|SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549


FORM 10-K
|--------------------------------------------------------------------

||X| | ANNUAL
REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For fiscal year
ended December 31, 2003
|--- | ----------------------------------------------------------------------------------------------------------------------------

|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:
|-----------------------------------------------------------------------------------------------------------------------------

|Title of Class
Not Applicable | Name of each exchange on which registered
Not Applicable
|----------------------------- | --------------------------------------------------------

|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
report(s)), 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 |_|     No |X|


The
aggregate market value of the voting and non-voting shares (based upon the closing price
reported by  Nasdaq on June 30, 2003) of Palomar Medical Technologies, Inc., held by
nonaffiliates was $46,849,692.  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 officer and director 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, 2004, 15,481,371 shares of common stock were outstanding.


DOCUMENTS
INCORPORATED BY REFERENCE


Portions
of the 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
|-----------------

|           |  |                                                                            | 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 |  |                                                                            | 49      

|
|

|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 was first to obtain FDA clearance for permanent hair reduction
| | - | ---------------------------------------------------------------------------

| |  | 1998
Palomar was first to obtain FDA clearance for high power diode laser system
| | - | --------------------------------------------------------------------------------

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

|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
optimally 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. to sell
all of the issued and outstanding common stock of Palomars subsidiary,
Star. Palomar completed the sale of Star to Coherent Inc. on April 27, 1999
(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).


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
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 (PFB). The project is scheduled
to last for nineteen months. Palomar believes that this device will be protected
by multiple patents within its patent portfolio.


-1-
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|Palomar
has one operating subsidiary, Palomar Medical Products, Inc. (PMP)
located at Palomars headquarters in Burlington, Massachusetts, which
oversees the manufacture and sale of Palomars laser and other light based
systems currently on the market.


Financial
Information About Industry Segments


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


Description
of Business


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 (pending FDA clearance)
| | - | --------------------------------------

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

| |  | 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. As compared to other light based hair removal devices,
Palomars Lux platform is more versatile, treats larger areas in less time,
are relatively painless and are more cost effective.


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. Then, 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, and most recently, in February
2004, Palomar introduced the StarLux Pulsed Light and Laser System with
increased power, a computer controlled touch screen, instant handpiece
recognition, integrated cooling, and a long pulse Nd:YAG laser handpiece for
effective treatment of visible leg veins and other vascular lesions. The StarLux
is expected to ship during the third quarter of 2004.


These
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. Palomar believes the StarLux, MediLux, EsteLux and
NeoLux systems are the most affordable and versatile cosmetic light-based
systems on the market.


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 on
the handpieces. Most of the Palomar handpieces provide 100,000 pulses before
they need to be replaced which is up to ten times more than competing systems.


-2-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
Lux pulsed light handpieces combine the latest flashlamp 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 treating 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 (pending FDA clearance) 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 (pending FDA clearance). 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.


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. 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. The Lux1064
effectively treats visible leg veins and other vascular conditions, and the
Lux1064 is the first multi-spot, high power laser handpiece to feature Smooth
Pulse technology and Contact Cooling. The Lux1064 is expected to ship during the
fourth quarter of 2004. Palomars patented 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. Fluencies 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. The StarLux full-color
screen allows easy finger-touch operation and instant handpiece recognition
while providing constant feedback on operating parameters.


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 state-of-the-art, 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 current 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.


-3-
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--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|SLP1000.
During 2000, Palomar received FDA clearance to market and sell the Palomar
SLP1000® Diode Laser System. 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. In the fourth quarter of 2003, Palomar
began the process of phasing out the selling of the SLP1000 product line.


Legacy
Products.Palomar no longer sells the EpiLaser or
E2000 hair removal laser systems or the RD-1200 Q-switched ruby
laser. 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.


Sales, Marketing
and Distribution


As
of December 31, 2003, Palomars sales and marketing organization
consisted of 33 employees. Palomars direct sales representatives operate
within their respective regions and engage customers directly, employ targeted
lead generation programs such as regional seminars and manage customer
opportunities through Palomars strategic distribution relationships with
independent sales representatives and exclusive distributors.


Direct Sales Force


Palomar
sells products in the U.S. primarily through its direct sales force to
dermatologists and cosmetic surgeons 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, 2003, Palomar utilized 31
distributors in 44 countries. Generally, Palomars distributors enter into
a one to two year agreement not to sell our competitors products.
Palomars sales strategy is to choose the most productive and practicable
distribution channel within each of its geographic markets.


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

| | December 31, | 
| | ------------ | 
|
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 
| |              | 

|-4-
|---

|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
principal 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.


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, and other products
for new markets, such as acne treatment, fat reduction and wrinkle removal.


As
of 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. (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. The project is scheduled to last for nineteen months. In Brauner
GJ, Flaudesmeyer KL. Pseudofolliculitis barbae: Medical consequences of
interracial friction in the US Army, Cutis, 1979, 23:61-66, PFB is called
the most significant dermatologic disease in the US Army, and,
according to Perry PK, Cook-Bolden FE , et al. Defining pseudofolliculitis
barbae in 2001, JAAD, 2002, 46:S113-S119, affects combat readiness, unit
cohesion, and individual morale of over 50% of African American and Hispanic
military personnel. 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.


-5-
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|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.


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 related United States patents, one related European Patent and other related
foreign 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. In addition, Palomar is the sole
owner of seven United States patents and corresponding foreign 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. 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.)


-6-
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|In
August 1995, Palomar entered into an agreement with The Massachusetts General
Hospital Corporation or Massachusetts General Hospital whereby Massachusetts
General Hospital agreed to conduct clinical trials on a laser treatment for hair
removal developed at Wellman Laboratories of Photomedicine (Clinical Trial
Agreement). In July 1999, Palomar amended this agreement to extend its
exclusive research relationship for an additional five years, until August 2004.
In addition to removal or reduction of hair, the agreement has been expanded to
include research and development in the 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 (hereinafter referred to, respectively, as hair
removal, fat removal, acne treatment, and
skin rejuvenation for simplicity).


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 and European Patent No. 0 806 913 B1. 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 and through
the License Agreement Palomar is an exclusive licensee in the field of hair
removal. 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. Palomar has the right
to sublicense patents licensed to it under the License Agreement. Palomar
currently licenses two competitors to U.S. Patent Nos. 5,595,568 and 5,735,844
and foreign counterparts, and Palomar licenses Gillette, to those patents and
other patents for the development and commercialization of a home-use,
light-based hair removal device for women. 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.


Dependence on a
Single Customer


For
the years ended December 31, 2003, 2002 and 2001, Palomar had two customers that
accounted for 20%, 35% and 36% of net sales, respectively. At December 31, 2003,
2002 and 2001, these customers accounted for 20%, 27% and 15% of trade
receivables outstanding, respectively.


Backlog


Palomars
backlog of firm orders for its continuing operations at December 31, 2003, 2002
and 2001 was approximately $438,000, $272,000 and $275,000, respectively.


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.)


Research and
Development


Palomars
research and development goals in the field of light based dermatological and
cosmetic procedures are to design systems that (1) permit effective
treatment and rapid treatment of large areas, (2) have high gross profits,
and (3) are manufactured at a low cost. Palomar addresses dermatological
and cosmetic procedure markets such as hair removal and aims to address other
markets including acne treatment, fat removal, and skin rejuvenation including
wrinkle removal and improvement of skin tone and texture.


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. The agreement provides 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, with $2.6 million provided during 2003.
(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)


-7-
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|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. The project is scheduled to last
for nineteen months.


During
fiscal 2003, 2002 and 2001, Palomar expended approximately $6.1 million, $4.4
million and $6.0 million, respectively, on research and development programs.
Due to the intense competition and rapid technological changes in the light
based industry, Palomar believes that it must continue to improve and refine its
existing products and services, and develop new applications for its
technology.(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.


Environmental
Protection Regulations


Palomar
and its products may be subject to federal, state, local or foreign regulations
relating to health and safety, environmental matters, quality assurance, and the
like. Palomars compliance with the laws that regulate the discharge of
materials into the environment or otherwise relate to the protection of the
environment does not have a material effect on its ongoing operations. Palomar
has not made any material expenditures for environmental control facilities.


Number of
Employees


As
of December 31, 2003, Palomar employed 119 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


Our
internet website address is www.palomarmedical.com. Our 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 through our
internet website as soon as reasonably practicable after we file 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


Palomar
is the exclusive licensee of U.S. Patent Nos. 5,595,568 and 5,735,844 from The
Massachusetts General Hospital Corporation. Pursuant to a Patent License
Agreement dated December 7, 1998, Lumenis paid Palomar a 7.5% royalty on net
sales of the LightSheer diode laser system. As of the quarter ended September
30, 2002, Palomar received approximately $3.6 million dollars in cumulative
royalties from Lumenis for sales of the LightSheer system. On October 24, 2002,
Lumenis told Palomar that it would no longer pay royalties for sales of the
LightSheer system and filed a complaint in the United States District Court for
the Northern District of California seeking a declaratory judgment that the
patents are invalid and/or unenforceable and not infringed by any Lumenis
products. Palomar believes that Lumenis claims are without merit, and on
October 29, 2002, Palomar filed a complaint in the Middlesex County Superior
Court in Massachusetts against Lumenis for breach of contract, breach of the
implied covenant of good faith and fair dealing, and violation of Massachusetts
General Laws Chapter 93A. Palomar has also answered Lumenis federal court
complaint in California with similar counter claims. On February 14, 2003,
Palomar terminated the Patent License Agreement and added counter claims of
patent infringement to Lumenis Federal Court complaint in California. The
Massachusetts state court action has been stayed pending the outcome of the
Federal Court action. A claim construction hearing (often referred to as a
Markman hearing) is scheduled for March 29, 2004. Following a Markman hearing, a
judge will rule on the meaning of disputed claim terms, that is, the judge will
construe the disputed claim terms.


