|UNITED STATES
                                                  SECURITIES AND EXCHANGE COMMISSION
                                                        WASHINGTON, D.C. 20549



FORM 10-KFOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

||X| | ANNUAL
REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For fiscal year
ended December 31, 2004
|--- | ----------------------------------------------------------------------------------------------------------------------------

|Commission file
number: 0-22340


PALOMAR MEDICAL TECHNOLOGIES, INC.(Exact name of registrant as specified in its charter)
|--------------------------------------------------------------------------------------------------------------------------

|Delaware(State or other jurisdiction ofincorporation or organization) | 04-3128178(I.R.S. Employer Identification No.)
|--------------------------------------------------------------------- | ----------------------------------------------

|82 Cambridge StreetBurlington, MA(Address of principal executive offices) | 01803(Zip Code)
|------------------------------------------------------------------------- | ---------------

|(781) 993-2300(Issuers telephone number, including area code)


Securities
registered pursuant to Section 12 (b) of the Act: None
|----------------------------------------------------------------------------------------------------------------------------------

|Securities registered pursuant to Section 12 (g) of the Act:Common Stock, $.01 par value


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes |X|     No |_|


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this Form 10-K. |_|


Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the  Act). Yes |X|     No |_|


The aggregate market value of the voting and non-voting common equity (based upon the closing price reported by Nasdaq on
June 30, 2004) of Palomar Medical Technologies, Inc., held by nonaffiliates was $204,869,095.  For purposes of this disclosure,
shares of common stock held by entities and individuals who own 5% or more of the outstanding common stock and shares of common stock
held by each officers and directors have been excluded in that such persons may be deemed to be "affiliates" as that term is defined
under the rules and regulations of the Securities Exchange Act of 1934.  This determination of affiliate status is not necessarily
conclusive.


As
of March 9, 2005, 16,708,069 shares of common stock were issued and outstanding.


DOCUMENTS
INCORPORATED BY REFERENCE

         
Portions of the registrant's definitive proxy statement to be filed prior to April 30, 2004, pursuant to Regulation 14A of
the Securities Exchange Act of 1934, are incorporated by reference into Part III of this Form 10-K.
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|TABLE OF CONTENTS
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|           |  |                                                                            | Page No.
|---------- |  | -------------------------------------------------------------------------- | --------
|PART
I     |  |                                                                            |         
|           | 
|Item 1.    |  | Business                                                                   |         
|           | 
|Item
2.    |  | Properties                                                                 |         
|           | 
|Item
3.    |  | Legal Proceedings                                                          |         
|           | 
|Item
4.    |  | Submission of Matters to a Vote of Security Holders                        |         
|           | 
|PART II    | 
|           | 
|Item
5.    |  | Market for Registrants Common Equity and Related Stockholder Matters      |         
|           | 
|Item
6.    |  | Selected Financial Data                                                    |         
|           | 
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results    |         
|           |  | of Operations                                                              |         
|           | 
|Item
7A.   |  | Quantitative and Qualitative Disclosures About Market Risk                 |         
|           | 
|Item
8.    |  | Financial Statements and Supplementary Data                                |         
|           | 
|Item
9.    |  | Changes in and Disagreements with Accountants on Accounting and            |         
|           |  | Financial Disclosures                                                      |         
|           | 
|Item
9A.   |  | Controls and Procedures                                                    |         
|           | 
|PART III   | 
|           | 
|Item
10.   |  | Directors and Executive Officers of the Registrant                         |         
|           | 
|Item
11.   |  | Executive Compensation                                                     |         
|           | 
|Item
12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related |         
|           |  | Stockholder Matters                                                        |         
|           | 
|Item
13.   |  | Certain Relationships and Related Transactions                             |         
|           | 
|Item
14.   |  | Principle Accountant Fees and Services                                     |         
|           | 
|PART IV    | 
|           | 
|Item
15.   |  | Exhibits, Financial Statement Schedules and Reports on Form 8-K            |         
|           | 
|SIGNATURES |  |                                                                            | 57      

|
|

|PART I




Item 1.
Business


Introduction


Palomar
Medical Technologies, Inc. (Palomar) is a leading researcher and developer of
light based systems for hair removal and other cosmetic procedures. Throughout its
history, Palomar has remained on the forefront of technology:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 1996
Palomar introduced the first high powered laser hair removal system
| | - | ------------------------------------------------------------------------

| |  | 1997
Palomar obtained FDA clearance for the first high powered laser hair removal system
| | - | ----------------------------------------------------------------------------------------

| |  | 1997
Palomar was first to obtain FDA clearance for high power diode laser system
| | - | --------------------------------------------------------------------------------

| |  | 1998
Palomar was the first to obtain FDA clearance for permanent hair reduction
| | - | -------------------------------------------------------------------------------

| |  | 1999
Palomar was first to obtain FDA clearance for sub-zero cooled laser system
| | - | -------------------------------------------------------------------------------

| |  | 2000
Palomar was first to obtain FDA clearance for a super long pulse laser system
| | - | ----------------------------------------------------------------------------------

| |  | 2001
Palomar introduced the cost effective and upgradeable Lux Platform
| | - | -----------------------------------------------------------------------

| |  | 2001
Palomar introduced the Q-Yag5(TM)system for tattoo and pigmented lesion removal
| | - | ------------------------------------------------------------------------------------

| |  | 2003
Palomar signed a Development and License Agreement with The Gillette Company (NYSE: G) to complete development and
commercialize a patented home-use, light based hair removal device for women
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2004
Palomar signed a Development and License Agreement with The Gillette Company (NYSE: G) to complete development and
commercialize a patented home-use, hair removal device for women
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2004
Palomar introduced the StarLux Pulsed Light and Laser system which incorporates a single power supply system capable of
              operating both lasers and lamps
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2004
Palomar was awarded a research contract by the Department of the Army to develop a light based self-treatment device
              for Pseudofolliculitis Barbae
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2004
Palomar signed a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc ("JJCC"), a Johnson &
              Johnson company (NYSE: JNJ), to develop, clinically test and potentially commercialize home-use, light based devices for
              (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or
              preventing acne
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar is continuously researching,
developing and testing new and exciting innovations to further advance the hair removal
market and other cosmetic applications, including fat reduction, acne treatment and skin
rejuvenation. With its unique focus on both the professional and consumer markets, Palomar
is positioned to capitalize on the ever expanding market for improving personal
appearance.


Palomar
was organized in 1987 to design, manufacture, market and sell lasers and other light based
products and related disposable items and accessories for use in medical and cosmetic
procedures. In December 1992, Palomar filed its initial public offering. Subsequently,
Palomar pursued an acquisition program, acquiring companies in its core laser business as
well as others, principally in the electronics industry, in order to spread risk and
bolster operating assets. By the beginning of 1997, Palomar had more than a dozen
subsidiaries. At the same time, having obtained FDA clearance to market its EpiLaser®
ruby laser hair removal system in March 1997, Palomar was well positioned to focus on what
it believed was the most promising product in its core laser business. Hence, under the
direction of a new board and management team, Palomar undertook a program in 1997, which
was completed in May of 1998, of exiting from all non-core businesses and investments and
focusing only on those businesses, which it believed, held the greatest promise for
maximizing stockholder value. Palomars exclusive focus then became the use of lasers
and other light based products in dermatology and cosmetic procedures.


In
December 1997 and January 1998, respectively, Palomar was the first company to receive FDA
clearance for a diode laser for hair removal and for leg vein treatment, the
LightSheer diode laser system manufactured by Star Medical Technologies, Inc.
(Star), a former subsidiary of Palomar. The LightSheer was the first
generation of high-powered diode lasers designed for hair removal, and like Palomars
EpiLaser and other prior hair removal products, the LightSheer incorporated technology
protected by patents licensed exclusively to Palomar from The Massachusetts General
Hospital Corporation (Massachusetts General Hospital).


On
December 7, 1998, Palomar entered into an Agreement with Coherent, Inc. (Coherent Medical
Group, a former subsidiary of Coherent, was subsequently sold to ESC Medical, now known as
Lumenis, Inc. and hereinafter referred to as Lumenis) to sell all
of the issued and outstanding common stock of Palomars subsidiary, Star. Palomar
completed the sale of Star to Lumenis on April 27, 1999.




-1-
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|On
February 14, 2003, Palomar entered into a Development and License Agreement with The
Gillette Company to complete development and commercialize a home-use, light based hair
removal device for women. Palomar believes that this device will be protected by multiple
patents within its patent portfolio. (See Note 12, Development and License Agreement
with Gillette and exhibit 10.14, The Development and License Agreement with
The Gillette Company effective February 14, 2003 with redacted exhibits.) On June
28, 2004 Palomar and Gillette announced that they completed the initial phase of their
agreement and that both parties would move into the next phase. In conjunction with
entering this next phase, the parties amended the agreement to provide for additional
development funding to further technical innovations.


On
February 18, 2004, Palomar announced that it was awarded a $2.5 million research contract
by the Department of the Army to develop a light based self-treatment device for
Pseudofolliculitis Barbae, or PFB, commonly known as razor bumps. Though the
project was scheduled to last for nineteen months, Palomar now believes it will need
several more months to complete the work.


On
September 1, 2004 Palomar entered into a Development and License Agreement with Johnson
& Johnson Consumer Companies, Inc (JJCC), a Johnson & Johnson company,
to develop, clinically test and potentially commercialize home-use, light based devices
for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of
skin aging; and (iii) reducing or preventing acne. Palomar believes that these devices
will be protected by multiple patents within its patent portfolio. (See Note 13,
Joint Development and License agreement with Johnson & Johnson Consumer
Companies (JJCC), a Johnson & Johnson company and exhibit 10.24,
Joint Development and License Agreement By and Between Palomar Medical Technologies
and Johnson and Johnson Companies, Inc. dated September 1, 2004).


Palomar
has one operating subsidiary, Palomar Medical Products, Inc. located at Palomars
headquarters in Burlington, Massachusetts, which oversees the manufacture and sale of
Palomars lamp and laser based systems currently on the market.


Financial Information
About Industry Segments


Palomar
conducts business in one industry segment, medical and cosmetic products and services.


Principal Products


Palomar researches,
develops, manufactures, markets, sells and services light based products used to perform
procedures addressing medical and cosmetic concerns. Palomar offers a comprehensive range
of products based on proprietary technologies that include, but are not limited to:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Hair removal
| | - | ------------

| |  | Non-invasive treatment of facial and leg veins and other benign vascular lesions, such as rosacea, spider veins, port wine
                stains and hemangiomas
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Removal of benign pigmented lesions such as age and sun spots
| | - | -------------------------------------------------------------

| |  | Tattoo removal
| | - | --------------

| |  | Acne treatment
| | - | --------------

| |  | Wrinkle removal
| | - | ---------------

| |  | Pseudofolliculitis Barbae or PFB treatment
| | - | ------------------------------------------

| |  | Treatment of red pigmentation in hypertrophic and keloid scars
| | - | --------------------------------------------------------------

| |  | Treatment of verrucae, skin tags, seborrheic keratosis
| | - | ------------------------------------------------------

| |  | Deep tissue heating for relief of muscle and joint pain
| | - | -------------------------------------------------------

| |  | Other skin treatments
| | - | ---------------------

|Market
surveys report that the great majority of men and women in the United States, and many
other parts of the world, employ one or more techniques to temporarily remove hair from
various parts of the body, including waxing, depilatories, tweezing and shaving. Compared
to these hair removal techniques, Palomars light based hair removal processes
provide significantly longer-term cosmetic improvement. Compared to other light based hair
removal devices, Palomars Lux platform is more versatile, treats larger areas in
less time, are less painful and are more cost effective.




-2-
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|Lux
Platform. With increasing market acceptance of light based treatments for
new applications, Palomar recognized the need for a cost effective platform that could
expand with the needs of customers. In 2001, Palomar announced the first product with the
Lux Platform: the EsteLux® Pulsed Light System. The EsteLux was first sold with the
LuxY handpiece for hair removal and treatment of pigmented lesions. In rapid
succession, Palomar developed five additional handpieces: LuxG, LuxR,
LuxRs, LuxB and LuxV, allowing customers to add additional applications
to their treatment portfolio and provide specifically tailored procedures.  In March
2003 at the American Academy of Dermatology tradeshow, Palomar introduced the higher
priced MediLux Pulsed Light System with the same six handpieces, but also with
higher power, faster repetition rate and a newsnap-on connector for faster changes
between handpieces. In October 2003, Palomar introduced the lower cost NeoLux Pulsed
Light System with three handpieces, the LuxY, LuxR and LuxRs, specifically targeted at the
beauty industry. In February 2004, Palomar enhanced the upgrade
opportunities for its customers with the introduction of the StarLux Pulsed Light
and Laser System with increased power, a computer controlled touch screen, instant
handpiece recognition, active contact cooling, and a long pulse Nd:YAG laser handpiece,
the Lux 1064. The StarLux began shipping in June of 2004. In January 2005, the Lux 1064
laser handpiece received FDA clearance, and in February 2005, Palomar introduced the
VisiLux 1064 handpiece with a digital camera and visualization screen for improved
imaging and treatment. In February 2005, Palomar introduced a new infrared handpiece,
the Lux IR.


The
Lux systems offer a suite of applications at a fraction of the cost of other competing
systems. Customers can invest in their first Lux system with one handpiece then purchase
additional handpieces as their practice grows and upgrade into a more powerful Lux system
when ready. The Lux platform enables Palomar to custom tailor products to fit almost any
professional medical office or spa location and provides customers with the comfort that
the system is able to grow with their practice. The StarLux, MediLux, EsteLux and NeoLux
systems are affordable and versatile cosmetic light based systems.


In
addition to being cost effective and upgradeable, the platform includes many technological
advances. For example, the platform includes Palomars Smooth Pulse technology which
sets a new standard in safe and comfortable treatments. The Smooth Pulse technology
spreads power evenly over the entire pulse of light allowing Palomar to provide ideal
wavelengths for faster results in fewer treatments. By contrast, competitive systems
deliver a power spike at the beginning of each pulse which can cause injury at the most
effective wavelengths. The Smooth Pulse technology also extends the life of the light
source allowing Palomar to offer one year, unlimited pulse count warranties or up to
100,000 pulses which ever occurs first on most lamp handpieces.
Palomar sells replacement handpieces
to existing customers providing a reoccurring revenue stream.


The
Lux pulsed light handpieces combine the latest technology with simple, streamlined
engineering that is both effective and economical. Long pulse widths and SpectruMax
filtering provide increased safety and efficacy. Efficacy is further improved through
Palomars Photon Recycling process which increases the effective fluence by capturing
light scattered out of the skin during treatments and redirecting it back into the
treatment target. Offering the largest spot size on the market and high repetition rates
allows for a fast coverage rate which is especially important when removing hair from
large areas such as legs and backs. A back or a pair of legs can be treated in
approximately thirty minutes, and a smaller area, such as the underarms, in even less
time. The systems simple operation opens its applications to a wider band of
worldwide users.


     EsteLux.
          During 2001, Palomar received FDA clearance to market and sell the Palomar
          EsteLux Pulsed Light System. In 2002 and 2003, Palomar offered six
          handpieces for the EsteLux system: LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV. These
          handpieces emit pulses of intense light to treat unwanted hair, solar lentigo
          (sunspots), rosacea, actinic bronzing, spider veins, birthmarks,
          telangiectasias, acne and more. The LuxY handpiece is used for hair removal for
          large body areas and for pigmented lesion treatments. The LuxG handpiece
          delivers the RejuveLux process  photofacial treatments that remove
          pigmented and vascular lesions to improve skin tone and texture. The LuxR
          handpiece can be used to remove hair on all skin types, from the fairest to the
          darkest, including deep tans. Likewise, the LuxRs handpiece can be used to
          remove hair on all skin types, but it has concentrated power in each pulse
          resulting in permanent hair reduction in fewer treatments. The LuxB handpiece
          provides effective treatment of lighter pigmented lesions on fair skin as well
          as leg and spider veins, and the LuxV handpiece treats pigmented lesions and
          mild to moderate acne. With these complimentary handpieces, the Lux Platform is
          one of the most affordable and multifaceted systems in the market.


     MediLux.
          In March 2003, Palomar launched the Palomar MediLux Pulsed Light System
          with the six handpieces also available on the EsteLux. The MediLux provides
          increased power, a faster repetition rate and a newsnap-on connector
          making it easier to switch among handpieces and provide treatments tailored to
          each individual being treated.


-3-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|NeoLux.
          In October 2003, Palomar launched the Palomar NeoLux Pulsed Light System,
          a less complex and less expensive system. The NeoLux is designed for the spa and
          salon market. A three button control panel enables easy operation and training.
          The NeoLux operates with the LuxY, LuxR and LuxRs handpieces to treat pigmented
          lesions and provide for hair removal on all skin types.


     StarLux.
          In February 2004, Palomar launched the Palomar StarLux Pulsed Light
          System, and in June 2004, Palomar began shipping this system. The StarLux has a
          single power supply capable of operating both lasers and lamps. The StarLux
          includes increased power, integrated contact cooling and a full color touch
          screen for easy operation. Currently, the StarLux operates five of the EsteLux /
          MediLux handpieces, namely the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition,
          the increased power of the StarLux allows for the operation of a long pulse
          Nd:YAG laser handpiece, the Lux1064. In January 2005, the Lux 1064 laser
          handpiece received FDA clearance for a variety of applications, including but
          not limited to removal of pigmented and vascular lesions, including visible leg
          veins, tattoo and hair removal, treatment of wrinkles, removal of red
          pigmentation in hypertrophic and keloid scars and treatment of
          pseudofolliculitis barbae. The Lux1064 is a high power laser handpiece
          to feature Smooth Pulse technology and Active Contact Cooling while also
          providing multiple spot sizes. Palomars patented Active Contact Cooling
          technology sends a chilled water supply through the handpieces, thus cooling the
          skin before, during, and after treatment. This unique feature ensures maximum
          safety and comfort during treatment. The StarLuxs high-powered treatments
          deliver long-lasting and even permanent results. For the lamp handpieces,
          fluences up to 50 J/cm2, the largest available spot size (up to 16 x
          46 mm), and a wide spectrum of optimal wavelengths (400-1400 nm), provide
          outstanding efficacy. With fluences up to 700 J/cm2, the Lux 1064
          provides visible leg vein removal. The StarLux full-color screen
          allows easy finger-touch operation and instant handpiece recognition while
          providing constant feedback on operating parameters. In February 2005, Palomar
          introduced the VisiLux 1064 handpiece which includes a digital camera and
          a visualization screen to provide enhanced imaging and magnification of the area
          of skin to be treated to increase ease of use and improve treatment. In February
          2005, Palomar also introduced a new infrared handpiece, the Lux IR, for deep
          tissue heating for relief of muscle and joint pain (pending FDA clearance).
          Palomar expects to seek further FDA clearances for the Lux IR including skin
          tightening, skin lifting and wrinkle removal.


Q-YAG
5. During 2001, Palomar received FDA clearance to market and sell the
Palomar Q-YAG 5 system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5
is a Q-switched, frequency-doubled Neodymium laser. This laser system
allows users to switch between a 1064-nm single-wavelength beam and a 1064/532-nm
mixed-wavelength beam. The combination of wavelengths allows users to treat a full
spectrum of colors and inks, and the systems design lowers costs and allows broader
use of the instrument. The single 1064-nm wavelength is ideal for treating darker tattoo
inks and dermal-pigmented lesions, such as Nevi of Ota common in Japan and other Pacific
Rim countries. The mixed 1064/532-nm wavelength is better suited for brighter colors and
epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength
permits brighter, more superficial and deeper and darker target areas to be treated
simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it
smaller and lighter than competitive systems, which is especially desirable for mobile
and/or small physician offices. These attributes reduce the cost, increase the reliability
of the system and eliminate costly optics and service problems that are common with other
high power Q-Switched lasers.


Legacy
Products.Palomar no longer sells the EpiLaser or E2000 hair
removal laser systems, the RD-1200 Q-switched ruby laser or SLP1000® Diode Laser
System. However, Palomar continues to service these systems. During 1996, using
Palomars core ruby laser technology, originally developed for tattoo removal and
pigmented lesions, Palomar developed a long pulse ruby laser, the EpiLaser, that was
specifically configured to allow the appropriate wavelength, energy level and pulse
duration to be absorbed effectively by the hair follicle without being absorbed by the
surrounding tissue. That, combined with a cooling handpiece, allowed for safe and
effective hair removal. In March 1997, Palomar was the first company to receive FDA
clearance to sell and market a ruby laser (the EpiLaser system) in the U.S. for hair
removal. The Palomar EpiLaser was cleared by the FDA for permanent hair reduction in March
1998. During 1998, Palomar introduced its second-generation ruby laser, the Palomar
E2000 hair removal laser system; a product that was superior to hair removal lasers
then available in a number of respects, including speed and efficacy. The FDA cleared the
E2000 for permanent hair reduction. The RD-1200 is a Q-switched ruby laser for
tattoo removal and treating pigmented lesions. The SLP1000 is a high-powered diode laser
that delivers energy over a relatively long time period using a technology called
Super Long Pulse Technology. The SLP1000 is the first diode laser using Super
Long Pulse Technology and interchangeable handpieces to provide hair removal and vascular
lesion treatments to virtually all skin types. In addition, the SLP1000 is compact and
easy to use.



-4-
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---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Sales,
Marketing and Distribution


As
of December 31, 2004, Palomars sales and marketing organization consisted of 41
employees. Palomars direct sales representatives operate within their respective
regions and engage customers directly and employ targeted lead generation programs such as
regional seminars. Palomar also manages customer opportunities through Palomars
strategic distribution relationships with exclusive distributors.


Direct Sales Force


Palomar
sells products in the U.S. primarily through its direct sales force to dermatologists,
cosmetic surgeons and general practitioners as well as to other licensed practitioners.
Palomars domestic direct sales force is organized into regions and each region is
managed by a regional sales manager. Palomars direct relationships with its
customers are generally governed either by customer purchase orders and Palomars
acknowledgement of those orders or by purchase contracts.


Global Distribution


In
Palomars international sales and marketing efforts, Palomar employs a global network
of strategic distributors. Palomar has established distribution relationships throughout
Europe, Japan, Australia, South and Central America, the Far East, and the Middle East. As
of December 31, 2004, Palomar utilized 35 distributors in 45 countries. Generally,
Palomars distributors enter into a one to two year agreement not to sell our
competitors products. Palomars sales strategy is to choose the most productive
and practicable distribution channel within each of its geographic markets.


The
following table shows product revenue relating to Palomars international sales
activities during each of the last three fiscal years by geographic region:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2004 | 2003 | 2002
|------------------------- | ---- | ---- | ----
|United States             |      | 63   | %   
|Japan                     |      | 10   |     
|Canada                    |      | 10   |     
|Europe                    |      | 7    |     
|Australia                 |      | 3    |     
|Asia/Pacific              |      | 6    |     
|South and Central America |      | 1    |     
|                          |     
|Total                     |      | 100  | %   
|                          |     

|Customer Service and
Support


Palomar
believes that a broad range of support services is essential to the successful deployment
and ongoing support of its products. In most cases, Palomars customer service and
support organization provides front line product support and is the problem resolution
interface. Palomar firmly believes that quick and effective delivery of service is
essential to Palomars customers. Palomar offers the following services: technical
assistance, hardware repair and replacement, loaner equipment to minimize end user
disruption, and professional and educational services.


Palomars
customer service center and depot repair facility is located at Palomars Burlington,
Massachusetts headquarters. Certain independent distributors also maintain service centers
and parts depots at their facilities and are required to attend Palomars formal
training to become certified in the repair and maintenance of each of Palomars
products.


Product
maintenance and repair following the warranty period provides an additional recurring
source of revenue. Customers may elect to purchase a service contract or purchase service
on a time-and-materials basis. Palomars service contracts vary by the type of system
and the level of service desired by the customer and typically last for one year. Initial
warranties on most products cover parts, service and shipping charges for twelve months.
Customers have the option to purchase an extended warranty (beyond the normal one year
coverage) as part of the purchase.



