethods of treating refractive vision disorders, or if future technologiesreplaced laser vision correction, these developments could delay or preventmarket acceptance of laser vision correction, which could have a materialadverse effect on our business, financial position and results of operations.

 

***The possibility oflong-term side effects and adverse publicity regarding laser correction surgerycould seriously harm our business.***

 

Laser vision correction is a relatively new procedure.Consequently, there is no long-term follow-up data beyond ten years that mightreveal additional complications or unknown side effects. Any future reportedside effects, other adverse events or

 

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unfavorable publicityinvolving patient outcomes resulting from the use of laser vision correctionsystems manufactured by us or any participant in the laser vision correctionmarket, may have a material adverse effect on our business, financial position,and results of operations.

 

***General economicconditions could have a negative impact on our business, financial position,and results of operations.***

 

Because laser vision correction is not subject toreimbursement from third-party payors such as insurance companies or governmentprograms, the cost of laser vision correction is typically borne by individualsdirectly. Accordingly, weak or uncertain economic conditions may causeindividuals to be less willing to incur the procedure cost associated withlaser vision correction as was evidenced by VISX’s decline in revenues from2002 compared to 2001 and from 2001 compared to 2000. A decline in economicconditions, especially in the United States, could result in a decline in thenumber of laser vision correction procedures performed and could have amaterial adverse effect on our business, financial position, and results ofoperations.

 

***While we devotesignificant resources to research and development, our research and developmentmay not lead to new products that achieve commercial success.***

 

Our research and development process is expensive,prolonged, and entails considerable uncertainty. Because of the complexitiesand uncertainties associated with ophthalmic research and development, productswe are currently developing may not complete the development process or obtainthe regulatory approvals required to market such products successfully. Theproducts currently in our development pipeline may not be approved byregulatory entities and may not be commercially successful, and our current andplanned products could be surpassed by more effective or advanced products.

 

***Any failure bythird party financing entities to satisfy their obligations to us wouldnegatively impact our financial condition.***

 

We have relationships with third party financing entitiesthat purchase our products directly and subsequently lease and/or sell theseproducts to end-user customers, or provide financing directly to customers whopurchase products directly from us. Should any third party financing entity orentities fail or refuse to pay us in a timely manner or at all, it couldnegatively affect our cash flows and could have a material adverse effect onour business, financial position and results of operations.

 

***If any of ouremployees, consultants or others breach their proprietary informationagreements, our competitive position could be harmed.***

 

We protect our proprietary technology, in part,through proprietary information and inventions agreements with employees,consultants and other parties. These agreements with employees and consultantsgenerally contain standard provisions requiring those individuals to assign tous, without additional consideration, inventions conceived or reduced topractice by them while employed or retained by us, subject to customary exceptions.If any of our employees, consultants or others breach these agreements ourcompetitors may learn of our trade secrets.

 

**Risks Relating to Our Indebtednessand Our Common Stock**

 

***We have a significant amount of debt. Our substantial indebtednesscould adversely affect our business, financial condition and results ofoperations and our ability to meet our payment obligations under our debt.***

 

We have a significant amount of debt and substantialdebt service requirements. As of December 31, 2005, we had approximately $560 millionof outstanding debt. Approximately $18.7 million of our revolving creditfacility was reserved to support letters of credit issued on our behalf andapproximately $231.3 million, exclusive of letters of credit, was available forfuture borrowings.

 

This level of debt could have significant consequenceson our future operations, including:

 

•                                          makingit more difficult for us to meet our payment and other obligations under ouroutstanding debt;

 

•                                          resultingin an event of default if we fail to comply with the financial and otherrestrictive covenants contained in our debt agreements, which event of defaultcould result in all of our debt becoming immediately due and payable;

 

•                                          reducingthe availability of our cash flow to fund working capital, capitalexpenditures, acquisitions and other general corporate purposes, and limitingour ability to obtain additional financing for these purposes;

 

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•                                          subjectingus to the risk of increased sensitivity to interest rate increases on ourindebtedness with variable interest rates, including borrowings under oursenior credit facility;

 

•                                          limitingour flexibility in planning for, or reacting to, and increasing ourvulnerability to, changes in our business, the industry in which we operate andthe general economy; and

 

•                                          placingus at a competitive disadvantage compared to our competitors that have lessdebt or are less leveraged.

 

Any of the above-listed factors could have an adverseeffect on our business, financial condition and results of operations and ourability to meet our payment obligations under the notes and our other debt.

 

***To service ourindebtedness, we will require a significant amount of cash. Our ability togenerate cash flow depends on many factors beyond our control.***

 

Our ability to meet our payment and other obligationsunder our debt depends on our ability to generate significant cash flow in thefuture. This, to some extent, is subject to general economic, financial,competitive, legislative and regulatory factors as well as other factors thatare beyond our control. We cannot assure holders that our business willgenerate cash flow from operations, or that future borrowings will be availableto us under our senior credit facility or otherwise, in an amount sufficient toenable us to meet our payment obligations under our debt and to fund otherliquidity needs. We made an irrevocable election to satisfy in cash ourconversion obligation with respect to the principal amount of any of our 2.50%convertible senior subordinated notes due 2024 (the “Existing 2.50% ConvertibleNotes”) converted after December 15, 2004, with any remaining amount of theconversion obligation to be satisfied in shares of our common stock, in eachcase, calculated as set forth in the indenture governing the Existing 2.50%Convertible Notes. In addition, because we made this election, the indentureprovides that we must satisfy in cash our obligations to repurchase anyExisting 2.50% Convertible Notes that holders put to us on January 15, 2010,July 15, 2014 and July 15, 2019.

 

If the Existing 2.50% Convertible Notes becomeconvertible pursuant to their terms and the holders elect to convert or ifholders elect to put their notes to us on the specified repurchase dates, wemay not have sufficient cash to satisfy our obligations. In addition, our1.375% convertible senior subordinated notes due 2025 contain similarprovisions, we may be unable to repurchase the notes for cash when required bythe holders, including following a fundamental change, or to pay the portion ofthe conversion value upon conversion of any notes by the holders. Ourrepurchase of any such notes may be prohibited by our other debt instruments,which could cause defaults and cross-defaults under our other debt agreements.If we are not able to generate sufficient cash flow to service our debtobligations, we may need to refinance or restructure our, sell assets, reduceor delay capital investments, or seek to raise additional capital. If we are unableto implement one or more of these alternatives, we may not be able to meet ourpayment obligations under the notes and our other debt.

 

***A significantamount of our debt agreements contain covenant restrictions that may limit ourability to operate our business.***

 

The agreements governing our senior credit facilitycontain covenant restrictions that limit our ability to operate our business,including restrictions on our ability to:

 

•                                          incuradditional debt or issue guarantees;

 

•                                          createliens;

 

•                                          makecertain investments;

 

•                                          enterinto transactions with our affiliates;

 

•                                          sellcertain assets;

 

•                                          redeemcapital stock or make other restricted payments;

 

•                                          declareor pay dividends or make other distributions to stockholders; and

 

•                                          consolidate,merge or transfer all or substantially all of our assets and the assets of oursubsidiaries on a consolidated basis.

 

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Our senior credit facility requires us to maintainspecific leverage, fixed charge coverage and interest coverage ratios. Ourability to comply with these covenants is dependent on our future performance,which will be subject to many factors, some of which are beyond our control,including prevailing economic conditions. Our failure to comply with theseobligations would prevent us from borrowing additional money under the facilityand could result in a default under it. If a default occurs under any of oursenior indebtedness, the relevant lenders could elect to declare theindebtedness, together with accrued interest and other fees, to be immediatelydue and payable and proceed against substantially all of our assets, which willserve as collateral securing the indebtedness. Moreover, if the lenders under afacility or other agreement in default were to accelerate the indebtednessoutstanding under that facility, it could result in a default under otherindebtedness. If all or any part of our indebtedness were to be accelerated, wemay not have or be able to obtain sufficient funds to repay it. In addition, wemay incur other indebtedness in the future that may contain financial or othercovenants that are more restrictive than those contained in our currentindentures.

 

As a result of these covenants, our ability to respondto changes in business and economic conditions and to obtain additionalfinancing, if needed, may be significantly restricted, and we may be preventedfrom engaging in transactions that might otherwise be beneficial to us. Inaddition, our failure to comply with these covenants could result in a defaultunder our debt, which could permit the holders to accelerate such debt. If anyof our debt is accelerated, we may not have sufficient funds available to repaysuch debt.

 

***Despite our and oursubsidiaries’ current levels of indebtedness, we may incur substantially moredebt, which could further exacerbate the risks associated with our substantialindebtedness.***

 

Although certain of our debt agreements containrestrictions on the incurrence of additional indebtedness, these restrictions aresubject to a number of qualifications and exceptions, and the indebtednessincurred in compliance with these restrictions could be substantial. Also,these restrictions do not prevent us from incurring obligations that do notconstitute “indebtedness” as defined in the relevant agreement. If new debt isadded to our current debt levels, the related risks that we now face couldintensify.

 

***Our stock price mayfluctuate as a result of a variety of factors, many of which are beyond ourcontrol. These factors include:***

 

•                                          quarterlyvariations in our operating results;

 

•                                          operatingresults that vary from the expectations of management, securities analysts andinvestors;

 

•                                          changesin expectations as to our future financial performance;

 

•                                          announcementsof innovations, new products, strategic developments, significant contracts,acquisitions and other material events by us or our competitors;

 

•                                          theoperating and securities price performance of other companies that investorsbelieve are comparable to us;

 

•                                          futuresales of our equity or equity-related securities;

 

•                                          changesin general conditions in our industry and in the economy, the financial marketsand the domestic or international political situation;

 

•                                          developmentsor disputes (including lawsuits) concerning proprietary rights;

 

•                                          departuresof key personnel; and

 

•                                          regulatoryconsiderations.

 

In addition, in recent years, the stock market ingeneral has experienced extreme price and volume fluctuations. This volatilityhas had a significant effect on the market price of securities issued by manycompanies for reasons often unrelated to their operating performance. Thesebroad market fluctuations may adversely affect our stock price, regardless ofour operating results.

 

24

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***Our stockholderrights plan, amended and restated certificate of incorporation and bylaws, aswell as provisions of Delaware law, could make it difficult for a third partyto acquire our company.***

 

We have a stockholder rights plan that may have theeffect of discouraging unsolicited takeover proposals. The rights issued underthe stockholder rights plan would cause substantial dilution to a person orgroup that attempts to acquire us on terms not approved in advance by our boardof directors. In addition, Delaware corporate law and our amended and restatedcertificate of incorporation and bylaws contain provisions that could delay,deter or prevent a change in control of our company or our management. Theseprovisions could also discourage proxy contests and make it more difficult forour stockholders to elect directors and take other corporate actions withoutthe concurrence of our management or board of directors. These provisions:

 

•                                          authorizeour board of directors to issue “blank check” preferred stock, which ispreferred stock that can be created and issued by our board of directors,without stockholder approval, with rights senior to those of common stock;

 

•                                          providefor a staggered board of directors and three-year terms for directors, so thatno more than one-third of our directors could be replaced at any annualmeeting;

 

•                                          providethat directors may be removed only for cause;

 

•                                          providethat stockholder action may be taken only at a special or regular meeting andnot by written consent;

 

•                                          providefor super-majority voting requirements for some provisions of our charter; and

 

•                                          establishadvance notice requirements for submitting nominations for election to theboard of directors and for proposing matters that can be acted upon by stockholdersat a meeting.

 

We are also subject to anti-takeover provisions underDelaware law, which could also delay or prevent a change of control. Together,these provisions of our amended and restated certificate of incorporation andbylaws, Delaware law and our stockholder rights plan may discouragetransactions that otherwise could provide for the payment of a premium overprevailing market prices of our common stock and, possibly, the notes, and alsocould limit the price that investors are willing to pay in the future forshares of our common stock and the notes.

 

**Item 1B.Unresolved Staff Comments**

 

We have no unresolvedwritten comments from the Commission.

 

**Item2. Properties**

 

Our principal executive offices and researchfacilities are located in Santa Ana, California, in a facility subleased by usthrough July 2015. We also have an administrative, research and development andmanufacturing facility in Santa Clara, California, leased by us through May2008. We conduct our global operations in facilities that we own or lease.Material facilities include administrative facilities in Australia, Canada,France, Germany, Hong Kong, Ireland, Italy, Spain and the United Kingdom. Wealso have two facilities in Japan, one used for administration and research anddevelopment and the other used for warehousing. We lease all of thesefacilities. In addition, we operate five manufacturing facilities: one inAñasco, Puerto Rico, where we lease the land and the facility, one in Madrid,Spain, where we own the land and the facility, one in Hangzhou, China, where weown the facility but lease the land, one in Uppsala, Sweden, where we own theland and the facility, and one in Groningen, Netherlands, where we own the landand the facility. We believe these facilities are adequate for the currentneeds of our business.

 

**Item 3.Legal Proceedings**

 

On December 3, 2003, we filed a complaint in the U.S.District Court for the District of Delaware against Alcon, Inc. and AlconLaboratories, Inc. for infringement of U.S. Patent Nos. 5,700,240 (BarwickPatent) and 6,059,765 (Cole/Sutton Patent). We alleged that Alcon’s “Infiniti”and “Series 20000 Legacy” phacoemulsification machines infringe the patents. Wesought damages and a permanent injunction. The trial of this matter began onApril 25, 2005 and concluded on May 6, 2005. The jury found both of our patentsto be valid and infringed by Alcon, and awarded us $94.8 million in damages.The jury further found that Alcon had willfully infringed both of our patents. OnJune 21, 2005, a bench trial was conducted by the Court to determine if we hadsufficiently marked our equipment with the patent numbers and to determine ifAlcon had waived any argument relating thereto.

 

25

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On December 16, 2005, theCourt ruled that we did not sufficiently mark our patents and reduced the juryaward from $94.8 million to $71.3 million. However, the Court further ruledthat Alcon had willfully infringed our patents and trebled the $71.3 milliondamage award to $213.9 million. The Court also granted our request for apermanent injunction on both patents. However, the Court stayed the injunctionon the Cole/Sutton Patent pending appeal. On January 20, 2006, judgmentwas entered including additional damages from March 2005 throughDecember 31, 2005 and interest based thereon, resulting in final damagesof $234.5 million. The Court further ordered Alcon to pay all of the Company’sattorney fees and costs, estimated at $4 million. Alcon filed an appeal of thefinal judgment on January 20, 2006. We cross appealed on February 3, 2006.On February 3, 2006, Alcon filed a motion for a new trial with the U.S.District Court for the District of Delaware. We opposed this motion onFebruary 24, 2006.

 

On January 28, 2004, Alcon Manufacturing, Ltd. filed acomplaint against us and Allergan, Inc. in the U.S. District Court for theNorthern District of Texas, Fort Worth Division, for infringement of U.S.Patent Nos. 4,832,685 and 4,935,005 (Haines Patents). Alcon alleged that our*Prestige* and*Sovereign* phacoemulsification systems and replacementcassettes infringe the patents. Alcon is seeking damages and a permanentinjunction. At Alcon’s request, the case has been stayed in Texas while theparties seek re-examination by the U.S. Patent and Trademark Office on theHaines Patents in light of another patent we allege invalidates the HainesPatents.

 

On January 4, 2005, Dr. James Nielsen filed acomplaint against us and Allergan, Inc. in the U.S. District Court of theNorthern District of Texas, Dallas Division, for infringement of U.S. PatentNo. 5,158,572. Dr. Nielsen alleges that our*Array* multifocal intraocular lens infringes the patent. He isseeking damages and a permanent injunction. The trial in this matter isscheduled to begin on November 6, 2006.

 

On August 8, 2005, Alcon Manufacturing, Ltd and AlconLaboratories, Inc. filed a complaint against us in the U.S. District Court forthe Northern District of Texas, Fort Worth Division, for infringement of U.S.Patent Nos. 4,921,477 (relating to a surgical irrigation and aspiration systemwith a dampening device); 5,199,943 (relating to an ultrasonic surgicalhandpiece); 5,188,589 (relating to a textured sleeve in a phacoemulsificationhandpiece); and 5,876,016 and 6,109,572 (both of which relate to an apparatusand method to elevate an infusion source in an ophthalmic surgical procedure). Alconalleged that we infringe these patents in the course of selling ourphacoemulsification systems or accessories, and is seeking damages and apermanent injunction. The trial in this matter is scheduled to begin on August14, 2006.

 

On September 13, 2005, Alcon Manufacturing, Ltd. fileda complaint against us in the U.S. District Court for the Northern District ofTexas, Dallas Division, for infringement of U.S Patent No. 5,273,056 relatingto the use of a combination of viscoelastics during ophthalmic surgery. Alconalleged that we infringed, contributorily infringed, and/or inducedinfringement of this patent, and is seeking damages and a permanent injunction.

 

We do not believe, based on current knowledge, thatany of the foregoing legal proceedings or claims are likely to have a materialadverse effect on our financial position, results of operations or cash flows.However, we may incur substantial expenses in defending against third partyclaims. In the event of a determination adverse to us or our subsidiaries, wemay incur substantial monetary liability, and be required to change ourbusiness practices. Either of these could have a material adverse effect on ourfinancial position, results of operations or cash flows.

 

While we are involved from time to time in litigationarising in the ordinary course of business, including product liability claims,we are not currently aware of any other actions against us or Allergan relatingto the optical medical device business that we believe would have a materialadverse effect on our business, financial condition, results of operations orcash flows. We may be subject to future litigation and infringement claims,which could cause us to incur significant expenses or prevent us from sellingour products. We operate in an industry susceptible to significant productliability claims. Product liability claims may be asserted against us in thefuture arising out of events not known to us at the present time. Under theterms of the contribution and distribution agreement effecting our spin-off,Allergan agreed to assume responsibility for, and to indemnify us against, allcurrent and future litigation relating to its retained businesses and we agreedto assume responsibility for, and to indemnify Allergan against, all currentand future litigation related to the optical medical device business.

 

**Item 4.Submission of Matters to a Vote of Security Holders**

 

We did not submit any matter during the fourth quarterof the fiscal year covered by this report to a vote of security holders,through the solicitation of proxies or otherwise.

 

26

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**PART II**

 

**Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities**

 

*Dividends.*We have never declared or paid any cash dividends on our common stock or any ofour securities. We do not expect to pay cash dividends on our capital stock inthe foreseeable future. We intend to retain our future earnings to continue tofund the development and growth of our business as well as repay long-termdebt. In addition, our amended and restated senior credit facility prohibits usfrom paying cash dividends.

 

*MarketInformation.* The following table shows the quarterly pricerange of our common stock during the periods listed.

 
| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| **Calendar Quarter** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** | **High** | ** ** |
| First                     |       | $        | 35.91      |     | $          | 44.53 |   | $ | 20.04 |   | $ | 24.73 |   |
| Second                    |       | 35.00    |       | 40.90    |       | 23.90 |   | 42.89 |   |
| Third                     |       | 37.25    |       | 43.30    |       | 34.84 |   | 42.67 |   |
| Fourth                    |       | 32.04    |       | 44.00    |       | 35.77 |   | 43.69 |   |
|                           |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

Our common stock islisted on the New York Stock Exchange and is traded under the symbol “EYE.” Theclosing price of our common stock was $44.48 on February 28, 2006.

 

The approximate number ofstockholders of record was 4,722 as of February 28, 2006.

 

*RecentSales of Unregistered Securities.* During the quarter ended December 31,2005, the Company issued an aggregate of 291,760 shares of common stock to alimited number of holders of the Company’s 3 1⁄2% Convertible SeniorSubordinated Notes due 2023 (the “3 1⁄2% convertible notes”) inexchange for approximately $5.4 million aggregate principal amount of the 3 1⁄2%convertible notes in privately negotiated transactions. The issuance of theshares of common stock was made in reliance on Section 3(a)(9) of theSecurities Act of 1933, as amended.

 

*Purchasesof Equity Securities by the Issuer.* The following sets forththe amount of the 3 1⁄2% convertible notes acquired by AMO duringthe quarter ended December 31, 2005:

 

**ISSUERPURCHASES OF EQUITY SECURITIES**

 
| **Period**                                            | ** ** | **Total  Number of  Shares or Units  Purchased** | ** ** | **Average  Price  Paid per Share or  Unit**                                                                      | ** ** | **Total  Number of  Shares or Units  Purchased as Part  of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number  (or Approximate  Dollar Value) of  Shares or Units that  May Yet Be  Purchased Under the  Plans or Programs** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                       | ** ** | ** **                                                                                                       | ** ** | ** **                                                                                          | ** ** | ** **                                                                                                                            |
| October 1,  2005 – October 28, 2005    |       | None                                             |       | —                                                                                                           |       | None                                                                                                |       | None                                                                                                                                  |
|                                                  |       |                                             |       |                                                                                                             |       |                                                                                                |       |                                                                                                                                  |
| October 29,  2005 – November 25, 2005  |       | $3,300,000 in  principal amount        |       | 48.69 shares of  common stock for each $1,000 principal amount of notes and accrued and unpaid  interest thereon |       | None                                                                                                |       | None                                                                                                                                  |
|                                                  |       |                                             |       |                                                                                                             |       |                                                                                                |       |                                                                                                                                  |
| November 26,  2005 – December 31, 2005 |       | $2,127,000 in  principal amount                  |       | 48.69 shares of  common stock for each $1,000 principal amount of notes and accrued and unpaid  interest thereon |       | None                                                                                                |       | None                                                                                                                                  |

 

27

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The following sets forth shares purchased fromemployees to pay taxes related to our equity incentive plan.

 

**ISSUER PURCHASES OF EQUITY SECURITIES**

 
| **Period**                                            | ** ** | **Total  Number of  Shares or Units  Purchased** | ** ** | **Average  Price  Paid per Share or  Unit** | ** ** | **Total  Number of  Shares or Units  Purchased as Part  of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number  (or Approximate  Dollar Value) of  Shares or Units that  May Yet Be  Purchased Under the  Plans or Programs** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                       | ** ** | ** **                                  | ** ** | ** **                                                                                          | ** ** | ** **                                                                                                                            |
| October 1,  2005 – October 28, 2005    |       | None                                             |       | —                                      |       | None                                                                                                |       | None                                                                                                                                  |
|                                                  |       |                                             |       |                                        |       |                                                                                                |       |                                                                                                                                  |
| October 29,  2005 – November 25, 2005  |       | 12                                               |       | $    40.23              |       | None                                                                                                |       | None                                                                                                                                  |
|                                                  |       |                                             |       |                                        |       |                                                                                                |       |                                                                                                                                  |
| November 26,  2005 – December 31, 2005 |       | None                                             |       | —                                      |       | None                                                                                                |       | None                                                                                                                                  |

 

**Item6. Selected Financial Data**

 

The following table sets forth selected financial dataas of and for each of the years in the five-year period ended December 31,2005, which has been derived from our audited consolidated financialstatements. After December 31, 2001, goodwill is no longer amortized.Goodwill amortization was $9.0 million in the year ended December 31,2001.

 

The selected financial data may not be indicativeof the results of operations or financial position that we would have obtainedif we had been an independent company during all pre-spin-off periodspresented.

 

28

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No earnings per share data is presented for each ofthe years in the two-year period ended December 31, 2002 as our earningswere a part of Allergan’s earnings through the close of business on June 28,2002.

 
| ** **                                                                      | ** ** | **For the Year Ended December 31,**       | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005(b)**                                                        | ** ** | **2004(a)** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations:**                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net  sales                                                                      |       | $                                                                  | 920,673    |   | $ | 742,099 |   | $ | 601,453 |   | $ | 538,087 |   | $ | 543,095 |   |
| Cost  of sales                                                                  |       | 353,325                                                            |       | 306,164 |   | 227,811 |   | 204,338 |   | 212,090 |   |
|                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Gross  profit                                                                   |       | 567,348                                                            |       | 435,935 |   | 373,642 |   | 333,749 |   | 331,005 |   |
|                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling,  general and administrative                                            |       | 396,599                                                            |       | 329,197 |   | 276,695 |   | 235,977 |   | 222,885 |   |
| Research  and development                                                       |       | 61,646                                                             |       | 45,616 |   | 37,413 |   | 29,917 |   | 28,990 |   |
| In-process  research and development                                            |       | 490,750                                                            |       | 28,100 |   | — |   | — |   | — |   |
| Business  repositioning                                                         |       | 29,680                                                             |       | — |   | — |   | — |   | — |   |
|                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Operating  (loss) income                                                        |       | (411,327                                                           | )          | 33,022 |   | 59,534 |   | 67,855 |   | 79,130 |   |
| Interest  expense                                                               |       | 29,332                                                             |       | 26,933 |   | 24,224 |   | 13,764 |   | 3,302 |   |
| Loss  on investments, net                                                       |       | —                                                             |       | — |   | — |   | 3,935 |   | 793 |   |
| Unrealized  (gain) loss on derivative instruments                               |       | (2,563                                                             | )          | 403 |   | 246 |   | 3,199 |   | (1,294 | ) |
| Loss  due to exchange of 3 1/2% Convertible Senior  Subordinated Notes due 2023 |       | 1,885                                                              |       | 116,282 |   | — |   | — |   | — |   |
| Other,  net                                                                     |       | 316                                                                |       | 10,620 |   | 17,802 |   | 2,385 |   | 385 |   |
|                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) before income taxes                                            |       | (440,297                                                           | )          | (121,216 | ) | 17,262 |   | 44,572 |   | 75,944 |   |
| Provision  for income taxes                                                     |       | 12,900                                                             |       | 8,154 |   | 6,905 |   | 18,662 |   | 20,594 |   |
|                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) before cumulative effect of change in accounting principle     |       | (453,197                                                           | )          | (129,370 | ) | 10,357 |   | 25,910 |   | 55,350 |   |
| Cumulative  effect of change in accounting principle, net of $160 of tax        |       | —                                                             |       | — |   | — |   | — |   | (391 | ) |
| Net  earnings (loss)                                                            |       | $                                                                  | (453,197   | ) | $ | (129,370 | ) | $ | 10,357 |   | $ | 25,910 |   | $ | 54,959 |   |
| Basic  earnings (loss) per share                                                |       | $                                                                  | (8.28      | ) | $ | (3.89 | ) | $ | 0.36 |   | — |   | — |   |
| Diluted  earnings (loss) per share                                              |       | $                                                                  | (8.28      | ) | $ | (3.89 | ) | $ | 0.35 |   | — |   | — |   |

 

----

(a)          Includes results of the acquired Pfizer Inc. SurgicalOphthalmic Business since June 26, 2004 (date of acquisition).

(b)         Includes results of the acquired VISX business since May 27,2005 (date of acquisition).

 
| ** **                                                        | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                        | ** ** | **(in thousands)**               | ** ** |
| **Balance Sheet Data:**                                           |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash  and equivalents                                             |       | $                                     | 40,826     |   | $ | 49,455 |   | $ | 46,104 |   | $ | 80,578 |   | $ | 6,957 |   |
| Current assets                                                    |       | 479,005                               |       | 376,825 |   | 252,492 |   | 274,494 |   | 210,552 |   |
| Total assets                                                      |       | 1,980,722                             |       | 1,076,534 |   | 461,345 |   | 463,206 |   | 377,466 |   |
| Current liabilities                                               |       | 260,116                               |       | 193,923 |   | 115,301 |   | 108,204 |   | 85,551 |   |
| Long term debt, net of  current portion and short-term borrowings |       | 500,000                               |       | 550,643 |   | 233,611 |   | 277,559 |   | 75,809 |   |
|                                                                   |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

29

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**Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

*The following discussion andanalysis presents the factors that had a material effect on AMO’s results ofoperations and cash flows during each of the three years in the period ended December 31,2005, and the Company’s financial position at that date. Except for thehistorical information contained herein, the following discussion containsforward-looking statements that involve risk and uncertainties. Our actualresults may differ significantly from the results discussed in theforward-looking statements. Factors that might cause such differences include,but are not limited to, those discussed in the section entitled “Risk Factors.”This discussion and analysis should be read in conjunction with the historicalconsolidated financial statements of AMO and related notes thereto includedelsewhere in this Form 10-K.*

 

**Overview**

 

We are a global leader in the development, manufactureand marketing of medical devices for the eye. We have two major product lines:ophthalmic surgical and eye care. Our ophthalmic surgical product line providesmedical devices for use in the cataract / implant and laser visioncorrection markets. In the cataract and implant market, we focus on the fourkey products required for cataract surgery – foldable intraocular lenses, orIOLs, implantation systems, phacoemulsification systems and viscoelastics. Inthe laser vision correction market, we market laser systems, diagnosticdevices, treatment cards and microkeratomes for use in laser eye surgery. Oureye care product line provides a full range of contact lens care products foruse with most types of contact lenses. These products include single-bottle,multi-purpose cleaning and disinfecting solutions, hydrogen peroxide-baseddisinfecting solutions, daily cleaners, enzymatic cleaners and contact lensrewetting drops. In addition, we sell contact lenses in Europe and Asia.

 

We have operations in approximately 20 countries andsell our products in approximately 60 countries and have organized ouroperations into four regions:

 

•                                          Americas (North and South America);

 

•                                          Europe, Africa and Middle East;

 

•                                          Japan; and

 

•                                          Asia Pacific (excluding Japan, butincluding Australia and New Zealand).

 

*Product Rationalization and Repositioning Plan*

 

On October 31,2005, our Board of Directors approved a product rationalization andrepositioning plan covering the discontinuation of non-strategic cataractsurgical and eye care products and the elimination or redeployment of resourcesthat support these product lines. The plan also includes organizational changesand potential reductions in force in manufacturing, sales and marketingassociated with these product lines, as well as organizational changes inresearch and development and other corporate functions designed to align theorganization with our strategy and strategic business unit organization. Asubstantial portion of expected operating cost benefits will result fromreductions in force and associated annualized employee compensation ofapproximately $14.2 million.

 

The planfurther calls for increasing our investment in key growth opportunities,specifically our refractive implant product line and international laser visioncorrection business, and accelerating the implementation of productivityinitiatives.

 

In the fourth quarter of2005, we incurred $42.3 million of pre-tax charges, which included $12.6million for inventory related charges included in cost of sales and $29.7million included in operating expenses for severance, relocation and otherone-time termination benefits of $14.0 million, asset write-downs of $9.2million, contractual obligations of $2.7 million and accelerated productivityand brand repositioning costs of $3.8 million. We expect to incur an additional$28 million to $38 million of charges in the first half of 2006, which will be recognized as the services areperformed and actions occur. The total charges that are expected to be incurredare within the range previously announced.

 

Certainforeign jurisdictions have laws and regulations which require consultations andnegotiations with works councils, labor organizations and local authorities.The outcome of these discussions will determine, in part, the restructuringsteps to be implemented and the associated cost. Therefore, the final costs ofthe business repositioning plan may be significantly different from ourinitial estimates.

 

30

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*Acquisition of VISX, Incorporated*

 

On May 27, 2005, pursuant to the Agreement andPlan of Merger (Merger Agreement), dated as of November 9, 2004, asamended, by and among Advanced Medical Optics, Inc. (AMO), Vault MergerCorporation, a wholly owned subsidiary of AMO, and VISX, Incorporated (VISX),we completed our acquisition of VISX, for total consideration of approximately$1.38 billion, consisting of approximately 27.8 million shares of AMO commonstock, the fair value of VISX stock options converted to AMO stock options andapproximately $176.2 million in cash (VISX Acquisition). *VISX* products include the *VISX STAR* Excimer Laser System, the *VISX WaveScan* System and *VISX* treatment cards.

 

The VISX Acquisition has been accounted for as apurchase business combination. Under the purchase method of accounting, theassets acquired and liabilities assumed were recorded at the date of acquisitionat their respective fair values. Our reported financial position and results ofoperations after May 27, 2005 include VISX and the impact of purchaseaccounting. Purchase accounting applied to the VISX Acquisition resulted in anon-cash in-process research and development charge of $488.5 million in theyear ended December 31, 2005.

 

*Acquisition of Pfizer Inc. Surgical Ophthalmic Business*

 

On June 26, 2004, we completed the acquisition ofthe Pfizer Inc. surgical ophthalmic business for $450 million in cash (PfizerAcquisition). We acquired ophthalmic surgical products and certainmanufacturing and research and development facilities located in Uppsala,Sweden, Groningen, Netherlands and Bangalore, India. The products acquiredinclude the *Healon*line of viscoelasticproducts used in ocular surgery, the *CeeOn*and*Tecnis* intraocular lenses and the*Baerveldt*glaucoma shunt.

 

The Pfizer Acquisition has been accounted for as apurchase business combination. Our reported financial position and results ofoperations after June 26, 2004 include Pfizer and the impact of purchaseaccounting. Purchase accounting applied to the Pfizer Acquisition resulted incharges in the year ended December 31, 2004, including an in-processresearch and development charge of $28.1 million and incremental cost of salesof $28.1 million from the sale of acquired inventory adjusted to fair value.During 2004, we also incurred other acquisition-related charges totalingapproximately $11.6 million as we integrated the Pfizer surgical ophthalmicbusiness and eliminated duplicative functions.

 

**Separation from Allergan**

 

Allergan spun-off its existing optical medical devicebusiness by contributing all of the assets related to the two business linesthat comprise the optical medical device business to us and distributing all ofour outstanding shares of common stock to its stockholders. We had no materialassets, liabilities or activities as a separate corporate entity until Allergan’scontribution to us of the optical medical device business. The contribution ofassets and distribution to Allergan stockholders was completed on June 29,2002. As a result of the spin-off, we are an independent public company andAllergan no longer maintains any stock ownership in us.

 

Prior to the spin-off, we entered into severalagreements with Allergan in connection with, among other things, transitionalservices, employee matters, manufacturing and tax sharing.

 

Under the manufacturing agreement, which ended on June 29,2005, Allergan manufactured certain of our eye care products and *VITRAX* viscoelastics from the date of thespin-off. We purchased these products from Allergan at a price equal toAllergan’s fully allocated costs plus 10%. During 2005, 2004 and 2003, wepurchased $41.9 million, $89.3 million and $77.0 million, respectively, ofproduct from Allergan. On an annual basis, a pricing “true up” calculation wasperformed during the first calendar quarter after the end of each year. This “trueup” calculation was based on the actual volume of products shipped by Allerganto us during the preceding year versus the forecasted volume submitted by usthat was used to calculate the invoiced prices. During the year, weperiodically reviewed the volume of purchases and accrued for estimatedshortfalls, if any. In October 2005, we received $0.8 million fromAllergan for the final “true up” calculation for the last six months of theagreement. In March 2005, we made a payment of $0.2 million to Allerganbased upon the “true up” calculation for the year ended December 31, 2004.In March 2004, we made a payment of $0.2 million to Allergan based uponthe “true up” calculation for the year ended December 31, 2003. Thesepayments have been recorded as an increase/decrease to cost of sales in theaccompanying consolidated statements of operations.

