|UNITED STATES
                                                  SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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

|ý | Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
            For the Fiscal Year Ended December 31, 2006
|- | --------------------------------------------------------------------------------------------------------------------------------------------

|o | Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
              For the transition period from ______ to ______
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------

|Commission file number: 0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.
|-------------------------------------------------------------------

|A Delaware Corporation | I.R.S Employer Identification No. 04-3128178
|---------------------- | --------------------------------------------

|82 Cambridge Street, Burlington, Massachusetts 01803
Registrant's telephone number, including area code: (781) 993-2300
Securities registered pursuant to Section 12(b) of the Act:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Title of each class
Common Stock, $0.01 par value | Name of each exchange on which registered
NASDAQ -Global Select Market
|------------------------------------------------- | ----------------------------------------------------------------------

|Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act.
  Yes oNo
ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange
Act.
  Yes oNo
ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90 days.
  YesýNo
o


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.ý

Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See
definition of "accelerated filer and large accelerated filer" in Rule 12b(2) of the Exchange Act. (Check one).

Large accelerated filer o  Accelerated filer  ý   Non-accelerated filer  o

Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act.    Yes  o    No   ý

The aggregate market value of the voting stock (common stock) held by non-affiliates of the registrant as of the close of business on
June 30, 2006 was $564,598,698. The number of shares outstanding of the registrant's common stock as of the close of business on
February 28, 2007 was 18,160,270.

DOCUMENTS INCORPORATED BY REFERENCE


Portions
of the registrant's definitive proxy statement to be filed prior to April 30, 2007,
pursuant to Regulation 14A of the Securities Exchange Act of 1934, are incorporated by
reference into Part III of this Form 10-K.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|Table of Contents
|-----------------

|           |                                                                                                            |    | Page No.
|---------- | ---------------------------------------------------------------------------------------------------------- | -- | --------
|PART I     |                                                                                                            |    |         
|           |                                                                                                            |    |         
|Item 1.    | Business                                                                                                   |    | 1       
|Item 1A.   | Risk Factors                                                                                               |    | 9       
|Item 1B.   | Unresolved Staff Comments                                                                                  |    | 18      
|Item 2.    | Properties                                                                                                 |    | 18      
|Item 3.    | Legal Proceedings                                                                                          |    | 18      
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                        |    | 20      
|           |                                                                                                            |    |         
|PART II   
|           |                                                                                                            |    |         
|Item 5.    | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Services |    | 20      
|Item 6.    | Selected Financial Data                                                                                    |    | 21      
|Item 7.    | Managements Discussion and Analysis of Financial Condition and Results of Operations                      |    | 22      
|Item 7A.   | Quantitative and Qualitative Disclosures About Market Risk                                                 |    | 35      
|Item 8.    | Financial Statements and Supplementary Data                                                                |    | 35      
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and
         Financial Disclosures             |    | 60      
|Item 9A.   | Controls and Procedures                                                                                    |    | 60      
|Item 9B.   | Other Information                                                                                          |    | 63      
|           |                                                                                                            |    |         
|PART III  
|           |                                                                                                            |    |         
|Item 10.   | Directors and Executive Officers of the Registrant                                                         |    | 63      
|Item 11.   | Executive Compensation                                                                                     |    | 63      
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management and Related
         Stockholder Matters    |    | 63      
|Item 13.   | Certain Relationships and Related Transactions                                                             |    | 63      
|Item 14.   | Principle Accountant Fees and Services                                                                     |    | 63      
|           |                                                                                                            |    |         
|PART IV   
|           |                                                                                                            |    |         
|Item 15.   | Exhibits and Financial Statement Schedules                                                                 |    | 63      
|           |                                                                                                            |    |         
|SIGNATURES |                                                                                                            | 68

|PART I


Item 1.  Business


Introduction


We
are a leading researcher and developer of innovative aesthetic light based systems for
hair removal and other cosmetic procedures.  For over a decade, we have been on the
forefront of technology breakthroughs.  A historical list of advancements by us includes:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 1996
we introduced the first high powered laser hair removal system
|- |  | -------------------------------------------------------------------

|o |  | 1997
we obtained FDA clearance for the first high powered laser hair removal system
|- |  | -----------------------------------------------------------------------------------

|o |  | 1997
we were first to obtain FDA clearance for high power diode laser system
|- |  | ----------------------------------------------------------------------------

|o |  | 1998
we were the first to obtain FDA clearance for permanent hair reduction
|- |  | ---------------------------------------------------------------------------

|o |  | 1999
we were first to obtain FDA clearance for sub-zero cooled laser system
|- |  | ---------------------------------------------------------------------------

|o |  | 2000
we were first to obtain FDA clearance for a super long pulse laser system
|- |  | ------------------------------------------------------------------------------

|o |  | 2001
we introduced the cost effective and upgradeable Lux Platform
|- |  | ------------------------------------------------------------------

|o |  | 2001
we introduced the Q-Yag5 system for tattoo and pigmented lesion removal
|- |  | -----------------------------------------------------------------------------

|o |  | 2003
we signed a Development and License Agreement with The Gillette Company to complete
development and commercialize a               patented home-use, light based hair removal
device for women
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|o |  | 2004
we were awarded a research contract by the United States Department of the Army to
develop a light based self-treatment               device for Pseudofolliculitis Barbae
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|o |  | 2005
we were awarded additional funding and a one year extension for our research contract
with the United States Department               of the Army to develop a light based
self-treatment device for Pseudofolliculitis Barbae
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2005
we began shipping the Lux 1064 handpiece for use with the StarLux System for removal
of leg veins and other conditions
|- |  | ----------------------------------------------------------------------------------------------------------------------------

|o |  | 2005
we began shipping the Lux IR Fractional Infrared handpiece for use with the StarLux
System for deep heating for pain               relief and in 2006 we received FDA
clearance for soft tissue coagulation
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2006
we were awarded additional funding and a five month extension for our research contract
with the United States               Department of the Army to develop a light based
self-treatment device for Pseudofolliculitis Barbae
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2006
we began shipping the Lux1540 Fractional Laser handpiece for use with the StarLux
System for soft tissue coagulation               and we are seeking FDA clearance for
skin resurfacing
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2006
we received a 510(k) over-the-counter (OTC) clearance from the FDA for a new, patented,
home use, light-based hair               removal device
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2007
we introduced the StarLux®500 Laser and Pulsed Light System featuring 70% more power
and increased functionality and               speed of treatment
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | 2007
we introduced four new handpieces including:
|- |  | -------------------------------------------------

|o |  | Lux1540-Z Fractional
Laser handpiece allowing control of micro-beam density and focal depth as well as spot
size
|- |  | -----------------------------------------------------------------------------------------------------------------

|o |  | LuxDeepIR Fractional
handpiece, the second generation of the LuxIR Fractional handpiece, including advanced
cooling,                       contact sensors and longer pulse duration
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | LuxW Pulsed
Light handpiece optimized for treatment of very light pigmented lesions, and
|- |  | -----------------------------------------------------------------------------------------

|o |  | LuxYs Pulsed
Light handpiece for permanent reduction of lighter, finer hair
|- |  | ----------------------------------------------------------------------------

|o |  | 2007 we expanded our Development and License Agreement with Gillette to allow for the development of an
additional home-use, light based hair removal device for women
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1
|-

|We are continuously researching,
developing and testing new and exciting innovations for a variety of cosmetic
applications, such as:
|-------------------------------------------------------------------------------------------------------------------------------------

|o |  | skin
rejuvenation, including tone and texture
|- |  | ---------------------------------------------

|o |  | skin
tightening, including laxity and lifting
|- |  | ---------------------------------------------

|o |  | pigmented
lesion removal, such as sun and age spots, freckles and melasma
|- |  | -------------------------------------------------------------------------

|o |  | vascular
lesion removal, such as spider veins, cherry angiomas and rosacea
|- |  | --------------------------------------------------------------------------

|o |  | leg
vein removal
|- |  | ----------------

|o |  | acne
treatment
|- |  | --------------

|o |  | scars,
including acne scars, stretch marks and warts
|- |  | ----------------------------------------------------

|o |  | fat
reduction, including cellulite
|- |  | ----------------------------------

|We
were 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, we filed our initial public offering. Subsequently,
we pursued an acquisition program, acquiring companies in our 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, we had more than a dozen subsidiaries. At the
same time, having obtained FDA clearance to market our EpiLaser® ruby laser hair
removal system in March 1997, we were well positioned to focus on what we believed was the
most promising product in our core laser business. Hence, under the direction of a new
board and management team, we 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 we believed held the greatest promise for maximizing stockholder value.
Our 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, we became 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., one
of our former subsidiaries. The LightSheer was the first generation of high-powered diode
lasers designed for hair removal, and like our EpiLaser and other prior hair removal
products, the LightSheer incorporated technology protected by patents licensed exclusively
to us from the General Hospital Corporation doing business as Massachusetts General
Hospital.


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


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. On June 28, 2004, we announced with Gillette that we completed the initial
phase of our agreement and that both parties would move into the next phase. In
conjunction with entering this next phase, the parties amended the agreement to provide
for additional development funding to further technical innovations. In September 2006, we
announced that Gillette had made the decision to move into the next phase of our
agreement. On December 8, 2006, we became the first company to receive a 510(k)
over-the-counter (OTC) clearance from the FDA for a new, patented, home use, light-based
hair removal device. OTC clearance allows the product to be marketed and sold directly to
consumers without a prescription. Under our agreement, Gillette paid us $2.5 million
following our receipt of the OTC clearance. In February 2007, we announced an amendment
to our agreement with Gillette to include the development and commercialization of an
additional light-based hair removal device for home use, and we also announced that we had
executed an Amended and Restated Joint Development Agreement to incorporate other prior
amendments and several new amendments to allow for more open collaboration through
commercialization.


On
February 18, 2004, we announced that we were awarded a $2.5 million research contract by
the United States Department of the Army to develop a light based self-treatment device
for Pseudofolliculitis Barbae, or PFB, commonly known as razor bumps. On
October 25, 2005, we announced that we were awarded additional funding of $888,000 for a
total of $3.4 million and a twelve month contract extension. On September 1, 2006, we were
awarded additional funding of $440,000 for a total of $3.8 million and an additional five
month extension until April 30, 2007.



2



On
September 1, 2004 , we entered into a Development and License Agreement with Johnson &
Johnson Consumer Companies, Inc. to develop, clinically test and potentially commercialize
home-use, light based devices for (i) reducing or reshaping body fat including cellulite;
(ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. We believe
that these devices will be protected by multiple patents within our patent portfolio.





We have one operating subsidiary, Palomar Medical Products, Inc. located at our headquarters in Burlington,
Massachusetts, which oversees the manufacture and sale of our lamp and laser based systems currently on the market.
In addition, we are in the process of forming Palomar Medical Technologies BV located in Amsterdam, The
Netherlands, which will market and distribute in Europe and the Middle East as well as provide certain services of
our products for those areas.



Market for Aesthetic
Procedures


The
market for light-based aesthetic procedures has seen significant growth over the past
decade, particularly in the last several years. Many factors are likely responsible for
this growth including the aging population of the United States and other industrialized
nations along with a desire to look and feel younger and a rising discretionary income
with which to pay for such procedures. Consumers often undergo aesthetic procedures to
improve their self-image and self-esteem, or to appear competitive in an ever-younger
workforce. Another important factor is the sophistication of the equipment for light-based
aesthetic procedures. Technological advancements made to the equipment have improved
safety, ease of use, efficacy, and cost which has in turn grown our customer base. Our
traditional customers have been plastic surgeons and dermatologists. However, increased
consumer demand and technological advancements as well as managed care and reimbursement
restrictions in the United States and similar constraints outside the United States, have
motivated non-traditional customers such as general practitioners, gynecologists,
surgeons, and others to offer aesthetic procedures. Such procedures have the advantage of
being provided on a fee-for-service basis. In addition, technological advances have
reduced both treatment and recovery times and made a broader variety of treatments for
different cosmetic issues possible, further increasing consumer demand.



Business Strategy


With
our unique focus on both the professional and consumer markets, we believe we are
positioned to capitalize on the ever expanding market for improving personal appearance.
Our strategy is three-fold: growth of our professional business, driving our technology
into the mass consumer markets, and executing our intellectual property enforcement
strategy.



Growth of Professional
Business.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Innovative
Products. We grow our professional business by investing significant resources in
research and development to allow us to continually introduce innovative, patented
products. For example, in the second half of 2006, we began shipping the Lux 1540
fractional laser handpiece, and in March 2007, we began shipping the new StarLux 500 Laser
and Pulsed Light System. We have led the industry in offering platforms that allow
practitioners to grow their practice by adding handpieces for additional applications and
by moving to higher power, more sophisticated systems. This strategy has been favorably
received through the years by our customers allowing us to leverage our installed base.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Expanding
Practitioner Base. We believe that our professional business has further growth
potential through non-traditional practitioners. In addition to our traditional base of
plastic surgeons and dermatologists, we intend to continue to market and sell to other
practitioners including general and family practitioners, gynecologists, surgeons,
physicians offering cosmetic treatments in medi-spa facilities and others.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Increasing
International Presence. We are expanding our international presence which we believe will be a significant opportunity for us.  We are in
the process of opening an office in Amsterdam, The Netherlands, to oversee our marketing and distribution efforts in
Europe and the Middle East and provide certain service for our products in these areas.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Driving Our Technology into
Consumer Market. We direct significant resources toward driving our technology into
the mass consumer markets, including with both The Gillette Company and Johnson &
Johnson Consumer Companies, Inc.


Intellectual Property
Enforcement. We are executing on our intellectual property enforcement strategy.  We have a portfolio of patents in a number of
areas.  In the light-based hair removal area, we tested two patents against Cutera, Inc. in two different lawsuits
which were successfully concluded in June 2006.  Cutera admitted that their products infringe our patents and that
the patents are both valid and enforceable.  In addition, Cutera agreed to pay us royalties on past sales, interest
on certain monies owed and $4 million to cover our legal costs over the entire litigation period.  The total amount
received from Cutera was $22 million.  Cutera also agreed to pay us royalties on future sales of hair removal
products.  In October, we announced that Cynosure agreed to take a license to these same hair removal patents, paid
us $10 million in back owed royalties, and agreed to pay us royalties on future sales of hair removal products.  Two
other competitors, Lumenis and Iridex, also pay us royalties on sales of hair removal products.  In July and August
2006, we filed suit against Alma Lasers, Inc. and Candela Corporation, respectively, for infringement of these same
hair removal patents.  We are reviewing various strategies with additional parties, including granting additional
licenses and further litigation, if necessary, which would seek money damages as well as injunctions.  (For more
information, see Item 3 Legal Proceedings.)

3







Financial Information
About Industry Segments


We
conduct business in one industry segment, medical and cosmetic products and services.



Principal Products


We research,
develop, manufacture, market, sell and service light based products used to perform
procedures addressing medical and cosmetic concerns. We offer a comprehensive range of
products based on proprietary technologies that include, but are not limited to:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | Hair
removal
|- |  | ------------

|o |  | Removal
of vascular lesions such as rosacea, spider veins, port wine stains and hemangiomas
|- |  | -------------------------------------------------------------------------------------------

|o |  | Removal
of leg veins
|- |  | --------------------

|o |  | Removal
of benign pigmented lesions such as age and sun spots, freckles and melasma
|- |  | -----------------------------------------------------------------------------------

|o |  | Tattoo
removal
|- |  | --------------

|o |  | Acne
treatment
|- |  | --------------

|o |  | Wrinkle
removal
|- |  | ---------------

|o |  | Pseudofolliculitis
Barbae or PFB treatment
|- |  | ------------------------------------------

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

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

|o |  | Skin
tightening through soft tissue coagulation
|- |  | -----------------------------------------------

|o |  | Scars,
including acne scars, stretch marks and warts
|- |  | ----------------------------------------------------

|o |  | Soft
tissue coagulation
|- |  | -----------------------

|o |  | 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, our light based hair removal processes
provides significantly longer-term cosmetic improvement.




Lux
Platform.With increasing market acceptance of light based treatments for new applications, we recognized the need
for a cost effective platform that could expand with the needs of our customers.  In 2001, we announced the first
product with the Lux Platform: the EsteLux® Pulsed Light System.  In March 2003, we introduced the higher priced
MediLux Pulsed Light System with the same six handpieces, but also with higher power, faster repetition rate and
a new snap-on connector for faster changes between handpieces.  In February 2004, we enhanced the upgrade
opportunities for our customers with the introduction of the StarLux® Pulsed Light and Laser System with
increased power, a computer controlled touch screen, instant handpiece recognition, active contact cooling, and a
long pulse Nd:YAG laser handpiece, the Lux1064.  In February 2005, we introduced a new infrared handpiece, the
LuxIR.  In June 2006, we introduced and began shipping the Lux1540 Fractional Laser handpiece.  In February
2007, we introduced the StarLux® 500 Pulsed Light and Laser System with 70% more power and increased
functionality and speed of treatment as compared to the original StarLux System.  Capable of achieving higher
peak and average power for greater efficacy with increased contact cooling for added safety and comfort, the
StarLux 500 offers customers faster treatment times, more flexibility and improved results. The StarLux 500 will
support the same suite of existing StarLux handpieces, as well as four new handpieces, the LuxDeepIR handpiece,
the Lux1540-Z handpiece, the LuxW handpiece and the LuxYs handpiece.


The
Lux systems offer a suite of applications at less cost than 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 us to custom tailor products to fit almost any
professional medical office or spa location and provide customers with the comfort that
the system is able to grow with their practice.





4


In
addition to being cost effective and upgradeable, the platform includes many technological
advances. For example, the platform includes our Smooth Pulse technology, a safe and
comfortable treatment that spreads power evenly over the entire pulse of light allowing us
to provide optimal wavelengths for faster results in fewer treatments. By contrast, many
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 extends the life of
the light source. We sell replacement handpieces to existing customers providing a
reoccurring revenue stream.


The
Lux pulsed light handpieces combine the latest technology with simple, streamlined
engineering that is both effective and economical. Long pulse widths and SpectruMax
filtering provide increased safety and efficacy. Efficacy is further improved through our
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 one of the largest spot sizes in the market and high repetition rates
allows for fast coverage which is especially important when removing hair from large areas
such as legs and backs. A back or a pair of legs can be treated in approximately thirty
minutes, and a smaller area, such as the underarms, in even less time. The systems
simple operation opens its applications to a wider band of worldwide users.


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


MediLux.          In
March 2003, we 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 snap-on connector making it
          easier to switch among handpieces and provide treatments tailored to each
          individual being treated.


StarLux.          In
February 2004, we launched the StarLux® Laser and Pulsed Light System,           and
in June 2004, we began shipping this system. The StarLux has a single power
          supply capable of operating both lasers and lamps. The StarLux includes
          increased power, active contact cooling and a full color touch screen for easy
          operation. Currently, the StarLux operates five of the EsteLux / MediLux
          handpieces, namely the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition, the
          increased power of the StarLux allows for the operation of a long pulse Nd:YAG
          laser handpiece, the Lux1064. In January 2005, the Lux1064 laser
handpiece           received FDA clearance for a variety of applications, including but
not limited           to removal of pigmented and vascular lesions, including visible leg
veins,           tattoo and hair removal, removal of red
pigmentation in           hypertrophic and keloid scars and treatment of PFB. The Lux1064
is a high power           laser handpiece featuring Smooth Pulse technology and Active
Contact Cooling           while also providing multiple spot sizes.


Our
patented Active Contact Cooling technology sends a chilled water supply through the
StarLux handpieces, thus cooling the skin before, during, and after treatment. This
feature is designed to ensure safety and comfort during treatment. The StarLuxs
high-powered treatments deliver long-lasting and even permanent results. The StarLux
full-color screen allows easy finger-touch operation and instant handpiece recognition
while providing constant feedback on operating parameters.



5






In
2005, we introduced and began shipping a new infrared handpiece, the LuxIR, for deep
tissue heating for relief of muscle and joint pain. In 2006, we received FDA clearance for
the LuxIR handpiece for soft tissue coagulation and began marketing the LuxIR for skin
tightening through soft tissue coagulation.




In
2006, we introduced and began shipping the Lux1540 Fractional Laser handpiece for
soft tissue coagulation. In 2007, we received FDA clearance for the Lux1540 for
non-ablative skin resurfacing. The Lux1540 delivers light in an array of high precision
microbeams which create narrow, deep columns of tissue coagulation that penetrate well
below the epidermis and into the dermis, while sparing the tissue surrounding the columns
from damage.


In February 2007, we introduced the Lux1540-Z Fractional Laser handpiece which allows the user to control
micro-beam density and focal depth as well as spot size.  We also introduced the LuxW Pulsed Light handpiece
optimized for treatment of very light pigmented lesions and LuxYs Pulsed Light handpiece for permanent reduction of
lighter, finer hair.




StarLux
500. In February 2007, we launched the StarLux® 500 Laser and Pulsed Light System, and began shipping in March 2007. The
StarLux 500 provides 70% more power and increased functionality and speed of treatment as compared to the original
StarLux.  The StarLux 500 operates all the handpieces available for the original StarLux System as well as the new
LuxDeepIR handpiece.  The LuxDeepIR Fractional handpiece is an upgrade of the LuxIR Fractional handpiece and
includes advanced cooling, contact sensors and longer pulse duration for improved safety and efficacy.