-5-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomars
customer service center not only provides technical assistance for each product line but
also provides the option to the end user to purchase additional service contracts,
replacement Lux handpieces, end-user marketing materials, and other complementary
accessory items. Palomar expects that as the Lux product installed base expands, product
revenue generated from the sale of replacement Lux handpieces will increase.


Products Under Development


Palomar
is engaged in developing products for the dermatology and cosmetic market. Products under
development include lasers, lamps and other light based products for the removal of
unwanted hair, tattoos, pigmented lesions, leg vein and other vascular lesions, acne, fat,
cellulite, and skin rejuvenation, including wrinkles and skin tone and texture. Palomar
performs its own research as well as with partners, including The Massachusetts General
Hospital Corporation (Massachusetts General Hospital). Product development is
performed by scientists and engineers at Palomars headquarters. Palomar directs
resources at both new products for existing markets such as the removal of unwanted hair,
vascular and pigmented lesions and tattoos, acne and wrinkle removal, and other products
for new markets, such as fat reduction, including treatment of cellulite.


On
February 14, 2003, Palomar entered into a Development and License Agreement with Gillette
to complete development and commercialize a home-use, light based hair removal device for
women. Palomar believes that this device will be protected by multiple patents within its
patent portfolio. This consumer hair removal device is expected to be safe and effective
for use on womens legs, underarms, bikini line and other areas where a woman might
find it necessary to shave, apply hair-removal creams, or undergo waxing, electrolysis, or
laser or other light based professional treatments in a doctors office, clinic, spa
or salon. The parties have completed the first phase and have decided to move into the next phase. The
original agreement provided up to $7 million in initial development support funding to be
paid by Gillette to Palomar over approximately the first 30 months of the agreement. Under
a June 2004 amendment, Gillette agreed to provide $2.1 million in additional development
funding over a 9-month extension of the development phase, which is now planned to be
completed by August 31, 2006. In 2004, Gillette provided $3.1 million in funded product
development. (See Note 12, Development and License Agreement with Gillette and
exhibit 10.14, The Development and License Agreement with The Gillette Company
effective February 14, 2003 with redacted exhibits)


On
February 18, 2004, Palomar announced that it was awarded a $2.5 million research contract
by the Department of the Army to develop a light based self-treatment device for
Pseudofolliculitis Barbae or PFB, commonly known as razor bumps. Though the
project was scheduled to last for nineteen months, Palomar believes it will need
several more months to complete the work. PFB is called the most significant
dermatologic disease in the US Army in an article by Brauner GJ, Flaudesmeyer KL.
entitled Pseudofolliculitis barbae: Medical consequences of interracial friction in
the US Army, Cutis, 1979, 23:61-66. PFB affects combat readiness, unit cohesion, and
individual morale of over 50% of African American and Hispanic military personnel
according to an article by Perry PK, Cook-Bolden FE, et al. entitled Defining
pseudofolliculitis barbae in 2001", JAAD, 2002, 46:S113-S119. The importance of a
solution to the PFB problem is increasing along with the changing demographics of the
military. According to Semiannual Race/Ethnic/Gender Profile by Service/Rank, Sept. 2000
the percentage of African-Americans and Hispanics in the services is currently twice that
in the civilian population and growing. Palomar believes that this device will be
protected by multiple patents within its patent portfolio.


As of September 1, 2004, Palomar entered into a Joint Development and License Agreement with Johnson & Johnson
Consumer Companies, Inc. (JJCC), a Johnson & Johnson company, to develop and commercialize home-use, light based
devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging;
and (iii) reducing or preventing acne. The agreement provides for JJCC to fund Palomar's research and clinical studies during
an initial proof-of-principle phase. At the end of the proof-of-principle phase, JJCC will decide whether or not to
continue with one or more of the devices in one or more of the fields into a development phase. Upon JJCC deciding to
continue, JJCC will be obligated to fund the development of the selected devices.  If JJCC decides not to continue, Palomar
may proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a
different party.  At the end of the development phase, JJCC will decide whether or not to commercialize one or more of
the devices in one or more fields. Upon JJCC deciding to commercialize one or more of the devices, JJCC will make
payments to Palomar for each selected field.  Upon commercial launch of the first device in each selected field, JJCC will
make a payment to Palomar, and for all devices sold for use in each selected field, JJCC shall pay Palomar a percentage of sales of
such devices and certain topical compounds.  If JJCC decides not to commercialize or fails to launch a device, Palomar may
proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a different party.  Palomar recognized $318,000 of funded
product development revenues from JJCC during the twelve months ended December 31, 2004.  Any amounts received in advance
of services performed are recorded as deferred revenue. Payments are not refundable if the development is not successful.
(See Note 13, Joint Development and License agreement with Johnson & Johnson Consumer Companies (JJCC), a Johnson &
Johnson company and exhibit *10.27 Joint Development and License Agreement by and between Palomar Medical Technologies,
Inc. and Johnson and Johnson Companies, Inc., dated September 1, 2004 (filed as Exhibit 99.1 to our Current Report on
Form 8-K, filed with the SEC on September 7, 2004, and incorporated herein by reference)




Production, Sources and
Availability of Materials


Palomars
manufacturing operations are located in Burlington, Massachusetts. Palomar maintains
control of and manufactures most key subassemblies in-house. Manufacturing consists of the
assembly and testing of components purchased from outside suppliers and contract
manufacturers. Each fully assembled system is subjected to a rigorous set of tests prior
to shipment to the customer or distributor. Palomar has obtained ISO 9001, ISO 13485, CDN
MDR, and Council Directive 93/42/EEC. Palomar is registered with the Federal Food and Drug
Administration.


Palomar
depends and will depend upon a number of outside suppliers for components used in its
manufacturing process. Most of Palomars components and raw materials are available
from a number of qualified suppliers. If Palomars suppliers are unable to meet
Palomars requirements on a timely basis, production could be interrupted until an
alternative source of supply is obtained. In 2002 and early 2003, Palomar experienced
significant failures and delays in a critical raw material component required for the SLP
1000. Although the component vendor has rectified the problem, there can be no assurance
that this situation will not re-occur in the future. Palomar has not experienced any other
delays in raw material for its products.


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|Patents and Licenses


Palomars
success and ability to compete are dependent on its ability to develop and maintain
proprietary technology and operate without infringing on the proprietary rights of others.
Palomar relies on a combination of patents, trademarks, trade secret and copyright laws
and contractual restrictions to protect its proprietary technology. These legal
protections afford only limited protection for its technology. Palomar is presently the
exclusive licensee of two United States patents and the non-exclusive licensee of three
United States patents and corresponding foreign patents and pending applications owned by
Massachusetts General Hospital, and Palomar is also the joint owner with and exclusive
licensee of Massachusetts General Hospital of three other United States patents and
corresponding foreign patent and pending applications. In addition, Palomar is the sole
owner of nine United States patents and corresponding foreign patent and pending
applications, and Palomar has rights to other patents under exclusive and non-exclusive
licenses.


Palomar
seeks to limit disclosure of its intellectual property by requiring employees, consultants
and any third party with access to Palomars proprietary information to execute
confidentiality agreements with Palomar and often agreements that include assignment of
rights provisions to Palomar. Due to rapid changes in technology, Palomar believes that
factors such as the technological and creative skills of its personnel, new product
developments and enhancements to existing products are as important as the various legal
protections of Palomars technology to establishing and maintaining a leadership
position.


Despite
Palomars efforts to protect its proprietary rights, unauthorized parties may attempt
to copy aspects of the products or to obtain and use information that Palomar regards as
proprietary. Policing unauthorized use of Palomars products is difficult. Litigation
may be necessary to enforce intellectual property rights, to protect our trade secrets, to
determine the validity and scope of the proprietary rights of others or to defend against
claims of infringement or invalidity. Any such resulting litigation could result in
substantial costs and diversion of resources and could have a material adverse effect on
the business, operating results and financial condition. There can be no assurance that
Palomars means of protecting proprietary rights will be adequate or that
Palomars competitors will not independently develop similar technology. Any failure
by Palomar to meaningfully protect Palomars proprietary rights could have a material
adverse effect on its business, operating results and financial condition.


Management
believes that none of Palomars current products infringe upon valid claims of
patents owned by third parties. However, there have been claims and there can be no
assurance that third parties will not make further claims of infringement with respect to
our current or future products.Any such claims, with or without merit, could be
time-consuming to defend, result in costly litigation, divert managements attention
and resources, cause product shipment delays or require us to enter into royalty or
licensing agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to us or at all. A successful claim of intellectual property
infringement against us and our failure or inability to license the infringed technology
or develop or license technology with comparable functionality could have a material
adverse effect on our business, financial condition and operating results. (See
Cautionary Statements.)


In
August 1995, Palomar entered into an agreement with The Massachusetts General Hospital
Corporation whereby Massachusetts General Hospital agreed to conduct clinical trials on a
laser treatment technology for hair removal developed at Wellman Laboratories of
Photomedicine (Clinical Trial Agreement). In July 1999, Palomar amended this
agreement to extend its research relationship for an additional five years, until August
2004, and to cover the additional fields of non-invasive, electromagnetic targeting of
subcutaneous fat, and treatment of sebaceous glands and related skin disorders (e.g.,
acne) using infrared light except when externally applied chromophores are used. On August
1, 2004 Palomar and Massachusetts General Hospital entered into a new agreement (the
Research Agreement) whereby Massachusetts General Hospital agreed to conduct
clinical and non-clinical research in the field of photo thermal removal or reduction of
hair, using light (hereinafter referred to, as hair removal,). The Research
Agreement has a term of three years, until August 2007, and Palomar will provide
Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct
and indirect costs of the research.


Palomar
also entered into a license agreement with Massachusetts General Hospital in August of
1995 (License Agreement) through which Palomar is the exclusive licensee of
certain U.S. and foreign issued patents and pending patent applications in the field of
hair removal, including U.S. Patent Nos. 5,595,568 and 5,735,844, European Patent Nos. 0
806 913 B1 and EP 1 230 900 B1 and Chinese Patent No. ZL96191751.2. At an opposition
hearing held December 1, 2004, EP 0 806 913 B1 was revoked and such revocation is being
appealed by Palomar and Massachusetts General Hospital. Under the Clinical Trial Agreement
and a joint patent agreement many joint patent applications have been filed. Palomar is a
joint owner of such joint patent applications On February 18, 2003, Palomar and
Massachusetts General Hospital signed a fourth amendment to the License Agreement,
providing Palomar with exclusive licenses in all fields to existing and future joint
patents and applications provided Palomar meets certain due diligence obligations.

-7-
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|Palomar
has the right to sublicense patents licensed to it under the License Agreement. Palomar
pays Massachusetts General Hospital royalties on sales of Palomars products covered
by these licensed patents and a percentage of the royalties Palomar receives from its
sub-licensees. Palomar currently sublicenses certain competitors to U.S. Patent Nos.
5,595,568 and 5,735,844 and foreign counterparts. One of these licensees is Lumenis, Inc.
On June 17, 2004, Palomar and Lumenis settled their on-going litigation concerning both
patent infringement and contractual matters and Lumenis agreed to pay $4.09 million over the
next six quarters for royalties due on sales of its LightSheer system made between July 1,
2002 and December 31, 2003. Beginning on January 1, 2004, Lumenis agreed to pay Palomar a
5% royalty on sales of the LightSheer and other professional laser hair removal devices
and modules. In addition, Lumenis granted Palomar a paid up license to a variety of
Lumenis patents for Palomars light based devices and Palomar granted Lumenis a
paid up license to the 568 and 844 patents for Lumenis lamp based
devices. Importantly, both parties have agreed to the validity and enforceability of each
others patents and not to challenge such validity and enforceability in the future.


Palomar
also licenses Gillette, to U.S. Patent Nos. 5,595,568 and 5,735,844 and foreign
counterparts and other patents for the development and commercialization of a home-use,
light based hair removal device for women. Palomar licenses JJCC to other patents for the
development and commercialization of home-use, light based devices for reducing fat
including cellulite, reducing appearance of skin aging, and reducing or preventing acne.


Dependence on a Single
Customer


For
the years ended December 31, 2004, 2003 and 2002, Palomar had two customers that accounted
for 9%, 20% and 35% of net sales, respectively. At December 31, 2004, 2003 and 2002, these
customers accounted for 6%, 20% and 27% of trade receivables outstanding, respectively.


-8-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Backlog


Palomar
generally does not maintain a high level of backlog. As a result, Palomar does not believe
that its backlog at any particular time is indicative of future sales levels.


Competition


The
market in which Palomar is engaged is subject to intense competition and rapid
technological change. Some of Palomars competitors have greater financial,
marketing, and technical resources than that of Palomar. Moreover, some competitors have
developed, and others may attempt to develop, products with applications similar to that
of Palomar. Palomar expects that there may be further consolidation of companies within
the light based industry via acquisitions, partnering arrangements or joint ventures.
Palomar competes primarily on the basis of technology, product performance, price,
quality, reliability, distribution and customer service and support. To remain
competitive, Palomar will be required to continue to develop new products and periodically
enhance its existing products. (See Cautionary Statements.)


Food and Drug
Administration Regulations


All
of Palomars current products are light based devices, which are subject to FDA
regulations for clinical testing, manufacturing, labeling, sale, distribution and
promotion. Before a new product or a new use of or claim for an existing product can be
marketed in the United States, Palomar must obtain clearance from the FDA. The types of
medical devices that we seek to market in the United States generally must receive either
510(k) clearance or PMA approval in advance from the U.S. Food and
Drug Administration (FDA) pursuant to the Federal Food, Drug, and Cosmetic
Act. The FDAs 510(k) clearance process usually takes from three to twelve months,
but it can last longer. The process of obtaining PMA approval is much more costly and
uncertain and generally takes from one to three years or even longer. To date, the FDA has
deemed Palomars products eligible for the 510(k) clearance process. Palomar believes
that most of its products in development will receive similar treatment. However, Palomar
cannot be sure that the FDA will not impose the more burdensome PMA approval process upon
one or more of future products, nor can Palomar be sure that 510(k) clearance or PMA
approval will ever be obtained for any product it proposes to market and failure to do so
could adversely affect Palomars ability to sell products.


Number of Employees


As
of December 31, 2004, Palomar employed 161 persons. Palomar is not subject to any
collective bargaining agreements, has never experienced a work stoppage and considers its
relations with its employees to be good.


SEC Filings Available on
Website


Palomars
internet website address is www.palomarmedical.com. Palomars annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and
Exchange Act of 1934 are available free of charge through Palomars internet website as soon as
reasonably practicable after Palomar files such material with, or furnish it to, the Securities
and Exchange Commission.


Item 2. Properties


Palomar
occupies approximately 44,000 square feet of office, manufacturing and research space in
Burlington, Massachusetts under a lease expiring in August 2009. Palomar believes that
this facility is in good condition and is suitable and adequate for its current
operations.


Item 3. Legal Proceedings


On
February 15, 2002, Palomar commenced an action for patent infringement in the United
States District Court for the District of Massachusetts against Altus Medical, Inc., now
known as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint
alleges Cuteras CoolGlide and CoolGlide Excel laser systems willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to Palomar by the Massachusetts
General Hospital. The Massachusetts General Hospital was added as a plaintiff in this
lawsuit. Cutera answered the complaint denying that its products infringe the asserted
patent and filed a counterclaim seeking a declaratory judgment that the asserted patent is
invalid and not infringed. Palomar and the Massachusetts General Hospital filed a reply
denying the material allegations of the counterclaims. Palomar and the Massachusetts
General Hospital have further alleged that Cuteras CoolGlide Vantage and CoolGlide
XEO laser systems also willfully infringe the asserted patent. On June 4, 2003, Cutera
amended their answer and asserted a counter claim alleging that the patent is
unenforceable due to inequitable conduct. Palomar and the Massachusetts General Hospital
believe that this claim is without merit and filed a reply denying the material
allegations of this counterclaim. A claim construction hearing (often referred to as a
Markman hearing) was held on June 12, 2003, and on February 27, 2004 the Judge issued her
ruling. Palomar believes the ruling largely embraced Palomars position. On January
14, 2005, Cutera filed a motion for summary judgment that the patent claims being asserted
are invalid and not infringed. Palomar and the Massachusetts General Hospital filed a
response vigorously defending both the validity of the patent claims and the infringement
of those claims by Cuteras CoolGlide products. A trial date has not yet been set. (See
Cautionary Statements)


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


Not applicable.



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|PART II


Item 5. Market for
Registrants Common Equity and Related Stockholder Matters


Palomars
common stock is currently traded on the Nasdaq National Market (Nasdaq) under
the symbol PMTI. The following table sets forth the high and low bid information on Nasdaq
for the common stock for the periods indicated. Such quotations reflect inter-dealer
prices, without retail markup, markdown or commission and do not necessarily represent
actual transactions.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                  | Fiscal Year 2004 |           
| | -------------------------------- | ---------------- | ----------
|
| | Quarter ended March 31, 2004     | $     18.45      | $     9.33
| | Quarter ended June 30, 2004      | 20.95            | 13.45     
| | Quarter ended September 30, 2004 | 23.67            | 13.00     
| | Quarter ended December 31, 2004  | 27.66            | 17.35     

| |                                  | Fiscal Year 2003 |             
| | -------------------------------- | ---------------- | ------------
|
| | Quarter ended March 31, 2003     | $       3.86     | $       1.00
| | Quarter ended June 30, 2003      | 5.86             | 3.02        
| | Quarter ended September 30, 2003 | 8.90             | 4.40        
| | Quarter ended December 31, 2003  | 11.00            | 6.16        

|As
of February 28, 2005, Palomar had 3,943 holders of record of common stock. This does not
include holdings in street or nominee names.


Palomar
has not paid dividends to its common stockholders since its inception and does not plan to
pay dividends to its common stockholders in the foreseeable future. Palomar intends to
retain substantially all earnings to finance the operations of the company. Palomar may
buy back shares of its common stock on the open market from time to time.


Item 6. Selected
Financial Data


The
following table sets forth selected consolidated financial data for each of the last five
fiscal years. This data should be read in conjunction with the detailed information,
financial statements and related notes, as well as Managements Discussion and
Analysis of Financial Condition and Results of Operations included elsewhere herein. The
historical results are not necessarily indicative of the results of operations to be
expected in the future.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-10-
|----

|Selected Financial Data               |          |          |          |          |          
|------------------------------------- | -------- | -------- | -------- | -------- | ---------
|
|
|
|Consolidated Statements of Operations |          |          |          |          |          
|Data:                                
|                                      |          |          |          |          |          
|Revenues:                            
|Product revenues                      | $ 45,810 | $ 31,332 | $ 22,549 | $ 11,158 | $   8,781
|Royalty revenues                      | 4,052    | 841      | 2,869    | 5,496    | 4,395    
|Funded product development            |          |          |          |          |          
|revenues                              | 4,570    | 2,600    | --       | --       | --       
|                                      |         
|Total revenues                        | 54,432   | 34,773   | 25,418   | 16,654   | 13,176   
|                                     
|Costs and expenses (income):         

|                                            |            |            |             |           |          
|------------------------------------------- | ---------- | ---------- | ----------- | --------- | ---------
|Cost of product revenues                    | 15,514     | 13,031     | 11,200      | 9,153     | 8,771    
|Cost of royalty revenues                    | 1,621      | 336        | 1,148       | 2,199     | 1,758    
|Research and development                    | 10,296     | 6,575      | 4,360       | 6,045     | 7,851    
|Selling and marketing                       | 12,030     | 8,483      | 5,785       | 3,504     | 3,153    
|General and administrative                  | 5,229      | 3,739      | 3,067       | 2,492     | 3,866    
|Goodwill and asset write-off                | --         | --         | --          | --        | 746      
|Gain from sale of subsidiary                | --         | --         | --          | --        | (2,440)  
|                                            |           
|Total cost and expenses                     | 44,690     | 32,164     | 25,560      | 23,393    | 23,705   
|                                            |           
|Income (loss) from operations               | 9,742      | 2,609      | (142)       | (6,739)   | (10,529) 
|                                           
|Other income (expense):                    
|Interest income                             | 256        | 74         | 74          | 759       | 1,203    
|Interest expense                            | (6)        | (28)       | (120)       | (98)      | (155)    
|Other income (expense), net                 | (214)      | 58         | 227         | 185       | 380      
|                                            |           
|Income (loss) before benefit                |            |            |             |           |          
|from income taxes                           | 9,778      | 2,713      | 39          | (5,893)   | (9,101)  
|                                           
|Benefit from income taxes                   | 855        | 656        | --          | 422       | 226      
|Cumulative effect of change                 |            |            |             |           |          
|in accounting method                        | --         | --         | --          | --        | (712)    
|                                            |           
|Net income (loss)                           | $ 10,633   | $   3,369  | $        39 | $(5,471)  | $(9,587) 
|                                            |           
|Basic net income (loss) per common         
|share:                                     
|Continuing operations                       | $     0.68 | $     0.25 | $        -- | $  (0.54) | $  (0.90)
|Cumulative effect of change                
|in accounting method                        | --         | --         | --          | --        | (0.07)   
|                                            |           
|Total basic net income (loss)               |            |            |             |           |          
|per common share                            | $     0.68 | $     0.25 | $        -- | $  (0.54) | $  (0.97)
|                                            |           
|Diluted net income (loss) per common share:
|Continuing operations                       | $     0.60 | $     0.21 | $        -- | $  (0.54) | $  (0.90)
|Cumulative effect of change                 |            |            |             |           |          
|in accounting method                        | --         | --         | --          | --        | (0.07)   
|                                            |           
|Total diluted net income (loss)            
|per common share                            | $     0.60 | $     0.21 | $        -- | $  (0.54) | $  (0.97)
|                                            |           
|Weighted average number of                  |            |            |             |           |          
|common shares outstanding:                  |            |            |             |           |          
|Basic                                       | 15,689     | 13,399     | 11,372      | 10,805    | 10,247   
|                                            |           
|Diluted                                     | 17,720     | 15,917     | 11,372      | 10,805    | 10,247   
|                                            |           

|                                 | Years Ended December 31, |         |          |          |         
|-------------------------------- | ------------------------ | ------- | -------- | -------- | --------
|
|Consolidated Balance Sheet Data: |                          |         |          |          |         
|                                 |                          |         |          |          |         
|Working capital                  | $28,163                  | $13,670 | $  3,934 | $  2,944 | $  8,864
|Total assets                     | 39,599                   | 21,660  | 13,398   | 13,171   | 21,000  
|Long-term debt                   | --                       | --      | --       | --       | 500     
|Total stockholders' equity       | 29,174                   | 14,364  | 4,718    | 3,896    | 9,365   

|Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations


Forward-looking
statements


This
Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All statements other than historical or
current facts, including, without limitation, statements about our business strategy,
plans and objectives of management and our future prospects, are forward-looking
statements. Although we believe that the expectations reflected in such forward-looking
statements are reasonable, such forward-looking statements are subject to risks and
uncertainties that could cause actual results to differ materially from these
expectations. Such risks and uncertainties include, without limitation, the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | financing of future operations, manufacturing risks, variations in our quarterly results,
the occurrence of unanticipated events and circumstances and general economic
conditions, including stock market volatility, results of future operations,
technological difficulties in developing or introducing new products, the results of
future research, lack of product demand and market acceptance for current and
future products, challenges in managing joint ventures, government contracts and
research with third parties, the impact of competitive products and pricing, governmental regulations with respect to medical devices, including whether FDA clearance will
be obtained for future products, the results of litigation, difficulties in
collecting royalties, potential infringement of third-party intellectual property
rights;
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-11-
|----

| | we
expect to face increased competition that could result in price reductions and reduced
margins, as well as loss of market share; and
|- | ---------------------------------------------------------------------------------------------------------------------------------------

| | other risks indicated below under the caption "Cautionary Statements".
|- | ----------------------------------------------------------------------

|These
risks and uncertainties are beyond our control and, in many cases; we cannot predict the
risks and uncertainties that could cause our actual results to differ materially from
those indicated by the forward-looking statements. When used in this document, the words
believes, plans, expects, anticipates,
intends, continue, may, will,
could, should, future, potential,
estimate, or the negative of such terms and similar expressions as they relate
to us or our management are intended to identify forward-looking statements. We
undertake no obligation to release publicly the result of any revisions to these
forward-looking statements that may be made to reflect events or circumstances after the
date hereof or to reflect the occurrence of unanticipated events.