 

The tax sharing agreement governs Allergan’s and ourrespective rights, responsibilities and obligations with respect to taxes forany tax period ending before, on or after the spin-off. Generally, Allergan isliable for all pre-spin-off taxes except for pre-spin-off taxes attributable toour business for 2002. In addition, the tax sharing agreement provides thatAllergan is liable for taxes that are incurred as a result of restructuringactivities undertaken to effectuate the spin-off. During 2005, we realizedfinal adjustments to accrued, pre-spin-off taxes attributable to our businessand payable to Allergan pursuant to this agreement. These 

 

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adjustmentsincluded a $1.4 million benefit from the resolution of a discrete item in thethird quarter of 2005, which was recorded in the income tax provision.

 

**Critical Accounting Policies and Estimates**

 

*Revenue Recognition and Accounts Receivable*

 

Revenue is realized or realizable and earned whenpersuasive evidence of an arrangement exists, delivery has occurred, the priceto the buyer is fixed or determinable and collectibility is reasonably assured.We record revenue from product sales when title and risk of ownership have beentransferred to the customer, which is typically upon delivery to the customer,with the exception of intraocular lenses distributed on a consignment basis,which is upon notification of implantation in a patient. We recognize licensefees and revenues from the sale of treatment cards to direct customers when weship the treatment cards as we have no continuing obligations or involvementsubsequent to shipment.

 

Some customers finance the purchase or rental of theirVISX equipment directly from us over periods ranging from one to three years.These financing agreements are classified as either rental or operating leasesor sales type leases as prescribed by Statement of Financial AccountingStandards No. 13, “Accounting for Leases.” Under sales type leases, systemrevenues are recognized based on the net present value of the expected cashflow after installation to direct customers in the United States and Japan orafter shipment to international distributors. Under rental or operating leasearrangements, rental revenue is recognized over the term of the agreement.

 

We generally permit returns of product if such productis returned in a timely matter, in good condition, and through the normalchannels of distribution. However, we do not accept returns of treatment cardsand we do not provide rights of return or exchange, price protection or stockrotation rights to any of our VISX product distributors. Return policies incertain international markets can be more stringent and are based on the termsof contractual agreements with the customers. Allowances for returns areprovided for based upon an analysis of our historical patterns of returnsmatched against the sales from which they originated. To date, historicalproduct returns have been within our estimates.

 

When we recognize revenue from the sale of ourproducts, certain allowances known and estimable at time of sale are recordedas a reduction to sales. These items include cash discounts, allowances andrebates. These items are reflected as a reduction to accounts receivable to theextent the customer will or is expected to reduce its payment on the relatedinvoice amounts. In addition, certain items such as rebates provided tocustomers that meet certain buying targets are paid to the customer subsequentto customer payment. Thus, such amounts are recorded as accrued liabilities.These provisions are estimated based on historical payment experience,historical relationship to revenues and estimated customer inventory levels. Ifthe historical data and inventory estimates used to calculate these provisionsdo not properly reflect future activity, our financial position, results ofoperations and cash flows could be impacted. To date, historical salesallowances have been within our estimates.

 

The allowance for doubtful accounts is determined byanalyzing specific customer accounts and assessing the risk of uncollectibilitybased on insolvency, disputes or other collection issues. In addition, weroutinely analyze the different aging categories and establish allowances basedon the length of time receivables are past due.

 

*Inventories*

 

Inventories are valued at the lower of first-in,first-out cost or market. On a regular basis, we evaluate inventorybalances for excess quantities and obsolescence by analyzing estimated demand,inventory on hand, sales levels and other information. Based on theseevaluations, inventory balances are reduced, if necessary.

 

*Goodwill and Long-Lived Assets*

 

On January 1, 2002, we adopted Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets”, whereby goodwill is no longer amortized, but instead is subject to aperiodic impairment review performed during the second quarter of each fiscalyear. In a business combination, goodwill is allocated to our various reportingunits, which are the same as our reportable operating segments based onrelative fair value of the assets acquired and liabilities assumed. As ouroperations comprise four reporting units (Americas, Europe/Africa/Middle East,Japan and Asia Pacific), we review the recoverability of goodwill by comparingeach unit’s fair value to the net book value of its assets. If the book valueof the reporting unit’s assets exceeds its fair value, the goodwill is writtendown to its implied fair value.

 

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Additionally, we review the carrying amount ofgoodwill whenever events and circumstances indicate that the carrying amount ofgoodwill may not be recoverable. Impairment indicators include, amongother conditions, cash flow deficits, historic or anticipated declines inrevenue or operating profit and adverse legal or regulatory developments. If itis determined such indicators are present and the review indicates goodwillwill not be fully recoverable, based upon discounted estimated cash flows, thecarrying value is reduced to implied fair value.

 

In the second quarters of 2005, 2004 and 2003, weperformed the annual impairment tests of goodwill, and no impairment wasindicated based on these tests.

 

In accordance with Statement of Financial AccountingStandards No. 144 “Accounting for the Impairment or Disposal of Long-livedAssets”, we assess potential impairment to our long-lived assets when events orchanges in circumstances indicate that the carrying amount of an asset may notbe fully recoverable. If required, an impairment loss is recognized as thedifference between the carrying value and the fair value of the assets.

 

*Income Taxes*

 

We account for income taxes under the asset andliability method, whereby deferred tax assets and liabilities are recognizedfor the future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply in the years in which those temporarydifferences are expected to be recovered or settled. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date. We evaluate the need to establish avaluation allowance for deferred tax assets based upon the amount of existingtemporary differences, the period in which they are expected to be recoveredand expected levels of taxable income. A valuation allowance to reduce deferredtax assets is established when it is “more likely than not” that some or all ofthe deferred tax assets will not be realized.

 

We record a liability for potential tax assessmentsbased on our estimate of the potential exposure. New laws and newinterpretations of laws and rulings by tax authorities may affect theliability for potential tax assessments. Due to the subjectivity and complexnature of the underlying issues, actual payments or assessments may differfrom estimates. To the extent our estimates differ from actual payments orassessments, income tax expense is adjusted. Our income tax returns in severallocations are being examined by the local taxation authorities. Managementbelieves that adequate amounts of tax and related interest, if any, have beenprovided for any adjustments that may result from these examinations.

 

*Stock-Based Compensation*

 

We measure stock-based compensation for option grantsto employees and members of the board of directors using the intrinsic valuemethod. The fair value of each option grant for determining the pro formadisclosure impact of stock-based compensation expense is estimated on the dateof grant using the Black-Scholes option-pricing model with weighted averageassumptions. These assumptions consist of expected dividend yield, expectedvolatility, expected life, and risk-free interest rate. If the assumptions usedto calculate the value of each option grant do not properly reflect futureactivity, the weighted average fair value of our grants could be impacted. Beginningin the first quarter of 2006, we will measure stock-based compensation usingthe fair value method under revised Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-Based Compensation,” issued by theFinancial Accounting Standards Board in December 2004. See “New AccountingStandards” section for further discussion.

 

Under the 2005 Incentive Compensation Plan as approvedin the special meeting of stockholders on May 26, 2005, we grantedrestricted stock to employees and members of the board of directors during theyear ended December 31, 2005. Restricted stock awards are valued based onthe market price of a share of non-restricted stock on the grant date and compensationexpense is recognized over the vesting period of the restricted stock.

 

*Acquired In-Process Research and Development*

 

Costs to acquire in-process research and development(IPR&D) projects and technologies which have no alternative future use andwhich have not reached technological feasibility at the date of acquisition areexpensed as incurred. The fair value of IPR&D projects and technologies isestimated based upon management’s assumptions such as projected regulatoryapproval dates, estimated future revenues and cost of goods sold of theproducts under development and expected sales and marketing costs. The majorrisks and uncertainties associated with the timely and successful completion ofthese projects consist of the ability to confirm the safety and efficacy of thetechnology based on the data from clinical trials and obtaining necessaryregulatory approvals. In addition, no assurance can be given that theunderlying assumptions used to forecast the cash flows or the timely and successfulcompletion of such projects will materialize, as estimated. For these reasons,among others, actual results may vary from the estimated results.

 

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**Comparing Fiscal Years Ended December 31, 2005, 2004 and2003**

 

*Net sales.* The following table sets forth, for theperiods indicated, net sales by geographic region and major product line.

 
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **(in thousands)**                    | ** ** |
| United  States:                          |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 246,087    |   | $ | 134,247 |   | $ | 108,921 |   |
| Eye  care                                |       | 56,402                                     |       | 52,635 |   | 44,537 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  United States                     |       | $                                          | 302,489    |   | $ | 186,882 |   | $ | 153,458 |   |
|                                     |       |                                       |       |   |   |   |   |
| Americas,  excluding United States:      |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 30,706     |   | $ | 20,139 |   | $ | 15,359 |   |
| Eye  care                                |       | 10,904                                     |       | 10,562 |   | 9,570 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  Americas, excluding United States |       | $                                          | 41,610     |   | $ | 30,701 |   | $ | 24,929 |   |
|                                     |       |                                       |       |   |   |   |   |
| Europe/Africa/Middle  East:              |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 202,670    |   | $ | 159,917 |   | $ | 112,105 |   |
| Eye  care                                |       | 95,926                                     |       | 103,806 |   | 99,991 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  Europe/Africa/Middle East         |       | $                                          | 298,596    |   | $ | 263,723 |   | $ | 212,096 |   |
|                                     |       |                                       |       |   |   |   |   |
| Japan:                                   |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 77,693     |   | $ | 62,856 |   | $ | 46,370 |   |
| Eye  care                                |       | 96,595                                     |       | 128,679 |   | 117,743 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  Japan                             |       | $                                          | 174,288    |   | $ | 191,535 |   | $ | 164,113 |   |
|                                     |       |                                       |       |   |   |   |   |
| Asia  Pacific:                           |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 62,650     |   | $ | 36,263 |   | $ | 23,753 |   |
| Eye  care                                |       | 41,040                                     |       | 32,995 |   | 23,104 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  Asia Pacific                      |       | $                                          | 103,690    |   | $ | 69,258 |   | $ | 46,857 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  net sales:                        |       |                                       |       |   |   |   |   |
| Ophthalmic  surgical                     |       | $                                          | 619,806    |   | $ | 413,422 |   | $ | 306,508 |   |
| Eye  care                                |       | 300,867                                    |       | 328,677 |   | 294,945 |   |
|                                     |       |                                       |       |   |   |   |   |
| Total  net sales                         |       | $                                          | 920,673    |   | $ | 742,099 |   | $ | 601,453 |   |
|                                     |       |                                       |       |   |   |   |   |
| U.S.                                     |       | 32.9                                       | %          | 25.2 | % | 25.5 | % |
| International  (excluding U.S.)          |       | 67.1                                       | %          | 74.8 | % | 74.5 | % |

 

We organize our operations into four regions: theAmericas, which includes North and South America, Europe/Africa/Middle East,Japan and Asia Pacific.

 

Net sales for 2005 increased by $178.6 million, or24.1%, to $920.7 million in 2005 from $742.1 million in 2004. The increase in2005 was primarily the result of sales of products acquired in the VISXAcquisition in 2005 and the full year impact of the purchase of the Pfizerophthalmic surgical business in June 2004, as well as increased sales oftechnologically advanced products due to continued market acceptance of theproducts. Net sales of acquired VISX products approximated $111.1 million in2005. Net sales of acquired Pfizer ophthalmic 

 

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surgicalproducts were $168.4 million in 2005, compared to net sales of $75.8 million in2004. These increases were partially offset by declines in our oldernon-promoted and discontinued products and eye care sales in Japan and Europe.The unfavorable impact from foreign currency fluctuations on net sales was $0.2million in 2005. The favorable impact from foreign currency fluctuations duringthe first nine months of 2005 were offset by a negative impact in the fourthquarter of 2005. Our net sales and earnings in future periods may benegatively impacted during times of a strengthening U.S. dollar.

 

The U.S. information is presented separately as it isour headquarters country, and U.S. sales represented 32.9%, 25.2%, and 25.5% oftotal net sales in 2005, 2004 and 2003, respectively. Additionally, sales inJapan represented 18.9%, 25.8%, and 27.3% of total net sales in 2005, 2004 and2003, respectively. No other country, or any single customer, generated over10% of total net sales in any of these years.

 

Net sales in the Americas, including the UnitedStates, increased $126.5 million, or 58.1%, in 2005 from 2004 and such increasecomprised a $122.4 million increase in sales of ophthalmic surgical productsand a $4.1 million increase in sales of eye care products. The increase insales of ophthalmic surgical products was primarily the result of sales ofproducts acquired in the VISX and Pfizer Acquisitions. Net sales of acquiredVISX products were $94.9 million in 2005. Net sales of acquired Pfizerproducts, including the *Healon* familyof viscoelastics and *Tecnis*intraocular lenses, were $49.7 million in 2005, compared to $21.0 million in2004. The increase in sales of eye care products was primarily due to anincrease in sales of *Complete*branded products. Net sales in the Americas include the favorable impact offoreign currency fluctuations of $2.3 million in 2005.

 

Net sales in Europe/Africa/Middle East increased $34.9million, or 13.2%, in 2005 from 2004 and such increase comprised a $42.8million increase in sales of ophthalmic surgical products and a $7.9 milliondecrease in sales of eye care products. Net sales of acquired VISX productswere $6.9 million in 2005. The increase in sales of ophthalmic surgicalproducts includes $68.7 million in sales of acquired Pfizer products, includingthe *Healon* family ofviscoelastics and *Tecnis*intraocular lenses, compared to $31.1 million in 2004. The increase in sales ofophthalmic surgical products also reflected an increase in net sales ofphacoemulsification products. The decrease in sales of eye care products wasprimarily due to a decrease in sales of hydrogen peroxide-based products due tothe overall market decline as the migration of single-bottle cleaning regimenscontinues. Net sales in Europe/Africa/Middle East include the unfavorableimpact of foreign currency fluctuations of $1.0 million primarily due to thestrengthening of the U.S. dollar versus the euro in 2005.

 

Net sales in Japan decreased $17.2 million, or 9.0%,in 2005 from 2004 and such decrease comprised a $32.0 million decrease in salesof eye care products, partially offset by a $14.8 million increase in sales ofophthalmic surgical products. The decrease in sales of eye care products wasprimarily due to decreases in sales of multipurpose solutions and hydrogenperoxide-based products resulting from the contracting market for theseproducts in Japan. We are seeing continuing shrinkage of the market forhydrogen-peroxide based products as contact lens wearers gravitate increasinglyto frequent replacement lenses that use more convenient multipurpose solutions.We also saw decreased sales of multipurpose products due to rapid growth ofdaily disposable lenses and our decision to discontinue our non-core products.The increase in sales of ophthalmic surgical products includes $32.9 million insales of acquired Pfizer products in 2005, compared to $18.2 million in 2004.Net sales of acquired VISX products were $2.6 million in 2005. Net sales inJapan include the unfavorable impact of foreign currency fluctuations of $ 3.2million resulting from the strengthening of the U.S. dollar versus the Japaneseyen in 2005.

 

Net sales in Asia Pacific increased $34.4 million, or49.7%, in 2005 from 2004 and such increase comprised a $26.4 million increasein sales of ophthalmic surgical products and a $8.0 million increase in salesof eye care products. The increase in sales of ophthalmic surgical productsincludes $17.1 million in sales of acquired Pfizer products in 2005, comparedto $5.5 million in 2004. We also saw increased sales of other promoted productsin 2005. Net sales of acquired VISX products were $6.7 million in 2005. Theincrease in sales of eye care products was primarily due to an increase insales of *Complete* brandedproducts. Net sales in Asia Pacific include the favorable impact of foreigncurrency fluctuations of $1.7 million in 2005.

 

Global sales of our ophthalmic surgical productsincreased $206.4 million, or 49.9%, in 2005 from 2004. Sales of our ophthalmicsurgical products increased primarily due to sales of products acquired in theVISX Acquisition and increased sales of our branded promoted products,including the *Healon* family ofviscoelastics, *Tecnis* and *ReZoom*intraocular lenses, and increased sales of *Sensar* intraocular lenses andphacoemulsification products. Ophthalmic surgical product sales were negativelyimpacted by decreased sales of non-promoted older-technology intraocular lensesand non-promoted viscoelastics. We believe that global sales of ophthalmicsurgical products will continue to grow due to sales of acquired products,including the *Healon* family ofviscoelastics, the *Tecnis*intraocular lens, the *Baerveldt*glaucoma shunt, the *VISX STAR*systems and treatment cards, and increased sales of our *Sensar* and *ReZoom* intraocular lenses. We expect the growth to bepartially offset by decreased sales of our older intraocular lenses as wecontinue our strategy of promoting our higher-technology intraocular lenses,*Tecnis*, *Sensar*and*ReZoom.*Net salesof acquired VISX products were $111.1 million in 2005. Net sales of acquiredPfizer products were $168.4 million in 2005, compared to $75.8 million in 2004.The favorable impact from foreign currency fluctuations during the first ninemonths of 2005 were offset by a negative impact in the fourth quarter of 2005.

 

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Global sales of our eye care products decreased $27.8million, or 8.5%, in 2005 from 2004. Sales of our eye care products decreasedprimarily due to decreased sales of hydrogen peroxide-based products,principally in Europe and Japan, where the migration to single-bottle cleaningregimens continues, and decreased sales of multipurpose solutions in Japan dueto an increase in the market for daily disposable lenses. The favorable impactfrom foreign currency fluctuations during the first nine months of 2005 wereoffset by a negative impact in the fourth quarter of 2005.

 

As part of our product rationalization andrepositioning plan to maximize our competitive advantage as the globalrefractive leader and improve the global penetration of our core cataract,refractive and eye care brands, we have discontinued a variety of non-strategiccataract surgical and eye care products that lack critical revenue mass, haveexperienced steadily declining sales trends and/or have generated relativelyunattractive margins. We expect the growth of our promoted products to offsetthe revenue decline related to these discontinued products.

 

Net sales for 2004 increased by $140.6 million, or23.4%, to $742.1 million in 2004 from $601.5 million in 2003. The increase in2004 was the result of sales of products acquired in the Pfizer Acquisition,sales gains of existing products in both product lines and favorable foreigncurrency changes. Net sales of acquired products approximated $75.8 million.Foreign currency fluctuations, particularly related to the Japanese yen and theeuro, increased sales by $37.5 million, or 6.2%, as compared to average ratesin effect in 2003.

 

Net sales in the Americas, including the United States,increased $39.2 million, or 22.0%, in 2004 from 2003 and such increase wascomprised of a $30.1 million increase in sales of ophthalmic surgical productsand a $9.1 million increase in sales of eye care products. Net sales in theAmericas include the favorable impact of foreign currency fluctuations of $1.6million. The increase in sales of ophthalmic surgical products includes $21.0million in sales of products acquired in the Pfizer Acquisition, including the *Healon* family of viscoelastics and *Tecnis* intraocular lenses, and increasedsales of the *Sensar* intraocularlens and phacoemulsification products. The increase in sales of eye careproducts was primarily due to an increase in sales of *Complete* branded products.

 

Net sales in Europe/Africa/Middle East increased $51.6million, or 24.3%, in 2004 from 2003 and such increase was comprised of a $47.8million increase in sales of ophthalmic surgical products and a $3.8 millionincrease in sales of eye care products. Net sales in Europe/Africa/Middle Eastinclude the favorable impact of foreign currency fluctuations of $22.0 millionprimarily due to the strengthening of the euro versus the U.S. dollar. Theincrease in sales of ophthalmic surgical products includes $31.1 million insales of products acquired in the Pfizer Acquisition, including the *Healon* family of viscoelastics and *Tecnis* intraocular lenses, and increasedsales of the *Sensar* intraocularlens and phacoemulsification products.

 

Net sales in Japan increased $27.4 million, or 16.7%,in 2004 from 2003 and such increase was comprised of a $16.5 million increasein sales of ophthalmic surgical products and a $10.9 million increase in salesof eye care products. Net sales in Japan include the favorable impact offoreign currency fluctuations of $11.8 million resulting from the strengtheningof the Japanese yen versus the U.S. dollar. The increase in sales of ophthalmicsurgical products includes $18.2 million in sales of products acquired in thePfizer Acquisition, including the *Healon*family of viscoelastics, and increased sales of the *Sensar* intraocular lens. The increase in sales of eye careproducts was primarily due to an increase in sales of *Complete* branded products and hydrogenperoxide-based products.

 

Net sales in Asia Pacific increased $22.4 million, or47.8%, in 2004 from 2003 and such increase was comprised of a $12.5 millionincrease in sales of ophthalmic surgical products and a $9.9 million increasein sales of eye care products. Net sales in Asia Pacific include the favorableimpact of foreign currency fluctuations of $2.1 million. The increase in salesof ophthalmic surgical products includes $5.5 million in sales of productsacquired in the Pfizer Acquisition, including the *Healon* family of viscoelastics and *CeeOn* intraocular lenses, and increasedsales of the *Sensar* intraocularlens and phacoemulsification products. The increase in sales of eye careproducts was primarily due to an increase in sales of *Complete* branded products and hydrogenperoxide-based products.

 

Global sales of our ophthalmic surgical productsincreased $106.9 million, or 34.9%, in 2004 from 2003. Sales of our ophthalmicsurgical products increased primarily due to sales of products acquired in thePfizer Acquisition of $75.8 million, including the *Healon* family of viscoelastics and the *Tecnis* and *CeeOn* intraocular lenses, and increased sales of *Sensar* intraocular lenses andphacoemulsification products and favorable currency changes. Foreign currencyfluctuations in 2004 increased international ophthalmic surgical sales by $19.2million, or 6.3%, as compared to average rates in effect in 2003.

 

Global sales of our eye care products increased $33.7million, or 11.4%, in 2004 from 2003. Sales of our eye care products increasedprimarily due to an increase in sales of *Complete*branded products and hydrogen peroxide-based products and favorable currencychanges. Foreign currency fluctuations in 2004 increased international eye caresales by $18.3 million, or 6.2%, as compared to average rates in effect in2003.

 

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For additional information relating to our geographicoperating segments, including operating income (loss) and long-lived assets,see Note 14 of Notes to Consolidated Financial Statements.

 

*Income and expenses.* The following table sets forth certainstatement of operations items as a percentage of net sales:

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net  sales                                        |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Cost  of sales                                    |       | 38.4                                       |       | 41.3 |   | 37.9 |   |
| Gross  margin                                     |       | 61.6                                       |       | 58.7 |   | 62.1 |   |
| Other  operating costs and expenses:              |       |                                       |       |   |   |   |   |
| Selling,  general and administrative              |       | 43.1                                       |       | 44.4 |   | 46.0 |   |
| Research  and development                         |       | 6.7                                        |       | 6.1 |   | 6.2 |   |
| In-process  research and development              |       | 53.3                                       |       | 3.8 |   | — |   |
| Business  repositioning                           |       | 3.2                                        |       | — |   | — |   |
| Operating  income (loss)                          |       | (44.7                                      | )          | 4.4 |   | 9.9 |   |
| Interest  expense                                 |       | 3.2                                        |       | 3.6 |   | 4.0 |   |
| Unrealized  (gain) loss on derivative instruments |       | (0.3                                       | )          | — |   | — |   |
| Other  non-operating expense, net                 |       | 0.2                                        |       | 17.1 |   | 3.0 |   |
| Earnings  (loss) before income taxes              |       | (47.8                                      | )%         | (16.3 | )% | 2.9 | % |
| Net  earnings (loss)                              |       | (49.2                                      | )%         | (17.4 | )% | 1.7 | % |

 

*Gross margin.* Our gross margin percentage increased asa percentage of net sales by 2.9 percentage points to 61.6% in 2005 from 58.7%in 2004. The increase in gross margin was largely driven by sales growth in thehigher margin *Healon*family ofviscoelastics and sales of acquired VISX products. Gross profit for 2005included a fourth quarter charge of $12.6 million, or a 1.4 percentage pointimpact on gross margin percentage, for inventory provisions associated with ourproduct rationalization and business repositioning plan. Gross profit for 2005was also negatively impacted by a $3.5 million charge, or a 0.4 percentagepoint impact, associated with manufacturing productivity improvements andintegration related costs. Our gross margin percentage decreased as a percentof net sales by 3.4 percentage points to 58.7% in 2004 from 62.1% in 2003.Gross profit for 2004 included a charge of $28.1 million, or 3.8 percentagepoint impact on gross margin percentage, for manufacturing profit capitalizedin inventory and expensed related to the Pfizer Acquisition. In addition,pre-production costs incurred at our manufacturing facility in Madrid, Spain,costs incurred for expansion of our manufacturing facility in Hangzhou, China,and higher costs of product supplied by Allergan contributed to the grossmargin percentage decrease, which was partially offset by sales growth in thehigher margin *Complete* brandedline of eye care products and sales of the *Healon*family of viscoelastics.

 

*Selling, general and administrative.* Selling, general and administrativeexpenses as a percentage of net sales was 43.1% in 2005, compared to 44.4% in2004. Selling, general and administrative expenses in 2005 includeapproximately $14.6 million in acquisition and integration-related charges andamortization expense of $26.7 million related to acquired intangible assets. Selling,general and administrative expenses in 2005 also include an $8.6 million chargeassociated with the termination of a distributor agreement in India that we hadwith our former parent, Allergan. In addition, selling, general andadministrative expenses in 2005 were impacted by selling costs associated withacquired VISX products of $16.2 million. Selling, general and administrativeexpenses decreased as a percent of net sales by 1.6 percentage points to 44.4 %in 2004 from 46.0% in 2003. Selling, general and administrative expenses for2004 include an aggregate $2.3 million charge to terminate a distributorcontract following the decision to move to a direct sales model in Belgium as aresult of the Pfizer Acquisition and severance paid to AMO employees consideredredundant upon completion of the Pfizer Acquisition. Amortization of intangibleassets was $5.6 million related to the acquired Pfizer intangible assets in2004. Amortization of intangible assets was $0.1 million in 2003. In 2004,selling, general and administrative expenses also include an additional $9.3million in acquisition integration-related charges.

 

*Research and development.*Research and development expenditures asa percentage of net sales in 2005 increased slightly as compared to 2004 and asa percentage of net sales remained relatively constant in 2004 as compared to2003. Our research and development strategy is to develop proprietary productsfor vision correction that are safe and effective and address unmet needs. During2005, we obtained FDA approval and launched the *ReZoom Multifocal* intraocular lens andthe *Tecnis**Acrylic*lens, a wavefront-designed monofocal intraocular lens . We are currentlyfocusing on new advancements that build on our *Tecnis,Healon*and *WhiteStar*technology, corneal and lens-based solutions to presbyopia and dry eyeproducts.

 

*In-process research and development*. In 2005, we incurred an in-processresearch and development (IPR&D) charge of $488.5 million related to theVISX Acquisition. This charge represented the estimated fair value of projectsthat, as of the 

 

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acquisitiondate, had not reached technological feasibility and had no alternative futureuse. The Company recorded $449.2 million of this amount in the second quarterof 2005 and $39.3 million in the third quarter of 2005. The additional chargein the third quarter of 2005 resulted primarily from the completion of theIPR&D valuation. The fair value assigned to IPR&D comprised thefollowing projects: High Myopia for *CustomVue*- $14.7 million, Excimer Laser Improvements - $56.2 million and Presbyopia -$417.6 million. The fair value of these projects was determined by performing adiscounted cash flow analysis using the “income” approach. Net cash flowsattributable to these projects were discounted to their present values at arate commensurate with the perceived risk, which for these projects ranged from19.0 to 21.0 percent. High myopia for *CustomVue*was forecasted to be approved for sale in the U.S. in late 2005. FDA approvalwas received in September 2005. A procedure to treat presbyopia isforecasted to be approved for sale in the U.S. in late 2006. Additionalresearch and development expenses needed prior to expected FDA approval forthese procedures are expected to range from $4 million to $6 million. Thisrange represents management’s best estimate as to the additional R&Dexpenses required to bring these products to market in the U.S. Additionalresearch and development expenses in the range of $8 million to $10 millionrepresent management’s best estimate as to the additional R&D expenses tobring excimer laser system improvements to market. Forecasted discounted cashflows for each product once launched include estimates for normal sustainingengineering and maintenance R&D. These projects are currently on track forthe expected approval dates. However, the major risks and uncertaintiesassociated with the timely and successful completion of these projects consistof the ability to confirm the safety and efficacy of the technology based onthe data from clinical trials and obtaining the necessary approvals. We can provideno assurance that the approvals will be received on this schedule or atall.

 

In 2004, we incurred an IPR&D charge of $28.1million related to the Pfizer Acquisition. This charge represented theestimated fair value of projects that, as of the acquisition date, had notreached technological feasibility and had no alternative future use. Theestimated fair value assigned to IPR&D comprised the following projects: *Tecnis* Monofocal - $1.6 million and *Tecnis* Multifocal - $26.5 million. Theestimated fair value of these IPR&D projects was estimated by performing adiscounted cash flow analysis using the “income” approach. These cash flowswere then discounted to a present value using a discount rate of 14.5%.Regulatory approval for the *Tecnis*Monofocal in Japan was expected and received in 2005. We also estimate that the*Tecnis* Multifocal will receiveits PMA in the U.S. in 2008, with approval in Japan in 2008. Additionalresearch and development expenses in the range of $2.5 million to $3.0 millionfor the *Tecnis* Multifocalrepresents our best estimate as to the additional research and developmentexpenses to bring these products to market. These projects are currently ontrack for the expected approval dates. However, the major risks anduncertainties associated with the timely and successful completion of theseprojects consist of the ability to confirm the safety and efficacy of thetechnology based on the data from clinical trials and obtaining the necessaryapprovals. We can provide no assurance that the approvals will be received onthis schedule or at all.

 

*Business repositioning costs.*On October 31,2005, our Board of Directors approved a product rationalization andrepositioning plan covering the discontinuation of non-strategic cataractsurgical and eye care products and the elimination or redeployment of resourcesthat support these product lines. The plan also includes organizational changesand potential reductions in force in manufacturing, sales and marketingassociated with these product lines, as well as organizational changes inresearch and development and other corporate functions designed to align theorganization with our strategy and strategic business unit organization. Theplan further calls for increasing our investment in key growth opportunities,specifically our refractive implant product line and international laser visioncorrection business, and accelerating the implementation of productivityinitiatives. We incurred $42.3 million in pre-tax charges during the fourthquarter of 2005 which included $12.6 million for inventory related chargesincluded in cost of sales and $29.7 million included in operating expenses forseverance, relocation and other one-time termination benefits of $14.0 million,asset write-downs of $9.2 million, contractual obligations of $2.7 million andaccelerated productivity and brand repositioning costs of $3.8 million. Weexpect to incur an additional $28 million to $38 million in charges in thefirst half of 2006. Thesecosts will be recognized as the services are performed and actions occur.

 

*Operating income*. Operating income (loss) was $(411.3)million, $33.0 million and $59.5 million in 2005, 2004 and 2003, respectively.Our 2005 operating loss was negatively impacted by an aggregate $559.9 millionin charges primarily related to the VISX Acquisition and our productrationalization and business repositioning initiatives as discussed above.

 

*Non-**operating**expense*. Interest expense was $29.3 million,$26.9 million and $24.2 million in 2005, 2004 and 2003, respectively. Interestexpense in 2005 includes a pro-rata write-off of debt issuance costs of $5.8million primarily associated with the termination of the term loan, partiallyoffset by the recognition of a realized gain on interest rate swaps of $0.8million. In 2004, interest expense included a net charge of $6.5 millioncomprised of a charge of $9.7 million for the pro-rata write-off of debtissuance costs and write-off of original issue discount and one-time commitmentfees net of a net realized gain on interest rate swaps of $3.2 million, allassociated with the prepayment of the Japan term loan in June 2004,consummation of the June 2004 tender offer for $70.0 million aggregateprincipal amount of the 9 1⁄4% senior subordinated notes, theexchange of $131.4 million aggregate principal amount of the 3 1⁄2%convertible senior subordinated notes and partial prepayment of the $250.0million June 2004 term loan. Interest expense in 2003 included a netcharge of $5.8 million comprised of a charge of $7.8 million for the pro-ratawrite-off of debt issuance costs and write-off of original issue discount netof a net realized gain on interest rate swaps of $2.0 

 

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millionassociated with the prepayment of a term loan in June 2003, theconsummation of the “Modified Dutch Auction” tender offer for $115.0 millionaggregate principal amount of the 9 1⁄4% senior subordinate notesin July 2003 and the repurchase of an additional $15.0 million aggregateprincipal amount of the 9 1⁄4% senior subordinate notes in September 2003.We anticipate interest expense to decrease in 2006 relative to 2005 due to the anticipatedoverall reduction in average borrowings outstanding during 2006 as well as thehigher percentage of our relatively low fixed rate convertible debt versus our variablerate debt. The anticipated increase in interest rates throughout 2006 willslightly offset these benefits.

 

We recorded an unrealized (gain) loss on derivativeinstruments of $(2.6) million, $0.4 million and $0.2 million in 2005, 2004 and2003 respectively. We record as “unrealized (gain) loss on derivativeinstruments” the mark to market adjustments on the outstanding foreign currencyoptions and forward contracts which we entered into to reduce the volatility ofexpected earnings in currencies other than the U.S. dollar.

 

In 2005, the loss due to exchange of the 3 1⁄2%convertible senior subordinated notes due 2023 of $1.9 million is comprised ofa non-cash charge of $1.7 million and a cash charge of $0.2 million. Inthe second quarter of 2005, we exchanged 160,695 shares of common stock for$3.0 million aggregate principal amount of the 3 1⁄2% convertiblesenior subordinated notes in a privately negotiated transaction. As a result, anon-cash charge of approximately $0.5 million representing the fair value ofshares issued as a premium was recorded. In the fourth quarter of 2005, weexchanged 291,760 shares of common stock and approximately $0.4 million in cashfor $5.6 million aggregate principal amount of the 3 1⁄2%convertible senior subordinated notes in privately negotiated transactions. Anon-cash charge of approximately $1.2 million and a cash charge of $0.2 millionrepresenting the fair value of shares issued as a premium were recorded.