Q-YAG
5. During 2001, we received FDA clearance to market and sell the Palomar
Q-YAG 5 system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5 is a
Q-switched, frequency-doubled Neodymium laser. 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 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 wavelength is better suited for brighter colors and
epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength
permits brighter, more superficial and deeper and darker target areas to be treated
simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it
smaller and lighter than competitive systems, which is especially desirable for mobile
and/or small physician offices. These attributes reduce the cost, increase the reliability
of the system and eliminate costly optics and service problems that are common with other
high power Q-Switched lasers.


Legacy
Products.We no longer sell the EpiLaser or E2000 hair removal
laser systems, the RD-1200 Q-switched ruby laser, SLP1000® Diode Laser System or
the NeoLux Pulsed Light System. However, we continue to service these systems. The service
of the RD-1200 has been contracted out to a third party service provider, and we have the
option of contracting out the service of the EpiLaser, E2000 and SLP 1000 systems to this
same party.



Global
Distribution


In our international sales and marketing efforts, we employ a global network of strategic distributors and have
established distribution relationships throughout Europe, Japan, Australia, South and Central America, the Far
East, and the Middle East. As of December 31, 2006, we utilized 44 distributors in 45 countries.  Generally, our
distributors enter into a one to two year contract which includes an agreement not to sell our competitors
products. Our sales strategy is to choose the most productive and practical distribution channel within each of
our geographic markets.


To
increase our presence in Europe, we are in the process of forming a subsidiary corporation
in The Netherlands. We will use this location to coordinate various marketing and
distribution activities in Europe and the Middle East as well as provide certain service
for our products sold in Europe.


The
following table shows product revenue relating to our international sales activities
during each of the last three fiscal years by geographic region:


6
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2006 | 2005 | 2004
|------------------------- | ---- | ---- | ----
|United States             |      | 75   | %   
|Japan                     |      | 3    | %   
|Canada                    |      | 8    | %   
|Europe                    |      | 6    | %   
|Australia                 |      | 1    | %   
|Asia / Pacific            |      | 5    | %   
|South and Central America |      | 2    | %   
|                          |      |     
|Total                     |      | 100  | %   

|Products Under Development


We
are 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 as well as
other cosmetic applications. We perform our own research and we also fund research at
various institutions throughout the world. Product development is performed by scientists
and engineers at our headquarters. We direct resources at both new products for existing
markets such as the removal of unwanted hair, vascular and pigmented lesions and tattoos,
acne and wrinkle removal, and other products for new markets, such as fat reduction,
including the treatment of cellulite.



Production, Sources and
Availability of Materials


Our
manufacturing operations are located in Burlington, Massachusetts. We maintain control of
and manufacture 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. We have obtained ISO 13485 2003, CDN MDR, and Council
Directive 93/42/EEC approvals. We are registered with the Federal Food and Drug
Administration.


We
depend and will depend upon a number of outside suppliers for components used in our
manufacturing process. Most of our components and raw materials are available from a
number of qualified suppliers. If our suppliers are unable to meet our requirements on a
timely basis, production could be interrupted until an alternative source of supply is
obtained.



Patents and Licenses


Our
success and ability to compete are dependent on our ability to develop and maintain
proprietary technology and operate without infringing on the proprietary rights of others.
We rely on a combination of patents, trademarks, trade secret and copyright laws and
contractual restrictions to protect our proprietary technology. These legal protections
afford only limited protection for our technology. We are presently the exclusive licensee
of two United States patents and the non-exclusive licensee of three United States patents
as well as corresponding foreign patents and pending applications owned by Massachusetts
General Hospital, and we are the joint owner with Massachusetts General Hospital of seven
other United States patents as well as corresponding United States pending applications
and foreign patents and pending applications. In addition, we are the sole owner of
sixteen United States patents as well as corresponding and non-corresponding United States
pending applications and foreign patents and pending applications, and have rights to
other patents under exclusive and non-exclusive licenses.


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

7






Despite
our efforts to protect our proprietary rights, unauthorized parties may attempt to copy
aspects of the products or to obtain and use information that we regard as proprietary.
Policing unauthorized use of our 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 our business,
operating results and financial condition. There can be no assurance that our means of
protecting proprietary rights will be adequate or that our competitors will not
independently develop similar technology. Any failure by us to meaningfully protect our
proprietary rights could have a material adverse effect on our business, operating results
and financial condition.


Management
believes that none of our current products infringe upon valid claims of patents owned by
third parties. However, there have been claims made against us 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 our 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 Item 3 Legal Proceedings for
more information.)



Backlog


Generally,
we do not maintain a high level of backlog. As a result, we do not believe that our
backlog at any particular time is indicative of future sales levels.



Competition


The
market in which we are engaged is subject to intense competition and rapid technological
change. Our competitors include but are not limited to: Candela, Inc., Cutera, Inc., Cynosure,
Inc., Syneron, Inc., Lumenis, Inc., Alma, Inc., Iridex, Inc. and other smaller
competitors. Some of our competitors have greater financial, marketing, and technical
resources than we have. Moreover, some competitors have developed, and others may attempt
to develop, products with applications similar to that of ours. We expect that there may
be further consolidation of companies within the light based industry via acquisitions,
partnering arrangements or joint ventures. We compete primarily on the basis of
technology, product performance, price, quality, reliability, distribution and customer
service. To remain competitive, we will be required to continue to develop new products
and periodically enhance our existing products.



Food and Drug
Administration Regulations


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 United States generally must receive either 510(k) clearance
or PMA approval in advance from the 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 our products eligible for the 510(k) clearance process. We believe that
most of 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 it proposes to market and failure to do so could
adversely affect our ability to sell products.



Number of Employees


As
of December 31, 2006, we employed 225 people. We are not subject to any collective
bargaining agreements, have not experienced a work stoppage and consider our relations
with our employees to be good.

8






Available Information


Our
internet site is www.palomarmedical.com. You can access our Investor
Relations webpage through our internet site, www.palomarmedical.com, by clicking on
the Investor Relations link to the heading SEC Filings. We make
available free of charge, on or through our Investor Relations webpage, our proxy
statements, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the
Securities Exchange Act of 1934, as amended (the Exchange Act), as soon as
reasonably practicable after such material is electronically filed with, or furnished to,
the SEC. We also makes available, through our Investor Relations webpage, via a link to
the SECs internet site, statements of beneficial ownership of our equity securities
filed by our directors, officers, 10% or greater shareholders and others under
Section 16 of the Exchange Act.



Item 1A. Risk Factors


This
report contains forward-looking statements that involve risks and uncertainties, such as
statements of our objectives, expectations and intentions. The cautionary statements made
in this report should be read as applicable to all forward-looking statements wherever
they appear in this report. Our actual results could differ materially from those
discussed herein. Factors that could cause or contribute to such differences include those
discussed below, as well as those discussed elsewhere in this report.


If we do not continue to develop
and commercialize new products and identify new markets for our products and technology,
we may not remain competitive, and our revenues and operating results could suffer.


The
aesthetic light based (both lasers and lamps) treatment system industry is subject to
continuous technological development and product innovation. If we do not continue to be
innovative in the development of new products and applications, our competitive position
will likely deteriorate as other companies successfully design and commercialize new
products and applications. We compete in the development, manufacture, marketing, sales
and servicing of light based devices with numerous other companies, some of which have
substantially greater direct worldwide sales capabilities. Our products also face
competition from medical products, prescription drugs and cosmetic procedures, such as
electrolysis and waxing.


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. In the event that we do not obtain FDA
clearances, our ability to market products in the United States and revenue derived there
from may be adversely affected.  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 FDA pursuant to the Federal Food, Drug, and Cosmetic
Act. The FDAs 510(k) clearance process can be expensive and 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 from
the time the pre-market approval application is submitted to the FDA until an approval is
obtained.


In
order to obtain pre-market approval and, in some cases, a 510(k) clearance, a product
sponsor must conduct well controlled clinical trials designed to test the safety and
effectiveness of the product. Conducting clinical trials generally entails a long,
expensive and uncertain process that is subject to delays and failure at any stage. The
data obtained from clinical trials may be inadequate to support approval or clearance of a
submission. In addition, the occurrence of unexpected findings in connection with clinical
trials may prevent or delay obtaining approval or clearance. If we conduct clinical
trials, they may be delayed or halted, or be inadequate to support approval or clearance,
for numerous reasons, including:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | FDA,
other regulatory authorities or an institutional review board may place a clinical trial
on hold;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | patients
may not enroll in clinical trials, or patient follow-up may not occur, at the rate we
expect;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | patients
may not comply with trial protocols;
|- |  | ---------------------------------------------

|o |  | institutional
review boards and third party clinical investigators may delay or reject our trial
protocol;
|- |  | ----------------------------------------------------------------------------------------------------------

|9
|-

|o |  | third
party clinical investigators may decline to participate in a trial or may not perform a
trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | third
party organizations may not perform data collection and analysis in a timely or accurate
manner;
|- |  | ------------------------------------------------------------------------------------------------------

|o |  | regulatory
inspections of our clinical trials or manufacturing facilities may, among other things,
require us to undertake               corrective action or suspend or terminate our
clinical trials, or invalidate our clinical trials;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | changes
in governmental regulations or administrative actions; and
|- |  | ------------------------------------------------------------------

|o |  | the
interim or final results of the clinical trials may be inconclusive or unfavorable as to
safety or effectiveness.
|- |  | ---------------------------------------------------------------------------------------------------------------------

|Medical devices may be marketed
only for the indications for which they are approved or cleared. The FDA may not approve
or clear indications that are necessary or desirable for successful commercialization.
Indeed, the FDA may refuse our requests for 510(k) clearance or pre-market approval of new
products, new intended uses or modifications to existing products. Our clearances can be
revoked if safety or effectiveness problems develop.


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.


We
often seek FDA clearance for additional indications for use. Clinical trials in support of
such clearances for additional indications may be costly and time-consuming. In the event
that we do not obtain additional FDA clearances, our ability to market products in the
United States and revenue derived therefrom may be adversely affected. Medical devices may
be marketed only for the indications for which they are approved or cleared, and if we are
found to be marketing our products for off-label, or non-approved, uses we might be
subject to FDA enforcement action or have other resulting liability.


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.


After clearance or approval of our
products, we are subject to continuing regulation by the FDA, and if we fail to comply
with FDA regulations, our business could suffer.


Even
after clearance or approval of a product, we are subject to continuing regulation by the
FDA, including the requirements that our facility be registered and our devices listed
with the agency. We are subject to Medical Device Reporting regulations, which require us
to report to the FDA if our products may have caused or contributed to a death or serious
injury or malfunction in a way that would likely cause or contribute to a death or serious
injury if the malfunction were to recur. We must report corrections and removals to the
FDA where the correction or removal was initiated to reduce a risk to health posed by the
device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the
device that may present a risk to health, and we must maintain records of other
corrections or removals. The FDA closely regulates promotion and advertising and our
promotional and advertising activities could come under scrutiny. If the FDA objects to
our promotional and advertising activities or finds that we failed to submit reports under
the Medical Device Reporting regulations, for example, the FDA may allege our activities
resulted in violations.

10






The
FDA and state authorities have broad enforcement powers. Our failure to comply with
applicable regulatory requirements could result in enforcement action by the FDA or state
agencies, which may include any of the following sanctions:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | letters,
warning letters, fines, injunctions, consent decrees and civil penalties;
|- |  | ----------------------------------------------------------------------------------

|o |  | repair,
replacement, refunds, recall or seizure of our products;
|- |  | ----------------------------------------------------------------

|o |  | operating
restrictions or partial suspension or total shutdown of production;
|- |  | -----------------------------------------------------------------------------

|o |  | refusing
or delaying our requests for 510(k) clearance or pre-market approval of new products or
new intended uses; and
|- |  | -----------------------------------------------------------------------------------------------------------------------

|o |  | criminal
prosecution.
|- |  | ---------------------

|If any of these events were to occur,
they could harm our business.


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. We may be required to submit pre-clinical and clinical
data depending on the nature of the changes. We may not be able to obtain additional
510(k) clearances or pre-market approvals for modifications to, or additional indications
for, our existing products in a timely fashion, or at all. Delays in obtaining future
clearances or approvals would adversely affect our ability to introduce new or enhanced
products into the market in a timely manner, which in turn would harm our revenue and
operating results. We have modified some of our marketed devices, but we believe that new
510(k) clearances are not required. We cannot be certain that the FDA would agree with any
of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k)
clearance for any modification, we also may be required to cease marketing and/or recall
the modified device until we obtain a new 510(k) clearance.


Federal regulatory reforms may
adversely affect our ability to sell our products profitably.


From
time to time, legislation is drafted and introduced in Congress that could significantly
change the statutory provisions governing the clearance or approval, manufacture and
marketing of a device. In addition, FDA regulations and guidance are often revised or
reinterpreted by the agency in ways that may significantly affect our business and our
products. It is impossible to predict whether legislative changes will be enacted or FDA
regulations, guidance or interpretations changed, and what the impact of such changes, if
any, may be.


We may also be subject to state
regulations.   State regulations, and changes to state regulations, may prevent
sales to particular end users or may restrict use of the products to particular end users
or under particular supervision 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 which complicates monitoring compliance. As a result, in some states
non-physicians may purchase and operate our products. In most states, it is within a
physicians discretion to determine whom they can supervise in the operation of our
products and the level of supervision. However, some states have specific regulations as
to appropriate supervision and who may be supervised. A state could disagree with our
decision to sell to a particular type of end user or change regulations to prevent sales
to particular types of end users or change regulations as to supervision requirements. In
several states applicable regulations are in flux.  Thus, state regulations and
changes to state regulations may decrease revenues or prevent growth of revenues.


Because we do not require training
for all users of our products, and sell our products to non-physicians, there exists an
increased potential for misuse of our products, which could harm our reputation and our
business.

11






Federal regulations allow us to sell our products to or on the order of practitioners
licensed by state law. The definition of licensed practitioners varies from
state to state. As a result, our products may be purchased or operated by physicians with
varying levels of training and, in many states, by non-physicians, including nurse
practitioners, chiropractors and technicians. Outside the United States, many
jurisdictions do not require specific qualifications or training for purchasers or
operators of our products. We do not supervise the procedures performed with our products,
nor do we require that direct medical supervision occur. Our products come with an
operators manual. We and our distributors offer product training sessions, but
neither we nor our distributors require purchasers or operators of our products to attend
training sessions. The lack of required training and the purchase and use of our products
by non-physicians may result in product misuse and adverse treatment outcomes, 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 or our business could suffer.


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, which requires manufacturers to follow elaborate design,
testing, control, documentation, and other quality assurance procedures. Because some of
our products involve the use of lasers, those products also are covered by a performance
standard for lasers set forth in FDA regulations. The laser performance standard imposes
specific record keeping, reporting, product testing and product labeling requirements.
These requirements include affixing warning labels to laser products as well as
incorporating certain safety features in the design of laser products. The FDA enforces
the Quality System Regulation and laser performance standards through periodic unannounced
inspections. We have been, and anticipate in the future being, subject to such
inspections. The complexity of the Quality System Regulation makes complete compliance
difficult to achieve. Also, the determination as to whether a Quality System Regulation
violation has occurred is often subjective. If the FDA finds that we have failed to comply
with the Quality System Regulation or other applicable requirements or take satisfactory
corrective action in response to an adverse Quality System Regulation inspection or comply
with applicable laser performance standards, the agency can institute a wide variety of
enforcement actions, including a public warning letter or other stronger remedies, such as
fines, injunctions, criminal and civil penalties, recall or seizure of our products,
operating  restrictions, partial suspension, or total shutdown of our production,
refusing to permit the import or export of our products, delaying or refusing our requests
for 510(k) clearance or PMA approval of new products, withdrawing product approvals
already granted or criminal prosecution, any of which could cause our business and
operating results to suffer.


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. 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.


If our new products do not gain
market acceptance, our revenues and operating results could suffer.


The
commercial success of the products and technology we develop will depend upon the
acceptance of these products by providers of aesthetic procedures and their patients and
clients. It is difficult for us to predict how successful recently introduced products, or
products we are currently developing, will be over the long term. If the products we
develop do not gain market acceptance, our revenues and operating results could suffer.


We
expect that many of the products we develop will be based upon new technologies or new
applications of existing technologies. It may be difficult for us to achieve market
acceptance of some of our products, particularly the first products that we introduce to
the market based on new technologies or new applications of existing technologies.
12






If demand for our aesthetic
treatment systems by non-traditional physician customers and spas does not develop as we
expect, our revenues will suffer and our business will be harmed.


Our
revenues from non-traditional physician customers and spa purchasers of our products
continue to increase. We believe, and our growth expectations assume, that we and other
companies selling light-based (lasers and lamps) aesthetic treatment systems have only
begun to penetrate these markets and that our revenues from selling to these markets will
continue to increase. If our expectations as to the size of these markets and our ability
to sell our products to participants in these markets are not correct, our revenues will
suffer and our business will be harmed.


If there is not sufficient
consumer demand for the procedures performed with our products, practitioner demand for
our products could decline, which would adversely affect our operating results.


Most
procedures performed using our aesthetic treatment systems are elective procedures that
are not reimbursable through government or private health insurance. The cost of these
elective procedures must be borne by the client. As a result, the decision to undergo a
procedure that utilizes our products may be influenced by a number of factors, including:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | consumer
awareness of procedures and treatments;
|- |  | ------------------------------------------------

|o |  | the
cost, safety and effectiveness of the procedure and of alternative treatments;
|- |  | ----------------------------------------------------------------------------------

|o |  | the
success of our and our customers' sales and marketing efforts to purchasers of these
procedures; and
|- |  | --------------------------------------------------------------------------------------------------------

|o |  | consumer
confidence, which may be affected by economic and other conditions.
|- |  | ----------------------------------------------------------------------------

|If
there is not sufficient demand for the procedures performed with our products,
practitioner demand for our products would be reduced, which would adversely affect our
operating results.


Our business and operations are
experiencing rapid growth. If we fail to effectively manage our growth, our business and
operating results could be harmed.


We
have experienced increased growth in the scope of our operations and the number of our
employees. This growth has placed significant demands on our management, as well as our
financial and operational resources. If we do not effectively manage our growth, the
efficiency of our operations and the quality of our products could suffer, which could
adversely affect our business and operating results. To effectively manage this growth, we
will need to continue to:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | implement
appropriate operational, financial and management controls, systems and procedures;
|- |  | ---------------------------------------------------------------------------------------------

|o |  | expand
our manufacturing capacity and scale of production;
|- |  | ----------------------------------------------------------

|o |  | expand
our sales, marketing and distribution infrastructure and capabilities; and
|- |  | ---------------------------------------------------------------------------------

|o |  | provide
adequate training and supervision to maintain high quality standards.
|- |  | -----------------------------------------------------------------------------

|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 and we purchase
some of these components from small, specialized vendors that are not well capitalized. We
do not have long-term contracts with some of these third parties for the supply of parts.
A disruption in the delivery of these key components, or our inability to obtain
substitute components or subassemblies from alternate sources at acceptable prices in a
timely manner, or our inability to obtain assembly or testing services could prevent us
from manufacturing products and result in a decrease in revenue.  We depend on an
acceptable level of reliability for purchased components.  Reliability below
expectations for key components could have an adverse affect on inventory and inventory
reserves. Any extended interruption in our supplies of third party components could
materially harm our business.

13






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 own and license a variety of patents and patent applications in the
United States and corresponding patents and patent applications in many foreign
jurisdictions. To date, however, our patent estate has not stopped other companies from
competing against us, and though we have licensed certain competitors to certain patents
and are enforcing those same patents against other competitors and intend to enforce
against others, we do not know how successful we will be in asserting our patents against
suspected infringers. Our pending and future patent applications may not issue as patents
or, if issued, may not issue in a form that will be advantageous to us. Even if issued,
patents may be challenged, narrowed, invalidated or circumvented, which could limit our
ability to stop competitors from marketing similar products or limit the length of term of
patent protection we may have for our products. Changes in either patent laws or in
interpretations of patent laws in the United States and other countries may diminish the
value of our intellectual property or narrow the scope of our patent protection.


In
addition to patented technology, we rely upon unpatented proprietary technology, processes
and know-how. We generally enter into 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 and define our intellectual property
ownership rights. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy or otherwise obtain and use our technology, proprietary
information and know-how and we may not have adequate remedies for any such breach.
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 and the value of our technology and products could be
adversely affected.  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.  In addition, our trade
secrets may otherwise become known or 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. Uncertainties resulting from
the initiation and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. 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.

14






Candela
Corporation has filed two patent infringement lawsuits against us. (See Item 3 Legal
Procedings.) Litigation with Candela is expected to be expensive and protracted, and our
intellectual property position may be weakened as a result of an adverse ruling or
judgment. Whether or not we are successful in the pending lawsuits, litigation consumes
substantial amounts of our financial resources and diverts managements attention
away from our core business. Public announcements concerning this litigation that are
unfavorable to us may in the future result in significant declines in our stock price. An
adverse ruling or judgment in this matter could cause our stock price to decline
significantly.



We may not be able to
successfully collect licensing royalties.


Material portions of our revenues consist of royalties from sub-licensing patents licensed
to us on an exclusive basis by Massachusetts General Hospital. If we are unable to collect
our licensing royalties, our revenues will decline.


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 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.