The following discussion should
be read in conjunction with, and is qualified in its entirety by, the consolidated
financial statements and notes thereto included in Item 8 of this Annual Report.
Historical results and percentage relationships among any amounts in the financial
statements are not necessarily indicative of trends in operating results for any future
periods.


Critical accounting
policies


Our
policies are more fully described in Note 1 of our Consolidated Financial Statements. As
disclosed in Note 1, the preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and assumptions about
future events that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ significantly from those estimates. We
believe that the following discussion addresses our most critical accounting policies,
which are those that are most important to the portrayal of our financial condition and
results of operations and require managements most difficult, subjective and complex
judgments.


Revenue
Recognition.  We recognize revenue in accordance with Securities
and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in
Financial Statements (SAB 104). SAB 104 requires that four basic criteria must be met
before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4)
collectibility is reasonably assured. Determination of criteria (3) and (4) are based on
managements judgments regarding the fixed nature of the fee charged for services
rendered and products delivered and the collectibility of those fees. Should changes in
conditions cause management to determine these criteria are not met for certain future
transactions, revenue recognized for any reporting period could be adversely affected. We
recognize product revenues upon shipment. If a product sale does not meet all of the above
criteria, the sale is deferred until all criteria are met. Provisions are made at the time
of revenue recognition for any applicable warranty costs expected to be incurred.


Periodically,
we sell products together with a product upgrade option that requires that the customer
pay an upgrade fee at the time of exercise, has no refund provisions and includes an
expiration date on the upgrade option. In accordance with Emerging Issues Task Force Issue
No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple
Deliverables, we defer the fair value ascribed to the upgrade option until the
expiration of the upgrade option or the exercise of the upgrade option and shipment of the
product upgrade.


Revenues
from the sale of service contracts is deferred and recognized on a straight-line basis
over the life of the service contract. Revenues from services administered by us that are
not covered by a service contract are recognized as the services are provided. In certain
instances, we sell products together with service contracts. We recognize revenue on such
multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the
relative fair market value of each element.




-12-
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|We
recognize royalty revenue from licensees upon receipt of cash payments since the royalty
amounts are not fixed and determinable at the end of a quarter. In general, licensees are
obligated to make payments 30 days after the end of each quarter.


We
account for funded development revenue from Gillette and Johnson & Johnson Consumer
Companies, Inc. (JJCC) in accordance with the work plan that was developed
with both Gillette and JJCC. Revenue is recognized under the contracts as costs are
incurred and services are rendered. Any amounts received in advance of costs incurred and
services rendered from Gillette or JJCC are recorded as deferred revenue.Payments
from both Gillette and JJCC are non refundable if the development is not successful.


We
provide services under a $2.5 million research contract with the United States Department
of the Army to develop a self-treatment light based device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered.


Accounts
Receivable Reserves.Allowances for doubtful accounts are estimated based
on estimates of losses related to customer receivable balances. In establishing the
appropriate provisions for customer receivable balances, we make assumptions with respect
to their future collectibility. Our assumptions are based on an individual assessment of a
customers credit quality as well as subjective factors and trends, including the
aging of receivable balances. Generally, these individual credit assessments occur prior
to the inception of the credit exposure and at regular reviews during the life of the
exposure and consider (a) a customers ability to meet and sustain their financial
commitments; (b) a customers current and projected financial condition; (c) the
positive or negative effects of the current and projected industry outlook; and (d) the
economy in general. Once we consider all of these factors, a determination is made as to
the probability of default. An appropriate provision is made, which takes into account the
severity of the likely loss on the outstanding receivable balance based on our experience
in collecting these amounts. Our level of reserves for our customer accounts receivable
fluctuates depending upon all of the factors mentioned above. We provide a general reserve
for doubtful accounts based on the aging of our accounts receivable balances, historical
experiences of write-offs and defaults.


We
also record a provision for estimated sales returns and allowances on product and service
related sales in the same period as the related revenues are recorded. These estimates are
based on the specific facts and circumstances of particular order, analysis of credit memo
data and other known factors. If the data we use to calculate these estimates do not
properly reflect reserve requirements, then a change in the allowances would be made in
the period in which such a determination is made and revenues in that period could be
adversely affected.



-13-
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|Inventory
Reserves.As a designer and manufacturer of high technology equipment, we
may be exposed to a number of economic and industry factors that could result in portions
of our inventory becoming either obsolete or in excess of anticipated usage. These factors
include, but are not limited to, technological changes in our markets, our ability to meet
changing customer requirements, competitive pressures in products and prices, reliability
and replacement of and the availability of key components from our suppliers. Our policy
is to establish inventory reserves when conditions exist that suggest that our inventory
may be in excess of anticipated demand or is obsolete based upon our assumptions about
future demand for our products and market conditions. Included in our inventory are
demonstration products that are used by our sales organization. We account for such
products as we do with any other finished goods item in our inventory in accordance with
the review of our entire inventory. We regularly evaluate our ability to realize the value
of our inventory based on a combination of factors including the following: historical
usage rates, forecasted sales or usage, product end of life dates, estimated current and
future market values and new product introductions. Assumptions used in determining our
estimates of future product demand may prove to be incorrect; in which case the provision
required for excess and obsolete inventory would have to be adjusted in the future. If
inventory is determined to be overvalued, we would be required to recognize such as cost
of goods sold at the time of such determination. Although we perform a detail review of
our forecasts of future product demand, any significant unanticipated changes in demand
could have a significant impact on the value of our inventory and our reported operating
results. Additionally, purchasing requirements and alternative usage avenues are explored
within these processes to mitigate inventory exposure. When recorded, our reserves are
intended to reduce the carrying value of its inventory to its net realizable value.




Warranty
Provision.We typically offer a one-year warranty for all of our products.
We provide for the estimated cost of product warranties at the time product revenue is
recognized. Factors that affect our warranty reserves include the number of units sold,
historical and anticipated rates of warranty repairs and the cost per repair. While we
engage in extensive product quality programs and processes, including actively monitoring
and evaluating the quality of our component suppliers, our estimated warranty obligation
is affected by ongoing product failure rates, specific product class failures outside of
our baseline experience, material usage and service delivery costs incurred in correcting
a product failure. If actual product failure rates, material usage or service delivery
costs differ from our estimates, revisions to the estimated warranty liability would be
required. Assumptions and historical warranty experience are evaluated on at least a
quarterly basis to determine the appropriateness of such assumptions. We assess the
adequacy of the warranty provision and we may adjust this provision if necessary.


Income
taxes. We currently have net operating loss (NOL) carryforwards
that can be utilized to offset future income for federal and state tax purposes. These
NOLs generate a significant deferred tax asset. However, we have recorded a valuation
allowance against this deferred tax asset as we have determined that it is more likely
than not that we will not be able to fully utilize the NOLs. Should our assumptions
regarding the utilization of these NOLs change, we may reduce some or all of this
valuation allowance, which would result in the recording of an income tax benefit. In
evaluating the potential exposure associated with the various tax filing positions, we
accrue charges for possible exposures. Based on the annual evaluations of tax positions,
we believe we have appropriately filed our tax returns and accrued for possible exposures.
To the extent we were to prevail in matters for which accruals have been established or be
required to pay amounts in excess of reserves, our effective tax rate in a given financial
period might be materially impacted.


Overview


We
are engaged in research, development, manufacturing and distribution of proprietary light
based systems for hair removal and other cosmetic treatments. Since our inception, we have
been able to develop a differentiated product mix of light based systems for cosmetic
treatments through our research and development as well as with our partnerships with
Massachusetts General Hospitals Wellman Laboratories and other centers throughout
the world. We are continually developing and testing new indications to further the
advancement in cosmetic light based hair removal techniques, cellulite reduction, acne
treatment, Pseudofolliculitis Barbae (PFB) treatment and skin rejuvenation.
During the year, we continued to build a strong relationship with the Gillette Company and
forged new alliances with the Johnson & Johnson Consumer Company (JJCC)
and the Department of the Army.


During
2004, we improved product gross profits by 66% due to a higher margin product mix and the
effects of increased sales volume in comparison to the same period in 2003. We also
strengthened our balance sheet since the end of last year, including more than doubling
our cash position and stockholders equity. The current ratio is now 3.7x, up
substantially from 2.9x at the end of 2003, and we have no long-term debt.


Our
reported revenues for the year ended December 31, 2004, were $54.4 million, up from $34.8
million for the year ended December 31, 2003. Gross profit from product sales increased to
$30.3 million (66 percent of revenues), up from $18.3 million (58 percent of revenues) in
the year-earlier period. We also reported net income of $10.6 million, or $0.60 per
diluted share, for the year ended December 31, 2004, versus net income of $3.4 million, or
$0.21 per diluted share, for the year ended December 31, 2003.


Over
the last three years, most of our revenue has included the Lux family of products with
their complementary handpieces, offering a suite of applications to the end user at a
lower cost than other competing systems. Customers can invest in their first Lux system
with one handpiece then purchase additional handpieces as their practice grows and if they
prefer upgrade into more powerful Lux systems when ready. Additionally, the Lux platform
enables us to custom tailor products to fit almost any professional medical office or
spa location and provides our customers with the comfort that the system can grow with
their practice. We have kept a commitment to continually provide value to customers who
invest in our Lux system platform. We believe the Lux family of products are the most
affordable and versatile cosmetic light based systems on the market.


The
StarLux, with its suite of handpieces, can be used for permanent hair reduction, the
treatment of pigmented lesions, vascular lesions, leg veins, acne, wrinkles and other
cosmetic applications. The StarLux can operate the LuxY, LuxG, LuxR,
LuxRs, and LuxV lamp handpieces as well as the Lux1064 Nd:YAG laser
handpiece. Incorporated into the StarLux is active contact cooling for safety, smooth
pulse technology for comfort, AccuSpectrum technology for versatility, photon
recycling for efficacy and a full-color touch screen for ease of use.


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|The
StarLux is welcomed into the Lux family of products by the MediLux, EsteLux® and
NeoLux Pulsed Light Systems. The EsteLux was the first Lux Platform product
introduced and can operate the LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV handpieces. The
MediLux has more power than that of the EsteLux, a higher repetition rate and a snap-on
connector for faster changes between handpieces. The MediLux can operate the same six
handpieces as the EsteLux, which allows customers to add additional applications to their
treatment portfolio and provide specifically tailored procedures to meet their demand. The
lower priced NeoLux was developed specifically for the beauty industry. The NeoLux is a
simple, three setting device that can operate the LuxY, LuxR and LuxRs handpieces.


Our
product revenue has increased each quarter during 2004 as compared to 2003 as a
result of the increased product demand for the StarLux and Lux family of products. Due to
this increased demand in the market place, we increased our domestic sales force
throughout 2004. Looking forward, we would expect as our installed base of Lux family of
products continues to increase that the demand for replacement handpieces will increase
resulting in additional product revenue.


During
2004, we continued to bolster our consumer device research and development programs. In
September, we entered into a joint development and license agreement with Johnson &
Johnson Consumer Companies (JJCC) to develop, clinically test and potentially
commercialize home-use, light based devices for reducing or reshaping body fat including
cellulite, reduce the appearance of skin aging and reducing or preventing acne. In June,
we moved into the next phase of our agreement with The Gillette Company to develop and
commercialize a home-use, light based hair removal device for woman. In addition, in
February, we were awarded a $2.5 million research contract by the U.S. Department of the
Army to develop a light based self-treatment device for the dermatologic disease
Pseudofolliculitis Barbae or PFB, a disease that affects combat readiness, unit cohesion
and individual moral of over 50% of African American and Hispanic military personnel.


We
continue to focus on delivering innovative light based systems and products to our
customers in order to drive revenue and earnings growth.


Recent developments


In
February 2005, we introduced the VisiLux 1064 handpiece, the LuxIR and the
DermaType  skinphotometer. The VisiLux1064 Laser handpiece features a built-in, high
resolution camera which projects an image of the treatment area onto an LCD screen mounted
on the handpiece. The LCD screen provides real-time digital imaging for clear evaluation
and treatment of leg veins and other targets. The camera magnifies the treatment area to
about 4.5 times the actual size and through a proprietary illumination system enhances the
image by contrasting the target against its background, for example, to provide clear
viewing of deep veins. This innovation offers unparalleled visibility, treatment precision
and ease of use while offering an additional laser alternative to our specialized family
of Lux handpieces. We plan to begin shipments of the VisiLux1064 handpiece by the end of
2005.


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|The
LuxIR Infrared handpiece will be offered with the StarLux and delivers pulses of infrared
light deep into the dermis to create carefully controlled areas of elevated temperature.
This handpiece is pending FDA clearance for the temporary relief of muscle and joint pain,
muscle relaxation and increased circulation. We intend to seek FDA clearance for creating
a smoother, tighter skin appearance as the technology has been shown to trigger a
biological response which leads to collagen remodeling in the dermis. Remodeled collagen
can fill the skin to smooth out fine wrinkles and minor sagging, and can also stimulate
increased collagen production to create visible long term results. This is our first
handpiece to utilize infrared light for the treatment of skin rejuvenation. We plan to
begin shipments of the LuxIR handpiece by the end of 2005.


The
DermaType Skinphotometer measures the melanin and blood content of skin in a matter of
seconds. With this device, our customers will be able to quickly and accurately determine
appropriate system settings for each patient to insure the safest and most accurate
treatments are provided. The DermaType Skinphotometer can be used in conjunction with the
StarLux, MediLux, EsteLux or NeoLux Systems, resulting in treatments perfectly tailored to
the patients individual skin type. This device is not yet available for sale. We
intend to seek FDA clearance for this device in the near future and begin shipments of the
DermaType Skinphotometer this summer.






Results of operations


Year 2004 Compared to
Year 2003


The
following table contains selected statement of operations information, which serves as the
basis of the discussion of our results of operations for the years ended December 31, 2004
and 2003, respectively (in thousands, except for percentages):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                        |  |          |   |     | Change |          
|--------------------------------------- |  | -------- | - | --- | ------ | ---------
|
|
|Revenues:                               |  |          |   |     |        |          
|Product revenues                        |  | $ 45,810 |   | 84  | %      | $ 31,332 
|Royalty revenues                        |  | 4,052    |   | 7   | %      | 841      
|Funded product development revenues     |  | 4,570    |   | 9   | %      | 2,600    
|                                        | 
|Total revenues                          |  | 54,432   |   | 100 | %      | 34,773   
|                                        | 
|Cost and expenses:                      | 
|Cost of product revenues                |  | 15,514   |   | 29  | %      | 13,031   
|Cost of royalty revenues                |  | 1,621    |   | 3   | %      | 336      
|Research & development                  |  | 10,296   |   | 19  | %      | 6,575    
|Selling & marketing                     |  | 12,030   |   | 22  | %      | 8,483    
|General & administrative                |  | 5,229    |   | 10  | %      | 3,739    
|                                        | 
|Total costs & expenses                  |  | 44,690   |   | 82  | %      | 32,164   
|                                        | 
|Income from operations                  |  | 9,742    |   | 18  | %      | 2,609    
|Interest income                         |  | 256      |   | -   | %      | 74       
|Interest expense                        |  | (6       | ) | -   | %      | (28      
|Other income (expense)                  |  | (214     | ) | -   | %      | 58       
|                                        | 
|Income before benefit from income taxes |  | 9,778    |   | 18  | %      | 2,713    
|Benefit from income taxes               |  | 855      |   | 2   | %      | 656      
|                                        | 
|Net income                              |  | $ 10,633 |   | 20  | %      | $   3,369
|                                        | 

|Product
revenues. Sales of the newly introduced StarLux Pulsed Light and Laser
System coupled with its additional handpieces were the leading contributor to our increase
in product revenues. In addition, product revenues were favorably impacted by an increase
of 5% in sales related to the other Lux family of products, which includes the
MediLux, EsteLux and NeoLux and their additional handpieces an increase of 26% in revenue
related to customer service sales offset by a decrease of 12% from sales related to the
Q-Yag 5 product line and a decrease of 90% of sales related to our legacy products (the
SLP1000 and the RD1200) as compared to the same period in 2003.


International
product revenue, consisting of sales by our distributors in Japan, Europe, Australia,
Asia\Pacific Rim and South and Central America and our sales shipped directly to
international customers was 37% of total product revenue for the year ended 2004 in
comparison to 47% for the same period in 2003. This decrease as a percentage of revenues
in international sales is directly attributed to the increase in domestic product sales
and a decrease in sales to Japan.


Royalty
revenues. The increase in royalty revenue during 2004, in comparison to the
same period in 2003, is attributed to our settlement agreement with Lumenis. Under the
terms of the settlement, Lumenis paid $868,000 in the second quarter of 2004 for back-owed
royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay $3.225
million over the next six quarters, or $537,500 per quarter, for back-owed royalties due
on sales of the LightSheer made between July 1, 2002 and December 31, 2003. Beginning on
January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the LightSheer and
other professional laser hair removal devices and modules. In addition, Lumenis granted us
a paid up license to a variety of Lumenis patents for our light based devices. We
granted Lumenis a paid up license to the 568 and 844 patents for Lumenis
professional lamp based devices. Both parties have agreed to the validity and
enforceability of each others patents and not to challenge such validity and
enforceability in the future. During 2004, Lumenis made payments of approximately $1.4
million relating to the 5% royalty and approximately $1.9 million for back-owed royalties
recorded as royalty revenue. (See Note 16, Settlement of Litigation.)


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|Funded
product development revenues.Funded development revenue increased during
2004 as compared to the same period in 2003. Funded development revenue is generated from
the development agreements with Gillette and Johnson & Johnson Consumer Companies,
Inc. (JJCC) as well as the United States Department of the Army. For both
Gillette and JJCC, Palomar receives payments quarterly in accordance with the work plan
that were developed with both Gillette and JJCC. Revenue is recognized under the contracts
as costs are incurred and services are rendered. Any amounts received in advance of costs
incurred and services rendered from Gillette or JJCC are recorded as deferred revenue. Payments are not refundable if the development is not successful. For the year ended
December 31, 2004, we recognized approximately $3.1 million and $318,000 of funded product
development revenue from Gillette and JJCC, respectively.


We
provide services under a $2.5 million research contract with the United States Department
of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby Palomar is reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. For the year
ended December 31, 2004, we recognized approximately $1.1 million of funded product
development revenues from the Department of the Army.


Cost
of product revenues. The cost of product revenues increased in absolute
dollars, but decreased as a percentage of total revenue to 29% in 2004 from 38% in 2003.
The increase in absolute dollars is directly attributable to increased variable costs
associated with increased product sales. This cost decreased as a percentage of total
revenue primarily due to a shift in sales mix to the higher priced StarLux Pulsed Light
and Laser System and the other Lux family of products from sales of higher
cost to produce legacy products such a the SLP1000 and RD1200. The Lux family
of products carry lower manufacturing costs as a result of their modular design. In
addition, increased sales volume has improved the absorption of fixed manufacturing
overhead at our manufacturing facility as approximately 70% of our manufacturing overhead
cost is fixed in nature and is spread over much higher sales volumes.


Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% in accordance with our license agreement with
Massachusetts General Hospital for each period in comparison to the same periods in 2003.
The increase in the cost of royalty revenues in absolute dollars is attributed to our
settlement agreement with Lumenis. (See Note 16, Settlement of Litigation.)


Research
and development expense. The increase in research and development expense
is a direct result of our spending related to the Gillette agreement, the JJCC agreement
and the research contract with the United States Department of the Army and our continued
commitment to introducing new platforms and enhancing our current family of products.



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|For
our research and development agreement with Gillette, costs related to payroll and payroll
related expenses increased by $125,000, material costs increased by $313,000 and other
clinical, consulting and overhead expenses increased by $776,000 as compared to the same
period in 2003, The Gillette agreement began in February 2003.


Expenses
relating to the Army contract, which began in February 2004, totaled approximately $1.1
million for the year ended December 31, 2004. Though the project was scheduled to last for
nineteen months, we believe we will need several more months to complete the work.


Expenses
relating to the JJCC agreement, which began in October 2004, totaled approximately
$300,000 for the year ended December 31, 2004.


Legal
expenses relating to the prosecution of new patents increased by approximately $218,000 in
comparison to the same period in 2003. We are committed to expanding our intellectual
property rights to protect discoveries made through our investment in research and
development.


Expenses
relating to the introduction of new products such as the StarLux, enhancements made to our
current family of products and research and development overhead increased by $1.4 million
for the twelve months ended December 31, 2004, in comparison to the same period in 2003.




The
spending on research and development reflects our commitment to continuing dermatology
research for a better understanding of various cosmetic and medical conditions and to
continuing research and development of devices and delivery systems to better treat those
various cosmetic and medical conditions. The research and development goals in the fields
of light based hair removal, pigmented and vascular lesion removal and acne treatment are
to design systems that: (1) permit effective treatment and more rapid treatment of large
areas, (2) have high gross margins, and (3) are manufactured at lower costs, to expand our
current markets. Furthermore, we are developing products to address other dermatology and
cosmetic conditions, including the fields of cellulite reduction and skin rejuvenation.


Selling
and marketing expense. The increase in selling and marketing expense is primarily
comprised of $1.9 million from payroll and payroll related expenses, approximately $1.8
million relating to tradeshows, consultants and other sales and marketing infrastructure
costs, $210,000 related to the write-off of certain third party demo inventory offset by a
decrease of approximately $384,000 relating to commission expense in comparison to the
same period in 2003. Domestic commission increased by approximately $678,000 correlating
with our increased domestic product revenue, European commissions increased by $47,000,
while Far East commissions decreased by approximately $1.1 million due to a change in our
commission structure with one of our Far East distributors. The increases directly
correlate with our increased revenues, upfront costs associated with both international
and domestic sales force and distribution channel expansion as well as the introduction of
our newest product, the StarLux Pulsed Light and Laser System.


General
and administrative expense. The increase in general and administrative
dollars is mainly attributed to increases to incentive compensation of $695,000, related
to our incentive compensation plan of 2004, an increase in costs related to corporate
governance as a result of the Sarbanes-Oxley Act of 2002 of $230,000, an increase in our
corporate legal expenses of approximately $505,000 and an increase in payroll and payroll
related expenses and other infrastructure costs of approximately $60,000 as compared to
the same period in 2003.


Interest
income. Interest income increased due to higher levels of excess cash on
hand as well as higher interest rates in comparison to the same periods in 2003.


Interest
expense.The decrease in interest expense is attributable to our reduction of
debt. On March 14, 2003, a director surrendered a $1 million Promissory Note in exchange
for 293,255 unregistered shares of our Common Stock at a price of $3.41 per share. The
price was calculated at 110% of our Common Stock trailing ten-day average closing price of
$3.10 per share.


Other
income (expense). Other income (expense), net, decreased in comparison to
the same period in 2003. This decrease is attributable to costs of $380,000 related to a
non-recurring expense from the settlement of litigation relating to a previously owned
subsidiarys facility lease offset by payments received from a previously written-off
note receivable and equity investment.


Benefit
from income taxes. We recognized a benefit from income taxes of $856,000 in
2004 as a result of a $1.1 million reduction in deferred income tax accruals associated with
tax deductions in a 1999 state tax return which were no longer required. Offsetting these
benefits, we provided a 3% effective tax rate for anticipated federal alternative minimum
taxes and minimum state income taxes due for 2004. We recognized a benefit for income
taxes of $656,000 in 2003 as result of a $470,000 carryback claim pursuant to the Economic
Stimulus package of 2002 and a $300,000 reduction in deferred income tax accruals
associated with certain tax deductions taken in our 1999 federal tax return which were no
longer required. Offsetting these benefits, we provided a 4% effective tax rate for
anticipated federal alternative minimum taxes and minimum state income taxes due for 2003.
Given our limited history of profitability, at this time we have fully reserved our
otherwise recognizable deferred tax asset, as its realization is uncertain.