-8-
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|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 has been 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 and it will have a considerable impact on the case as it proceeds
toward trial. A trial date has not yet been set. (See Cautionary
Statements)




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


Not applicable.


PART II




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


Palomars
common stock is currently traded on the Nasdaq Small Cap Market
(Nasdaq) under the symbol PMTI. The following table sets forth the
high and low prices quoted 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 2003 | 
|-------------------------------- | ---------------- | 
|
|                                
|Quarter Ended March 31, 2003     |                  | 
|Quarter Ended June 30, 2003      |                  | 
|Quarter Ended September 30, 2003 |                  | 
|Quarter Ended December 31, 2003  |                  | 

|                                 | Fiscal Year 2002 | 
|-------------------------------- | ---------------- | 
|
|                                
|Quarter Ended March 31, 2002     |                  | 
|Quarter Ended June 30, 2002      |                  | 
|Quarter Ended September 30, 2002 |                  | 
|Quarter Ended December 31, 2002  |                  | 

|As
of February 28, 2004, Palomar had 4,126 holders of record of common stock. This
does not include holdings in street or nominee names.


-9-
|----------------------------------------------------------------------------------------------------------------------------------------------

|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 of Palomar. 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.


Selected Financial
Data
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            | Years Ended December 31, | 
|------------------------------------------- | ------------------------ | 
|
|
|Consolidated Statements of Operations Data: |                          | 
|                                            |                          | 
|Revenues:                                   |                          | 
|Product revenues                            |                          | 
|Royalty revenues                            |                          | 
|Funded product development revenues         |                          | 
|                                            |                          | 
|Total revenues                              |                          | 
|                                            |                          | 
|Costs and expenses (income):                |                          | 
|Cost of product revenues                    |                          | 
|Cost of royalty revenues                    |                          | 
|Research and development                    |                          | 
|Selling and marketing                       |                          | 
|General and administrative                  |                          | 
|Goodwill and asset write-off                |                          | 
|Costs incurred for proxy contest            |                          | 
|Settlement and litigation costs             |                          | 
|Gain from sale of subsidiary (1)            |                          | 
|                                            |                          | 
|Total cost and expenses (income)            |                          | 
|                                            |                          | 
|Income (loss) from operations               |                          | 
|                                            |                          | 
|Other income (expense):                     |                          | 
|Interest income                             |                          | 
|Interest expense                            |                          | 
|Other income                                |                          | 
|Swiss franc redemption                      |                          | 
|                                            |                          | 
|Income (loss) before benefit (provision)    |                          | 
|from income taxes                           |                          | 
|                                            |                          | 
|Benefit (provision) from income taxes       |                          | 
|Cumulative effect of change in accounting   |                          | 
|method                                      |                          | 
|Net loss from discontinued operations       |                          | 
|                                            |                          | 
|Net income (loss)                           |                          | 
|                                            |                          | 
|                                            |                          | 
|Basic net income (loss) per common share:   |                          | 
|Continuing operations                       |                          | 
|Cumulative effect of change in              |                          | 
|accounting method                           |                          | 
|Discontinued operations                     |                          | 
|                                            |                          | 
|Total basic net income (loss) per           |                          | 
|common share                                |                          | 
|                                            |                          | 
|                                            |                          | 
|Diluted net income (loss) per common share: |                          | 
|Continuing operations                       |                          | 
|Cumulative effect of change in              |                          | 
|accounting method                           |                          | 
|Discontinued operations                     |                          | 
|                                            |                          | 
|Total diluted net income (loss) per common  |                          | 
|share                                       |                          | 
|                                            |                          | 
|                                            |                          | 
|Weighted average number of common           |                          | 
|shares outstanding:                         |                          | 
|                                            |                          | 
|Basic                                       |                          | 
|                                            |                          | 
|                                            |                          | 
|Diluted                                     |                          | 
|                                            |                          | 

|-10-
|----

|                                 | Years Ended December 31, | 
|-------------------------------- | ------------------------ | 
|
|Consolidated Balance Sheet Data: |                          | 
|                                 |                          | 
|Working capital                  |                          | 
|Total assets                     |                          | 
|Long-term debt                   |                          | 
|Total stockholders equity       |                          | 

|(1) The
following event is related to the gain from sale of subsidiary:


On
December 7, 1998, Palomar entered into an Agreement and Plan of Reorganization
(the Agreement) with Coherent Inc. (Coherent) to sell
all of the issued and outstanding common stock of Star Medical Technology, Inc.
(Star), Palomars majority-owned subsidiary, to Coherent. This
sale was approved by a majority of the stockholders of Palomar on April 21,
1999. On April 27, 1999, Palomar completed the sale of Star to Coherent and
received net proceeds of $49,736,023. Additionally, $3,254,907 was held in
escrow until April 27, 2000 as security for any claims that Coherent may have
had under the Agreement. During 2000, in connection with the lapse of the escrow
period, Palomar recognized a deferred gain of $2,439,556, net of certain
commitments and contingencies related to the sale. In 2001, ESC Medical Systems
Ltd acquired Coherent Medical Group, including Star, from Coherent Inc. and
changed its name to Lumenis Ltd.




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


Executive
Summary


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, fat reduction, acne
treatment, Pseudofolliculitis Barbae or PFB and skin rejuvenation.


Over
the past year, we improved product gross margins significantly due to a higher
margin product mix and the effects of increased sales volume. We also
strengthened our balance sheet since the end of last year, including more than
doubling our cash position and more than tripling stockholders equity. The
current ratio is now 2.9x, up substantially from 1.5x at the end of 2002, and we
have no long-term debt.


Our
reported revenues for the year ended December 31, 2003, were $34.8 million, up
from $25.4 million for the year ended December 31, 2002. Gross profit from
product sales increased to $18.3 million (58 percent of revenues), up from $11.3
million (50 percent of revenues) in the year-earlier period. We also reported
net income of $3.4 million, or $0.21 per diluted share, for the year ended
December 31, 2003, versus net income of $39,000, or $0.00 per diluted share, for
the year ended December 31, 2002.


Over
the last two 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 upgrade into a more powerful Lux systems when ready.
Additionally, the Lux platform enables Palomar 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.


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|During
2003, we introduced two new systems to the Lux family of products: the
MediLux Pulsed Light System and the NeoLux Pulsed Light System. The
MediLux, a higher priced product is designed with the medical practitioner in
mind, has more power than that of the EsteLux® Pulsed Light System, a higher
repetition rate and a snap-on connector for faster changes between handpieces.
The MediLux can operate the LuxY, LuxG, LuxR, LuxRs,
LuxB and LuxV handpieces, 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
quarterly product revenue has increased each quarter during 2003 as compared to
2002 as a result of the increased product demand for our Lux family of products.
Due to this increased demand in the market place, we doubled our domestic sales
force in the fourth quarter of 2003. 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
and higher margins.


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. We believe that this device will be protected by
multiple patents within our patent portfolio. During 2003, we received from
Gillette $2.6 million to fund 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)


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 2004, we introduced the newest addition to the Lux family of products:
the StarLux Pulsed Light and Laser System. In comparison to other Lux
products, the StarLux has increased power, a computer controlled touch screen,
instant handpiece recognition, integrated cooling, the ability to operate the
LuxG, LuxR, LuxRs, LuxV and the Lux1064 handpieces. We expect to start
commercial shipment of StarLux products in the third quarter of 2004.


On
February 18, 2004, 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. The project is scheduled to last for nineteen
months.


Critical
Accounting Policies


Our
policies are more fully described in Note 1 of the 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
SEC Staff Accounting Bulletin No. 101 (SAB 101), Revenue
Recognition in Financial Statements, as amended by SAB 101A and 101B and SAB
104. SAB 101/104 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 and acceptance. Provisions are made at the time
of revenue recognition for any applicable warranty costs expected to be
incurred. 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 the revenue element in accordance
with SAB 104 and EITF Issue No. 00-21, Accounting for Revenue Arrangements
with Multiple Deliverables. Royalty revenues are recognized upon receipt of
cash payments.


-12-
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|We
account for funded product development revenue under the Gillette agreement
ratably over the funding period as received. Any amounts received in advance are
recorded as deferred revenue. Payments are not refundable if the development is
not successful. (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)


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.


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.
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 the 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.Products sold are generally covered by a warranty for
a period of one year. We provide for the estimated cost of product warranties at
the time revenue is recognized. 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. Warranty cost accruals are adjusted from
time to time when warranty claim experience differs from estimates.


-13-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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.


Results of
Operations


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                        |        | 
|Royalty
revenues                        |        | 
|Funded
product development revenues     |        | 
|                                        |        | 
|Total
revenues                          |        | 
|                                        |        | 
|Cost and
expenses:                      |        | 
|Cost
of product revenues                |        | 
|Cost
of royalty revenues                |        | 
|Research
& development                  |        | 
|Selling
& marketing                     |        | 
|General
& administrative                |        | 
|                                        |        | 
|Total
costs & expenses                  |        | 
|                                        |        | 
|Income
(loss) from operations           |        | 
|Interest
income                         |        | 
|Interest
expense                        |        | 
|Other
income                            |        | 
|                                        |        | 
|Income before
benefit from income taxes |        | 
|Benefit from
income taxes               |        | 
|                                        |        | 
|Net income                              |        | 
|                                        |        | 

|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 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 RD-1200 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 49% of total product revenue for the
year ended 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.