Managing our relationships with
Gillette (now part of The Procter & Gamble Company), the United States Department of
the Army, and Johnson & Johnson Consumer Companies, Inc may divert the attention of
key technical personnel and management from the core business.   If any of these
parties end the relationship our stock price could fall, and we may be unable to bring
home use devices to the market.


We
believe that our relationships with Gillette, the United States Department of the Army and
Johnson & Johnson Consumer Companies, Inc. represent unique opportunities to bring
light based devices to the mass market. Significant resources and the attention of key
technical personnel and management have been and may continue to be directed to the
development and commercialization of such devices even though such devices will not likely
be commercialized for several years, if ever.  In addition, we cannot be sure that
these parties will agree with our interpretation of the terms of the agreements, that the
agreements will provide us with marketable products in the future or that we will receive
payments for any of the products developed under the agreements.  During the terms of
the agreements, Gillette and Johnson & Johnson have the ability to choose not to
continue and may terminate the agreements.  If Gillette or Johnson & Johnson
terminates their agreement with us, the price of our common stock could fall
significantly, and we will not receive certain payments.  We may proceed to develop
and commercialize the devices on our own or with a third party.  However, there can
be no assurance that we will be able to successfully implement such a strategy.  In
addition, after commercialization of such devices, Gillette and Johnson & Johnson are
to pay us a percentage of net sales of such devices. Certain of these percentages of net
sales are only owed if the devices are covered by valid patents.  There can be no
assurance that valid patents will cover the devices in any or all countries, in which the
devices will be manufactured, used or sold.  This could have a material adverse
effect on our business, results of operations and financial condition.


The expense and potential
unavailability of liability insurance coverage for our customers could adversely affect
our ability to sell our products and our financial condition.


Some
of our customers and prospective customers have had difficulty in procuring or maintaining
liability insurance to cover their operation and use of our products. Medical malpractice
carriers are withdrawing coverage in some states or substantially increasing premiums. If
this trend continues or worsens, our customers may discontinue using our products, and
potential customers may elect not to purchase laser and other light-based products.

15






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 approximately 225 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.


Product liability suits could be
brought against us due to a defective design, material or workmanship or due to misuse of
our products. These lawsuits could be expensive and time consuming and result in
substantial damages to us and increases in our insurance rates.


If
our products are defectively designed, manufactured or labeled, contain defective
components or are misused, we may become subject to substantial and costly litigation by
our customers or their patients or clients. 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. Misusing our products or failing to adhere to operating
guidelines for our products can cause severe burns or other damage to the eyes, skin or
other tissue. We are routinely involved in claims related to the use of our products.
Product liability claims could divert managements attention from our core business,
be expensive to defend and result in sizable damage awards against us. Our current
insurance coverage may not be sufficient to cover these claims. Moreover, in the future,
we may not be able to obtain insurance in amount or scope sufficient to provide us with
adequate coverage against potential liabilities. Any product liability claims brought
against us, with or without merit, could increase our product liability insurance rates
or prevent us from securing continuing coverage, could harm our reputation in the
industry and reduce product sales. We would need to pay any product losses in excess of
our insurance coverage out of cash reserves, harming our financial condition and
adversely affecting our operating results.


We face risks associated with
product warranties.


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


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


We sell a significant amount of our products and services outside the U.S. 
International product revenue, consisting of sales from our distributors in Japan, Europe,
Australia, Asia\Pacific Rim and South and Central America and sales shipped directly to
international locations from the United States, 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, including but not limited to political and economic instability and difficulties in
managing our foreign operations.  In particular, longer payment cycles common in
foreign markets, credit risk and delays in obtaining necessary import or foreign
certification or 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.


We rely on third party
distributors to market and sell a large portion of our products. If these distributors do
not commit the necessary resources to effectively market and sell our products or if our
relationships with these distributors are disrupted, our business and operating results
may be harmed.



16



In
the United States, we sell our products through our internal sales organization. Outside
of this market, we sell our products through third party distributors. Our sales and
marketing success in these other markets depends on these distributors, in particular
their sales and service expertise and relationships with the customers in the marketplace.
We do not control these distributors, and they may not be successful in marketing our
products. Third party distributors may terminate their relationships with us, or fail to
commit the necessary resources to market and sell our products to the level of our
expectations. If current or future third party distributors do not perform adequately, or
if we fail to maintain our existing relationships with these distributors or fail to
recruit and retain distributors in particular geographic areas, our revenue from
international sales may be adversely affected and our operating results could suffer.



We may not be able to sustain or
increase profitability and we may seek additional financing to grow the business.



Although
we have generated a profit in recent years, we have a history of losses. We may not be
able to sustain or increase profitability on a quarterly or annual basis. If our
operating results fall below the expectations of investors or public market analysts, the
price of our common stock could decline.


We
may determine, depending upon the opportunities available, to seek additional debt or
equity financing to fund the costs of 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 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 may continue to issue options, warrants and other equity
rights 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 charter documents, Delaware
law and our shareholder rights plan may discourage potential takeover attempts.


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


We
are also subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law, which prohibits us from engaging in a business combination
with an interested stockholder for a period of three years after the date of
the transaction in which the person becomes an interested stockholder, unless the business
combination is approved in a prescribed manner. The application of Section 203 may limit
the ability of stockholders to approve a transaction that they may deem to be in their
best interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers or tender
offers or could delay or prevent certain changes in control or our management, including
transactions in which stockholders might otherwise receive a premium for their shares over
the then current market price.


In
April 1999, we adopted a shareholder rights plan or poison pill. This is
intended to protect shareholders from unfair or coercive takeover practices.


17






Any acquisitions that we make
could disrupt our business and harm our financial condition.


From
time to time, we evaluate potential strategic acquisitions of complementary businesses,
products or technologies, as well as consider joint ventures and other collaborative
projects. We may not be able to identify appropriate acquisition candidates or strategic
partners, or successfully negotiate, finance or integrate any businesses, products or
technologies that we acquire. Any acquisition we pursue could diminish our cash available
to us for other uses or be dilutive to our stockholders, and could divert
managements time and resources from our core operations.



Our stock price may be
volatile.


Our
common stock price may be volatile. The stock market in general has experienced extreme
volatility that has often been unrelated to the operating performance of particular
companies. The market price for our common stock may be influenced by many factors,
including:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|o |  | the
success of competitive products or technologies;
|- |  | ----------------------------------------------------

|o |  | regulatory
developments in the United States and foreign countries;
|- |  | -------------------------------------------------------------------

|o |  | developments
or disputes concerning patents or other foreign countries;
|- |  | -----------------------------------------------------------------------

|o |  | the
recruitment or departure of key personnel;
|- |  | ----------------------------------------------

|o |  | variations
in our financial results or those of companies that are perceived to be similar to us;
|- |  | -------------------------------------------------------------------------------------------------

|o |  | market
conditions in our industry and issuance of new or changed securities analyst's reports or
recommendations; and
|- |  | ---------------------------------------------------------------------------------------------------------------------

|o |  | general
economic, industry and market conditions.
|- |  | -------------------------------------------------

|Item 1B. Unresolved
Staff Comments


None



Item 2. Properties


We
lease a facility totaling approximately 55,000 square feet of office, manufacturing and
research space in Burlington, Massachusetts. The lease expires in August 2009. We believe
that this facility is in good condition and is suitable and adequate for our current
operations.



Item 3. Legal Proceedings


On
February 15, 2002 and April 7, 2005, we commenced actions for patent infringement in the
United States District Court for the District of Massachusetts against Cutera, Inc.
seeking both monetary damages and injunctive relief. The Massachusetts General Hospital in
Boston, Massachusetts was added as a plaintiff in these lawsuits. In the first suit,
Cuteras CoolGlide Laser Systems, including the CoolGlide CV, Excel, Vantage and Xeo,
were alleged to infringe U.S. Patent No. 5,735,844. In the second lawsuit, Cuteras
Lamp Systems, including the CoolGlide Xeo and Solera Opus platforms using the PW770
handpiece, were alleged to infringe both the 5,735,844 Patent as well as U.S. Patent No.
5,595,568 (the Anderson Patents). We have an exclusive license to these
patents from the Massachusetts General Hospital.


On
June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.
Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to
the Anderson Patents (U.S. Patent Nos. 5,595,568 & 5,735,844) in the professional
field, excluding the consumer field which is exclusively licensed to Gillette. Cutera
admitted that their products infringe the Anderson Patents and that these patents are
valid and enforceable. In addition, Cutera agreed not to challenge the infringement,
validity and enforceability of the Anderson Patents in the future. Cutera paid us an
estimated payment for royalties due on past sales of their laser- and lamp-based
hair removal systems beginning with their initial sales in 2000 through March 31, 2006,
interest and reimbursement of our legal costs. The final amounts due to us were subject to
an audit by an independent accounting firm which was completed in the fourth quarter of
2006. Starting on April 1, 2006, Cutera began paying us a royalty on sales of its
existing light-based hair removal systems, and Cutera will pay us a royalty on sales
of its later developed light-based hair removal systems.



18






For
more information, please see the Settlement Agreement, the Non-Exclusive Patent License Agreement, the Consent
Judgments and Stipulations of Dismissal filed as Exhibits 99.1, 99.2, 99.3 and 99.4 to a
Current Report on our Form 8-K filed June 5, 2006.


On
July 7, 2006, we commenced an action for patent infringement against Alma Lasers, Inc. in
the United States District Court for the District of Massachusetts seeking both monetary
damages and injunctive relief. The complaint alleges Almas Harmony, Soprano and
Sonata Systems which use pulsed light and laser technology for hair removal willfully
infringe the Anderson Patents, which are exclusively licensed to us by the Massachusetts
General Hospital. On July 27, 2006, we filed an amended complaint including an additional
claim against Alma for unfair competition due to infringement by Almas Harmony
System of the distinctive trade dress of our products, including the unique, distinctive,
and immediately recognizable design of our EsteLux, MediLux and StarLux Systems
(Palomars Trade Dress). We are seeking both monetary and injunctive
relief on the new claim. Alma answered the complaint denying that its products infringe
valid claims of the asserted patents and our Trade Dress and filing a counterclaim seeking
a declaratory judgment that the asserted patents are invalid and not infringed. We filed a
reply denying the material allegations of the counterclaims. Both this lawsuit and Palomar
v Candela (described below) have been transferred to Judge Rya Zobel, the Judge who
presided over Palomar v Cutera, Inc. Alma, Palomar and Candela have agreed to a joint
Markman Hearing for both lawsuits, currently scheduled for August 2, 2007, and to follow
the discovery schedule set in Palomar v. Candela. The current schedule has the parties
ready for trial by June 2008 though no trial date has yet been set. We filed an amended
complaint on February 22, 2007 to add the Massachusetts General Hospital as a plaintiff
and to further allege that Almas new Soprano XL system infringes the Anderson
Patents.


On
August 9, 2006, we commenced an action for patent infringement against Candela Corporation
in the United States District Court for the District of Massachusetts seeking both
monetary damages and injunctive relief. The complaint alleges Candelas GentleYAG and
GentleLASE systems which use laser technology for hair removal willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General
Hospital. Candela answered the complaint denying that its products infringe valid claims
of the asserted patents and filing a counterclaim seeking a declaratory judgment that the
asserted patent and U.S. patent No. 5,595,568 are invalid and not infringed. We filed a
reply denying the material allegations of the counterclaims. Both this lawsuit and Palomar
v Alma (described above) have been transferred to Judge Rya Zobel, the judge who presided
over Palomar v Cutera, Inc. Alma, Palomar and Candela have agreed to a joint Markman
Hearing for both lawsuits, currently scheduled for August 2, 2007, and to follow the
discovery schedule set in this lawsuit. The current schedule has the parties ready for
trial by June 2008 though no trial date has yet been set. We filed an amended complaint on
February 16, 2007 to add the Massachusetts General Hospital as a plaintiff. In addition,
we further allege that Candelas new GentleMAX system willfully infringes U.S. Patent
No. 5,735,844 and that Candelas new Light Station system willfully infringes both
U.S. Patent Nos. 5,735,844 and 5,595,568. On February 16, 2007, Candela filed an amended answer to our complaint adding allegations of inequitable
conduct, double patenting and violation of Massachusetts General Laws Chapter 93A.  On February 28, 2007 Palomar
filed a response to Candelas amended complaint pointing out many weaknesses in Candelas new allegations.


On
August 10, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the District of Massachusetts seeking both
monetary damages and injunctive relief. The complaint alleges that our StarLux System with
the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne
treatment, that our QYAG5 System willfully infringes U.S. Patent No. 5,312,395 which is
directed to treatment of pigmented lesions, and that our StarLux System with the LuxG
handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle
treatment. On October 25, 2006, Candela filed an amended complaint which did not include
U.S. Patent No. 6,659,999. Consequently, Candela no longer alleges that the StarLux System with
LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is
seeking to enjoin us from selling these products in the United States if found to infringe
the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On October 30,
2006 we answered the complaint denying that our products infringe the asserted patents and
filing counterclaims seeking declaratory judgments that the asserted patents are invalid
and not infringed. In addition, with regard to U.S. Patent No. 5,312,395, we filed a
counter claim of inequitable conduct. Judge Joseph Tauro has been appointed as the
presiding judge. Following a scheduling hearing on January 18, 2007, the Judge set a
partial discovery schedule but did not yet set a date for a Markman Hearing. We are
defending the action vigorously and believe that we have meritorious defenses of
non-infringement, invalidity and inequitable conduct. However, litigation is unpredictable
and we may not prevail in successfully defending or asserting our position. If we do not
prevail, we may be ordered to pay substantial damages for past sales and an ongoing
royalty for future sales of products found to infringe in the United States. We could also
be ordered to stop selling any products in the United States that are found to infringe.

19






On
December 19, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the Eastern District of Texas, seeking both
monetary damages and injunctive relief. The complaint alleges that our StarLux System with
the LuxY handpiece willfully infringes U.S. Patent No. 6,659,999 and that our StarLux
System with the Lux1540 handpiece willfully infringes related U.S. Patent Nos. 5,810,801
and 6,120,497. All three asserted patents are directed to wrinkle treatment. Candela is
seeking to enjoin us from selling these products in the United States if found to infringe
the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On January 10,
2007, we answered the complaint denying that our products infringe the asserted patents
and filing counterclaims seeking declaratory judgments that the asserted patents are
invalid and not infringed. In addition, on January 10, 2007, we filed a motion to transfer
this lawsuit from Texas to Massachusetts. This motion was denied on February 23, 2007. We
are defending the action vigorously and believe that we have meritorious defenses of
non-infringement and invalidity. However, litigation is unpredictable and we may not
prevail in successfully defending or asserting our position. If we do not prevail, we may
be ordered to pay substantial damages for past sales and an ongoing royalty for future
sales of products found to infringe in the United States. We could also be ordered to stop
selling any products that are found to infringe in the United States.


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


None



PART II


Item 5.  Market for
Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of equity
Securities


Our
common stock is currently traded on the NASDAQ Global Select Market under the symbol PMTI.
The following table sets forth the high and low information on NASDAQ for the common stock
for the periods indicated. Such quotations reflect inter-dealer prices, without retail
markup, markdown or commission and do not necessarily represent actual transactions.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Fiscal Year 2005 |         
|-------------------------------- | ---------------- | --------
|
|Quarter ended March 31, 2005     |                  | $     30
|Quarter ended June 30, 2005      |                  | 27      
|Quarter ended September 30, 2005 |                  | 30      
|Quarter ended December 31, 2005  |                  | 39      

|                                 | Fiscal Year 2006 |         
|-------------------------------- | ---------------- | --------
|
|Quarter ended March 31, 2006     |                  | $     41
|Quarter ended June 30, 2006      |                  | 48      
|Quarter ended September 30, 2006 |                  | 50      
|Quarter ended December 31, 2006  |                  | 58      

|As
of February 28, 2007, we had 3,250 holders of record of common stock.
This does not include holdings in street or nominee names.

20






We
have not paid dividends to our common stockholders since our inception and do not plan to
pay dividends to our common stockholders in the foreseeable future. We intend to retain
substantially all earnings to finance our operations. We may buy back shares of our common
stock on the open market from time to time.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Performance Graph

Item 6. Selected
Financial Data


The
following table sets forth selected consolidated financial data for each of the last five
fiscal years. This data should be read in conjunction with the detailed information,
financial statements and related notes, as well as Managements Discussion and
Analysis of Financial Condition and Results of Operations included elsewhere herein. The
historical results are not necessarily indicative of the results of operations to be
expected in the future.
21
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                                       | For the years ended December 31, |  |   |         |  
|------------------------------------------------------------------------------------------------------ | -------------------------------- |  | - | ------- | -
|
|
|Consolidated Statements of Operations Data:                                                            |                                  |  |   |         |  
|                                                                                                       |                                  | 
|Revenues:                                                                                              |                                  | 
|Product revenues                                                                                       |                                  |  | $ | 92,222  |  
|Royalty revenues                                                                                       |                                  |  |   | 30,481  |  
|Funded product development revenues                                                                    |                                  |  |   | 3,841   |  
|                                                                                                       |                                  |  |   |         |  
|Total revenues                                                                                         |                                  |  |   | 126,544 |  
|Costs and expenses:                                                                                    |                                  | 
|Cost of product revenues                                                                               |                                  |  |   | 26,897  |  
|Cost of royalty revenues                                                                               |                                  |  |   | 12,192  |  
|Research and development (1)                                                                           |                                  |  |   | 14,056  |  
|Selling and marketing (1)                                                                              |                                  |  |   | 22,467  |  
|General and administrative (1)                                                                         |                                  |  |   | 7,645   |  
|                                                                                                       |                                  |  |   |         |  
|Total cost and expenses                                                                                |                                  |  |   | 83,257  |  
|                                                                                                       |                                  |  |   |         |  
|Income (loss) from operations                                                                          |                                  |  |   | 43,287  |  
|                                                                                                       |                                  |  |   |         |  
|Other income, net                                                                                      |                                  |  |   | 4,719   |  
|                                                                                                       |                                  |  |   |         |  
|Income before income taxes                                                                             |                                  |  |   | 48,006  |  
|Provision (benefit) for income taxes                                                                   |                                  |  |   | (4,971  | )
|                                                                                                       |                                  |  |   |         |  
|Net Income                                                                                             |                                  |  | $ | 52,977  |  
|                                                                                                       |                                  |  |   |         |  
|Net income per common share:                                                                           |                                  | 
|Basic                                                                                                  |                                  |  | $ | 3.02    |  
|                                                                                                       |                                  |  |   |         |  
|Diluted                                                                                                |                                  |  | $ | 2.62    |  
|                                                                                                       |                                  |  |   |         |  
|Weighted average number of common shares outstanding:                                                  |                                  | 
|Basic                                                                                                  |                                  |  |   | 17,519  |  
|                                                                                                       |                                  |  |   |         |  
|Diluted                                                                                                |                                  |  |   | 20,209  |  
|                                                                                                       |                                  |  |   |         |  
|                                                                                                       |                                  |  |   |         |  
|(1) Certain reclassifications have been made to prior year amounts to conform to the 2006 presentation |                                  |  |   |         |  

|                                                | For the years ended December 31, |  |   |         | 
|----------------------------------------------- | -------------------------------- |  | - | ------- | 
|
|                                               
|Consolidated balance sheet data:               
|                                                |                                  | 
|Cash and cash equivalents                       |                                  |  | $ | 36,817  | 
|Available-for-sale investments, at market value |                                  |  |   | 67,352  | 
|Working capital                                 |                                  |  |   | 115,891 | 
|Total assets                                    |                                  |  |   | 141,162 | 
|Total stockholder's equity                      |                                  |  |   | 117,132 | 

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


Forward-looking statements


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


22
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

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

|
|

| |  |  |  |  | other risks contained in Item 1A under the caption Risk Factors.
| |  |  |  | - | ------------------------------------------------------------------

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


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



Critical accounting
policies


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


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



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




23


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


We
generally recognize royalty revenue from licensees upon receipt of cash payments since the
royalty amounts are not determinable at the end of a quarter. Licensees are obligated to
make payments between 30 and 45 days after the end of each quarter. If at the end of a
quarter, royalty revenue from licenses are determinable we record royalty revenue during
the period earned. Periodically, as we sign on new licensees, in the period determinable
and earned we recognize back-owed royalties. We have the right under our license
agreements to engage independent auditors to review the royalty calculations. The amounts
owed as a result of these audits may be higher or lower than previously recognized.


We
have funded product development revenue from the development agreements with Gillette,
Johnson & Johnson Consumer Companies, Inc. and the United States Department of the
Army. For both Gillette and Johnson & Johnson, we have received payments quarterly in
accordance with the work plans that were developed with both Gillette and Johnson &
Johnson. Revenue is recognized under the contracts as costs are incurred and services are
rendered. Any amounts received in advance of costs incurred and services rendered are
recorded as deferred revenue. Payments are not refundable if the development is
not successful.


We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. Our revenue
from the contract is subject to government audit.


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. Included in our inventory are
demonstration products that are used by our sales organization. We account for such
products as we do with any other finished goods item in our inventory in accordance with
the review of our entire inventory. We regularly evaluate our ability to realize the value
of our inventory based on a combination of factors including the following: historical
usage rates, forecasted sales or usage, product end of life dates, estimated current and
future market values and new product introductions. Assumptions used in determining our
estimates of future product demand may prove to be incorrect, in which case the provision
required for excess and obsolete inventory would have to be adjusted in the future. If
inventory is determined to be overvalued, we would be required to recognize such as cost
of goods sold at the time of such determination. Although we perform a detailed review of
our forecasts of future product demand, any significant unanticipated changes in demand
could have a significant impact on the value of our inventory and our reported operating
results. Additionally, purchasing requirements and alternative usage avenues are explored
within these processes to mitigate inventory exposure. When recorded, our reserves are
intended to reduce the carrying value of our inventory to its net realizable value.