-18-
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|Year 2003 Compared to
Year 2002


The
following table contains selected statement of operations information, which serves as the
basis of the discussion of our results of operations for the years ended December 31, 2003
and 2002, respectively (in thousands, except for percentages):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                        |  |           |   |     | Change |            
|--------------------------------------- |  | --------- | - | --- | ------ | -----------
|
|
|Revenues:                               |  |           |   |     |        |            
|Product revenues                        |  | $ 31,332  |   | 90  | %      | $ 22,549   
|Royalty revenues                        |  | 841       |   | 3   | %      | 2,869      
|Funded product development revenues     |  | 2,600     |   | 7   | %      | --         
|                                        | 
|Total revenues                          |  | 34,773    |   | 100 | %      | 25,418     
|                                        | 
|Cost and expenses:                      | 
|Cost of product revenues                |  | 13,031    |   | 38  | %      | 11,200     
|Cost of royalty revenues                |  | 336       |   | 1   | %      | 1,148      
|Research & development                  |  | 6,575     |   | 19  | %      | 4,360      
|Selling & marketing                     |  | 8,483     |   | 24  | %      | 5,785      
|General & administrative                |  | 3,739     |   | 11  | %      | 3,067      
|                                        | 
|Total costs & expenses                  |  | 32,164    |   | 92  | %      | 25,560     
|                                        | 
|Income (loss) from operations           |  | 2,609     |   | 8   | %      | (142       
|Interest income                         |  | 74        |   | -   | %      | 74         
|Interest expense                        |  | (28       | ) | -   | %      | (120       
|Other income                            |  | 58        |   | -   | %      | 227        
|                                        | 
|Income before benefit from income taxes |  | 2,713     |   | 8   | %      | 39         
|Benefit from income taxes               |  | 656       |   | 2   | %      | --         
|                                        | 
|Net income                              |  | $   3,369 |   | 10  | %      | $        39
|                                        | 

|Product
revenues. Increases in unit sales and the average selling prices of the
Lux family of products were the leading contributor to the increase in product
revenues. The Lux family of products, consisting of the MediLux, EsteLux,
NeoLux and related additional handpieces increased 52% for the year ended 2003 in
comparison to the same period in 2002. Product revenues were favorably impacted by an
increase of 4% in sales related to the Q-Yag 5 product line and an increase of 45% in
revenue related to customer service sales offset by a decrease of 28% of sales related to
the SLP1000 and a decrease of 27% of sales related to the RD-1200 product line in
comparison to the same period in 2002. Market acceptance of the Lux family of
products has been increasing since its introduction in September 2001. We have
discontinued the RD1200 product line and have begun the process of phasing out the SLP1000
product line.


International
product revenue, consisting of sales by our distributors in Japan, Europe, Australia,
Asia\Pacific Rim and South and Central America and our sales shipped directly to
international customers was 47% of total product revenue during 2003 in comparison to 54%
for the same period in 2002. This decrease as a percentage of revenues in international
sales is directly attributed to the increase in domestic product sales and a decrease in
sales to Japan.


Royalty
revenues. The decrease in royalty revenues in comparison to the same period
in 2002 is attributed to Lumenis Inc.s failure to make its royalty payments starting
in October 2002. (See Note 16, Settlement of Litigation.)


Funded
product development revenues.For the year ended 2003, funded product
development revenue of $2.6 million was for work performed in connection with payments
made by Gillette. On February 14, 2003, we entered into a Development and License
Agreement with Gillette to complete development and commercialize a home-use, light based
hair removal device for women. (See Note 12, Development and License Agreement with
Gillette and exhibit 10.14, The Development and License Agreement with The
Gillette Company effective February 14, 2003 with redacted exhibits)


Cost
of product revenues. The cost of product revenues decreased as a percentage
of product revenue to 42% in 2003 from 50% in 2002. This cost decreased as a percentage of
product revenue primarily due to improved gross profit recognized on the Lux
family of products as a result of lower manufacturing costs associated with the
Lux product lines. In addition, the increased sales volume has improved the
absorption of manufacturing overhead at our manufacturing facility for each product line.


-19-
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|In
connection with our increased focus on the Lux product lines and a de-emphasis
and discontinuation of certain other existing products, during the fourth quarter of 2003,
we wrote off an additional $316,000 to cost of product revenues relating to the SLP1000
and RD 1200 product lines. Approximately $200,000 was written off in relation to the
SLP1000 product line for prior generation and obsolete and excess inventory and $116,000
was written off in relation to the RD 1200 product line for excess inventories. While we
have discontinued the active marketing of certain products, we remain committed to
servicing both product lines and will maintain adequate service inventories for each.


During
2002, we experienced unusually high warranty claims for the SLP1000 due to issues related
to a key component. Accordingly, we increased our warranty reserve by $250,000 in the
third quarter of 2002 bringing the total warranty reserve related to this key component to
approximately $380,000. During 2003, we qualified a new vendor for the key component and
began replacing this key component. As of the end of 2003, we believed that the
replacement part had effectively rectified the problem and that the warranty reserve was
significantly in excess of estimated requirements. Consequently, we decreased our warranty
reserve and reduced cost of goods sold by approximately $336,000 in the fourth quarter of
2003.


Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% for both periods. The decrease in royalty
revenues is attributed to Lumenis failure to make its royalty payments resulting in
a reduced cost of royalty due to Massachusetts General Hospital. (See Note 16, Settlement
of Litigation.)


Research
and development expense. The increase in research and development expense
is a direct result of our spending related to the Gillette agreement and our continued
commitment to introducing new platforms and enhancing our current family of products. For
our research and development agreement with Gillette, we have increased our research and
clinical staffing by 25%. This increase in staffing has increased our payroll and payroll
related expenses by approximately $600,000. In addition to this increase in payroll and
payroll related expenses, we have incurred costs of approximately $730,000 on materials
and consultants for prototypes related to the Gillette agreement. The investment in the
Lux platform has allowed us to use the same platforms to introduce new applications by
developing new handpieces and other complimentary features as opposed to developing new
systems for each application. We continue our development of product platform enhancements
and additional platforms. The spending on research and development reflects the our
commitment to continuing dermatology research for a better understanding of various
cosmetic and medical conditions and to continuing research and development of devices and
delivery systems to better treat those various cosmetic and medical conditions. The
research and development goals in the fields of light based hair removal and pigmented and
vascular lesion removal are to design systems that: (1) permit effective treatment and
more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured
at lower costs, to expand our current markets. Furthermore, we are developing products to
address other dermatology and cosmetic conditions, including the fields of cellulite
reduction, acne treatment and skin rejuvenation.


Legal
expenses relating to the prosecution of new patents increased by approximately $517,000 in
comparison to the same period in 2002. We are committed to expanding intellectual property
rights to protect discoveries made through our investment in research and development.


Selling
and marketing expense. The increase in selling and marketing expenses is
associated with an increase in direct sales force commissions of approximately $472,000,
an increase in international commissions of approximately $132,000, an increase in
commissions related to our independent representatives of approximately $652,000 and a
doubling of our domestic sales force in October 2003. These increases directly correlate
with our increased revenues, upfront costs associated with both international and domestic
sales force and distribution channel expansion as well as costs associated with regional
and international trade show and other marketing expenses.


General
and administrative expense. The increase in general and administrative
dollars is primarily related to increases to our incentive compensation plan of 2003 and
an increase in general liability and directors and officer insurance premiums.


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|Interest
income.Interest income remained consistent in 2003 and 2002. The increase
in excess cash to invest in 2003 was offset by a reduction in interest rates.


Interest
expense. The interest expense decrease is attributable to our reduction of
debt. On March 14, 2003, a director surrendered a $1 million Promissory Note in exchange
for 293,255 unregistered shares of our Common Stock at a price of $3.41 per share. The
price was calculated at 110% of our Common Stock trailing ten-day average closing price of
$3.10 per share.


Other
income. Other income is attributable to payments received from a previously
written-off note receivable and equity investment.


Benefit
from income taxes. We recognized a benefit from income taxes of $656,000 in
2003 as result of a $470,000 carryback claim pursuant to the Economic Stimulus package of
2002 and a $300,000 reduction in deferred income tax accruals associated with certain tax
deductions taken in our 1999 federal tax return which were no longer required. Offsetting
these benefits, we provided a 4% effective tax rate for anticipated federal alternative
minimum taxes and minimum state income taxes due for 2003. We recorded no tax provision in
2002 as we only had $39,000 net income for the year and were able to fully offset minimum
taxes with net operating loss carryforwards. We have fully reserved our otherwise
recognizable deferred tax asset, as its realization is uncertain.


Liquidity and capital
resources


The
following table sets forth, for the periods indicated, a year-over year comparison of key
components of our liquidity and capital resources (000s omitted except in current
ratio calculation):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          |  |          | Change
2004 to 2003 |        
|------------------------- |  | -------- | ------------------- | -------
|
|Operating cash flows      |  | $ 11,787 |                     | $ 1,195
|Investing cash flows      |  | (15,669  | )                   | (214   
|Financing cash flows      |  | 3,432    |                     | 5,029  
|Capital expenditures, net |  | 619      |                     | 302    

|Additionally,
our cash position, working capital, accounts receivable, inventories, working capital and
current ratio are shown below for the periods indicated.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   |  |          | Change
2004 to 2003 |         
|---------------------------------- |  | -------- | ------------------- | --------
|
|Cash and cash equivalents          |  | $  7,509 |                     | $  7,959
|Available-for-sale investments, at | 
|market value                       |  | 17,650   |                     | 2,600   
|Accounts receivable, net           |  | 7,123    |                     | 6,637   
|Inventories, net                   |  | 5,866    |                     | 3,385   
|Working capital                    |  | 28,163   |                     | 13,669  

|As
of December 31, 2004, we had $25.2 million in cash and cash equivalents and
available-for-sale investments. We believe that our current cash balances and expected
future cash flows will be sufficient to meet our anticipated cash needs for working
capital, capital expenditures and other activities for at least the next 12 months. As of
December 31, 2004, we had no borrowings or long-term debt.


Cash
provided by operating activities increased for the twelve months ended December 31, 2004
compared to the same period in 2003. This increase primarily reflects the effects of an
increase in net profit and a decrease in working capital requirements. Cash used in
investing activities decreased during 2004 compared to the same period in 2003. These
amounts primarily reflect cash used for purchases of property and equipment, purchases of
available-for-sale investments offset by proceeds from the sale of available-for-sale
investments. Cash provided by financing activities decreased for the twelve month period
ended December 31, 2004 compared to the same period in 2003. This decrease was
primarily due to a decrease in sales of common stock offset partially due to an increase
in exercises of stock options.


-21-
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|We
anticipate that capital expenditures for 2005 will total approximately $400,000,
consisting primarily of machinery, equipment, computers and peripherals. We expect to
finance these expenditures with cash on hand.


On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light based, hair removal device for
women. The agreement provides up to $7 million in initial development support funding to
be paid by Gillette to us over approximately the first 30 months of the agreement. On June
28, 2004, Palomar and The Gillette Company announced that they completed the initial phase
of this agreement, and both parties moved into the next phase. The original agreement
provided for $7 million in development funding from Gillette. Under this amendment,
Gillette will provide $2.1 million in additional development funding to further technical
innovations over a 9-month extension of the development phase, which is now planned to be
completed by August 31, 2006. We recognized $3.1 million of funded product development
revenues from Gillette during the twelve months ended December 31, 2004. Any amounts
received in advance of services performed are recorded as deferred revenue. Payments are
not refundable if the development is not successful.


In
the first quarter of 2004, we began providing services under a $2.5 million research
contract with the Department of the Army to develop a light based self-treatment device
for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby
we are reimbursed for the expenses incurred in connection with PFB research plus an 8%
fee. Revenue is recognized under the contract as the costs are incurred and the services
are rendered. This revenue is included in funded product development revenue in the
accompanying statements of operations. Though the project was scheduled to last for
nineteen months, we now believe it will need several more months to complete the work. We
recognized $1.1 million of funded product development revenues from the Department of the
Army during the twelve months ended December 31, 2004.


On
June 22, 2004, we announced that we had reached a settlement agreement with Lumenis
resolving their on-going litigation concerning both patent infringement and contractual
matters. Pursuant to the settlement, the federal action in the Northern District of
California and the state court action in Massachusetts were dismissed with prejudice.
Under the terms of the settlement, Lumenis paid $868,000 in the second quarter for
back-owed royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to
pay $3.225 million over the next six quarters, or $537,500 per quarter, for back-owed
royalties due on sales of the LightSheer made between July 1, 2002 and December 31, 2003.
Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the
LightSheer and other professional laser hair removal devices and modules. In addition,
Lumenis granted us a paid up license to a variety of Lumenis patents for our light
based devices. We granted Lumenis a paid up license to the 568 and 844 patents
for Lumenis lamp based devices. Both parties have agreed to the validity and
enforceability of each others patents and not to challenge such validity and
enforceability in the future. For the twelve months ended December 31, 2004, Lumenis made
payments of approximately $1.4 million relating to the 5% royalty and approximately $1.9
million for back-owed royalties recorded as royalty revenue.



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|Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson Consumer Companies, Inc. (JJCC), a Johnson & Johnson
company, to develop and commercialize home-use, light based devices in the fields of (i)
reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin
aging; and (iii) reducing or preventing acne. The agreement provides for JJCC to fund our
research and clinical studies during an initial proof-of-principle phase. At the end of
the proof-of-principle phase, JJCC will decide whether or not to continue with one or more
of the devices in one or more of the fields into a development phase. Upon JJCC deciding
to continue, JJCC will be obligated to fund the development of the selected devices. 
If JJCC decides not to continue, we may proceed in fields not selected by JJCC to develop
and commercialize these and other devices on our own or with a different party. At the end
of the development phase, JJCC will decide whether or not to commercialize one or more of
the devices in one or more fields. Upon JJCC deciding to commercialize one or more of the
devices, JJCC will make payments to us for each selected field. Upon commercial launch of
the first device in each selected field, JJCC will make a payment to us, and for all
devices sold for use in each selected field, JJCC shall pay us a percentage of sales of
such devices and certain topical compounds. If JJCC decides not to commercialize or fails
to launch a device, we may proceed in fields not selected by JJCC to develop and
commercialize these and other devices on our own or with a different party. We recognized
$318,000 of funded product development revenues from JJCC during the twelve months ended
December 31, 2004. Any amounts received in advance of services performed are recorded as
deferred revenue. Payments are not refundable if the development is not successful.



Contractual obligations


On
August 1, 2004, we entered into a new agreement with Massachusetts General Hospital
whereby it agreed to conduct clinical and non-clinical research in the field of photo
thermal removal or reduction of hair, using light. The agreement has a term of three
years, until August 2007, and we will provide Massachusetts General Hospital at least
$230,000 on an annual basis to cover the direct and indirect costs of the research. We
have the right to exclusively license, on royalty terms to be negotiated, the inventions
we fund that are discovered during this research.


We
are a party to a license agreement, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties. Royalty expense
in 2004 totaled approximately $2.8 million.


We
are obligated to make future payments under various contracts, including non-cancelable
inventory purchase commitments and our operating lease relating to our Burlington,
Massachusetts manufacturing, research and development and administrative offices.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2004, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (000s omitted):
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   |        |         | Payments due by period |         |       
|---------------------------------- | ------ | ------- | ---------------------- | ------- | ------
|
|Operating lease                    | $4,509 | $   949 | $2,848                 | $   712 | $   --
|Purchase commitments               | 2,790  | 2,790   | --                     | --      | --    
|                                   |       
|Total contractual cash obligations | $7,299 | $3,739  | $2,848                 | $   712 | $   --
|                                   |       
|                                  

|Recently issued
accounting standards


In
December 2004, the FASB issued SFAS 123(R), Share-Based Payment. SFAS No.
123(R) revises SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation
guidance. SFAS 123(R) will require compensation costs related to share-based payment
transactions to be recognized in the financial statements (with limited exceptions). The
amount of compensation cost will be measured based on the grant-date fair value of the
equity or liability instruments issued. Compensation cost will be recognized over the
period that an employee provides service in exchange for the award. This statement is
effective as of the beginning of the first interim or annual reporting period that begins
after June 15, 2005. We will adopt the standard as of the effective date. (See Note 1,
Stock based compensation for the effect on our financial statements.)


In
November 2004, the FASB issued FASB Statement No. 151, Inventory Costs,
an amendment of ARB No. 43, Chapter 4. The amendments made by Statement 151 clarify that
abnormal amounts of idle facility expense, freight, handling costs, and wasted materials
(spoilage) should be recognized as current-period charges and require the allocation of
fixed production overheads to inventory based on the normal capacity of the production
facilities. SFAS 151 is effective for inventory costs incurred during fiscal years
beginning after June 15, 2005. We do not believe there will be a material effect upon our
financial condition or results of operations from the adoption of the provisions of SFAS
151.



-23-
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|Cautionary statements


Our future revenue may decrease if
we are unable to successfully develop and market new products.


Light
based technology is rapidly changing and improving. In order to be successful, we must
continue to make significant investments in research and development in order to develop
in a timely and cost-effective manner, new products that meet changing market demands,
enhance existing products, and achieve market acceptance for such products. We have in the
past experienced delays in developing and marketing new products and enhancing existing
products. Furthermore, some of our new products under development are based on unproven
technology and/or technology with which we have no previous experience. In addition, the
market for professional hair removal light based devices may already be saturated. At
present, broader market acceptance of light based hair removal is critical to our success
and we intend to continue our goals of bringing light based hair removal devices to the
mass consumer market. We also intend to continue to diversify our product line by
developing cosmetic light based products for uses other than hair and tattoo removal,
treatment of acne and wrinkles, and treatment of pigmented and vascular lesions. There can
be no assurance that we will be able to successfully implement such strategy in a timely
fashion or at all and our failure to do so could decrease our future revenue.


Our failure to respond to rapid
changes in technology could make our products obsolete and we may be unable to compete
with companies having superior financial, marketing and other resources.


The
light based cosmetic and dermatology industry is highly competitive and companies
frequently introduce new products. We compete in the development, manufacture, marketing,
sales and servicing of light based devices with numerous other companies, some of which
have substantially greater financial, marketing and other resources than us. Our products
also face competition from medical products, prescription drugs and cosmetic procedures,
such as electrolysis and waxing, among others. We may not be able to differentiate our
products from the products of our competitors, and customers may not consider our products
to be superior to competing products or procedures, especially if competitive products and
procedures are offered at lower prices. Our competitors may develop products or new
technologies that make our products obsolete or less competitive. If forecasted demand
decreases, we could have excess inventories which may result in a write-off of some or all
of our inventory.


We may need to secure additional
financing and without such additional financing we may be unable to fund ongoing
operations or grow the business.


Although
we have generated a profit in recent years, we have a history of losses. We may have to
secure additional financing to complete our research and development activities,
commercialize our current and proposed light based products, and fund ongoing operations.
However, there can be no assurance that such financing will be obtained. We may also
determine, depending upon the opportunities available, to seek additional debt or equity
financing to fund the costs of operations or expansion. Additionally, if we incur
indebtedness to fund increased levels of accounts receivable, finance the acquisition of
capital equipment, or if we issue debt securities in connection with any acquisition we
will be subject to risks associated with incurring substantial additional indebtedness.
Our quarterly operating results are and may continue to be volatile, and that may hurt the
price of our common stock. If our operating results fall below the expectations of
investors or public market analysts, the price of our common stock could decline.


Failure to receive shipments of
critical components could reduce revenues and reduced reliability of critical components
could increase expenses.


We
develop light based systems that incorporate third-party components. Some of these items
are custom made or otherwise not readily available on the market. We purchase some of
these components from small, specialized vendors that are not well capitalized. A
disruption in the delivery of these key components could prevent us from manufacturing
products and result in a decrease in revenue. We depend on an acceptable level of
reliability for purchased components. Reliability below expectations for key components
could have an adverse affect on inventory and inventory reserves.


-24-
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|Our products are subject to
numerous medical device regulations. Compliance is expensive and time-consuming. Without
necessary clearances, we may be unable to sell products and compete effectively.


All
of our current products are light based devices, which are subject to FDA regulations for
clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new
product or a new use of or claim for an existing product can be marketed in the United
States, we must obtain clearance from the FDA. The types of medical devices that we seek
to market in the U.S. generally must receive either 510(k) clearance or
PMA approval in advance from the U.S. Food and Drug Administration (FDA)
pursuant to the Federal Food, Drug, and Cosmetic Act. The FDAs 510(k) clearance
process usually takes from four to twelve months, but it can last longer. The process of
obtaining PMA approval is much more costly and uncertain and generally takes from one to
three years or even longer. To date, the FDA has deemed our products eligible for the
510(k) clearance process. We believe that our products in development will receive similar
treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA
approval process upon one or more of our future products, nor can we be sure that 510(k)
clearance or PMA approval will ever be obtained for any product we propose to market and
our failure to do so could adversely affect our ability to sell our products.


Our
products are subject to similar regulations in many international markets. Complying with
these regulations is necessary for our strategy of expanding the markets for sales of our
products into these countries. Compliance with the regulatory clearance process in any
country is expensive and time consuming. Regulatory clearances may necessitate clinical
testing, limitations on the number of sales and limitations on the type of end user, among
other things. In certain instances, these constraints can delay planned shipment schedules
as design and engineering modifications are made in response to regulatory concerns and
requests. We may not be able to obtain clearances in each country in a timely fashion or
at all, and our failure to do so could adversely affect our ability to sell our products
in those countries.


We have modified some of our
products and sold them under prior 510(k) clearances. The FDA could retroactively decide
the modifications required new 510(k) clearances and require us to cease marketing and/or
recall the modified products.


Any
modification to one of our 510(k) cleared devices that could significantly affect its
safety or effectiveness, or that would constitute a major change in its intended use,
requires a new 510(k) clearance. The FDA requires every manufacturer to make this
determination in the first instance, but the FDA can review any such decision. We have
modified some of our marketed devices, but we believe that new 510(k) clearances are not
required. We cannot be certain that the FDA would agree with any of our decisions not to
seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any
modification, we also may be required to cease marketing and/or recall the modified device
until we obtain a new 510(k) clearance.


We may also be subject to state
regulations. State regulations, and changes to state regulations, may prevent sales to
particular end users which may decrease revenues or prevent growth of revenues.


Our
products may also be subject to state regulations. Federal regulation allows our products
to be sold to and used by licensed practitioners as determined on a state-by-state basis.
As a result, in some states non-physicians may purchase and operate our product. However,
a state could disagree with our decision to sell to a particular type of end user or
change regulations preventing sales to particular types of end users. Thus, state
regulations and changes to state regulations may decrease revenues or prevent growth of
revenues. The purchase and use of our products by non-physicians may result in their
misuse, which could harm our reputation and expose us to costly product liability
litigation.


Achieving complete compliance with
FDA regulations is difficult, and if we fail to comply, we could be subject to FDA
enforcement action.


We
are subject to inspection and market surveillance by the FDA to determine compliance with
regulatory requirements. The FDAs regulatory scheme is complex, especially the
Quality System Regulation (QSR), which requires manufacturers to follow
elaborate design, testing, control, documentation, and other quality assurance procedures.
This complexity makes complete compliance difficult to achieve. Also, the determination as
to whether a QSR violation has occurred is often subjective. If the FDA finds that we have
failed to comply with the QSR or other applicable requirements, the agency can institute a
wide variety of enforcement actions, including a public warning letter or other stronger
remedies, such as fines, injunctions, and civil penalties, recall or seizure of our
products, operating restrictions, partial suspension, or total shutdown of our production,
refusing our requests for 510(k) clearance or PMA approval of new products, withdrawing
product approvals already granted or criminal prosecution.


-25-
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|Failure to manage our
relationships with third party researchers effectively may limit our access to new
technology, increase the cost of licensing new technology, and divert management attention
from our core business.