-14-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Royalty
revenues.  The decrease in royalty revenues in comparison to the same period in 2002 is
attributed to  Lumenis Inc.s (Lumenis) failure to make its royalty payments
starting in October 2002. (See Legal Proceedings)


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.


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 line. 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 year end, we believe 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 Legal Proceedings).


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 fat reduction, acne treatment and
skin rejuvenation.


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.


-15-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|General
and Administrative Expense. The increase in general and
administrative dollars of $1.2 million is directly related to increases to
incentive compensation of approximately $792,000, related to our incentive
compensation plan of 2003, additional legal expenses of approximately $250,000
incurred as a result of enforcing our patent position against infringers and an
increase in our D&O\ general liability insurance premiums of approximately
$157,000.


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
Palomars 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
for Income Taxes. 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. 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.


Year 2002
Compared to Year 2001


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, 2002 and 2001, respectively (in thousands, except for
percentages):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | Change | 
|----------------------------------- | ------ | 
|
|
|Revenues:                           |        | 
|Product revenues                    |        | 
|Royalty revenues                    |        | 
|Funded product development revenues |        | 
|                                    |        | 
|Total revenues                      |        | 
|                                    |        | 
|                                    |        | 
|Cost and expenses:                  |        | 
|Cost of product revenues            |        | 
|Cost of royalty revenues            |        | 
|Research & development              |        | 
|Selling & marketing                 |        | 
|General & administrative            |        | 
|                                    |        | 
|Total costs & expenses              |        | 
|                                    |        | 
|                                    |        | 
|Income (loss) from operations       |        | 
|Interest income                     |        | 
|Interest expense                    |        | 
|Other income                        |        | 
|                                    |        | 
|                                    |        | 
|Income (loss) before benefit from   |        | 
|income taxes                        |        | 
|Benefit from income taxes           |        | 
|                                    |        | 
|Net income (loss)                   |        | 
|                                    |        | 

|-16-
|----

|Product
revenues. The leading contributor to the increase in product
revenues were sales related to the EsteLux product line and its additional
handpieces which had lower price points than Palomars other products.


International
product revenue, consisting of sales by our distributors in Japan, Europe,
Australia, Asia\Pacific Rim and South and Central America and sales shipped
directly to international customers from the United States was 54% of total
product revenue in 2002 and 2001.


Royalty
revenues.  Royalty revenues decreased in 2002 as compared to 2001 due to Lumenis failure
to make its  royalty payments starting in October 2002. (See "Legal
Proceedings")


Cost
of product revenues. The cost of product revenues decreased as a
percentage of product revenues to 50% from 79% in 2001. This cost decreased as a
percentage of product revenue primarily due to the introduction of the Estelux
product line, including its additional handpieces that carry an improved gross
profit as compared to existing products due to lower manufacturing costs. In
addition, the increased sales volume improved the absorption of manufacturing
overhead at our manufacturing facility for each product line.


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 Legal Proceedings)


Research
and Development Expense. The decreases in both dollars and as a
percentage of revenues for research and development expenses were a direct
result of the investments that we made in prior periods in the development of
product platforms. These platforms have allowed us to introduce new applications
by developing new handpieces and other complimentary features. 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 and pigmented and
vascular lesion removal are to design systems that: (1) permit effective
treatment and more rapid treatment of large areas, (2) have higher gross
margins, and (3) are manufactured at lower costs, to expand our current markets.
Furthermore, we are developing products to address dermatology and cosmetic
conditions other than hair, including the fields of fat reduction, acne
treatment and skin rejuvenation.


Selling
and Marketing Expense. The increase in selling and marketing expenses
is associated with direct sales force and international commissions of $2.0
million which are correlated with increased revenues, upfront costs associated
with both international and domestic sales force of approximately $150,000 and
distribution channel expansion and additional marketing expenses of
approximately $63,000 associated with the roll-out of the our new product lines.


General
and Administrative Expense. The increase in general and
administrative dollars of $600,000 is directly related to additional legal
expenses incurred as a result of enforcing our patent position against
infringers.


Interest
Income. The decrease in interest income is due to lower cash
balances invested and lower interest rates in 2002 as compared to the same
period in 2001.


Interest
Expense.The increase in interest expense is due to a higher average
debt balance in 2002 as a result of the note payable to a related party as
compared to 2001.


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


Benefit
from Income Taxes. We have not recorded a provision for income
taxes in 2002 due to only having $39,000 net income and the utilization of net
operating loss carryforwards. The benefit for income taxes in 2001 was the
result of previously provided state income taxes no longer required. We have
fully reserved our otherwise recognizable deferred tax asset, as its realization
is uncertain.


Liquidity
and Capital Resources


As
of December 31, 2003, we had $10.6 million in cash and cash equivalents. The
sales of our current products and future products will be critical to our future
liquidity.


We
believe that cash balances will be sufficient to meet anticipated cash
requirements for the next twelve months.


-17-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Cash
provided by operating activities amounted to $1,195,000 for the twelve months
ended December 31, 2003 compared to $565,000 for the same period in 2002. This
increase primarily reflects the effects of a net profit offset by working
capital requirements (primarily accounts receivable) associated with our sales
growth. Cash used by investing activities totaled $115,000 for the twelve months
ended December 31, 2003 compared to $93,000 for the same period in 2002. These
amounts primarily reflect cash used for purchases of property and equipment.
Cash provided by financing activities amounted to $5.0 million for the twelve
month period ended December 31, 2003 compared to a use of $717,000 for the same
period in 2002. This increase was a result of sales of common stock, and
exercises of stock options and purchases of common stock pursuant to the
employee stock purchase plan offset by costs related to the issuance of common
stock.


We
anticipate that capital expenditures for 2004 will total approximately $400,000,
consisting primarily of machinery, equipment, computers and peripherals. We
expect to finance these expenditures with cash on hand.


Lumenis
stopped making royalty payments due since October 30, 2002 for sales of their
Lightsheer diode laser system. On February 14, 2003, we terminated our license
agreement with Lumenis (see Legal Proceedings). During the second
quarter of 2003, Carl Zeiss Meditec AG, parent company to Asclepion-Meditec AG,
notified us that it had sold Asclepion to EL.EN and Quanta System and,
consequently, terminated the sub-license agreement between Asclepion and us
effective July 31, 2003. Asclepion paid us a minimum royalty payment of fifty
thousand dollars ($50,000) per year, prorated in the first and last years. We
face risks associated with pending litigation and there can be no assurance that
these royalty amounts from other third parties will not decrease or that we will
be able to collect all licensing royalties owed by current licensees or increase
royalties by sub-licensing additional third parties.


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 over approximately the first
30 months of the agreement, with $2.6 million provided during 2003. (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
March 14, 2003, a director surrendered the $1 million principal balance of a
Promissory Note in exchange for 293,255 unregistered shares of the
Palomars common stock with no registration rights at a price of $3.41 per
share. The price was calculated at 110% of the Palomars common stock
trailing ten-day average closing price of $3.10 per share.


On
March 14, 2003, we 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 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.


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. The grant will be paid monthly as
expenses are incurred. The project is scheduled to last for nineteen months.


Contractual
Obligations


Substantially
all of our existing operating leases relate to our Burlington, Massachusetts
manufacturing, research and development and administrative offices. The facility
lease expires in August 2009.


In
August 1995, we entered into an agreement with Massachusetts General Hospital
whereby Massachusetts General Hospital agreed to conduct clinical trials on a
laser treatment for hair removal/reduction developed at Wellman Laboratories of
Photomedicine. In July 1999, we further amended this agreement to extend its
exclusive research agreement for an additional five years. In addition to laser
hair removal, the agreement has been expanded to include research and
development in the fields of fat removal and acne treatment. We have the right
to exclusively license, on royalty terms to be negotiated, the Palomar-funded
inventions in the relevant fields. Under the terms of this agreement, we have
paid Massachusetts General Hospital $475,000 on an annual basis for clinical
research through August 2004. We are a party to a license agreement, as amended,
with Massachusetts General Hospital whereby the Company is obligated to pay
royalties to Massachusetts General Hospital. Royalty expense in 2003 totaled
approximately $896,000.


-18-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
following table summarizes our estimated minimum future contractual commitments
at December 31, 2003, excluding royalty and employment obligations because they
are variable and/or subject to uncertain timing (in thousands):
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | Payments due by period | 
|---------------------------------- | ---------------------- | 
|
|                                  
|Operating Leases                   |                        | 
|Purchase Commitments               |                        | 
|                                   |                        | 
|Total contractual cash obligations |                        | 
|                                   |                        | 

|Recently
Issued Accounting Standards


In
January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an interpretation of ARB
51. The primary objectives of this interpretation are to provide guidance
on the identification of entities for which control is achieved through means
other than through voting rights (variable interest entities) and
how to determine when and which business enterprise (the primary
beneficiary) should consolidate the variable interest entity. This new
model for consolidation applies to an entity in which either (i) the equity
investors (if any) do not have a controlling financial interest; or (ii) the
equity investment at risk is insufficient to finance that entitys
activities without receiving additional subordinated financial support from
other parties. In addition, FIN 46 requires that the primary beneficiary, as
well as all other enterprises with a significant variable
interest in a variable interest entity, make additional disclosures. Certain
disclosure requirements of FIN 46 were effective for financial statements issued
after January 31, 2003.