 

In 2004, the loss due to exchange of the 3 1⁄2%convertible senior subordinated notes of $116.3 million is comprised of anon-cash charge of $111.7 million and a cash charge of $4.6 million. In the secondquarter of 2004, we exchanged approximately 5.8 million shares of common stockand $4.6 million of cash for approximately $108.6 million in aggregateprincipal amount of these notes. Because these notes were not convertible intoequity at such time, a non-cash charge of $107.2 million and a cash charge of$4.6 million was recorded. The $107.2 million non-cash charge was comprised ofa charge of $89.1 million representing the difference between the fair marketvalue of 5.3 million shares of common stock issued in exchange for the notesand the principal amount of notes exchanged and a charge of $18.1 millionrepresenting the fair market value of 0.5 million shares of common stock issuedas a premium. The $4.6 million cash charge represented cash issued as apremium. In the remainder of 2004, we exchanged approximately 1.2 millionshares of common stock for approximately $22.8 million in aggregate principalamount of these notes. As a result, a non-cash charge of $4.5 millionrepresenting the fair value of shares issued as a premium was recorded.

 

Other net non-operating expense was $0.3 million for2005. Other non-operating expense of $10.6 million for 2004 included $10.8million paid for the repurchase of the 9 1⁄4%  senior subordinated notes and early debtextinguishment costs and fees of $0.1 million aggregating $10.9 millionpartially offset by foreign exchange gains and interest income. Othernon-operating expense of $17.8 million for 2003 included an aggregate premiumof $19.4 million paid for the partial repurchase of the 9 1⁄4%senior subordinated notes net of a foreign currency gain of $2.7 millionresulting from the settlement of certain intercompany notes and relatedtransfer of cash utilized for the prepayment of a term loan and partialrepurchase of the 9 1⁄4% senior subordinated notes, whichaggregated $16.8 million.

 

*Income taxes*. In 2005, we recorded a provision forincome taxes of $12.9 million on a pre-tax loss of $440.3 million. The pre-taxloss in 2005 included an in-process research and development charge of $490.8million, a non-cash charge of $1.7 million and a cash charge of $0.2 million relatedto the exchange of the 3 1⁄2% convertible senior subordinated notes and acharge of $8.6 million associated with the termination of a distributionagreement in India with Allergan, for which no tax benefit was provided onthese items. We have provided a tax provision at 33% on the remaining income,which was partially offset by tax benefits from the American Jobs Creation Actof 2004 and final adjustments with Allergan, which are discussed below. Incometaxes are provided on taxable income at the statutory rates applicable to suchincome and we have provided for U.S. federal income taxes and anticipatedforeign withholding taxes on the undistributed earnings of non-U.S.subsidiaries.

 

The American Jobs Creation Act of 2004 was signed intolaw in October 2004, which allows companies to elect to repatriate cashinto the United States in 2005 at a special, temporary effective tax rate of5.25 percent. Based on our evaluation of the amount of foreign earnings that wehave elected to treat under this special provision, the income tax benefit ofthe repatriation was $5.7 million in 2005.

 

The lower tax rate in 2005 reflects continuingimplementation of our long-term tax strategies, as well as final adjustments ofpreviously accrued pre-spin-off taxes attributable to our business in 2002 andpayable to Allergan pursuant to a pre-spin tax sharing agreement. Theseadjustments included a $1.4 million benefit from the resolution of a discreteitem in the third quarter, which was recorded in the income tax provision.

 

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We believe our future effective income tax rate may varydepending on our mix of domestic and international taxable income or loss andthe various tax and treasury methodologies that we implement, including ourpolicy regarding repatriation of future accumulated foreign earnings.

 

In 2004, we recorded a provision for income taxes of$8.2 million even though we had a pre-tax loss of $121.2 million. We recordedsuch provision as no tax benefit has been recognized for the IPR&D chargeof $28.1 million nor for the aggregate charge of $116.3 million related to theexchange of the 3 1⁄2% convertible senior subordinated notes.Income taxes are provided on taxable income at the statutory rates applicableto such income and we have provided for U.S. federal income taxes and foreignwithholding taxes on the undistributed earnings of non-U.S. subsidiaries. Weprovided a tax provision at 35% on the remaining income in 2004, compared tothe effective tax rate of 40% in 2003. The lower tax rate in 2004 reflectedcontinuing implementation of our long-term tax strategies.

 

*Net earnings (loss).*Net earnings (loss) was $(453.2) million,$(129.4) million and $10.4 million in 2005, 2004 and 2003, respectively. Thenet loss in 2005 included an aggregate after-tax charge of $536.9 million,primarily due to the VISX Acquisition, business repositioning costs,integration related costs, and termination of a distributor agreement in India,write-off of debt issuance costs and exchange of the 3 1⁄2% convertiblesenior subordinated notes, partially offset by tax benefits from the AmericanJobs Creation Act of 2004 and final adjustments with Allergan.

 

The net loss in 2004 included an aggregate after-taxcharge of $175.5 million related to the following: the manufacturing profitcapitalized in inventory and expensed related to the Pfizer Acquisition; thecharge to terminate a distributor contract following the decision to move to adirect sales model in Belgium as a result of the Pfizer Acquisition andseverance paid to AMO employees considered redundant upon completion of thePfizer Acquisition; the in-process research and development charge related tothe Pfizer Acquisition; the pro-rata write-off of debt issuance costs andwrite-off of original issue discount net of a net realized gain on interestrate swaps; and the charges related to the repurchase of the 9 1⁄4%  senior subordinated notes and the exchange ofthe 3 1⁄2% convertible senior subordinated notes.

 

Net earnings in 2003 included an aggregate after-taxcharge of $13.5 million related to the pro-rata write-off of debt issuancecosts and write-off of original issue discount net of a net realized gain oninterest rate swaps and a net charge related to the prepayment of a term loanand partial repurchase of the 9 1⁄4%  senior subordinated notes.

 

**Liquidity and Capital Resources**

 

Management assesses our liquidity by our ability togenerate cash to fund operations. Significant factors in the management ofliquidity are: funds generated by operations; levels of accounts receivable,inventories, accounts payable and capital expenditures; adequate lines ofcredit; and financial flexibility to attract long-term capital on satisfactoryterms. As of December 31, 2005, we had cash and equivalents of $40.8million.

 

Historically, we have generated cash from operationsin excess of working capital requirements, and we expect to do so in thefuture. Net cash provided by operating activities in 2005 was $20.8 millioncompared to $39.7 million in 2004 and $48.0 million in 2003. Operating cashflow decreased in 2005 compared to 2004 due to increases in cash paid forincome taxes, timing of accounts payable payments and inventory buildup,partially offset by the favorable impact of the VISX acquisition and timing ofaccounts receivable collections. The inventory buildup was due in part to “bridging”stock related to the recent transfer of eye care manufacturing from Allergan andthe increases in the size and scope of our global manufacturing network. Operatingcash flow decreased in 2004 compared to 2003 primarily as a result of earlydebt extinguishment costs paid in cash and an increase in accounts receivablepartially offset by an increase in accounts payable. The increase in accountsreceivable was primarily due to the additional sales of acquired Pfizerproducts and the increase in accounts payable was primarily due to theadditional costs incurred in operating the acquired Pfizer manufacturingfacilities in Uppsala, Sweden, Groningen, Netherlands and Bangalore, India andexpansion of our eye care manufacturing facilities in Madrid, Spain andHangzhou, China in preparation for our transition of eye care manufacturingfrom Allergan. Additionally, in February 2004, we received approximately$4.7 million from Allergan. This payment ended a dispute between us andAllergan regarding the ownership of a certain value added tax receivable duefrom France. As part of the settlement with Allergan, we were responsiblefor paying penalties and expenses associated with the receivable, whichaggregated less than $0.5 million.

 

Net cash used in investing activities was $79.9million, $482.2 million, and $41.1 million in 2005, 2004 and 2003, respectively.The 2005 capital expenditures are primarily comprised of expenditures toupgrade our viscoelastics manufacturing facility in Uppsala, Sweden. The 2005amount includes $36.9 million net cash paid primarily for the acquisition ofVISX. The 2004 capital expenditures are primarily comprised of expansion of ourmanufacturing facilities in preparation for the transition away from theAllergan manufacturing agreement, expenditures at the acquired manufacturingfacilities and construction of research and development facilities at ourleased headquarters. The 2004 amount also includes the $456.7 million PfizerAcquisition purchase price, which was financed with a portion of the proceedsfrom the issuance of $350.0 million of 2 1⁄2% convertible seniorsubordinated notes and a $250.0 million term loan. In November 2003, wecompleted the purchase of an 

 

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existingmanufacturing facility in Madrid, Spain. We financed the approximately $21.4million purchase of this facility with available cash and borrowings under oursenior credit facility. Expenditures for property, plant and equipment totaled$23.1 million, $17.5 million, and $12.6 million in 2005, 2004, and 2003,respectively. We expect to incur significant capital expenditures with respectto the Uppsala, Sweden manufacturing facility during the next year in order toseparate the facility from existing Pfizer operations. Expenditures fordemonstration (demo) and bundled equipment, primarily phacoemulsification andmicrokeratome surgical equipment, were $11.1 million, $6.8 million, and $7.0million in 2005, 2004, and 2003, respectively. We maintain demo and bundledequipment to facilitate future sales of similar equipment and related productsto our customers. Expenditures for capitalized internal-use software were $8.8million, $2.4 million, and $0.7 million in 2005, 2004, and 2003, respectively.The 2005 software expenditures were due to acquisition related integrations andimprovements to support common global technology platforms. We capitalizeinternal-use software costs after technical feasibility has been established.In 2006, we expect to invest approximately $ 60.0 million to $ 70.0 million inproperty, plant and equipment, demo and bundled equipment, and capitalizedsoftware as part of the overall expansion of our business.

 

Net cash provided by financing activities was $54.0million in 2005, which comprised $150.0 million of proceeds from the issuanceof the 1.375% convertible senior subordinated notes, $60.0 million ofborrowings primarily under the senior revolving credit facility, $45.8 millionof proceeds from the sale of stock to employees and $0.8 million proceedsreceived after settling an interest rate swap agreement, reduced by $194.2million of debt repayments and $8.4 million of financing related costs.

 

Net cash provided by financing activities was $442.2million in 2004, which primarily comprised $350.0 million of proceeds from theissuance of the 2 1⁄2% convertible senior subordinated notes anda $250.0 million term loan, partially offset by repayment of debt of $149.2million and financing related costs of $16.6 million.

 

Net cash used in financing activities was $43.5million in 2003, which primarily comprised $162.4 million of long-term debtborrowings and $6.0 million from the sale of stock to employees reduced bylong-term debt repayments of $205.0 million and financing related costs of $7.3million.

 

In January 2005, we entered into an amendment to oursenior credit facility to provide for an increase of $100.0 million in therevolving loan commitments and an additional $100.0 million in term loancommitments. On May 27, 2005, we and certain of our subsidiaries, asguarantors thereunder, entered into an amendment to provide for an additional increaseof $100.0 million in the revolving loan commitments under the senior creditfacility, which amounts were made available to us to finance, in part, ouracquisition of VISX, and are available for working capital and other generalcorporate purposes subject to satisfaction of certain conditions. This amendmentalso provides for termination of $100.0 million of existing term loancommitment. The amendment increased the revolving loan commitments to $300.0million. The maturity of the senior credit facility on June 25, 2009 remainsunchanged.

 

On May 27, 2005, we borrowed approximately $200.0million under the senior revolving credit facility to fund the cash portion ofthe VISX Acquisition. In June 2005, we repaid approximately $123.0 millionof revolver borrowings with acquired VISX cash.

 

At December 31, 2005, we had $50.0 million of borrowingsoutstanding under the revolving credit facility. Approximately $18.7 million ofthe revolving credit facility was reserved to support letters of credit issuedon our behalf for normal operating purposes and we had approximately $231.3million undrawn and available revolving loan commitments. At December 31,2005, we had $10.0 million of borrowings outstanding under a short-term loanfrom Bank of Ireland to our subsidiary, AMO Ireland. This loan was supported bya $10.0 million letter of credit which was part of the $18.7 million of lettersof credit noted previously. This loan was paid in its entirety on February 21,2006 and is no longer available for borrowing.

 

Our senior credit facility provides that we will maintaincertain financial and operating covenants which include, among otherprovisions, maintaining specific leverage and coverage ratios. Certaincovenants under the senior credit facility may limit the incurrence ofadditional indebtedness. The senior credit facility prohibits dividendpayments. We were in compliance with these covenants at December 31, 2005.Our senior credit facility is secured by a first priority perfected lien on,and pledge of, all of the combined company’s present and future property andassets (subject to certain exclusions), 100% of the stock of the domesticsubsidiaries, 66% of the stock of the foreign subsidiaries and all present andfuture intercompany debts.

 

In the second quarter of 2005, we exchanged 160,695shares of common stock for $3.0 million aggregate principal amount of 3 1⁄2%convertible senior subordinated notes in a privately negotiated transaction. Inthe fourth quarter of 2005, we exchanged 291,760 shares of common stock andapproximately $0.4 million in cash for $5.6 million aggregate principal amountof 3 1⁄2% convertible senior subordinated notes in privatelynegotiated transactions.

 

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On July 18, 2005, we issued $150.0 million of1.375% convertible senior subordinated notes (Senior Subordinated Notes) due July 1,2025. Interest on the Senior Subordinated Notes is payable on January 1and July 1 of each year, commencing on January 1, 2006. The SeniorSubordinated Notes are convertible into 21.0084 shares of our common stock foreach $1,000 principal amount of the Senior Subordinated Notes (conversion priceof approximately $47.60 per share), subject to adjustment. The SeniorSubordinated Notes may be converted, at the option of the holders, intocash or under certain circumstances, cash and shares of our common stock at anytime on or prior to the trading day preceding June 1, 2011. We haveelected to satisfy in cash the conversion obligation with respect to theprincipal amount of the Senior Subordinated Notes.

 

On July 21, 2005, we paid off the balance of ourterm loan, including approximately $149.1 million of principal andapproximately $1.2 million of accrued interest, using the net proceeds from the1.375% convertible senior subordinated notes and existing cash. As a result ofthe repayment, the term loan is no longer available for borrowing.

 

Our cash position includes amounts denominated inforeign currencies, and the repatriation of those cash balances from some ofour non-U.S. subsidiaries may result in additional tax costs. However,these cash balances are generally available without legal restriction to fundordinary business operations.

 

We believe that the net cash provided by our operatingactivities, supplemented as necessary with borrowings available under ourrevolving credit facility and existing cash and equivalents, will providesufficient resources to fund the expected 2006 capital expenditures, and tomeet our working capital requirements, debt service and other cash needs overthe next year.

 

We are partially dependent upon the reimbursementpolicies of government and private health insurance companies. Government andprivate sector initiatives to limit the growth of health care costs, includingprice regulation and competitive pricing, are continuing in many countrieswhere we do business. As a result of these changes, the marketplace has placedincreased emphasis on the delivery of more cost-effective medical therapies.While we have been unaware of significant price resistance resulting from thetrend toward cost containment, changes in reimbursement policies and otherreimbursement methodologies and payment levels could have an adverse effect onour pricing flexibility.

 

Additionally, the current trend among U.S. hospitalsand other customers of medical device manufacturers is to consolidate intolarger purchasing groups to enhance purchasing power. The enhanced purchasingpower of these larger customers may also increase the pressure on productpricing, although we are unable to estimate the potential impact at this time.

 

*Inflation.* Although at reduced levels in recentyears, inflation may cause upward pressure on the cost of goods andservices used by us. The competitive and regulatory environments in manymarkets substantially limit our ability to fully recover these higher coststhrough increased selling prices. We continually seek to mitigate the adverseeffects of inflation through cost containment and improved productivity andmanufacturing processes.

 

*Foreign currency fluctuations.* Approximately 67%, 75%, and 74% of ourrevenues in the years ended December 31, 2005, 2004 and 2003,respectively, were derived from operations outside the United States, and asignificant portion of our cost structure is denominated in currencies otherthan the U.S. dollar, primarily the Japanese yen and the euro. Therefore, weare subject to fluctuations in sales and earnings reported in U.S. dollars as aresult of changing currency exchange rates.

 

The impact of foreign currency fluctuations on saleswas a $0.2 million decrease in 2005, $37.5 million and $48.1 million increasein 2004 and 2003, respectively. The sales increases in 2004 and 2003 were dueprimarily to a strengthening of the Japanese yen and euro versus the U.S.dollar.

 

*Contractual obligations*. The following represents a list of ourmaterial contractual obligations and commitments as of December 31, 2005: 

 
| ** **                                                                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                          | ** ** | **Less Than  1 Year**           | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than  5 Years** | ** ** | **Total** | ** ** |
| ** **                                                                          | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-term  debt, principal amount (a)                                               |       | $                                         | —     |   | $ | — |   | $ | — |   | $ | 500.0 |   | $ | 500.0 |   |
| Cash  commitments for interest expense                                              |       | 12.2                                      |       | 21.6 |   | 21.6 |   | 148.5 |   | 203.9 |   |
| Operating  lease obligations                                                        |       | 15.1                                      |       | 19.7 |   | 8.6 |   | 24.5 |   | 67.9 |   |
| IT  services                                                                        |       | 3.9                                       |       | 3.6 |   | — |   | — |   | 7.5 |   |
| Other  purchase obligations, primarily purchases of inventory and capital equipment |       | 49.6                                      |       | 12.8 |   | — |   | — |   | 62.4 |   |
|                                                                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(a) excludesshort-term borrowings of $60.0 million.

 

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*Off-balancesheet arrangements.*We had no off-balance sheet arrangementsat December 31, 2005.

** **

**New Accounting Standards**

 

In November 2004, Statement of FinancialAccounting Standards No. 151, “Inventory Costs-an amendment of ARB No. 43,Chapter 4” (SFAS No. 151), was issued. This Statement amends the guidancein ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accountingfor abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage). SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. We do notexpect adoption of this standard to have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

In December 2004, the Financial AccountingStandards Board (FASB) issued a revision of Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123R).SFAS No. 123R supersedes Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees” (Opinion 25), and its relatedimplementation guidance and eliminates the alternative to use Opinion 25’sintrinsic value method of accounting that was provided in Statement 123 asoriginally issued. Under Opinion 25, issuing stock options to employeesgenerally resulted in recognition of no compensation cost. SFAS No. 123Rrequires entities to recognize the cost of employee services received inexchange for awards of equity instruments based on the grant-date fair value ofthose awards (with limited exceptions). SFAS No. 123R is effective for thefirst annual reporting period that begins after June 15, 2005. On March 29,2005, the Securities and Exchange Commission (SEC) issued Staff AccountingBulletin 107 (SAB 107), which expresses the views of the SEC regarding theinteraction between SFAS No. 123R and certain SEC rules andregulations and provides the SEC’s views regarding the valuation ofshare-based payment arrangements for public companies. In particular, SAB 107provides guidance related to share-based payment transactions with nonemployees,the transition from nonpublic to public entity status, valuation methods(including assumptions such as expected volatility and expected term), theaccounting for certain redeemable financial instrument issues under share-basedpayment arrangements, the classification of compensation expense, non-GAAPfinancial measures, first-time adoption of SFAS No. 123R in an interimperiod, capitalization of compensation costs related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS No. 123R, the modification of employeeshare options prior to adoption of SFAS No. 123R, and disclosures inManagement’s Discussion and Analysis of Financial Condition and Results ofOperations subsequent to adoption of SFAS No. 123R. We will adopt SFAS No. 123Rin the first quarter of fiscal 2006. As a result of the provisions of SFAS No. 123Rand SAB 107, we expect the compensation charge under SFAS No. 123R toreduce diluted net income per share by approximately $0.15 to $0.20 per sharefor fiscal 2006. However, the assessment of the estimated compensation chargeis affected by stock prices as well as assumptions regarding a number ofcomplex and subjective variables and the related tax impact. These variablesinclude, but are not limited to, the volatility of the stock price and employeestock option exercise behaviors.

 

In December 2004, the FASB issued FASB StaffPosition No. FSP 109-1, “Application of FASB Statement No. 109, “Accountingfor Income Taxes” (FSP No. 109-1), to the Tax Deduction on QualifiedProduction Activities Provided by the American Jobs Creation Act of 2004.”  The American Jobs Creation Act (AJCA) introducesa special 9% tax deduction on qualified production activities. FSP No. 109-1clarifies that this tax deduction should be accounted for as a special taxdeduction in accordance with Statement 109. Although FSP No. 109-1 iseffective immediately, we have not completed the analysis and do not expect tobe able to complete the analysis until after Congress or the TreasuryDepartment provides additional clarifying language on the key elements of theprovision. Based on our current analysis, the adoption of FSP No. 109-1does not have a material impact on our consolidated financial position, resultsof operations, or cash flows.

 

In December 2004, the FASB issued FASB StaffPosition No. FSP 109-2, “Accounting and Disclosure Guidance for theForeign Earnings Repatriation Provision within the American Jobs Creation Actof 2004” (FSP No. 109-2). The AJCA introduces an elected limited time 85%dividends received deduction on the repatriation of certain foreign earnings toa U.S. taxpayer (repatriation provision), provided certain criteria are met. FSPNo. 109-2 provides accounting and disclosure guidance for the repatriationprovision. During the fourth quarter of 2005, we elected to repatriate $43.2million of eligible foreign earnings. Since we provide taxes currently onforeign earnings, the election of this provision enabled us to realize a taxbenefit of $5.7 million during the fourth quarter of 2005.

 

In May 2005, the FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 154, “Accounting Changes andError Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.”SFAS No. 154 requires retrospective application to prior periods’financial statements for changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. SFAS No. 154 also requires that retrospectiveapplication of a change in accounting principle be limited to the directeffects of the change. Indirect effects of a change in accounting principle,such as a change in non-discretionary profit-sharing payments resulting from anaccounting change, should be recognized in the period of the accounting change.SFAS No. 154 also requires that a change in depreciation, amortization, ordepletion method for long-lived, non-financial assets be accounted for as achange in accounting estimate effected by a change in accounting principle. 

 

43

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SFAS154 is effective for accounting changes and corrections of errors made infiscal years beginning after December 15, 2005. Early adoption ispermitted for accounting changes and corrections of errors made in fiscal yearsbeginning after the date this Statement is issued. We are  required to adopt the provisions of SFAS 154,as applicable, beginning in fiscal 2006. We do not expect the adoption of thisstandard to have a material impact on our consolidated financial position,results of operations or cash flows.

 

**Item7A. Quantitative and Qualitative Disclosures About Market Risk**

 

We routinely monitor the risks associated withfluctuations in currency exchange rates and interest rates. We address theserisks through controlled risk management that may include the use ofderivative financial instruments to economically hedge or reduce theseexposures. We do not expect to enter into financial instruments for trading orspeculative purposes.

 

Given the inherent limitations of forecasting and theanticipatory nature of the exposures intended to be hedged, there can be noassurance that such programs will offset more than a portion of the adversefinancial impact resulting from unfavorable movements in either interest orforeign exchange rates. In addition, the timing of the accounting forrecognition of gains and losses related to mark-to-market instruments for anygiven period may not coincide with the timing of gains and losses relatedto the underlying economic exposures and, therefore, may adversely affectour operating results and financial position.

 

To ensure the adequacy and effectiveness of ourinterest rate and foreign exchange hedge positions, we continually monitor,from an accounting and economic perspective, our interest rate swap positionsand foreign exchange forward and option positions, when applicable, both on astand-alone basis and in conjunction with our underlying interest rate andforeign currency exposures.

 

*Interest rate risk.* At December 31, 2005, our debtcomprises primarily domestic borrowings of which $500.0 million is fixed ratedebt and $60.0 million is variable rate debt.

 

In July 2004, we entered into an interest rate swapagreement, which effectively converted the interest rate on $125.0 million ofterm loan borrowings from a floating rate to a fixed rate. This interest rateswap qualified as a cash flow hedge and would have matured in July 2006.In April 2005, we terminated the interest rate swap. Upon termination, we receivedapproximately $0.8 million and included the related gain of approximately $0.5million, which includes the accrued but unpaid net amount between us and theswap counterparty, as a component of accumulated other comprehensive income inthe second quarter of 2005. As a result of the repayment of the term loan in July 2005,the gain on the interest rate swap of $0.8 million was fully recognized as areduction to the interest expense in the third quarter of 2005. At December 31,2005, there are no outstanding interest rate swaps.

 

In 2002, we entered into two interest rate swapagreements, which effectively converted the interest rate on $150.0 million ofthe 9 1⁄4% senior subordinated notes from a fixed to a floating rate andconverted the interest rate on $50.0 million of term loan borrowings from afloating to a fixed rate. The interest rate swaps had maturity dates beginningin 2005 and qualified as either fair value or cash flow hedges. Changes in fairvalue of the interest rate swap agreement qualifying as a cash flow hedge wererecorded in other comprehensive income to the extent such changes wereeffective and as long as the cash flow hedge requirements were met. In May 2003and October 2002, we realized the value of the interest rate swapsqualifying as fair value hedges. We received an aggregate of approximately$14.8 million, of which approximately $6.3 million represented the netsettlement of the accrued but unpaid amount between us and the swap counterparties.The remaining amount of approximately $8.5 million was recorded as anadjustment to the carrying amount of the 9 1⁄4% senior subordinated notes asa premium and was being amortized over the remaining life of the 9 1⁄4% seniorsubordinated notes. At December 31, 2003, after recognizing a pro-rataportion of the gain upon repurchase of a portion of the 9 1⁄4% senior subordinatednotes, the unamortized gain on these interest rate swaps was $3.5 million. As aresult of the June 2004 repurchase of the remaining 9 1⁄4% senior subordinatednotes, the remaining unamortized gain on the interest rate swaps was fullyrecognized.

 

In May 2003, we terminated the interest rate swapqualifying as a cash flow hedge. We paid approximately $2.4 million andincluded the related loss of approximately $2.3 million as a component ofaccumulated other comprehensive income. As a result of the prepayment of theterm loan in June 2003, the loss on the interest rate swap was fullyrecognized as interest expense.

 

44

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The tables below present information about our debtobligations and interest rate derivatives for the years ended December 31,2005 and 2004:

 

**December 31,2005**

 
| ** **                      | ** ** | **Maturing in**                                          | ** ** | ** ** | ** ** | **Fair Market ** | ** ** |
|---------------------------------|------------|---------------------------------------------------------------|------------|------------|------------|----------------------------|------------|
| ** **                      | ** ** | **2006**                                                      | ** ** | **2007**   | ** ** | **2008**                   | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Value** | ** ** |
| ** **                      | ** ** | **(in thousands, except interest rates)** | ** ** |
| **LIABILITIES**                 |       |                                                          |       |       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| **Debt Obligations:**           |       |                                                          |       |       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Fixed  Rate                     |       | $                                                             | —     |       | $          | —                     |       | $ | — |   | $ | — |   | $ | — |   | $ | 350,000 |   | $ | 350,000 |   | $ | 376,705 |   |
| Weighted  Average Interest Rate |       | —                                                        |       | —     |       | —                     |       | — |   | — |   | 2.50 | % | 2.50 | % |   |   |
| Fixed  Rate                     |       | $                                                             | —     |       | $          | —                     |       | $ | — |   | $ | — |   | $ | — |   | $ | 150,000 |   | $ | 150,000 |   | $ | 150,948 |   |
| Weighted  Average Interest Rate |       | —                                                        |       | —     |       | —                     |       | — |   | — |   | 1.375 | % | 1.375 | % |   |   |
| Variable  Rate                  |       | $                                                             | 10,000     |       | $          | —                     |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 10,000 |   | $ | 10,000 |   |
| Weighted  Average Interest Rate |       | 4.61                                                          | %          | —     |       | —                     |       | — |   | — |   | — |   | 4.61 | % |   |   |
| Variable  Rate                  |       | $                                                             | 50,000     |       | $          | —                     |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 50,000 |   | $ | 50,000 |   |
| Weighted  Average Interest Rate |       | 6.22                                                          | %          | —     |       | —                     |       | — |   | — |   | — |   | 6.22 | % |   |   |
| Total  Debt Obligations         |       | $                                                             | 60,000     |       | $          | —                     |       | $ | — |   | $ | — |   | $ | — |   | $ | 500,000 |   | $ | 560,000 |   | $ | 587,653 |   |
| Weighted  Average Interest Rate |       | 5.95                                                          | %          | —     |       | —                     |       | — |   | — |   | 2.16 | % | 2.57 | % |   |   |

 

**December 31,2004**

 
| ** **                      | ** ** | **Maturing in**                       | ** ** | ** ** | ** ** | **Fair Market** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                      | ** ** | **2005**                                   | ** ** | **2006**   | ** ** | **2007**             | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Value** | ** ** |
| ** **                      |       | **(in  thousands, except interest rates)** |       |
| **LIABILITIES**                 |       |                                       |       |       |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| **Debt Obligations:**           |       |                                       |       |       |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Fixed  Rate                     |       | $                                          | —     |       | $          | —               |       | $ | — |   | $ | — |   | $ | — |   | $ | 350,000 |   | $ | 350,000 |   | $ | 379,750 |   |
| Weighted  Average Interest Rate |       | —                                     |       | —     |       | —               |       | — |   | — |   | 2.50 | % | 2.50 | % |   |   |
| Fixed  Rate                     |       | $                                          | —     |       | $          | —               |       | $ | — |   | $ | — |   | $ | — |   | $ | 8,600 |   | $ | 8,600 |   | $ | 18,311 |   |
| Weighted  Average Interest Rate |       | —                                     |       | —     |       | —               |       | — |   | — |   | 3.50 | % | 3.50 | % |   |   |
| Variable  Rate                  |       | $                                          | 1,950      |       | $          | 1,950                |       | $ | 1,950 |   | $ | 94,559 |   | $ | 93,584 |   | $ | — |   | $ | 193,993 |   | $ | 193,993 |   |
| Weighted  Average Interest Rate |       | 4.50                                       | %          | 4.50       | %          | 4.50                 | %          | 4.50 | % | 4.50 | % | — |   | 4.50 | % |   |   |
| Total  Debt Obligations         |       | $                                          | 1,950      |       | $          | 1,950                |       | $ | 1,950 |   | $ | 94,559 |   | $ | 93,584 |   | $ | 358,600 |   | $ | 552,593 |   | $ | 592,054 |   |
| Weighted  Average Interest Rate |       | 4.50                                       | %          | 4.50       | %          | 4.50                 | %          | 4.50 | % | 4.50 | % | 2.52 | % | 3.22 | % |   |   |
| **INTEREST RATE DERIVATIVES**   |       |                                       |       |       |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest  Rate Swaps:           |       |                                       |       |       |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Variable  to Fixed              |       | $                                          | —     |       | $          | 125,000              |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 125,000 |   | $ | 319 |   |
| Average  Pay Rate               |       | —                                     |       | 3.05       | %          | —               |       | — |   | — |   | — |   | 3.05 | % |   |   |
| Average  Receive Rate           |       | —                                     |       | 2.57       | %          | —               |       | — |   | — |   | — |   | 2.57 | % |   |   |

 

*Foreign currency risk. *Overall, we are a net recipient ofcurrencies other than the U.S. dollar and, as such, we benefit from a weakerdollar and are adversely affected by a stronger dollar relative to majorcurrencies worldwide. Accordingly, changes in exchange rates, and in particulara strengthening of the U.S. dollar, may negatively affect our consolidatednet sales and gross profit as expressed in U.S. dollars.

 

45

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We may enter into foreign exchange option andforward contracts to reduce earnings and cash flow volatility associated withforeign exchange rate changes to allow management to focus its attention on itscore business operations. Accordingly, we enter into contracts which change invalue as foreign exchange rates change to economically offset the effect ofchanges in value of foreign currency assets and liabilities, commitments andanticipated foreign currency denominated sales and operating expenses. We enterinto foreign exchange option and forward contracts in amounts between minimumand maximum anticipated foreign exchange exposures, generally for periods notto exceed one year. We do not enter into foreign exchange option and forwardcontracts for trading purpose.

 

We use foreign currency option contracts, whichprovide for the sale of foreign currencies to offset foreign currency exposuresexpected to arise in the normal course of our business. While these instrumentsare subject to fluctuations in value, such fluctuations are anticipated tooffset changes in the value of the underlying exposures. The principalcurrencies subject to this process are the Japanese yen and the euro. Theforeign exchange forward contracts are entered into to protect the value offoreign currency denominated monetary assets and liabilities and the changes inthe fair value of the foreign currency forward contracts were economicallydesigned to offset the changes in the revaluation of the foreign currencydenominated monetary assets and liabilities. These forward contracts aredenominated in currencies which represent material exposures. The changes inthe fair value of foreign currency option and forward contracts are recordedthrough earnings as “Unrealized (gain) loss on derivative instruments” whileany realized gains or losses on expired contracts are recorded through earningsas “Other, net” in the accompanying consolidated statements of operations. Anypremium cost of purchased foreign exchange option contracts are recorded in “Othercurrent assets” and amortized over the life of the options.

 

The following tables provide information about ourforeign currency derivative financial instruments outstanding as of December 31,2005 and 2004. The information is provided in U.S. dollar amounts, as presentedin our consolidated financial statements.