24






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


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


On
January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as
permitted under SFAS 123(R). Under this transition method, compensation cost recognized in
2006 includes compensation cost for all share-based payments granted prior to but not yet
vested as of December 31, 2005, based on the grant-date fair value estimated in accordance
with the provisions of SFAS 123. In accordance with the modified prospective method of
adoption, our results of operations and financial position for prior periods have not been
restated.


As
permitted under SFAS No. 123 and SFAS 123R, we use the Black-Scholes option pricing model
to estimate the fair value of stock option grants. Key input assumptions used to estimate
the fair value of stock options include the exercise price of the award, the expected
option term, the expected volatility of our stock over the options expected term,
the risk-free interest rate over the options expected term and our expected annual
dividend yield. Expected volatilities are based on historical volatilities of our common
stock and other factors; the expected life represents the weighted average period of time
that options granted are expected to be outstanding giving consideration to vesting
schedules and our historical exercise patterns; and the risk-free rate is based on the
U.S. Treasury yield curve in effect at the time of grant for periods corresponding with
the expected life of the option. Our assumed dividend yield of zero is based on the fact
that we have never paid cash dividends and have no present intention to pay cash
dividends.




If
factors change and we employ different assumptions for estimating stock-based compensation
expense in future periods, or if we decide to use a different valuation model, the
stock-based compensation expense we recognize in future periods may differ significantly
from what we have recorded in the current period and could materially affect our operating
income, net income and earnings per share. It may also result in a lack of comparability
with other companies that use different models, methods and assumptions. The Black-Scholes
option-pricing model was developed for use in estimating the fair value of traded options
that have no vesting restrictions and are fully transferable. These characteristics are
not present in our option grants. Existing valuation models, including the Black-Scholes
model, may not provide reliable measures of the fair values of our stock-based
compensation. Consequently, there is a risk that our estimates of the fair values of our
stock-based compensation awards on the grant dates may bear little resemblance to the
actual values realized upon the exercise, expiration, early termination or forfeiture of
those stock-based payments in the future. Certain stock-based payments, such as employee
stock options, may expire with little or no intrinsic value compared to the fair values
originally estimated on the grant date and reported in our financial statements.
Alternatively, the value realized from these instruments may be significantly higher than
the fair values originally estimated on the grant date and reported in our financial
statements. The guidance in SFAS 123R is relatively new and the application of these
principles may be subject to further interpretation and refinement over time.


25






Prior
to December 31, 2005, we followed the provisions of SFAS No. 123, Accounting
for Stock-Based Compensation. The provisions of SFAS No. 123 allowed companies to
either expense the estimated fair value of stock options or to continue to follow the
intrinsic value method set forth in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), but disclose
the pro forma effects on net income had the fair value of the options been expensed. We
elected to apply APB 25 in accounting for our stock option incentive plans.


In
accordance with APB 25 and related interpretations, compensation expense for stock options
was recognized in income based on the excess, if any, of the quoted market price of the
stock at the grant date of the award or other measurement date over the amount an employee
must pay to acquire the stock. Generally, the exercise price for stock options granted to
employees was equal to the fair market value of our common stock at the date of grant,
thereby resulting in no recognition of compensation expense by us prior to December 31,
2005.


Income
taxes. We record deferred tax assets and liabilities based on the net tax
effects of tax credits, operating loss carryforwards and temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and the
amounts used for income tax purposes.


We
regularly review deferred tax assets for recoverability taking into consideration such
factors as historical losses, projected future taxable income and the expected timing of
the reversals of existing temporary differences. SFAS No. 109, Accounting for
Income Taxes, requires us to maintain a valuation allowance when it is more likely
than not that some portion or all of the deferred tax assets will not be realized. For
2006, we removed the valuation allowance related to deferred tax assets based on the
conclusion that there was sufficient positive evidence to support that it was more likely
than not that the deferred tax asset would be realized. This resulted in a non-cash, $7.6
million tax benefit recorded through our 2006 provision for income taxes.


In
addition to the tax assets described above, we have deferred tax assets totaling $25
million, resulting from the exercise of employee stock options. In accordance with SFAS
No. 109 and SFAS No. 123R, recognition of these assets would occur upon utilization
of these deferred tax assets to reduce taxes payable and would result in a credit to
additional paid-in capital within stockholders equity rather than the provision for
income taxes. For 2006, 2005 and 2004 the impact to paid-in capital resulting from the
exercise of employee stock options was $1.2 million, $180,000 and $191,000, respectively.


In
evaluating the potential exposure associated with the various tax filing positions, we
accrue charges for possible exposures. Based on the annual evaluations of tax positions,
we believe we have appropriately filed our tax returns and accrued for possible exposures.
To the extent we were to prevail in matters for which accruals have been established or be
required to pay amounts in excess of reserves, our effective tax rate in a given financial
period might be materially impacted.





Overview


We
are engaged in research, development, manufacturing and distribution of proprietary light
based systems for hair removal and other cosmetic treatments. Since our inception, we have
been able to develop a differentiated product mix of light based systems for cosmetic
treatments through our research and development as well as with our partnerships
throughout the world. We are continually developing and testing new indications to further
the advancement in cosmetic light based treatments.


During
2006, we improved product gross profits by 46% due to a higher margin product mix and the
effects of increased sales volume in comparison to the same period in 2005. We
strengthened our balance sheet since the end of 2005, including increasing our cash and
investment position by 111% and stockholders equity by 126%. Our current ratio is
now 5.8x, up from 4.5x at the end of 2005, and we have no debt.
26






Our
revenues for the year ended December 31, 2006, were $126.5 million, up from $76.2 million
for the year ended December 31, 2005. Gross profit from product sales increased to $65.3
million (71% of product revenues), up from $44.9 million (68% of product revenues) in the
year-earlier period. We also reported net income of $53.0 million, or $2.62 per diluted
share, for the year ended December 31, 2006, versus net income of $17.5 million, or $0.91
per diluted share, for the year ended December 31, 2005.


Sales from our Lux family of products remained strong throughout 2006 and our product revenue increased
each quarter as compared to 2005.  The Lux line of products consists of the StarLux Laser and Pulsed Light System,
the MediLux and the EsteLux® Pulsed Light Systems, including a base unit and multiple, optional  handpieces. The
Lux family of products contains some of the most versatile systems in the market today.  The investments that we
made in the past into new technologies have paid off as the demand for our Lux family continued to increase in 2006.



Results of operations



Year 2006 Compared to
Year 2005


The following table contains selected income statement information, which serves as the basis of the
discussion of our results of operations for the years ended December 31, 2006 and 2005, respectively (in thousands,
except for percentages):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | 2006 | 2005       | 2006 to 2005 |     |   |        
|------------------------------------ | ---- | ---------- | ------------ | --- | - | -------
|
|
|Revenues:                            |      |            |              |     |   |        
|Product revenues                     |      | $   92,223 |              | 73  | % | $65,824
|Royalty revenues                     |      | 30,481     |              | 24  | % | 4,921  
|Funded product development revenues  |      | 3,840      |              | 3   | % | 5,409  
|                                     |      |            |              |     |   |        
|Total revenues                       |      | 126,544    |              | 100 | % | 76,154 
|                                     |      |            |              |     |   |        
|Cost and expenses:                   |     
|Cost of product revenues             |      | 26,897     |              | 21  | % | 20,952 
|Cost of royalty revenues             |      | 12,192     |              | 10  | % | 1,968  
|Research & development               |      | 14,056     |              | 11  | % | 11,339 
|Selling & marketing                  |      | 22,467     |              | 18  | % | 17,234 
|General & administrative             |      | 7,645      |              | 6   | % | 7,907  
|                                     |      |            |              |     |   |        
|Total costs and expenses             |      | 83,257     |              | 66  | % | 59,400 
|                                     |      |            |              |     |   |        
|Income from operations               |      | 43,287     |              | 34  | % | 16,754 
|Interest income                      |      | 4,719      |              | 4   | % | 1,172  
|                                     |      |            |              |     |   |        
|Income before income taxes           |      | 48,006     |              | 38  | % | 17,926 
|Provision (benefit) for income taxes |      | (4,971     | )            | -4% |   | 473    
|                                     |      |            |              |     |   |        
|Net Income                           |      | $   52,977 |              | 42  | % | $17,453
|                                     |      |            |              |     |   |        

|Product
revenues. Sales of our StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces were
the leading contributor to our increase in product revenues.  Product revenues were favorably impacted by an
increase of 59% in sales related to the StarLux Laser and Pulsed Light System and an increase of 49% in revenue
related to customer service, offset by a decrease of 44% related to the other Lux family of products, which
includes the MediLux and EsteLux, and a decrease of 40% from sales related to the Q-Yag 5 product line as compared
to the same period in 2005. StarLux product sales increased as more customers opted for the higher powered, faster
and more versatile StarLux systems that are capable of utilizing both laser and
lamp based applications to treat various cosmetic conditions.  Customer service revenue increased as an
increased number of customers purchase replacement handpieces.  The decline in revenues from other Lux products was
directly attributable to the customer acceptance of the StarLux product line and its additional laser and light
based handpieces.





27






International
product revenue, consisting of sales by our independent sales agents in Canada and distributors in Japan, Europe, Australia,
Asia\Pacific Rim and South and Central America and our sales shipped directly to
international customers was 25% of total product revenue for the year ended 2006 in
comparison to 29% for the same period in 2005. While international product sales increased
in absolute dollars in 2006 compared to 2005, they declined as a percentage of revenues
due to the much larger increase in domestic product sales.


Royalty
revenues. Royalty revenues increased during 2006 in comparison to the same
period in 2005. This increase is attributed to the execution of a new patent license
agreement with Cynosure, a royalty audit of Laserscope providing back-owed royalties from
Laserscopes product sales from January 1, 2001 through June 30, 2006 and the
settlement of our patent infringement lawsuits against Cutera, offset by Lumenis making
its final installment for back-owed royalties during the fourth quarter in 2005.


For
the year ended December 31, 2006, Lumenis made current royalty payments to us of
approximately $1.6 million. For the year ended December 31, 2005, Lumenis made current
royalty payments to us of approximately $2.1 million and approximately $2.2 million for
back-owed royalties recorded as royalty revenue.


On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera through
the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.  Under the License Agreement, we granted Cutera
a non-exclusive, royalty bearing license to the Anderson Patents in the professional field, excluding the
consumer field which is exclusively licensed to Gillette. Cutera admitted that their products infringe the
Anderson Patents and that these patents are valid and enforceable. In addition, Cutera agreed not to challenge
the infringement, validity and enforceability of the Anderson Patents in the future. Cutera paid us $22 million
as an estimated payment for royalties due on past sales of their laser- and lamp-based hair removal systems
beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs.
Cutera subsequently informed us that they believed the actual liability for past royalties, interest and legal
costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as
deferred revenue at June 30, 2006 to be applied against future amounts owed, which was fully recognized as
royalty revenue as of December 31, 2006.  The final amounts due were subject to audit by an independent
accounting firm which was completed during the fourth quarter, resulting in an additional $648,000 of royalty and
interest. Starting on April 1, 2006, Cutera began paying us royalties on sales of its existing light-based hair
removal systems, and Cutera will pay us royalties on sales of its later developed light-based hair removal systems.
For the year ended December 31, 2006 we recognized $16.1 million of royalty revenues from Cutera.


On October 18, 2006, we entered into a new Non-exclusive Patent License Agreement with Laserscope  and
terminated our prior license agreement with them. Under the new license agreement, Laserscope pays us a royalty on
sales of its current light-based hair removal products, including the Lyra and Gemini Laser Systems and the Solis
IPL System, as well as on sales of new light-based hair removal systems developed in the future. As a result of a
royalty audit of Laserscopes product sales from January 1, 2001 through June 30, 2006, there was an increase in the
third quarter royalty revenue of $2.2 million for back-owed royalties. For the years ended December 31, 2006 and
2005, we recognized $2.8 million and $621,000 of royalty revenues from Laserscope, respectively.  American Medical
Systems Holdings, Inc. acquired Laserscope in July of 2006 and subsequently sold the assets of Laserscopes
aesthetic division to Iridex Corporation, effective in the first quarter of 2007.  As a result, the license
agreement between Palomar and Laserscope has been assigned to Iridex.  Iridex has assumed all of Laserscopes
rights and obligations under the license agreement.


On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc.
Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing license to the Anderson Patents and
foreign counterparts. In return Cynosure granted us a non-royalty bearing (fully paid-up), non-exclusive license to
eight Cynosure patents and patent applications, including counterparts.  Cynosure also paid us $10 million on
November 7, 2006 as royalties on sales of their laser- and lamp-based hair removal systems made before October 1,
2006. Beginning October 1, 2006, Cynosure will pay us royalties on sales of its light-based hair removal systems as well as future developed hair removal systems. For the year ended December 31, 2006 we recognized
$10 million of royalty revenue from Cynosure.




Funded
product development revenues.Funded development revenue decreased during
2006 as compared to the same period in 2005. Funded product development revenue is
generated from the development agreements with Gillette, Johnson & Johnson Consumer
Companies, Inc. and the United States Department of the Army.


During
2006, we recognized approximately $1.1 million and $1.5 million of funded product
development revenue from Gillette and Johnson & Johnson Consumer Companies, Inc.,
respectively. During 2005, we recognized approximately $2.8 million and $1.6 million of funded product development revenue from Gillette and Johnson &
Johnson Consumer Companies, Inc., respectively. The decrease in funded product development from Gillette during
2006 was the result of the completion of the development phase under the agreement that culminated with FDA
clearance in December 2006.  Upon FDA clearance, Gillette made a $2.5 million payment in December 2006, which
will be recorded as revenue over a 12 month period, as we are obligated to perform additional services and remain
exclusive to Gillette during that period in consideration for this payment.

28






We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. During 2006
and 2005, we recognized approximately $1.3 million and $1.0 million, respectively, of
funded product development revenues from the United States Department of the Army.


Cost
of product revenues. The cost of product revenues increased in absolute dollars, but decreased as a percentage of product revenue to
29% in 2006 from 32% in 2005.  The increase in absolute dollars was attributed to a shift in product mix to the
higher priced StarLux Laser and Pulsed Light System, additional handpieces and a shift in product sales to North
America and by a net decrease in cost of product revenues as a result of a non-recurring adjustment made to
product royalties offset by the write-off of certain customer service loaner inventory.


In
addition, increased sales volume has improved the absorption of fixed manufacturing
overhead at our manufacturing facility as approximately 70% of our manufacturing overhead
cost is fixed in nature and is spread over much higher sales volumes.


Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% in accordance with our license agreement with
Massachusetts General Hospital for each period in comparison to the same periods in 2005.
The increase in the cost of royalty revenues in absolute dollars during 2006 as compared
to 2005 are attributed to the increase in royalty revenue recognized from our licensees.


Research
and development expense. The increase in research and development expense
is a direct result of our spending related to the Johnson & Johnson Consumer
Companies, Inc. agreement and the research contract with the United States Department of
the Army and our continued commitment to introducing new platforms and enhancing our
current family of products, offset by a decrease in spending under the Gillette agreement
in 2006.


For
our research and development agreement with Gillette, costs related to payroll and payroll
related expenses decreased by $698,000, material costs decreased by $484,000 and other
clinical, consulting and overhead expenses decreased by $857,000 as compared to the same
period in 2005.


For
our research agreement with the United States Department of the Army, costs related to
payroll and payroll related expenses increased by $69,000, material costs increased by
$72,000 and other clinical, consulting and overhead expenses increased by $81,000 as
compared to the same period in 2005.


For
our joint development agreement with Johnson & Johnson Consumer Companies, Inc., costs
related to payroll and payroll related expenses increased by $40,000 and material costs,
other clinical, consulting and overhead expenses increased by $314,000 as compared to the
same period in 2005.




Expenses
relating to the introduction of new products, enhancements made to our current family of
products and research and development overhead increased by $4.2 million in comparison to
the same period in 2005. This increase is attributed to increases in payroll and payroll
related expenses, material costs, other clinical, consulting and over-head expenses.


Selling
and marketing expense. The increase in selling and marketing expense is primarily
comprised of $1.8 million from payroll and payroll related expenses, approximately $1.5
million relating to tradeshows, consultants and other sales and marketing infrastructure
costs, $160,000 related to the write-off of certain demo inventory and by an increase of
approximately $1.6 million relating to commission expense in comparison to the same period
in 2005. Domestic commission increased by approximately $2.0 million correlating with our
increased domestic product revenue offset by a decrease of $452,000 in commissions related
to European and Far East commissions.



29






General
and administrative expense.          The decrease in general and administrative dollars is mainly attributed to decreases in our corporate legal
expenses of $3.0 million and other infrastructure costs of approximately $1.2 million offset by increases to
incentive compensation of $2.3 million related to our incentive compensation plan of 2006, an increase in payroll
and payroll related expenses of $711,000, an increase in bad debt expense of $872,000, as compared to the same
period in 2005.  This decrease in legal costs is mainly attributed to the settlement of our patent infringement
lawsuits against Cutera where Cutera reimbursed us approximately $3.8 million (net of payments owed to the
Massachusetts General Hospital) for legal expenses incurred in connection with the patent infringement lawsuits.


Interest
income.          Interest income increased due to the increase in cash balances and the settlement of our patent
infringement lawsuits against Cutera where Cutera paid us approximately $1.2 million (net of what was paid to the
Massachusetts General Hospital) in interest in comparison to the same period in 2005.


Provision
(benefit) for income taxes.          The income tax benefit for fiscal year 2006 was approximately $5.0 million, which consisted of a $7.6
million non-cash federal and state valuation allowance release offset by federal and state income taxes of
approximately $2.6 million.  Based on current and preceding years results of operations and anticipated profit
levels in future periods, we believe that it is more likely than not that our deferred tax assets will be
realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded
against those deferred tax assets. In reaching this conclusion, we weighed both negative and positive evidence
regarding the realizability of these deferred tax assets and considered the extent to which the evidence could be
objectively verified. We expect that in 2007, our effective tax rate will be more in line with combined federal
and state statutory rates.




During
2005, we provided approximately a 3% effective tax rate for anticipated federal
alternative minimum taxes and minimum state income taxes due for 2005.



Year 2005 Compared to
Year 2004


The
following table contains selected income statement information, which serves as the basis
of the discussion of our results of operations for the years ended December 31, 2005 and
2004, respectively (in thousands, except for percentages):


30
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                     | 2005 | 2004    | 2005 to 2004 |     |   |         
|------------------------------------ | ---- | ------- | ------------ | --- | - | --------
|
|
|Revenues:                            |      |         |              |     |   |         
|Product revenues                     |      | $65,824 |              | 86  | % | $ 45,810
|Royalty revenues                     |      | 4,921   |              | 7   | % | 4,052   
|Funded product development revenues  |      | 5,409   |              | 7   | % | 4,570   
|                                     |      |         |              |     |   |         
|Total revenues                       |      | 76,154  |              | 100 | % | 54,432  
|                                     |      |         |              |     |   |         
|Cost and expenses:                   |     
|Cost of product revenues             |      | 20,952  |              | 27  | % | 15,514  
|Cost of royalty revenues             |      | 1,968   |              | 3   | % | 1,621   
|Research & development               |      | 11,339  |              | 15  | % | 9,562   
|Selling & marketing                  |      | 17,234  |              | 23  | % | 11,747  
|General & administrative             |      | 7,907   |              | 10  | % | 6,246   
|                                     |      |         |              |     |   |         
|Total costs and expenses             |      | 59,400  |              | 78  | % | 44,690  
|                                     |      |         |              |     |   |         
|Income from operations               |      | 16,754  |              | 22  | % | 9,742   
|Interest income                      |      | 1,172   |              | 2   | % | 35      
|                                     |      |         |              |     |   |         
|Income before income taxes           |      | 17,926  |              | 24  | % | 9,777   
|Provision (benefit) for income taxes |      | 473     |              | 1   | % | (856    
|                                     |      |         |              |     |   |         
|Net Income                           |      | $17,453 |              | 23  | % | $ 10,633
|                                     |      |         |              |     |   |         

|Product
revenues. Sales of StarLux Laser and Pulsed Light Systems coupled with its additional handpieces were the leading contributor
to our increase in product revenues.  Product revenues were favorably impacted by an increase of 330% in sales
related the StarLux Laser and Pulsed Light System and an increase of 53% in revenue related to customer service
offset by a decrease of 45% related to the other Lux family of products, which includes the MediLux and EsteLux
and their additional handpieces and a decrease of 25% from sales related to the Q-Yag 5 product line as compared to
the same period in 2004.  StarLux product sales increased as more customers opted for these higher powered, faster
and more versatile systems that are capable of utilizing both laser and lamp based applications to treat various
cosmetic conditions. Customer service revenue increased as more and more customers purchased replacement
handpieces.  The decline in revenues from other Lux products was directly attributable to the customer acceptance of
the StarLux 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 29% of total product revenue for the year ended 2005 in
comparison to 37% for the same period in 2004. While international product sales increased
in absolute dollars in 2005 compared to 2004, they declined as a percentage of revenues in
international sales due to the much larger increase in domestic product sales.


