|UNITED STATES
                                        SECURITIES AND EXCHANGE COMMISSION
                                              Washington, 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, 2005
|- | --------------------------------------------------------------------------------------------------------------------------------------------

|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, MA 01803
Registrants telephone number, including are 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  National Market
|------------------------------------------------- | ------------------------------------------------------------------

|Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.   YesoNo 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.  Yeso  No 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.  Yesý  No 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.o


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 fileroAccelerated filerý Non-accelerated fileroIndicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange
Act.YesoNoý

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, 2005 was $291,857,697. The number of shares outstanding of the registrants common
stock (par value $0.01) as of the close of business on February 28, 2006 was 17,287,401.

                                        DOCUMENTS INCORPORATED BY REFERENCE


Portions
of the registrants definitive proxy statement to be filed prior to April 30, 2005,
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                                                                   |         
|           | 
|Item 1A.   |  | Cautionary Statements                                                      |         
|           | 
|Item 1B.   |  | Unresolved Staff Comments                                                  |         
|           | 
|Item
2.    |  | Properties                                                                 |         
|           | 
|Item
3.    |  | Legal Proceedings                                                          |         
|           | 
|Item
4.    |  | Submission of Matters to a Vote of Security Holders                        |         
|           | 
|PART II    | 
|           | 
|Item 5.    |  | Market for Registrants Common Equity, Related Stockholder Matters and     |         
|           |  | Issuer Purchases of
                    Equity Services                    |         
|           | 
|Item
6.    |  | Selected Financial Data                                                    |         
|           | 
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results    |         
|           |  | of Operations                                                              |         
|           | 
|Item
7A.   |  | Quantitative and Qualitative Disclosures About Market Risk                 |         
|           | 
|Item
8.    |  | Financial Statements and Supplementary Data                                |         
|           | 
|Item
9.    |  | Changes in and Disagreements with Accountants on Accounting and            |         
|           |  | Financial Disclosures                                                      |         
|           | 
|Item
9A.   |  | Controls and Procedures                                                    |         
|           | 
|Item
9B.   |  | Other Information                                                          |         
|           | 
|PART III   | 
|           | 
|Item
10.   |  | Directors and Executive Officers of the Registrant                         |         
|           | 
|Item
11.   |  | Executive Compensation                                                     |         
|           | 
|Item
12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related |         
|           |  | Stockholder Matters                                                        |         
|           | 
|Item
13.   |  | Certain Relationships and Related Transactions                             |         
|           | 
|Item
14.   |  | Principle Accountant Fees and Services                                     |         
|           | 
|PART IV    | 
|           | 
|Item
15.   |  | Exhibits and Financial Statement Schedules                                 |         
|           | 
|SIGNATURES |  |                                                                            | 58      

|
|

|PART I



Item 1. Business


Introduction


We
are a leading researcher and developer of light based systems for hair removal and other
cosmetic procedures. Throughout our history, we remained on the forefront of technology:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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(TM)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(TM)handpiece for use with the StarLux System for removal
of leg veins               and treatment of wrinkles 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 we intend to seek FDA clearance for skin
tightening
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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


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 were 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 General Hospital Corporation doing business as Massachusetts General Hospital.


1






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 The Gillette
Company 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 October 2005, Procter & Gamble Company (NYSE: PG) completed its acquisition of
Gillette.


On
February 18, 2004, 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
$3,388,000 and a twelve month contract extension.


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 Palomars
headquarters in Burlington, Massachusetts, which oversees the manufacture and sale of our
lamp and laser based systems currently on the market.


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

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

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

| | 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.  Compared to other light based
hair removal devices, our Lux platform is more versatile, treats larger areas in less
time, is less painful and is more cost effective.


2






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 October 2003,
we introduced the lower cost NeoLux Pulsed Light System specifically targeted at the
beauty industry.  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 Lux 1064.  In
February 2005, we introduced a new infrared handpiece, the LuxIR.


The
Lux systems offer a suite of applications at a fraction of the cost of other competing
systems. Customers can invest in their first Lux system with one handpiece then purchase
additional handpieces as their practice grows and upgrade into a more powerful Lux system
when ready.  The Lux platform enables 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.