 

| ** **                                  | ** ** | **December 31, 2005**    | ** ** | **December 31, 2004**             | ** ** |
|---------------------------------------------|------------|-------------------------------|------------|----------------------------------------|------------|
| ** **                                  | ** ** | **Notional  Amount**          | ** ** | **Average  Contract  or Strike  Rate** | ** ** | **Notional  Amount** | ** ** | **Average  Contract  or Strike  Rate** | ** ** |
| ** **                                  | ** ** | **(in $ millions)** | ** ** | ** **                             | ** ** | **(in $ millions)** | ** ** | ** ** | ** ** |
| **Foreign currency forward contracts:**     |       |                          |       |                                   |       |   |   |   |   |
| **Receive US$/Pay Foreign Currency:**       |       |                          |       |                                   |       |   |   |   |   |
| Swedish  Krona                              |       | $                             | 31.5       |                                   | 7.94       |   | — |   | — |   |
| U.K.  Pound                                 |       | 5.2                           |       | 1.72                                   |       | — |   | — |   |
| Swiss  Franc                                |       | 1.5                           |       | 1.31                                   |       | — |   | — |   |
| **Pay US$/Receive Foreign Currency:**       |       |                          |       |                                   |       |   |   |   |   |
| Japanese  Yen                               |       | 3.0                           |       | 117.45                                 |       | — |   | — |   |
| Euro                                        |       | 5.9                           |       | 1.19                                   |       | — |   | — |   |
| Canadian  Dollar                            |       | 3.4                           |       | 1.17                                   |       | — |   | — |   |
| Australia  Dollar                           |       | 2.9                           |       | 0.73                                   |       | — |   | — |   |
|                                        |       |                          |       |                                   |       |   |   |   |   |
| **Total Notional**                          | ** ** | **$**                         | **53.4**   | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Estimated Fair Value**                    | ** ** | **$**                         | **—** |                                   |       |   |   |   |   |   |
|                                        |       |                          |       |                                   |       |   |   |   |   |
| **Foreign currency purchased put options:** |       |                          |       |                                   |       |   |   |   |   |
| Japanese  Yen                               |       | $                             | 66.2       |                                   | 117.83     |   | $ | 67.3 |   | 114.40 |   |
| Euro                                        |       | 40.2                          |       | 1.18                                   |       | 56.9 |   | 1.15 |   |
| **Foreign currency sold call options:**     |       |                          |       |                                   |       |   |   |   |   |
| Japanese  Yen                               |       | 60.0                          |       | 106.60                                 |       | — |   | — |   |
| Euro                                        |       | 43.0                          |       | 1.26                                   |       | — |   | — |   |
|                                        |       |                          |       |                                   |       |   |   |   |   |
| **Total Notional**                          | ** ** | **$**                         | **209.4**  | ** **                             | ** ** |   | **$** | **124.2** |   |   |   |
| **Estimated Fair Value**                    | ** ** | **$**                         | **1.1**    | ** **                             | ** ** |   | **$** | **0.1** |   |   |   |

 

46

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The notional principal amount provides one measure ofthe transaction volume outstanding as of the end of the period, and does notrepresent the amount of our exposure to market loss. The estimate of fair valueis based on applicable and commonly used prevailing financial marketinformation as of December 31, 2005 and 2004, respectively. The amountsultimately realized upon settlement of these financial instruments, togetherwith the gains and losses on the underlying exposures, will depend on actualmarket conditions during the remaining life of the instruments.

 

The impact of foreign exchange risk managementtransactions on income was a net realized loss of $2.0 million, $1.9 millionand $2.5 million in 2005, 2004 and 2003, respectively, which are recorded in “Other,net” on the accompanying consolidated statements of operations.

 

47

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**Item8: Financial Statements and Supplementary Data**

 

**Index to Financial Statements**

 
| ** **                                                                                                                                                         | **Page No** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
|                                                                                                                                                               |        |
| Consolidated Balance  Sheets at December 31, 2005 and December 31, 2004                                                                                  | 49          |
|                                                                                                                                                               |        |
| Consolidated  Statements of Operations for Each of the Years in the Three-Year Period Ended  December 31, 2005                                                | 50          |
|                                                                                                                                                               |        |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for Each  of the Years in the Three-Year Period Ended December 31, 2005 | 51          |
|                                                                                                                                                               |        |
| Consolidated  Statements of Cash Flows for Each of the Years in the Three-Year Period Ended  December 31, 2005                                                | 52          |
|                                                                                                                                                               |        |
| Notes to  Consolidated Financial Statements                                                                                                                        | 53          |
|                                                                                                                                                               |        |
| Report of  Independent Registered Public Accounting Firm                                                                                                           | 83          |

 

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**ADVANCED MEDICAL OPTICS, INC.**

 

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                             | ** ** | **As of December 31,**                     | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| ** **                                                                                             | ** ** | **(In thousands, except share data)** | ** ** |
| **ASSETS**                                                                                             |       |                                                      |       |   |   |
| Current  assets                                                                                        |       |                                                      |       |   |   |
| Cash  and equivalents                                                                                  |       | $                                                         | 40,826     |   | $ | 49,455 |   |
| Trade  receivables, net                                                                                |       | 238,761                                                   |       | 189,465 |   |
| Inventories                                                                                            |       | 104,820                                                   |       | 85,028 |   |
| Deferred  income taxes                                                                                 |       | 66,476                                                    |       | 40,250 |   |
| Other  current assets                                                                                  |       | 28,122                                                    |       | 12,627 |   |
| Total  current assets                                                                                  |       | 479,005                                                   |       | 376,825 |   |
| Property,  plant and equipment, net                                                                    |       | 115,725                                                   |       | 118,639 |   |
| Deferred  income taxes                                                                                 |       | 12,626                                                    |       | — |   |
| Other  assets                                                                                          |       | 52,473                                                    |       | 41,825 |   |
| Intangible  assets, net                                                                                |       | 495,609                                                   |       | 147,895 |   |
| Goodwill                                                                                               |       | 825,284                                                   |       | 391,350 |   |
| Total  assets                                                                                          |       | $                                                         | 1,980,722  |   | $ | 1,076,534 |   |
|                                                                                                   |       |                                                      |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                         |       |                                                      |       |   |   |
| Current  liabilities                                                                                   |       |                                                      |       |   |   |
| Current  portion of long-term debt and short-term borrowings                                           |       | $                                                         | 60,000     |   | $ | 1,950 |   |
| Accounts  payable                                                                                      |       | 64,045                                                    |       | 77,824 |   |
| Accrued  compensation                                                                                  |       | 43,406                                                    |       | 31,451 |   |
| Other  accrued expenses                                                                                |       | 90,666                                                    |       | 67,042 |   |
| Income  taxes                                                                                          |       | 1,434                                                     |       | 15,656 |   |
| Deferred  income taxes                                                                                 |       | 565                                                       |       | — |   |
| Total  current liabilities                                                                             |       | 260,116                                                   |       | 193,923 |   |
| Long-term  debt, net of current portion                                                                |       | 500,000                                                   |       | 550,643 |   |
| Deferred  income taxes                                                                                 |       | 182,179                                                   |       | 29,570 |   |
| Other  liabilities                                                                                     |       | 28,365                                                    |       | 26,128 |   |
| Commitments  and contingencies                                                                         |       |                                                      |       |   |   |
| Stockholders’  equity                                                                             |       |                                                      |       |   |   |
| Preferred  stock, $.01 par value; 5,000,000 shares authorized, none issued                             |       | —                                                    |       | — |   |
| Common  stock, $.01 par value; 240,000,000 shares authorized; 67,832,010 and  37,069,452 shares issued |       | 678                                                       |       | 371 |   |
| Additional  paid-in capital                                                                            |       | 1,586,864                                                 |       | 310,437 |   |
| Accumulated  deficit                                                                                   |       | (557,586                                                  | )          | (104,389 | ) |
| Accumulated  other comprehensive income (loss)                                                         |       | (19,870                                                   | )          | 69,874 |   |
| Less  treasury stock, at cost (1,397 and 1,379 shares)                                                 |       | (24                                                       | )          | (23 | ) |
| Total  stockholders’ equity                                                                       |       | 1,010,062                                                 |       | 276,270 |   |
| Total  liabilities and stockholders’ equity                                                       |       | $                                                         | 1,980,722  |   | $ | 1,076,534 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**ADVANCED MEDICAL OPTICS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                                                 | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                 | ** ** | **(In thousands, except per share data)** | ** ** |
| Net  sales                                                                                 |       | $                                                                  | 920,673    |   | $ | 742,099 |   | $ | 601,453 |   |
| Cost  of sales                                                                             |       | 353,325                                                            |       | 306,164 |   | 227,811 |   |
| Gross  profit                                                                              |       | 567,348                                                            |       | 435,935 |   | 373,642 |   |
| Selling,  general and administrative                                                       |       | 396,599                                                            |       | 329,197 |   | 276,695 |   |
| Research  and development                                                                  |       | 61,646                                                             |       | 45,616 |   | 37,413 |   |
| In-process  research and development                                                       |       | 490,750                                                            |       | 28,100 |   | — |   |
| Business  repositioning                                                                    |       | 29,680                                                             |       | — |   | — |   |
| Operating  income (loss)                                                                   |       | (411,327                                                           | )          | 33,022 |   | 59,534 |   |
| Non-operating  expense (income):                                                           |       |                                                               |       |   |   |   |   |
| Interest  expense                                                                          |       | 29,332                                                             |       | 26,933 |   | 24,224 |   |
| Unrealized  (gain) loss on derivative instruments                                          |       | (2,563                                                             | )          | 403 |   | 246 |   |
| Loss  due to exchange of 31⁄2% Convertible Senior Subordinated Notes due 2023 (note  6) |       | 1,885                                                              |       | 116,282 |   | — |   |
| Other,  net                                                                                |       | 316                                                                |       | 10,620 |   | 17,802 |   |
|                                                                                       |       | 28,970                                                             |       | 154,238 |   | 42,272 |   |
| Earnings  (loss) before income taxes                                                       |       | (440,297                                                           | )          | (121,216 | ) | 17,262 |   |
| Provision  for income taxes                                                                |       | 12,900                                                             |       | 8,154 |   | 6,905 |   |
| Net  earnings (loss)                                                                       |       | $                                                                  | (453,197   | ) | $ | (129,370 | ) | $ | 10,357 |   |
| Net  earnings (loss) per share:                                                            |       |                                                               |       |   |   |   |   |
| Basic                                                                                      |       | $                                                                  | (8.28      | ) | $ | (3.89 | ) | $ | 0.36 |   |
| Diluted                                                                                    |       | $                                                                  | (8.28      | ) | $ | (3.89 | ) | $ | 0.35 |   |
| Weighted  average number of shares outstanding:                                            |       |                                                               |       |   |   |   |   |
| Basic                                                                                      |       | 54,764                                                             |       | 33,284 |   | 29,062 |   |
| Diluted                                                                                    |       | 54,764                                                             |       | 33,284 |   | 29,644 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

50

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**ADVANCED MEDICAL OPTICS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)**

 
| ** **                                                                                                                 | ** ** | ** **              | ** ** | ** **         | ** ** | ** **                    | ** ** | ** **       | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other**  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------|------------|-------------------------------|------------|------------------|------------|------------------------|------------|-------------------------|------------|------------|------------|-------------------|------------|------------|------------|------------------------|------------|
| ** **                                                                                                                 | ** ** | **Common Stock**   | ** ** | **Additional**     | ** ** | **Unearned**                  | ** ** | **(Accumulated** | ** ** | **Comprehensive**      | ** ** | **Treasury Stock** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                                 | ** ** | **Shares**              | ** ** | **Par Value** | ** ** | **Paid In Capital** | ** ** | **Compensation** | ** ** | **Deficit)**           | ** ** | **Income (Loss)**  | ** ** | **Shares** | ** ** | **Amount**        | ** ** | **Total**  | ** ** | **Income (Loss)** | ** ** |
| ** **                                                                                                                 | ** ** | **(in thousands)** | ** ** |
| **Balance at December 31, 2002**                                                                                      |       | 28,724                  |       | $                  | 287        |                          | $          | 47,455           |       | $                      | —     |                    | $          | 14,624     |       | $                 | 3,331      |       | (3         | )                      | $          | (13 | ) | $ | 65,684 |   |   |   |
| Comprehensive  income                                                                                                      |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Net  earnings                                                                                                              |       |                    |       |               |       |                          |       |             |       | 10,357                 |       |                    |       |       |       |              |       | 10,357     |       | $                      | 10,357     |   |
| Other  comprehensive income:                                                                                               |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Foreign  currency translation adjustments, net of $6,598 of tax                                                            |       |                    |       |               |       |                          |       |             |       |                   |       | 9,365                   |       |       |       |              |       | 9,365      |       | 9,365                  |       |
| Unrealized  gain on derivative instruments qualifying as cash flow hedges, net of $1,745  of tax                           |       |                    |       |               |       |                          |       |             |       |                   |       | 2,507                   |       |       |       |              |       | 2,507      |       | 2,507                  |       |
| Reclassification  adjustment for realized loss on derivatives included in net earnings, net of  $928 of tax                |       |                    |       |               |       |                          |       |             |       |                   |       | (1,335                  | )          |       |       |              |       | (1,335     | )          | (1,335                 | )          |
| Total  comprehensive income                                                                                                |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       | $                      | 20,894     |   |
| Issuance  of common stock under stock option plan                                                                          |       | 426                     |       | 4                  |       | 3,794                         |       |             |       |                   |       |                    |       |       |       |              |       | 3,798      |       |                   |       |
| Issuance  of common stock under stock purchase plans                                                                       |       | 217                     |       | 2                  |       | 2,040                         |       |             |       |                   |       |                    |       | 13         |       | 118               |       | 2,160      |       |                   |       |
| Issuance  of restricted stock                                                                                              |       | 12                      |       | 1                  |       | 165                           |       | (166             | )          |                   |       |                    |       |       |       |              |       | —     |       |                   |       |
| Expense  of compensation plan                                                                                              |       |                    |       |               |       |                          |       | 102              |       |                   |       |                    |       |       |       |              |       | 102        |       |                   |       |
| Tax  benefits from employee stock plans                                                                                    |       |                    |       |               |       | 674                           |       |             |       |                   |       |                    |       |       |       |              |       | 674        |       |                   |       |
| Purchase  of treasury stock, at cost                                                                                       |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       | (11        | )          | (120              | )          | (120       | )          |                   |       |
| **Balance at December 31, 2003**                                                                                      |       | 29,379                  |       | $                  | 294        |                          | $          | 54,128           |       | $                      | (64        | )                       | $          | 24,981     |       | $                 | 13,868     |       | (1         | )                      | $          | (15 | ) | $ | 93,192 |   |   |   |
|                                                                                                                       |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Comprehensive  loss                                                                                                        |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Net  loss                                                                                                                  |       |                    |       |               |       |                          |       |             |       | (129,370               | )          |                    |       |       |       |              |       | (129,370   | )          | $                      | (129,370   | ) |
| Other  comprehensive loss:                                                                                                 |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Foreign  currency translation adjustments                                                                                  |       |                    |       |               |       |                          |       |             |       |                   |       | 55,799                  |       |       |       |              |       | 55,799     |       | 55,799                 |       |
| Unrealized  gain on derivative instrument qualifying as cash flow hedge, net of $112 of  tax                               |       |                    |       |               |       |                          |       |             |       |                   |       | 207                     |       |       |       |              |       | 207        |       | 207                    |       |
| Total  comprehensive loss                                                                                                  |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       | $                      | (73,364    | ) |
| Issuance  of common stock in connection with convertible note exchanges                                                    |       | 7,021                   |       | 70                 |       | 243,881                       |       |             |       |                   |       |                    |       |       |       |              |       | 243,951    |       |                   |       |
| Issuance  of common stock under stock option plan                                                                          |       | 490                     |       | 5                  |       | 4,934                         |       |             |       |                   |       |                    |       |       |       |              |       | 4,939      |       |                   |       |
| Issuance  of common stock under stock purchase plans                                                                       |       | 171                     |       | 2                  |       | 3,051                         |       |             |       |                   |       |                    |       |       |       |              |       | 3,053      |       |                   |       |
| Issuance  of restricted stock                                                                                              |       | 8                       |       |               |       | 265                           |       | (265             | )          |                   |       |                    |       |       |       |              |       | —     |       |                   |       |
| Expense  of compensation plan                                                                                              |       |                    |       |               |       |                          |       | 219              |       |                   |       |                    |       |       |       |              |       | 219        |       |                   |       |
| Tax  benefits from employee stock plans                                                                                    |       |                    |       |               |       | 4,288                         |       |             |       |                   |       |                    |       |       |       |              |       | 4,288      |       |                   |       |
| Purchase  of treasury stock, at cost                                                                                       |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       | (8                | )          | (8         | )          |                   |       |
| **Balance at December 31, 2004**                                                                                      |       | 37,069                  |       | $                  | 371        |                          | $          | 310,547          |       | $                      | (110       | )                       | $          | (104,389   | )          | $                 | 69,874     |       | (1         | )                      | $          | (23 | ) | $ | 276,270 |   |   |   |
|                                                                                                                       |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Comprehensive  loss                                                                                                        |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Net  loss                                                                                                                  |       |                    |       |               |       |                          |       |             |       | (453,197               | )          |                    |       |       |       |              |       | (453,197   | )          | $                      | (453,197   | ) |
| Other  comprehensive loss:                                                                                                 |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| Foreign  currency translation adjustments                                                                                  |       |                    |       |               |       |                          |       |             |       |                   |       | (89,537                 | )          |       |       |              |       | (89,537    | )          | (89,537                | )          |
| Reclassification  adjustment for realized gain on derivative instrument qualifying as cash flow  hedge, net of $112 of tax |       |                    |       |               |       |                          |       |             |       |                   |       | (207                    | )          |       |       |              |       | (207       | )          | (207                   | )          |
| Total  comprehensive loss                                                                                                  |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       | $                      | (542,941   | ) |
| Issuance  of common stock in connection with convertible note exchanges                                                    |       | 453                     |       | 4                  |       | 10,126                        |       |             |       |                   |       |                    |       |       |       |              |       | 10,130     |       |                   |       |
| Issuance  of common stock under stock option plan                                                                          |       | 2,305                   |       | 23                 |       | 41,388                        |       |             |       |                   |       |                    |       |       |       |              |       | 41,411     |       |                   |       |
| Issuance  of common stock under stock purchase plans                                                                       |       | 144                     |       | 1                  |       | 4,429                         |       |             |       |                   |       |                    |       |       |       |              |       | 4,430      |       |                   |       |
| Issuance  of restricted stock                                                                                              |       | 74                      |       | 1                  |       | 4,008                         |       | (4,008           | )          |                   |       |                    |       |       |       |              |       | 1          |       |                   |       |
| Cancellation  of restricted stock                                                                                          |       |                    |       |               |       | (49                           | )          | 49               |       |                   |       |                    |       |       |       |              |       | —     |       |                   |       |
| Issuance  of common stock under VISX acquisition                                                                           |       | 27,787                  |       | 278                |       | 1,202,907                     |       |             |       |                   |       |                    |       |       |       |              |       | 1,203,185  |       |                   |       |
| Expense  of compensation plan                                                                                              |       |                    |       |               |       |                          |       | 1,245            |       |                   |       |                    |       |       |       |              |       | 1,245      |       |                   |       |
| Tax  benefits from employee stock plans                                                                                    |       |                    |       |               |       | 16,332                        |       |             |       |                   |       |                    |       |       |       |              |       | 16,332     |       |                   |       |
| Transfer  of restricted stock to treasury stock                                                                            |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       | (1                | )          | (1         | )          |                   |       |
|                                                                                                                       |       |                    |       |               |       |                          |       |             |       |                   |       |                    |       |       |       |              |       |       |       |                   |       |
| **Balance at December 31, 2005**                                                                                      |       | 67,832                  |       | $                  | 678        |                          | $          | 1,589,688        |       | $                      | (2,824     | )                       | $          | (557,586   | )          | $                 | (19,870    | )          | (1         | )                      | $          | (24 | ) | $ | 1,010,062 |   |   |   |

 

Seeaccompanying notes to consolidated financial statements.

 

51

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**ADVANCED MEDICAL OPTICS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                   | ** ** | **(in thousands)**                    | ** ** |
| **Cash flows provided by operating activities**                                              |       |                                       |       |   |   |   |   |
| Net  earnings (loss):                                                                        |       | $                                          | (453,197   | ) | $ | (129,370 | ) | $ | 10,357 |   |
| Adjustments  to reconcile net earnings (loss) to net cash provided by operating  activities: |       |                                       |       |   |   |   |   |
| Amortization  and write-off of original issue discount and debt issuance costs               |       | 9,284                                      |       | 11,028 |   | 9,687 |   |
| Amortization  and write-off of net realized gain on interest rate swaps                      |       | (773                                       | )          | (3,466 | ) | (2,631 | ) |
| Depreciation  and amortization                                                               |       | 51,588                                     |       | 23,616 |   | 15,547 |   |
| Deferred  income taxes                                                                       |       | (5,104                                     | )          | (16,737 | ) | (9,356 | ) |
| Tax  benefit from issuance of stock under stock plans                                        |       | —                                     |       | 4,288 |   | 674 |   |
| In-process  research and development                                                         |       | 490,750                                    |       | 28,100 |   | — |   |
| Loss  on exchange of convertible senior subordinated notes                                   |       | 1,670                                      |       | 111,702 |   | — |   |
| Loss  on investments and assets                                                              |       | 13,165                                     |       | 1,047 |   | 756 |   |
| Unrealized  (gain) loss on derivatives                                                       |       | (2,563                                     | )          | 403 |   | 246 |   |
| Expense  of compensation plan                                                                |       | 1,245                                      |       | 219 |   | 102 |   |
| Changes  in assets and liabilities, net of effect of acquisition:                            |       |                                       |       |   |   |   |   |
| Trade  receivables                                                                           |       | (27,780                                    | )          | (48,459 | ) | 6,202 |   |
| Inventories                                                                                  |       | (14,720                                    | )          | 13,198 |   | 7,214 |   |
| Other  current assets                                                                        |       | (7,170                                     | )          | (1,514 | ) | 5,396 |   |
| Accounts  payable                                                                            |       | (27,328                                    | )          | 39,759 |   | (8,882 | ) |
| Accrued  expenses and other liabilities                                                      |       | 6,684                                      |       | 7,294 |   | 14,574 |   |
| Income  taxes                                                                                |       | (16,802                                    | )          | 5,775 |   | (2,174 | ) |
| Other  non-current assets                                                                    |       | 1,887                                      |       | (7,215 | ) | 264 |   |
|                                                                                         |       |                                       |       |   |   |   |   |
| Net  cash provided by operating activities                                                   |       | 20,836                                     |       | 39,668 |   | 47,976 |   |
|                                                                                         |       |                                       |       |   |   |   |   |
| **Cash flows from investing activities**                                                     |       |                                       |       |   |   |   |   |
| Acquisition  of business, net of cash acquired                                               |       | (36,867                                    | )          | (456,709 | ) | — |   |
| Additions  to property, plant and equipment                                                  |       | (23,097                                    | )          | (17,492 | ) | (12,605 | ) |
| Purchase  of net assets of manufacturing facility                                            |       | —                                     |       | — |   | (21,359 | ) |
| Proceeds  from sale of property, plant and equipment                                         |       | 48                                         |       | 1,172 |   | 556 |   |
| Additions  to capitalized internal-use software                                              |       | (8,816                                     | )          | (2,415 | ) | (674 | ) |
| Additions  to demonstration and bundled equipment                                            |       | (11,135                                    | )          | (6,778 | ) | (6,971 | ) |
|                                                                                         |       |                                       |       |   |   |   |   |
| Net  cash used in investing activities                                                       |       | (79,867                                    | )          | (482,222 | ) | (41,053 | ) |
|                                                                                         |       |                                       |       |   |   |   |   |
| **Cash flows from financing activities**                                                     |       |                                       |       |   |   |   |   |
| Proceeds  from issuance of convertible senior subordinated notes                             |       | 150,000                                    |       | 350,000 |   | 140,000 |   |
| Short-term  borrowings, net                                                                  |       | 60,000                                     |       | — |   | — |   |
| Long-term  debt borrowings                                                                   |       | —                                     |       | 250,000 |   | 22,376 |   |
| Repayment  of long-term debt                                                                 |       | (194,166                                   | )          | (149,243 | ) | (205,000 | ) |
| Financing  related costs                                                                     |       | (8,459                                     | )          | (16,553 | ) | (7,316 | ) |
| Proceeds  from issuance of common stock                                                      |       | 45,841                                     |       | 7,992 |   | 5,958 |   |
| Net  proceeds from settlement of interest rate swaps                                         |       | 773                                        |       | — |   | 582 |   |
| Purchase  of treasury stock                                                                  |       | —                                     |       | (8 | ) | (120 | ) |
|                                                                                         |       |                                       |       |   |   |   |   |
| Net  cash provided by (used in) financing activities                                         |       | 53,989                                     |       | 442,188 |   | (43,520 | ) |
|                                                                                         |       |                                       |       |   |   |   |   |
| Effect  of exchange rates on cash and equivalents                                            |       | (3,587                                     | )          | 3,717 |   | 2,123 |   |
| Net  increase (decrease) in cash and equivalents                                             |       | (8,629                                     | )          | 3,351 |   | (34,474 | ) |
| Cash  and equivalents at beginning of year                                                   |       | 49,455                                     |       | 46,104 |   | 80,578 |   |
| Cash  and equivalents at end of year                                                         |       | $                                          | 40,826     |   | $ | 49,455 |   | $ | 46,104 |   |
|                                                                                         |       |                                       |       |   |   |   |   |
| **Supplemental disclosure of cash flow information**                                         |       |                                       |       |   |   |   |   |
| Cash  paid during the year for:                                                              |       |                                       |       |   |   |   |   |
| Interest                                                                                     |       | $                                          | 22,005     |   | $ | 21,472 |   | $ | 23,391 |   |
| Income  taxes                                                                                |       | 34,805                                     |       | 14,225 |   | 13,727 |   |
|                                                                                         |       |                                       |       |   |   |   |   |
| Supplemental  non-cash investing and financing activities:                                   |       |                                       |       |   |   |   |   |
| Exchange  of convertible notes into common stock                                             |       | $                                          | 8,600      |   | $ | 131,400 |   | $ | — |   |
| Acquisition  of VISX, Incorporated (Note 3)                                                  |       | 1,203,185                                  |       | — |   | — |   |

 

See accompanying notes to consolidated financialstatements. 

 

52

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**ADVANCEDMEDICAL OPTICS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2005, 2004 and 2003**

 

**Note 1: Description of Business**

 

Advanced Medical Optics, Inc. (AMO) develops,manufactures and markets medical devices for the eyes in two major productlines, ophthalmic surgical and eye care. The ophthalmic surgical product lineprovides medical devices for use in the cataract / implant and laservision correction markets. In the cataract and implant surgery market, theCompany focuses on the four key products required for cataract surgery –foldable intraocular lenses (IOLs), implantation systems, phacoemulsificationsystems and viscoelastics. In the laser vision correction market, the Companymarkets laser systems, diagnostic devices, treatment cards and microkeratomesfor use in laser eye surgery. The eye care product line provides a full rangeof contact lens care products for use with most types of contact lenses. Theseproducts include single-bottle, multi-purpose cleaning and disinfectingsolutions, hydrogen peroxide-based disinfecting solutions, daily cleaners,enzymatic cleaners and contact lens rewetting drops. In addition, the Company sellscontact lenses in Europe and Asia. The Company sells its products inapproximately 60 countries and has direct operations in approximately 20countries.

 

On June 29, 2002, Allergan, Inc. (Allergan)transferred its optical medical device business consisting of the ophthalmicsurgical and eye care product lines to the Company in connection with atax-free spin-off. Allergan distributed 28,723,512 shares of AMO on June 29,2002 to Allergan stockholders of record on June 14, 2002 by means of atax-free dividend. The spin-off resulted in AMO operating as an independententity with publicly traded common stock. Unless the context indicatesotherwise, references to the Company and AMO refer to Allergan’s opticalmedical device business for periods prior to June 29, 2002 and to AMO andits subsidiaries for the periods on or after such date.

 

Allergan has no ownership interest in AMO after June 29,2002, but performed certain services for AMO pursuant to various agreementsthat are outlined in Note 8. However, unless released by third parties,Allergan may remain liable for certain obligations and liabilities thatwere transferred to and assumed by AMO. The Company is obligated to indemnifyAllergan for liabilities related to those transferred obligations and liabilities.

 

**Note 2: Summary of Significant Accounting Policies**

 

This summary of significant accounting policies ispresented to assist the reader in understanding and evaluating the consolidatedfinancial statements. These policies are in conformity with accountingprinciples generally accepted in the United States of America and have beenapplied consistently in all material respects. The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements, thereported amounts of revenues and expenses during the reporting period, andrelated disclosures. Actual results could differ from those estimates.

 

***Basis of Presentation***

 

The consolidated financial statements include theaccounts of AMO and all of its subsidiaries. All significant transactions amongthe consolidated entities have been eliminated from the consolidated financialstatements.

 

***Foreign Currency Translation***

 

The financial position and results of operations ofAMO’s foreign operations are generally determined using local currency as thefunctional currency. Assets and liabilities of these operations are translatedat the exchange rate in effect at each year-end. Income statement amounts aretranslated at the average rate of exchange prevailing during the year.Translation adjustments arising from the use of differing exchange rates fromperiod to period are included in accumulated other comprehensive income instockholders’ equity. Gains and losses resulting from foreign currencytransactions and remeasurements relating to foreign operations deemed to beoperating in U.S. dollar functional currency are included in “Other, net” inthe accompanying consolidated statements of operations.

 

53

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***Cash and Equivalents***

 

The Company considers cash and equivalents to includecash in banks, money market mutual funds and time deposits with financialinstitutions with original maturities of 90 days or less.

 

***Investments***

 

The Company has non-marketable equity investments inconjunction with its various collaboration arrangements. The non-marketableequity investments are recorded at cost and are evaluated periodically forother than temporary declines in fair value. The company uses the followingcriteria to determine if such a decline should be considered other thantemporary:

 

•                   the duration and extent to which themarket value has been less than cost;

 

•                   the financial condition and near-termprospects of the investee;

 

•                   the reasons for the decline in marketvalue;

 

•                   the investee’s performance against productdevelopment milestones; and

 

•                   the Company’s ability and intent to holdthe investment for a period of time sufficient to allow for any anticipatedrecovery in market value.

 

If it is determined that a decline of any investmentis other than temporary, then the carrying value would be written down to fairvalue, and the write-down would be included in earnings as a loss.

 

***Inventories***

 

Inventories are valued at the lower of first-in,first-out cost or market. On a regular basis, the Company evaluates itsinventory balances for excess quantities and obsolescence by analyzing demand,inventory on hand, sales levels and other information. Based on theseevaluations, inventory balances are written down, if necessary.

 

***Property, Plant and Equipment***

 

Property, plant and equipment are stated at cost.Additions, major renewals and improvements are capitalized, while maintenanceand repairs are expensed. For financial reporting purposes, depreciation isgenerally provided on the straight-line method over the useful lives of therelated assets, which are 20 to 40 years for buildings and improvements andfrom 3 to 15 years for machinery and equipment. Leasehold improvements areamortized over the life of the related facility lease or the asset, whicheveris shorter. Accelerated depreciation methods are generally used for income taxpurposes.

 

***Goodwill and Long-Lived Assets***

 

Goodwill represents the excess of acquisition costsover the fair value of net assets of purchased businesses. Intangible assetsinclude licensing agreements, trademarks, customer relationships and technologyrights and are amortized over their estimated useful lives ranging from 3 to 19years.

 

The Company has adopted Statement of FinancialAccounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”,whereby goodwill is no longer amortized, but instead is subject to a periodicimpairment review performed during the second quarter of each fiscal year. In abusiness combination, goodwill is allocated to the Company’s various reporting units,which are the same as the Company’s reportable operating segments based onrelative fair value of the assets acquired and liabilities assumed. As theCompany’s operations are composed of four reporting units (Americas,Europe/Africa/Middle East, Japan and Asia Pacific), the Company reviews therecoverability of its goodwill on an annual basis by comparing each unit’s fairvalue to the net book value of its assets. If the book value of the reportingunit’s assets exceeds its fair value, the goodwill is written down to itsimplied fair value. In the second quarters of 2005, 2004 and 2003, the Companyperformed its annual impairment tests of its goodwill, and no impairment wasindicated based on these tests.

 

Additionally, the Company reviews the carrying amountof goodwill whenever events and circumstances indicate that the carrying amountof goodwill may not be recoverable. Impairment indicators include, amongother conditions, cash flow deficits, historic or anticipated declines inrevenue or operating profit and adverse legal or regulatory developments. If itis 

 

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determinedsuch indicators are present and the review indicates goodwill will not be fullyrecoverable, based upon discounted estimated cash flows, the carrying value isreduced to implied fair value.

 

In accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-lived Assets,” the Company assessespotential impairment to its long-lived assets when events or changes in circumstancesindicate that the carrying amount of an asset may not be fullyrecoverable. If required, an impairment loss is recognized as the differencebetween the carrying value and the fair value of the assets.

 

***Capitalized Software***

 

The Company capitalizes certain internal-use computersoftware costs after technological feasibility has been established. Thesecapitalized costs are amortized utilizing the straight-line method over theirestimated economic life not to exceed three years.

 

***Demonstration (Demo) and Bundled Equipment***

 

In the normal course of business, the Companymaintains demo and bundled equipment, primarily phacoemulsification andmicrokeratome surgical equipment, for the purpose and intent of selling similarequipment or related products to the customer in the future. Demo and bundledequipment are not held for sale and are recorded as other non-current assets.The assets are amortized utilizing the straight-line method over theirestimated economic life not to exceed three years.

 

***Revenue Recognition and Accounts Receivable***

 

Revenue is realized or realizable and earned whenpersuasive evidence of an arrangement exists, delivery has occurred, the priceto the buyer is fixed or determinable and collectibility is reasonably assured.The Company records revenue from product sales when title and risk of ownershiphave been transferred to the customer, which is typically upon delivery to thecustomer, with the exception of intraocular lenses distributed on a consignmentbasis, which is upon notification of implantation in a patient. The Companyrecognizes license fees and revenues from the sale of treatment cards to directcustomers when it ships the treatment cards as it has no continuing obligationsor involvement subsequent to shipment.

 

Some customers finance the purchase or rental of theirVISX equipment directly from the Company over periods ranging from one to threeyears. These financing agreements are classified as either rental or operatingleases or sales type leases as prescribed by SFAS No. 13, “Accounting forLeases.”  Under sales type leases, equipmentrevenues are recognized based on the net present value of the expected cashflow after installation to direct customers in the United States and Japan orafter shipment to international distributors. Under rental or operating leasearrangements, rental revenue is recognized over the term of the agreement.

 

The Company generally permits returns of product ifsuch product is returned in a timely matter, in good condition, and through thenormal channels of distribution. However, the Company does not accept returnsof treatment cards and does not provide rights of return or exchange, priceprotection or stock rotation rights to any VISX product distributors. Returnpolicies in certain international markets can be more stringent and are basedon the terms of contractual agreements with the customers. Allowances forreturns are provided for based upon an analysis of the Company’s historicalpatterns of returns matched against the sales from which they originated. Todate, historical product returns have been within the Company’s estimates.

 

When the Company recognizes revenue from the sale ofproducts, certain allowances known and estimable at time of sale are recordedas a reduction to sales. These items include cash discounts, allowances andrebates. These items are reflected as a reduction to accounts receivable to theextent the customer will or is expected to reduce its payment on the relatedinvoice amounts. In addition, certain items such as rebates provided tocustomers that meet certain buying targets are paid to the customer subsequentto customer payment. Thus, such amounts are recorded as accrued liabilities.These provisions are estimated based on historical payment experience, historicalrelationship to revenues and estimated customer inventory levels. To date,historical sales allowances have been within the Company’s estimates.