Royalty
revenues. During 2005, we received approximately $2.8 million from
sub-licensee payments and approximately $2.2 million from back-owed royalties recorded as
royalty revenue as compared to $1.7 million from sub-licensee payments and approximately
$1.9 million from back-owed royalties recorded as royalty revenue in 2004. Sub-license
revenues increased in 2005 as compared to 2004 due to our sub-licensees increased
product revenues and an over-all general strengthening in our marketplace.


Funded
product development revenues.Funded development revenue increased during
2005 as compared to the same period in 2004. Funded development revenue is generated from
the development agreements with Gillette and Johnson & Johnson Consumer Companies,
Inc., as well as the United States Department of the Army. For the year ended December 31,
2005, we recognized approximately $2.8 million and $1.6 million of funded product
development revenue from Gillette and Johnson & Johnson Consumer Companies, Inc.,
respectively. For the year ended December 31, 2004, we recognized approximately $3.1
million and $318,000 of funded product development revenue from Gillette and Johnson &
Johnson Consumer Companies, Inc., respectively. The Johnson & Johnson Consumer
Companies, Inc. development contract began in October of 2004.


31



We
provide services under a $3.4 million research contract with the United States Department
of the Army to develop a light based self-treatment device for PFB. The contract is a cost
plus fee arrangement whereby we are reimbursed for the expenses incurred in connection
with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs
are incurred and the services are rendered. For the years ended December 31, 2005 and
2004, we recognized approximately $1.0 million and $1.1 million of funded product
development revenues, respectively, from the United States Department of the Army.


Cost
of product revenues.The cost of product revenues increased in absolute dollars, but decreased as a percentage of product
revenue to 32% in 2005 from 34% in 2004.  The increase in absolute dollars is directly attributable to increased
variable costs associated with increased product sales. This cost decreased as a percentage of total revenue
primarily due to a shift in sales mix to the higher priced, higher margin StarLux Laser and Pulsed Light System. The
Lux family of products carry lower manufacturing costs as a result of their modular design.  In addition,
increased sales volume has improved the absorption of fixed manufacturing overhead at our manufacturing facility as
approximately 70% of our manufacturing overhead cost is fixed in nature and is spread over much higher sales
volumes.


Cost
of royalty revenues. As a percentage of royalty revenues, the cost
of royalty revenues was consistent at 40% in accordance with our license agreement with
Massachusetts General Hospital for each period in comparison to the same periods in 2004.
The increase in the cost of royalty revenues in absolute dollars is attributed to our
settlement agreement with Lumenis.


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


For
our research and development agreement with Gillette, costs related to payroll and payroll
related expenses increased by $67,000, material costs increased by $42,000 and other
clinical, consulting and overhead expenses decreased by $194,000 as compared to the same
period in 2004.


For
our research agreement with the United States Department of the Army, costs related to
payroll and payroll related expenses increased by $177,000, material costs decreased by
$165,000 and other clinical, consulting and overhead expenses decreased by $111,000 as
compared to the same period in 2004.


Expenses
relating to the Johnson & Johnson Consumer Companies, Inc. agreement totaled
approximately $1.5 million for the year ended December 31, 2005. The Johnson & Johnson
Consumer Companies, Inc. agreement began in October of 2004 and we incurred minimal
expenses relating to this project in 2004.


Expenses
relating to the introduction of new products, enhancements made to our current family of
products and research and development overhead increased by $462,000 for the twelve months
ended December 31, 2005, in comparison to the same period in 2004.


Selling
and marketing expense. The increase in selling and marketing expense is primarily
comprised of $1.6 million from payroll and payroll related expenses, approximately $2.5
million relating to tradeshows, consultants and other sales and marketing infrastructure
costs, $123,000 related to certain third party demo inventory and by an increase of
approximately $1.3 million relating to commission expense in comparison to the same period
in 2004. Domestic commission increased by approximately $868,000 correlating with our
increased domestic product revenue, European commissions decreased by $47,000, while Far
East commissions increased by approximately $353,000. The increases directly correlate
with our increased revenues, upfront costs associated with both international and domestic
sales force and distribution channel expansion.


General
and administrative expense. The increase in general and administrative
dollars is mainly attributed to increases to incentive compensation of $1.6 million
related to our incentive compensation plan of 2005, a decrease of $134,000 in costs
related to corporate governance as more costs were incurred in 2004 as it was our first
year of complying with Section 404 of the Sarbanes-Oxley Act of 2002,an increase in our
corporate legal expenses of approximately $127,000 and an increase in payroll and payroll
related expenses and other infrastructure costs of approximately $94,000 as compared to
the same period in 2004.

32






Interest
income. Interest income increased due to higher levels of cash on hand as
well as higher interest rates in comparison to the same periods in 2004.


Provision(benefit) for income taxes. During 2005, we provided approximately a
3% effective tax rate for anticipated federal alternative minimum taxes and minimum state
income taxes due for 2005. During 2004, we recognized a benefit from income taxes of
$856,000 as a result of a $1.1 million reduction in deferred income tax accruals
associated with tax deductions in a 1999 state tax return which were no longer required.
Offsetting these benefits, we provided a 3% effective tax rate for anticipated federal
alternative minimum taxes and minimum state income taxes due for 2004. We have net
operating loss carryforwards that can be utilized to offset future income for federal and
state tax purposes. These net operating losses generate a significant deferred tax asset.
However, at this time, we have recorded a valuation allowance against this deferred tax
asset as of December 31, 2005 and 2004 as there was significant uncertainty that we would
be able to fully utilize our net operating losses.



Liquidity and capital
resources


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

|                          |  |  | 2006 to 2005 |        
|------------------------- |  |  | ------------ | -------
|
|Operating cash flows      |  |  | $            | 44,286 
|Investing cash flows      |  |  |              | (29,288
|Financing cash flows      |  |  |              | 11,283 
|Capital expenditures, net |  |  |              | 694    

|Additionally,
our cash and investment position, accounts receivable, inventories and working capital are
shown below for the periods indicated (000s omitted).
|---------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                |  |  | 2006 to 2005 |        
|----------------------------------------------- |  |  | ------------ | -------
|
|Cash and cash equivalents                       |  |  | $            | 36,817 
|Available-for-sale investments, at market value |  |  |              | 67,352 
|Accounts receivable, net                        |  |  |              | 15,443 
|Inventories, net                                |  |  |              | 11,012 
|Working capital                                 |  |  |              | 115,891

|As
of December 31, 2006, we had $104 million in cash and cash equivalents and
available-for-sale investments. We believe that our current cash balances and expected
future cash flows will be sufficient to meet our anticipated cash needs for working
capital, capital expenditures and other activities for at least the next 12 months. As of
December 31, 2006, we had no borrowings or debt.




Cash
provided by operating activities increased for the twelve months ended December 31, 2006
compared to the same period in 2005. This increase primarily reflects the effects of an
increase in net profit, offset by an increase in working capital requirements. Cash used
in investing activities decreased during 2006 compared to the same period in 2005. These
amounts primarily reflect cash used for purchases of property and equipment, purchases of
available-for-sale investments offset by proceeds from the sale of available-for-sale
investments. Cash provided by financing activities increased for the twelve month period
ended December 31, 2006 compared to the same period in 2005. This increase was
primarily due to an increase in exercises of stock options.

33






We
anticipate that capital expenditures for 2007 will total approximately $1 million
consisting primarily of leasehold improvements, machinery, equipment, computers and
peripherals. We expect to finance these expenditures with cash on hand.


Effective
as of February 14, 2003, we 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. (See Note 11 for more information.)


In
the first quarter of 2004, we began providing services under a research contract with the
United States Department of the Army to develop a light based self-treatment device for
PFB. (See Note 13 for more information.)


On
June 17, 2004, we reached a settlement agreement with Lumenis resolving on-going
litigation concerning both patent infringement and contractual matters. (See Note 15 for
more information.)


Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson Consumer Companies, Inc. to develop and commercialize home-use,
light based devices in the fields of (i) reducing or reshaping body fat including
cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.
(See Note 12 for more information.)


On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc.
through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.  (See Note 16 for more
information.)


On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and
terminated our prior license agreement with them. (See Note 17 for more information.)


On
November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc. (See Note 18 for more information.)



Contractual obligations


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


We
are a party to a license agreement, as amended, with Massachusetts General Hospital
whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of
certain products as well as 40% of royalties received from third parties. Royalty expense
in 2006 totaled approximately $13.5 million.


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


On
January 18, 2006, we signed an amendment to our lease to add an additional 12,000 square
feet. Rent expense, including this new lease, will total approximately $1.165 million per
year, expiring in August of 2009.




The
following table summarizes our estimated contractual cash obligations as of December 31,
2006, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (000s omitted):
34
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                              | Payments due by period |          |  |        | 
|----------------------------- | ---------------------- | -------- |  | ------ | 
|
|Operating lease               |                        | $  3,107 |  | $1,165 | 
|Purchase commiments           |                        | 7,854    |  | 7,854  | 
|                              |                        |          |  |        | 
|Total contractual obligations |                        | $10,961  |  | $9,019 | 
|                              |                        |          |  |        | 

|Recently issued
accounting standards


In
June 2006, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes an
interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting
for uncertainty in income taxes recognized in an enterprises financial statements in
accordance with Statement of Financial Accounting Standards (SFAS) 109, Accounting
for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or expected to
be taken in a tax return. FIN 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48
is effective for fiscal years beginning after December 15, 2006. We are currently
analyzing FIN 48 and believe the adoption of FIN 48 will not have a material impact on our
financial condition, results of operations or liquidity.



In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No.
157).  This Statement defines fair value, establishes a framework for measuring fair
value and expands disclosure of fair value measurements.  SFAS No. 157 applies under
other accounting pronouncements that require or permit fair value measurements and
accordingly, does not require any new fair value measurements.  SFAS No. 157 is
effective for financial statements issued for fiscal years beginning after November 15,
2007.  We are currently analyzing SFAS No. 157 and believe the adoption of SFAS No.
157 will not have a material impact on our financial condition, results of operations or
liquidity.





Item 7A. Quantitative
and Qualitative Disclosures About Market Risk


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








Item 8. Financial
Statements and Supplementary Data.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| |                                                                                                     |  | Page
| | --------------------------------------------------------------------------------------------------- |  | ----
| | Report of Independent Registered Public Accounting Firm                                             |  | 36  
| | Consolidated Balance Sheets - December 31, 2006 and 2005                                            |  | 37  
| | Consolidated Statements of Income - Years ended December 31, 2006, 2005
     and 2004               |  | 38  
| | Consolidated Statements of Stockholders' Equity - Years ended December 31, 2006,
     2005 and 2004 |  | 39  
| | Consolidated Statements of Cash Flows - Years ended December 31, 2006, 2005
     and 2004           |  | 40  
| | Notes to Consolidated Financial Statements                                                          |  | 41  

|35


Report of Independent
Registered Public Accounting Firm



The Board of Directors
and Stockholders



Palomar Medical
Technologies, Inc.:


We have audited the accompanying
consolidated balance sheets of Palomar Medical Technologies, Inc. and subsidiaries as of
December 31, 2006 and 2005, and the related consolidated statements of income,
stockholders equity, and cash flows for each of the three years in the period ended
December 31, 2006. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements
based on our audits.


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


In our opinion, the financial
statements referred to above present fairly, in all material respects, the consolidated
financial position of Palomar Medical Technologies, Inc. and subsidiaries at December 31,
2006 and 2005, and the consolidated results of its operations and its cash flows for each
of the three years in the period ended December 31, 2006, in conformity with U.S.
generally accepted accounting principles.


As discussed in Note 1 to the
consolidated financial statements, on January 1, 2006, the Company adopted the provisions
of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment,
which requires the Company to recognize expense related to the fair value of share-based
compensation awards.


We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of Palomar Medical Technologies Inc.s internal control over financial
reporting as of December 31, 2006, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated March 5, 2007 expressed an unqualified opinion
thereon.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 5, 2007         |                      

|36


Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated Balance
Sheets
|------------------------------------------------------------------------------------

|                                                                                          | December 31,
2006 | December 31,
2005
|----------------------------------------------------------------------------------------- | ----------------- | -----------------
|Assets                                                                                    |                   |                  
|Current assets:                                                                           |                   |                  
|Cash and cash equivalents                                                                 |                   |                  
|Available-for-sale investments, at market value                                           |                   |                  
|Accounts receivable, net of allowance of $950,000 and $984,392,              respectively |                   |                  
|Inventories                                                                               |                   |                  
|Deferred tax assets                                                                       |                   |                  
|Other current assets                                                                      |                   |                  
|                                                                                          |                   |                  
|Total current assets                                                                      |                   |                  
|                                                                                          |                   |                  
|Property and equipment, net                                                               |                   |                  
|                                                                                          |                   |                  
|Other assets                                                                              |                   |                  
|                                                                                          |                   |                  
|Total Assets                                                                              |                   |                  
|                                                                                          |                   |                  
|Liabilities and Stockholders' Equity                                                      |                   |                  
|Current liabilities:                                                                      |                   |                  
|Accounts payable                                                                          |                   |                  
|Accrued liabilities                                                                       |                   |                  
|Deferred revenue                                                                          |                   |                  
|                                                                                          |                   |                  
|Total current liabilities                                                                 |                   |                  
|                                                                                          |                   |                  
|Commitments and Contingencies (Note 7)                                                    |                   |                  
|                                                                                          |                   |                  
|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 - 18,063,103 and 17,126,467 shares, respectively                                   |                   |                  
|Additional paid-in capital                                                                |                   |                  
|Accumulated deficit                                                                       |                   |                  
|                                                                                          |                   |                  
|Total stockholders' equity                                                                |                   |                  
|                                                                                          |                   |                  
|Total liabilities and stockholders equity                                                |                   |                  
|                                                                                          |                   |                  

|See
accompanying notes to consolidated financial statements.

37



Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated
Statements of Income
|---------------------------------------------------------------------------------------------------------------------------------------------------------

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

|See
accompanying notes to consolidated financial statements.


38


Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated
Statements of Stockholders Equity
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                            | Common Stock |  |  |            | 
|----------------------------------------------------------- | ------------ |  |  | ---------- | 
|
|Balance, December 31, 2003                                  |              |  |  | 14,554,407 | 
|Net income                                                  |              |  |  | --         | 
|Issuance of stock for employee stock purchase plan          |              |  |  | 20,052     | 
|Issuance of stock for employer 401(k) matching contribution |              |  |  | 50,156     | 
|Costs incurred related to the issuance of common stock      |              |  |  | --         | 
|Tax benefit from the exercise of stock options              |              |  |  | --         | 
|Exercise of warrants                                        |              |  |  | 38,000     | 
|Exercise of stock options                                   |              |  |  | 1,568,887  | 
|                                                            |              |  |  |            | 
|Balance, December 31, 2004                                  |              |  |  | 16,231,502 | 
|                                                            |              |  |  |            | 
|Net income                                                  |              |  |  | --         | 
|Issuance of stock for employer 401(k) matching contribution |              |  |  | 11,124     | 
|Costs incurred related to the issuance of common stock      |              |  |  | --         | 
|Tax benefit from the exercise of stock options              |              |  |  | --         | 
|Exercise of warrants                                        |              |  |  | 50,000     | 
|Exercise of stock options                                   |              |  |  | 833,841    | 
|                                                            |              |  |  |            | 
|Balance, December 31, 2005                                  |              |  |  | 17,126,467 | 
|                                                            |              |  |  |            | 
|Net income                                                  |              |  |  | --         | 
|Issuance of stock for employer 401(k) matching contribution |              |  |  | 9,355      | 
|Costs incurred related to the issuance of common stock      |              |  |  | --         | 
|Tax benefit from the exercise of stock options              |              |  |  | --         | 
|Exercise of warrants                                        |              |  |  | 55,000     | 
|Exercise of stock options                                   |              |  |  | 872,281    | 
|Stock-based compensation expense                            |              |  |  | --         | 
|                                                            |              |  |  |            | 
|Balance, December 31, 2006                                  |              |  |  | 18,063,103 | 
|                                                            |              |  |  |            | 

|See
accompanying notes to consolidated financial statements.


39


Palomar Medical
Technologies, Inc. and Subsidiaries Consolidated
Statements of Cash Flows
|-------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                        | Years Ended December 31, |  |  
|--------------------------------------------------------------------------------------- | ------------------------ |  | -
|
|Cash flows from operating activities:                                                   |                          |  |  
|Net income                                                                              |                          |  | $
|                                                                                        |                          |  |  
|Adjustments to reconcile net income  to net cash provided by      operating activities: |                          | 
|Depreciation and amortization                                                           |                          |  |  
|Stock-based compensation expense                                                        |                          |  |  
|Provision for bad debt                                                                  |                          |  |  
|Inventory write-off                                                                     |                          |  |  
|Changes in assets and liabilities:                                                      |                          | 
|Accounts receivable                                                                     |                          |  |  
|Inventories                                                                             |                          |  |  
|Deferred tax assets                                                                     |                          |  |  
|Other current assets                                                                    |                          |  |  
|Accounts payable                                                                        |                          |  |  
|Accrued liabilities                                                                     |                          |  |  
|Deferred income taxes                                                                   |                          |  |  
|Deferred revenue                                                                        |                          |  |  
|                                                                                        |                          |  |  
|Net cash from operating activities                                                      |                          |  |  
|                                                                                        |                          |  |  
|                                                                                        |                          |  |  
|Cash flows used in investing activities:                                                |                          | 
|Purchases of property and equipment                                                     |                          |  |  
|Purchases of available-for-sale investments                                             |                          |  |  
|Proceeds from sale of available-for-sale investments                                    |                          |  |  
|                                                                                        |                          |  |  
|Net cash used in investing activities                                                   |                          |  |  
|                                                                                        |                          |  |  
|Cash flows from financing activities:                                                   |                          | 
|Proceeds from the exercise of stock options and warrants                                |                          |  |  
|Tax benefit from the exercise of stock options                                          |                          |  |  
|Costs incurred related to issuance of common stock                                      |                          |  |  
|                                                                                        |                          |  |  
|Net cash from 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 income taxes                                                              |                          |  | $
|                                                                                        |                          |  |  
|                                                                                        |                          |  |  
|Supplemental disclosure of noncash financing and investing activities:                  |                          | 
|Issuance of stock for employer 401(k) matching contribution                             |                          |  | $
|                                                                                        |                          |  |  
|                                                                                        |                          |  |  

|See
accompanying notes to consolidated financial statements.

40



Palomar Medical
Technologies, Inc. and Subsidiaries Notes to Consolidated
Financial Statements



Note 1  Summary of
Significant Accounting Policies



Business


We
are engaged in research, development, manufacturing and distribution of proprietary laser
and lamp (light based) systems for cosmetic treatments.



Basis of Presentation


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



Reclassifications


Beginning
in 2006 certain expenses previously reported as research and development expenses and
selling and marketing expenses are reported as general and administrative expenses.
Accordingly, such amounts from previous years have been reclassified in the accompanying
financial statements to conform to the current year presentation.



Use of Estimates


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


In
the ordinary course of accounting for the items discussed above, we makes changes in
estimates as appropriate, and as we become aware of circumstances surrounding those
estimates. Such changes and refinements in estimation methodologies are reflected in
reported results of operations in the period in which the changes are made and, if
material, their effects are disclosed in the Notes to the Consolidated Financial
Statements.



Cash and Cash Equivalents


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



Investments Securities
Available-For-Sale


Investment
securities, which primarily consist of state and municipal auction rate securities and
variable rate demand obligations, are classified as available for sale under
provisions of Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities and are recorded at fair value. We
invest in short-term investments that are generally highly liquid. Any unrealized gains
and losses, net of income tax effects, would be computed on the basis of specific
identification and reported as a component of Accumulated Other Comprehensive Income
(Loss) in our Consolidated Statements of Stockholders Equity. Substantially all of
our short-term investments have contractual maturities of twelve months or less. Because
of the short term to maturity, amortized costs approximate fair values for all of these
securities. Unrealized gains and losses for 2006, 2005 and 2004 were not material.



Accounts Receivable
Reserve

41






We
maintain an allowance for losses resulting from the inability of our customers to make
required payments. We regularly evaluate the collectibility of our 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 us, we record a specific allowance to reduce the related receivable
to the amount that we expect to recover given all information present. 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 a 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 affected.
Accounts receivable allowance activity consisted of the following for the years ended
December 31, 2006, 2005 and 2004, respectively.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,              | 2006 | 2005 | 2004
|---------------------------- | ---- | ---- | ----
|Balance at beginning of year |      |      | $   
|Additions                    |      |      |     
|Deductions                   |      |      |     
|                             |      |      |     
|Balance at end of year       |      |      | $   
|                             |      |      |     

|Inventories


Inventories
are valued at the lower of cost (first in, first-out method) or market, and includes
material, labor and manufacturing overhead. At December 31, 2006 and 2005, inventories
consisted of the following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2006        | 2005        
|--------------- | ----------- | ------------
|Raw materials   | $4,669,750  | $  2,485,550
|Work in process | 1,998,420   | 1,170,862   
|Finished goods  | 4,343,540   | 3,096,698   
|                |             |             
|                | $11,011,710 | $6,753,110  
|                |             |             

|Our
policy is to establish inventory reserves when conditions exist that suggest that
inventory may be in excess of anticipated demand or is obsolete based upon assumptions
about future demand for products and market conditions. Included in our finished goods
inventory are $1,180,634 in 2006 and $952,832 in 2005 of demonstration products that are
used by our sales organization. We account for such products as we do with any other
finished goods item in our inventory in accordance with the review of our entire
inventory. We regularly evaluate 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 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 costs as cost of goods sold at the
time of such determination. Although we perform a detailed review of our forecasts of
future product demand, any significant unanticipated changes in this demand could have a
significant impact on the value of our inventory and our reported operating results.