In
December 2003, the FASB issued FIN No. 46 (revised December 2003),
Consolidation of Variable InterestEntities (FIN
46-R) to address certain FIN 46 implementation issues. The effective dates
and impact of FIN 46 and FIN 46-R are as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (i) | Special
purpose entities (SPEs) created prior to February 1,  2003. We must apply
either the provisions of FIN 46 or early adopt the  provisions of FIN 46-R at the end of
the first interim or annual reporting  period ending after December 15, 2003.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (ii) | Non-SPEs
created prior to February 1, 2003. We are required to adopt FIN  46-R at the end of
the first interim or annual reporting period ending after  March 15, 2004.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (iii) | All
entities, regardless of whether a SPE, that were created subsequent to  January 31, 2003.
The provisions of FIN 46 were applicable for variable  interests in entities obtained
after January 31, 2003. The company is required  to adopt FIN 46-R at the end of the
first interim or annual reporting period  ending after March 15, 2004.
| | ----- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The  adoption of the provisions
applicable to SPEs and all other variable interests  obtained after January 31, 2003 did
not have a material impact our financial  statements. We are currently evaluating the
impact of adopting FIN 46-R  applicable to Non-SPEs created prior to February 1, 2003but do not  expect a material impact.


Statement Under the
Private Securities Litigation Reform Act


In
addition to the other information in this Form 10-K, the following cautionary
statements should be considered carefully in evaluating Palomar and its
business. Statements contained in this Form 10-K that are not historical facts
may contain certain forward-looking information, as defined by (i) the Private
Securities Litigation Reform Act of 1995 (the Reform Act) and (ii)
releases by the SEC including but not limited to statements relating to new
markets, development and introduction of new products, and financial projections
that involve risk and uncertainties that may individually or mutually impact the
matters herein, and cause actual results, events and performance to differ
materially from such forward-looking statements. Our actual results could differ
materially from those suggested in such forward-looking statements due to the
risk factors identified below and other factors including, without limitation,
risks concerning the timing of new product introductions, 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 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, and/or other factors, which are detailed from time to time in
Palomars SEC reports, including the report on Form 10-K for the year ended
December 31, 2003 and Palomars quarterly reports on Form 10-Q. Readers are
cautioned not to place undue reliance on these forward-looking statements, which
speak only as of the date hereof. Palomar undertakes no obligation to release
publicly the results 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 cautionary statements below
are being made pursuant to the provisions of the Reform Act and with the
intention of obtaining the benefits of safe harbor provisions of the Reform Act.
Forward looking statements include statements regarding our expectations,
beliefs, intentions or strategies regarding the future and can be identified by
forward-looking words such as anticipate, believe,
could, estimate, expect, intend,
may, should, will, and would or
similar words.


-19-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 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 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 quarters, 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.


-20-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 product 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.


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 were 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.


-21-
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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.


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.


-22-
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|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
management of us, 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 (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. (See note 9,
Stockholders Equity and exhibit 10.15, Rights Agreement
with American Stock Transfer and Trust Company dated April 21, 1999)


We  may not be able to
successfully collect licensing royalties.


In
past years, material portions of our revenues consisted of royalties from
sub-licensing patents licensed to us on an exclusive basis by Massachusetts
General Hospital.


Lumenis
failed to make the royalty payments due since October 30, 2002 for sales of
their Lightsheer diode laser system. On February 14, 2003, we terminated our
license agreement with Lumenis. (See Legal Proceedings) This
reduction and any other loss or reduction in our royalty revenues could have a
material adverse effect on the business and financial condition, affect future
liquidity and prevent us from maintaining profitability. We face risks
associated with pending litigation and there can be no assurance that the
royalty amounts from other third parties will not decrease or that we will be
able to collect all licensing royalties owed by current licensees or increase
royalties by sub-licensing additional third parties.


We
are involved in disputes with other third parties, including Cutera, Inc.
(formerly Altus Medical Inc., See Legal Proceedings). Such disputes have
resulted in litigation with such parties. 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 have a material adverse effect on our
business, financial condition and results of operations.


-23-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 125 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
approximately half 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 approximately half 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 49%
of total product revenue for the year ended 2003, 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.


-24-
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|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. 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.
(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)


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 is scheduled to last for
nineteen months, 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.


We  face risks associated with
Section 11 (a)(4) Securities Act of 1933.


Prior to
June 28, 2002, Arthur Andersen LLP served as our independent auditors. On March
14, 2002, Arthur Andersen was indicted on federal obstruction of justice charges
arising from the governments investigation of Enron Corporation and on
June 15, 2002, Arthur Andersen was found guilty. Arthur Andersen ceased
practicing before the SEC by August 31, 2002. On June 28, 2002, we dismissed
Arthur Andersen and retained Ernst & Young LLP as its independent auditors
for its fiscal year ended December 31, 2002. SEC rules require us to present
historical audited financial statements in various SEC filings, such as
registration statements, along with Arthur Andersens consent to our
inclusion of Arthur Andersens audit report in those filings. Since Arthur
Andersen no longer practices public accounting, we will not be able to obtain
the consent of Arthur Andersen to the inclusion of Arthur Andersens audit
report in our relevant current and future filings. The SEC has provided
regulatory relief designed to allow companies that file reports with the SEC to
dispense with the requirement to file a consent of Arthur Andersen in certain
circumstances, but purchasers of securities sold under our registration
statements, which were not filed with the consent of Arthur Andersen to the
inclusion of Arthur Andersens audit report will not be able to sue Arthur
Andersen pursuant to Section 11(a)(4) of the Securities Act of 1933 and
therefore the purchasers right of recovery under that section may be
limited as a result of the lack of our ability to obtain Arthur Andersens
consent.




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.


-25-
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--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Item 8.
Financial Statements and Supplementary Data.


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

|                                                                                 | Page
|-------------------------------------------------------------------------------- | ----
|                                                                                 |     
|Report of Independent Auditors                                                   |     
|                                                                                 |     
|Report of Independent Public Accountants                                         |     
|                                                                                 |     
|Consolidated Balance Sheets - December 31, 2003 and 2002                         |     
|                                                                                 |     
|Consolidated Statements of Operations - Years ended December 31, 2003, 2002      |     
|and 2001                                                                         |     
|                                                                                 |     
|Consolidated Statements of Stockholders Equity - Years ended December 31, 2003, |     
|2002 and 2001                                                                    |     
|                                                                                 |     
|Consolidated Statements of Cash Flows - Years ended December 31, 2003, 2002      |     
|and 2001                                                                         |     
|                                                                                 |     
|Notes to Consolidated Financial Statements                                       |     

|-26-
|----

|Report
of Independent Auditors


The Board of Directors and StockholdersPalomar Medical Technologies, Inc:


We
have audited the accompanying consolidated balance sheets of Palomar Medical
Technologies, Inc. (a Delaware corporation) and subsidiaries as of December 31,
2003 and 2002 and the related consolidated statements of operations,
stockholders equity and cash flows for the years then ended. The
consolidated financial statements of Palomar Medical Technologies, Inc. and
subsidiaries for the year ended December 31, 2001 were audited by other auditors
who have ceased operations and whose report dated January 29, 2002 was modified
to express substantial doubt about the Companys ability to continue as a
going concern. 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 auditing standards generally accepted in
the 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. and subsidiaries as of December 31, 2003 and 2002 the
consolidated results of their operations and their cash flows for the years then
ended in conformity with accounting principles generally accepted in the United
States.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | /s/ Ernst & Young LLP
| |  | ---------------------

|Boston, MassachusettsJanuary 30, 2004


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

|The  following report is a
copy of the accountants report previously issued by  Arthur Andersen LLP. This
report has not been reissued by Arthur Andersen.


Report
of Independent Public Accountants


To Palomar Medical Technologies, Inc:


We
have audited the accompanying consolidated balance sheets of Palomar Medical
Technologies, Inc. (a Delaware corporation) and subsidiaries as of December 31,
2000 and 2001 and the related consolidated statements of operations,
stockholders equity (deficit)and cash flows for each of the three years in
the period ended December 31, 2001. 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 auditing standards generally accepted in
the 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 financial position of Palomar Medical Technologies, Inc.
and subsidiaries as of December 31, 2000 and 2001 and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001 in conformity with accounting principles generally accepted in
the United States.


The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has suffered recurring losses
from operations that raise substantial doubt about the Companys ability to
continue as a going concern. Managements plans in regard to these matters
are also described in Note 1 to the consolidated financial statements. The
accompanying consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.