 

The allowance for doubtful accounts is determined byanalyzing specific customer accounts and assessing the risk of uncollectibilitybased on insolvency, disputes or other collection issues. In addition, theCompany routinely analyzes the different aging categories and establishesallowances based on the length of time receivables are past due (based on contractualterms). A write-off will occur if the settlement of the account receivable isless than the carrying amount or the Company determines the balance will not becollected.

 

55

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***Concentration of Credit Risk***

 

Financial instruments that potentially subject theCompany to credit risk principally consist of trade receivables. Wholesaledistributors, major retail chains, and managed care organizations account for asubstantial portion of trade receivables. This risk is limited due to the largenumber of customers comprising the Company’s customer base, and theirgeographic dispersion. Ongoing credit evaluations of customers’ financialcondition are performed and, generally, no collateral is required. The Company maintainsreserves for potential credit losses and such losses, in the aggregate, havenot exceeded management’s expectations.

 

***Income Taxes***

 

The Company records income taxes under the asset andliability method, whereby deferred tax assets and liabilities are recognizedfor the future tax consequences attributable to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases, and for operating loss and tax creditcarryforwards. Deferred tax assets and liabilities are measured using enactedtax rates expected to apply in the years in which those temporary differencesare expected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. Management evaluates the need to establish avaluation allowance for deferred tax assets based upon the amount of existingtemporary differences, the period in which they are expected to be recoveredand expected levels of taxable income. A valuation allowance to reduce deferredtax assets is established when it is “more likely than not” that some or all ofthe deferred tax assets will not be realized.

 

In preparing its consolidated financial statements,the Company is required to estimate its income taxes in each jurisdiction inwhich it operates. This process involves estimating the current liability aswell as assessing temporary differences resulting from differing treatment ofitems for tax and financial accounting purposes. Significant managementjudgment is required in determining the provision for income taxes and deferredtax assets and liabilities.

 

***Stock-Based Compensation***

 

The Company measures stock-based compensation foroption grants to employees and members of the board of directors using theintrinsic value method. The fair value of each option grant for determining thepro forma disclosure impact of stock-based compensation expense is estimated onthe date of grant using the Black-Scholes option-pricing model with weightedaverage assumptions. These assumptions consist of expected dividend yield,expected volatility, risk-free interest rate and expected life.

 

Under the 2005 Incentive Compensation Plan as approvedin the special meeting of stockholders on May 26, 2005, the Companygranted restricted stock to employees and members of the board of directors in May 2005.Restricted stock awards are valued based on the market price of a share ofnon-restricted stock on the grant date and compensation expense is recognizedover the vesting period of the restricted stock.

 

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Had compensation expense for the Company’s stockoptions and employee stock purchase plans been recognized based upon the fairvalue of awards granted, the Company’s net earnings (loss) would have decreased(increased) to the following pro forma amounts (in thousands, except per sharedata):

 
| ** **                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net earnings (loss):                                                                   |       |     |       |     |       |     |       |
| As  reported:                                                                          |       | $        | (453,197   | )        | $          | (129,370 | )          | $ | 10,357 |   |
| Stock-based  compensation expense included in reported net earnings (loss), net of tax |       | 834      |       | 99       |       | 61       |       |
| Stock-based  compensation expense determined under fair value based method, net of tax |       | (11,800  | )          | (7,117   | )          | (4,939   | )          |
| Pro  forma                                                                             |       | $        | (464,163   | )        | $          | (136,388 | )          | $ | 5,479 |   |
|                                                                                   |       |     |       |     |       |     |       |
| Earnings  per share:                                                                   |       |     |       |     |       |     |       |
| As  reported:                                                                          |       |     |       |     |       |     |       |
| Basic                                                                                  |       | $        | (8.28      | )        | $          | (3.89    | )          | $ | 0.36 |   |
| Diluted                                                                                |       | $        | (8.28      | )        | $          | (3.89    | )          | $ | 0.35 |   |
| Pro  forma:                                                                            |       |     |       |     |       |     |       |
| Basic                                                                                  |       | $        | (8.48      | )        | $          | (4.10    | )          | $ | 0.19 |   |
| Diluted                                                                                |       | $        | (8.48      | )        | $          | (4.10    | )          | $ | 0.18 |   |

 

The value of each option isestimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted average assumptions:

 
| ** **                   | ** ** | **Stock Options** | ** ** | **ESPP** | ** ** |
|------------------------------|------------|------------------------|------------|----------|------------|
| ** **                   | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected  dividend yield     |       | 0.0                    | %          | 0.0      | %          | 0.0 | % | 0.0 | % | 0.0 | % | 0.0 | % |
| Expected  volatility         |       | 36.0                   | %          | 42.3     | %          | 34.8 | % | 35.3 | % | 37.3 | % | 33.9 | % |
| Risk-free  interest rate     |       | 3.8                    | %          | 3.8      | %          | 2.9 | % | 3.9 | % | 1.2 | % | 1.1 | % |
| Expected  life (in years)    |       | 5.0                    |       | 4.9      |       | 4.8 |   | 0.5 |   | 0.5 |   | 0.5 |   |
| Weighted-average  fair value |       | $                      | 14.52      |     | $          | 14.05 |   | $ | 4.87 |   | $ | 9.09 |   | $ | 6.35 |   | $ | 3.83 |   |
|                              |            |                        |            |          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Research and Development***

 

Research and development costs are charged to expensewhen incurred.

 

***Acquired In-Process Research and Development***

 

Costs to acquire in-process research and development(IPR&D) projects and technologies which have no alternative future use andwhich have not reached technological feasibility at the date of acquisition areexpensed as incurred (see Note 3).

 

***Comprehensive Income (Loss)***

 

Comprehensive income (loss) encompasses all changes inequity other than those with stockholders and consists of net earnings (loss),foreign currency translation adjustments and unrealized gains/losses onderivative instruments, if applicable.

 

***Recently Adopted and Issued Accounting Standards***

 

In November 2004, Statement of FinancialAccounting Standards No. 151, “Inventory Costs-an amendment of ARB No. 43,Chapter 4” (SFAS No. 151), was issued. This Statement amends the guidancein ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accountingfor abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage). SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The Companydoes not expect adoption of this standard to have a material impact on itsconsolidated financial position, results of operations or cash flows.

 

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In December 2004, the Financial AccountingStandards Board (FASB) issued a revision of Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123R).SFAS No. 123R supersedes Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees,” (Opinion 25) and its relatedimplementation guidance and eliminates the alternative to use Opinion 25’sintrinsic value method of accounting that was provided in Statement 123 asoriginally issued. Under Opinion 25, issuing stock options to employeesgenerally resulted in recognition of no compensation cost. SFAS No. 123Rrequires entities to recognize the cost of employee services received inexchange for awards of equity instruments based on the grant-date fair value ofthose awards (with limited exceptions). SFAS No. 123R is effective for thefirst annual reporting period that begins after June 15, 2005. On March 29,2005, the Securities and Exchange Commission (SEC) issued Staff AccountingBulletin 107 (SAB 107) which expresses the views of the SEC regarding theinteraction between SFAS No. 123R and certain SEC rules andregulations and provides the SEC’s views regarding the valuation of share-basedpayment arrangements for public companies. In particular, SAB 107 providesguidance related to share-based payment transactions with nonemployees, thetransition from nonpublic to public entity status, valuation methods (includingassumptions such as expected volatility and expected term), the accounting forcertain redeemable financial instrument issues under share-based paymentarrangements, the classification of compensation expense, non-GAAP financialmeasures, first-time adoption of SFAS No. 123R in an interim period,capitalization of compensation costs related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS No. 123R, the modification of employeeshare options prior to adoption of SFAS No. 123R, and disclosures inManagement’s Discussion and Analysis of Financial Condition and Results of Operationssubsequent to adoption of SFAS No. 123R. The Company will adopt SFAS No. 123Rin the first quarter of fiscal 2006. As a result of the provisions of SFAS No. 123Rand SAB 107, the Company expects the compensation charge under SFAS No. 123Rto reduce diluted net income per share by approximately $0.15 to $0.20 pershare for fiscal 2006. However, the assessment of the estimated compensationcharge is affected by stock prices as well as assumptions regarding a number ofcomplex and subjective variables and the related tax impact. These variablesinclude, but are not limited to, the volatility of the stock price and employeestock option exercise behaviors.

 

In December 2004, the FASB issued FASB StaffPosition No. FSP 109-1, “Application of FASB Statement No. 109, “Accountingfor Income Taxes” (FSP No. 109-1), to the Tax Deduction on QualifiedProduction Activities Provided by the American Jobs Creation Act of 2004.”  The American Jobs Creation Act (AJCA),introduces a special 9% tax deduction on qualified production activities. FSP No. 109-1clarifies that this tax deduction should be accounted for as a special taxdeduction in accordance with Statement 109. Although FSP No. 109-1 iseffective immediately, the Company has not completed the analysis and does notexpect to be able to complete the analysis until after Congress or the TreasuryDepartment provides additional clarifying language on the key elements of theprovision. Based on the Company’s current analysis, the adoption of FSP No. 109-1does not have a material impact on its consolidated financial position, resultsof operations, or cash flows.

 

In December 2004, the FASB issued FASB StaffPosition No. FSP 109-2, “Accounting and Disclosure Guidance for theForeign Earnings Repatriation Provision within the American Jobs Creation Actof 2004” (FSP No. 109-2). The AJCA introduces an elected limited time 85%dividends received deduction on the repatriation of certain foreign earnings toa U.S. taxpayer (repatriation provision), provided certain criteria are met. FSPNo. 109-2 provides accounting and disclosure guidance for the repatriationprovision. During the fourth quarter of 2005, the Company elected to repatriate$43.2 million of eligible foreign earnings. Since the Company provides taxescurrently on foreign earnings, the election of this provision enabled theCompany to realize a tax benefit of $5.7 million during the fourth quarter of2005.

 

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS No. 154). SFAS No. 154 requires retrospective application toprior periods’ financial statements for changes in accounting principle, unlessit is impracticable to determine either the period-specific effects or thecumulative effect of the change. SFAS No. 154 also requires thatretrospective application of a change in accounting principle be limited to thedirect effects of the change. Indirect effects of a change in accountingprinciple, such as a change in non-discretionary profit-sharing paymentsresulting from an accounting change, should be recognized in the period of theaccounting change. SFAS No. 154 also requires that a change indepreciation, amortization, or depletion method for long-lived, non-financialassets be accounted for as a change in accounting estimate effected by a changein accounting principle. SFAS No. 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005. Early adoption is permitted for accounting changes and corrections oferrors made in fiscal years beginning after the date SFAS No. 154 isissued. The Company is required to adopt the provisions of SFAS No. 154,as applicable, beginning in fiscal 2006. The Company does not expect theadoption of this standard to have a material impact on its consolidatedfinancial position, results of operations or cash flows.

 

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**Note 3: Acquisitions**

 

*VISX,**Incorporated**(VISX)*

 

On May 27, 2005, pursuant to the Agreement andPlan of Merger (Merger Agreement), dated as of November 9, 2004, asamended, by and among AMO, Vault Merger Corporation, a wholly owned subsidiaryof AMO, and VISX, AMO completed its acquisition of VISX, for totalconsideration of approximately $1.38 billion, consisting of approximately27.8 million shares of AMO common stock, the fair value of VISX stockoptions converted to AMO stock options and approximately $176.2 million in cash(VISX Acquisition). VISX products include the *VISXSTAR*Excimer Laser System, the *VISXWaveScan*System and *VISX*treatment cards. As a result of the VISX Acquisition, the Company became theleader in the design and development of proprietary technologies and systemsfor laser vision correction of refractive vision disorders.

 

The VISX Acquisition has been accounted for as apurchase business combination. Under the purchase method of accounting, theassets acquired and liabilities assumed are recorded at the date of acquisitionat their respective fair values.

 

The results of operations of the VISX Acquisition havebeen included in the accompanying consolidated statements of operations fromthe date of the VISX Acquisition. The total cost of the VISX Acquisition is asfollows (in thousands):

 

 

| Cash  consideration to VISX stockholders              |   | $         | 176,167   |   |
|-------------------------------------------------------|--------|-----------|-----------|--------|
| Fair  value of AMO shares issued to VISX stockholders |   | 1,136,605 |      |
| Fair  value of vested VISX stock options              |   | 66,580    |      |
| Direct  transaction fees and expenses                 |   | 15,765    |      |
| Cash  and cash equivalents acquired                   |   | (156,765  | )         |
|                                                  |   |      |      |
| Total  purchase price                                 |   | $         | 1,238,352 |   |

 

The above purchase price has been allocated based onthe fair values of assets acquired and liabilities assumed.

 

The purchase price has been allocated as follows (inthousands):

 

| Inventories                                                                 |   | $        | 11,918    |   |
|-----------------------------------------------------------------------------|--------|----------|-----------|--------|
| Accounts  receivable, net                                                   |   | 39,353   |      |
| Other  current assets                                                       |   | 22,129   |      |
| Property,  plant and equipment                                              |   | 3,350    |      |
| Other  non-current assets                                                   |   | 8,038    |      |
| Intangible  assets                                                          |   | 402,300  |      |
| In-process  research and development                                        |   | 488,500  |      |
| Goodwill                                                                    |   | 479,016  |      |
| Accounts  payable                                                           |   | (16,032  | )         |
| Other  current liabilities                                                  |   | (43,957  | )         |
| Non-current  deferred tax liability, primarily related to intangible assets |   | (156,263 | )         |
|                                                                        |   |     |      |
| Net  assets acquired                                                        |   | $        | 1,238,352 |   |

 

The purchase price allocation will be finalized in2006 upon completion of integration activities. Of the $402.3 million ofacquired intangible assets, $239.5 million was assigned to developed technologyrights that have a weighted-average useful life of approximately 10.1 years,$22.4 million was assigned to customer relationships with a useful life of 5years and $140.4 million was assigned to the VISX trade name with an indefiniteuseful life. The amounts assigned to intangible assets were based onmanagement’s estimate of the fair value.

 

Identification andallocation of value to the identified intangible assets was based on theprovisions of SFAS No. 141, “Business Combinations,” (SFAS No. 141). The fairvalue of the identified intangible assets was estimated by performing a discountedcash flow analysis using the “income” approach. This method includes a forecastof direct revenues and costs associated with the respective intangible assetsand charges for economic returns on tangible and intangible assets utilized incash flow generation. Net cash flows attributable to the identified intangibleassets are discounted to their present value at a rate commensurate with theperceived risk. The projected cash flow assumptions considered contractualrelationships, customer attrition, eventual development of new technologies andmarket competition.

 

The estimates of expecteduseful lives are based on guidance from SFAS No. 141 and take intoconsideration the effects of competition, regulatory changes and possibleobsolescence. The useful lives of technology rights are based on the number ofyears in which net cash flows have been projected. The useful lives of customerrelationships was estimated based upon the length of the contracts currently inplace, probability based estimates of contract renewals in the future andnatural growth and diversification of other potential customers, which wereconsidered insignificant. Management considers the VISX trade name to be theleading name in excimer laser vision correction procedures. VISX’s estimatedmarket share of 60 percent demonstrates its commercial success. Managementintends to maintain and continue to market existing and new products under theVISX trade name. As management intends to continue to use the VISX trade nameindefinitely, an indefinite life was assigned.

 
| Assumptions used in forecasting cash flows for each  of the identified intangible assets included consideration of the following: |
|-----------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                              |
|                                                                                                                              | • | VISX historical  operating margins |
|                                                                                                                              | • | Number of procedures  and devices VISX has developed and had approved by the FDA |
|                                                                                                                              | • | VISX market share |
|                                                                                                                              | • | Contractual and  non-contractual relationships with large groups of surgeons and |
|                                                                                                                              | • | Patents and exclusive  licenses held. |

 

A history of operatingmargins and profitability, a strong scientific, service and manufacturingemployee base and a leading presence in the excimer laser market were among thefactors that contributed to a purchase price resulting in the recognition ofgoodwill.

 

The acquired goodwill, which is not deductible for taxpurposes, has been allocated to the Americas operating segment.

 

*In-process research and development (IPR&D)*

 

Approximately $488.5 million of the purchase pricerepresents the estimated fair value of projects that, as of the VISXAcquisition date, had not reached technological feasibility and had noalternative future use. The Company recorded $449.2 million of this amount inthe second quarter of 2005 and $39.3 million in the third quarter of 2005. Theadditional charge in the

 

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thirdquarter of 2005 resulted primarily from the completion of the IPR&Dvaluation. The fair value assigned to IPR&D comprised the followingprojects (in thousands):

 

| ** **                        | ** ** | **Value of** | ** ** |
|-----------------------------------|------------|-------------------|------------|
| ** **                        | ** ** | **IPR&D**     | ** ** |
| ** **                        | ** ** | **Acquired**      | ** ** |
|                              |       |              |       |
| High  Myopia for* CustomVue* |       | $                 | 14,700     |   |
| Excimer  Laser Improvements       |       | 56,200            |       |
| Presbyopia                        |       | 417,600           |       |
|                              |       |              |       |
| Total                             |       | $                 | 488,500    |   |

 

The fair value of these projects was determined byperforming a discounted cash flow analysis using the “income” approach. Netcash flows attributable to these projects were discounted to their presentvalues at a rate commensurate with the perceived risk, which for these projectsranged from 19.0 to 21.0 percent. The following assumptions underlie the fairvalue as of the VISX Acquisition date:

 

•                  A high myopia procedure for *CustomVue* was forecasted to be approvedfor sale in the U.S. in late 2005. A procedure to treat presbyopia isforecasted to be approved for sale in the U.S. in late 2006. Additionalresearch and development expenses needed prior to expected FDA approval forthese procedures are expected to range from $4 million to $6 million. Thisrange represents management’s best estimate as to the additional R&Dexpenses required to bring these products to market in the U.S. Forecasteddiscounted cash flows for each product once launched include estimates fornormal sustaining engineering and maintenance R&D;

 

•                  Additional research and developmentexpenses in the range of $8 million to $10 million represent management’s bestestimate as to the additional R&D expenses to bring excimer laser systemimprovements to market. Like the other IPR&D projects, maintenance R&Dand sustaining engineering costs were allocated to the forecasted cash flowsonce commercialized;

 

•                  Revenue that is reasonably likely toresult from the approved and unapproved potential uses of identifiableintangible assets that includes the estimated number of units to be sold,estimated selling prices, estimated market penetration and estimated marketshare and year-over-year growth rates over the product cycles. These estimateswere based on management’s consideration of life cycles for similar productsVISX has previously launched, the competitive landscape, and previous successin working with the FDA; and

 

•                  The cost structure was assumed to be similarto that for existing products.

 

The major risks and uncertainties associated with thetimely and successful completion of these projects consist of the ability toconfirm the safety and efficacy of the technology based on the data fromclinical trials and obtaining necessary regulatory approvals. In addition, noassurance can be given that the underlying assumptions used to forecast thecash flows or the timely and successful completion of such projects willmaterialize, as estimated. For these reasons, among others, actual results may varysignificantly from the estimated results.

 

In September 2005, high myopia *CustomVue* was approved by FDA.

 

*Pfizer Inc. Surgical Ophthalmic Business*

 

On June 26, 2004, pursuant to a stock and assetpurchase agreement dated as of April 21, 2004, the Company completed thepurchase of Pfizer Inc.’s surgical ophthalmic business for $450.0 million incash (Pfizer Acquisition). Pfizer’s surgical ophthalmic business manufacturedand marketed surgical devices for the eyes. The Company acquired ophthalmicsurgical products and certain manufacturing and research and developmentfacilities located in Uppsala, Sweden, Groningen, Netherlands and Bangalore,India. The products acquired include the *Healon*line of viscoelastic products used in ocular surgery, the *CeeOn* and *Tecnis*intraocular lenses and the*Baerveldt* glaucoma shunt. The Pfizer Acquisition has been accountedfor as a purchase business combination.

 

The following unaudited pro forma information assumesthe VISX Acquisition and the Pfizer Acquisition occurred on January 1,2004. These unaudited pro forma results have been prepared for informationalpurposes only and do not purport to represent what the results of operationswould have been had the VISX Acquisition and the Pfizer Acquisition occurred asof 

 

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thedate indicated, nor of future results of operations. The unaudited pro formaresults for years ended December 31, 2005 and 2004 are as follows (inthousands, except per share data):

 

| ** **           | ** ** | **Year Ended  December 31, 2005** | ** ** | **Year Ended  December 31, 2004** | ** ** |
|----------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Net  sales           |       | $                                                | 1,000,842  |                                             | $          | 982,834 |   |
| Net  earnings        |       | 37,377                                           | (1)        | 70,603                                           | (2)        |
| Earnings  per share: |       |                                             |       |                                             |       |
| Basic  (3)           |       | $                                                | 0.57       |                                             | $          | 1.09 |   |
| Diluted  (4)         |       | $                                                | 0.54       |                                             | $          | 1.04 |   |

 

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(1)                   The unaudited pro forma information for the year endedDecember 31, 2005 excludes the following non-recurring charges related tothe VISX Acquisition: a $488.5 million in-process research and developmentcharge and a $2.0 million charge for the amortization and write-off of debtissuance costs. The unaudited pro forma information also reflects an $11.7million increase in amortization related to management’s estimate of the fairvalue of intangible assets acquired as the result of the VISX Acquisition and a$4.7 million increase in interest expense resulting from additional borrowingsincurred to fund the cash portion of the VISX Acquisition and related costs andamortization of deferred financing costs. Approximately $11.0 million of mergercharges incurred by VISX is not excluded from the unaudited pro formainformation for the year ended December 31, 2005.

 

(2)                   The unaudited pro forma information for the year endedDecember 31, 2004 excludes the following non-recurring charges related tothe Pfizer Acquisition: incremental cost of sales of $28.1 million from thesale of acquired inventory adjusted to fair value, a $28.1 million in-processresearch and development charge, a charge of $6.5 million for the write-off ofdebt issuance costs, one-time commitment fee and original issue discount, netof the recognition of realized gains on interest rate swaps; and early debtextinguishment costs of $127.2 million. The unaudited pro forma informationalso reflects a $2.3 million decrease in depreciation and amortization relatedto the fair value of property, plant and equipment and identifiable intangibleassets acquired in the Pfizer Acquisition and a $4.1 million increase ininterest expense resulting from the recapitalization to fund the PfizerAcquisition.

 

The unaudited pro formainformation for the year ended December 31, 2004 also includes a $28.2million increase in amortization related to management’s estimate of the fairvalue of intangible assets acquired as the result of the VISX Acquisition andan $11.4 million increase in interest expense resulting from additionalborrowings incurred to fund the cash portion of the VISX Acquisition andrelated costs and amortization of deferred financing costs.

 

(3)                   The weighted average number of shares outstanding usedfor the computation of basic earnings per share for the year ended December 31,2005 reflects the issuance of 27.8 million shares of AMO’s common stock toVISX stockholders less the 16.6 million weighted average shares related tothe VISX Acquisition already included in basic shares outstanding.

 

The weighted averagenumber of shares outstanding used for the computation of basic earnings pershare for the year ended December 31, 2004 reflects the issuance of7.0 million shares of AMO’s common stock in the private exchanges of the 31/2% Convertible Senior Subordinated Notes less the3.6 million weighted average shares related to the private exchangesalready included in basic shares outstanding. The weighted average number ofshares outstanding used for the computation of basic earnings per share for theyear ended December 31, 2004 also includes the 27.8 million sharesissued to VISX stockholders as the result of the VISX Acquisition.

 

(4)                   The weighted average number of shares outstanding usedfor the computation of diluted earnings per share for the year ended December 31,2005 includes the aggregate dilutive effect of approximately 3.3 millionshares for stock options and awards, the remaining 3 1/2%Convertible Senior Subordinated Notes and VISX options exchanged for AMO stockoptions

 

The weighted averagenumber of shares outstanding used for the computation of diluted earnings pershare for the year ended December 31, 2004 includes the aggregate dilutiveeffect of approximately 3.6 million shares for stock options and awards,the remaining 3 1/2% Convertible Senior SubordinatedNotes and VISX options exchanged for AMO stock options.

 

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*Quest**VisionTechnology, Inc.**(Quest**)*

 

In June 2005, the Company acquired Quest, anoptical medical device research and development company, for approximately $2.5million. Approximately $2.3 million of the purchase price was expensed asIPR&D in the year ended December 31, 2005, as it represents theestimated fair value of projects that had not reached technological feasibilityand had no alternative future use at the date of acquisition. The acquisitionof Quest was not material to the historical consolidated financial position,results of operations or cash flows of the Company.

 

**Note4:  Product Rationalization and BusinessRepositioning**

 

On October 31, 2005, theCompany’s Board of Directors approved a product rationalization andrepositioning plan covering the discontinuation of non-strategic cataractsurgical and eye care products and the elimination or redeployment of resourcesthat support these product lines. The plan also includes organizational changesand potential reductions in force in manufacturing, sales and marketingassociated with these product lines, as well as organizational changes inresearch and development and other corporate functions designed to align theorganization with our strategy and strategic business unit organization.

 

The plan further calls forincreasing the Company’s investment in key growth opportunities, specifically theCompany’s refractive implant product line and international laser visioncorrection business, and accelerating the implementation of productivityinitiatives.

 

Certain foreignjurisdictions have laws and regulations which require consultations andnegotiations with works councils, labor organizations and local authorities.The outcome of these discussions will determine, in part, the restructuringsteps to be implemented and the associated cost. Therefore, the final costs ofthe business repositioning plan may be significantly different from theCompany’s initial estimates.

 

The Company incurred $42.3million in pre-tax charges during the fourth quarter of 2005 as follows (inthousands):

 
| **Business Repositioning Costs Reported In:** | ** ** | **Costs  Incurred** | ** ** | **Cash  Payments** | ** ** | **Non-Cash  Adjustments** | ** ** | **Balance at  December 31,  2005** | ** ** |
|-------------------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------------|------------|----------------------------------------------|------------|
|                                                              | ** ** | ** **          | ** ** | ** **         | ** ** | ** **                | ** ** | ** **                                   | ** ** |
| Cost of sales -                                    | ** ** | ** **          | ** ** | ** **         | ** ** | ** **                | ** ** | ** **                                   | ** ** |
| Inventory  provisions                                             |       | $                   | 12,585     |               | $          | —                    |       | $                                            | (12,585    | ) | $ | — |   |
|                                                              |       |                |       |               |       |                      |       |                                         |       |   |   |   |   |
| Operating  Expenses -                                             |       |                |       |               |       |                      |       |                                         |       |
| Severance,  relocation and related costs                          |       | 14,020              |       | (5,241             | )          | —                    |       | 8,779                                        |       |
| Asset  write-downs                                                |       | 9,172               |       | —             |       | (9,172                    | )          | —                                       |       |
| Contractual  obligations                                          |       | 2,641               |       | —             |       | —                    |       | 2,641                                        |       |
| Productivity  initiatives and brand repositioning costs           |       | 3,847               |       | (2,964             | )          | —                    |       | 883                                          |       |
|                                                              |       | 29,680              |       | (8,205             | )          | (9,172                    | )          | 12,303                                       |       |
|                                                              |       | $                   | 42,265     |               | $          | (8,205                    | )          | $                                            | (21,757    | ) | $ | 12,303 |   |

 

Severance, relocation andrelated costs were incurred for worldwide workforce reductions due to theCompany’s discontinuing certain non-core products and infrastructure andprocess improvements associated with the Company’s productivity initiatives.The majority of the workforce reductions occurred in Japan, the United Statesand Europe across all business functions. Asset write-downs resulted from theimpairment and disposal of long-lived assets from the reduction in expectedfuture cash flows from certain discontinued non-core products andreconfiguration and streamlining of certain facilities. The fair values ofimpaired assets were based on probability weighted expected cash flows asdetermined in accordance with SFAS No. 144.

 

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**Note 5:Composition of Certain Financial Statement Captions**

 
| ** **                                                                                                | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                                                                                | ** ** | **(in thousands)** | ** ** |
| Trade  receivables, net                                                                                   |       |                    |       |   |   |
| Trade  receivables                                                                                        |       | $                       | 247,849    |   | $ | 196,908 |   |
| Less  allowance for doubtful accounts                                                                     |       | 9,088                   |       | 7,443 |   |
|                                                                                                      |       |                    |       |   |   |
|                                                                                                      |       | $                       | 238,761    |   | $ | 189,465 |   |
| Inventories                                                                                               |       |                    |       |   |   |
| Finished  products, including consignment inventory of $11,890 and $9,107 in 2005 and  2004, respectively |       | $                       | 66,492     |   | $ | 69,928 |   |
| Work  in process                                                                                          |       | 13,148                  |       | 6,942 |   |
| Raw  materials                                                                                            |       | 25,180                  |       | 8,158 |   |
|                                                                                                      |       |                    |       |   |   |
|                                                                                                      |       | $                       | 104,820    |   | $ | 85,028 |   |
| Property,  plant and equipment, net                                                                       |       |                    |       |   |   |
| Land                                                                                                      |       | $                       | 8,987      |   | $ | 9,497 |   |
| Buildings  and leasehold improvements                                                                     |       | 79,502                  |       | 65,987 |   |
| Machinery,  equipment and furniture                                                                       |       | 94,819                  |       | 102,193 |   |
|                                                                                                      |       |                    |       |   |   |
|                                                                                                      |       | 183,308                 |       | 177,677 |   |
| Less  accumulated depreciation and amortization                                                           |       | 67,583                  |       | 59,038 |   |
|                                                                                                      |       |                    |       |   |   |
|                                                                                                      |       | $                       | 115,725    |   | $ | 118,639 |   |

 

***Intangible assets, net***

 
| ** **                      | ** ** | ** **                    | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------|------------|-------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| **(In thousands)**         | ** ** | **Useful  Life (Years)** | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization**   | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Amortizing  Intangible Assets:  |       |                          |       |                            |       |                            |       |   |   |   |   |
| Licensing                       |       | 3 - 5                         |       | $                               | 4,590      |                            | $          | (4,113 | ) | $ | 4,590 |   | $ | (3,983 | ) |
| Technology  rights              |       | 8 - 19                        |       | 348,379                         |       | (26,128                         | )          | 136,165 |   | (5,371 | ) |
| Trademarks                      |       | 13.5                          |       | 14,689                          |       | (1,995                          | )          | 17,440 |   | (946 | ) |
| Customer  relationships         |       | 5                             |       | 22,400                          |       | (2,613                          | )          | — |   | — |   |
|                            |       |                          |       | 390,058                         |       | (34,849                         | )          | 158,195 |   | (10,300 | ) |
| Nonamortizing  Tradename (VISX) |       | Indefinite                    |       | 140,400                         |       | —                          |       | — |   | — |   |
|                            |       |                          |       | $                               | 530,458    |                            | $          | (34,849 | ) | $ | 158,195 |   | $ | (10,300 | ) |

 

The intangible assets balance increased due to theacquired intangible assets as the result of the VISX Acquisition, net of theimpact of foreign currency fluctuation. Amortization expense was $26.9 million,$5.6 million and $0.1 million in 2005, 2004 and 2003, respectively, and isrecorded in selling, general and administrative in the accompanyingconsolidated statements of operations. Amortization expense is expected to be$38.6 million in 2006, $37.6 million in 2007 and 2008, $37.4 million in 2009,$34.8 million in 2010 and $169.2 million thereafter. Actual amortizationexpense may vary due to the impact of foreign currency fluctuations.

 

***Goodwill***

 
| ** **                 | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | **(In thousands)**     | ** ** |
| Goodwill:                  |       |                        |       |                        |       |
| Americas                   |       | $                           | 614,017    |                        | $          | 135,001 |   |
| Europe/Africa/Middle  East |       | 78,049                      |       | 103,360                     |       |
| Japan                      |       | 100,887                     |       | 120,709                     |       |
| Asia  Pacific              |       | 32,331                      |       | 32,280                      |       |
|                       |       | $                           | 825,284    |                        | $          | 391,350 |   |

 

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The increase in goodwill in 2005 is due to goodwillresulting from the VISX Acquisition (see Note 3), partially offset byforeign currency fluctuations.

 

**Note 6: Debt**

 
| **(In thousands)**                                       | ** ** | **Average Rate  of Interest** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                    | ** ** | ** **                              | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Convertible  Senior Subordinated Notes due 2024               |       | 2.50                                    | %          | $                           | 350,000    |                        | $          | 350,000 |   |
| Convertible  Senior Subordinated Notes due 2023               |       | 3.50                                    | %          | —                      |       | 8,600                       |       |
| Convertible  Senior Subordinated Notes due 2025               |       | 1.375                                   | %          | 150,000                     |       | —                      |       |
| Bank  term loan                                               |       | 4.50                                    | %          | —                      |       | 193,993                     |       |
| Short  term borrowings                                        |       | 5.95                                    | %          | 60,000                      |       | —                      |       |
|                                                          |       |                                    |       |                        |       |                        |       |
|                                                          |       |                                    |       | 560,000                     |       | 552,593                     |       |
| Less  current maturities                                      |       |                                    |       | 60,000                      |       | 1,950                       |       |
|                                                          |       |                                    |       |                        |       |                        |       |
| Total  debt, net of current portion and short term borrowings |       |                                    |       | $                           | 500,000    |                        | $          | 550,643 |   |

 

***Senior Credit Facility***

 

On June 25, 2004, the Company amended andrestated its senior credit facility to provide a $250.0 million term loan and a$100.0 million revolving credit facility. The amended and restated seniorcredit facility matures on June 25, 2009. In January 2005, theCompany entered into an amendment to the senior credit facility to provide foran increase of $100.0 million in the revolving loan commitments and anadditional $100.0 million in term loan commitments. On May 27, 2005, theCompany and certain of its subsidiaries, as guarantors thereunder, entered intoan amendment to provide for an additional increase of $100.0 million in therevolving loan commitments under the senior credit facility, which amounts weremade available to AMO to finance, in part, AMO’s acquisition of VISX, and areavailable for working capital and other general corporate purposes subject tosatisfaction of certain conditions. This amendment also provides fortermination of $100.0 million of existing term loan commitment. The amendmentincreased the revolving loan commitments to $300.0 million. The maturity of thesenior credit facility on June 25, 2009 remains unchanged.

 

During the second quarter of 2005, the Company paidapproximately $44.5 million of the term loan. On June 30 2005, the Companypaid approximately $0.4 million of the term loan. On July 21, 2005, theCompany repaid the balance of its term loan, including approximately $149.1million of principal and approximately $1.2 million of accrued interest, usingthe net proceeds from the 1.375% convertible senior subordinated notes (seebelow) and existing cash. As a result of the repayment of the term loan, theCompany wrote off remaining debt issuance costs of approximately $3.8 millionin the third quarter of 2005.