In
addition to being cost effective and upgradeable, the platform includes many
technological advances. For example, the platform includes our Smooth Pulse technology
which sets a new standard in safe and comfortable treatments.  The Smooth Pulse
technology spreads power evenly over the entire pulse of light allowing us to provide
ideal wavelengths for faster results in fewer treatments.  By contrast, competitive
systems deliver a power spike at the beginning of each pulse which can cause injury at
the most effective wavelengths.  The Smooth Pulse technology extends the life of the
light source allowing us to offer one year warranties on most of our lamp based handpieces.
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.


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 new snap-on connector making it easier to switch among handpieces and provide
treatments tailored to each individual being treated.


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

3






StarLux. In
February 2004, we launched the StarLux Pulsed Light 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 Lux 1064 laser handpiece received FDA
clearance for a variety of applications, including but not limited to removal of
pigmented and vascular lesions, including visible leg veins, tattoo and hair removal,
treatment of wrinkles, removal of red pigmentation in hypertrophic and keloid scars and
treatment of PFB.  The Lux1064 is a high power laser handpiece to feature 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
handpieces, thus cooling the skin before, during, and after treatment. This unique
feature ensures maximum safety and comfort during treatment.  The StarLux's high-powered
treatments deliver long-lasting and even permanent results. The StarLux full-color screen
allows easy finger-touch operation and instant handpiece recognition while providing
constant feedback on operating parameters.  In February 2005, we introduced a new
infrared handpiece, the Lux IR, and received FDA clearance for deep tissue heating for
relief of muscle and joint pain in June 2005.  We began shipments of the Lux IR in
December 2005.  We intend to seek further FDA clearances for the Lux IR including skin
tightening, skin lifting and wrinkle removal.



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 or SLP1000® Diode Laser 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, 2005, we utilized 35 distributors in 51 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.


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

|At December 31,           | 2005 | 2004 | 2003
|------------------------- | ---- | ---- | ----
|United States             |      | 71   | %   
|Japan                     |      | 7    |     
|Canada                    |      | 7    |     
|Europe                    |      | 6    |     
|Australia                 |      | 3    |     
|Asia/Pacific              |      | 4    |     
|South and Central America |      | 2    |     
|                          |      |      |     
|Total                     |      | 100  | %   
|                          |      |      |     

|4






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.  We
perform our own research as well as with partners, including Massachusetts General
Hospital.  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 treatment
of cellulite.


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. This consumer hair removal device is expected to be safe and effective
for use on womens legs, underarms, bikini line and other areas where a woman might find
it necessary to shave, apply hair-removal creams, or undergo waxing, electrolysis, or
laser or other light based professional treatments in a doctors office, clinic, spa or
salon.  The parties have completed the first phase and have decided to move into the next
phase.  The original agreement provided up to $7 million in initial development support
funding to be paid by Gillette to us over approximately the first 30 months of the
agreement.  Under a June 2004 amendment, Gillette agreed to provide $2.1 million in
additional development funding over a 9-month extension of the development phase, which
is now planned to be completed by August 31, 2006.  As of December 31, 2005, Gillette has
provided $8.5 million in funded product development.


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 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 $3,388,000 and a twelve month
contract extension.  PFB is called the most significant dermatologic disease in the US
Army in an article by Brauner GJ, Flaudesmeyer KL. entitled Pseudofolliculitis barbae:
Medical consequences of interracial friction in the US Army, Cutis, 1979, 23:61-66.  PFB
affects  combat  readiness, unit cohesion, and individual morale of over 50% of African
American and Hispanic military personnel according to an article by Perry PK, Cook-Bolden
FE , et al. entitled Defining pseudofolliculitis barbae in 2001, JAAD, 2002,
46:S113-S119. The importance of a solution to the PFB problem is increasing along with
the changing demographics of the military.  According to Semiannual Race/Ethnic/Gender
Profile by Service/Rank, Sept. 2000 the percentage of African-Americans and Hispanics in
the services is currently twice that in the civilian population and growing.  We believe
that this device will be protected by multiple patents within our patent portfolio.


On
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. As of December
31, 2005, we recognized $1.9 million of funded product development revenues from Johnson & Johnson
Consumer Companies, Inc.


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.  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 and corresponding foreign patents and pending applications owned by
Massachusetts General Hospital, and we are the joint owner with and exclusive licensee of
Massachusetts General Hospital of three other United States patents and corresponding
foreign patent and pending applications.   In addition, we are the sole owner of fourteen
United States patents and corresponding foreign patent and pending applications, and have
rights to other patents under exclusive and non-exclusive licenses.