As
explained in Note 2(h) to the consolidated financial statements, effective
January 1, 2000, the Company changed its method of accounting for revenue
recognition for royalties through the adoption of Staff Accounting Bulletin No.
101, Revenue Recognition in Financial Statements.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | ARTHUR ANDERSEN LLP
| |  | -------------------

|Boston, MassachusettsJanuary 29, 2002


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

|Palomar  Medical
Technologies, Inc. and Subsidiaries


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

|                                                                             | December 31,
2003  | December 31,
2002
|---------------------------------------------------------------------------- | ------------------ | -----------------
|Assets                                                                       |                    |                  
|Current assets:                                                             
|Cash and cash equivalents                                                    | $10,558,946        | $4,450,076       
|Accounts receivable, net of allowance of $862,114 and $553,559, respectively | 6,637,246          | 4,047,277        
|Inventories                                                                  | 3,385,316          | 3,847,493        
|Other current assets                                                         | 384,785            | 269,940          
|                                                                             |                    |                  
|Total current assets                                                         | 20,966,293         | 12,614,786       
|                                                                             |                    |                  
|Property and equipment, net                                                  | 582,898            | 485,286          
|                                                                             |                    |                  
|Other assets                                                                 | 111,074            | 298,268          
|                                                                             |                    |                  
|Total Assets                                                                 | $21,660,265        | $13,398,340      
|                                                                             |                    |                  
|Liabilities and Stockholders' Equity                                        
|                                                                             |                    |                  
|Current liabilities:                                                        
|Note payable to related party                                                | $               -- | $1,000,000       
|Accounts payable                                                             | 655,923            | 1,320,202        
|Accrued liabilities                                                          | 4,979,896          | 4,619,303        
|Deferred income taxes                                                        | 1,100,000          | 1,400,000        
|Deferred revenue                                                             | 560,897            | 341,084          
|                                                                             |                    |                  
|Total current liabilities                                                    | 7,296,716          | 8,680,589        
|                                                                             |                    |                  
|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 - 14,554,407 and 11,538,706 shares, respectively                      | 145,544            | 115,387          
|Additional paid-in capital                                                   | 168,267,820        | 162,021,265      
|Accumulated deficit                                                          | (154,049,815)      | (157,418,901)    
|                                                                             |                    |                  
|Total stockholders' equity                                                   | 14,363,549         | 4,717,751        
|                                                                             |                    |                  
|Total liabilities and stockholders equity                                   | $21,660,265        | $13,398,340      
|                                                                             |                    |                  

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

|-29-
|----

|Palomar
Medical Technologies, Inc. and Subsidiaries


Consolidated
Statements of Operations
|-------------------------------------------------------------------------------------------

|                                               | Years Ended December 31, |             |             
|---------------------------------------------- | ------------------------ | ----------- | ------------
|                                               | 2003                     | 2002        | 2001        
|Revenues:                                      |                          |             |             
|Product revenues                               | $31,332,125              | $22,548,451 | $11,157,770 
|Royalty revenues                               | 840,614                  | 2,869,085   | 5,496,034   
|Funded product development revenues            | 2,600,000                | --          | --          
|                                               |                          |             |             
|Total revenues                                 | 34,772,739               | 25,417,536  | 16,653,804  
|                                               |                          |             |             
|                                               |                          |             |             
|Costs and expenses:                           
|Cost of product revenues                       | 13,031,316               | 11,200,077  | 9,153,090   
|Cost of royalty revenues                       | 336,245                  | 1,147,635   | 2,198,413   
|Research and development                       | 6,057,987                | 4,359,346   | 6,045,343   
|Selling and marketing                          | 8,483,138                | 5,785,326   | 3,504,176   
|General and administrative                     | 4,255,487                | 3,066,945   | 2,491,961   
|                                               |                          |             |             
|Total costs and expenses                       | 32,164,173               | 25,559,329  | 23,392,983  
|                                               |                          |             |             
|Income (loss) from operations                  | 2,608,566                | (141,793)   | (6,739,179) 
|                                               |                          |             |             
|Interest income                                | 74,006                   | 73,647      | 758,938     
|Interest expense                               | (28,340)                 | (119,379)   | (98,114)    
|Other income                                   | 58,333                   | 226,638     | 185,786     
|                                               |                          |             |             
|Income (loss) before benefit from income taxes | 2,712,565                | 39,113      | (5,892,569) 
|                                               |                          |             |             
|Benefit from income taxes                      | 656,521                  | --          | 422,000     
|                                               |                          |             |             
|Net income (loss)                              | $3,369,086               | $39,113     | $(5,470,569)
|                                               |                          |             |             
|Net income (loss) per share:                  
|Basic                                          | $0.25                    | $0.00       | $(0.54)     
|                                               |                          |             |             
|Diluted                                        | $0.21                    | $0.00       | $(0.54)     
|                                               |                          |             |             
|Weighted average number of shares outstanding:
|Basic                                          | 13,399,178               | 11,372,228  | 10,805,143  
|                                               |                          |             |             
|Diluted                                        | 15,917,392               | 11,372,228  | 10,805,143  
|                                               |                          |             |             

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

|-30-
|----

|Palomar Medical
Technologies, Inc. and Subsidiaries


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

|                                                                         | Preferred Stock |        | Common Stock |           | Treasury Stock |            | Additional |           | Accumulated Other |          | Total |                 |  
|------------------------------------------------------------------------ | --------------- | ------ | ------------ | --------- | -------------- | ---------- | ---------- | --------- | ----------------- | -------- | ----- | --------------- | -
|
|Balance, December 31, 2000                                               |                 | 6,000  |              | $      60 |                | 11,074,393 |            | $ 110,744 |                   | (763,835 | )     | $(2,799,075     | )
|Net  loss                                                                |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|Issuance of stock for employee stock purchase plan                       |                 |       |              |          |                |           |            |          |                   | 70,856   |       | 259,493         |  
|Issuance of stock for 2000 employer 401(k) matching         contribution |                 |       |              |          |                |           |            |          |                   | 119,948  |       | 440,209         |  
|Costs incurred related to the issuance of common stock                   |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|Unrealized gain on available-for-sale investments                        |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                
|Comprehensive income (loss)                                              |                 |        |              |           |                |            |            |           |                   |          |       |                 |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                
|Preferred stock dividends                                                |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                 |  
|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 2001 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       |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                
|Comprehensive income                                                     |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                
|Preferred stock dividends                                                |                 |       |              |          |                |           |            |          |                   |         |       |                |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                 |  
|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 2002 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 |                   |         |       | $              |  
|                                                                         |                 |        |              |           |                |            |            |           |                   |          |       |                 |  

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


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

|
|

|Palomar
Medical Technologies, Inc. and Subsidiaries


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

|                                                                                 | Years Ended December 31, |      |     
|-------------------------------------------------------------------------------- | ------------------------ | ---- | ----
|                                                                                 | 2003                     | 2002 | 2001
|Cash flows from operating activities:                                            |                          |      |     
|Net income (loss)                                                                |                          |      | $   
|                                                                                 |                          |      |     
|Adjustments to reconcile net income (loss)                                       |                          |     
|to net cash provided by (used in) operating activities:                          |                          |     
|Depreciation and amortization                                                    |                          |      |     
|Increase in accounts receivable allowance                                        |                          |      |     
|Issuance of commons stock for services                                           |                          |      |     
|Tax benefit from the exercise of stock options                                   |                          |      |     
|Changes in assets and liabilities,                                               |                          |     
|Accounts receivable                                                              |                          |      |     
|Inventories                                                                      |                          |      |     
|Other current assets                                                             |                          |      |     
|Accounts payable                                                                 |                          |      |     
|Accrued liabilities                                                              |                          |      |     
|Deferred income taxes                                                            |                          |      |     
|Deferred revenue                                                                 |                          |      |     
|                                                                                 |                          |      |     
|Net cash provided by (used in) operating activities                              |                          |      |     
|                                                                                 |                          |      |     
|Cash flows from investing activities:                                            |                          |     
|Purchases of property and equipment                                              |                          |      |     
|Purchases of available-for-sale investments                                      |                          |      |     
|Proceeds from sale of available-for-sale investments                             |                          |      |     
|Decrease (increase) in other assets                                              |                          |      |     
|                                                                                 |                          |      |     
|Net cash provided by (used in) investing activities                              |                          |      |     
|                                                                                 |                          |      |     
|Cash flows from financing activities:                                            |                          |     
|Proceeds from the exercise of stock options and employee stock     purchase plan |                          |      |     
|Payment on convertible debenture                                                 |                          |      |     
|Costs incurred related to issuance of common stock                               |                          |      |     
|Proceeds from the issuance of notes payable to related party                     |                          |      |     
|Proceeds from sale of common stock                                               |                          |      |     
|                                                                                 |                          |      |     
|Net cash provided by (used in) financing activities                              |                          |      |     
|                                                                                 |                          |      |     
|Net increase (decrease) in cash and cash equivalents                             |                          |      |     
|Cash and cash equivalents, beginning of the period                               |                          |      |     
|                                                                                 |                          |      |     
|Cash and cash equivalents, end of the period                                     |                          |      | $   
|                                                                                 |                          |      |     
|Supplemental disclosure of cash flow information:                                |                          |     
|Cash paid for interest                                                           |                          |      | $   
|                                                                                 |                          |      |     
|Supplemental disclosure of noncash financing and investing activities:           |                          |     
|Issuance of stock for employer 401(k) matching contribution                      |                          |      | $   
|                                                                                 |                          |      |     
|Unrealized gain on available-for-sale investments                                |                          |      | $   
|                                                                                 |                          |      |     
|Preferred stock accrued dividends and interest                                   |                          |      | $   
|                                                                                 |                          |      |     
|Issuance of stock for settlement                                                 |                          |      | $   
|                                                                                 |                          |      |     
|Exchange of note payable for common stock                                        |                          |      | $   
|                                                                                 |                          |      |     
|Conversion of preferred stock                                                    |                          |      | $   
|                                                                                 |                          |      |     
|Exercise of warrants pursuant to net exercise provision                          |                          |      | $   
|                                                                                 |                          |      |     

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

|-32-
|----

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


(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.