 

On May 27, 2005, the Company borrowedapproximately $200.0 million under the senior revolving credit facility to fundthe cash portion of the VISX Acquisition. In June 2005, the Company repaidapproximately $123.0 million of revolver borrowings with acquired VISX cash.

 

At December 31, 2005, the Company had $50.0million borrowings outstanding under the revolving credit facility.Approximately $18.7 million of the revolving credit facility was reserved tosupport letters of credit issued on the Company’s behalf for normal operatingpurposes and the Company has approximately $231.3 million undrawn and availablerevolving loan commitments. At December 31, 2005, the Company had $10.0million of borrowings outstanding under a short-term loan from Bank of Irelandto an AMO subsidiary, AMO Ireland. This loan was supported by a $10.0 millionletter of credit which was part of the $18.7 million of letters of creditnoted above. This loan was paid in its entirety on February 21, 2006 andis no longer available for borrowing.

 

Borrowings under the revolving credit facility, ifany, bear interest at current market rates plus a margin based upon the Company’sratio of debt to EBITDA, as defined. The incremental interest margin onborrowings under the revolving credit facility decreases as the Company’s ratioof debt to EBITDA decreases to specified levels. Under the senior creditfacility, certain transactions may trigger mandatory prepayment ofborrowings, if any. Such transactions may include equity or debtofferings, certain asset sales and extraordinary receipts. The Company pays a quarterlyfee (1.95% per annum at December 31, 2005) on the average balance ofoutstanding letters of credit and a quarterly commitment fee (0.375% per annumat December 31, 2005) on the average unused portion of the revolvingcredit facility. The senior credit facility provides that the Company willmaintain certain financial and operating covenants which include, among otherprovisions, maintaining specific leverage and coverage ratios. Certaincovenants under the senior credit facility may limit the incurrence ofadditional indebtedness. The 

 

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seniorcredit facility prohibits dividend payments. The Company was in compliance withthese covenants at December 31, 2005. The senior credit facility issecured by a first priority perfected lien on, and pledge of, all of thecombined company’s present and future property and assets (subject to certainexclusions), 100% of the stock of the domestic subsidiaries, 66% of the stockof foreign subsidiaries and all present and future intercompany debts.

 

***31⁄2% Convertible Senior Subordinated Notes Due 2023 (ExistingNotes)***

 

On June 24, 2003, the Company issued $140.0million of Existing Notes due April 15, 2023. Interest on the ExistingNotes was payable on April 15 and October 15 of each year, commencingon October 15, 2003. The Existing Notes were convertible into 48.69 sharesof AMO’s common stock for each $1,000 principal amount of Existing Notes(conversion price of $20.54 per share), subject to adjustment.

 

In the quarter ended June 25, 2004, the Companyexchanged approximately 5.8 million shares of common stock and approximately$4.6 million in cash for approximately $108.6 million in aggregate principalamount of Existing Notes in privately negotiated transactions with a limitednumber of holders (Private Exchanges). The Private Exchanges resulted in anaggregate increase of $216.4 million to common stock and additional paid-incapital. Because the Existing Notes were not convertible into equity at thetime of the Private Exchanges, a non-cash charge of approximately $107.2million and a cash charge of approximately $4.6 million were recorded. The$107.2 million non-cash charge was comprised of a charge of $89.1 millionrepresenting the difference between the fair value of 5.3 million shares ofcommon stock issued in exchange for the notes and the principal amount of notesexchanged and a charge of $18.1 million representing the fair value of 0.5million shares of common stock issued as a premium. The $4.6 million cashcharge represented cash issued as a premium. The Company also recorded a chargeof approximately $3.2 million for the write-off of the pro-rata portion ofcapitalized debt related costs. During the remainder of 2004, the Companyexchanged approximately 1.2 million shares of common stock for approximately$22.8 million in aggregate principal amount of Existing Notes. These exchangesresulted in an increase of $27.6 million to common stock and additional paid-incapital. A non-cash charge of $4.5 million representing the fair value ofshares issued as a premium was recorded. During the last half of 2004, theCompany also prepaid $55.0 million of the term loan. As a result of theexchanges and the partial repayment of the term loan, the Company recorded a chargeof $1.9 million for the write-off of the pro-rata portion of capitalized debtrelated costs.

 

In the second quarter of 2005, the Company exchanged160,695 shares of common stock for $3.0 million aggregate principal amount ofthe Existing Notes in a privately negotiated transaction. The exchange resultedin an increase of $3.5 million to common stock and paid-in capital. A non-cashcharge of $0.5 million representing the fair value of shares issued as apremium was recorded. In the fourth quarter of 2005, the Company exchanged291,760 shares of common stock and approximately $0.4 million in cash for $5.6million aggregate principal amount of the Existing Notes in privatelynegotiated transactions. The exchange resulted in an aggregate increase of $6.6million to common stock and paid-in capital. A non-cash charge of $1.2 million anda cash charge of $0.2 million representing the fair value of shares issued as apremium were recorded.

 

***21⁄2% Convertible Senior Subordinated Notes Due 2024 (Notes)***

 

On June 22, 2004, the Company issued $350.0million of Notes due July 15, 2024. Interest on the Notes is payable on January 15and July 15 of each year, commencing on January 15, 2005. The Notesare convertible into 19.9045 shares of AMO’s common stock for each $1,000 principalamount of Notes (conversion price of approximately $50.24 per share), subjectto adjustment. The Notes may be converted, at the option of the holders,on or prior to the final maturity date under certain circumstances, including:

 

•                  during any fiscal quarter commencingafter September 24, 2004, if the closing sale price per share of AMO’scommon stock exceeds 130% of the conversion price for at least 20 trading daysin the 30 consecutive trading day period ending on the last trading day of thepreceding fiscal quarter;

 

•                  during the five business days after anyfive consecutive trading day period in which the trading price of the Notes foreach day was less than 95% of the conversion value of the Notes; provided thatholders may not convert their Notes in reliance on this provision after July 15,2019, if on any trading day during such trading period the closing sale priceper share of AMO’s common stock was between 100% and 130% of the then currentconversion price. This conversion tenure represents an embedded derivative.However, based on the de minimis value associated with this feature, no value wasassigned at issuance and at December 31, 2005;

 

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•                  upon the occurrence of specified ratingsevents with respect to the Notes. This conversion feature represents anembedded derivative. However, based on the de minimis value associated withthis feature, no value has been assigned at issuance and at December 31,2005;

 

•                  if the Notes have been called forredemption;

 

•                  if a fundamental change occurs; or

 

•                  upon the occurrence of specifiedcorporate events.

 

Uponconversion, the Company has the right to deliver, in lieu of shares of commonstock, cash or a combination of cash and shares of common stock.

 

The Company may redeem some or all of the Notesfor cash, on or after January 20, 2010, for a price equal to 100% of theprincipal amount plus accrued and unpaid interest, including contingentinterest, if any, to but excluding the redemption date.

 

The Notes contain put options, which may requirethe Company to repurchase all or a portion of the Notes on January 15,2010, July 15, 2014, and July 15, 2019 at a repurchase price of 100%of the principal amount plus accrued and unpaid interest, including contingentinterest (as described below), if any, to but excluding the repurchase date.The Company may choose to pay the repurchase price in cash, shares ofcommon stock or a combination of cash and shares of common stock.

 

Under the indenture for the Notes, the Company may irrevocablyelect to satisfy in cash the conversion obligation with respect to theprincipal amount of the Notes and the Company made such election prior to December 31,2004. As such, any future dilutive effect of the Notes will be calculated underthe net share settlement method. As a result of this election, the Company alsois required to satisfy in cash its obligations to repurchase any Notes thatholders may put to the Company on January 15, 2010, July 15,2014 and July 15, 2019.

 

Beginning with the six-month interest periodcommencing January 15, 2010, holders of the Notes will receive contingentinterest payments during any six-month interest period if the trading price ofthe Notes for each of the five trading days ending on the second trading dayimmediately preceding the first day of the applicable six-month interest periodequals or exceeds 120% of the principal amount of the Notes. The contingentinterest payable will equal 0.25% of the average trading price of $1,000principal amount of Notes during the five trading days immediately precedingthe first day of the applicable six-month interest period. This contingentinterest payment feature represents an embedded derivative. However, based onthe de minimis value associated with this feature, no value has been assignedat issuance and at December 31, 2005 and 2004.

 

On or prior to January 15, 2010, upon theoccurrence of a fundamental change, under certain circumstances, the Companywill pay a make whole premium on Notes converted in connection with, ortendered for repurchase upon, the fundamental change. The make whole premiumwill be payable, in the same form of consideration into which the Company’scommon stock has been exchanged or converted, on the repurchase date for theNotes after the fundamental change, both for Notes tendered for repurchase andfor Notes converted in connection with the fundamental change. The amount ofthe make whole premium, if any, will be based on the Company’s stock price onthe effective date of the fundamental change. This make whole premium featurerepresents an embedded derivative. However, based on the de minimis valueassociated with this feature, no value has been assigned at issuance and at December 31,2005 and 2004.

 

The Company utilizes a convertible bond pricing modeland a probability weighted valuation model, as applicable, to determine thefair values of the embedded derivatives noted above.

 

The proceeds from the June 2004 term loan and aportion of the net proceeds from the Notes aggregating $450.0 million were usedto fund the Pfizer Acquisition. In addition, approximately $80.8 million of thenet proceeds from the Notes were used to consummate the June 2004 tenderoffer to purchase the remaining $70.0 million aggregate outstanding principalamount of the Company’s 91⁄4% senior subordinated notes and pay the relatedpremium and consent fees. As a result of the purchase of the 91⁄4% seniorsubordinated notes, the Company recorded a charge of approximately $10.8million for the premium and consent fees paid and a net gain of $0.7 millionfor the write-off of capitalized debt related costs and recognition of therealized gain on interest rate swaps.

 

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***1.375% Convertible Senior Subordinated Notes Due 2025(Senior Subordinated Notes)***

 

On July 18, 2005, the Company issued $150.0million of Senior Subordinated Notes due July 1, 2025. Interest on theSenior Subordinated Notes is payable on January 1 and July 1 of eachyear, commencing on January 1, 2006. The Senior Subordinated Notes areconvertible into 21.0084 shares of AMO’s common stock for each $1,000 principalamount of the Senior Subordinated Notes (conversion price of approximately$47.60 per share), subject to adjustment. The Senior Subordinated Notes may beconverted, at the option of the holders, into cash or under certaincircumstances, cash and shares of AMO’s common stock at any time on or prior tothe trading day preceding June 1, 2011, subject to prior redemption orrepurchase only during the specified periods under the following circumstances:

 

•                  during the five business days after anyfive consecutive trading day period in which the trading price per $1,000principal amount of the Senior Subordinated Notes for each day of such measurementperiod was less than 103% of the conversion value, which equals the product ofthe closing sales price of AMO’s common stock and the conversion rate then ineffect. This conversion feature represents an embedded derivative. Since thisfeature has no measurable impact on the fair value of the Senior SubordinatedNotes and no separate trading market exists for this derivative, the value ofthe embedded derivative was determined to be de minimis. Accordingly, no valuehas been assigned at issuance and at December 31, 2005;

 

•                  if a fundamental change occurs; or

 

•                  upon the occurrence of specifiedcorporate events.

 

On and after June 1, 2011, to (and including) thetrading day preceding the maturity date, subject to prior redemption orrepurchase, the Senior Subordinated Notes will be convertible into cash and, ifapplicable, shares of AMO’s common stock regardless of the foregoingcircumstances.

 

With respect to each $1,000 principal amount of theSenior Subordinated Notes surrendered for conversion, the Company will deliverthe conversion value to holders as follows: (1) an amount in cash (the “principalreturn”) equal to the lesser of (a) the aggregate conversion value of theSenior Subordinated Notes to be converted and (b) $1,000, and (2) ifthe aggregate conversion value of the Senior Subordinated Notes to be convertedis greater than the principal return, an amount in shares equal to suchaggregate conversion value, less the principal return.

 

The Company may redeem some or all of the SeniorSubordinated Notes for cash, on or after July 6, 2011, for a price equalto 100% of the principal amount plus accrued and unpaid interest, includingcontingent interest (as described below), if any, to but excluding theredemption date.

 

The Senior Subordinated Notes contain put options,which may require the Company to repurchase in cash all or a portion ofthe Senior Subordinated Notes on July 1, 2011, July 1, 2016, andJuly 1, 2021 at a repurchase price equal to 100% of the principal amountplus accrued and unpaid interest, including contingent interest (as describedbelow), if any, to but excluding the repurchase date.

 

Beginning with the six-month interest periodcommencing July 1, 2011, holders of the Senior Subordinated Notes willreceive contingent interest payments during any six-month interest period ifthe trading price of the Senior Subordinated Notes for each of the five tradingdays ending on the second trading day immediately preceding the first day ofthe applicable six-month interest period equals or exceeds 120% of theprincipal amount of the Senior Subordinated Notes. The contingent interestpayable will equal 0.25% of the average trading price of $1,000 principalamount of the Senior Subordinated Notes during the five trading daysimmediately preceding the first day of the applicable six-month interestperiod. This contingent interest payment feature represents an embeddedderivative. Since this feature has no measurable impact on the fair value ofthe Senior Subordinated Notes and no separate trading market exists for thisderivative, the value of the embedded derivative was determined to be deminimis. Accordingly, no value was assigned at issuance and at December 31,2005.

 

On or prior to July 1, 2011, upon the occurrenceof a fundamental change, under certain circumstances, the Company will providefor a make whole amount by increasing, for the time period described herein,the conversion rate by a number of additional shares for any conversion of theSenior Subordinated Notes in connection with such fundamental changetransactions. The amount of additional shares will be determined based on theprice paid per share of AMO’s common stock in the transaction constituting afundamental change and the effective date of such transaction. This make wholepremium feature represents an embedded derivative. Since this feature has nomeasurable impact on the fair value of the Senior Subordinated Notes and noseparate trading market exists for this derivative, the value of the embeddedderivative was determined to be de minimis. Accordingly, no value has beenassigned at issuance and at December 31, 2005.

 

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On July 21, 2005, the Company repaid the balanceof its term loan, including approximately $149.1 million of principal andapproximately $1.2 million of accrued interest, using the net proceeds from theSenior Subordinated Notes and existing cash.

 

As of December 31, 2005, the aggregate maturitiesof total long-term debt of $500.0 million are due after 2010.

 

**Note 7: Financial Instruments**

 

In the normal course of business, the Company’soperations are exposed to risks associated with fluctuations in interest ratesand foreign currency exchange rates. The Company addresses these risks throughcontrolled risk management that may include the use of derivativefinancial instruments to economically hedge or reduce these exposures. TheCompany does not enter into financial instruments for trading or speculativepurposes.

 

The Company enters into derivative financial instrumentswith major financial institutions that have at least an “A” or equivalentcredit rating. The Company has not experienced any losses on its derivativefinancial instruments to date due to credit risk and management believes thatsuch risk is remote.

 

***Interest Rate Risk Management***

 

At December 31, 2005, the Company’s debt iscomprised primarily of domestic borrowings of which $500.0 million is fixedrate debt and $60.0 million is variable rate debt.

 

In July 2004, the Company entered into aninterest rate swap agreement, which effectively converted the interest rate on$125.0 million of term loan borrowings from a floating rate to a fixed rate.This interest rate swap qualified as a cash flow hedge and would have maturedin July 2006. In April 2005, the Company terminated the interest rateswap. Upon termination, the Company received approximately $0.8 million andincluded the related net gain of approximately $0.5 million, which includes theaccrued but unpaid net amount between the Company and the swap counterparty, asa component of accumulated other comprehensive income in the second quarter of2005. As a result of the repayment of the term loan in July 2005, the gainon the interest rate swap of $0.8 million was fully recognized as a reductionto the interest expense in the third quarter of 2005. At December 31,2005, there are no outstanding interest rate swaps.

 

In 2002, the Company entered into two interest rateswap agreements, which effectively converted the interest rate on $150.0million of the 9 1⁄4% senior subordinated notes from a fixed to a floatingrate and converted the interest rate on $50.0 million of term loan borrowingsfrom a floating to a fixed rate. The interest rate swaps had maturity datesbeginning in 2005 and qualified as either fair value or cash flow hedges.Changes in fair value of the interest rate swap agreement qualifying as a cashflow hedge were recorded in other comprehensive income to the extent suchchanges were effective and as long as the cash flow hedge requirements weremet. In May 2003 and October 2002, the Company realized the value ofthe interest rate swaps qualifying as fair value hedges. The Company receivedan aggregate of approximately $14.8 million, of which approximately $6.3million represented the net settlement of the accrued but unpaid amount betweenthe Company and the swap counterparties. The remaining amount of approximately$8.5 million was recorded as an adjustment to the carrying amount of the 9 1⁄4%senior subordinated notes as a premium and was being amortized over theremaining life of the 9 1⁄4% senior subordinated notes. At December 31,2003, after recognizing a pro-rata portion of the gain upon repurchase of aportion of the 9 1⁄4% senior subordinated notes, the unamortized gain onthese interest rate swaps was $3.5 million. As a result of the June 2004repurchase of the remaining 9 1⁄4% senior subordinated notes, the remainingunamortized gain on the interest rate swaps was fully recognized.

 

In May 2003, the Company terminated the interestrate swap qualifying as a cash flow hedge. The Company paid approximately $2.4million and included the related loss of approximately $2.3 million as acomponent of accumulated other comprehensive income. As a result of theprepayment of the term loan in June 2003, the loss on the interest rateswap was fully recognized as interest expense.

 

***Foreign Exchange Risk Management***

 

The Company enters into foreign exchange option andforward contracts to reduce earnings and cash flow volatility associated withforeign exchange rate changes to allow management to focus its attention on itscore business operations. Accordingly, the Company enters into contracts whichchange in value as foreign exchange rates change to economically offset theeffect of changes in value of foreign currency assets and liabilities,commitments and anticipated foreign currency denominated sales and operatingexpenses. The Company enters into foreign exchange option and forward contractsin 

 

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amountsbetween minimum and maximum anticipated foreign exchange exposures, generallyfor periods not to exceed one year. These derivative instruments are notdesignated as accounting hedges.

 

The Company uses foreign currency option contracts,which provide for the sale of foreign currencies to offset foreign currencyexposures expected to arise in the normal course of the Company’s business.While these instruments are subject to fluctuations in value, such fluctuationsare anticipated to offset changes in the value of the underlying exposures. Theprincipal currencies subject to this process are the Japanese yen and the euro.The foreign exchange forward contracts are entered into to protect the value offoreign currency denominated monetary assets and liabilities and the changes inthe fair value of the foreign currency forward contracts were economicallydesigned to offset the changes in the revaluation of the foreign currencydenominated monetary assets and liabilities. These forward contracts aredenominated in currencies which represent material exposures. The changes inthe fair value of foreign currency option and forward contracts are recordedthrough earnings as “Unrealized (gain) loss on derivative instruments” whileany realized gains or losses on expired contracts are recorded through earningsas “Other, net” in the accompanying consolidated statements of operations. Anypremium cost of purchased foreign exchange option contracts are recorded in “Othercurrent assets” and amortized over the life of the options.

 

The following table provides information about ourforeign currency derivative financial instruments outstanding as of December 31,2005 and 2004, respectively. The information is provided in U.S. dollaramounts, as presented in our consolidated financial statements.

 
| ** **                                  | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | ** **                      | ** ** | **Average Contract**       | ** ** | ** ** | ** ** | **Average Contract** | ** ** |
| ** **                                  | ** ** | **Notional**                    | ** ** | **or Strike**              | ** ** | **Notional** | ** ** | **or Strike** | ** ** |
| ** **                                  | ** ** | **Amount**                      | ** ** | **Rate**                        | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                                  | ** ** | **(in $ millions)**   | ** ** | ** **                      | ** ** | **(in $ millions)** | ** ** | ** ** | ** ** |
| **Foreign currency forward contracts:**     |       |                            |       |                            |       |   |   |   |   |
| **Receive US$/Pay Foreign Currency:**       |       |                            |       |                            |       |   |   |   |   |
| Swedish  Krona                              |       | $                               | 31.5       |                            | 7.94       |   | — |   | — |   |
| U.K.  Pound                                 |       | 5.2                             |       | 1.72                            |       | — |   | — |   |
| Swiss  Franc                                |       | 1.5                             |       | 1.31                            |       | — |   | — |   |
| **Pay US$/Receive Foreign Currency:**       |       |                            |       |                            |       | — |   | — |   |
| Japanese  Yen                               |       | 3.0                             |       | 117.45                          |       | — |   | — |   |
| Euro                                        |       | 5.9                             |       | 1.19                            |       | — |   | — |   |
| Canadian  Dollar                            |       | 3.4                             |       | 1.17                            |       | — |   | — |   |
| Australia  Dollar                           |       | 2.9                             |       | 0.73                            |       | — |   | — |   |
|                                        |       |                            |       |                            |       |   |   |   |   |
| **Total Notional**                          | ** ** | **$**                           | **53.4**   | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Estimated Fair Value**                    | ** ** | **$**                           | **—** |                            |       |   |   |   |   |   |
|                                        |       |                            |       |                            |       |   |   |   |   |
| **Foreign currency purchased put options:** |       |                            |       |                            |       |   |   |   |   |
| Japanese  Yen                               |       | $                               | 66.2       |                            | 117.83     |   | $ | 67.3 |   | 114.40 |   |
| Euro                                        |       | 40.2                            |       | 1.18                            |       | 56.9 |   | 1.15 |   |
| **Foreign currency sold call options:**     |       |                            |       |                            |       |   |   |   |   |
| Japanese  Yen                               |       | 60.0                            |       | 106.60                          |       | — |   | — |   |
| Euro                                        |       | 43.0                            |       | 1.26                            |       | — |   | — |   |
|                                        |       |                            |       |                            |       |   |   |   |   |
| **Total Notional**                          | ** ** | **$**                           | **209.4**  | ** **                      | ** ** |   | **$** | **124.2** |   |   |   |
| **Estimated Fair Value**                    | ** ** | **$**                           | **1.1**    | ** **                      | ** ** |   | **$** | **0.1** |   |   |   |

 

The notional principal amount provides one measure ofthe transaction volume outstanding as of the end of the period, and does notrepresent the amount of the Company’s exposure to market loss. The estimate offair value is based on applicable and commonly used prevailing financial marketinformation as of December 31, 2005 and 2004, respectively. The amounts 

 

69

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ultimatelyrealized upon settlement of these financial instruments, together with thegains and losses on the underlying exposures, will depend on actual marketconditions during the remaining life of the instruments.

 

The impact of foreign exchange risk managementtransactions on income was a net realized loss of $2.0 million, $1.9 millionand $2.5 million in 2005, 2004 and 2003, respectively, which are recorded in “Other,net” in the accompanying consolidated statements of operations.

 

***Fair Value of Financial Instruments***

 

At December 31, 2005 and 2004, the Company’sfinancial instruments included cash and equivalents, trade receivables,accounts payable and borrowings. The carrying amount of cash and equivalents,trade receivables and accounts payable approximates fair value due to theshort-term maturities of these instruments. The fair value of long-term debtwas estimated based on quoted market prices at year-end.

 

The carrying amount and estimated fair value of theCompany’s financial instruments at December 31 were as follows (in thousands):

 

| ** **                                                   | ** ** | **2005**             | ** ** | **2004**            | ** ** |
|--------------------------------------------------------------|------------|----------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Current  portion of long-term debt and short-term borrowings |       | $                    | 60,000     |                | $          | 60,000 |   | $ | 1,950 |   | $ | 1,950 |   |
| Long-term  debt                                              |       | 500,000              |       | 527,653             |       | 550,643 |   | 590,104 |   |
|                                                              |            |                      |            |                     |            |  |  |  |  |  |  |  |  |

 

**Note 8: Related Party Transactions**

 

Prior to June 29, 2002, the Company entered intoseveral agreements with Allergan in connection with, among other things,transitional services, employee matters, manufacturing and tax sharing. Theseagreements generally required the Company to indefinitely indemnify Allerganfrom liabilities related to the business contributed to AMO.

 

The transitional services agreement set forth chargesgenerally intended to allow Allergan to fully recover the allocated costs ofproviding certain services, plus all out-of-pocket expenses, except that AMOpaid to Allergan a commission related to AMO products that were sold byAllergan during the transition period. The Company recovered costs fromAllergan in a similar manner for services provided by AMO. All transitionalservices under the transitional services agreement have terminated.

 

Under the manufacturing agreement, which ended on June 29,2005, Allergan manufactured certain eye care products and *VITRAX* viscoelastics from the date of the June 29,2002 spin-off. The Company purchased these products from Allergan at a priceequal to Allergan’s fully allocated costs plus 10%. During 2005, 2004 and 2003,the Company purchased $41.9 million, $89.3 million and $77.0 million,respectively, of product from Allergan. On an annual basis, a pricing “true up”calculation was performed during the first calendar quarter. This “true up”calculation was based upon the actual volume of products shipped by Allergan toAMO during the preceding year versus the forecasted volume submitted by AMOthat was used to calculate the invoiced prices. During the year, the Companyperiodically reviewed the volume of purchases and accrued for estimatedshortfalls, if any. The Company received $0.8 million from Allergan in October 2005as the final “true-up” amount for the six months ended June 29, 2005.

 

The following table summarizes the charges fromAllergan for the above-mentioned transitional services for 2005, 2004 and 2003(in thousands):

 
| ** **                                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Selling,  general and administrative expenses, net of $921 and $1,165 charged to  Allergan |       | $        | —     |     | $          | (198     | )          | $ | 1,884 |   |
|                                                                                       |       |     |       |     |       |     |       |
| Research  and development                                                                  |       | —   |       | 185      |       | 465      |       |
|                                                                                       |       |     |       |     |       |     |       |
| Manufacturing  “true up” payment (receipt), net                                  |       | (637     | )          | 233      |       | (629     | )          |
|                                                                                            |            |          |            |          |            |          |            |  |  |  |

 

70

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As of December 31, 2005, an interest-freerelocation loan of $0.5 million, collateralized by real property, was outstandingfrom the chief executive officer. The principal amount of the loan is payableupon the earlier to occur of (a) 60 days following the chief executiveofficer’s termination of employment; (b) the date of the sale or othertransfer of the property or (c) July 3, 2007. This relocation loan isevidenced by a promissory note dated July 3, 2002, prior to the adoptionof the Sarbanes-Oxley Act of 2002.

 

**Note 9: Income Taxes**

 

The Company’s income before provision for income taxeswas generated from the United States and international operations as follows: 

 
| ** **                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in thousands)**                    | ** ** |
|                                  |       |                                       |       |   |   |   |   |
| Earnings  (loss) before income taxes: |       |                                       |       |   |   |   |   |
| U.S.                                  |       | $                                          | (497,583   | ) | $ | (105,537 | ) | $ | 976 |   |
| Foreign                               |       | 57,286                                     |       | (15,679 | ) | 16,286 |   |
|                                  |       |                                       |       |   |   |   |   |
| Earnings  (loss) before income taxes  |       | $                                          | (440,297   | ) | $ | (121,216 | ) | $ | 17,262 |   |

 

The Company’s provision for income taxes consists ofthe following:

 
| ** **                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                       |       |   |   |   |   |
| Income  tax expense:        |       |                                       |       |   |   |   |   |
| Current                     |       |                                       |       |   |   |   |   |
| U.S.  federal               |       | $                                          | 130        |   | $ | 8,780 |   | $ | 5,741 |   |
| Foreign                     |       | 17,846                                     |       | 15,739 |   | 6,877 |   |
| U.S.  state and Puerto Rico |       | 28                                         |       | 372 |   | 3,643 |   |
|                        |       |                                       |       |   |   |   |   |
| Total  current              |       | 18,004                                     |       | 24,891 |   | 16,261 |   |
|                        |       |                                       |       |   |   |   |   |
| Deferred:                   |       |                                       |       |   |   |   |   |
| U.S.  federal               |       | (903                                       | )          | (13,286 | ) | (11,002 | ) |
| Foreign                     |       | (3,062                                     | )          | (2,665 | ) | 2,833 |   |
| U.S.  state and Puerto Rico |       | (1,139                                     | )          | (786 | ) | (1,187 | ) |
|                        |       |                                       |       |   |   |   |   |
| Total  deferred             |       | (5,104                                     | )          | (16,737 | ) | (9,356 | ) |
|                        |       |                                       |       |   |   |   |   |
| Total                       |       | $                                          | 12,900     |   | $ | 8,154 |   | $ | 6,905 |   |

 

The reconciliations of the U.S. federal statutory taxrate to the Company’s effective tax rate are as follows:

 
| ** **                                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Statutory  rate of tax expense                                                                            |       | 35.0                                       | %          | 35.0 | % | 35.0 | % |
| State  taxes, net of U.S. tax benefit                                                                     |       | 0.3                                        |       | 1.5 |   | 5.6 |   |
| In-process  research and development charges                                                              |       | (39.0                                      | )          | (8.1 | ) | — |   |
| Convertible  note exchanges                                                                               |       | (0.1                                       | )          | (31.2 | ) | — |   |
| Other  permanent items                                                                                    |       | 2.4                                        |       | (1.5 | ) | 3.3 |   |
| Foreign  income, including U.S. tax effect of foreign earnings and dividends, net of  foreign tax credits |       | (2.1                                       | )          | — |   | (6.2 | ) |
| Net  change in valuation allowance                                                                        |       | 0.4                                        |       | (1.5 | ) | 2.0 |   |
| Other                                                                                                     |       | 0.3                                        |       | (0.9 | ) | 0.3 |   |
| Effective  tax rate                                                                                       |       | (2.8                                       | )%         | (6.7 | )% | 40.0 | % |

 

71

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Temporary differences and carryforwards, which giverise to a significant portion of deferred tax assets and liabilities at December 31,2005 and 2004, were as follows: 

 
| ** **                                                      | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**               | ** ** |
|                                                            |       |                                  |       |   |   |
| Deferred  tax assets                                            |       |                                  |       |   |   |
| Net  operating loss carryforwards                               |       | $                                     | 23,265     |   | $ | 5,298 |   |
| Reserves  and accrued expenses                                  |       | 6,854                                 |       | 8,440 |   |
| Capitalized  expenses                                           |       | 204                                   |       | 488 |   |
| Intercompany  profit in inventory                               |       | 12,281                                |       | 6,451 |   |
| Net  benefit on foreign earnings, including foreign tax credits |       | 26,220                                |       | 23,038 |   |
| Federal  and State tax credits                                  |       | 3,691                                 |       | 2,516 |   |
| Inventory  reserves and variances                               |       | 4,932                                 |       | 4,140 |   |
| Fixed  assets, net of accumulated depreciation                  |       | —                                |       | 236 |   |
| All  other                                                      |       | 5,123                                 |       | 4,944 |   |
|                                                            |       | 82,570                                |       | 55,551 |   |
| Less:  valuation allowance                                      |       | (7,913                                | )          | (8,239 | ) |
|                                                            |       |                                  |       |   |   |
| Total  deferred tax asset                                       |       | 74,657                                |       | 47,312 |   |
|                                                            |       |                                  |       |   |   |
| Deferred  tax liabilities                                       |       |                                  |       |   |   |
| Capitalized  intangible assets                                  |       | 175,420                               |       | 35,644 |   |
| Fixed  assets, net of accumulated depreciation                  |       | 1,104                                 |       | — |   |
| All  other                                                      |       | 1,775                                 |       | 988 |   |
|                                                            |       |                                  |       |   |   |
| Total  deferred tax liabilities                                 |       | 178,299                               |       | 36,632 |   |
|                                                            |       |                                  |       |   |   |
| Net  deferred tax asset (liability)                             |       | $                                     | (103,642   | ) | $ | 10,680 |   |

 

In 2005, deferred taxes were provided for U.S. federaland state income taxes and anticipated foreign withholding taxes onundistributed earnings of non-U.S. subsidiaries.

 

As of December 31, 2005, the Company hasapproximately $50.0 million and $8.2 million of federal and various state taxnet operating losses, respectively, available for carryforward that will beginto expire in 2014. The Company also has approximately $18.6 million of variousforeign net operating losses available for carryforward that will begin toexpire in 2013 if not utilized. A valuation allowance has been provided oncertain foreign tax loss carry forwards ($5.6 million) and certain U.S. long-termdeferred tax assets ($2.3 million) as ultimate utilization is uncertain.

 

In addition, as of December 31, 2005, the Companyhas approximately $12.7 million of foreign tax credit carryforwards that willbegin to expire in 2014. Based on the Company’s position that all foreignearnings will be taxed in the U.S. and the projected future earnings of theCompany’s foreign subsidiaries, management believes it is “more likely than not”that the Company will realize the benefit of these foreign tax credits.

 

As of December 31, 2005, the Company hasapproximately $1.5 million in federal research and development credits whichwill begin to expire in 2020. In addition, the Company has approximately $2.2million in various state credits which will begin to expire in 2010.

 

The Company evaluates the realizability of itsdeferred tax assets by assessing its valuation allowance and by adjusting theamount of such allowance, if necessary. At December 31, 2005 managementbelieves that it is “more likely than not” that it will realize the benefit ofits deferred tax assets. The factors used to assess the likelihood ofrealization are the Company’s forecast of future taxable income and availabletax planning strategies that could be implemented to realize the net deferredtax assets. Failure to achieve forecasted taxable income in the applicabletaxing jurisdictions could affect the ultimate realization of deferred taxassets and could result in an increase in the Company’s effective tax rate onfuture earnings. The change in valuation allowance in 2005 related primarily tothe establishment of valuation allowances on net operating losses in foreignjurisdictions as well as the write-off of valuation allowances and associateddeferred tax assets with respect to withholding taxes on undistributed earningswhere the withholding is no longer anticipated to be incurred.

 

72

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The American Jobs Creation Act of 2004 (the “Act”),signed into law in October 2004, allowed companies to elect to repatriatecash into the United States in 2005 at a special, temporary effective tax rateof 5.25 percent. On December 6, 2005, the Board of Directors approvedmanagement’s plan for reinvestment and repatriation of specific foreignearnings under the Act. The Company repatriated $43.2 million under theprovisions of the Act. Since the Company provides taxes currently on foreignearnings, the election of this provision enabled the Company to realize a taxbenefit of $5.7 million in the fourth quarter of 2005.

 

During 2005, the Company realized final adjustments toaccrued, pre-spin-off taxes attributable to our business and payable toAllergan pursuant to a pre-spin tax sharing agreement. These adjustmentsincluded a $1.4 million benefit from the resolution of a discrete item in thethird quarter, which was recorded in the income tax provision.