5






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.


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 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


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. 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 up 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.

6






Number of Employees


As
of December 31, 2005, we employed 188 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.


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.  Cautionary
statements


The
risks and uncertainties described below together with all of the other information
included in this filing, including the financial statements and related notes should be
carefully considered. If any of the following risks actually occurs, our business,
prospects, financial condition and results of operations may be materially harmed. In
this event, the market price of our common stock could decline and you could lose part or
all of your investment.


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 laser and light based 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 financial, marketing and other resources than us, as well as 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.  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 up 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.

7






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:
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---------------------------------------------------------------------------

| | 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;
| | - |  | ------------------------------------------------------------------------------------------------------------------------

| | 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.


With
regard to our recently introduced LuxIR handpiece for use with the StarLux Pulsed Light
and Laser System, we currently have FDA clearance to market the product in the United
States for only deep heating for pain relief and not for other indications, such as for
soft tissue coagulation. We are continuing to seek a clearance from the FDA to market the
LuxIR for additional indications, but there are no assurances as to when, or whether, we
will ever obtain such a clearance. We cannot promote or advertise in the United States
for any indications other than deep heating until we receive additional FDA clearances.
Clinical trials in support of 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 the LuxIR in the United States and revenue derived there from 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.

8






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 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.


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:
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| | o |  | untitled
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 in a timely manner, which in turn would harm our revenue and operating results.
 The FDA requires every manufacturer to make this determination in the first instance,
but the FDA can review any such decision. We have modified some of our marketed devices,
but we believe that new 510(k) clearances are not required. We cannot be certain that the
FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA
requires us to seek 510(k) clearance for any modification, we also may be required to
cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.


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 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.  In addition, these
regulations are in many instances in flux.  As a result, in some states non-physicians
may purchase and operate our product. However, a state could disagree with our decision
to sell to a particular type of end user or change regulations preventing sales to
particular types of end users. Thus, state regulations and changes to state regulations
may decrease revenues or prevent growth of revenues.
9






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.


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

10






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.


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 lasers and other light-based 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 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:
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---------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 significant 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.
| | - |  | -----------------------------------------------------------------------------

|11






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


We
develop light based systems that incorporate third-party components. Some of these items
are custom made or otherwise not readily available on the market. We purchase some of
these components from small, specialized vendors that are not well capitalized. 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.


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 Cutera, Inc. 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 non-disclosure agreements with our
employees and third parties with whom we work, including but not limited to consultants
and vendors, to restrict access to, and distribution of, our proprietary information.
Despite our efforts to protect our proprietary rights, unauthorized parties may attempt
to copy or otherwise obtain and use our technology, 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.
12






We may not be able to
successfully collect licensing royalties.


In
past years and following the settlement with Lumenis, material portions of our revenues
consist of royalties from sub-licensing patents licensed to us on an exclusive basis by
Massachusetts General Hospital. If we are unable to collect our licensing royalties, our
revenues will decline.  In addition, we informed Laserscope, one of our licensees, that
we disputed its method for calculating its royalty payment to us.  In the quarter ended
September 30, 2005, we exercised our right under the license agreement with Laserscope to
engage an independent auditor to conduct a review of Laserscopes royalty calculations
and payments under such agreement.  The independent auditors issued a report of their
findings in November 2005 and we are attempting to resolve the dispute through
negotiations.  However, there can be no assurance that we will be able to resolve it
through such negotiations.


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


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


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


On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light based hair removal device for
women.  On June 28, 2004 Palomar and Gillette announced that they completed the initial
phase of their agreement and that both parties would move into the next phase. In
conjunction with entering this next phase, the parties amended the agreement to provide
for additional development funding to further technical innovations. We believe that this
represents a unique opportunity to bring light based devices to the mass market.  Under
the agreement, significant resources and the attention of key technical personnel and
management will be directed to the development of such a device even though such device
will not likely be commercialized for several years, if ever.  In addition, we cannot be
sure that Gillette will agree with our interpretation of the terms of the agreement, that
the agreement will provide us with marketable products in the future or that we will
receive payments for any of the products developed under the agreement.  During the term
of the agreement, Gillette has the ability to choose not to continue and may terminate
the agreement.  If Gillette terminates the agreement, the price of our common stock could
fall significantly, and we will not receive certain payments.  We may proceed to develop
and commercialize the device on our own or with a third party.  However, there can be no
assurance that we will be able to successfully implement such a strategy.  In addition,
after commercialization of such device, Gillette is to pay us a percentage of net sales
of such device. Certain of these percentages of net sales are only owed if the device is
covered by valid patents.  There can be no assurance that valid patents will cover the
device in any or all countries, in which the device will be manufactured, used or sold.  This
could have a material adverse effect on our business, results of operations and financial
condition.
13