We
are dependent upon third-party researchers over whom we do not have absolute control to
satisfactorily conduct and complete research on our behalf. We are also dependent upon
third-party researchers to grant us licensing terms, which may or may not be favorable for
products and technology which they may develop. At present, our principal research partner
is the Wellman Laboratories of Photomedicine at Massachusetts General Hospital. We provide
research funding, light technology and optics know-how in return for licensing rights with
respect to specific dermatologic and cosmetic applications and patents. In return for
certain exclusive license rights, we are subject to due diligence obligations in order to
maintain such exclusivity. Our success will be dependent upon the results of research with
our partners and meeting due diligence obligations. We cannot be sure that third-party
researchers will agree with our interpretation of the terms of our agreements, that we
will meet our due diligence obligations, or that such research agreements will provide us
with marketable products in the future or that any of the products developed under these
agreements will be profitable for us.


Our common stock could be further
diluted by the conversion of outstanding options and warrants.


In
the past, we have issued and still have outstanding convertible securities in the form of
options and warrants. We have and may continue to issue options and warrants as
compensation for services and incentive compensation for our employees, directors and
consultants or others who provide services to us. We have a substantial number of shares
of common stock reserved for issuance upon the conversion and exercise of these
securities. Such a conversion would dilute our stockholders and could adversely affect the
market price of our common stock.


Our proprietary technology has
only limited protections which may not prevent competitors from copying our new
developments. This may impair our ability to compete effectively, and we may expend
significant resources enforcing our intellectual property rights to prevent such copying.


Our
business could be materially and adversely affected if we are not able to adequately
protect our intellectual property rights. We rely on a combination of patent, copyright,
trademark and trade secret laws, licenses and confidentiality agreements to protect our
proprietary rights. We generally enter into non-disclosure agreements with our employees
and third parties with whom we work, including but not limited to consultants and vendors,
to restrict access to, and distribution of, our proprietary information. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to copy or
otherwise obtain and use our technology. Monitoring unauthorized use of our technology is
difficult and we cannot be certain that the steps we have taken will prevent unauthorized
use of our technology, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as in the United States. If competitors are able to use
our technology, our ability to compete effectively could be harmed. Costly and time
consuming lawsuits may be necessary to enforce and defend patents issued or licensed
exclusively to us,, to protect our trade secrets and/or know-how or to determine the
enforceability, scope and validity of others intellectual property rights. Such
lawsuits may result in patents issued or licensed exclusively to us to be found invalid
and unenforceable. Our competitors also may independently develop technologies that are
substantially equivalent or superior to our technology and which do not infringe our
patents.


Claims by others that our products
infringe their patents or other intellectual property rights could prevent us from
manufacturing and selling some of our products or require us to pay royalties or incur
substantial costs from litigation or development of non-infringing technology.


-26-
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|In
recent years, there has been significant litigation in the United States involving patents
and other intellectual property rights. The light based cosmetic and dermatology industry
in particular is characterized by a large number of patents and related litigation
regarding patents and other intellectual property rights. Because our resources are
limited and patent applications are maintained in secrecy for a period of time, we can
conduct only limited searches to determine whether our technology infringes any patents or
patent applications. Any claims for patent infringement, regardless of merit, could be
time-consuming, result in costly litigation and diversion of technical and management
personnel, cause shipment delays, require us to develop non-infringing technology or to
enter into royalty or licensing agreements. Although patent and intellectual property
disputes in the light based industry have often been settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial and often require
the payment of ongoing royalties, which could have a negative impact on gross margins.
There can be no assurance that necessary licenses would be available to us on satisfactory
terms, or that we could redesign our products or processes to avoid infringement, if
necessary. Accordingly, an adverse determination in a judicial or administrative
proceeding or failure to obtain necessary licenses could prevent us from manufacturing and
selling some of our products. This could have a material adverse effect on our business,
results of operations and financial condition.


Our charter documents and Delaware
law may discourage potential takeover attempts.


Our
Second Restated Certificate of Incorporation and our By-laws contain provisions that could
discourage takeover attempts or make more difficult the acquisition of a substantial block
of our common stock. Our By-laws require a stockholder to provide to our Secretary advance
notice of director nominations and business to be brought by such stockholder before any
annual or special meeting of stockholders, as well as certain information regarding such
nomination and/or business, the stockholder and others known to support such proposal and
any material interest they may have in the proposed business. They also provide that a
special meeting of stockholders may be called only by the affirmative vote of a majority
of the board of directors. These provisions could delay any stockholder actions that are
favored by the holders of a majority of our outstanding stock until the next
stockholders meeting. In addition, the board of directors is authorized to issue
shares of our common stock and preferred stock that, if issued, could dilute and adversely
affect various rights of the holders of common stock and, in addition, could be used to
discourage an unsolicited attempt to acquire control of us.


We
are also subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law, which prohibits us from engaging in a business combination
with an interested stockholder for a period of three years after the date of
the transaction in which the person becomes an interested stockholder, unless the business
combination is approved in a prescribed manner. The application of Section 203 may limit
the ability of stockholders to approve a transaction that they may deem to be in their
best interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers or tender
offers or could delay or prevent certain changes in control or our management, including
transactions in which stockholders might otherwise receive a premium for their shares over
the then current market price. In April 1999, we adopted a shareholder rights plan. This
is intended to protect shareholders from unfair or coercive takeover practices. In
accordance with the shareholder rights plan, the Board of Directors declared a dividend
distribution of Series A right for each share of common stock outstanding until the rights
become exercisable.


We may not be able to
successfully collect licensing royalties.


In
past years and now again following the settlement with Lumenis, material portions of our
revenues consist of royalties from sub-licensing patents licensed to us on an exclusive
basis by Massachusetts General Hospital.


We
have sued Cutera, Inc. (formerly Altus Medical Inc., See Legal Proceedings) for patent
infringement, and we are involved in patent disputes with other third parties. Such other
disputes may also result in litigation. We have incurred, and likely will continue to
incur, legal expenses in connection with such matters. There can be no assurance that such
litigation will result in favorable outcomes for us. Any adverse result in litigation
could weaken the strength of the patents involved, and have a material adverse effect on
our business, financial condition and results of operations.


-27-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We may be unable to attract and
retain key executives and research and development personnel that we need to succeed.


As
a small company with less than 175 employees, our success depends on the services of key
employees in executive and research and development positions. The loss of the services of
one or more of these employees could have a material adverse effect on our business. Our
future success will depend in large part upon our ability to attract, retain, and motivate
highly skilled employees. We cannot be certain that we will be able to do so.


We face a risk of financial
exposure to product liability claims in the event that the use of our products results in
personal injury.


Our
products are and will continue to be designed and manufactured with numerous safety
features, but it is possible that consumers could be adversely affected by use of one of
our products. Furthermore, in the event that any of our products prove to be defectively
designed and manufactured, we may be required to recall and redesign such products.
Although we have not experienced any material losses due to product liability claims to
date, there can be no assurance that we will not experience such losses in the future. We
maintain general liability insurance and umbrella coverage; however, there can be no
assurance that such coverage will continue to be available on terms acceptable to us or
that such coverage will be adequate for liabilities actually incurred. In the event we are
found liable for damages in excess of the limits of our insurance coverage or if any claim
or product recall results in significant adverse publicity against us, our business,
financial condition and results of operations could be materially and adversely affected.
In addition, although our products have been and will continue to be designed to operate
in a safe manner, and although we attempt to educate customers with respect to the proper
use of our products, misuse of our products by personnel over whom we cannot exert control
may result in the filing of product liability claims or significant adverse publicity
against us.


Disappointing quarterly revenue or
operating results could cause the price of our common stock to fall.


Our
quarterly revenue and operating results are difficult to predict and may swing sharply
from quarter to quarter.  If our quarterly revenue or operating results fall
below the expectations of investors or public market analysts, the price of our common
stock could fall substantially. Our quarterly revenue is difficult to forecast for many
reasons, some of which are outside of our control. For example, many factors are related
to market supply and demand, including potential increases in the level and intensity of
price competition between our competitors and us, potential decrease in demand for our
products and possible delays in market acceptance of our new products. Other factors are
related to our customers and include changes in or extensions of our customers
budgeting and purchasing cycles and changes in the timing of product sales in anticipation
of new product introductions or enhancements by us or our competitors. Factors related to
our operations may also cause quarterly revenue or operating results to fall below
expectations, including absence of significant product backlogs, our effectiveness in our
manufacturing process, unsatisfactory performance of our distribution channels, service
providers, or customer support organizations, and timing of any acquisitions and related
costs.


We face risks associated
with product warranties.


We
could incur substantial costs as a result of product failures for which we are responsible
under warranty obligations.


Because we derive a significant
amount of our revenue from international sales, we are susceptible to currency
fluctuations, long payment cycles, credit risks and other risks associated with conducting
business overseas.


We
sell a significant amount of our products and services outside the U.S. International
product revenue, consisting of sales from our distributors in Japan, Europe, Australia,
Asia\Pacific Rim and South and Central America and sales shipped directly to international
locations from the United States was 37% of total product revenue for the year ended 2004,
and we expect that international sales will continue to be significant. As a result, a
major part of our revenues and operating results could be adversely affected by risks
associated with international sales. In particular, longer payment cycles common in
foreign markets, credit risk and delays in obtaining necessary import or foreign
regulatory approvals for products may occur. In addition, significant fluctuations in the
exchange rates between the U.S. dollar and foreign currencies could cause us to lower our
prices and thus reduce our profitability, or could cause prospective customers to push out
orders to later dates because of the increased relative cost of our products in the
aftermath of a currency devaluation or currency fluctuation.


-28-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Managing our relationship with
Gillette effectively may divert the attention of key technical personnel and management
from the core business. If Gillette ends the relationship our stock price could fall, and
we may be unable to bring a home use hair removal device for women to the market.


On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light based hair removal device for
women. On June 28, 2004 Palomar and Gillette announced that they completed the initial
phase of their agreement and that both parties would move into the next phase. In
conjunction with entering this next phase, the parties amended the agreement to provide
for additional development funding to further technical innovations. We believe that this
represents a unique opportunity to bring light based devices to the mass market. Under the
agreement, significant resources and the attention of key technical personnel and
management will be directed to the development of such a device even though such device
will not likely be commercialized for several years, if ever. In addition, we cannot be
sure that Gillette will agree with our interpretation of the terms of the agreement, that
the agreement will provide us with marketable products in the future or that we will
receive payments for any of the products developed under the agreement. During the term of
the agreement, Gillette has the ability to choose not to continue and may terminate the
agreement. If Gillette terminates the agreement, the price of our common stock could fall
significantly, and we will not receive certain payments. We may proceed to develop and
commercialize the device on our own or with a third party. However, there can be no
assurance that we will be able to successfully implement such a strategy. In addition,
after commercialization of such device, Gillette is to pay us a percentage of net sales of
such device. Certain of these percentages of net sales are only owed if the device is
covered by valid patents. There can be no assurance that valid patents will cover the
device in any or all countries, in which the device will be manufactured, used or sold.
This could have a material adverse effect on our business, results of operations and
financial condition.


Managing our contract with the
Army effectively may divert the attention of key technical personnel and management from
the core business. We may be unable to complete the project within the time period which
may impact our ability to receive future government contracts.


On
February 18, 2004, we announced that we were awarded a $2.5 million research contract by
the Department of the Army to develop a light based self-treatment device for
Pseudofolliculitis Barbae or PFB. We believe this represents a unique opportunity to
address PFB. Although the project was scheduled to last for nineteen months, we now
believe it will take several additional months to complete the work. There can be no
assurance that we will be able to complete the project within that time period which may
impact our ability to receive future government contracts. Under the agreement,
significant resources and the attention of key technical personnel and management will be
directed to the development of such a device even though such device will not likely be
ready for military use for several years, if ever.


-29-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Managing our relationship with
Johnson & Johnson Consumer Companies (JJCC) effectively may divert the
attention of key technical personnel and management from the core business. If JJCC ends
the relationship our stock price could fall, and we may be unable to bring to market
home-use, devices for (i) reducing or reshaping body fat including cellulite;
(ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.


On
September 1, 2004, we entered into a Development and License Agreement with Johnson &
Johnson Consumer Companies, Inc. (JJCC), a Johnson & Johnson company, to
develop and commercialize home-use, light based devices in the fields of (i) reducing or
reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii)
reducing or preventing acne. We believe that this represents a unique opportunity to bring
light based devices to the mass market. Under the agreement, significant resources and the
attention of key technical personnel and management will be directed to the development of
such devices even though such devices will not likely be commercialized for several years,
if ever. In addition, we cannot be sure that JJCC will agree with our interpretation of
the terms of the agreement, that the agreement will provide us with marketable products in
the future or that we will receive payments for any of the products developed under the
agreement.During the term of the agreement, JJCC has the ability to choose not to
continue and may terminate the agreement. If JJCC terminates the agreement, the price of
our common stock could fall significantly, and we will not receive certain payments. We
may proceed to develop and commercialize the devices on our own or with a third party.
However, there can be no assurance that we will be able to successfully implement such a
strategy.In addition, after commercialization of such device, JJCC is to pay us a
percentage of net sales of such device. Certain of these percentages of net sales are only
owed if the device is covered by valid patents. There can be no assurance that valid
patents will cover these devices in any or all countries, in which the devices will be
manufactured, used or sold. This could have a material adverse effect on our business,
results of operations and financial condition.



Item 7A. Quantitative
and Qualitative Disclosures About Market Risk


Our
primary market risk exposures are in the areas of interest rate risk. Our investment
portfolio of cash equivalents and debt securities is subject to interest rate
fluctuations, but we believe this risk is immaterial because of the short-term nature of
these investments.

Item 8.
Financial Statements and Supplementary Data.


Palomar
Medical Technologies, Inc. and SubsidiariesIndex to
Consolidated Financial Statements
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                 | Page
|-------------------------------------------------------------------------------- | ----
|                                                                                 |     
|                                                                                 |     
|Report of Independent Registered Public Accounting Firm                          |     
|                                                                                 |     
|Consolidated Balance Sheets - December 31, 2004 and 2003                         |     
|                                                                                 |     
|Consolidated Statements of Income - Years ended December 31, 2004, 2003          |     
|and 2002                                                                         |     
|                                                                                 |     
|Consolidated Statements of Stockholders Equity - Years ended December 31, 2004, |     
|2003 and 2002                                                                    |     
|                                                                                 |     
|Consolidated Statements of Cash Flows - Years ended December 31, 2004, 2003      |     
|and 2002                                                                         |     
|                                                                                 |     
|Notes to Consolidated Financial Statements                                       |     

|-30-
|----

|Report of Independent Registered
Public Accounting Firm


The Board of Directors
and Stockholders  Palomar Medical Technologies, Inc.:


We have audited the accompanying
consolidated balance sheets of Palomar Medical Technologies, Inc. as of December 31, 2004
and 2003, and the related consolidated statements of income, stockholders equity,
and cash flows for each of the three years in the period ended December 31, 2004. These
financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on our audits.


We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion.


In our opinion, the financial
statements referred to above present fairly, in all material respects, the consolidated
financial position of Palomar Medical Technologies, Inc. at December 31, 2004 and 2003,
and the consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 2004, in conformity with U.S. generally accepted
accounting principles.


We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of Palomar Medical Technologies Inc.s internal control over financial
reporting as of December 31, 2004, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated March 7, 2005 expressed an unqualified opinion
thereon.



Ernst & Young LLP
Boston, MassachusettsMarch
7, 2005


-31-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Consolidated Balance
Sheets
|---------------------------------------------------------------------------------

|                                                                                 | December 31,
2004 | December 31,
2003
|-------------------------------------------------------------------------------- | ----------------- | -----------------
|Assets                                                                           |                   |                  
|Current assets:                                                                  |                  
|Cash and cash equivalents                                                        |                   | $     7,508,856  
|Available-for-sale investments, at market value                                  |                   | 17,650,000       
|Accounts receivable, net of allowance of $979,392 and $862,114,     respectively |                   | 7,122,745        
|Inventories                                                                      |                   | 5,866,494        
|Other current assets                                                             |                   | 440,254          
|                                                                                 |                   |                  
|Total current assets                                                             |                   | 38,588,349       
|                                                                                 |                   |                  
|Property and equipment, net                                                      |                   | 899,368          
|                                                                                 |                   |                  
|Other assets                                                                     |                   | 111,074          
|                                                                                 |                   |                  
|Total Assets                                                                     |                   | $   39,598,791   
|                                                                                 |                   |                  
|Liabilities and Stockholders' Equity                                             |                  
|Current liabilities:                                                             |                  
|Accounts payable                                                                 |                   | $        971,030 
|Accrued liabilities                                                              |                   | 8,014,207        
|Deferred income taxes                                                            |                   | --               
|Deferred revenue                                                                 |                   | 1,439,639        
|                                                                                 |                   |                  
|Total current liabilities                                                        |                   | 10,424,876       
|                                                                                 |                   |                  
|Commitments and Contingencies (note 8)                                           |                  
|                                                                                 |                   |                  
|Stockholders' equity:                                                            |                   |                  
|Preferred stock, $.01 par value-                                                 |                   |                  
|Authorized - 1,500,000 shares                                                    |                   |                  
|Issued -  none                                                                   |                   | --               
|Common stock, $.01 par value-                                                    |                  
|Authorized - 45,000,000 shares                                                   |                  
|Issued - 16,231,502 and 14,554,407 shares, respectively                          |                   | 162,315          
|Additional paid-in capital                                                       |                   | 172,428,102      
|Accumulated deficit                                                              |                   | (143,416,502     
|                                                                                 |                   |                  
|Total stockholders' equity                                                       |                   | 29,173,915       
|                                                                                 |                   |                  
|Total liabilities and stockholders equity                                       |                   | $   39,598,791   
|                                                                                 |                   |                  

|The accompanying notes are an integral part of these consolidated financial statements
-32-
|-------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Consolidated
Statements of Income
|---------------------------------------------------------------------------------------

|                                               | Years Ended December 31, |  |  
|---------------------------------------------- | ------------------------ |  | -
|
|Revenues:                                      |                          |  |  
|Product revenues                               |                          |  | $
|Royalty revenues                               |                          |  |  
|Funded product development revenues            |                          |  |  
|                                               |                          |  |  
|Total revenues                                 |                          |  |  
|                                               |                          |  |  
|Costs and expenses:                            |                          | 
|Cost of product revenues                       |                          |  |  
|Cost of royalty revenues                       |                          |  |  
|Research and development                       |                          |  |  
|Selling and marketing                          |                          |  |  
|General and administrative                     |                          |  |  
|                                               |                          |  |  
|Total costs and expenses                       |                          |  |  
|                                               |                          |  |  
|Income (loss) from operations                  |                          |  |  
|                                               |                          |  |  
|Interest income                                |                          |  |  
|Interest expense                               |                          |  |  
|Other income (expense), net                    |                          |  |  
|                                               |                          |  |  
|Income before benefit from income taxes        |                          |  |  
|                                               |                          |  |  
|Benefit from income taxes                      |                          |  |  
|                                               |                          |  |  
|Net income                                     |                          |  | $
|                                               |                          |  |  
|Net income per share:                          |                          | 
|Basic                                          |                          |  | $
|                                               |                          |  |  
|Diluted                                        |                          |  | $
|                                               |                          |  |  
|Weighted average number of shares outstanding: |                          | 
|Basic                                          |                          |  |  
|                                               |                          |  |  
|Diluted                                        |                          |  |  
|                                               |                          |  |  

|The accompanying notes are an integral part of these consolidated financial statements
-33-
|-------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Consolidated
Statements of Stockholders Equity
|-----------------------------------------------------------------------------------------------------

|                                                                      | Preferred Stock |        | Common Stock |           | Treasury Stock |            | Additional |           |  |                 | Total |                
|--------------------------------------------------------------------- | --------------- | ------ | ------------ | --------- | -------------- | ---------- | ---------- | --------- |  | --------------- | ----- | ---------------
|
|Balance, December 31, 2001                                            |                 | 6,000  |              | $      60 |                | 11,074,393 |            | $ 110,744 |  | (573,031        | )     | $(2,099,373    
|Net  income                                                           |                 |       |              |          |                |           |            |          |  |                |       |               
|Issuance of stock for employee stock purchase plan                    |                 |       |              |          |                | 24,202     |            | 242       |  | 13,617          |       | 49,839         
|Issuance of stock for employer 401(k) matching contribution           |                 |       |              |          |                |           |            |          |  | 148,855         |       | 545,362        
|Costs incurred related to the issuance of common stock                |                 |       |              |          |                |           |            |          |  |                |       |               
|Issuance of stock for settlement                                      |                 |       |              |          |                | 358,547    |            | 3,585     |  |                |       |               
|Issuance of stock for services                                        |                 |       |              |          |                | 25,000     |            | 250       |  |                |       |               
|Conversion of convertible preferred stock                             |                 | (6,000 | )            | (60       | )              | 56,564     |            | 566       |  | 410,559         |       | 1,504,172      
|Preferred stock dividends                                             |                 |       |              |          |                |           |            |          |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Comprehensive income                                                  |                 |       |              |          |                |           |            |          |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Balance, December 31, 2002                                            |                 |       |              |          |                | 11,538,706 |            | 115,387   |  |                |       |               
|Net income                                                            |                 |       |              |          |                |           |            |          |  |                |       |               
|Issuance of stock for employee stock purchase plan                    |                 |       |              |          |                | 22,422     |            | 224       |  |                |       |               
|Issuance of stock for employer 401(k) matching contribution           |                 |       |              |          |                | 184,109    |            | 1,841     |  |                |       |               
|Costs incurred related to the issuance of common stock                |                 |       |              |          |                |           |            |          |  |                |       |               
|Tax benefit from the exercise of stock options                        |                 |       |              |          |                |           |            |          |  |                |       |               
|Exercise of warrants                                                  |                 |       |              |          |                | 99,000     |            | 990       |  |                |       |               
|Exercise of stock options                                             |                 |       |              |          |                | 1,416,915  |            | 14,169    |  |                |       |               
|Exchange of note payable from related party          for common stock |                 |       |              |          |                | 293,255    |            | 2,933     |  |                |       |               
|Sale of common stock                                                  |                 |       |              |          |                | 1,000,000  |            | 10,000    |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Comprehensive income                                                  |                 |       |              |          |                |           |            |          |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Balance, December 31, 2003                                            |                 |       |              |          |                | 14,554,407 |            | 145,544   |  |                |       |               
|Net income                                                            |                 |       |              |          |                |           |            |          |  |                |       |               
|Issuance of stock for employee stock purchase plan                    |                 |       |              |          |                | 20,052     |            | 200       |  |                |       |               
|Issuance of stock for employer 401(k) matching contribution           |                 |       |              |          |                | 50,156     |            | 502       |  |                |       |               
|Costs incurred related to the issuance of common stock                |                 |       |              |          |                |           |            |          |  |                |       |               
|Tax benefit from the exercise of stock options                        |                 |       |              |          |                |           |            |          |  |                |       |               
|Exercise of warrants                                                  |                 |       |              |          |                | 38,000     |            | 380       |  |                |       |               
|Exercise of stock options                                             |                 |       |              |          |                | 1,568,887  |            | 15,689    |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Comprehensive income                                                  |                 |       |              |          |                |           |            |          |  |                |       |               
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                
|Balance, December 31, 2004                                            |                 |       |              | $        |                | 16,231,502 |            | $ 162,315 |  | $              |       | $             
|                                                                      |                 |        |              |           |                |            |            |           |  |                 |       |                

|The accompanying notes are an integral part of these consolidated financial statements
-34-
|-------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Consolidated
Statements of Cash Flows
|-------------------------------------------------------------------------------------------

|                                                             | Years Ended December 31, |                  |  
|------------------------------------------------------------ | ------------------------ | ---------------- | -
|
|Cash flows from operating activities:                        |                          |                  |  
|Net income                                                   |                          | $ 10,633,313     |  
|                                                             |                         
|Adjustments to reconcile net income  to net cash provided by |                         
|(used in) operating activities:                              |                         
|Depreciation and amortization                                |                          | 302,993          |  
|Provision for bad debt                                       |                          | 305,571          |  
|Inventory write-off                                          |                          | 210,000          |  
|Tax benefit from the exercise of stock options               |                          | 191,434          |  
|Issuance of common stock for services                        |                          | --               |  
|Changes in assets and liabilities,                           |                         
|Accounts receivable                                          |                          | (791,070         | )
|Inventories                                                  |                          | (2,691,178       | )
|Other current assets                                         |                          | (55,469          | )
|Accounts payable                                             |                          | 315,107          |  
|Accrued liabilities                                          |                          | 3,587,643        |  
|Deferred income taxes                                        |                          | (1,100,000       | )
|Deferred revenue                                             |                          | 878,742          |  
|                                                             |                          |                 
|Net cash provided by operating activities                    |                          | 11,787,086       |  
|                                                             |                          |                 
|Cash flows from investing activities:                        |                         
|Purchases of property and equipment                          |                          | (619,463         | )
|Purchases of available-for-sale investments                  |                          | (22,450,000      | )
|Proceeds from sale of available-for-sale investments         |                          | 7,400,000        |  
|Decrease in other assets                                     |                          | --               |  
|                                                             |                          |                 
|Net cash used in investing activities                        |                          | (15,669,463      | )
|                                                             |                          |                 
|Cash flows from financing activities:                        |                         
|Proceeds from the exercise of stock options, warrants and    |                         
|employee stock purchase plan                                 |                          | 3,511,887        |  
|Costs incurred related to issuance of common stock           |                          | (79,600          | )
|Proceeds from sale of common stock                           |                          | --               |  
|Payment on convertible debt                                  |                          | --               |  
|                                                             |                          |                 
|Net cash provided by (used in) financing activities          |                          | 3,432,287        |  
|                                                             |                          |                 
|Net increase in cash and cash equivalents                    |                          | (450,090         | )
|Cash and cash equivalents, beginning of the period           |                          | 7,958,946        |  
|                                                             |                          |                 
|Cash and cash equivalents, end of the period                 |                          | $   7,508,856    |  
|                                                             |                          |                 
|Supplemental disclosure of cash flow information:            |                         
|                                                             |                          |                  |  
|Cash paid for interest                                       |                          | $          6,086 |  
|                                                             |                          |                 
|Cash paid for income taxes                                   |                          | $        28,555  |  
|                                                             |                          |                 

|                                                                       |  |                    | 
|---------------------------------------------------------------------- |  | ------------------ | 
|
|Supplemental disclosure of noncash financing and investing activities: |  |                    | 
|                                                                       |  |                    | 
|Issuance of stock for employer 401(k) matching contribution            |  | $     553,332      | 
|                                                                       |  |                   
|Exchange of note payable for common stock                              |  | $               -- | 
|                                                                       |  |                   
|Exercise of warrants pursuant to net exercise provision                |  | $               -- | 
|                                                                       |  |                   
|Preferred stock accrued dividends and interest                         |  | $               -- | 
|                                                                       |  |                   
|Issuance of stock for settlement                                       |  | $               -- | 
|                                                                       |  |                   
|Conversion of preferred stock                                          |  | $               -- | 
|                                                                       |  |                   

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


-35-
|---------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements


Note 1  Summary of
Significant Accounting Policies


Business


Palomar
is engaged in research, development, manufacturing and distribution of proprietary light
based systems for hair removal and other cosmetic treatments.