Property and Equipment


Property
and equipment are recorded at cost. Repairs and maintenance costs are expensed as
incurred. Depreciation and amortization are provided using the straight-line method over
the estimated useful lives of property and equipment. At December 31, 2006 and 2005,
property and equipment consist of the following:



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

|At December 31,               | 2006       | 2005        | Estimated
useful life                            
|----------------------------- | ---------- | ----------- | -------------------------------------------------
|Machinery and equipment       | $1,759,984 | $1,536,879  | 3 - 8 years                                      
|Furniture and fixtures        | 2,516,408  | 2,146,247   | 5 years                                          
|Leasehold improvements        | 394,330    | 293,555     | Shorter of estimated useful life or term of lease
|                              |            |             |                                                  
|                              | 4,670,722  | 3,976,681  
|Less accumulated depreciation | 3,540,737  | 3,067,005  
|                              |            |             |                                                  
|Total                         | $1,129,985 | $   909,676
|                              |            |             |                                                  

|Revenue Recognition


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


Periodically,
we sell products together with a product upgrade option that requires that the customer
pay an upgrade fee at the time of exercise, has no refund provisions and includes an
expiration date on the upgrade option. In accordance with EITF 00-21, we defer the fair
value ascribed to the upgrade option until the expiration of the upgrade option or the
exercise of the upgrade option and shipment of the product upgrade.


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


We
generally recognize royalty revenue from licensees upon receipt of cash payments since the
royalty amounts are not determinable at the end of a quarter. Licensees are obligated to
make payments between 30 and 45 days after the end of each quarter. If at the end of a
quarter, royalty revenue from licenses are determinable we record royalty revenue during
the period earned. Periodically, as we sign on new licensees, in the period determinable
and earned we recognize back-owed royalties. We have the right under our license
agreements to engage independent auditors to review the royalty calculations. The amounts
owed as a result of these audits may be higher or lower than previously recognized.


We
account for funded development revenue from Gillette and Johnson & Johnson Consumer
Companies, Inc. in accordance with the work plan that was developed with both Gillette and
Johnson & Johnson Consumer Companies, Inc. Revenue is recognized under the contracts
as costs are incurred and services are rendered. Any amounts received in advance of costs
incurred and services rendered from Gillette or Johnson & Johnson Consumer Companies,
Inc are recorded as deferred revenue.As of December 31, 2006, we have deferred
$2.3 million and $63,000 relating to Gillette and Johnson & Johnson Consumer
Companies, Inc., respectively.Payments are not refundable if the development is
not successful. During 2006, we recognized approximately $1.1 million and $1.4 million of
funded product development revenue from Gillette and Johnson & Johnson Consumer
Companies, Inc., respectively. During 2005, we recognized approximately $2.8 million and
$1.6 million of funded product development revenue from Gillette and Johnson & Johnson
Consumer Companies, Inc., respectively. During 2004, we recognized approximately $3.1
million and $318,000 of funded product development revenue from Gillette and Johnson &
Johnson Consumer Companies, Inc., respectively.






43


We
provide services under a $3.8 million research contract with the United States Department
of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized
under the contract as the costs are incurred and the services are rendered. Our revenue
from the contract is subject to government audit. During 2006, 2005 and 2004, we
recognized approximately $1.3, $1.0 million and $1.1 million, respectively, of funded
product development revenues from the United States Department of the Army.


In
accordance with EITF 00-10, reimbursed shipping and handling costs are included in revenue
with the offsetting expense included in selling and marketing. Included in revenues are
$304,000, $249,000 and $208,000 of reimbursed shipping and handling costs during 2006,
2005 and 2004, respectively.



Product Warranty Costs


We
typically offer a one-year warranty for all of our base products. We provide for the estimated
cost of product warranties at the time product revenue is recognized. Factors that affect
our warranty reserves include the number of units sold, historical and anticipated rates
of warranty repairs and the cost per repair. We assess the adequacy of the warranty
provision and we may adjust this provision if necessary.


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 sheets for the
years ended December 31, 2006 and 2005.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                     | 2006 | 2005
|--------------------------------------------------- | ---- | ----
|Warranty accrual, beginning of year                 |      |     
|Charged to costs and expenses relating to new sales |      |     
|Costs of product warranty claims                    |      |     
|                                                    |      |     
|Warranty accrual, end of year                       |      |     
|                                                    |      |     

|Research and Development
Expenses


We
charge research and development expenses to operations as incurred.



Advertising costs


Advertising
costs are included as part of selling and marketing expense and are expensed as incurred.
Advertising expense for the years end December 31, 2006, 2005 and 2004, were $485,000,
$347,000 and $250,000, respectively.



Net Income per Common
Share


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

|At December 31,                                                | 2006       | 2005       | 2004      
|-------------------------------------------------------------- | ---------- | ---------- | ----------
|Basic weighted average common shares outstanding               | 17,519,242 | 16,831,185 | 15,688,855
|Potential common shares pursuant to stock options and warrants | 2,689,445  | 2,327,153  | 2,031,006 
|                                                               |            |            |           
|Diluted weighted average common shares outstanding             | 20,208,687 | 19,158,338 | 17,719,861
|                                                               |            |            |           

|44






For
the years ended December 31, 2006 and 2005, all potential shares related to outstanding
stock options and warrants were included in diluted weighted average shares outstanding.
In 2004, we had 14,672 shares that were not included in diluted weighted average shares
outstanding as they were antidilutive.





Stock based
compensation


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


On
January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as
permitted under SFAS 123(R). Under this transition method, compensation cost recognized in
2006 includes compensation cost for all share-based payments granted prior to but not yet
vested as of December 31, 2005, based on the grant-date fair value estimated in accordance
with the provisions of SFAS 123. In accordance with the modified prospective method of
adoption, our results of operations and financial position for prior periods have not been
restated.


Our
income before taxes and net income was $462,067 lower for the twelve months ended December
31, 2006 as a result of stock-based compensation expense as a result of the adoption of
SFAS 123(R). The compensation expense reduced both basic and diluted earnings per share by
$0.03 and $0.02, respectively. As of December 31, 2006, there was $16,105 of unrecognized
compensation expense related to non-vested market-based share awards.


Prior
to December 31, 2005, we followed the provisions of SFAS No. 123, Accounting
for Stock-Based Compensation. The provisions of SFAS No. 123 allowed companies to
either expense the estimated fair value of stock options or to continue to follow the
intrinsic value method set forth in Accounting Principles Board Opinion (APB 25), but
disclose the pro forma effects on net income had the fair value of the options been
expensed. We elected to apply APB 25 in accounting for our stock option incentive plans.


In
accordance with APB 25 and related interpretations, compensation expense for stock options
was recognized based on the excess, if any, of the quoted market price of the stock at the
grant date of the award or other measurement date over the amount an employee must pay to
acquire the stock. Generally, the exercise price for stock options granted to employees
was equal to the fair market value of our common stock at the date of grant, thereby
resulting in no recognition of compensation expense by us prior to December 31, 2005.


Had
compensation cost for our stock option plans been determined based on the fair value
method set forth in SFAS No. 123 during the prior years, our net income and basic and
diluted net income per common share would have been changed to the pro forma amounts
indicated below:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                | 2005 | 2004
|---------------------------------------------- | ---- | ----
|Net income, as reported                        |      |     
|Add: Stock-based compensation included in      |      |     
|reported net income                            |      |     
|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                                      |      |     

|There
were no options granted during the twelve months ended December 31, 2006.


45






On
May 11, 2005, we granted 645,000 options that were also fully vested in 2005 to
employees and directors with exercise prices equal to fair market value on the date of
grant of $24.63, and expire ten years from the date of grant. Of the $8,284,820 pro forma
expense in 2005, $7,568,817 relates to these options. In accordance with newly issued SFAS
123(R), had we granted these options with longer time-based vesting, we would have
incurred significant stock-based payment expenses in future years upon adoption of SFAS
123 (R).





We
granted 1,968,000 options in 2004 that were also fully vested in 2004 to employees and
directors with exercise prices equal to fair market value on the date of grant, ranging
from $13.66 to $26.00, and expire ten years from the date of grant. Of the $18,476,383 pro
forma expense in 2004, $17,623,462 relates to these options. In accordance with newly
issued SFAS 123(R), had we granted these options with longer time-based vesting. We would
have incurred significant stock-based payment expenses in future years upon adoption of
SFAS 123(R).


We granted 1,440,000 performance based options in 2004 to employees and directors with exercise prices
equal to fair market value on the date of grant of $16.53, and expire ten years from the date of grant. 815,000 of
these options vest upon the Launch Decision, and 625,000 of these options vest twelve months after the Launch
Decision, of Gillette to continue commercialization of a patented home-use, light based hair removal device for
women pursuant to our Development and License Agreement with them dated February 14, 2003.  As of December 31, 2006,
1,365,000 unvested performance based options are outstanding, consisting of 775,000 of the options that will only
vest upon the Launch Decision, and 590,000 of the options that will only vest twelve months after the Launch
Decision, of Gillette to continue commercialization of a patented home-use, light based hair removal device for
women pursuant to our Amended and Restated Development and License Agreement with them, executed February 14, 2007
and effective as of February 14, 2003.  We will incur a stock-based payment expense upon the vesting of these
performance based options.


We
use the Black-Scholes option pricing model to calculate the grant-date fair value of an
award. Key input assumptions used to estimate the fair value of stock options include the
exercise price of the award, the expected option term, the expected volatility of our
stock over the options expected term, the risk-free interest rate over the
options expected term and our expected annual dividend yield. Expected volatilities
are based on historical volatilities of our common stock and other factors; the expected
life represents the weighted average period of time that options granted are expected to
be outstanding giving consideration to vesting schedules and our historical exercise
patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at
the time of grant for periods corresponding with the expected life of the option. The fair
value of each option was estimated on the grant date using the Black-Scholes
option-pricing model with the following assumptions:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                            | 2005        | 2004          
|---------------------------------------------------------- | ----------- | --------------
|Risk-free interest rate                                    | 3.57%       | 2.55%         
|Expected dividend yield                                    | --          | --            
|Expected lives                                             | 2 years     | 2 years       
|Expected volatility                                        | 86%         | 100%          
|Grant date fair value of options granted during the period | $     11.73 | $         8.99

|Based on our historical turnover rates, we assumed an annual estimated forfeiture rate of zero when we
calculated the estimated compensation cost for the year ended December 31, 2006. A recovery of prior expense will
be recorded if the actual forfeitures are higher than estimated. Prior to the adoption of SFAS 123(R),
forfeitures were not estimated at the time of award.







Prior
to the adoption of SFAS 123(R), we presented all tax benefits of deductions from the
exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS
123(R) requires the cash flows resulting from the tax benefits resulting from tax
deductions in excess of compensation cost recognized for those options to be classified as
financing cash flows.



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 us to credit risk consist primarily of cash and cash equivalents,
available-for-sale securities and accounts receivable. We place cash and cash equivalents
and available-for-sale securities in established financial institutions. We have no
significant off-balance-sheet risk or concentration of credit risk, such as foreign
exchange contracts, options contracts or other foreign hedging arrangements. Our 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. We
maintain an allowance for potential credit losses. Our accounts receivable credit risk is
not concentrated within any one geographic area. We have 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
our accounts receivable.



46







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, 2006
and 2005, financial instruments consisted principally of cash, cash equivalents,
available-for-sale securities and accounts receivable. The fair value of financial
instruments pursuant to SFAS No. 107 approximated their carrying values at December 31,
2006 and 2005. Fair values have been determined through information obtained from market
sources and management estimates.



Comprehensive Income


SFAS
No. 130, Reporting Comprehensive Income, establishes standards for reporting and
displaying comprehensive income and its components in the consolidated financial
statements. Comprehensive income is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances from
non-owner sources. Comprehensive income is the same as net income for all periods
presented.



Income Taxes


We
account for income taxes using an asset and liability approach that requires the
recognition of deferred tax assets and liabilities for the expected future tax
consequences of events that have been recognized in the financial statements or tax
returns. In estimating future tax consequences, all expected future events are considered
other than enactments of changes in tax laws or rates. Valuation allowances are
established as necessary to reduce deferred tax assets in the event that realization of
the assets is considered unlikely.


Recently issued accounting standards

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement No. 109 (FIN 48). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in
accordance with Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes. FIN 48
prescribes a recognition threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently analyzing FIN 48 and
believe the adoption of FIN 48 will not have a material impact on our financial condition, results of operations
or liquidity.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No. 157).  This Statement
defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value
measurements.  SFAS No. 157 applies under other accounting pronouncements that require or permit fair value
measurements and accordingly, doe s not require any new fair value measurements. SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15, 2007.  We are currently analyzing SFAS
No. 157 and believe the adoption of SFAS No. 157 will not have a material impact on our financial condition,
results of operations or liquidity.




47




Note 2  Segment
and Geographic Information


In
accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, operating segments are identified as components of an enterprise about
which separate discrete financial information is available for evaluation by the chief
operating decision maker, or decision-making group, in making decisions how to allocate
resources and assess performance. Our chief decision-maker, as defined under SFAS No. 131,
is a combination of the Chief Executive Officer and the Chief Financial Officer. To date,
we have viewed our operations and manage our business as principally one segment, medical
and cosmetic products and services, and our 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 our principal operating segment.


The
following table represents percentages of product revenue by geographic destination for
2006, 2005 and 2004:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2006 | 2005 | 2004
|------------------------- | ---- | ---- | ----
|United States             |      | 75   | %   
|Japan                     |      | 3    | %   
|Canada                    |      | 8    | %   
|Europe                    |      | 6    | %   
|Australia                 |      | 1    | %   
|Asia / Pacific            |      | 5    | %   
|South and Central America |      | 2    | %   
|                          |      |      |     
|Total                     |      | 100  | %   

|Note 3  Research
and Development Arrangement


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





Note 4  Income
Taxes


We
provide 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 income consists of the following:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2006 | 2005 | 2004
|--------------- | ---- | ---- | ----
|Federal:        |      |      |     
|Current         |      |      | $   
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|State:          |      |     
|Current         |      |      |     
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|                |      |      |     
|Total           |      |      | $   
|                |      |      |     

|A
reconciliation of the federal statutory rate to our effective tax rate is as follows:
48
|------------------------------------------------------------------------------------------

|At December 31,                                               | 2006 | 2005  | 2004
|------------------------------------------------------------- | ---- | ----- | ----
|Income tax provision at federal statutory rate                |      | 35.0  | %   
|Increase (decrease) in tax resulting from-                    |     
|State income taxes, net of federal benefit                    |      | 2.4   |     
|Change in valuation allowance, net operating loss utilization |      | (49.0 | )   
|Reduction in tax reserves                                     |      | --    |     
|Other                                                         |      | 1.2   |     
|                                                              |      |       |     
|Provision (benefit) for income taxes                          |      | (10.4 | %)  
|                                                              |      |       |     

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

|At December 31,                   | 2006 | 2005
|--------------------------------- | ---- | ----
|Net operating loss carry forwards |      |     
|Nondeductible accruals            |      |     
|Nondeductible reserves            |      |     
|Tax credits                       |      |     
|                                  |      |     
|Deferred tax assets               |      |     
|Valuation allowance               |      |     
|                                  |      |     
|Total                             |      |     
|                                  |      |     

|Under SFAS No. 109 Accounting for Income Taxes, we can only recognize a deferred tax asset for future
benefit of our tax loss, temporary differences 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, we considered
numerous factors, including historical profitability, estimated future taxable income and the industry in which
we operate.  Based on current and preceding years results of operations and anticipated profit levels, we believe
that our deferred tax asset is more likely than not realizable.  The change in the valuation allowance between
2005 and 2006 is due primarily to utilization of net operating losses in 2006 and that the deferred tax asset was
fully realizable.




In
addition to the tax assets described above, we have deferred tax assets totaling $25
million, resulting from the exercise of employee stock options. In accordance with SFAS
No. 109 and SFAS No. 123R, recognition of these assets would occur upon utilization
of these deferred tax assets to reduce taxes payable and would result in a credit to
additional paid-in capital within stockholders equity rather than the provision for
income taxes. For 2006, 2005 and 2004 the impact to paid-in capital resulting from the
exercise of employee stock options was $1.2 million, $180,000 and $191,000, respectively.
As part of the adoption of Statement 123(R), we have chosen to derecognize our
deferred tax asset and the related valuation allowance resulting from the excess tax
benefit of stock options.


At
December 31, 2006, we 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 $78 million and $2.0 million, respectively, to be used to offset
future taxable income. These net operating loss carry forwards will expire through 2024.


We
establish reserves based on managements assessment of exposure associated with
permanent tax differences and tax credits. The tax reserves are analyzed periodically and
adjustments are made, as events occur to warrant adjustment to the reserve. We recorded a
reversal of previously provided state income taxes of $1.1 million in 2004 relating to the
sale of a subsidiary as a result of the closing of certain statutory periods for assessing
tax for such transaction.



Note 5  401(k) Plan


We
have 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 our discretion, we may make a matching contribution in
cash or our common stock up to 50% of all employee contributions in each plan year. Our
contributions to our employees vest over a three-year period from date of hire.



49






During
2006, 2005 and 2004, we matched in Palomar common stock 50% of all employee contributions
by issuing 9,355, 11,124 and 50,156 shares of common stock, respectively, to the 401(k)
Plan in satisfaction of our employer match for employee contributions. The number of
shares of common stock reserved for issuance under the 401(k) Plan was initially 1,000,000
shares. As of December 31, 2006, 280,450 shares of common stock remained available for
issuance there under.



Note 6  Accrued
Liabilities


At
December 31, 2006 and 2005,accrued liabilities consisted of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2006 | 2005        
|----------------------------- | ---- | ------------
|Payroll and employee benefits |      | $  7,207,167
|Commissions                   |      | 1,599,915   
|Royalties                     |      | 3,929,007   
|Warranties                    |      | 1,120,420   
|Other                         |      | 1,941,567   
|                              |      |             
|Total                         |      | $15,798,076 
|                              |      |             

|Note 7 
Commitments and Contingencies



Operating lease and
purchase commitments


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



On
January 18, 2006, we signed an amendment to this lease to add an additional 12,000 square
feet. Rent expense, including this new lease, will total approximately $1.165 million per
year, expiring in August of 2009.


The
following table summarizes our estimated contractual cash obligations as of December 31,
2006, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,      | 2007       | 2008            | 2009         | 2010        | 2011    | Thereafter  
|-------------------- | ---------- | --------------- | ------------ | ----------- | ------- | ------------
|Purchase commitments | $7,854,000 | $            -- | $         -- | $        -- | $    -- | $         --
|Operating lease      | 1,165,000  | 1,165,000       | 777,000      | --          | --      | --          
|                     |            |                 |              |             |         |             
|Total                | $9,019,000 | $1,165,000      | $777,000     | $        -- | $    -- | $         --
|                     |            |                 |              |             |         |             

|We
incurred rent expense of $1,147,000, $1,074,000 and $1,053,000 for the years ended
December 31, 2006, 2005 and 2004, respectively.



Royalties


We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby we are
obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as 40% of
royalties received from third parties related to certain patents.  For the years ended December 31, 2006, 2005 and
2004, approximately $13,465,000, $3,690,000 and $2,818,000 of royalty expense, respectively, was incurred under this
agreement.



Litigation



50






On
February 15, 2002 and April 7, 2005, we commenced actions for patent infringement in the
United States District Court for the District of Massachusetts against Cutera, Inc.
seeking both monetary damages and injunctive relief. The Massachusetts General Hospital in
Boston, Massachusetts was added as a plaintiff in these lawsuits. In the first suit,
Cuteras CoolGlide Laser Systems, including the CoolGlide CV, Excel, Vantage and Xeo,
were alleged to infringe U.S. Patent No. 5,735,844. In the second lawsuit, Cuteras
Lamp Systems, including the CoolGlide Xeo and Solera Opus platforms using the PW770
handpiece, were alleged to infringe both the 5,735,844 Patent as well as U.S. Patent No.
5,595,568 (the Anderson Patents). We have an exclusive license to these
patents from the Massachusetts General Hospital.


On
June 5, 2006, we announced the resolution of our patent infringement lawsuits against
Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.
Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to
the Anderson Patents (U.S. Patent Nos. 5,595,568 & 5,735,844) in the professional
field, excluding the consumer field which is exclusively licensed to Gillette. Cutera
admitted that their products infringe the Anderson Patents and that these patents are
valid and enforceable. In addition, Cutera agreed not to challenge the infringement,
validity and enforceability of the Anderson Patents in the future. Cutera paid us an
estimated payment for royalties due on past sales of their laser- and lamp-based
hair removal systems beginning with their initial sales in 2000 through March 31, 2006,
interest and reimbursement of our legal costs. The final amounts due to us were subject to
an audit by an independent accounting firm which was completed in the fourth quarter of
2006. Starting on April 1, 2006, Cutera began paying us a royalty on sales of its
existing light-based hair removal systems, and Cutera will pay us a  royalty on sales
of its later developed light-based hair removal systems.