Use of Estimates


The
preparation of consolidated 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 maturities of three months or less when purchased.


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
adversely affected. Accounts receivable allowance activity consisted of the
following for the years ended December 31, 2003, 2002 and 2001, respectively.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Period | Balance,Beginning ofPeriod |      | Additions |  | Write - offs |         | Balance, Endof Period |  
| | ------ | -------------------------- | ---- | --------- |  | ------------ | ------- | --------------------- | -
| |        |                           
| |        |                            | 2003 |           |  | $            | 554,000 |                       | $
| |        |                            |      |           |  |              |         |                      
| |        |                            | 2002 |           |  | $            | 397,000 |                       | $
| |        |                            |      |           |  |              |         |                      
| |        |                            | 2001 |           |  | $            | 306,000 |                       | $
| |        |                            |      |           |  |              |         |                      

|Inventories


Inventories
are stated at the lower of cost (first-in, first-out) or market. At December 31,
2003 and 2002, inventories consisted of the following:


-33-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                | December 31, | 
|--------------- | ------------ | 
|
|Raw materials   |              | 
|Work-in-process |              | 
|Finished
goods  |              | 
|                |              | 
|                |              | 
|                |              | 

|Because
work-in-process and finished goods inventories turn rapidly, labor and
manufacturing overhead costs are charged to cost of sales as incurred.


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. 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 its 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.


During
2003, Palomar increased its inventory reserves for certain end of life products
totaling $566,327 that is meant to reserve all but the estimated required
inventory needed to service the existing installed base of product. This reserve
will be relieved as the product is sold or otherwise disposed of.


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. At December 31, 2003 and 2002, property
and equipment consist of the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   | December 31, |  | Estimated |          
|---------------------------------- | ------------ |  | --------- | ---------
|
|Machinery and equipment            |              |  | $         | 1,008,960
|Furniture
and fixtures             |              |  |           | 1,721,254
|Leasehold
improvements             |              |  |           | 257,326  
|                                   |              |  |           |          
|                                   |              |  |           | 2,987,540
|Less:
Accumulated depreciation and |              | 
|amortization                       |              |  |           | 2,404,642
|                                   |              |  |           |          
|                                   |              |  | $         | 582,898  
|                                   |              |  |           |          

|Revenue Recognition


Palomar
recognizes revenue in accordance with Securities and Exchange Commission (SEC)
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (SAB 101), as amended by SAB 101A and 101B and SAB 104. SAB
101/104 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. 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 the
revenue element in accordance with SAB 104 and Emerging Issues Task Force
(EITF) Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. Royalty revenues are recognized upon receipt of cash
payments.


-34-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Palomar
accounts for funded product development revenue under the Gillette agreement
ratably over the funding period as payments are received. For the year ended
December 31, 2003, Palomar received from Gillette $2,600,000 to fund
development. Any amounts received in advance are recorded as deferred revenue.
Payments are not refundable if the development is not successful. (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)


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 $99,000, $55,000 and $12,000 of reimbursed shipping and
handling costs for the years ended December 31, 2003, 2002 and 2001,
respectively.


Product Warranty
Costs


In
November 2002, the Financial Accounting Standards Board (FASB)
issued Interpretation No. 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others (the Interpretation) which expands on the accounting guidance of
Statements No. 5, 57 and 107 and incorporates without change the provisions of
FASB Interpretation No. 34, which is being superseded. Guarantees meeting the
characteristics described in the Interpretation are to be recognized at fair
value and significant disclosure rules have been implemented even if the
likelihood of the guarantor making payments is remote. The disclosure
requirements were effective for financial statements of interim or annual
periods ending after December 15, 2002, while the initial measurement provisions
were applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. Certain guarantees are excluded from the initial recognition
provisions of the interpretation; however, specific disclosures are still
required.


Palomars
products generally carry a standard one-year warranty. Palomar sets aside a
reserve based on anticipated warranty claims at the time product revenue is
recognized. In anticipation of actual warranty claims, Palomar amortizes the
reserve ratably over the life of the warranty thereby offsetting actual warranty
claims incurred. Actual warranty claims incurred and charged to product costs of
sale during an interim period may be more or less than the amount of amortized
warranty reserve allocated against them. Factors that affect Palomars
product warranty liability include the number of installed units, the
anticipated cost of warranty repairs and historical and anticipated rates of
warranty claims.


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, 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 our product warranty accrual, which is a component of other
accrued liabilities on the consolidated balance sheet for the years ended
December 31, 2003 and 2002.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                           | 2003 |  | 2002 |         
|------------------------------------------ | ---- |  | ---- | --------
|                                           |      | 
|Warranty accrual, beginning of year        |      |  | $    | 822,219 
|Provision (reduction) related to           |      | 
|preexisting warranties                     |      |  |      | (336,327
|Plus accruals related to new sales         |      |  |      | 964,000 
|Less amortization of prior period accruals |      |  |      | (864,963
|                                           |      | 
|Warranty accrual, end of year              |      |  | $    | 584,929 
|                                           |      | 

|-35-
|----

|Research and
Development Expenses


Palomar
charges research and development expenses to operations as incurred.


Net Income (Loss)
per Common Share


Basic
net income (loss) per share is determined by dividing net income (loss),
adjusted for preferred stock dividends, by the weighted average common shares
outstanding during the period. Diluted net income (loss) per share is determined
by dividing net income (loss), 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 and the assumed conversion of all
convertible debt obligations and convertible preferred stock. The reconciliation
of basic and diluted weighted average shares outstanding is as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                      | Years Ended December 31, | 
|----------------------------------------------------- | ------------------------ | 
|
|Basic weighted average common shares outstanding      |                          | 
|Potential common shares pursuant to stock options and |                          | 
|Warrants                                              |                          | 
|                                                      |                          | 
|Diluted weighted average common shares outstanding    |                          | 
|                                                      |                          | 

|Palomars
net income (loss) attributable to common stockholders for the years ended 2003,
2002 and 2001 is as follows:
|----------------------------------------------------------------------------------------------------------------------

|                                                               | Years Ended December 31, | 
|-------------------------------------------------------------- | ------------------------ | 
|
|Net income (loss) as reported                                  |                          | 
|Preferred stock dividends                                      |                          | 
|                                                               |                          | 
|Adjusted net income (loss) attributable to common shareholders |                          | 
|                                                               |                          | 

|For
the years ended 2003, 2002 and 2001, potential common shares related to 408,968,
3,578,058, 4,233,112, respectively, of outstanding stock options, stock warrants
and convertible debt and equity securities, were not included in diluted
weighted average shares outstanding as they were antidilutive.


Stock based
compensation


Palomar
follows 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.


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, 2003,
2001 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, 2003, 2002 and 2001 for Palomar are as follows:


-36-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                           | December 31, | 
|---------------------------------------------------------- | ------------ | 
|
|Risk-free interest rate                                    |              | 
|Expected dividend yield                                    |              | 
|Expected lives                                             |              | 
|Expected volatility                                        |              | 
|Grant date fair value of options granted during the period |              | 

|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:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                        | December 31, | 
|------------------------------------------------------- | ------------ | 
|
|Net income (loss) , as reported                         |              | 
|Add: Stock-based compensation included in reported net  |              | 
|income (loss)                                           |              | 
|Less: Preferred stock dividends                         |              | 
|Less: Total stock-based employee compensation expense   |              | 
|determined under fair value based method for all awards |              | 
|                                                        |              | 
|Pro forma net income (loss)                             |              | 
|                                                        |              | 
|                                                        |              | 
|Diluted net income (loss) per share:                    |              | 
|As reported                                             |              | 
|Pro forma                                               |              | 

|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 and accounts receivable. Palomar
places its cash and cash equivalents 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.


Palomar
performs periodic credit evaluations of its customers financial condition
and generally does not require collateral. For the years ended December 31,
2003, 2002 and 2001, Palomar had two customers that accounted for 20%, 35% and
26% of net sales, respectively. At December 31, 2003, 2002 and 2001, these
customers accounted for 20%, 27% and 15% 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, 2003 and 2002, financial instruments consisted principally of cash,
cash equivalents, 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, 2003 and 2002. Fair values have been determined
through information obtained from market sources and management estimates.


-37-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Recent Accounting
Pronouncements


In
January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an interpretation of ARB
51. The primary objectives of this interpretation are to provide guidance
on the identification of entities for which control is achieved through means
other than through voting rights (variable interest entities) and
how to determine when and which business enterprise (the primary
beneficiary) should consolidate the variable interest entity. This new
model for consolidation applies to an entity in which either (i) the equity
investors (if any) do not have a controlling financial interest; or (ii) the
equity investment at risk is insufficient to finance that entitys
activities without receiving additional subordinated financial support from
other parties. In addition, FIN 46 requires that the primary beneficiary, as
well as all other enterprises with a significant variable
interest in a variable interest entity, make additional disclosures. Certain
disclosure requirements of FIN 46 were effective for financial statements issued
after January 31, 2003.