Basis of Presentation


The
accompanying consolidated financial statements reflect the consolidated financial
position, results of operations and cash flows of Palomar and all of its wholly owned
subsidiaries. All intercompany transactions have been eliminated in consolidation.


Reclassifications


Certain
amounts in the accompanying consolidated financial statements have been reclassified to
conform to the current year presentation.


Use of Estimates


The
preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the consolidated financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results could differ
from those estimates.


Cash and Cash Equivalents


Cash
equivalents consist of short-term, highly liquid investments which are readily convertible
into cash with original maturities of three months or less when purchased. Cash
equivalents consist primarily of institutional money market funds.


Accounts Receivable
Allowance


Palomar
maintains an allowance for losses resulting from the inability of its customers to make
required payments. Palomar regularly evaluates the collectibility of its trade receivables
based on a combination of factors, which may include dialogue with the customer to
determine the cause in delay of payments, the use of collection agencies, and / or the use
of litigation. In the event that it is determined that the customer may not be able to
meet its full obligation to Palomar, Palomar records a specific allowance to reduce the
related receivable to the amount that Palomar expects to recover given all information
present. Palomar also records a provision for estimated sales returns and allowances on
product and service related sales in the same period as the related revenues are recorded.
These estimates are based on the specific facts and circumstances of a particular order,
analysis of credit memo data and other known factors. If the data Palomar uses to
calculate these estimates do not properly reflect reserve requirements, then a change in
the allowances would be made in the period in which such a determination is made and
revenues in that period could be affected. Accounts receivable allowance
activity including sales returns and allowances consisted of the following for the years
ended December 31, 2004, 2003 and 2002, respectively.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,              | 2004 | 2003      | 2002
|---------------------------- | ---- | --------- | ----
|Balance at beginning of year |      | $ 862,000 |     
|Additions                    |      | 306,000   |     
|Deductions                   |      | (189,000  | )   
|                             |     
|Balance at end of year       |      | $ 979,000 |     
|                             |     

|-36-
|----

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Inventories


Inventories
are valued at the lower of cost (first in, first-out method) or market, and includes
material, labor and manufacturing overhead. At December 31, 2004 and 2003, inventories
consisted of the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2004         | 2003        
|--------------- | ------------ | ------------
|Raw materials   | $  3,613,032 | $  1,842,797
|Work in process | 840,795      | 375,865     
|Finished goods  | 1,412,667    | 1,166,654   
|                |             
|                | $  5,866,494 | $  3,385,316
|                |             

|Palomars
policy is to establish inventory reserves when conditions exist that suggest that
inventory may be in excess of anticipated demand or is obsolete based upon assumptions
about future demand for products and market conditions. Included in Palomars
finished goods inventory are $504,545 in 2004 and $401,552 in 2003 of demonstration
products that are used by Palomars sales organization. Palomar accounts for such
products as they do with any other finished goods item in Palomars inventory in
accordance with the review of Palomars entire inventory. Palomar regularly evaluates
the ability to realize the value of inventory based on a combination of factors including
the following: historical usage rates, forecasted sales or usage, product end of life
dates, estimated current and future market values and new product introductions.
Assumptions used in determining managements estimates of future product demand may
prove to be incorrect; in which case the provision required for excess and obsolete
inventory would have to be adjusted in the future. If inventory is determined to be
overvalued, Palomar would be required to recognize such costs as cost of goods sold at the
time of such determination. Although Palomar performs a detailed review of its forecasts
of future product demand, any significant unanticipated changes in demand could have a
significant impact on the value of Palomars inventory and Palomars reported
operating results.


Property and Equipment


Property
and equipment are recorded at cost. Repairs and maintenance costs are expensed as
incurred. Depreciation and amortization are provided using the straight-line method over
the estimated useful lives of property and equipment. At December 31, 2004 and 2003,
property and equipment consist of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2004        | 2003        | Estimated
useful life                         
|----------------------------- | ----------- | ----------- | ----------------------------------------------
|Machinery and equipment       | $1,376,668  | $1,008,960  | 3-8 years                                     
|Furniture and fixtures        | 1,936,779   | 1,721,254   | 5 years                                       
|Leasehold improvements        | 293,555     | 257,326     | Shorter ofestimateduseful life orterm of lease
|                              |            
|                              | 3,607,002   | 2,987,540  
|Less accumulated depreciation | 2,707,635   | 2,404,642  
|                              |            
|Total                         | $   899,367 | $   582,898 |                                               
|                              |            

|Revenue Recognition


Palomar
recognizes revenue in accordance with Securities and Exchange Commission (SEC) Staff
Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104).
SAB 104 requires that four basic criteria must be met before revenue can be recognized:
(1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably
assured. Determination of criteria (3) and (4) are based on managements judgments
regarding the fixed nature of the fee charged for services rendered and products delivered
and the collectibility of those fees. Should changes in conditions cause management to
determine these criteria are not met for certain future transactions, revenue recognized
for any reporting period could be adversely affected. Palomar recognizes product revenues
upon shipment. If a product sale does not meet all of the above criteria, the sale is
deferred until all criteria are met. Provisions are made at the time of revenue
recognition for any applicable warranty costs expected to be incurred.
-37-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Periodically,
Palomar sells products together with a product upgrade option that requires that the
customer pay an upgrade fee at the time of exercise, has no refund provisions and includes
an expiration date on the upgrade option. In accordance with Emerging Issues Task Force
Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with
Multiple Deliverables, Palomar defers the fair value ascribed to the upgrade option
until the expiration of the upgrade option or the exercise of the upgrade option and
shipment of the product upgrade.


Revenues
from the sale of service contracts is deferred and recognized on a straight-line basis
over the life of the service contract. Revenues from services administered by Palomar that
are not covered by a service contract are recognized as the services are provided. In
certain instances, Palomar sells products together with service contracts. Palomar
recognizes revenue on such multiple-element arrangements in accordance with SAB 104 and
EITF-0021, based on the relative fair value of each element.


Palomar
recognizes royalty revenue from licensees upon receipt of cash payments since the royalty
amounts are not fixed and determinable at the end of a quarter. In general, licensees are
obligated to make payments 30 days after the end of each quarter.


Palomar
accounts for funded development revenue from Gillette and Johnson & Johnson Consumer
Companies, Inc. (JJCC) in accordance with the work plan that was developed
with both Gillette and JJCC. Revenue is recognized under the contracts as costs are
incurred and services are rendered. Any amounts received in advance of costs incurred and
services rendered from Gillette or JJCC are recorded as deferred revenue.As of
December 31, 2004, Palomar has deferred $750,000 relating to JJCC.Payments are not
refundable if the development is not successful. During 2004, Palomar recognized
approximately $3.1 million and $318,000 of funded product development revenue from Gillette
and JJCC, respectively. During 2003, Palomar recognized approximately $2.6 million of funded
product development revenue from Gillette.


Palomar
provides services under a $2.5 million research contract with the Department of the Army
to develop a light based self-treatment device for Pseudofolliculitis Barbae or PFB. The
contract is a cost plus fee arrangement whereby Palomar is reimbursed for the expenses
incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the
contract as the costs are incurred and the services are rendered. During 2004, Palomar
recognized approximately $1.1 million of funded product development revenues from the United
States Department of the Army.


In
accordance with EITF 00-10, reimbursed shipping and handling costs are included in revenue
with the offsetting expense included in selling and marketing. Included in revenues are
$208,000, $99,000 and $55,000 of reimbursed shipping and handling costs during 2004, 2003
and 2002, respectively.


Product Warranty Costs


Palomar
typically offers a one-year warranty for all of its products. Palomar provides for the
estimated cost of product warranties at the time product revenue is recognized. Factors
that affect the Companys warranty reserves include the number of units sold,
historical and anticipated rates of warranty repairs and the cost per repair. Palomar
assesses the adequacy of the warranty provision and Palomar may adjust this provision if
necessary.


During
2002, Palomar experienced unusually high warranty claims for the SLP1000 due to issues
related to a key component. Accordingly, Palomar increased its warranty reserve by
$250,000 in the third quarter of 2002 bringing the total warranty reserve relating to this
key component to approximately $380,000. During 2003, Palomar qualified a new vendor for
the key component and began replacing this key component. As of year end 2003, Palomar
believed that the replacement part had effectively rectified the problem and that the
warranty reserve was significantly in excess of estimated requirements. Consequently,
Palomar decreased its warranty reserve and reduced cost of goods sold by approximately
$336,000 in the fourth quarter of 2003. The following table provides the detail of the
change in Palomars product warranty accrual, which is a component of other accrued
liabilities on the consolidated balance sheet for the years ended December 31, 2004 and
2003.-38-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
|------------------------------------------------------------------------------------------------

|At December 31,                                      | 2004 | 2003        
|---------------------------------------------------- | ---- | ------------
|Warranty accrual, beginning of year                  |      | $    584,929
|Charged to costs and expenses  relating to new sales |      | 1,260,695   
|Costs incurred / write-offs                          |      | (1,123,584  
|                                                     |     
|Warranty accrual, end of year                        |      | $    722,040
|                                                     |     
|                                                     |     

|Research and Development
Expenses


Palomar
charges research and development expenses to operations as incurred.


Net Income per Common
Share


Basic
net income per share is determined by dividing net income, adjusted for preferred stock
dividends, by the weighted average common shares outstanding during the period. Diluted
net income per share is determined by dividing net income, adjusted for preferred stock
dividends, by the diluted weighted average shares outstanding during the period. Diluted
weighted average shares reflect the dilutive effect, if any, of common stock options and
warrants based on the treasury stock method. The reconciliation of basic and diluted
weighted average shares outstanding is as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                       | 2004       | 2003       | 2002      
|----------------------------------------------------- | ---------- | ---------- | ----------
|Basic weighted average common shares outstanding      | 15,688,855 | 13,399,178 | 11,372,228
|Potential common shares pursuant to stock options and
|warrants                                              | 2,031,006  | 2,518,214  | --        
|                                                      |           
|Diluted weighted average common shares outstanding    | 17,719,861 | 15,917,392 | 11,372,228
|                                                      |           

|Palomars
net income (loss) attributable to common stockholders during 2004, 2003 and 2002 is as
follows:
|---------------------------------------------------------------------------------------------------------

|At December 31,                                   | 2004 | 2003        | 2002
|------------------------------------------------- | ---- | ----------- | ----
|Net income as reported                            |      | $10,633,313 |     
|Preferred stock dividends                         |      | --          |     
|                                                  |     
|Adjusted net income (loss) attributable to common |      |             |     
|stockholders                                      |      | $10,633,313 |     
|                                                  |     

|For
the years ended 2004, 2003 and 2002, potential common shares related to 14,672, 408,968
and 3,578,058, respectively, of outstanding stock options, and warrants were not included
in diluted weighted average shares outstanding as they were antidilutive.


Stock based compensation


Palomar
follows intrinsic value method under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25) and related interpretations, in
accounting for its stock-based compensation plans, rather than the alternative fair value
accounting method provided for under SFAS No. 123, Accounting for Stock-Based
Compensation. Under APB 25, when the exercise price of options granted under these
plans equals the market price of the underlying stock on the date of grant, no
compensation expense is required. In accordance with EITF 96-18, Palomar records
compensation expense equal to the fair value of options and warrants granted to
non-employees over the vesting period, which is generally the period of service.
-39-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
On
December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement
No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No.
123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement
No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is
similar to the approach described in Statement 123.  However, Statement 123(R)
requires all share-based payments to employees, including grants of employee stock options
to be recognized in the income statement based on their fair values. Pro forma disclosure
is no longer an alternative.


Statement
123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in
periods in which financial statements have not yet been issued.  Palomar expects to adopt
Statement 123(R) on July 1, 2005. Statement
123(R) permits public companies to adopt its requirements using one of two methods:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1. |  | A modified prospective method in which compensation cost is
               recognized beginning with the effective date (a) based on the requirements of
               Statement 123(R) for all share-based payments granted after the effective date
               and (b) based on the requirements of Statement 123 for all awards granted to
               employees prior to the effective date of Statement 123(R) that remain unvested
               on the effective date.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2. |  | A modified retrospective method which includes the requirements of
               the modified prospective method described above, but also permits entities to
               restate based on the amounts previously recognized under Statement 123 for
               purposes of pro forma disclosures either (a) all prior periods presented or (b)
               prior interim periods of the year of adoption.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar
is in the process of evaluating whether it will adopt the modified-prospective
or the modified-retrospective method.


As
permitted by Statement 123, Palomar currently accounts for share-based payments to
employees using Opinion 25s intrinsic value method and, as such, generally
recognizes no compensation cost for employee stock options.  Accordingly, the
adoption of Statement 123(R)s fair value method will have an impact on our results
of operations, although it will have no impact on our overall financial position. As a
result of the adoption of Statement 123(R), Palomar plans to minimize share-based
compensation to employees in the future. Assuming the Company uses the Black Scholes option pricing model and
no other share-based payments are
granted in the future, the adoption of Statement 123(R) is predicted to increase 2005 and
2006 compensation expense by quarter as follows: September 30, 2005 by $180,000, December
31, 2005 by $180,000, March 31, 2006 by $180,000, June 30, 2006 by $170,000, September 30,
2006 by 95,000 and December 31, 2006 by $45,000.   However, had Palomar adopted
Statement 123(R) in prior periods, the impact of that standard would have approximated the
impact of Statement 123 as described in the disclosure of pro forma net income and
earnings per share.  Statement 123(R) also requires the benefits of tax deductions in
excess of recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow as required under current literature.  This
requirement will reduce net operating cash flows and increase net financing cash flows in
periods after adoption.  While the company cannot estimate what those amounts will be
in the future (because they depend on, among other things, when employees exercise stock
options), the amount of operating cash flows recognized in prior periods for such excess
tax deductions were $191,434 and $52,500 in 2004 and,2003, respectively.


The
Company is currently using the Black-Scholes option-pricing model and will consider
whether the Black-Scholes option-pricing model or the lattice option-pricing model will be
used in the future.


The
following tables illustrate the assumptions used and the effect on net income and earnings
per share if Palomar had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation. Palomar has computed the pro forma disclosures required
under SFAS No. 123 for all stock options granted to employees of Palomar in the years
ended December 31, 2004, 2003 and 2002 using the Black-Scholes option-pricing model
prescribed by SFAS No. 123.


The
weighted average assumptions used to calculate the SFAS No. 123 pro forma disclosure and
the resulting grant date fair values for the years ended December 31, 2004, 2003 and 2002
for Palomar are as follows:
-40-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
|------------------------------------------------------------------------------------------------

|At December 31,                                            | 2004    | 2003    | 2002   
|---------------------------------------------------------- | ------- | ------- | -------
|Risk-free interest rate                                    | 2.55%   | 3.00%   | 3.24%  
|Expected dividend yield                                    | --      | --      | --     
|Expected lives                                             | 2 years | 4 years | 4 years
|Expected volatility                                        | 100%    | 111%    | 111%   
|Grant date fair value of options granted during the period | $8.99   | $3.96   | $0.68  

|Pro Forma Disclosure


The
pro forma effect on Palomar of applying SFAS No. 123 for all options and warrants to
purchase common stock of Palomar would be as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                | 2004 | 2003              | 2002
|---------------------------------------------- | ---- | ----------------- | ----
|Net income, as reported                        |      | $ 10,633,313      |     
|Add: Stock-based compensation included in      |     
|reported net income                            |      | --                |     
|Less: Preferred stock dividends                |      | --                |     
|Less:  Total stock-based employee compensation |     
|expense determined under fair value based      |     
|method for all awards                          |      | (18,476,383       | )   
|                                               |     
|Pro forma net income (loss)                    |      | $(7,843,070       | )   
|                                               |     
|Diluted net income (loss) per share:           |     
|As reported                                    |      | $            0.60 |     
|Pro forma                                      |      | $           (0.44 | )   
|                                               |     

|The
Company granted 1,968,000 options in 2004 that were also fully vested in 2004 to employees
and directors with exercise prices equal to fair market value on the date of grant,
ranging from $13.66 to $26.00, and expire ten years from the date of grant. Of the
$18,476,383 pro forma expense in 2004, $17,623,462 relates to these options. In accordance
with newly issued Statement of Financial Accounting Standards No. 123(R) (SFAS 123R), had
the Company granted these options with longer time-based vesting, the Company would have
incurred significant stock-based payment expenses in future years upon adoption of SFAS
123R.




The Company granted 1,440,000 performance based options in 2004 to employees and directors with exercise prices
equal to fair market value on the date of grant of $16.53, and expire ten years from the date of grant. 815,000 of these
options vest upon the election, and 625,000 of these options vest twelve months after the election, of Gillette to
continue commercialization of a patented home-use, light based hair removal device for women pursuant to our Development
and License Agreement with them dated February 14, 2003. (See Note 12, Development and License Agreement with
Gillette.)  The Company will incur a stock-based payment expense upon the vesting of these performance based options.


Concentration of Credit
Risk


SFAS
No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet
Risk and Financial Instruments with Concentrations of Credit Risk, requires disclosure
of any significant off-balance-sheet and credit risk concentrations. Financial instruments
that subject Palomar to credit risk consist primarily of cash and cash equivalents, available-for-sale securities and
accounts receivable. Palomar places its cash and cash equivalents and available-for-sale securities in established financial
institutions. Palomar has no significant off-balance-sheet risk or concentration of credit
risk, such as foreign exchange contracts, options contracts or other foreign hedging
arrangements. Palomars trade accounts receivables are primarily from sales to end
users and distributors servicing the medical and beauty industry, and reflect a broad
domestic and international base. Palomar maintains an allowance for potential credit
losses. Palomars accounts receivable credit risk is not concentrated within any one
geographic area. Palomar has not experienced significant losses related to receivables
from any individual customers or groups of customers in any specific industry or by
geographic area. Due to these factors, no additional credit risk beyond amounts provided
for collection losses is believed by management to be inherent in Palomars accounts
receivable.

-41-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Palomar
performs periodic credit evaluations of its customers financial condition and
generally does not require collateral. For the years ended December 31, 2004, 2003 and
2002, Palomar had two customers that accounted for 9%, 20% and 35% of net sales,
respectively. At December 31, 2004, 2003 and 2002, these customers accounted for 6%, 20%
and 27% of trade receivables outstanding, respectively.


Disclosures About Fair
Value of Financial Instruments


SFAS
No. 107,Disclosure About Fair Value of Financial Instruments, requires disclosure
of an estimate of the fair value of certain financial instruments. At December 31, 2004
and 2003, financial instruments consisted principally of cash, cash equivalents, available-for-sale
securities, accounts
receivable and accounts payable and debt. The fair value of financial instruments pursuant
to SFAS No. 107 approximated their carrying values at December 31, 2004 and 2003. Fair
values have been determined through information obtained from market sources and
management estimates.


Recent Accounting
Pronouncements


In
December 2004, the FASB issued SFAS 123(R), Share-Based Payment. SFAS No.
123(R) revises SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation
guidance. SFAS 123(R) will require compensation costs related to share-based payment
transactions to be recognized in the financial statements (with limited exceptions). The
amount of compensation cost will be measured based on the grant-date fair value of the
equity or liability instruments issued. Compensation cost will be recognized over the
period that an employee provides service in exchange for the award. This statement is
effective as of the beginning of the first interim or annual reporting period that begins
after June 15, 2005. The Company will adopt the standard as of the effective date. See
Note 1, Stock based compensation for the effect on the Companys financial
statements.


In
November 2004, the FASB issued FASB Statement No. 151, Inventory Costs,
an amendment of ARB No. 43, Chapter 4. The amendments made by Statement 151 clarify that
abnormal amounts of idle facility expense, freight, handling costs, and wasted materials
(spoilage) should be recognized as current-period charges and require the allocation of
fixed production overheads to inventory based on the normal capacity of the production
facilities. SFAS 151 is effective for inventory costs incurred during fiscal years
beginning after June 15, 2005. Palomar does not believe there will be a material effect
upon its financial condition or results of operations from the adoption of the provisions
of SFAS 151.


Note 2  Segment
and Geographic Information


In
accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, operating segments are identified as components of an enterprise about
which separate discrete financial information is available for evaluation by the chief
operating decision maker, or decision-making group, in making decisions how to allocate
resources and assess performance. Palomars chief decision-maker, as defined under
SFAS No. 131, is a combination of the Chief Executive Officer and the Chief Financial
Officer. To date, Palomar has viewed its operations and manages its business as
principally one segment, medical and cosmetic products and services, and Palomars
long-lived assets are located in one facility in the United States. As a result, the
financial information disclosed herein represents all of the material financial
information related to Palomars principal operating segment.