For
more information, please see the Settlement Agreement, the Non-Exclusive Patent License Agreement, the Consent
Judgments and Stipulations of Dismissal filed as Exhibits 99.1, 99.2, 99.3 and 99.4 to a
Current Report on our Form 8-K filed June 5, 2006.


On
July 7, 2006, we commenced an action for patent infringement against Alma Lasers, Inc. in
the United States District Court for the District of Massachusetts seeking both monetary
damages and injunctive relief. The complaint alleges Almas Harmony, Soprano and
Sonata Systems which use pulsed light and laser technology for hair removal willfully
infringe the Anderson Patents, which are exclusively licensed to us by the Massachusetts
General Hospital. On July 27, 2006, we filed an amended complaint including an additional
claim against Alma for unfair competition due to infringement by Almas Harmony
System of the distinctive trade dress of our products, including the unique, distinctive,
and immediately recognizable design of our EsteLux, MediLux and StarLux Systems
(Palomars Trade Dress). We are seeking both monetary and injunctive
relief on the new claim. Alma answered the complaint denying that its products infringe
valid claims of the asserted patents and our Trade Dress and filing a counterclaim seeking
a declaratory judgment that the asserted patents are invalid and not infringed. We filed a
reply denying the material allegations of the counterclaims. Both this lawsuit and Palomar
v Candela (described below) have been transferred to Judge Rya Zobel, the Judge who
presided over Palomar v Cutera, Inc. Alma, Palomar and Candela have agreed to a joint
Markman Hearing for both lawsuits, currently scheduled for August 2, 2007, and to follow
the discovery schedule set in Palomar v. Candela. The current schedule has the parties
ready for trial by June 2008 though no trial date has yet been set. We filed an amended
complaint on February 22, 2007 to add the Massachusetts General Hospital as a plaintiff
and to further allege that Almas new Soprano XL system infringes the Anderson
Patents.




On
August 9, 2006, we commenced an action for patent infringement against Candela Corporation
in the United States District Court for the District of Massachusetts seeking both
monetary damages and injunctive relief. The complaint alleges Candelas GentleYAG and
GentleLASE systems which use laser technology for hair removal willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General
Hospital. Candela answered the complaint denying that its products infringe valid claims
of the asserted patents and filing a counterclaim seeking a declaratory judgment that the
asserted patent and U.S. patent No. 5,595,568 are invalid and not infringed. We filed a
reply denying the material allegations of the counterclaims. Both this lawsuit and Palomar
v Alma (described above) have been transferred to Judge Rya Zobel, the judge who presided
over Palomar v Cutera, Inc. Alma, Palomar and Candela have agreed to a joint Markman
Hearing for both lawsuits, currently scheduled for August 2, 2007, and to follow the
discovery schedule set in this lawsuit. The current schedule has the parties ready for
trial by June 2008 though no trial date has yet been set. We filed an amended complaint on
February 16, 2007 to add the Massachusetts General Hospital as a plaintiff. In addition,
we further allege that Candelas new GentleMAX system willfully infringes U.S. Patent
No. 5,735,844 and that Candelas new Light Station system willfully infringes both
U.S. Patent Nos. 5,735,844 and 5,595,568. .  On February 16, 2007, Candela filed an amended answer to our complaint adding allegations of inequitable conduct,
double patenting and violation of Massachusetts General Laws Chapter 93A.  On February 28, 2007 Palomar filed a
response to Candelas amended complaint pointing out many weaknesses in Candelas new allegations.
51






On
August 10, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the District of Massachusetts seeking both
monetary damages and injunctive relief. The complaint alleges that our StarLux System with
the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne
treatment, that our QYAG5 System willfully infringes U.S. Patent No. 5,312,395 which is
directed to treatment of pigmented lesions, and that our StarLux System with the LuxG
handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle
treatment. On October 25, 2006, Candela filed an amended complaint which did not include
U.S. Patent No. 6,659,999. Consequently, Candela no longer alleges that the StarLux System with
LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is
seeking to enjoin us from selling these products in the United States if found to infringe
the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On October 30,
2006 we answered the complaint denying that our products infringe the asserted patents and
filing counterclaims seeking declaratory judgments that the asserted patents are invalid
and not infringed. In addition, with regard to U.S. Patent No. 5,312,395, we filed a
counter claim of inequitable conduct. Judge Joseph Tauro has been appointed as the
presiding judge. Following a scheduling hearing on January 18, 2007, the Judge set a
partial discovery schedule but did not yet set a date for a Markman Hearing. We are
defending the action vigorously and believe that we have meritorious defenses of
non-infringement, invalidity and inequitable conduct. However, litigation is unpredictable
and we may not prevail in successfully defending or asserting our position. If we do not
prevail, we may be ordered to pay substantial damages for past sales and an ongoing
royalty for future sales of products found to infringe in the United States. We could also
be ordered to stop selling any products in the United States that are found to infringe.


On
December 19, 2006, Candela Corporation commenced an action for patent infringement against
us in the United States District Court for the Eastern District of Texas, seeking both
monetary damages and injunctive relief. The complaint alleges that our StarLux System with
the LuxY handpiece willfully infringes U.S. Patent No. 6,659,999 and that our StarLux
System with the Lux1540 handpiece willfully infringes related U.S. Patent Nos. 5,810,801
and 6,120,497. All three asserted patents are directed to wrinkle treatment. Candela is
seeking to enjoin us from selling these products in the United States if found to infringe
the patents, and to obtain compensatory and treble damages, reasonable costs and
attorneys fees, and other relief as the court deems just and proper. On January 10,
2007, we answered the complaint denying that our products infringe the asserted patents
and filing counterclaims seeking declaratory judgments that the asserted patents are
invalid and not infringed. In addition, on January 10, 2007, we filed a motion to transfer
this lawsuit from Texas to Massachusetts. This motion was denied on February 23, 2007. We
are defending the action vigorously and believe that we have meritorious defenses of
non-infringement and invalidity. However, litigation is unpredictable and we may not
prevail in successfully defending or asserting our position. If we do not prevail, we may
be ordered to pay substantial damages for past sales and an ongoing royalty for future
sales of products found to infringe in the United States. We could also be ordered to stop
selling any products that are found to infringe in the United States.






Employment Agreements


We
have 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 us without cause, non-renewal by us or termination
by us for good reason without a change in control, these employment agreements provide for
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.




52







Note 8 
Stockholders Equity



Common Stock


During
1998, we sold 1,457,142 shares of common stock to a group of investors for $10,200,000. In
addition, we 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 expired at December 31, 2003. Under the terms of this private placement, we are
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 our transfer agent. During 2006, 2005 and 2004, we paid $83,077, $59,049 and
$79,600, respectively, related to this fee. These amounts have been charged to additional
paid-in capital.



Preferred Stock


Our
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. We have
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.



Rights Agreement


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. Each right entitles the registered holder to purchase from us 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 our common stock or announces a tender or exchange offer for 15% or more
of our 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 our common stock, which have a market value of twice the purchase price
of the right. In the event that we are acquired in a merger or other business combination
transaction or more than 50% of our assets or earning power is sold, each holder shall
thereafter have the right to receive, upon exercise of each right, that number of shares
of common stock of the acquiring company that, at the time of such transaction, would have
a market value of two times the $8 per share exercise price. The rights will not be
exercisable until certain events occur. The Board of Directors may elect to terminate the
rights under certain circumstances.







Note 9  Stock
Option Plans and Warrants



Stock Options


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

53






The
following table summarizes all stock option activity of Palomar for the years ended
December 31, 2004, 2005 and 2006:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                      | Number of
Shares | Exercise Price | Weighted
Average
Exercise
Price | Weighted
Average
Remaining
Contractual
Term | Aggregate
Intrinsic Value
|--------------------------------------------------------------------- | ---------------- | -------------- | ------------------------------- | ------------------------------------------- | -------------------------
|Outstanding, December 31, 2003                                        | 3,126,687        | $0.90 - $10.59 | $              2.30             | 7.12                                        | $25,627,729              
|Granted                                                               | 3,454,500        | 9.93 - 26.00   | 16.70                          
|Exercised                                                             | (1,568,887)      | 0.90 - 16.53   | 2.00                           
|Canceled                                                              | (44,898)         | 1.00 - 18.36   | 11.95                          
|                                                                      |                  |                |                                 |                                             |                          
|Outstanding, December 31, 2004                                        | 4,967,402        | 0.90 - 26.00   | 12.33                           | 8.51                                        | 67,919,865               
|Granted                                                               | 645,000          | 24.63 - 24.63  | 24.63                          
|Exercised                                                             | (833,841)        | 0.90 - 19.00   | 5.42                           
|Canceled                                                              | (28,596)         | 2.19 - 16.53   | 13.83                          
|                                                                      |                  |                |                                 |                                             |                          
|Outstanding, December 31, 2005                                        | 4,749,965        | 0.90 - 26.00   | 15.20                           | 8.02                                        | 94,378,778               
|Granted                                                               | --               | --             | --                              |                                            
|Exercised                                                             | (872,267)        | 0.90 - 26.00   | 11.39                          
|Canceled                                                              | (55,331)         | 4.50 - 16.53   | 15.09                          
|                                                                      |                  |                |                                 |                                             |                          
|Outstanding, December 31, 2006                                        | 3,822,367        | 0.90 - 26.00   | 16.07                           | 7.19                                        | 131,978,861              
|                                                                      |                  |                |                                 |                                             |                          
|Exercisable, December 31, 2004                                        | 3,132,937        | 0.90 - 26.00   | 11.31                           | 8.13                                        | 46,037,788               
|                                                                      |                  |                |                                 |                                             |                          
|Exercisable, December 31, 2005                                        | 3,167,018        | 0.90 - 26.00   | 15.09                           | 7.90                                        | 63,292,431               
|                                                                      |                  |                |                                 |                                             |                          
|Exercisable, December 31, 2006                                        | 2,448,537        | $0.90 - $26.00 | $            15.82              | 7.09                                        | $85,150,767              
|                                                                      |                  |                |                                 |                                             |                          
|Vested and expected to vest at                                       
|December 31, 2006 (1)                                                 | 3,822,367       
|                                                                      |                  |                |                                 |                                             |                          
|Available for future issuances underthe plans as of December 31, 2006 | 75,035           |               
|                                                                      |                  |                |                                 |                                             |                          

|(1) |  | Includes 1,365,000 unvested performance based options, consisting of 775,000 of
          the options that will only vest upon the Launch Decision, and 590,000 of the
          options that will only vest twelve months after the Launch Decision, of Gillette
          to continue commercialization of a patented home-use, light based hair removal
          device for women pursuant to our Development and License Agreement with them
          dated February 14, 2003.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
total intrinsic value for options exercised during the year ended December 31, 2004, 2005
and 2006 was $23,266,599, $18,020,301 and $30,116,146, respectively.


The
following table summarizes information about stock options outstanding as of December 31,
2006:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |              |           |             
|------------------- | ------------------- | ---------- | ------------ | --------- | ------------
|
|$0.90-$1.00         | 227,861             | 4.66 years | $       0.97 | 227,861   | $       0.97
|1.51-2.19           | 57,833              | 3.27 years | 1.97         | 57,833    | 1.97        
|2.68-3.19           | 69,772              | 2.50 years | 3.17         | 69,772    | 3.17        
|4.08-5.05           | 138,662             | 6.52 years | 4.96         | 138,662   | 4.96        
|6.22-8.23           | 28,099              | 6.77 years | 6.68         | 28,099    | 6.68        
|10.24-14.31         | 25,831              | 7.24 years | 12.25        | 19,999    | 12.10       
|16.00-23.61         | (1) 2,593,80        | 7.36 years | 16.55        | 1,225,811 | 16.56       
|24.06-26.00         | 680,500             | 8.38 years | 24.64        | 680,500   | 24.64       
|                    |                     |            |              |           |             
|$0.90-$26.00        | (1) 3,822,36        | 7.19 years | $     16.07  | 2,448,537 | $15.82      
|                    |                     |            |              |           |             

|54
|--

|(1) |  | Includes 1,365,000 unvested performance based options, consisting of 775,000 of
          the options that will only vest upon the Launch Decision, and 590,000 of the
          options that will only vest twelve months after the Launch Decision, of Gillette
          to continue commercialization of a patented home-use, light based hair removal
          device for women pursuant to our Development and License Agreement with them
          dated February 14, 2003.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Warrants


The
following table summarizes all warrant activity of Palomar for the years ended December
31, 2004, 2005 and 2006:
|-------------------------------------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Exercise Price | Weighted
Average
Exercise
Price | WeightedAverage
Remaining
Contractual
Term | Aggregate
Intrinsic Value
|------------------------------ | ---------------- | -------------- | ------------------------------- | ------------------------------------------ | -------------------------
|Outstanding, December 31, 2003 |                  | 218,000        |                                 | $1.97 - $3.50                              |                          
|Exercised                      |                  | (38,000        | )                               | 1.97 - 3.50                                |                          
|                               |                  |                |                                 |                                            |                          
|Outstanding, December 31, 2004 |                  | 180,000        |                                 | 1.97 - 3.19                                |                          
|Exercised                      |                  | (50,000        | )                               | 1.97 -3.19                                 |                          
|                               |                  |                |                                 |                                            |                          
|Outstanding, December 31, 2005 |                  | 130,000        |                                 | 1.97 - 3.19                                |                          
|Exercised                      |                  | (55,000        | )                               | 1.97 - 3.19                                |                          
|                               |                  |                |                                 |                                            |                          
|Outstanding, December 31, 2006 |                  | 75,000         |                                 | 1.97 - 3.19                                |                          
|                               |                  |                |                                 |                                            |                          
|Exercisable, December 31, 2004 |                  | 180,000        |                                 | 1.97 - 3.19                                |                          
|                               |                  |                |                                 |                                            |                          
|Exercisable, December 31, 2005 |                  | 130,000        |                                 | 1.97 - 3.19                                |                          
|                               |                  |                |                                 |                                            |                          
|Exercisable, December 31, 2006 |                  | 75,000         |                                 | $1.97 - $3.19                              |                          
|                               |                  |                |                                 |                                            |                          

|The
total intrinsic value for warrants exercised during the year ended December 31, 2004, 2005
and 2006 was $481,306, $1,301,406 and $2,288,312, respectively.




The
ranges of exercise prices for warrants outstanding and exercisable at December 31, 2006
are as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Warrants Outstanding | Warrants Exercisable |            |            |        |      
|-------------------- | -------------------- | ---------- | ---------- | ------ | -----
|
|$1.97 - $2.81        | 40,000               | 3.26 years | $     2.39 | 40,000 | $2.39
|3.19                 | 35,000               | 2.41 years | 3.19       | 35,000 | 3.19 
|                     |                      |            |            |        |      
|$1.97-$3.19          | 75,000               | 2.86 years | $     2.76 | 75,000 | $2.76
|                     |                      |            |            |        |      

|Reserved Shares


At
December 31, 2006, the Company has reserved shares of its common stock for the following:
55
|-----------------------------------------------------------------------------------------------------------------

|At December 31,      |          
|-------------------- | ---------
|Stock option plans   | 3,897,402
|Warrants             | 75,000   
|Employee 401(k) plan | 280,450  
|                     |          
|Total                | 4,252,852
|                     |          

|Employee Stock Purchase
Plan


Under
the terms of the Palomar Medical Technologies, Inc. 1996 Employee Stock Purchase Plan (the
Purchase Plan), all employees were eligible to purchase our 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 year ended December 31, 2004 employees purchased
20,052 of our common stock for $258,321pursuant to the Purchase Plan. The Purchase Plan
was terminated after the December 31, 2004 purchase, and therefore no shares were
available for future issuance under the Purchase Plan.



Note 10  Quarterly
Results of Operations (Unaudited)


The
following tables present a condensed summary of quarterly results of operations for the
years ended December 31, 2005 and 2006 (in thousands, except per share data).
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      | 2005 |           |  |          
|--------------------- | ---- | --------- |  | ---------
|
|Revenues              |      | $17,045   |  | $18,223  
|Cost and expenses     |      | 13,635    |  | 14,381   
|                      |      |           |  |          
|Net income            |      | $  3,516  |  | $  4,008 
|                      |      |           |  |          
|Net income per share: |     
|Basic                 |      | $    0.21 |  | $    0.24
|Diluted               |      | $    0.19 |  | $    0.21

|
|

|                      | 2006 |           |  |          
|--------------------- | ---- | --------- |  | ---------
|
|Revenues              |      | $22,455   |  | $36,657  
|Cost and expenses     |      | 16,577    |  | 20,384   
|                      |      |           |  |          
|Net income            |      | $  6,244  |  | $17,367  
|                      |      |           |  |          
|Net income per share: |     
|Basic                 |      | $    0.36 |  | $    1.00
|Diluted               |      | $    0.31 |  | $    0.86

|Note 11 
Development and License Agreement with Gillette


Effective
as of February 14, 2003, we entered into a Development and License Agreement (the
Agreement) with Gillette to complete the development and commercialize a
home-use, light based hair removal device for women. In October 2005, Procter & Gamble
Company (NYSE: PG) completed its acquisition of Gillette. Under the Agreement, Procter
& Gamble, as the acquiring party, assumed all of Gillettes rights and
obligations. The agreement provided for up to $7 million in support of research and
development to be paid by Gillette over approximately 30 months. Effective as of June 28,
2004, we completed the initial phase of the agreement and both parties decided to move
onto the next phase. Accompanying this decision, we amended the original agreement,
whereby Gillette provided $2.1 million in additional development funding to further
technical innovations over a 9-month extension of the development phase, which was
completed on August 31, 2006 (the Development Phase).


56






On
September 29, 2006, in response to a first decision point in the Agreement, Gillette
decided to continue with the project. Consequently, after over-the-counter clearance was
obtained from the United States Food and Drug Administration for the device, Gillette was
obligated to make a development completion payment to us of $2.5 million, which was paid
on December 26, 2006. The $2.5 million payment will be recorded as revenue over a 12 month
period, as we are obligated to perform additional services to Gillette during that period
in consideration for this payment.


After
making the development completion payment to us 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 us of $10 million. If Gillette decides not to continue
to commercialize the device, we may proceed to commercialize the device on our own or with
a different party.


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


After
launch of the first device for females, Gillette will pay us 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 us work exclusively with Gillette, Gillette will continue
to be obligated to pay us 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 us in connection with jointly developed
products, Gillette is required to make certain lump sum and net sales based payments to us
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 us for the
development and commercialization of home-use, light based hair removal devices for men.


For
the year ended December 31, 2006, 2005 and 2004, we recognized $1.1 million, $2.8 million
and $3.1 million of funded product development revenues from Gillette, respectively.


On
February 21, 2007, we announced an amendment to our agreement with Gillette to include the
development and commercialization of an additional light-based hair removal device for
home use, and we also announced that we had executed an amended and restated joint
development agreement to incorporate other prior amendments and several new amendments to
allow for more open collaboration through commercialization. With regard to the additional
light-based hair removal device for home use, we will complete certain development
activities in consultation with Gillette during an eleven month program, scheduled to end
by January 13, 2008. Gillette will provide us with development payments of $1.2 million
and an additional $300,000 upon the completion of certain deliverables.






Note 12  Joint
Development and License agreement with Johnson & Johnson Consumer Companies, Inc.


Effective
as of September 1, 2004, we entered into a Joint Development and License Agreement with
Johnson & Johnson Consumer Companies, Inc. to develop and commercialize home-use,
light based devices in the fields of (i) reducing or reshaping body fat including
cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.
Under the agreement Johnson & Johnson funds our research and clinical studies during
an initial proof-of-principle phase. At the end of the proof-of-principle phase, Johnson
& Johnson will decide whether or not to continue with one or more of the devices in
one or more of the fields into a development phase. Johnson & Johnson decides to
continue, Johnson & Johnson will be obligated to fund the development of the selected
devices.  If Johnson & Johnson Consumer Companies, Inc. decides not to continue,
we may proceed in fields not selected by Johnson & Johnson to develop and
commercialize these and other devices on its own or with a different party.


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



57






For
the year ended December 31, 2006, 2005 and 2004, we recognized approximately $1.4 million,
$1.6 million and $318,000, respectively, of funded product development revenues from
Johnson & Johnson and deferred $63,000, $375,000 and $750,000, respectively, of
advance payments received from Johnson & Johnson for which services were not yet
provided.



Note 13  Research
contract with the United States Department of the Army


In
the first quarter of 2004, we began providing services under a $2.5 million research
contract with the United States Department of the Army to develop a light based
self-treatment device for Pseudofolliculitis Barbae or PFB. On October 25, 2005, we
announced that it had been awarded additional funding of $888,000 for a total of $3.4
million and a twelve month extension. On September 1, 2006, we were awarded additional
funding of $440,000 for a total of $3.8 million and an additional five month extension
until April 30, 2007. The contract is a cost plus fee arrangement whereby we are
reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Our
revenue from the contract is subject to government audit.


For
the year ended December 31, 2006, 2005 and 2004, we recognized $1.3 million, $1.0 million
and $1.1million of funded product development revenues under this agreement,
respectively.