In
December 2003, the FASB issued FIN No. 46 (revised December 2003),
Consolidation of Variable InterestEntities (FIN
46-R) to address certain FIN 46 implementation issues. The effective dates
and impact of FIN 46 and FIN 46-R are as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (iv) | Special
purpose entities (SPEs) created prior to February 1,  2003. Palomar must
apply either the provisions of FIN 46 or early adopt the  provisions of FIN 46-R at the
end of the first interim or annual reporting  period ending after December 15, 2003.
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (v) | Non-SPEs
created prior to February 1, 2003. Palomar is required to adopt  FIN 46-R at the end
of the first interim or annual reporting period ending after  March 15, 2004.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (vi) | All
entities, regardless of whether a SPE, that were created subsequent to  January 31, 2003.
The provisions of FIN 46 were applicable for variable  interests in entities obtained
after January 31, 2003. Palomar is required to  adopt FIN 46-R at the end of the first
interim or annual reporting period ending  after March 15, 2004.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
adoption of the provisions applicable to SPEs and all other variable interests obtained after
January 31, 2003 did not have a material impact on Palomars financial statements. Palomar is
currently evaluating the impact of adopting FIN 46-R applicable to Non-SPEs created prior to
February 1, 2003but does not expect a material impact.


(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 2003, 2002 and 2001:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          | Years Ended December 31, | 
|------------------------- | ------------------------ | 
|
|United States             |                          | 
|Japan                     |                          | 
|Canada                    |                          | 
|Europe                    |                          | 
|Australia                 |                          | 
|Asia/Pacific              |                          | 
|South and Central America |                          | 
|                          |                          | 
|Total                     |                          | 
|                          |                          | 

|-38-
|----

|(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 for hair removal/reduction developed at
Wellman Laboratories of Photomedicine. In July 1999, Palomar further amended
this agreement to extend its exclusive research agreement for an additional five
years. In addition to laser hair removal, the agreement has been expanded to
include research and development in the fields of fat removal and acne
treatment. Palomar has the right to exclusively license, on royalty terms to be
negotiated, Palomar-funded inventions in the relevant fields. Under the terms of
this agreement, Palomar paid Massachusetts General Hospital $475,000 on an
annual basis for clinical research through August 2004.


(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:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|         | December 31, | 
|-------- | ------------ | 
|
|Federal: |              | 
|Current  |              | 
|Deferred |              | 
|         |              | 
|         |              | 
|State:   |              | 
|Current  |              | 
|Deferred |              | 
|         |              | 
|         |              | 
|         |              | 
|Total    |              | 
|         |              | 

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

|                                                              | December 31, | 
|------------------------------------------------------------- | ------------ | 
|
|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:
|-----------------------------------------------------------------------------------------------------------------------

|                                        | 2003 |  | 2002 |            
|--------------------------------------- | ---- |  | ---- | -----------
|Net
      operating loss carry forwards |      |  | $    | 41,222,000 
|Nondeductible
      accruals            |      |  |      | 446,000    
|Nondeductible
      reserves            |      |  |      | 1,762,000  
|Tax
      credits                       |      |  |      | 2,145,000  
|                                        |      |  |      |            
|Deferred
      tax assets               |      |  |      | 45,575,000 
|                                        |      |  |      |            
|Valuation
      allowance               |      |  |      | (45,575,000
|                                        |      |  |      |            
|                                        |      |  | $    |           
|                                        |      |  |      |            

|-39-
|----

|At
December 31, 2003, 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 $109 million and $2.1
million, respectively, to be used to offset future taxable income. These net
operating loss carry forwards will expire through 2023. 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.


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
has previously recorded reserves for taxes that may become payable as a result
of federal and state audits. Palomar establishes reserves based on managements
assessment of permanent tax differences. Palomar has periodically recorded a
reduction in the tax reserves as a result of the closing of certain statutory
periods for assessing tax.


(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
2003, 2002 and 2001, Palomar matched in Palomar stock 50% of all employee
contributions by issuing 184,109, 148,855 and 119,948 shares of stock,
respectively, to the 401(k) Plan in satisfaction of its employer match for the
2002, 2001 and 2000 employee contributions. For the year ended December 31,
2003, Palomar has accrued $215,000 for the 2003 match. 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, 2003, 351,085 shares of common stock remained
available for issuance there under.


During
January 2003, Palomar issued 38,819 shares for the 401(k) Plan in satisfaction
of its employer match for 2003.


(6)
Accrued Liabilities


At
December 31, 2003 and 2002,accrued liabilities consisted of the
following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                              | December 31, | 
|----------------------------- | ------------ | 
|
|Payroll and employee benefits |              | 
|Commissions                   |              | 
|Royalties                     |              | 
|Warranty                      |              | 
|Other                         |              | 
|                              |              | 
|Total                         |              | 
|                              |              | 

|-40-
|----

|(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.


(8)
Commitments and Contingencies


Operating Leases


Palomar
has entered into an operating lease for its corporate office, research facility,
and manufacturing operation. This lease has a monthly rent associated with it of
approximately $75,000 per month, which is adjusted annually for certain other
costs, such as inflation, taxes and utilities, and expires in August 2009.


Future
minimum payments under Palomars operating lease at December 31, 2003 are
approximately as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Years EndedDecember 31, |  |            | 
| | ----------------------- |  | ---------- | 
| |                         |  | 2004       | 
| |                         |  | 2005       | 
| |                         |  | 2006       | 
| |                         |  | 2007       | 
| |                         |  | 2008       | 
| |                         |  | Thereafter | 
| |                         | 
| |                         |  |            | 

|Palomar
incurred rent expense of $ 948,000, 942,000 and $870,000 for the years ended
December 31, 2003, 2002 and 2001, respectively. This rental expense was offset
by $166,000, $168,000 and $140,000 in 2003, 2002 and 2001, 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.


Royalties


Palomar
is required to pay a royalty under a license agreement with Massachusetts
General Hospital (see Note 3). For the years ended December 31, 2003, 2002 and
2001, approximately $896,000, $1,921,000 and $2,572,000 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.


Palomar
is the exclusive licensee of U.S. Patent Nos. 5,595,568 and 5,735,844 (the
568 and 844 patents) from The Massachusetts General Hospital
Corporation. Pursuant to a Patent License Agreement dated December 7, 1998,
Lumenis paid Palomar a 7.5% royalty on net sales of the LightSheer diode laser
system. As of the quarter ended September 30, 2002, Palomar received
approximately $3.6 million dollars in cumulative royalties from Lumenis for
sales of the LightSheer system. On October 24, 2002, Lumenis told Palomar that
it would no longer pay royalties for sales of the LightSheer system and filed a
complaint in the United States District Court for the Northern District of
California seeking a declaratory judgment that the 568 and 844
patents are invalid and/or unenforceable and not infringed by any Lumenis
products. Palomar believes that Lumenis claims are without merit, and on
October 29, 2002, Palomar filed a complaint in the Middlesex County Superior
Court in Massachusetts against Lumenis for breach of contract, breach of the
implied covenant of good faith and fair dealing, and violation of Massachusetts
General Laws Chapter 93A. Palomar has also answered Lumenis Federal Court
complaint in California with similar counter claims. On February 14, 2003,
Palomar terminated the Patent License Agreement and added counter claims of
patent infringement to Lumenis Federal Court complaint in California. The
Massachusetts state court action has been stayed pending the outcome of the
Federal Court action. A claim construction hearing (often referred to as a
Markman hearing) is scheduled for March 29, 2004. Following a Markman hearing, a
judge will rule on the meaning of disputed claim terms, that is, the judge will
construe the disputed claim terms.


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

|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 (the
844 patent), which is exclusively licensed to Palomar by
Massachusetts General Hospital. Massachusetts General Hospital has been 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 Massachusetts General Hospital filed a reply denying the material
allegations of the counterclaims. Palomar and 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
844 patent is unenforceable due to inequitable conduct. Palomar and
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, the Judge issued her ruling. Palomar believes the
ruling largely embraced Palomars position and it will have a considerable
impact on the case as it proceeds toward trial. A trial date has not yet been
set.


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.


(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 2003, 2002 and 2001, Palomar paid
$203,750, $247,500 and $251,875 respectively, related to this fee. These amounts
have been charged to additional paid-in capital.


During
2002, in connection with the settlement of litigation relating to Varljen v. H.J. Meyers,
Inc., et. al.,  Palomar delivered the balance of 358,547 shares of Palomars common stock
owed under the settlement agreement.


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.


-42-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
Series F redeemable convertible preferred stock (Series F
Preferred), together with any accrued but unpaid dividends, was
convertible into common stock at 80% of the average closing bid price for the 10
trading days preceding the conversion date, but in no event less than $21.00 or
more than $112.00. The conversion price for the Series F Preferred was
adjustable for certain dilutive events, as defined. The Series F Preferred was
redeemable under certain conditions at Palomars option, at an amount equal
to the amount of liquidation preference determined as of the applicable
redemption date. The Series F Preferred had a liquidation preference equal to
$1,000 per share of redeemable convertible preferred stock, plus accrued but
unpaid dividends and accrued but unpaid interest. The Series F Preferred
stockholders did not have any voting rights except on matters affecting the
Series F Preferred. Dividends were payable quarterly at 8% per annum in arrears.
Dividends not paid on the payment date, whether or not such dividends have been
declared; bore interest at the rate of 10% per annum until paid. 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 the 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.


(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 4,778,571 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.