The
following table represents percentages of product revenue by geographic destination for
2004, 2003 and 2002:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2004 | 2003 | 2002
|------------------------- | ---- | ---- | ----
|United States             |      | 63   | %   
|Japan                     |      | 10   |     
|Canada                    |      | 10   |     
|Europe                    |      | 7    |     
|Australia                 |      | 3    |     
|Asia/Pacific              |      | 6    |     
|South and Central America |      | 1    |     
|                          |      |     
|Total                     |      | 100  | %   
|                          |      |     
|                          |     

|-42-
|----

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Note 3  Research
and Development Arrangement


In
August 1995, Palomar entered into an agreement with The Massachusetts General Hospital
Corporation whereby Massachusetts General Hospital agreed to conduct clinical trials on a
laser treatment technology for hair removal/reduction developed at Wellman Laboratories of
Photomedicine (the Clinical Trial Agreement). In July 1999, Palomar amended
this agreement to extend it for an additional five years, until August 2004, and to cover
the additional fields of non-invasive, electromagnetic targeting of subcutaneous fat, and
treatment of sebaceous glands and related skin disorders (e.g., acne) using infrared light
except when externally applied chromophores are used. Palomar has the right to exclusively
license, on royalty terms to be negotiated, Palomar-funded inventions that were discovered
during this research. Under the terms of the Clinical Trial Agreement, Palomar paid
Massachusetts General Hospital $475,000 on an annual basis through August 2004. On August
1, 2004 Palomar and Massachusetts General Hospital entered into a new agreement (the
Research Agreement) whereby Massachusetts General Hospital agreed to conduct
clinical and non-clinical research in the field of photo thermal removal or reduction of
hair, using light (hereinafter referred to, as hair removal). The Research
Agreement has a term of three years, until August 2007, and Palomar will provide
Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct
and indirect costs of the research. Palomar has the right to exclusively license, on
royalty terms to be negotiated, Palomar-funded inventions that are discovered during this
research.


Note 4  Income
Taxes


Palomar
provides for income taxes under the liability method in accordance with SFAS
No. 109,Accounting for Income Taxes.The provision (benefit) for income taxes
in the accompanying consolidated statements of operations consists of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2004 | 2003         | 2002
|--------------- | ---- | ------------ | ----
|Federal:        |      |              |     
|Current         |      | $    232,584 |     
|Deferred        |      | --           |     
|                |      |             
|                |      | 232,584      |     
|State:          |     
|Current         |      | 11,703       |     
|Deferred        |      | (1,100,000   | )   
|                |      |             
|                |      | (1,088,297   | )   
|                |      |             
|Total           |      | $  (855,713  | )   
|                |      |             
|                |     

|A
reconciliation of the federal statutory rate to Palomars effective tax rate is as
follows:
|---------------------------------------------------------------------------------------------

|At December 31,                                          | 2004 | 2003 | 2002
|-------------------------------------------------------- | ---- | ---- | ----
|Income tax provision (benefit) at federal statutory rate |      |      |     
|Increase (decrease) in tax resulting from-               |      |     
|State income taxes, net of federal benefit               |      |      |     
|Change in valuation allowance, net operating loss        |      |      |     
|utilization                                              |      |     
|Reduction in tax reserves                                |      |      |     
|Other                                                    |      |      |     
|                                                         |      |     
|Benefit for income taxes                                 |      |      |     
|                                                         |      |     

|The
components of the net deferred tax asset recognized in the accompanying consolidated
balance sheets are as follows:
-43-
|----------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
|------------------------------------------------------------------------------------------------

|At December 31,                   | 2004 | 2003
|--------------------------------- | ---- | ----
|Net operating loss carry forwards |      |     
|Nondeductible accruals            |      |     
|Nondeductible reserves            |      |     
|Tax credits                       |      |     
|                                  |      |     
|Deferred tax assets               |      |     
|Valuation allowance               |      |     
|                                  |      |     
|                                  |      |     
|                                  |      |     

|At
December 31, 2004, Palomar had available, subject to review and possible adjustment by the
Internal Revenue Service, federal net operating loss carry forwards and tax credit carry
forwards of approximately $114 million and $2.4 million, respectively, to be used to
offset future taxable income. These net operating loss carry forwards will expire through
2024. A portion of Palomars net operating losses were created by the excess tax
benefits associated with stock options and will be realized through increases to
stockholders equity when utilized. A portion of Palomars losses may be limited to
changes in ownership, as defined by the Internal Revenue Code. Under SFAS No. 109, Palomar
can only recognize a deferred tax asset for future benefit of its tax loss and tax credit
carry forwards to the extent that it is more likely than not that these assets
will be realized. In determining the realizability of these assets, Palomar considered
numerous factors, including historical profitability, estimated future taxable income and
the industry in which it operates. Given our limited history of profitability, at this
time we have fully reserved our otherwise recognizable deferred tax asset, as its
realization is uncertain.


During
the year ended December 31, 2003, Palomar recognized a tax benefit of $470,000, which is
associated with the recovery of carry back operating losses paid in prior years pursuant
to the Economic Stimulus package of 2002.


Palomar recorded a reversal of previously provided state income taxes of
$1.1 million and $300,000 in 2004 and 2003 respectively, relating to the sale of a subsidiary as a result of the closing of certain
statutory periods for assessing tax for such transaction.


Note 5  401(k) Plan


Palomar
has a 401(k) Plan, which covers substantially all employees who have attained the age of
18 and are employed for at least a three-month period. Employees may contribute up to the
maximum amount allowed by the Internal Revenue Service, subject to restrictions defined by
the Internal Revenue Service. At Palomars discretion, Palomar may make a matching
contribution in cash or Palomars common stock up to 50% of all employee
contributions in each plan year. Palomar contributions vest over a three-year period from
date of hire.


During
2004, 2003 and 2002, Palomar matched in Palomar stock 50% of all employee contributions by
issuing 50,156, 184,109 and 148,855 shares of stock, respectively, to the 401(k) Plan in
satisfaction of its employer match for employee contributions. The number of shares of
common stock reserved for issuance under the 401(k) Plan was initially 1,000,000 shares.
As of December 31, 2004, 300,929 shares of common stock remained available for issuance
thereunder.


Note 6  Accrued
Liabilities


At
December 31, 2004 and 2003,accrued liabilities consisted of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2004       | 2003      
|----------------------------- | ---------- | ----------
|Payroll and employee benefits | $2,417,820 | $1,464,070
|Commissions                   | 977,332    | 1,018,677 
|Royalties                     | 2,392,324  | 687,398   
|Warranty                      | 722,040    | 584,929   
|Other                         | 1,504,691  | 1,224,822 
|                              |           
|Total                         | $8,014,207 | $4,979,896
|                              |           
|                             

|-44-
|----

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Note 7  Note
Payable to Related Party


On
September 28, 2001, Palomar issued a promissory note to a Director for $1,000,000 bearing
interest at a rate of 5.5% per annum due upon demand. On March 14, 2003, the director
exchanged the $1 million principal balance of the Promissory Note into 293,255
unregistered shares of Palomars Common Stock at a price of $3.41 per share. The
price was calculated at 110% of Palomars Common Stock trailing ten-day average
closing price of $3.10 per share.


Note 8 
Commitments and Contingencies



Operating lease and
purchase commitments


Palomar
is obligated to make future payments under various contracts, including non-cancelable
inventory purchase commitments and our operating lease relating to our Burlington,
Massachusetts manufacturing, research and development and administrative offices.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2004, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,      | 2005      | 2006    | 2007    | 2008    | 2009    | Thereafter
|-------------------- | --------- | ------- | ------- | ------- | ------- | ----------
|Purchase commitments | 2,790,000 | --      | --      | --      | --      | -         
|Operating lease      | 949,000   | 949,000 | 949,000 | 949,000 | 712,000 | -         
|                     |          
|Total                | 3,739,000 | 949,000 | 949,000 | 949,000 | 712,000 | -         
|                     |          

|Palomar
incurred rent expense of $1,053,000, $948,000 and $942,000 for the years ended December
31, 2004, 2003 and 2002, respectively. This rental expense was offset by $4,600, $166,000
and $168,000 in 2004, 2003 and 2002, respectively, from a tenant subleasing from Palomar
approximately 4,000 square feet of Palomars facility. As of January 31, 2004, the
tenants sublease was terminated and Palomar began utilizing this 4,000 square feet.


Research and development
arrangement


In
August 1995, Palomar entered into an agreement with The Massachusetts General Hospital
Corporation whereby Massachusetts General Hospital agreed to conduct clinical trials on a
laser treatment technology for hair removal/reduction developed at Wellman Laboratories of
Photomedicine (the Clinical Trial Agreement). In July 1999, Palomar amended
this agreement to extend it for an additional five years, until August 2004, and to cover
the additional fields of non-invasive, electromagnetic targeting of subcutaneous fat, and
treatment of sebaceous glands and related skin disorders (e.g., acne) using infrared light
except when externally applied chromophores are used. Palomar has the right to exclusively
license, on royalty terms to be negotiated, Palomar-funded inventions that were discovered
during this research. Under the terms of the Clinical Trial Agreement, Palomar paid
Massachusetts General Hospital $475,000 on an annual basis through August 2004. On August
1, 2004 Palomar and Massachusetts General Hospital entered into a new agreement (the
Research Agreement) whereby Massachusetts General Hospital agreed to conduct
clinical and non-clinical research in the field of photo thermal removal or reduction of
hair, using light (hereinafter referred to, as hair removal). The Research
Agreement has a term of three years, until August 2007, and Palomar will provide
Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct
and indirect costs of the research. Palomar has the right to exclusively license, on
royalty terms to be negotiated, Palomar-funded inventions that are discovered during this
research.
-45-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Royalties


Palomar
is a party to a license agreement, as amended, with Massachusetts General Hospital whereby
the Company is obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties. For the years
ended December 31, 2004, 2003 and 2002, approximately $2,818,000, $896,000 and $1,921,000
of royalty expense, respectively, was incurred under this agreement.


Litigation


Palomar
is a party to various legal proceedings incident to its business. Except as noted below,
there are no legal proceedings pending or threatened against Palomar that management
believes could have a material adverse effect on Palomars consolidated financial
position.


On
February 15, 2002, Palomar commenced an action for patent infringement in the United
States District Court for the District of Massachusetts against Altus Medical, Inc., now
known as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint
alleges Cuteras CoolGlide and CoolGlide Excel laser systems willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to Palomar by the Massachusetts
General Hospital. The Massachusetts General Hospital was added as a plaintiff in this
lawsuit. Cutera answered the complaint denying that its products infringe the asserted
patent and filed a counterclaim seeking a declaratory judgment that the asserted patent is
invalid and not infringed. Palomar and the Massachusetts General Hospital filed a reply
denying the material allegations of the counterclaims. Palomar and the Massachusetts
General Hospital have further alleged that Cuteras CoolGlide Vantage and CoolGlide
XEO laser systems also willfully infringe the asserted patent. On June 4, 2003, Cutera
amended their answer and asserted a counter claim alleging that the patent is
unenforceable due to inequitable conduct. Palomar and the Massachusetts General Hospital
believe that this claim is without merit and filed a reply denying the material
allegations of this counterclaim. A claim construction hearing (often referred to as a
Markman hearing) was held on June 12, 2003, and on February 27, 2004 the Judge issued her
ruling. Palomar believes the ruling largely embraced Palomars position. On January
14, 2005, Cutera filed a Motion for Summary Judgment that the patent claims being asserted
are invalid and not infringed. Palomar and the Massachusetts General Hospital have filed a
response vigorously defending both the validity of the patent claims and the infringement
of those claims by Cuteras CoolGlide products. A trial date has not yet been set.
(See Cautionary Statements)


Employment Agreements


Palomar
has two-year employment agreements with certain officers. These employment agreements
automatically renew for successive two-year periods absent notice of non-renewal by either
party. In the event of termination by Palomar without cause, non-renewal by Palomar or
termination by Palomar for good reason without a change in control, these employment
agreements provide two years salary as then in effect, in addition to any earned
incentive compensation, and continued benefits and insurance payments for two years. The
agreements further provide that in the event of termination by reason of death,
beneficiaries receive the officers base salary for one year following death (plus
any pro rata bonus to which the officer would have been entitled). In the event of
termination due to a change in control of Palomar, the agreements provide three times the
annual salary as then in effect (plus any bonus to which the officer would have been
entitled) and the continuation of benefits and insurance payments for two years.


Note 9 
Stockholders Equity


Common Stock


During
1998, Palomar sold 1,457,142 shares of common stock to a group of investors for
$10,200,000. In addition, Palomar issued callable warrants with a three-year term to these
investors to purchase 1,457,142 shares of common stock at an exercise price of $21.00 per
share, all of which are expired at December 31, 2003. Under the terms of this private
placement, Palomar is obligated to pay the investors a fee of 5% per annum (payable
quarterly) of the dollar value invested in Palomar as long as the investors continue to
hold their common stock in their name at Palomars transfer agent. During 2004, 2003
and 2002, Palomar paid $79,600, $203,750 and $247,500, respectively, related to this fee.
These amounts have been charged to additional paid-in capital.
-46-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
On
March 14, 2003, Palomar completed a private placement with Craig Drill Capital, a private
investment firm based in New York City, for the purchase of 1 million unregistered shares
of Palomars common stock with no registration rights at a price of $3.41 per share
for an aggregate subscription price of $3.4 million. The price was calculated at 110% of
Palomars common stock trailing ten-day average closing price of $3.10 per share.


Preferred Stock


Palomars
Amended and Restated Certificate of Incorporation provides for, and the Board of Directors
and stockholders authorized, 1,500,000 shares of $0.01 par value preferred stock. Palomar
has designated 100,000 shares as Series A Participating Cumulative Preferred Stock
(Series A) in connection with the Rights Agreement discussed below. No shares
of Series A have been issued. However, upon issuance the Series A will be entitled to
vote, receive dividends, and have liquidation rights. The remaining authorized preferred
stock is undesignated and the Board of Directors has the authority to issue such shares in
one or more series and to fix the relative rights and preferences without vote or action
by the stockholders.


During
2002, preferred stockholders converted all 6,000 shares of their Series F Preferred Stock
including $2,267,553 of accrued dividends and interest into 467,123 shares of
Palomars common stock.


Rights Agreement


In
April 1999, Palomar adopted a shareholder rights plan (Rights Plan). The
Rights Plan is intended to protect shareholders from unfair or coercive takeover
practices. In accordance with the Rights Plan, the Board of Directors declared a dividend
distribution of Series A right for each share of common stock outstanding until the rights
become exercisable. Each right entitles the registered holder to purchase from Palomar one
one-thousandth (1/1000th) of a share of Series A for $8, adjusted for certain
events. The rights will be exercisable if a person or group acquires beneficial ownership
of 15% or more of Palomars common stock or announces a tender or exchange offer for
15% or more of Palomars common stock. At such time, each holder of a right (other
than the 15% holder) will thereafter have a right to purchase, upon payment of the
purchase price of the right, that number of one one-thousandths (1/1000ths) of Series A
shares equivalent to the number of common shares of Palomars common stock, which
have a market value of twice the purchase price of the right. In the event that Palomar is
acquired in a merger or other business combination transaction or more than 50% of its
assets or earning power is sold, each holder shall thereafter have the right to receive,
upon exercise of each right, that number of shares of common stock of the acquiring
company that, at the time of such transaction, would have a market value of two times the
$8 per share exercise price. The rights will not be exercisable until certain events
occur. The Board of Directors may elect to terminate the rights under certain
circumstances.


Note 10  Stock
Option Plans and Warrants


Stock Options


Palomar
has several Stock Option Plans (the Plans) that provide for the issuance of a
maximum of 8,778,571 shares of common stock, which may be issued as incentive stock
options (ISOs) or nonqualified stock options. Under the terms of the Plans,
ISOs may not be granted at less than the fair market value on the date of grant (and in no
event less than par value); in addition, ISO grants to holders of 10% of the combined
voting power of all classes of Palomar stock must be granted at an exercise price of not
less than 110% of the fair market value at the date of grant. Pursuant to the Plans,
options are exercisable at varying dates, as determined by the board of directors, and
have terms not to exceed 10 years (five years for 10% or greater stockholders). The board
of directors, in its discretion, may convert the optionees ISOs into nonqualified
stock options at any time prior to the expiration of such ISOs.


The
following table summarizes all stock option activity of Palomar for the years ended
December 31, 2002, 2003 and 2004:
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|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
|------------------------------------------------------------------------------------------------

|                                               | Number of
Shares | Exercise Price | Weighted
Average
Exercise Price
|---------------------------------------------- | ---------------- | -------------- | -------------------------------
|Outstanding, December 31, 2001                 |                  | 3,536,464      |                                
|Granted                                        |                  | 745,000        |                                
|Canceled                                       |                  | (120,622       | )                              
|                                               |                 
|Outstanding, December 31, 2002                 |                  | 4,160,842      |                                
|Granted                                        |                  | 485,000        |                                
|Exercised                                      |                  | (1,416,915     | )                              
|Canceled                                       |                  | (102,240       | )                              
|                                               |                 
|Outstanding, December 31, 2003                 |                  | 3,126,687      |                                
|Granted                                        |                  | 3,454,500      |                                
|Exercised                                      |                  | (1,568,887     | )                              
|Canceled                                       |                  | (44,898        | )                              
|                                               |                 
|Outstanding, December 31, 2004                 |                  | 4,967,402      |                                
|                                               |                 
|Exercisable, December 31, 2002                 |                  | 1,871,191      |                                
|                                               |                 
|Exercisable, December 31, 2003                 |                  | 1,923,550      |                                
|                                               |                 
|Exercisable, December 31, 2004                 |                  | 3,132,937      |                                
|                                               |                 
|Available for future issuances under the plans |                 
|as of December 31, 2004                        |                  | 649,336        |                                
|                                               |                 

|The
ranges of exercise prices for options outstanding and options exercisable at December 31,
2004 are as follows:
|------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |              |            |             
|------------------- | ------------------- | ---------- | ------------ | ---------- | ------------
|
|$0.90-$1.00         | 712,857             | 6.49 years | $       0.98 | 650,358    | $       0.99
|1.51-2.19           | 198,166             | 5.32 years | 1.95         | 188,167    | 1.98        
|2.51-3.19           | 226,138             | 4.49 years | 3.17         | 226,138    | 3.17        
|4.08-5.22           | 313,575             | 8.50 years | 4.96         | 82,602     | 4.94        
|6.22-8.23           | 77,166              | 8.78 years | 6.79         | 25,171     | 6.78        
|9.93-14.31          | 60,000              | 9.18 years | 11.85        | 20,001     | 12.86       
|16.00-19.00         | 3,294,500           | 9.36 years | 16.54        | 1,855,500  | 16.55       
|23.61-26.00         | 85,000              | 9.90 years | 25.17        | 85,000     | 25.17       
|                   
|$0.90-$26.00        | 4,967,402           | 8.51 years | $     12.33  | $3,132,937 | 11.31       
|                   

|Warrants


The
following table summarizes all warrant activity of Palomar for the years ended December
31, 2002, 2003 and 2004:
-48-
|------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
|------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Exercise Price | Weighted
Average
Exercise Price
|------------------------------ | ---------------- | -------------- | -------------------------------
|Outstanding, December 31, 2001 |                  | 1,958,691      |                                
|Outstanding, December 31, 2002 |                  | 1,958,691      |                                
|Exercised                      |                  | (225,000       | )                              
|Canceled                       |                  | (1,515,691     | )                              
|                               |                  |               
|Outstanding, December 31, 2003 |                  | 218,000        |                                
|Exercised                      |                  | (38,000        | )                              
|                               |                  |               
|Outstanding, December 31, 2004 |                  | 180,000        |                                
|                               |                  |               
|Exercisable, December 31, 2002 |                  | 1,932,027      |                                
|                               |                  |               
|Exercisable, December 31, 2003 |                  | 218,000        |                                
|                               |                  |               
|Exercisable, December 31, 2004 |                  | 180,000        |                                
|                               |                  |               

|On
September 29, 2000, Palomar issued warrants to purchase 225,000 shares of Palomars
common stock at $3.50 per share. The aggregate purchase price was $787,500 and the
warrants expire 5 years from the date of issuance. These warrants were issued to an
investment banking firm as partial payment for investment banking services. The closing
price of Palomars common stock on September 29, 2000 was $2.59 per share and the
warrants were appropriately valued and expensed using the Black-Scholes method in
accordance with Statement of Financial Accounting Standards No. 123.


In
order to minimize dilution of Palomars common stock, on October 1, 2003, the
investment banking firm agreed to surrender the warrant in exchange for Palomar issuing
99,000 shares of common stock to certain nominees of the investment banking firm. The
number of shares of common stock was calculated through a cashless net spread
analysis of the cost of purchasing 225,000 shares at the $3.50 warrant exercise price
versus $6.25, which was the closing price of Palomars common stock on October 1,
2003.


The
ranges of exercise prices for warrants outstanding and exercisable at December 31, 2004
are as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Warrants Outstanding | Warrants Exercisable |            |            |         |           
|-------------------- | -------------------- | ---------- | ---------- | ------- | ----------
|
|$      1.97          | 55,000               | 5.08 years | $     1.97 | 55,000  | $     1.97
|2.81-3.19            | 125,000              | 4.58 years | 3.13       | 125,000 | 3.13      
|                     |                     
|$1.97-$3.18          | 180,000              | 4.73 years | $     2.77 | 180,000 | $     2.77
|                     |                     

|Reserved Shares


At
December 31, 2004, the Company has reserved shares of its common stock for the following:
|--------------------------------------------------------------------------------------------------------------

|At December 31,      |          
|-------------------- | ---------
|Warrants             | 180,000  
|Stock option plans   | 5,616,738
|Employee 401(k) plan | 300,929  
|                     |          
|Total                | 6,097,667
|                     |          

|Employee Stock Purchase
Plan


Under
the terms of the Palomar Medical Technologies, Inc. 1996 Employee Stock Purchase Plan (the
Purchase Plan), all employees are eligible to purchase Palomars common
stock at an exercise price equal to 85% of the fair market value of the common stock with
a look back provision of three months. During the years ended December 31, 2004, 2003 and
2002, employees purchased 20,052, 22,422 and 37,819 shares, respectively, of
Palomars common stock for $258,321, $37,613 and $30,209, respectively, pursuant to
the Purchase Plan. The Purchase Plan was terminated after the December 31, 2004 purchase,
and therefore no shares are available for future issuance under the Purchase Plan.
-49-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Note 11  Quarterly
Results of Operations (Unaudited)


The
following table presents a condensed summary of quarterly results of operations for the
years ended December 31, 2004 and 2003 (in thousands, except per share data).
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      | 2004      |           |           |          
|--------------------- | --------- | --------- | --------- | ---------
|
|Revenues              | $10,834   | $13,230   | $13,947   | $16,421  
|Cost and expenses     | 9,675     | 11,200    | 11,863    | 11,061   
|                      |          
|Net income            | $  1,159  | $  2,030  | $  2,084  | $  5,360 
|                      |          
|Net income per share:
|Basic                 | $    0.08 | $    0.13 | $    0.13 | $    0.33
|Diluted               | $    0.07 | $    0.12 | $    0.12 | $    0.29

|                      | 2003    |         |         |          
|--------------------- | ------- | ------- | ------- | ---------
|
|Revenues              | $6,842  | $8,672  | $9,182  | $10,077  
|Cost and expenses     | 6,533   | 8,051   | 8,569   | 9,011    
|                      |        
|Net income            | $   358 | $1,069  | $   904 | $  1,038 
|                      |        
|Net income per share:
|Basic                 | $  0.03 | $  0.08 | $  0.07 | $    0.07
|Diluted               | $  0.03 | $  0.07 | $  0.05 | $    0.06

|Note 12 
Development and License Agreement with Gillette


Effective
as of February 14, 2003, Palomar entered into a Development and License Agreement with
Gillette to complete the development and commercialize a home-use, light based hair
removal device for women. The agreement provided for up to $7 million in support of
research and development to be paid by Gillette over approximately 30 months. Effective as
of June 28, 2004, Palomar and Gillette completed the initial phase of the agreement and
both parties decided to move onto the next phase. Accompanying this decision, Palomar and
Gillette amended the original agreement, whereby, Gillette will provide $2.1 million in
additional development funding to further technical innovations over a 9-month extension
of the development phase, which is now planned to be completed by August 31, 2006.