 

The Company records a liability for potential taxassessments based on its estimate of the potential exposure. New laws and newinterpretations of laws and rulings by tax authorities may affect theliability for potential tax assessments. Due to the subjectivity and complexnature of the underlying issues, actual payments or assessments may differfrom estimates. To the extent the Company’s estimates differ from actualpayments or assessments, income tax expense is adjusted. The Company’s incometax returns in several locations are being examined by the local taxationauthorities. Management believes that adequate amounts of tax and relatedinterest, if any, have been provided for any adjustments that may resultfrom these examinations.

 

**Note 10: Employee Retirement and Other Benefit Plans**

 

***Pension and Postretirement Benefit Plans***

 

The Company sponsors defined benefit pension plans inJapan and in certain European countries.

 

Components of net periodic benefit cost under theJapan and European pension plans in 2005, 2004 and 2003 were as follows (inthousands):

 
| ** **                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service  cost                       |       | $        | 1,822      |     | $          | 1,815    |       | $ | 1,380 |   |
| Interest  cost                      |       | 471      |       | 467      |       | 366      |       |
| Expected  return on plan assets     |       | (207     | )          | (197     | )          | (111     | )          |
| Amortization  of transition amount  |       | —   |       | 2        |       | 3        |       |
| Amortization  of prior service cost |       | 63       |       | 63       |       | 59       |       |
| Recognized  net actuarial loss      |       | —   |       | 36       |       | 22       |       |
| Net  periodic benefit cost          |       | $        | 2,149      |     | $          | 2,186    |       | $ | 1,719 |   |

 

The weighted-average assumptions used to determine netperiodic benefit costs were as follows:

 
| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount  rate:                  |       |     |       |     |       |     |       |
| Japan                            |       | 2.00     | %          | 1.80     | %          | 1.80     | %          |
| European  plans                  |       | 5.25     | %          | 5.50     | %          | 5.50     | %          |
| Expected  return on plan assets: |       |     |       |     |       |     |       |
| Japan                            |       | 2.5      | %          | 3.00     | %          | 3.00     | %          |
| European  plans (unfunded plans) |       | N/A      |       | N/A      |       | N/A      |       |
| Rate  of compensation increase:  |       |     |       |     |       |     |       |
| Japan                            |       | 3.00     | %          | 3.00     | %          | 3.00     | %          |
| European  plans                  |       | 3.00     | %          | 3.30     | %          | 3.30     | %          |

 

73

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Components of the change in benefit obligation, changein plan assets and funded status for the Company’s defined benefit pensionplans for December 31, 2005, and 2004 were as follows (in thousands):

 
| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Change  in benefit obligation:                  |       |     |       |     |       |
| Benefit  obligation, beginning of period        |       | $        | 16,170     |     | $          | 14,875 |   |
| Service  cost                                   |       | 1,822    |       | 1,815    |       |
| Interest  cost                                  |       | 471      |       | 467      |       |
| Actuarial  (gain) loss                          |       | 2,665    |       | (1,504   | )          |
| Benefits  paid                                  |       | (166     | )          | (385     | )          |
| Impact  of foreign currency translation         |       | (2,354   | )          | 902      |       |
|                                            |       |     |       |     |       |
| Benefit  obligation, end of period              |       | $        | 18,608     |     | $          | 16,170 |   |
|                                            |       |     |       |     |       |
| Change  in plan assets:                         |       |     |       |     |       |
| Fair  value of plan assets, beginning of period |       | $        | 8,041      |     | $          | 5,919 |   |
| Actual  return on plan assets                   |       | 1,348    |       | 312      |       |
| Company  contribution                           |       | 1,848    |       | 1,811    |       |
| Benefits  paid                                  |       | (166     | )          | (385     | )          |
| Impact  of foreign currency translation         |       | (1,252   | )          | 384      |       |
|                                            |       |     |       |     |       |
| Fair  value of plan assets, end of period       |       | $        | 9,819      |     | $          | 8,041 |   |
|                                            |       |     |       |     |       |
| Funded  status of plans                         |       | (8,789   | )          | (8,129   | )          |
| Unrecognized  net actuarial loss                |       | 1,799    |       | 395      |       |
| Unrecognized  prior service cost                |       | 340      |       | 458      |       |
| Fourth  quarter contributions                   |       | 517      |       | 502      |       |
|                                            |       |     |       |     |       |
| Accrued  benefit cost                           |       | $        | (6,133     | )        | $          | (6,774 | ) |

 

The funded status of the pension benefits presentedwas measured as of September 30. The Company adopted this measurement dateto conform to its internal cost management systems. Assumptions used indetermining benefit obligations are as follows:

 
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Discount  rate:                 |       |     |       |     |       |
| Japan                           |       | 2.00     | %          | 2.00     | %          |
| European  plans                 |       | 4.25     | %          | 5.25     | %          |
| Rate  of compensation increase: |       |     |       |     |       |
| Japan                           |       | 3.00     | %          | 3.00     | %          |
| European  plans                 |       | 3.50     | %          | 3.00     | %          |

 

The accumulated benefit obligation for the definedbenefit plans was $12.8 million and $11.3 million at December 31, 2005 and2004, respectively.

 

There are no assets in the European plans. The Japanpension plan asset allocation as of the measurement date (September 30)and the target asset allocation, presented as a percentage of total Japanpension plan assets, were as follows:

 
| ** **         | ** ** | **2005** | ** ** | **2004** | ** ** | **Target  Allocation** | ** ** |
|--------------------|------------|----------|------------|----------|------------|------------------------|------------|
| Equity  securities |       | 51.4     | %          | 47.8     | %          | 45-55                  | %          |
| Debt  securities   |       | 42.5     | %          | 47.8     | %          | 45-55                  | %          |
| Real  estate       |       | 0.0      | %          | 0.0      | %          | 0                      | %          |
| Other              |       | 6.1      | %          | 4.4      | %          | 5-10                   | %          |
| Total              |       | 100.0    | %          | 100.0    | %          |                   |       |

 

74

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As of September 30, 2005, the Japan plan assetsare invested using a passive investment strategy. Asset allocations andinvestment performance is reviewed by the Benefits Committee with a view toensuring that sufficient liquidity will be available to meet expected cash flowrequirements.

 

The expected long-term rate of return on plan assetsassumption is based on numerous factors including historical rates of return,long-term inflation assumptions, current and future financial market conditionsand expected asset allocation.

 

The Company expects to contribute $11.1 million to itsdefined benefit plans in 2006.

 

The following estimated future benefit payments areexpected to be paid in the years indicated (in thousands):

 

| **Year**  | ** ** | **Amount** | ** ** |
|-----------|------------|------------|------------|
| 2006      |       | $          | 254        |   |
| 2007      |       | 275        |       |
| 2008      |       | 300        |       |
| 2009      |       | 630        |       |
| 2010      |       | 347        |       |
| 2011-2015 |       | 4,454      |       |
|           |            |            |            |  |

 

***Savings and Investment Plan***

 

AMO employees in the U.S. and Puerto Rico are eligibleto participate in the Advanced Medical Optics, Inc. 401(k) Plan (thePlan). Under the Plan, participants’ contributions, up to 8% of compensation,qualify for a 50% Company match. Participants are immediately vested in theircontributions and are 100% vested in Company contributions after three years ofservice. The Company also provides an annual profit sharing contribution.Participants vest ratably over five years in the Company’s profit sharingcontributions. The Company contributed $6.7 million, $5.4 million and $4.6million in 2005, 2004 and 2003, respectively, to the Plan.

 

**Note 11: Common Stock**

 

The Company has an incentive compensation plan thatprovides for the granting of stock options, restricted stock, restricted stockunit and other stock-based incentive awards to directors, employees andconsultants. Options granted to employees become exercisable 25% per yearbeginning twelve months after the date of grant and have a ten year term. TheCompany measures stock-based compensation for option grants to employees usingthe intrinsic value method. Restricted stock awards are valued based on themarket price of a share of non-restricted stock on the grant date. No compensationexpense has been recorded for stock-based incentive plans other than forrestricted stock awards. A total of 5,000,000 shares of common stock have beenauthorized for issuance under the incentive compensation plan.

 

During 2005, the Company granted 104,272 shares ofrestricted stock and restricted stock units to certain directors and employees.Compensation expense recognized for restricted stock awards was $1.2 million in2005.

 

During 2004 and 2003, the Company granted 8,047 and11,833 shares, respectively, of restricted stock to certain directors in lieuof annual cash retainers. Compensation expense recognized for the restrictedstock awards was $0.2 million and $0.1 million in 2004 and 2003, respectively.

 

75

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The following is a summary of stock option activity:

 
| ** **                      | ** ** | **2005**                    | ** ** | **2004**                                   | ** ** | **2003**                    | ** ** |
|---------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **Number of  Options** | ** ** | **Weighted Average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted Average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of year |       | 5,734,466                   |       | $                                          | 15.64      |                        | 5,069,348  |   | $ | 10.56 |   | 5,005,513 |   | $ | 9.78 |   |
| Options  granted                |       | 5,726,028                   |       | 28.39                                      |       | 1,269,300                   |       | 33.67 |   | 864,000 |   | 14.18 |   |
| Options  exercised              |       | (2,306,174                  | )          | 17.96                                      |       | (490,111                    | )          | 10.08 |   | (425,841 | ) | 8.92 |   |
| Options  canceled               |       | (295,914                    | )          | 30.32                                      |       | (114,071                    | )          | 14.24 |   | (374,324 | ) | 10.48 |   |
|                            |       |                        |       |                                       |       |                        |       |   |   |   |   |   |   |
| Outstanding,  end of year       |       | 8,858,406                   |       | $                                          | 22.79      |                        | 5,734,466  |   | $ | 15.64 |   | 5,069,348 |   | $ | 10.56 |   |
|                            |       |                        |       |                                       |       |                        |       |   |   |   |   |   |   |
| Exercisable,  end of year       |       | 5,890,209                   |       | $                                          | 19.28      |                        | 2,558,433  |   | $ | 10.05 |   | 1,603,165 |   | $ | 9.16 |   |

 

The following table summarizes information regardingoptions outstanding and options exercisable at December 31, 2005:

 
| ** **                              | ** ** | **Outstanding**             | ** ** | **Exercisable**                                        | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|--------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number of  Options** | ** ** | **Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $5.00—$9.99                        |       | 2,339,382                   |       | 5.51                                                   |       | $ | 8.76 |   | 1,884,991 |   | $ | 8.71 |   |
| $10.00—$17.99                      |       | 1,619,579                   |       | 5.85                                                   |       | 13.82 |   | 1,300,330 |   | 13.82 |   |
| $18.00—$27.99                      |       | 1,239,274                   |       | 5.51                                                   |       | 24.28 |   | 1,212,774 |   | 24.38 |   |
| $28.00—$33.99                      |       | 1,865,191                   |       | 7.77                                                   |       | 32.46 |   | 1,060,784 |   | 31.51 |   |
| $34.00—$42.00                      |       | 1,794,980                   |       | 8.62                                                   |       | 38.09 |   | 431,330 |   | 37.56 |   |
|                                         |            |                             |            |                                                        |            |  |  |  |  |  |  |  |  |

 

The Company has two employee stock purchase plans(ESPP) for eligible employees to purchase shares of the Company’s common stockat 85% of the lower of the closing price of the Company’s common stock on thefirst or last day of the six-month purchase period. Under the ESPP, employeescan authorize the Company to withhold up to 10% of their compensation duringany offering period for common stock purchases, subject to certain limitations.A total of up to 4,867,235 shares of common stock have been reserved forissuance under the ESPP. During 2005, 143,808 shares of common stock wereissued under the ESPP for an aggregate purchase price of $4.4 million. During2004, 171,212 shares of common stock were issued under the ESPP for anaggregate purchase price of $3.1 million. During 2003, 230,120 shares of commonstock, including 12,708 shares of treasury stock, were issued for an aggregatepurchase price of $2.2 million. As of December 31, 2005, employeewithholdings under the ESPP aggregated $0.7 million.

 

On June 24, 2002, the Company adopted astockholders’ rights plan to protect stockholders’ rights in the event of a proposedor actual acquisition of 15% or more of the outstanding shares of the Company’scommon stock. As part of this plan, each share of the Company’s commonstock carries a right to purchase one one-hundredth (1/100th) of ashare of Series A Junior Participating Preferred Stock, par value $0.01per share, subject to adjustment, which becomes exercisable only upon theoccurrence of certain events. The rights are subject to redemption at theoption of the Board of Directors at a price of $0.01 per right until theoccurrence of certain events. The rights expire on June 24, 2012, unlessearlier redeemed or exchanged by the Company.

 

**Note 12:Earnings Per Share**

 

Basic earnings per share is calculated by dividing netearnings by the weighted average number of common shares outstanding during theperiod. Diluted earnings per share is calculated by adjusting net earnings and theweighted average outstanding shares, assuming the conversion of all potentiallydilutive convertible securities, stock options and stock purchase plan awards.Due to the net loss, basic and diluted earnings per share are the same for theyears ended December 31, 2005 and 2004.

 

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The table below presents the computation of basic anddiluted earnings (loss) per share for the years ended December 31, 2005,2004 and 2003:

 
| ** **                             | ** ** | **2005**                                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                             | ** ** | **(in thousands, except  per share amounts)** | ** ** |
| Basic  and diluted net earnings (loss) |       | $                                                                 | (453,197   | )        | $          | (129,370 | )          | $ | 10,357 |   |
|                                   |       |                                                              |       |     |       |     |       |
| Basic  common shares outstanding       |       | 54,764                                                            |       | 33,284   |       | 29,062   |       |
| Effect  of dilutive securities:        |       |                                                              |       |     |       |     |       |
| Stock  options and awards              |       | —                                                            |       | —   |       | 582      |       |
|                                   |       |                                                              |       |     |       |     |       |
| Diluted  common shares outstanding     |       | 54,764                                                            |       | 33,284   |       | 29,644   |       |
|                                   |       |                                                              |       |     |       |     |       |
| Basic  earnings (loss) per share       |       | $                                                                 | (8.28      | )        | $          | (3.89    | )          | $ | 0.36 |   |
|                                   |       |                                                              |       |     |       |     |       |
| Diluted  earnings (loss) per share     |       | $                                                                 | (8.28      | )        | $          | (3.89    | )          | $ | 0.35 |   |

 

For 2005, the dilutive effect of stock options andstock purchase plan awards of approximately 2,674,000 shares and the dilutiveeffect of the 3 1⁄2% convertible senior subordinated notes of approximately290,000 shares have been excluded from the computation of diluted loss pershare as the effect would be anti-dilutive. For 2004, the dilutive effect ofstock options and stock purchase plan awards of approximately 2,125,000 sharesand the dilutive effect of the 3 1⁄2% convertible senior subordinated notesof approximately 3,559,000 shares have been excluded from the computation ofdiluted loss per share as the effect would be anti-dilutive. For 2003, thedilutive effect of the 3 1⁄2% convertible senior subordinated notes ofapproximately 1,704,000 shares has been excluded from the computation ofdiluted earnings per share as the effect would be anti-dilutive.

 

The Company will settle in cash the principal amountof the 2 1⁄2% convertible senior subordinated notes and the 1.375%convertible senior subordinated notes. In addition, there were no potentiallydiluted common shares associated with the 2 1⁄2% convertible seniorsubordinated notes and the 1.375% convertible senior subordinated notes as theCompany’s year end stock price was less than the conversion prices of thenotes.

 

**Note 13: Commitments and Contingencies**

 

The Company leases certain facilities, officeequipment and automobiles and provides for payment of taxes, insurance andother charges on certain of these leases. Rental expense was $17.8 million,$20.4 million, and $16.1 million in 2005, 2004, and 2003, respectively.

 

Future minimum rental payments under non-cancelableoperating lease commitments with a term of more than one year as of December 31,2005, are as follows: $15.1 million in 2006; $12.0 million in 2007; $7.7million in 2008; $4.6 million in 2009; $4.0 million in 2010 and $24.5 millionthereafter.

 

In August 2002, the Company entered into aninformation technology services outsourcing agreement expiring in November 2007.Future annual payments under this agreement are as follows: $3.9 million in2006 and $3.6 million in 2007.

 

On December 3, 2003, the Company filed acomplaint in the U.S. District Court for the District of Delaware against Alcon, Inc.and Alcon Laboratories, Inc. for infringement of U.S. Patent Nos.5,700,240 (Barwick Patent) and 6,059,765 (Cole/Sutton Patent). The Companyalleged that Alcon’s “Infiniti” and “Series 20000 Legacy” phacoemulsificationmachines infringe the patents. The Company sought damages and a permanentinjunction. The trial of this matter began on April 25, 2005 and concludedon May 6, 2005. The jury found both of AMO’s patents to be valid andinfringed by Alcon, and awarded AMO $94.8 million in damages. The jury furtherfound that Alcon had willfully infringed both of AMO’s patents. On June 21,2005, a bench trial was conducted by the Court to determine if the Company hadsufficiently marked the Company’s equipment with the patent numbers and todetermine if Alcon had waived any argument relating thereto. On December 16,2005, the Court ruled that the Company did not sufficiently mark its patentsand reduced the jury award from $94.8 million to $71.3 million. However, the Courtfurther ruled that Alcon had willfully infringed the Company’s patents andtrebled the $71.3 million damage award to $213.9 million. The Court alsogranted the Company’s request for a permanent injunction on both patents. However,the Court stayed the injunction on the Cole/Sutton Patent pending appeal. On January 20,2006, judgment was entered including additional damages from March 2005through December 31, 2005 and interest based thereon, resulting in finaldamages of $234.5 million. The Court further ordered Alcon to pay all of theCompany’s attorney fees and costs, estimated at $4 million. Alcon filed anappeal of the final judgment on January 20, 2006. AMO cross appealed on February 3,2006. On February, 3, 2006, Alcon filed a motion for a new trial with the U.S.District Court for the District of Delaware. AMO opposed this motion on February 24,2006.

 

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On January 28, 2004, Alcon Manufacturing, Ltd.filed a complaint against AMO and Allergan, Inc. in the U.S. DistrictCourt for the Northern District of Texas, Fort Worth Division, for infringementof U.S. Patent Nos. 4,832,685 and 4,935,005 (Haines Patents). Alcon allegedthat AMO’s *Prestige* and *Sovereign* phacoemulsification systems andreplacement cassettes infringe the patents. Alcon is seeking damages and apermanent injunction. At Alcon’s request, the case has been stayed in Texaswhile the parties seek re-examination by the U.S. Patent and Trademark Officeon the Haines Patents in light of another patent the Company allegesinvalidates the Haines Patents.

 

On January 4, 2005, Dr. James Nielsen fileda complaint against the Company and Allergan, Inc. in the U.S. DistrictCourt of the Northern District of Texas, Dallas Division, for infringement ofU.S. Patent No. 5,158,572. Dr. Nielsen alleges that the Company’s *Array*multifocal intraocular lensinfringes the patent. He is seeking damages and a permanent injunction. Thetrial in this matter is scheduled to begin on November 6, 2006.

 

On August 8, 2005, Alcon Manufacturing, Ltd andAlcon Laboratories, Inc. filed a complaint against the Company in the U.S.District Court for the Northern District of Texas, Fort Worth Division, forinfringement of U.S. Patent Nos. 4,921,477 (relating to a surgical irrigationand aspiration system with a dampening device); 5,199,943 (relating to anultrasonic surgical handpiece); 5,188,589 (relating to a textured sleeve in aphacoemulsification handpiece); and 5,876,016 and 6,109,572 (both of whichrelate to an apparatus and method to elevate an infusion source in anophthalmic surgical procedure). Alcon alleged that the Company infringed thesepatents in the course of selling the Company’s phacoemulsification systems oraccessories, and is seeking damages and a permanent injunction. The trial inthis matter is scheduled to begin on August 14, 2006.

 

On September 13, 2005, Alcon Manufacturing, Ltd.filed a complaint against the Company in the U.S. District Court for theNorthern District of Texas, Dallas Division, for infringement of U.S Patent No. 5,273,056relating to the use of a combination of viscoelastics during ophthalmicsurgery. Alcon alleged that the Company infringed, contributorily infringed,and/or induced infringement of this patent, and is seeking damages and apermanent injunction.

 

The Company does not believe, based on currentknowledge, that any of the foregoing legal proceedings or claims are likely tohave a material adverse effect on its financial position, results of operationsor cash flows. However, the Company may incur substantial expenses indefending against third party claims. In the event of a determination adverseto the Company or its subsidiaries, the Company may incur substantialmonetary liability, and be required to change its business practices. Either ofthese could have a material adverse effect on the Company’s financial position,results of operations or cash flows.

 

While the Company is involved from time to time inlitigation arising in the ordinary course of business, including productliability claims, the Company is not currently aware of any other actionsagainst AMO or Allergan relating to the optical medical device business thatthe Company believes would have a material adverse effect on the Company’sbusiness, financial condition, results of operations or cash flows. The Companymay be subject to future litigation and infringement claims, which couldcause the Company to incur significant expenses or prevent the Company fromselling its products. The Company operates in an industry susceptible tosignificant product liability claims. Product liability claims may beasserted against AMO in the future arising out of events not known to theCompany at the present time. Under the terms of the contribution anddistribution agreement affecting the spin-off, Allergan agreed to assumeresponsibility for, and to indemnify AMO against, all current and futurelitigation relating to its retained businesses and the Company agreed to assumeresponsibility for, and to indemnify Allergan against, all current and futurelitigation related to the optical medical device business.

 

**Note 14: Business Segment Information**

 

The Company has organized its operations into fourgeographic operating segments or regions: the Americas, which includes Northand South America, Europe/Africa/Middle East, Japan and Asia Pacific (excludingJapan, but including Australia and New Zealand).

 

The United States information is presented separatelyas it is the Company’s headquarters country, and U.S. sales represented 32.9%,25.2% and 25.5% of total net sales in 2005, 2004 and 2003, respectively.Additionally, sales in Japan represented 18.9%, 25.8% and 27.3% of total netsales in 2005, 2004 and 2003, respectively. No other country, or singlecustomer, generates over 10% of total net sales.

 

Operating income attributable to each operatingsegment is based upon the management assignment of costs to such regions, whichincludes the manufacturing standard cost of goods produced by the Company’smanufacturing operations (or 

 

78

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thecost to acquire goods from third parties), freight, duty and local distributioncosts, and royalties. The Company uses other measures of segment performance,whereby the impact of business repositioning costs and non-recurringacquisition related costs are excluded. The Company presents the measure whichmanagement believes is determined in accordance with the measurement principlesconsistent with those used in measuring the corresponding amounts in theconsolidated financial statements.

 

Income from manufacturing operations is not assignedto geographic regions because most manufacturing operations produce productsfor more than one region. Research and development costs are corporate costs.

 

Tangible, long-lived assets are assigned by regionbased upon management responsibility for such assets. Depreciation andamortization and capital expenditures are assigned by operating segments basedupon management responsibility for such items.

 

As a result of the VISX Acquisition, balances ofidentifiable assets in the Americas segment have increased significantly,mainly due to the intangible assets and goodwill acquired. Balances ofidentifiable assets attributable to other operating segments are materially consistentwith December 31, 2004 balances.

 

79

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**Geographic Operating Segments**

 
| ** **                               | ** ** | **Net Sales**      | ** ** | **Operating Income (Loss)** | ** ** |
|------------------------------------------|------------|-------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **2005**                | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **(in thousands)** | ** ** |
| United  States:                          |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | $                       | 246,087    |                                  | $          | 134,247 |   | $ | 108,921 |   |   |   |   |   |   |   |
| Eye  care                                |       | 56,402                  |       | 52,635                                |       | 44,537 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  United States                     |       | 302,489                 |       | 186,882                               |       | 153,458 |   | $ | 135,462 |   | $ | 53,256 |   | $ | 34,369 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Americas,  excluding United States       |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | 30,706                  |       | 20,139                                |       | 15,359 |   |   |   |   |   |   |   |
| Eye  care                                |       | 10,904                  |       | 10,562                                |       | 9,570 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  Americas, excluding United States |       | 41,610                  |       | 30,701                                |       | 24,929 |   | 11,571 |   | 5,330 |   | 2,872 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Europe/Africa/Middle  East:              |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | 202,670                 |       | 159,917                               |       | 112,105 |   |   |   |   |   |   |   |
| Eye  care                                |       | 95,926                  |       | 103,806                               |       | 99,991 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  Europe/Africa/Middle East         |       | 298,596                 |       | 263,723                               |       | 212,096 |   | 103,624 |   | 77,197 |   | 52,075 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Japan:                                   |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | 77,693                  |       | 62,856                                |       | 46,370 |   |   |   |   |   |   |   |
| Eye  care                                |       | 96,595                  |       | 128,679                               |       | 117,743 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  Japan                             |       | 174,288                 |       | 191,535                               |       | 164,113 |   | 64,610 |   | 65,160 |   | 54,137 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Asia  Pacific:                           |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | 62,650                  |       | 36,263                                |       | 23,753 |   |   |   |   |   |   |   |
| Eye  care                                |       | 41,040                  |       | 32,995                                |       | 23,104 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  Asia Pacific                      |       | 103,690                 |       | 69,258                                |       | 46,857 |   | 21,892 |   | 13,575 |   | 4,097 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Segments  total                          |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ophthalmic  surgical                     |       | 619,806                 |       | 413,422                               |       | 306,508 |   |   |   |   |   |   |   |
| Eye  care                                |       | 300,867                 |       | 328,677                               |       | 294,945 |   |   |   |   |   |   |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  segments                          |       | 920,673                 |       | 742,099                               |       | 601,453 |   | 337,159 |   | 214,518 |   | 147,550 |   |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Manufacturing  operations                |       | —                  |       | —                                |       | — |   | 81,843 |   | 33,440 |   | 28,281 |   |
| Research  and development                |       | —                  |       | —                                |       | — |   | (61,646 | ) | (45,616 | ) | (37,413 | ) |
| In-process  research and development     |       | —                  |       | —                                |       | — |   | (490,750 | ) | (28,100 | ) | — |   |
| Business  repositioning                  |       | —                  |       | —                                |       | — |   | (42,265 | ) | — |   | — |   |
| Elimination  of inter-company profit     |       | —                  |       | —                                |       | — |   | (99,135 | ) | (53,546 | ) | (37,561 | ) |
| General  corporate                       |       | —                  |       | —                                |       | — |   | (136,533 | ) | (87,674 | ) | (41,323 | ) |
|                                     |       |                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Total                                    |       | $                       | 920,673    |                                  | $          | 742,099 |   | $ | 601,453 |   | $ | (411,327 | ) | $ | 33,022 |   | $ | 59,534 |   |

 

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| ** **                         | ** ** | **Identifiable Assets** | ** ** | **Property, Plant and Equipment** | ** ** | **Other Long-lived Assets** | ** ** |
|------------------------------------|------------|------------------------------|------------|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2005**                     | ** ** | **2004**                                         | ** ** | **2003**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                         |       | **(in  thousands)**          |       |
| United  States                     |       | $                            | 1,300,100  |                                             | $          | 294,557                               |       | $ | 141,072 |   | $ | 19,577 |   | $ | 14,577 |   | $ | 13,732 |   | $ | 35,856 |   | $ | 27,560 |   | $ | 14,184 |   |
| Americas,  excluding United States |       | 15,878                       |       | 12,400                                           |       | 8,956                                 |       | 629 |   | 120 |   | 96 |   | 2,144 |   | 1,817 |   | 1,250 |   |
| Europe/Africa/  Middle East        |       | 188,382                      |       | 227,504                                          |       | 108,732                               |       | 3,669 |   | 3,077 |   | 3,457 |   | 4,321 |   | 3,511 |   | 2,963 |   |
| Japan                              |       | 174,307                      |       | 215,126                                          |       | 99,390                                |       | 1,132 |   | 1,965 |   | 1,930 |   | 3,785 |   | 4,618 |   | 4,863 |   |
| Asia  Pacific                      |       | 79,284                       |       | 60,315                                           |       | 28,273                                |       | 1,045 |   | 676 |   | 652 |   | 2,329 |   | 1,196 |   | 1,314 |   |
| Segments  total                    |       | 1,757,951                    |       | 809,902                                          |       | 386,423                               |       | 26,052 |   | 20,415 |   | 19,867 |   | 48,435 |   | 38,702 |   | 24,574 |   |
| Manufacturing  operations          |       | 236,307                      |       | 274,977                                          |       | 60,698                                |       | 89,673 |   | 98,224 |   | 48,269 |   | 4,038 |   | 3,123 |   | 2,505 |   |
| Adjustments  and eliminations      |       | (4,907,935                   | )          | (2,376,403                                       | )          | (698,261                              | )          | — |   | — |   | — |   | — |   | — |   | — |   |
| General  corporate                 |       | 4,893,999                    |       | 2,368,058                                        |       | 712,485                               |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Total                              |       | $                            | 1,980,722  |                                             | $          | 1,076,534                             |       | $ | 461,345 |   | $ | 115,725 |   | $ | 118,639 |   | $ | 68,136 |   | $ | 52,473 |   | $ | 41,825 |   | $ | 27,079 |   |

 
| ** **                         | ** ** | **Depreciation and Amortization** | ** ** | **Capital Expenditures** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|-------------------------------|------------|
| ** **                         | ** ** | **2005**                                    | ** ** | **2004**                      | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(in thousands)**                     | ** ** |
| United  States                     |       | $                                           | 24,765     |                          | $          | 4,098 |   | $ | 3,865 |   | $ | 7,076 |   | $ | 2,893 |   | $ | 2,447 |   |
| Americas,  excluding United States |       | 1,250                                       |       | 820                           |       | 869 |   | 583 |   | 58 |   | 62 |   |
| Europe/Africa/Middle  East         |       | 2,888                                       |       | 2,696                         |       | 2,925 |   | 1,871 |   | 257 |   | 1,076 |   |
| Japan                              |       | 1,114                                       |       | 1,297                         |       | 1,817 |   | 121 |   | 718 |   | 985 |   |
| Asia  Pacific                      |       | 854                                         |       | 1,161                         |       | 1,149 |   | 736 |   | 369 |   | 261 |   |
| Segments  total                    |       | 30,871                                      |       | 10,072                        |       | 10,625 |   | 10,387 |   | 4,295 |   | 4,831 |   |
| Manufacturing  operations          |       | 20,717                                      |       | 13,544                        |       | 4,922 |   | 12,710 |   | 13,197 |   | 7,774 |   |
| General  corporate                 |       | —                                      |       | —                        |       | — |   | — |   | — |   | — |   |
|                               |       |                                        |       |                          |       |   |   |   |   |   |   |   |   |
| Total                              |       | $                                           | 51,588     |                          | $          | 23,616 |   | $ | 15,547 |   | $ | 23,097 |   | $ | 17,492 |   | $ | 12,605 |   |

 

In each geographic segment, the Company marketsproducts in two product lines: ophthalmic surgical and eye care. The ophthalmicsurgical product line includes intraocular lenses, phacoemulsificationequipment, viscoelastics, technologies and systems for laser vision correctionof refractive vision disorders, and other products related to cataract andrefractive surgery. The eye care product line includes cleaning, storage,disinfection and rewetting products for the consumer contact lens market, aswell as contact lenses. The Company has global marketing strategy teams toensure development and execution of a consistent marketing strategy forproducts in all geographic operating segments. There were no transfers betweenproduct lines.

 

**Net Sales By Product Line**

 
| ** **           | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **           | ** ** | **(in thousands)** | ** ** |
| Ophthalmic  Surgical |       | $                       | 619,806    |     | $          | 413,422  |       | $ | 306,508 |   |
| Eye  Care            |       | 300,867                 |       | 328,677  |       | 294,945  |       |
| Net  sales           |       | $                       | 920,673    |     | $          | 742,099  |       | $ | 601,453 |   |

 

81

----

 

**Note 15: Quarterly Results (Unaudited)**

 
| ** **                         | ** ** | **First  Quarter**                                                 | ** ** | **Second  Quarter(c)** | ** ** | **Third  Quarter(d)** | ** ** | **Fourth  Quarter(e)** | ** ** | **Total Year** | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|------------------------|------------|----------------|------------|
| ** **                         | ** ** | **(in thousands, except per share data)** | ** ** |
| **2005 (a)**                       |       |                                                               |       |                   |       |                  |       |                   |       |           |       |
| Net  sales                         |       | $                                                                  | 192,519    |                   | $          | 227,092               |       | $                      | 248,233    |           | $          | 252,829 |   | $ | 920,673 |   |
| Gross  profit                      |       | 122,080                                                            |       | 139,614                |       | 160,781               |       | 144,873                |       | 567,348        |       |
| Net  earnings (loss)               |       | 13,826                                                             |       | (438,115               | )          | (31,215               | )          | 2,307                  |       | (453,197       | )          |
| Basic  earnings (loss) per share   |       | 0.37                                                               |       | (9.53                  | )          | (0.47                 | )          | 0.03                   |       | (8.28          | )          |
| Diluted  earnings (loss) per share |       | 0.35                                                               |       | (9.53                  | )          | (0.47                 | )          | 0.03                   |       | (8.28          | )          |
| **2004 (b)**                       |       |                                                               |       |                   |       |                  |       |                   |       |           |       |
| Net  sales                         |       | $                                                                  | 150,307    |                   | $          | 168,741               |       | $                      | 198,366    |           | $          | 224,685 |   | $ | 742,099 |   |
| Gross  profit                      |       | 90,635                                                             |       | 104,730                |       | 109,472               |       | 131,098                |       | 435,935        |       |
| Net  earnings (loss)               |       | 4,747                                                              |       | (112,541               | )          | (31,708               | )          | 10,132                 |       | (129,370       | )          |
| Basic  earnings (loss) per share   |       | 0.16                                                               |       | (3.67                  | )          | (0.89                 | )          | 0.28                   |       | (3.89          | )          |
| Diluted  earnings (loss) per share |       | 0.15                                                               |       | (3.67                  | )          | (0.89                 | )          | 0.26                   |       | (3.89          | )          |

 

----

(a)                   Fiscal quarters in 2005 endedon March 25, June 24, September 30 and December 31.

(b)                  Fiscal quartersin 2004 ended on March 26, June 25, September 24 and December 31.

(c)                   Includes a$451.5 million in-process research and development charge, debtrecapitalization related costs of $2.4 million and $4.7 million in chargesassociated with recent acquisitions and integrations in the second quarter offiscal 2005.Includes debt recapitalization related costs of $126.3 million in the secondquarter of fiscal 2004.