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


On
February 18, 2004, we announced that we were awarded a $2.5 million research contract by
the Department of the Army to develop a light based self-treatment device for PFB.  This
represents a unique opportunity to address PFB.  On October 25, 2005, we announced that
we received additional funding of $888,000 and a twelve month extension of this contract. We
believe we can complete the project within the extension. However, there can be no
assurance that we will be able to complete the project within that time period which may
impact our ability to receive future government contracts.  Under the agreement,
significant resources and the attention of key technical personnel and management will be
directed to the development of such a device even though such device will not likely be
ready for military use for several years, if ever.


Managing our relationship with
Johnson & Johnson Consumer Companies, Inc. effectively may divert the attention of key
technical personnel and management from the core business.  If Johnson & Johnson
Consumer Companies, Inc. ends the relationship our stock price could fall, and we may be
unable to bring to market 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.


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


Failure to maintain effective
internal controls over financial reporting could have a material adverse effect on our
business, operating results and stock price



Beginning with our annual report for our fiscal year ended, December 31, 2004,
Section 404 of the Sarbanes-Oxley Act of 2002 required us to include a report by our
management on our internal controls over financial reporting. Such report must contain an
assessment by management of the effectiveness of our internal controls over financial
reporting as of the end of our fiscal year and a statement as to whether or not such
internal controls are effective. Such report must also contain a statement that our
independent auditors have issued an attestation report on managements assessment of such
internal controls.  Our efforts to comply with Section 404 have resulted in, and
are likely to continue to result in, significant costs, the commitment of time and
operational resources and the diversion of managements attention. If our management
identifies one or more material weaknesses in our internal controls over financial
reporting, we will be unable to assert that such internal controls are effective. If we
are unable to assert that our internal controls over financial reporting are effective
our business may be harmed.
14






We have not paid dividends in the
past and do not expect to pay dividends in the future, and any return on investment may
be limited to the value of our stock.


We
have never paid cash dividends on our common stock and do not anticipate paying cash
dividends on our common stock in the foreseeable future. The payment of dividends on our
common stock will depend on our earnings, financial condition and other business and
economic factors affecting us at such time as our board of directors may consider
relevant. If we do not pay dividends, our stock may be less valuable because a return on
your investment will only occur if our stock price appreciates.


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.



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


As
a small company with less than 200 employees, our success depends on the services of key
employees in executive and research and development positions. The loss of the services
of one or more of these employees could have a material adverse effect on our business.  Our
future success will depend in large part upon our ability to attract, retain, and
motivate highly skilled employees. We cannot be certain that we will be able to do so.


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


Our
products are and will continue to be designed and manufactured with numerous safety
features, but it is possible that consumers could be adversely affected by use of one of
our products. Furthermore, in the event that any of our products prove to be defectively
designed and manufactured, we may be required to recall and redesign such products.
 Product liability claims could divert managements attention from our core business, be
expensive to defend and result in sizable damage awards against us.  Although we have not
experienced any material losses due to product liability claims to date, there can be no
assurance that we will not experience such losses in the future. We maintain general
liability insurance and umbrella coverage; however, there can be no assurance that such
coverage will continue to be available on terms acceptable to us or that such coverage
will be adequate for liabilities actually incurred. In the event we are found liable for
damages in excess of the limits of our insurance coverage or if any claim or product
recall results in significant adverse publicity against us, our business, financial
condition and results of operations could be materially and adversely affected. In
addition, although our products have been and will continue to be designed to operate in
a safe manner, and although we attempt to educate customers with respect to the proper
use of our products, misuse of our products by personnel over whom we cannot exert
control may result in the filing of product liability claims or significant adverse
publicity against us. 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.
15






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.