Note 14  Product
upgrade options


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





Note 15 
Settlement of Lumenis Litigation


On
June 22, 2004, we announced that we had reached a settlement with Lumenis Ltd. resolving
our on-going litigation concerning both patent infringement and contractual matters.
Pursuant to the settlement, the parties dismissed with prejudice both the federal action
in the Northern District of California as well as the state court action in Massachusetts.
Palomar and Lumenis executed a Settlement Agreement and a Patent License Agreement. Under
the Patent License Agreement, we granted Lumenis a non-exclusive, royalty bearing license
to the Anderson Patents in the professional field, excluding the consumer field which is
exclusively licensed to the Gillette Company.


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


In
addition, Lumenis granted us a paid up license to a variety of Lumenis patents for
our light based devices. We granted Lumenis a paid up license to the Anderson Patents for
Lumenis lamp based devices. Both parties have agreed to the validity and
enforceability of each others patents and not to challenge such validity and
enforceability in the future.



58






For
the year ended December 31, 2006, Lumenis made royalty payments of approximately $1.6
million. For the year ended December 31, 2005, Lumenis made payments of approximately $4.3
million, including approximately $2.2 million for back-owed royalties. For the year ended
December 31, 2004, Lumenis made royalty payments of approximately $3.3 million, including
approximately $1.9 million for back-owed royalties.


For
more information, please see the Settlement Agreement and the Patent License Agreement
filed as Exhibits 99.1 and 99.2 to our Current Report on Form 8-K filed June 22, 2004.



Note 16 
Settlement of Cutera Litigation


On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc.
through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement.  Under the License
Agreement, we granted Cutera a non-exclusive, royalty bearing license to the Anderson Patents in the professional
field, excluding the consumer field which is exclusively licensed to the Gillette Company. Cutera admitted that
their products infringe the Anderson Patents and that these patents are valid and enforceable. In addition, Cutera
agreed not to challenge the infringement, validity and enforceability of the Anderson Patents in the future. Cutera
paid us $22 million as an estimated payment for royalties on past sales of their laser and lamp-based hair removal
systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal
costs. Cutera subsequently informed us that they believed the actual liability for past royalties, interest and
legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million
as deferred revenue at June 30, 2006 to be applied against future amounts owed. The final amounts due were subject to
an audit by an independent accounting firm which was completed during the fourth quarter, resulting in an additional
$648,000 of royalty and interest. Under our license agreement with the Massachusetts General Hospital, we pay to the
Massachusetts General Hospital 40% of all royalty and interest payments from Cutera. In connection with the
settlement, during the three and six months ended June 30, 2006, we recorded $13.6 million of royalty revenue and
$5.4 million in cost of royalties.  We also recorded, net of amounts owed to the General Hospital, $3.8 million as a
reduction in general and administrative expense and $1.2 million in interest income.  Starting on April 1, 2006,
Cutera began paying us a royalty on sales of its existing light-based hair removal systems, and Cutera will pay us a
royalty on sales of its later developed light-based hair removal systems. For the year ended December 31, 2006 we
recognized $16.1 million of royalty revenues from Cutera.


For the year ended December 31, 2006 we recognized $16.1 million of royalty revenues from Cutera. As of December 31,
2006, there was no deferred royalty revenue to be applied against future amounts owed.




For more information, please see the Settlement Agreement, the Non-Exclusive Patent License Agreement, the
Consent Judgments and Stipulations of Dismissal filed as Exhibits 99.1, 99.2, 99.3 and 99.4 to our Current Report on
Form 8-K filed June 5, 2006.



Note 17 
Laserscope Agreement


On
October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated
the prior license agreement. Under the new license agreement, Laserscope will pay us a
royalty on sales of its current light-based hair removal products, including the Lyra and
Gemini Laser Systems and the Solis IPL System, as well as on sales of new light-based hair
removal systems developed in the future.


As
a result of a royalty audit of Laserscopes product sales from January 1, 2001
through June 30, 2006, there was an increase in the third quarter royalty revenue of $2.2
million for back-owed royalties. For the years ended December 31, 2006, 2005 and 2004 we
recognized $2.8 million, $621,000, and $571,000 of royalty revenues from Laserscope,
respectively.

American Medical Systems Holdings, Inc. acquired Laserscope in July of 2006 and subsequently sold
the assets of Laserscope's aesthetic division to Iridex Corporation, effective in the first quarter of 2007. As a result, the license
agreement between Palomar and Laserscope has been assigned to Iridex.  Iridex has assumed all of Laserscopes
rights and obligations under the license agreement.


For
more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit
99.2 to our Current Report on Form 8-K filed October 26, 2006.


59







Note 18  Cynosure
Agreement


On
November 7, 2006 we announced the execution of a Non-Exclusive Patent License Agreement
with Cynosure, Inc. Under this Agreement, we granted to
Cynosure a non-exclusive, royalty bearing license to the Anderson Patents and foreign
counterparts. In return, Cynosure granted us a non-royalty bearing (fully paid up),
non-exclusive license to eight Cynosure patents and patent applications, including
counterparts, Cynosure also paid us $10 million on November 7, 2006 as a royalty on sales
of their laser- and lamp-based hair removal systems made before October 1, 2006. Beginning
October 1, 2006, Cynosure will pay us a royalty on sales of light-based hair removal
systems as well as future developed hair removal systems. For the year ended December 31,
2006 we recognized $10 million of royalty revenue from Cynosure.


For
more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit
99.2 to our Current Report on Form 8-K filed today.

         Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.
        None.



Item 9A. Controls and
Procedures



Evaluation of disclosure
controls and procedures


We
have 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.


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



Changes in internal
controls



There
have been no changes in our internal control over financial reporting that occurred during
the quarter ended December 31, 2006 that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.



Managements report
on internal controls


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



Internal
control over financial reporting cannot provide absolute assurance of achieving financial
reporting objectives because of its inherent limitations. Internal control over financial
reporting is a process that involves human diligence and compliance and is subject to
lapses in judgment and breakdowns resulting from human failures. Internal control over
financial reporting also can be circumvented by collusion or improper management override.
Because of such limitations, there is a risk that material misstatements may not be
prevented or detected on a timely basis by internal control over financial reporting.
However, these inherent limitations are known features of the financial reporting process.
Therefore, it is possible to design into the process safeguards to reduce, though not
eliminate, this risk.
60






Management
has used the framework set forth in the report entitled Internal
ControlIntegrated Framework published by the Committee of Sponsoring
Organizations (COSO) of the Treadway Commission to evaluate the effectiveness
of our internal control over financial reporting. Management has concluded that our
internal control over financial reporting was effective as of December 31, 2006. Ernst
& Young LLP, a registered public accounting firm that has audited the financial
statements included in this Annual Report on Form 10-K has issued an attestation report on
managements assessment of our internal control over financial reporting.
61







Report of Independent
Registered Public Accounting Firm



The Board of Directors
and StockholdersPalomar Medical Technologies, Inc.:


We
have audited managements assessment, included in the accompanying Managements
Report on Internal Control over Financial Reporting, that Palomar Medical Technologies,
Inc. maintained effective internal control over financial reporting as of December 31,
2006, based on criteria established in Internal ControlIntegrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO
criteria). Palomar Medical Technologies, Inc.s management is responsible for
maintaining effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our responsibility is to
express an opinion on managements assessment and an opinion on the effectiveness of
the companys internal control over financial reporting based on our audit.



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


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


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


In
our opinion, managements assessment that Palomar Medical Technologies, Inc.
maintained effective internal control over financial reporting as of December 31, 2006, is
fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion,
Palomar Medical Technologies, Inc. maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2006, based on the COSO
criteria.


We
also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Palomar Medical
Technologies, Inc. as of December 31, 2006 and 2005, and the related consolidated
statements of income, stockholders equity, and cash flows for each of the three
years in the period ended December 31, 2006 of Palomar Medical Technologies, Inc. and our
report dated March 5, 2007 expressed an unqualified opinion thereon.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|Boston, Massachusetts |                      
|March 5, 2007         |                      

|62







Item 9B. Other
Information


None.



PART III



Item 10. Directors and
Executive Officers of the Registrant.





We
incorporate information required by this item by reference to the sections responsive
hereto of our 2007 annual proxy statement to be filed prior to April 30, 2007.



Item 11. Executive
Compensation.


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2007 annual proxy statement to be filed prior to April 30, 2007.

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 responsive
hereto of our 2007 annual proxy statement to be filed prior to April 30, 2007.



Item 13. Certain
Relationships and Related Transactions.


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2007 annual proxy statement to be filed prior to April 30, 2007.



Item 14. Principal
Accountant Fees and Services.


We
incorporate the information required by this item by reference to the sections responsive
hereto of our 2007 annual proxy statement to be filed prior to April 30, 2007.



PART IV


     Item 15.    
          Exhibits, Financial Statement Schedules.


     (a)       
          The following documents are filed as part of this report:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1)     Financial
Statements
| | ----------------------------

| | Report of
Independent Registered Public Accounting Firm on Consolidated Financial Statements
| | --------------------------------------------------------------------------------------------

| | Consolidated Balance
Sheets as of December 31, 2006           and December 31, 2005
| | -----------------------------------------------------------------------------------

| | Consolidated Statements
of Income for the years ended December 31, 2006, December 31, 2005            and December 31,
2004
| | ---------------------------------------------------------------------------------------------------------------------------

| | Consolidated Statements
of Stockholders Equity for the years ended December 31, 2006,             December 31, 2005 and
December 31, 2004
| | ------------------------------------------------------------------------------------------------------------------------------------------

| | Consolidated Statements
of Cash Flows for the years ended December 31, 2006, December 31, 2005           and December
31, 2004
| | ------------------------------------------------------------------------------------------------------------------------------

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

| | (2)     Financial
Statement Schedules
| | -------------------------------------

|63
|--

| | All schedules
have been omitted because they are not required or because the required information          is
given in the Consolidated Financial Statements or Notes thereto.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b)       
          Listing
of Exhibits
|----------------------------------------

|        |                                                                                                               |  | Incorporated by Reference |                
|------- | ------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------------
|
|3.1     | Certificate of Designation, Preferences and Rights of the   Series A Participating Cumulative Preferred Stock |  | 10-Q                      | May 17, 1999   
|        |                                                                                                               |  |                          
|3.2     | Second Restated Certificate of Incorporation                                                                  |  | S-3                       | January 1, 1999
|        |                                                                                                               |  |                          
|3.3     | Certificate of Amendment to Certificate of Incorporation                                                      |  | 10-K                      | March 17, 2004 
|        |                                                                                                               |  |                          
|3.4     | Amended and Restated By-Laws                                                                                  |  | 10-Q                      | August 9, 2000 
|        |                                                                                                               |  |                          
|4.1     | Specimen certificate of common stock                                                                          |  | 10-Q                      | May 17, 1999   
|        |                                                                                                               |  |                          
|4.2     | Form of rights certificate                                                                                    |  | 8-K                       | April 21, 1999 
|        |                                                                                                               |  |                          
|4.3     | Rights Agreement with American Stock Transfer & Trust Company dated April 20, 1999                            |  | 8-K                       | April 21, 1999 
|        |                                                                                                               |  |                          
|        |                                                                                                               |  |                          
|10.1*   | Second Amended 1991 Stock Option Plan                                                                         |  | 10-Q                      | August 16, 1999
|        |                                                                                                               |  |                          
|        |                                                                                                               |  |                          
|10.2*   | Second Amended 1993 Stock Option Plan                                                                         |  | 10-Q                      | August 16, 1999
|        |                                                                                                               |  |                          
|10.3*   | Second Amended 1995 Stock Option Plan                                                                         |  | 10-Q                      | August 16, 1999
|        |                                                                                                               |  |                          
|10.4*   | Second Amended 1996 Stock Option Plan                                                                         |  | 10-Q                      | August 16, 1999
|        |                                                                                                               |  |                          
|10.5*   | 1998 Incentive and Non-Qualified Stock Option Plan                                                            |  | DEF 14A                   | April 22, 1998 
|        |                                                                                                               |  |                          
|10.6*   | 2004 Stock Incentive Plan                                                                                     |  | DEF 14A                   | March 17, 2004 
|        |                                                                                                               |  |                          
|10.8*   | 401(k) Plan                                                                                                   |  | S-8                       | October 4, 1995
|        |                                                                                                               |  |                          
|10.9*+  | 2006 Incentive Compensation Program with Louis P. Valente                                                     |  | 10-K                      | March 6, 2006  
|        |                                                                                                               |  |                          
|10.10*+ | 2006 Incentive Compensation Program with Joseph P. Caruso                                                     |  | 10-K                      | March 6, 2006  
|        |                                                                                                               |  |                          
|10.11*+ | 2006 Incentive Compensation Program with Paul S. Weiner                                                       |  | 10-K                      | March 6, 2006  
|        |                                                                                                               |  |                          
|10.12*  | Employment Agreement with Louis P. Valente dated July 1, 2001                                                 |  | 10-K                      | March 17, 2004 
|        |                                                                                                               |  |                          

|64
|--

|       |                                                                                                       |  | Incorporated by Reference |                  
|------ | ----------------------------------------------------------------------------------------------------- |  | ------------------------- | -----------------
|
|10.13* | Employment Agreement with Joseph P. Caruso dated July 1, 2001                                         |  | 10-K                      | March 17, 2004   
|       |                                                                                                       |  |                          
|10.14* | Employment Agreement with Paul S. Weiner dated July 1, 2001                                           |  | 10-K                      | March 17, 2004   
|       |                                                                                                       |  |                          
|10.15  | Form of common stock purchase warrant                                                                 |  | S-8                       | June 22, 1998    
|       |                                                                                                       |  |                          
|10.16  | Form of common stock purchase warrant                                                                 |  | S-8                       | May 21, 2004     
|       |                                                                                                       |  |                          
|10.17  | Form of common stock purchase warrant                                                                 |  | S-8                       | May 21, 2004     
|       |                                                                                                       |  |                          
|10.18  | Lease for 82 Cambridge Street, Burlington, MA dated June 17, 1999                                     |  | 10-Q                      | August 16, 1999  
|       |                                                                                                       |  |                          
|10.19  | First Amendment to Lease for 82 Cambridge Street, Burlington, MA dated March 20, 2000                 |  | 10-K                      | March 6, 2006    
|       |                                                                                                       |  |                          
|10.20  | Second Amendment to Lease for 82 Cambridge Street, Burlington, MA dated January 18, 2006              |  | 10-K                      | March 6, 2006    
|       |                                                                                                       |  |                          
|10.21  | License Agreement with The General Hospital Corporation dated  August 18, 1995                        |  | 10-K                      | February 12, 1999
|       |                                                                                                       |  |                          
|10.22  | First Amendment to License Agreement with The General  Hospital Corporation                           |  | 10-K                      | February 12, 1999
|       |                                                                                                       |  |                          
|10.23  | Second Amendment to License Agreement with The General Hospital Corporation                           |  | 10-K                      | February 12, 1999
|       |                                                                                                       |  |                          
|10.24+ | Third and Fourth Amendments to License Agreement with The  General Hospital Corporation               |  | 10-K                      | March 27, 2003   
|       |                                                                                                       |  |                          
|10.25+ | Research Agreement with The General Hospital Corporation dated August 1, 2004                         |  | 8-K                       | November 18, 2004
|       |                                                                                                       |  |                          
|10.26+ | The Development and License Agreement with The Gillette Company dated February 14, 2003               |  | 8-K                       | February 19, 2003
|       |                                                                                                       |  |                          
|10.27  | Amendment to the Development and License Agreement with The  Gillette Company dated February 14, 2003 |  | 8-K                       | June 28, 2004    
|       |                                                                                                       |  |                          
|10.28  | Amendment to the Development and License Agreement with The  Gillette Company dated October 2, 2003   |  | 8-K                       | June 28, 2004    
|       |                                                                                                       |  |                          
|10.29  | Second Amendment to the Development and License Agreement with The Gillette Company                   |  | 8-K                       | June 28, 2004    
|       |                                                                                                       |  |                          
|10.30+ | Third Amendment to the Development and License Agreement with   The Gillette Company                  |  | 10-K                      | March 6, 2006    
|       |                                                                                                       |  |                          

|65
|--

|       |                                                                                                                                                                                               |   | Incorporated by Reference |                  
|------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | -----------------
|
|10.31+ | Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. dated September 1, 2004                                                                               |   | 8-K                       | September 7, 2004
|       |                                                                                                                                                                                               |   |                          
|10.32  | Settlement Agreement with The General Hospital Corporation, Lumenis, Inc. and Lumenis, Ltd. dated June 17, 2004                                                                               |   | 8-K                       | June 22, 2004    
|       |                                                                                                                                                                                               |   |                          
|10.33+ | Patent License Agreement with Lumenis, Inc. dated June 17, 2004                                                                                                                               |   | 8-K                       | June 22, 2004    
|       |                                                                                                                                                                                               |   |                          
|10.34+ | Fifth Amendment to License Agreement with The General  Hospital dated March 20, 2006                                                                                                          |   | 10-Q                      | May 9, 2006      
|       |                                                                                                                                                                                               |   |                          
|10.35+ | First Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. dated May 1, 2006.                                                                 |   | 10-Q                      | August 8, 2006   
|       |                                                                                                                                                                                               |   |                          
|10.36  | Settlement Agreement dated June 2, 2006 between Palomar Medical Technologies, Inc., The General Hospital Corporation and Cutera, Inc.                                                         |   | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                               |   |                          
|10.37  | Patent License Agreement dated June 2, 2006 between Palomar Medical Technologies, Inc. and Cutera, Inc.                                                                                       |   | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                               |   |                          
|10.38  | Consent Judgments, Palomar v Cutera                                                                                                                                                           |   | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                               |   |                          
|10.39  | Stipulations of Dismissal, Palomar v Cutera                                                                                                                                                   |   | 8-K                       | June 5, 2006     
|       |                                                                                                                                                                                               |   |                          
|10.40  | Non Exclusive Patent License Agreement dated November 6, 2006 between Palomar Medical Technologies, Inc. and Cynosure, Inc.                                                                   |   | 8-K                       | November 7, 2006 
|       |                                                                                                                                                                                               |   |                          
|10.41  | FDA notification letter of 510K OTC clearance for a new,  patented home use, light-based hair removal device                                                                                  |   | 8-K                       | December 11, 2006
|       |                                                                                                                                                                                               |   |                          
|10.42* | 2007 Incentive Compensation Program  Executive Level                                                                                                                                         |   | 8-K                       | February 9, 2007 
|       |                                                                                                                                                                                               |   |                          
|10.43+ | Amended and Restated Development and License Agreement effective as of February 14, 2003 restated as of February 14,2007, between Palomar Medical Technologies, Inc. and The Gillette Company |   | 8-K                       | February 21, 2007
|       |                                                                                                                                                                                               |   |                          
|10.44+ | Amendment to the Amended and Restated Development and License Agreement, dated February 14, 2007, between Palomar Medical Technologies, Inc. and The Gillette Company                         |   | 8-K                       | February 21, 2007
|       |                                                                                                                                                                                               |   |                          
|21.1   | List of subsidiaries                                                                                                                                                                          | X |                           |                  
|       |                                                                                                                                                                                               |   |                          

|66
|--

|     |                                                                                                                                 |   | Incorporated by Reference | 
|---- | ------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------- | 
|
|23.1 | Consent of Ernst & Young LLP                                                                                                    | X |                           | 
|     |                                                                                                                                 |   |                          
|31.1 | Certification of Chief Executive Officer pursuant to Section  302 of the Sarbanes-Oxley Act of 2002                             | X |                           | 
|     |                                                                                                                                 |   |                          
|31.2 | Certification of Chief Financial Officer pursuant to Section  302 of the Sarbanes-Oxley Act of 2002                             | X |                           | 
|     |                                                                                                                                 |   |                          
|32.1 | Certification of Chief Executive Officer and Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | X |                           | 
|     |                                                                                                                                 |   |                          
|+    | Portions of this exhibit have been omitted pursuant to a request for confidential treatment.                                    |   |                           | 
|     |                                                                                                                                 |   |                          
|*    | Management contract or compensatory plan or arrangement                                                                         |   |                           | 
|     |                                                                                                                                 |   |                          

|67



SIGNATURES


Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized on March 7, 2007.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Palomar Medical
Technologies, Inc.
| |  | ----------------------------------

| |                                                                         
| | ------------------------------------------------------------------------
| | By:/s/ Paul S. Weiner
      Paul S. Weiner
      Chief Financial Officer
| |                                                                         

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

|Name                    | Capacity                           | Date         
|----------------------- | ---------------------------------- | -------------
|                        |                                    |              
|/s/Louis P. Valente     | Chairman of the Board of Directors | March 7, 2007
|Louis P. Valente        |                                    |              
|                        |                                    |              
|/s/Joseph P. Caruso     | President, Chief Executive Officer | March 7, 2007
|Joseph P. Caruso        | and  Director                      |              
|                        |                                    |              
|/s/Paul S. Weiner       | Chief Financial Officer            | March 7, 2007
|Paul S. Weiner          |                                    |              
|                        |                                    |              
|/s/Nicholas P. Economou | Director                           | March 7, 2007
|Nicholas P. Economou    |                                    |              
|                        |                                    |              
|/s/A. Neil Pappalardo   | Director                           | March 7, 2007
|A. Neil Pappalardo      |                                    |              
|                        |                                    |              
|/s/James G. Martin      | Director                           | March 7, 2007
|James G. Martin         |                                    |              
|                        |                                    |              
|/s/Jeanne Cohane        | Director                           | March 7, 2007
|Jeanne Cohane           |                                    |              

|68
|--