At
the end of the 30-month period, or such later date as regulatory clearance is obtained for
the device, Gillette will decide whether or not to continue with the project based on all
the information known at that time. Upon Gillette deciding to continue, Gillette will be
obligated to make a development completion payment to Palomar of $2.5 million. If Gillette
decides not to continue, Palomar may proceed to develop and commercialize the device on
its own or with a different party.


After
Gillette makes the development completion payment to Palomar of $2.5 million, Gillette
will conduct approximately 12 months of commercial assessment tests with respect to the
device. Based on the commercial assessment tests, Gillette will then decide whether or not
to continue with the project. Upon deciding to continue, Gillette will be obligated to
make a development completion payment to Palomar of $10 million. If Gillette decides not
to continue to commercialize the device, Palomar may proceed to commercialize the device
on its own or with a different party.
-50-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Commencing
12 months after the $10 million development completion payment, Gillette will be obligated
to pay Palomar annual collaboration payments of $10 million for as long as Gillette elects
to have Palomar work exclusively with Gillette.


After
launch of the first device for females, Gillette will pay Palomar a percentage of net
sales of the device, subject in certain instances to various reductions and offsets.
Again, for as long as Gillette elects to have Palomar work exclusively with Gillette,
Gillette will continue to be obligated to pay Palomar annual collaboration payments of $10
million, which will be offset against the net sales percentage payments.


In
addition to the amounts to be paid by Gillette to Palomar in connection with jointly
developed products, Gillette is required to make certain lump sum and net sales based
payments to Palomar in the event that Gillette launches independent light based female
hair removal products. Gillette also receives the right to enter into a separate agreement
with Palomar for the development and commercialization of home-use, light based hair
removal devices for men.


For
the year ended December 31, 2004 and 2003, Palomar recognized $3.1 million and $2.6
million of funded product development revenues from Gillette, respectively.


Note 13  Joint Development
and License agreement with Johnson & Johnson Consumer Companies (JJCC), a
Johnson & Johnson company


Effective
as of September 1, 2004, Palomar entered into a Joint Development and License Agreement
with Johnson & Johnson Consumer Companies, Inc. (JJCC), a Johnson &
Johnson company, to develop and commercialize home-use, light based devices in the fields
of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of
skin aging; and (iii) reducing or preventing acne.


The
agreement provides for JJCC to fund Palomars research and clinical studies during an
initial proof-of-principle phase. At the end of the proof-of-principle phase, JJCC will
decide whether or not to continue with one or more of the devices in one or more of the
fields into a development phase. Upon JJCC deciding to continue, JJCC will be obligated to
fund the development of the selected devices.  If JJCC decides not to continue,
Palomar may proceed in fields not selected by JJCC to develop and commercialize these and
other devices on its own or with a different party.


At
the end of the development phase, JJCC will decide whether or not to commercialize one or
more of the devices in one or more fields. Upon JJCC deciding to commercialize one or more
of the devices, JJCC will make payments to Palomar for each selected field. Upon
commercial launch of the first device in each selected field, JJCC will make a payment to
Palomar, and for all devices sold for use in each selected field, JJCC shall pay Palomar a
percentage of sales of such devices and certain topical compounds. If JJCC decides not to
commercialize or fails to launch a device, Palomar may proceed in fields not selected by
JJCC to develop and commercialize these and other devices on its own or with a different
party.


For
the year ended December 31, 2004, Palomar recognized approximately $318,000 of funded
product development revenues from JJCC and deferred $750,000 of advance payments received
from JJCC for which services were not yet provided.


Note 14  Research
contract with the Department of the Army


In
the first quarter of 2004, Palomar began providing services under a $2.5 million research
contract with the Department of the Army to develop a light based self-treatment device
for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby
Palomar is reimbursed for the expenses incurred in connection with PFB research plus an 8%
fee. This revenue is included in funded product development revenue in the accompanying
statements of operations. Palomar has recognized $1.1 million of funded product
development revenues from the Department of the Army for the year ended December 31, 2004.
Palomars revenue from the contract may be subject to government audit. Palomar is
unaware of any specific adjustments or open items that could result from any such audit.
-51-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements
Note 15  Product
upgrade options


During
the quarter ended March 31, 2004, Palomar introduced the StarLux Pulsed Light and Laser
System. Palomar began commercially shipping StarLux products at the end of the second
quarter of 2004. In connection with this product introduction and during the first six
months of 2004, Palomar offered certain customers an upgrade option to trade-in their
newly purchased product for a new StarLux system for an upgrade fee. In addition, each
upgrade option included a specific expiration date. For a customer to exercise their
upgrade right, the customer was required to sign an agreement indicating their exercise
together with the upgrade fee, invoiced separately. Palomar received approximately $6.4
million of orders that included the upgrade option and deferred approximately $1.5 million
of revenue during the first two quarters of 2004. During the last six months of 2004,
Palomar recognized as revenue approximately $1.4 million of previously deferred product
revenue relating to this upgrade option upon expiration and approximately $535,000 upon
the exercise of the upgrade option, including upgrade fees with the exercise of the
upgrade option.


Note 16 
Settlement of Litigation


On
June 22, 2004, Palomar and Lumenis Ltd. announced that both parties reached a settlement
resolving their on-going litigation concerning both patent infringement and contractual
matters. Pursuant to the settlement, the parties dismissed with prejudice both the federal
action in the Northern District of California as well as the state court action in
Massachusetts.


Under
the terms of the settlement, Lumenis paid $868,000 in the second quarter for back-owed
royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay $3.225
million over the next six quarters, or $537,500 per quarter, for back-owed royalties due
on sales of the LightSheer made between July 1, 2002 and December 31, 2003. Beginning on
January 1, 2004, Lumenis agreed to pay Palomar a 5% royalty on sales of the LightSheer and
other professional laser hair removal devices and modules.


In
addition, Lumenis granted Palomar a paid up license to a variety of Lumenis patents
for Palomars light based devices. Palomar granted Lumenis a paid up license to the
568 and 844 patents for Lumenis lamp based devices. Both parties have
agreed to the validity and enforceability of each others patents and not to challenge such
validity and enforceability in the future.


For
the twelve months ended December 31, 2004, Lumenis made payments of approximately
$1.4 million relating to the 5% royalty and approximately $1.9 million for back-owed
royalties recorded as royalty revenue.

-52-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar Medical
Technologies, Inc. and Subsidiaries


Notes to Consolidated
Financial Statements


Item 9.       Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.
         Not applicable.


Item 9A. Controls and
Procedures


Evaluation of disclosure
controls and procedures


Our
management has evaluated the effectiveness of our disclosure controls and procedures as of
the end of the period covered by this report. Based upon that evaluation, our chief
executive officer and chief financial officer concluded that our discloser controls and
procedures were effective to provide reasonable assurance that we record, process,
summarize and report the information we must disclose in reports that we file or submit
under the Securities Exchange Act of 1934, as amended, within the time periods specified
in the SECs rules and forms.


The
effectiveness of a system of disclosure controls and procedures is subject to various
inherent limitations, including cost limitations, judgments used in decision making,
assumptions about the likelihood of future events, the soundness of internal controls, and
the risk of fraud. Because of these limitations, there can be no assurance that any system
of disclosure controls and procedures will be successful in preventing all errors or fraud
or in making all material information known in a timely manner to the appropriate levels
of management.


Changes in internal
controls


There
have been no changes in our internal control over financial reporting that occurred during
the quarter ended December 31, 2004 that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.


Managements report
on internal controls


Managements
Report on Internal Control over Financial Reporting


Our
management is responsible for establishing and maintaining adequate internal control over
financial reporting. Our internal control system was designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles.


Internal
control over financial reporting cannot provide absolute assurance of achieving financial
reporting objectives because of its inherent limitations. Internal control over financial
reporting is a process that involves human diligence and compliance and is subject to
lapses in judgment and breakdowns resulting from human failures. Internal control over
financial reporting also can be circumvented by collusion or improper management override.
Because of such limitations, there is a risk that material misstatements may not be
prevented or detected on a timely basis by internal control over financial reporting.
However, these inherent limitations are known features of the financial reporting process.
Therefore, it is possible to design into the process safeguards to reduce, though not
eliminate, this risk.


Management
has used the framework set forth in the report entitled Internal
ControlIntegrated Framework published by the Committee of Sponsoring
Organizations (COSO) of the Treadway Commission to evaluate the effectiveness
of our internal control over financial reporting. Management has concluded that our
internal control over financial reporting was effective as of December 31, 2004. Ernst
& Young LLP, a registered public accounting firm that has audited the financial
statements included in this Annual Report on Form 10-K has issued an attestation report on
managements assessment of our internal control over financial reporting.


Report of independent
registered public accounting firm
-53-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Report of Independent
Registered Public Accounting Firm


The Board of Directors
and Stockholders Palomar Medical Technologies, Inc.:


We have audited managements
assessment, included in the accompanying Managements Report on Internal Control over
Financial Reporting, that Palomar Medical Technologies, Inc. maintained effective internal
control over financial reporting as of December 31, 2004, based on criteria established in
Internal ControlIntegrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Palomar Medical
Technologies, Inc.s management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
managements assessment and an opinion on the effectiveness of the companys
internal control over financial reporting based on our audit.


We conducted our audit in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether effective internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.


A companys internal control
over financial reporting is a process designed to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and (3)
provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material
effect on the financial statements.


Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.


In our opinion, managements
assessment that Palomar Medical Technologies, Inc. maintained effective internal control
over financial reporting as of December 31, 2004, is fairly stated, in all material
respects, based on the COSO criteria. Also, in our opinion, Palomar Medical Technologies,
Inc. maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2004, based on the COSO criteria.


We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
consolidated balance sheets of Palomar Medical Technologies, Inc. as of December 31, 2004
and 2003, and the related consolidated statements of income, stockholders equity,
and cash flows for each of the three years in the period ended December 31, 2004 of
Palomar Medical Technologies, Inc. and our report dated March 7, 2005 expressed an
unqualified opinion thereon.




Ernst & Young LLP
Boston, MassachusettsMarch
7, 2005
-54-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART III


We
have omitted the information required in Part III of this annual report because we intend
to include that information in our definitive proxy statement for our 2005 annual meeting
of stockholders, which we expect to file before 120 days after the end of fiscal 2004. We
incorporate that information in this annual report by reference to our 2005 proxy
statement.


Item 10. Directors and
Executive Officers of the Registrant.


We
incorporate information required by this item by reference to the sections captioned
Executive Officers, Election of Directors and Section 16(a)
Beneficial Ownership Reporting Compliance in our 2005 annual proxy statement.


Item 11. Executive
Compensation.


We
incorporate the information required by this item by reference to the section captioned
Executive Officer Compensation in our 2005 annual proxy statement.


Item 12. Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder
                Matters.


We
incorporate the information required by this item by reference to the sections captioned
Security Ownership of Certain Beneficial Owners and Management and
Equity Compensation Plan Disclosure in our 2005 annual proxy statement.


Item 13. Certain
Relationships and Related Transactions.


We
incorporate the information required by this item by reference to the section captioned
Certain Relationships and Related Transactions in our 2005 annual proxy
statement.


Item 14. Principal
Accountant Fees and Services.


We
incorporate the information required by this item by reference to the section captioned
Independent Auditor Fees in our 2005 annual proxy statement.

-55-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART IV


Item 15. Exhibits,
Financial Statement Schedules and Reports on Form 8-K.


     (a)    
          Financial Statements, Schedules and Exhibits.The following
          Consolidated Financial Statements of Palomar and its subsidiaries are filed as
          part of this report on Form 10-K:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                 | Page
|-------------------------------------------------------------------------------- | ----
|                                                                                 |     
|Report of Independent Registered Public Accounting Firm                          |     
|                                                                                 |     
|Consolidated Balance Sheets - December 31, 2004 and 2003                         |     
|                                                                                 |     
|Consolidated Statements of Income - Years ended December 31, 2004, 2003          |     
|and 2002                                                                         |     
|                                                                                 |     
|Consolidated Statements of Stockholders Equity - Years ended December 31, 2004, |     
|2003 and 2002                                                                    |     
|                                                                                 |     
|Consolidated Statements of Cash Flows - Years ended December 31, 2004, 2003      |     
|and 2002                                                                         |     
|                                                                                 |     
|Notes to Consolidated Financial Statements                                       |     

|(b)  Reports on Form
8-K.


On
October 28, 2004, we filed a current report on Form 8-K, which reported our financial
results for our fiscal quarter ended September 30, 2004.


On
November 18, 2004, we filed a current report on Form 8-K, which announced that on November
12, 2004 the Company entered into a Research Agreement, effective August 1, 2004, with The
Massachusetts General Hospital Corporation whereby Massachusetts General Hospital, a
Massachusetts corporation, agreed to conduct clinical and basic studies related to the
research and development of light based treatment for hair removal/reduction at Wellman
Laboratories of Photomedicine. The Research Agreement has a three year term, and the
Company has the right to exclusively license, on royalty terms to be negotiated,
Palomar-funded inventions.


On
December 21, 2004, we filed a current report on Form 8-K, which announced Mr. Jay
Delahanty resigned from the Board of Directors of Palomar Medical Technologies, Inc.,
effective immediately, due to illness.


(c)     Exhibits





We
have listed the exhibits filed as part of this annual report in the accompanying exhibit
index, which follows the signature page to this annual report.
-56-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|SIGNATURES


Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized on March 10, 2005.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | PALOMAR MEDICAL TECHNOLOGIES, INC.
By: /s/ Paul S. Weiner

Paul S. Weiner
Chief Financial Officer
| |  | ---------------------------------------------------------------------------------------------------------------

|Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed by
the following persons on behalf of the registrant in the capacities and on the dates
indicated.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Name |  | Capacity |  | Date | 
|---- |  | -------- |  | ---- | 

|/s/ Louis P. ValenteLouis P. Valente | Chairman of the Board of Directors | March 10, 2005
|-------------------------------------------------- | ---------------------------------- | --------------

|/s/ Joseph P. CarusoJoseph P. Caruso | President, Chief Executive Officer and Director | March 10, 2005
|-------------------------------------------------- | ----------------------------------------------- | --------------

|/s/ Paul S. WeinerPaul S. Weiner | Chief Financial Officer | March 10, 2005
|---------------------------------------------- | ----------------------- | --------------

|/s/ Nicholas P. EconomouNicholas P. Economou | Director | March 10, 2005
|---------------------------------------------------------- | -------- | --------------

|/s/ A. Neil PappalardoA. Neil Pappalardo | Director | March 10, 2005
|------------------------------------------------------ | -------- | --------------

|/s/ James G. MartinJames G. Martin | Director | March 10, 2005
|------------------------------------------------ | -------- | --------------

|/s/ Jeanne CohaneJeanne Cohane | Director | March 10, 2005
|-------------------------------------------- | -------- | --------------

|-57-
|----

|EXHIBIT INDEX
|-------------

|Exhibit No. |  | Description
|----------- |  | -----------

| | 3.1 |  | Certificate of Designation, Preferences and Rights of the Series A Participating Cumulative
                   Preferred Stock (filed as Exhibit 4.2 to our Quarterly Report on Form 10-Q for the period ended
                   March 31, 1999, and incorporated herein by reference)
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3.2 |  | Second Restated Certificate of Incorporation (filed as Exhibit 3.1 to our Registration Statement
                   on Form S-3 (Registration No. 333-70391), and incorporated herein by reference)
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3.3 |  | Restated Bylaws (filed as Exhibit 3.1 to our Current Report on Form 8-K, filed with the SEC on
                   December 16, 1999, and incorporated herein by reference)
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3.4 |  | Certificate of Amendment of Certificate of Incorporation (filed as Exhibit 3.4 to our Annual
                   Report on Form 10-K, filed with the SEC on March 17, 2004, and incorporated herein by reference)
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4.1 |  | Specimen certificate for common stock (filed as Exhibit 4.1 to our Annual Report on Form 10-K/A
                   for the year ended December 31, 1996, and incorporated herein by reference)
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4.2 |  | Form of Rights Certificate (filed as Exhibit 4.3 to our Current Report on Form 8-K, filed with
                   the SEC on April 21, 1999, and incorporated herein by reference)
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.1 |  | Second Amended 1991 Stock Option Plan (filed as Exhibit 4.1 to our Quarterly Report on Form 10-Q
                   for the period ended June 30, 1999, and incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.2 |  | Second Amended 1993 Stock Option Plan (filed as Exhibit 4.2 to our Quarterly Report on Form 10-Q
                   for the period ended June 30, 1999, and incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.3 |  | Second Amended 1995 Stock Option Plan (filed as Exhibit 4.3 to our Quarterly Report on Form 10-Q
                   for the period ended June 30, 1999, and incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.4 |  | Second Amended 1996 Stock Option Plan (filed as Exhibit 4.4 to our Quarterly Report on Form 10-Q
                   for the period ended June 30, 1999, and incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.5 |  | Third Amended 1996 Employee Stock Purchase Plan (filed as Exhibit 4.5 to our Quarterly Report on
                   Form 10-Q for the period ended June 30, 1999, and incorporated herein by reference)
| | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.6 |  | Form of Warrant to Purchase Common Stock (filed as Exhibit 4(d) to our Registration Statement on
                   Form S-8 (Registration No. 333-55821), and incorporated herein by reference)
| | ---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.7 |  | 1998 Incentive and Non-qualified  Stock Option Plan (filed as Exhibit 4(c) to our Registration
                   Statement on Form S-8 (Registration No. 333-55821), and incorporated herein by reference)
| | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.8 |  | Lease for premises at 82 Cambridge Street, Burlington, Massachusetts dated June 17, 1999 (filed
                   as Exhibit 10.4 to our Quarterly Report on Form 10-Q for the period ended June 30, 1999, and
                   incorporated herein by reference)
| | ---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.9 |  | License Agreement between Palomar and Massachusetts General Hospital dated August 18, 1995
                   (filed as Exhibit 10.46 to our Annual Report on Form 10-K for the year ended December 31, 1998,
                   and incorporated herein by reference)
| | ---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.10 |  | First Amendment to License Agreement between Palomar and Massachusetts General Hospital dated
                   August 18, 1995  (filed as Exhibit 10.47 to our Annual Report on Form 10-K for the year ended
                   December 31, 1998, and incorporated herein by reference)
| | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.11 |  | Second Amendment to License Agreement between Palomar and Massachusetts General Hospital dated
                   August 18, 1995 (filed as Exhibit 10.48 to our Annual Report on Form 10-K for the year ended
                   December 31, 1998, and incorporated herein by reference)
| | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.12 |  | Palomars 401(k) Plan (filed as Exhibit 99(h) to our Registration Statement on Form S-8
                   (Registration No. 333-97710), and incorporated herein by reference)
| | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | *10.13 |  | Third and Fourth Amendments to License Agreement between Palomar and Massachusetts General
                   Hospital dated August 18, 1995 (filed as Exhibit 10.13 to our Annual Report on Form 10-K for the
                   year ended December 31, 2002, and incorporated herein by reference)
| | ------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | *10.14 |  | The Development and License Agreement with The Gillette Company effective February 14, 2003 (filed
                   as Exhibit 10.1 to our Current Report on Form 8-K, filed with the SEC on February 19, 2003, and
                   incorporated herein by reference)
| | ------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.15 |  | Rights Agreement with American Stock Transfer and Trust Company dated April 20, 1999 (filed as
                   Exhibit 4.1 to our Current Report on Form 8-K, filed with the SEC on April 21, 1999, and
                   incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.16 |  | Employment Agreement dated July 1, 2001, between Palomar and Louis P. Valente (filed as Exhibit
                   10.16 to our Annual Report on Form 10-K, filed with the SEC on March 17, 2004, and incorporated
                   herein by reference)
| | ------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-58-
|----

| | +10.17 |  | Employment Agreement dated July 1, 2001, between Palomar and Joseph P. Caruso (filed as Exhibit
                   10.17 to our Annual Report on Form 10-K, filed with the SEC on March 17, 2004, and incorporated
                   herein by reference)
| | ------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.18 |  | Employment Agreement dated July 1, 2001, between Palomar and Paul S. Weiner (filed as Exhibit
                   10.18 to our Annual Report on Form 10-K, filed with the SEC on March 17, 2004, and incorporated
                   herein by reference)
| | ------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | +10.19 |  | 2004 Stock Incentive Plan (filed as Appendix A to our Proxy Statement, filed with the SEC on March
                   17, 2004, and incorporated herein by reference)
| | ------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.20 |  | Form of Warrant to purchase common stock at $3.1875 per share (filed as Exhibit 99.1 to our
                   Registration Statement on Form S-8 (Registration No. 333-115719), and incorporated herein by
                   reference)
| | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.21 |  | Form of Warrant to purchase common stock at $1.96875 and $2.8125 per share (filed as Exhibit 99.2
                   to our Registration Statement on Form S-8 (Registration No. 333-115719), and incorporated herein
                   by reference)
| | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.22 |  | Settlement Agreement dated June 17, 2004 between Palomar Medical Technologies, Inc., The General
                   Hospital Corporation, Lumenis, Inc. and Lumenis, Ltd. (filed as Exhibit 99.1 to our Current Report
                   on Form 8-K, filed with the SEC on June 22, 2004, and incorporated herein by reference)
| | ----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | *10.23 |  | Patent License Agreement dated June 17, 2004 between Palomar Medical Technologies, Inc. and
                   Lumenis, Inc. (filed as Exhibit 99.2 to our Current Report on Form 8-K, filed with the SEC on June
                   22, 2004, and incorporated herein by reference)
| | ------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.24 |  | Amendment to the Development and License Agreement dated June 24, 2004 between Palomar Medical
    Technologies, Inc. and The Gillette Company (filed as Exhibit 99.1 to our Current Report on Form
                   8-K, filed with the SEC on June 28, 2004, and incorporated herein by reference)
| | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.25 |  | Amendment to the Development and License Agreement dated October 2, 2003 between Palomar Medical
                   Technologies, Inc. and The Gillette Company (filed as Exhibit 99.2 to our Current Report on Form
                   8-K, filed with the SEC on June 28, 2004, and incorporated herein by reference)
| | ----- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.26 |  | Amendment to the Development and License Agreement dated February 14, 2003 between Palomar Medical
                   Technologies, Inc. and The Gillette Company (filed as Exhibit 99.3 to our Current Report on Form
                   8-K, filed with the SEC on June 28, 2004, and incorporated herein by reference)
| | ----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | *10.27 |  | Joint Development and License Agreement by and between Palomar Medical Technologies, Inc. and
                   Johnson and Johnson Companies, Inc., dated September 1, 2004 (filed as Exhibit 99.1 to our Current
                   Report on Form 8-K, filed with the SEC on September 7, 2004, and incorporated herein by reference)
| | ------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | *10.28 |  | Research Agreement Agreement with The Massachusetts General Hospital dated August 1, 2004 (filed
                   as Exhibit 99.1 to our Current Report on Form 8-K, filed with the SEC on November 18, 2004, and
                   incorporated herein by reference)
| | ------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 21.1 |  | List of Subsidiaries.
| | ---- |  | ---------------------

| | 23.1 |  | Consent of Ernst & Young LLP
| | ---- |  | ----------------------------

| | 31.1 |  | Rule 13a-14(a)/15d-14(a) certification of principal executive officer
| | ---- |  | ---------------------------------------------------------------------

| | 31.2 |  | Rule 13a-14(a)/15d-14(a) certification of principal financial officer
| | ---- |  | ---------------------------------------------------------------------

| | 32.1 |  | Section 1350 certification of principal executive officer and principal financial officer
| | ---- |  | -----------------------------------------------------------------------------------------

|
|

|+ | Management
contract or compensatory plan or arrangement.
|- | --------------------------------------------------------

|* | Filed
under application for confidential treatment.
|- | ---------------------------------------------------

|-59-
|----