-43-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
following table summarizes all stock option activity of Palomar for the years
ended December 31, 2001, 2002 and 2003:
|-------------------------------------------------------------------------------------------------------------------------

|                                                     | Number ofShares |  | ExercisePrice |            | Weighted AverageExercise Price
|---------------------------------------------------- | --------------- |  | ------------- | ---------- | ------------------------------
|Outstanding, December 31, 2000                       |                 |  |               | 1,760,785  |                               
|Granted                                              |                 |  |               | 1,996,100  |                               
|Canceled                                             |                 |  |               | (220,421   | )                             
|                                                     |                 |  |               |            |                               
|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  |                               
|                                                     |                 |  |               |            |                               
|Exercisable, December 31, 2001                       |                 |  |               | 955,929    |                               
|                                                     |                 |  |               |            |                               
|Exercisable, December 31, 2002                       |                 |  |               | 1,871,191  |                               
|                                                     |                 |  |               |            |                               
|Exercisable, December 31, 2003                       |                 |  |               | 1,923,550  |                               
|                                                     |                 |  |               |            |                               
|Available for future issuances under the Plans as of |                 | 
|December 31, 2003                                    |                 |  |               | 61,051     |                               
|                                                     |                 |  |               |            |                               

|The
ranges of exercise prices for options outstanding and options exercisable at
December 31, 2003 are as follows:
|------------------------------------------------------------------------------------------------------------------

|Options Outstanding |  | Options Exercisable | 
|------------------- |  | ------------------- | 
|
|$0.90-$1.00         |  | 1,414,148           | 
|1.42-2.07           |  | 578,166             | 
|2.19-3.19           |  | 649,873             | 
|4.08-5.22           |  | 383,500             | 
|6.22-8.23           |  | 86,000              | 
|10.24-10.59         |  | 15,000              | 
|                    |  |                     | 
|$0.90-$10.59        |  | 3,126,687           | 
|                    |  |                     | 

|Warrants


The
following table summarizes all warrant activity of Palomar for the years ended
December 31, 2001, 2002 and 2003:
|-------------------------------------------------------------------------------------------------------------------------------

|                               | Number ofShares |  | ExercisePrice |            | Weighted AverageExercise Price
|------------------------------ | --------------- |  | ------------- | ---------- | ------------------------------
|Outstanding, December 31, 2000 |                 |  |               | 2,571,559  |                               
|Canceled                       |                 |  |               | (612,868   | )                             
|                               |                 |  |               |            |                               
|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    |                               
|                               |                 |  |               |            |                               
|Exercisable, December 31, 2001 |                 |  |               | 1,905,359  |                               
|                               |                 |  |               |            |                               
|Exercisable, December 31, 2002 |                 |  |               | 1,932,027  |                               
|                               |                 |  |               |            |                               
|Exercisable, December 31, 2003 |                 |  |               | 218,000    |                               
|                               |                 |  |               |            |                               

|-44-
|----

|The
ranges of exercise prices for warrants outstanding and exercisable at December
31, 2003 are as follows:
|-----------------------------------------------------------------------------------------------------------

|Warrants Outstanding |  | Warrants Exercisable | 
|-------------------- |  | -------------------- | 
|
|$1.97                |  | 60,000               | 
|2.81-3.50            |  | 158,000              | 
|                     |  |                      | 
|$1.97-$3.50          |  | 218,000              | 
|                     |  |                      | 

|Reserved Shares


At
December 31, 2003, the Company has reserved shares of its common stock for the
following:
|--------------------------------------------------------------------------------------------------------------

|Warrants                     |  | 218,000   | 
|---------------------------- |  | --------- | 
|Stock option plans           |  | 3,187,738 | 
|Employee stock purchase plan |  | 312,258   | 
|Employee 401(k) plan         |  | 351,085   | 
|                             |  |          
|Total                        |  | 4,069,081 | 
|                             |  |          

|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, 2003, 2002 and 2001, employees purchased 22,422, 37,819
and 70,856 shares, respectively, of Palomars common stock for
approximately $38,000, $30,000 and $86,000, respectively, pursuant to the
Purchase Plan. At December 31, 2003, 312,258 shares are available for future
issuance under the Purchase Plan.


(11)
Quarterly Results of Operations (Unaudited)


The
following table presents a condensed summary of quarterly results of operations
for the years ended December 31, 2002 and 2003 (in thousands, except per share
data).
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             | 2002 | 
|---------------------------- | ---- | 
|
|                            
|Revenues                     |      | 
|Cost and expenses            |      | 
|Net income (loss)            |      | 
|Net income (loss) per share: |      | 
|Basic                        |      | 
|Diluted                      |      | 

|                      | 2003 | 
|--------------------- | ---- | 
|
|                     
|Revenues              |      | 
|Cost and expenses     |      | 
|Net income            |      | 
|Net income per share: |      | 
|Basic                 |      | 
|Diluted               |      | 

|-45-
|----

|(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 provides for
up to $7 million in support of research and development to be paid by Gillette
over approximately 30 months.


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.


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 female device, 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. (See
exhibit 10.14, The Development and License Agreement with The Gillette
Company effective February 14, 2003 with redacted exhibits)


(13)
Subsequent Event


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. The project is scheduled to last
for nineteen months.




Item 9.  Changes in
and Disagreements with Accountants on Accounting and Financial Disclosures.


Not
applicable.




Item 9A.
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 disclosure 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.


During
the fourth quarter of fiscal 2003, there were no changes in our internal control
over financial reporting that have affected, or are reasonably likely to affect,
materially our internal control over financial reporting.


-46-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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
2004 annual meeting of stockholders, which we expect to file before 120 days
after the end of fiscal 2003. We incorporate that information in this annual
report by reference to our 2004 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 2004
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 2004 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 2004
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 2004
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 2004 annual proxy
statement.


-47-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 Auditors                                                   |     
|                                                                                 |     
|Report of Independent Public Accountants                                         |     
|                                                                                 |     
|Consolidated Balance Sheets - December 31, 2003 and 2002                         |     
|                                                                                 |     
|Consolidated Statements of Operations - Years ended December 31, 2003, 2002      |     
|and 2001                                                                         |     
|                                                                                 |     
|Consolidated Statements of Stockholders Equity - Years ended December 31, 2003, |     
|2002 and 2001                                                                    |     
|                                                                                 |     
|Consolidated Statements of Cash Flows - Years ended December 31, 2003, 2002      |     
|and 2001                                                                         |     
|                                                                                 |     
|Notes to Consolidated Financial Statements                                       |     

|(b) Reports  on Form
8-K.On October 23, 2003, we filed a current report on Form 8-K,  which reported our
financial results for our fiscal quarter ended September 30,  2003 under Item 5.


(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.


-48-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|SIGNATURES


Pursuant
to the requirements of the Securities Act of 1934, the Registrant certifies that
it has caused this Report to be signed on its behalf by the undersigned,
thereunto duly authorized, in the Town of Burlington in the Commonwealth of
Massachusetts on March 17, 2004.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|POWER OF
ATTORNEY


KNOW
ALL BY THESE PRESENTS that each individual whose signature appears below hereby
constitutes and appoints Paul S. Weiner and Joseph P. Caruso, and each of them,
his or her true and lawful attorneys-in-fact and agents with full power of
substitution, for him or her and in his or her name, place and stead, in any and
all capacities, to sign any and all amendments to this annual report on Form
10-K, and to file the same, with all exhibits thereto, and all documents in
connection therewith, with the Securities and Exchange Commission, granting unto
said attorneys-in-fact and agents, and each of them, full power and authority to
do and perform each and every act and thing which they, or any of them, may deem
necessary or advisable to be done in connection with this annual report on Form
10-K, as fully to all intents and purposes as he or she might or could do in
person, hereby ratifying and confirming all that said attorneys-in-fact and
agents or any of them, or any substitute or substitutes for any or all of them,
may lawfully do or cause to be done by virtue hereof.


Pursuant
to the requirements of the Securities 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 17, 2004
|-------------------------------------------------- | ---------------------------------- | --------------

|/s/ Joseph P. CarusoJoseph P. Caruso | President, Chief Executive Officer and Director | March 17, 2004
|-------------------------------------------------- | ----------------------------------------------- | --------------

|/s/ Paul S. WeinerPaul S. Weiner | Chief Financial Officer | March 17, 2004
|---------------------------------------------- | ----------------------- | --------------

|/s/ Nicholas P. EconomouNicholas P. Economou | Director | March 17, 2004
|---------------------------------------------------------- | -------- | --------------

|/s/ A. Neil PappalardoA. Neil Pappalardo | Director | March 17, 2004
|------------------------------------------------------ | -------- | --------------

|/s/ James G. MartinJames G. Martin | Director | March 17, 2004
|------------------------------------------------ | -------- | --------------

|/s/ Jeanne CohaneJeanne Cohane | Director | March 17, 2004
|-------------------------------------------- | -------- | --------------

|/s/ Jay DelahantyJay Delahanty | Director | March 17, 2004
|-------------------------------------------- | -------- | --------------

|-49-
|----

|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
| | --- |  | --------------------------------------------------------

| | 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 Company 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 |  | Redacted
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
with  redacted exhibits (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
| | ----- |  | ------------------------------------------------------------------------------

| | 10.17 |  | Employment
Agreement, dated July 1, 2001, between Palomar and Joseph P. Caruso
| | ----- |  | ------------------------------------------------------------------------------

|-50-
|----

| | 10.18 |  | Employment
Agreement, dated July 1, 2001, between Palomar and Paul S. Weiner
| | ----- |  | ----------------------------------------------------------------------------

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

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

| | 23.2 |  | Notice
regarding Arthur Andersen LLP (filed as Exhibit 16 on Form 8-K, filed with the SEC on
July  8, 2002, and incorporated herein by reference)
| | ---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------

| | 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
| | ---- |  | --------------------------

|
|

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

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

|-51-
|----