(d)                  Includes a $39.3million in-process research and development charge, debt recapitalizationrelated charges of $3.8 million, an $8.6 million charge for the termination ofa distributor agreement and $9.7 million in charges associated with recentacquisitions and integrations in the third quarter of fiscal 2005 and a $1.4million benefit from the resolution of a discrete item as the result of finaladjustments to accrued, pre-spin-off taxes attributable to the Company’sbusiness and payable to Allergan pursuant to a pre-spin tax sharing agreement.

Includesdebt recapitalization related costs of $5.0 million, $2.3 million in chargesmostly for termination of a distributor agreement, a $28.1 million in-processresearch and development charge and a charge of $14.1 million for manufacturingprofit capitalized in inventory and expensed in the third quarter of fiscal2004.

(e)                   Includes $42.3million in charges associated with product rationalization and repositioninginitiatives, debt recapitalization related costs of $1.4 million, $4.0 millionin charges associated with recent acquisitions and integrations and a taxbenefit of $5.7 million for repatriation of foreign earnings in the fourthquarter of fiscal 2005.

Includesdebt recapitalization related costs of $2.3 million and a charge of $14.1million for manufacturing profit capitalized in inventory and expensed in thefourth quarter of fiscal 2004.

 

82

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**Report of Independent RegisteredPublic Accounting Firm**

 

To theBoard of Directors and Stockholders of Advanced Medical Optics, Inc:

 

We have completedintegrated audits of Advanced Medical Optics, Inc.’s 2005 and 2004consolidated financial statements and of its internal control over financialreporting as of December 31, 2005, and an audit of its 2003 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on our audits,are presented below.

 

Consolidated financial statements and financial statementschedule

 

In our opinion, the consolidated financial statements listed inthe index appearing under Item 15(a) (1)  present fairly, in allmaterial respects, the financial position of Advanced Medical Optics, Inc.and its subsidiaries at December 31, 2005 and December 31, 2004, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2005 in conformity with accountingprinciples generally accepted in the United States of America. In addition, in our opinion, the financialstatement schedule listed in the index appearing under Item 15(a) (2) presentsfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and financial statement schedule basedon our audits. We conducted our audits of these statements in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, ona test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

Internal control overfinancial reporting

 

Also, in our opinion,management’s assessment, included in Management’s Report on Internal Controlover Financial Reporting appearing under Item 9A, that the Company maintainedeffective internal control over financial reporting as of December 31,2005 based on criteria established in *Internal Control -Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), is fairly stated, in allmaterial respects, based on those criteria. Furthermore, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin *Internal Control - Integrated Framework*issued by the COSO. The Company’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express opinions on management’s assessment and onthe effectiveness of the Company’s internal control over financial reportingbased on our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects. An audit ofinternal control over financial reporting includes obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we consider necessaryin the circumstances. We believe that our audit provides a reasonable basis forour opinions.

 

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

83

----

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

 
| /s/  PRICEWATERHOUSECOOPERS LLP |   |
|---------------------------------|--------|
|                            |
|                            |
| PricewaterhouseCoopers  LLP     |
| Orange County,  California      |
| March 13,  2006            |

 

 

84

----

 

**Item 9.Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

 

None.

 

**Item 9A.Controls and Procedures**

 

Evaluation of DisclosureControls and Procedures

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our principal executive officer andprincipal financial officer, of the effectiveness of the design and operationof our disclosure controls and procedures. Based on this evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) underthe Securities Exchange Act of 1934) are effective.

 

Changes in InternalControl over Financial Reporting

 

Our management evaluatedour internal control over financial reporting and there have been no changesduring the fiscal quarter ended December 31, 2005 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

Management’s Report onInternal Control over Financial Reporting

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting. Our internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Because of itsinherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls may becomeinadequate because of changes in conditions, or that the degree of compliance withthe policies or procedures may deteriorate. Our management assessed theeffectiveness of the Company’s internal control over financial reporting as of December 31,2005. In making this assessment, it used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control - Integrated Framework*.Based on our assessment, we have concluded that, as of December 31, 2005,the Company’s internal control over financial reporting is effective based onthose criteria.

 

AMO’s independentregistered public accounting firm has issued an attestation report on ourassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005. This report begins on page 83.

 

**Item 9B. Other Information**

 

None.

85

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**PART III**

 

**Item 10.Directors and Executive Officers of Advanced Medical Optics, Inc.**

 

Information required bythis item, including that required pursuant to Item 401 of Regulation S-K, isincluded under the headings “Election of Directors” and “Executive Officers” inour proxy statement for the 2006 annual meeting of stockholders (the “ProxyStatement”), which will be filed no later than 120 days after the close of ourfiscal year ended December 31, 2005 and which is incorporated herein byreference.

 

The information requiredby Item 405 of Regulation S-K is included in the Proxy Statement under the section entitled“Section 16(a) Beneficial Ownership Reporting Compliance” and isincorporated herein by reference.

 

**Item 11.Executive Compensation**

 

The sections entitled “CertainRelationships and Related Transactions,” “Executive Compensation,” and “Comparisonof Cumulative Total Return,” and the subsection entitled “Director Compensation”included in the Proxy Statement are incorporated herein by reference.

 

**Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters**

 

The common stockinformation in the section entitled “Ownership of Our Stock” in the ProxyStatement is incorporated herein by reference. The information regardingsecurities authorized for issuance under equity compensation plans in the subsection ofour Proxy Statement entitled “Equity Compensation Plans Approved by Stockholders”is incorporated herein by reference.

 

**Item 13.Certain Relationships and Related Transactions**

 

The section entitled“Certain Relationships and Related Transactions” in the Proxy Statement isincorporated herein by reference.

 

**Item 14.Principal Accountant Fees and Services**

 

The section entitled“Independent Registered Public Accounting Firm” in the Proxy Statement isincorporated herein by reference.

 

86

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**PART IV**

 

**Item 15.Exhibits and Financial Statement Schedules**

 

(a)                                  Indexto Financial Statements

 
| ** ** | ** ** | **Page No.**                                                                                                                                                       |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                         |
|       | 1.         | Financial Statements  included in Part II of this report:                                                                                                     |   |
|       |       |                                                                                                                                                               |   |
|       |       | Consolidated Balance  Sheets at December 31, 2005 and December 31, 2004                                                                                  | 49 |
|       |       |                                                                                                                                                               |   |
|       |       | Consolidated  Statements of Operations for Each of the Years in the Three-Year Period Ended  December 31, 2005                                                | 50 |
|       |       |                                                                                                                                                               |   |
|       |       | Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for Each  of the Years in the Three-Year Period Ended December 31, 2005 | 51 |
|       |       |                                                                                                                                                               |   |
|       |       | Consolidated  Statements of Cash Flows for Each of the Years in the Three-Year Period Ended  December 31, 2005                                                | 52 |
|       |       |                                                                                                                                                               |   |
|       |       | Notes to  Consolidated Financial Statements                                                                                                                        | 53-82 |
|       |       |                                                                                                                                                               |   |
|       |       | Report of Independent  Registered Public Accounting Firm                                                                                                           | 83 |
|       |       |                                                                                                                                                               |   |
|       | 2.         | Schedules Supporting  the Consolidated Financial Statements:                                                                                                       |   |
|       |       |                                                                                                                                                               |   |
|       |       | Schedule numbered in accordance with Rule 5-04  of Regulation S-X: II Valuation and Qualifying Accounts                                                  | S-8 |
|            |            |                                                                                                                                                                    |  |  |

 

All other schedules havebeen omitted for the reason that the required information is presented infinancial statements or notes thereto, the amounts involved are not significantor the schedules are not applicable.

 

(b)                                 Item601 Exhibits

 

Reference is made to theIndex of Exhibits beginning at page S-4 of this report.

 

(c)                                  OtherFinancial Statements

 

There are no financialstatements required to be filed by Regulation S-X which are excluded from thisreport by Rule 14 a-3(b)(1).

 

87

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Date: March 13,  2006 |   | ADVANCED MEDICAL OPTICS, INC. |
|----------------------------|--------|------------------------------------|
|                       |   |                               |
|                       |   |                               |
|                       |   | By                                 |   | /s/ JAMES. V. MAZZO |
|                       |   |                               |   | James V. Mazzo |
|                       |   |                               |   | President and Chief Executive  Officer, Director |

 

We, the undersigneddirectors and officers of Advanced Medical Optics, Inc., hereby severallyconstitute James V. Mazzo and Aimee S. Weisner, and each of them singly, ourtrue and lawful attorneys with full power to them and each of them to sign forus, in our names in the capacities indicated below, any and all amendments tothis Annual Report on Form 10-K filed with the Securities and ExchangeCommission.

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the date indicated.

 

 
| Date:  March 13, 2006 |   | By     |   | /s/ JAMES. V. MAZZO                                                              |
|---------------------------------|--------|--------|--------|----------------------------------------------------------------------------------|
|                            |   |   |   | James V. Mazzo                                                                   |
|                            |   |   |   | President and Chief  Executive Officer, Director                                 |
|                            |   |   |   | (Principal Executive  Officer)                                                   |
|                            |   |   |   |                                                                             |
|                            |   |   |   |                                                                             |
| Date:  March 8, 2006  |   | By     |   | /s/ RICHARD A. MEIER                                                             |
|                            |   |   |   | Richard A. Meier                                                                 |
|                            |   |   |   | Executive Vice  President of Operations and Finance and Chief  Financial Officer |
|                            |   |   |   | (Principal Financial  Officer)                                                   |
|                            |   |   |   |                                                                             |
|                            |   |   |   |                                                                             |
| Date:  March 8, 2006  |   | By     |   | /s/ ROBERT F. GALLAGHER                                                          |
|                            |   |   |   | Robert F. Gallagher                                                              |
|                            |   |   |   | Vice President and  Controller                                                   |
|                            |   |   |   | (Principal Accounting  Officer)                                                  |
|                            |   |   |   |                                                                             |
|                            |   |   |   |                                                                             |
| Date:  March 13, 2006 |   | By     |   | /s/ WILLIAM R. GRANT                                                             |
|                            |   |   |   | William R. Grant                                                                 |
|                            |   |   |   | Chairman of the Board                                                            |
|                            |   |   |   |                                                                             |
|                            |   |   |   |                                                                             |
| Date:  March 13, 2006 |   | By     |   | /s/ CHRISTOPHER G.  CHAVEZ                                                       |
|                            |   |   |   | Christopher G. Chavez,  Director                                                 |
|                            |   |   |   |                                                                             |
|                            |   |   |   |                                                                             |
| Date:  March 13, 2006 |   | By     |   | /s/ ELIZABETH H. DÁVILA                                                     |   |
|                            |   |   |   | Elizabeth H. Dávila,  Director                                              |

 

S-1

----

 
| Date:  March 8, 2006  |   | By     |   | /s/ WILLIAM J. LINK,  PH.D.       |
|---------------------------------|--------|--------|--------|-----------------------------------|
|                            |   |   |   | William J. Link, Ph.D.,  Director |
|                            |   |   |   |                              |
|                            |   |   |   |                              |
| Date:  March 13, 2006 |   | By     |   | /s/ MICHAEL A.  MUSSALLEM         |
|                            |   |   |   | Michael A. Mussallem,  Director   |
|                            |   |   |   |                              |
|                            |   |   |   |                              |
| Date:  March 13, 2006 |   | By     |   | /s/ DEBORAH J. NEFF               |
|                            |   |   |   | Deborah J. Neff,  Director        |
|                            |   |   |   |                              |
|                            |   |   |   |                              |
| Date:  March 8, 2006  |   | By     |   | /s/ JAMES O. ROLLANS              |
|                            |   |   |   | James O. Rollans,  Director       |

 

S-2

----

 

**Exhibitsand Financial Statement Schedules**

 

**(a) Exhibits**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.1(a)               |       | Amended and Restated  Certificate of Incorporation (incorporated by reference to Exhibit 3.1  of Amendment No. 2 to Registration Statement on Form 10 (“Form 10”)  filed on May 6, 2002).                                                                                                                                                                                                                                                                                                                                                             |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.1(b)               |       | Amendment to Amended  and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1  of Quarterly Report on Form 10-Q filed on August 3, 2005).                                                                                                                                                                                                                                                                                                                                                                                                     |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 3.2                  |       | Amended and Restated  Bylaws (incorporated by reference to Exhibit 3.2 of Amendment No. 2  to Form 10 filed on May 6, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.1                  |       | Specimen Common Stock  Certificate (incorporated by reference to Exhibit 4.1 of Amendment No. 2  to Form 10 filed on May 6, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.2                  |       | Rights Agreement, dated  as of June 24, 2002, by and between Advanced Medical Optics, Inc.  and Mellon Investor Services, as Rights Agent, which includes the form of  Certification of Designations of the Series A Junior Participating  Preferred Stock of Advanced Medical Optics, Inc. as Exhibit A, the form of  Right Certificate as Exhibit B and the Summary of Rights to Purchase  Preferred Shares as Exhibit C (incorporated by reference to Exhibit 4.1  to Current Report on Form 8-K filed on June 25, 2002). |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.3                  |       | Indenture, dated as of June 22,  2004, between Advanced Medical Optics, Inc. and U.S. Bank National  Association, as Trustee (incorporated by reference to Exhibit 4.1 of  Current Report on Form 8-K filed on June 23, 2004).                                                                                                                                                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.4                  |       | Registration Rights  Agreement, dated as of June 22, 2004, among Advanced Medical Optics, Inc.  and Lehman Brothers Inc., Banc of America Securities LLC and Morgan Stanley &  Co. Incorporated, as Initial Purchasers (incorporated by reference to Exhibit 4.2  of Current Report on Form 8-K filed on June 23, 2004).                                                                                                                                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.5                  |       | Indenture, dated as of July 18,  2005, between Advanced Medical Optics, Inc. and U.S. Bank National  Association, as Trustee (incorporated by reference to Exhibit 4.1 of  Current Report on Form 8-K filed on July 19, 2005).                                                                                                                                                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.6                  |       | Registration Rights Agreement,  dated as of July 18, 2005, between Advanced Medical Optics, Inc.  and Morgan Stanley & Co. Incorporated, J.P. Morgan Securities Inc.  and UBS Securities LLC, as the Initial Purchasers (incorporated by reference  to Exhibit 4.2 of Current Report on Form 8-K filed on July 19,  2005).                                                                                                                                                                                                                             |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.1                 |       | Contribution and  Distribution Agreement, dated as of June 24, 2002, by and between  Allergan, Inc. and Advanced Medical Optics, Inc. (incorporated by  reference to Exhibit 10.1 of Form S-4 Registration Statement filed  on August 8, 2002).                                                                                                                                                                                                                                                                                                            |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2                 |       | Employee Matters  Agreement, dated as of June 24, 2002, by and between Allergan, Inc.  and Advanced Medical Optics, Inc. (incorporated by reference to Exhibit 10.3  of Form S-4 Registration Statement filed on August 8, 2002).                                                                                                                                                                                                                                                                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3                 |       | Tax Sharing Agreement,  dated as of June 24, 2002, by and between Allergan, Inc. and  Advanced Medical Optics, Inc. (incorporated by reference to Exhibit 10.4  of Form S-4 Registration Statement filed on August 8, 2002).                                                                                                                                                                                                                                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.4                 |       | Employment Agreement,  dated as of January 18, 2002, by and between Advanced Medical Optics, Inc.  and James Mazzo (incorporated by reference to Exhibit 10.8 of Form 10).*                                                                                                                                                                                                                                                                                                                                                                                          |

 

S-3

----

 
| 10.5(a)  |   | Form of Employment  Agreement between Advanced Medical Optics, Inc. and those parties  identified on Exhibit 10.5(b) (incorporated by reference to Exhibit 10.9(a) of  Form 10).*                                               |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                               |
| 10.5(b)  |   | Updated Schedule of  parties to the Employment Agreement filed as Exhibit 10.5(a) (incorporated  by reference to Exhibit 10.6(b) of Annual Report on Form 10-K  filed on March 2, 2005).*                                       |
|     |   |                                                                                                                                                                                                                                                               |
| 10.5(c)  |   | Employment Agreement,  dated as of June 28, 2002, by and between Advanced Medical Optics, Inc.  and Holger Heidrich (incorporated by reference to Exhibit 10.20 of Form S-4  Registration Statement filed on August 8, 2002).*            |
|     |   |                                                                                                                                                                                                                                                               |
| 10.6     |   | Form of Indemnity  Agreement (incorporated by reference to Exhibit 10.7 of Form S-4  Registration Statement filed on August 8, 2002).*                                                                                                         |
|     |   |                                                                                                                                                                                                                                                               |
| 10.7(a)  |   | Form of Change in  Control Agreement between Advanced Medical Optics, Inc. and those  parties identified on Exhibit 10.7(b) (incorporated by reference to  Exhibit 10.7 of Current Report on Form 8-K filed on May 18,  2005).* |
|     |   |                                                                                                                                                                                                                                                               |
| 10.7(b)  |   | Schedule of  executive officers party to the Change in Control Agreement filed as Exhibit 10.7(a) (incorporated  by reference to Exhibit 10.8 of Current Report on Form 8-K filed on  May 18, 2005).*                                |
|     |   |                                                                                                                                                                                                                                                               |
| 10.8(a)  |   | Advanced Medical Optics, Inc.  2002 Bonus Plan (incorporated by reference to Exhibit 10.8 of Form S-4  Registration Statement filed on August 8, 2002).*                                                                                       |
|     |   |                                                                                                                                                                                                                                                               |
| 10.8(b)  |   | First Amendment to  Advanced Medical Optics, Inc. 2002 Bonus Plan (incorporated by reference  to Exhibit 10.1 of Quarterly Report on Form 10-Q filed on November 8,  2002).*                                                                   |
|     |   |                                                                                                                                                                                                                                                               |
| 10.8(c)  |   | 2005 Performance Objective  under the Advanced Medical Optics, Inc. 2002 Bonus Plan (incorporated by  reference to Exhibit 10.1 of Quarterly Report on Form 10-Q -K filed  on April 29, 2005).*                                                |
|     |   |                                                                                                                                                                                                                                                               |
| 10.8(d)  |   | Amended 2005  Performance Objectives under the Advanced Medical Optics, Inc. 2002  Bonus Plan (incorporated by reference to Exhibit 10.1 of Current Report  on Form 8-K filed on July 27, 2005).*                                              |
|     |   |                                                                                                                                                                                                                                                               |
| 10.8(e)  |   | 2006 Performance  Objective under the Advanced Medical Optics, Inc. 2002 Bonus Plan.*                                                                                                                                                                         |
|     |   |                                                                                                                                                                                                                                                               |
| 10.9(a)  |   | Advanced Medical Optics, Inc.  401(k) Plan (incorporated by reference to Exhibit 10.1 of Form S-8  Registration Statement filed on June 21, 2002).*                                                                                            |
|     |   |                                                                                                                                                                                                                                                               |
| 10.9(b)  |   | First Amendment to  Advanced Medical Optics, Inc. 401(k) Plan (incorporated by reference to Exhibit 10.10(b) of  Annual Report on Form 10-K filed on March 14, 2003).*                                                                    |
|     |   |                                                                                                                                                                                                                                                               |
| 10.9(c)  |   | Second Amendment to  Advanced Medical Optics, Inc. 401(k) Plan (incorporated by reference to Exhibit 10.3  of Quarterly Report on Form 10-Q filed on November 6, 2003)*                                                                        |
|     |   |                                                                                                                                                                                                                                                               |
| 10.9(d)  |   | Third Amendment to  Advanced Medical Optics, Inc. 401(k) Plan.*                                                                                                                                                                                               |
|     |   |                                                                                                                                                                                                                                                               |
| 10.10(a) |   | Amended and Restated  Advanced Medical Optics, Inc. 2002 Incentive Compensation Plan  (incorporated by reference to Exhibit A to Proxy Statement for the 2004  Annual Meeting of Stockholders filed on April 15, 2004).*                            |
|     |   |                                                                                                                                                                                                                                                               |
| 10.10(b) |   | First Amendment to  Advanced Medical Optics, Inc. 2002 Incentive Compensation Plan, as  amended and restated (incorporated by reference to Exhibit 10.1 to  Current Report on Form 8-K filed on November 23, 2004).*                           |
|     |   |                                                                                                                                                                                                                                                               |
| 10.11(a) |   | Advanced Medical Optics, Inc.  2005 Incentive Compensation Plan (incorporated by reference to Exhibit 99.10  of Form S-8 Registration Statement filed on May 27, 2005).*                                                                       |
|     |   |                                                                                                                                                                                                                                                               |
| 10.11(b) |   | Form of  Nonqualified Stock Option Grant Terms and Conditions under Advanced Medical  Optics, Inc. 2005 Incentive Compensation Plan (incorporated by reference  to Exhibit 10.2 of Current Report on Form 8-K filed on May 18,  2005).*   |

 

S-4

----

 
| 10.11(c) |   | Form of Employee  Restricted Unit Grant Terms and Conditions under Advanced Medical Optics, Inc.  2005 Incentive Compensation Plan (incorporated by reference to Exhibit 10.3  of Current Report on Form 8-K filed on May 18, 2005).*                                                                                    |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.11(d) |   | Form of Employee  Restricted Stock Grant Terms and Conditions under Advanced Medical Optics, Inc.  2005 Incentive Compensation Plan (incorporated by reference to Exhibit 10.4  of Current Report on Form 8-K filed on May 18, 2005).*                                                                                   |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.11(e) |   | Form of  Nonemployee Director Restricted Stock Grant Agreement under Advanced Medical  Optics, Inc. 2005 Incentive Compensation Plan (incorporated by reference  to Exhibit 10.5 of Current Report on Form 8-K filed on May 18,  2005).*                                                                                 |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.11(f) |   | Form of  Performance Award Agreement under Advanced Medical Optics, Inc. 2005  Incentive Compensation Plan (incorporated by reference to Exhibit 10.6  of Current Report on Form 8-K filed on May 18, 2005).*                                                                                                            |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.12(a) |   | Advanced Medical Optics, Inc.  2002 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.3  of Form S-8 Registration Statement filed on June 21, 2002).*                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.12(b) |   | First Amendment to  Advanced Medical Optics, Inc. 2002 Employee Stock Purchase Plan  (incorporated by reference to Exhibit 10.1 of Quarterly Report on Form 10-Q  filed on November 2, 2004).*                                                                                                                                |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.12(c) |   | Amended and Restated  Advanced Medical Optics, Inc. 2002 Employee Stock Purchase Plan  (incorporated by reference to Exhibit 99.8 of Form S-8 Registration  Statement filed on May 27, 2005.*                                                                                                                                 |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.13(a) |   | Advanced Medical Optics, Inc.  International Stock Purchase Plan (incorporated by reference to Exhibit 10.4  of Form S-8 Registration Statement filed on June 21, 2002).*                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.13(b) |   | First Amendment to  Advanced Medical Optics, Inc. 2002 International Stock Purchase Plan  (incorporated by reference to Exhibit 10.2 of Quarterly Report on Form 10-Q  filed on November 2, 2004).*                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.13(c) |   | Amended and Restated  Advanced Medical Optics, Inc. 2002 International Stock Purchase Plan  (incorporated by reference to Exhibit 99.9 of Form S-8 Registration  Statement filed on May 27, 2005).*                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.14(a) |   | Advanced Medical Optics, Inc.  Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10.5  of Form S-8 Registration Statement filed on June 21, 2002).*                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.14(b) |   | First Amendment to  Advanced Medical Optics, Inc. Executive Deferred Compensation Plan  (incorporated by reference to Exhibit 10.4 of Quarterly Report on Form 10-Q  filed on November 6, 2003).*                                                                                                                             |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.15    |   | Advanced Medical Optics, Inc.  2005 Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10.15  of Annual Report on Form 10-K filed on March 2, 2005).*                                                                                                                                                 |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.16    |   | Consent to Sublease and  Second Amendment to Lease, dated as of May 24, 2002, by and among Andrew  Place Two LLC, as landlord, Ingram Micro, Inc., as tenant and Advanced  Medical Optics, Inc., as subtenant (incorporated by reference to Exhibit 10.5  of Quarterly Report on Form 10-Q filed on June 24, 2002). |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.17    |   | Sublease Agreement,  dated as of May 24, 2002, by and between Advanced Medical Optics, Inc.  and Ingram Micro, Inc. for the premises located at 1700 East St. Andrew  Place, Santa Ana, California 92705 (incorporated by reference to Exhibit 10.6  of Quarterly Report on Form 10-Q filed on June 24, 2002).      |
|     |   |                                                                                                                                                                                                                                                                                                                                              |
| 10.18    |   | Information Technology  Services Agreement, dated August 23, 2002, by and between Advanced  Medical Optics, Inc. and Siemens Business Services, Inc.  (incorporated by reference to Exhibit 10.2 of Quarterly Report on Form 10-Q  filed on November 8, 2002).                                                      |

 

S-5

----

 
| 10.19(a) |   | Amended and Restated  Credit Agreement, dated June 17, 2003, by and among AMO, General  Electric Capital Corporation (“General Electric”), as Syndication Agent, Bank  One, N.A., as Documentation Agent, Bank of America N.A., as Administrative  Agent, Foreign Currency Fronting Lender and LLC Issuer, Banc of America  Securities LLC (‘BAS”), as Sole-Bookrunner and BAS and General Electric as  Co-Lead Arrangers (incorporated by reference to Exhibit 99.2 of AMO’s  Current Report on Form 8-K filed June 19, 2003).                                                                                                                                                      |
|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.19(b) |   | Amendment No. 1  and Waiver to Amended and Restated Credit Facility, dated July 18, 2003  (incorporated by reference to Exhibit 10.1 of Advanced Medical Optics  Inc.’s Quarterly Report on Form 10-Q filed August 5, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.19(c) |   | Amendment No. 2 to  Amended and Restated Credit Agreement, dated September 19, 2003  (incorporated by reference to Exhibit 10.1 of Advanced Medical Optics, Inc.’s  Quarterly Report on Form 10-Q filed November 6, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.19(d) |   | Amendment No. 3 to  June 17, 2003 Amended and Restated Credit Agreement, dated as of May 28,  2004 (incorporated by reference to Exhibit 10.1 to Quarterly Report on Form 10-Q  filed August 3, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.19(e) |   | Amendment No. 4 to  June 17, 2003 Amended and Restated Credit Agreement, dated as of June 15,  2004 (incorporated by reference to Exhibit 10.2 to Quarterly Report on Form 10-Q  filed August 3, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.20(a) |   | Second Amended and  Restated Credit Agreement dated as of June 25, 2004, among Advanced  Medical Optics, Inc., as the Borrower, certain of its subsidiaries, as  the Guarantors, Lehman Commercial Paper Inc., as Syndication Agent, General  Electric Capital Corporation and Bank One, NA, as Co-Documentation Agents,  Bank of America, N.A., as Administrative Agent, Swing Line Lender, Foreign  Currency Fronting Lender and L/C Issuer, and the other lenders party thereto,  and Banc of America Securities LLC and Lehman Brothers Inc., as Joint Lead  Arrangers and Joint Book Runners (incorporated by reference to Exhibit 10.3  of Quarterly Report on Form 10-Q filed on August 3, 2004). |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.20(b) |   | First Amendment to  Second Amended and Restated Credit Agreement, dated as of January 7,  2005, among Advanced Medical Optics, Inc., certain of its subsidiaries,  as Guarantors, Morgan Stanley Senior Funding, Inc., as Syndication  Agent, JPMorgan Chase Bank, N.A., US Bank and Union Bank of California, N.A.,  as Co-Documentation Agents, Bank of America, N.A., as Administrative Agent,  Swing Line Lender, Foreign Currency Fronting Lender and L/C Issuer, and the  other lenders party thereto (incorporated by reference to Exhibit 99.1  of Current Report on Form 8-K filed on January 13, 2005).                                                                                   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.20(c) |   | Second Amendment to  Second Amended and Restated Credit Agreement, dated as of May 27, 2005,  among Advanced Medical Optics, Inc., the Guarantors party thereto,  Morgan Stanley Senior Funding, Inc., as Syndication Agent, and Bank of  America, N.A., as Administrative Agent, and the lenders party thereto  (incorporated by reference to Exhibit 99.1 of Current Report on Form 8-K  filed on May 31, 2005).                                                                                                                                                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.21(a) |   | Term Loan Facility  Agreement, dated September 24, 2003, by and among AMO Japan, K.K. as  Borrower, Advanced Medical Optics, Inc., as Guarantor, Bank of America  N.A., Tokyo Branch, as Lender and Agent and the Lenders named therein  (incorporated by reference to Exhibit 10.2 of Advanced Medical Optics, Inc.’s  Quarterly Report on Form 10-Q filed November 6, 2003).                                                                                                                                                                                                                                                                                                                 |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.21(b) |   | Agreement to Amend Term  Loan Facility Agreement, dated February 27, 2004 (incorporated by  reference to Exhibit 10.27(b) of Advanced Medical Optics, Inc.’s  Annual Report on Form 10-K filed March 12, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.21(c) |   | Agreement to Amend Term  Loan Facility Agreement, dated as of April 28, 2004, by and among AMO  Japan K.K., Advanced Medical Optics, Inc., Bank of America, N.A., and  the Lenders named therein (incorporated by reference to Exhibit 10.3 of  Advanced Medical Optics, Inc.’s Quarterly Report on Form 10-Q filed  May 3, 2004).                                                                                                                                                                                                                                                                                                                                                             |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.22    |   | Manufacturing and  Supply Agreement, dated November 10, 2003, by and between Advanced  Medical Optics, Inc. and Nicholas Piramal India Limited (confidential  portions have been omitted and filed                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |

 

S-6

----

 
|     |   | separately with the  Commission) (incorporated by reference to Exhibit 10.28 of Annual Report  on Form 10-K filed on March 12, 2004).                                                                                                                                                                                                 |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.23    |   | Stock and Asset  Purchase Agreement, dated as of April 21, 2004, by and between Pfizer  Inc. and Advanced Medical Optics, Inc. (incorporated by reference to Exhibit 10.1  of Quarterly Report on Form 10-Q filed on May 3, 2004).                                                                                          |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.24    |   | Commitment Letter,  dated as of April 21, 2004, by and among Bank of America, N.A., Banc of  America Securities LLC, Lehman Commercial Paper Inc., Lehman Brothers Inc., and  Advanced Medical Optics, Inc. (incorporated by reference to Exhibit 10.2  of Quarterly Report on Form 10-Q filed on May 3, 2004).             |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.25(a) |   | Agreement and Plan of  Merger, dated as of November 9, 2004, by and among Advanced Medical  Optics, Inc., Vault Merger Corporation, and VISX, Incorporated (“VISX  Merger Agreement”) (incorporated by reference to Exhibit 2.1 of Current  Report on Form 8-K filed on November 10, 2004).                       |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.25(b) |   | Amendment No. 1,  dated as of December 3, 2004, by and among Advanced Medical Optics, Inc.,  Vault Merger Corporation, and VISX, Incorporated, to amend the VISX Merger  Agreement (incorporated by reference to Exhibit 2.2 of Form S-4  Registration Statement filed on December 6, 2004).                           |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.25(c) |   | Amendment No. 2,  dated as of March 17, 2005, by and among Advanced Medical Optics, Inc.,  Vault Merger Corporation, and VISX, Incorporated, to amend the VISX Merger  Agreement, as amended (incorporated by reference to Exhibit 2.1 of  Current Report on Form 8-K filed on March 22, 2005).                        |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.26    |   | VISX, Incorporated 2001  Nonstatutory Stock Option Plan (incorporated by reference to Exhibit 99.2  of Form S-8 Registration Statement filed on May 27, 2005).*                                                                                                                                                                       |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.27    |   | VISX, Incorporated 2000  Stock Plan (incorporated by reference to Exhibit 99.4 of Form S-8  Registration Statement filed on May 27, 2005).*                                                                                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.28    |   | VISX, Incorporated 1995  Director Option and Stock Deferral Plan (incorporated by reference to Exhibit 99.5  of Form S-8 Registration Statement filed on May 27, 2005).*                                                                                                                                                              |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.29    |   | VISX, Incorporated 1995  Stock Plan (incorporated by reference to Exhibit 99.6 of Form S-8  Registration Statement filed on May 27, 2005).*                                                                                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 10.30    |   | Lease dated July 16,  1992 between VISX, Incorporated and Sobrato Interests, a California limited  partnership, as amended on October 2, 1992, March 8, 1996 and March 29,  2002 (incorporated by reference to Exhibit 10.7 of VISX, Incorporated’s  Current Report on Form 8-K filed on November 18, 2004). |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 21.1     |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 23.1     |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                           |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 24.1     |   | Power of Attorney  (included as part of the signature page).                                                                                                                                                                                                                                                                                    |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 31.1     |   | Certification of James  V. Mazzo pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                     |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 31.2     |   | Certification of  Richard A. Meier pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                                                                                                                                 |
| 32.1     |   | Certification of James  V. Mazzo and Richard A. Meier pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                               |

 

----

*  Management contract or compensatory plan orarrangement.

 

S-7

----

 

**SCHEDULE II**

 

**ADVANCEDMEDICAL OPTICS, INC.**

 

**VALUATIONAND QUALIFYING ACCOUNTS**

 

**YEARSENDED DECEMBER 31, 2005, 2004, AND 2003**

 

**(INMILLIONS)**

 
| **Allowance**         | ** ** | **Balance at** | ** ** | ** **       | ** ** | ** **        | ** ** | **Balance**      | ** ** |
|-----------------------|------------|---------------------|------------|------------------|------------|-------------------|------------|------------------|------------|
| **For Doubtful** | ** ** | **Beginning**       | ** ** | ** **       | ** ** | ** **        | ** ** | **at End**  | ** ** |
| **Accounts**          | ** ** | **of Year**    | ** ** | **Additions(a)** | ** ** | **Deductions(b)** | ** ** | **of Year** | ** ** |
| ** **            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** |
| 2005                  |       | $                   | 7.4        |             | $          | 2.6               |       | $                | (0.9       | ) | $ | 9.1 |   |
|                  |       |                |       |             |       |              |       |             |       |
| 2004                  |       | 8.6                 |       | 2.3              |       | (3.5              | )          | 7.4              |       |
|                  |       |                |       |             |       |              |       |             |       |
| 2003                  |       | 5.5                 |       | 3.1              |       | —            |       | 8.6              |       |
|                       |            |                     |            |                  |            |                   |            |                  |            |  |  |  |  |

 

----

(a)                   Includes $2.0 million additions from VISX Acquisitionand $0.6 million charged to earnings in 2005.

(b)                  Accounts written off.

 

S-8

----