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


Although
we have generated a profit in recent years, we have a history of losses. We may 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 operations or expansion.  Additionally, if we incur
indebtedness to fund increased levels of accounts receivable, finance the acquisition of
capital equipment, or if we issue debt securities in connection with any acquisition we
will be subject to risks associated with incurring substantial additional indebtedness.


Our common stock could be further
diluted by the conversion of outstanding options and warrants.
16






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 and
Delaware law may discourage potential takeover attempts.


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


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




Item 1B.  Unresolved Staff
Comments


None.


Item 2.  Properties


We
lease a facility totaling approximately 56,000 square feet of office, manufacturing and
research space in Burlington, Massachusetts. The lease was amended on January 18, 2006 to
add 12,000 square feet and 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, we commenced an action for patent infringement in the United States
District Court for the District of Massachusetts against Altus Medical, Inc., now known
as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint
alleges Cuteras CoolGlide and CoolGlide Excel laser systems willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General
Hospital. The Massachusetts General Hospital was added as a plaintiff in this lawsuit.
Cutera answered the complaint denying that its products infringe the asserted patent and
filed a counterclaim seeking a declaratory judgment that the asserted patent is invalid
and not infringed. Together with Massachusetts General Hospital and us, we have filed a
reply denying the material allegations of the counterclaims. Together with Massachusetts
General Hospital, we have alleged that Cuteras CoolGlide Vantage and CoolGlide XEO laser
systems also willfully infringe the asserted patent. On June 4, 2003, Cutera amended
their answer and asserted a counter claim alleging that the patent is unenforceable due
to inequitable conduct. Together with Massachusetts General Hospital, we believe that
this claim is without merit and filed a reply denying the material allegations of this
counterclaim. A claim construction hearing (often referred to as a Markman hearing) was
held on June 12, 2003, and on February 27, 2004, the judge issued her ruling. We believe
that the ruling largely embraced our position and will have a considerable impact on the
case as it proceeds toward trial. On January 14, 2005, Cutera filed a motion for summary
judgment that the patent claims being asserted are invalid and not infringed.  A hearing
was held March 17, 2005, and on December 12, 2005, the Judge issued a ruling denying
Cuteras motion for summary judgment and making several findings in our favor. On
October 6, 2005, Cutera filed a motion to modify construction of the Claim Term Applicator,
and on December 12, 2005 the Judge issued a ruling denying Cuteras motion.  A trial date
has been set for May 30, 2006.
17






On
April 7, 2005, together with the Massachusetts General Hospital, we commenced a second
action 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 complaint alleges Cuteras products using pulsed light technology for hair removal
willfully infringe U.S. patent Nos. 5,595,568 and 5,735,844, which are exclusively
licensed to us by the Massachusetts General Hospital.  Cuteras products include the
Solera Opus product in the Solera Platform and other products using pulsed light and
light-based technology in Cuteras XEO platform. Cuteras PW 770 handpiece is utilized in
the Solera and XEO Platforms.  Instead of answering the complaint, Cutera filed a motion
to dismiss for lack of personal jurisdiction in Massachusetts, and Cutera then filed
identical lawsuits in California and Delaware seeking a declaratory judgment that the
5,595,568 and 5,735,844 patents are not infringed, are invalid, and that the patents are
unenforceable due to inequitable conduct.  Together with the Massachusetts General
Hospital, we believe Cutera is subject to personal jurisdiction in Massachusetts and have
filed a response opposing their motion.  The parties are waiting for the judge to issue
a ruling.



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 National Market under the symbol PMTI.
 The following table sets forth the high and low bid information on NASDAQ for the common
stock for the periods indicated.  Such quotations reflect inter-dealer prices, without
retail markup, markdown or commission and do not necessarily represent actual
transactions.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|                                 | Fiscal Year 2004 |           
|-------------------------------- | ---------------- | ----------
|
|Quarter ended March 31, 2004     | $     18.45      | $     9.33
|Quarter ended June 30, 2004      | 20.95            | 13.45     
|Quarter ended September 30, 2004 | 23.67            | 13.00     
|Quarter ended December 31, 2004  | 27.66            | 17.35     

|                                 | Fiscal Year 2005 |            
|-------------------------------- | ---------------- | -----------
|
|Quarter ended March 31, 2005     | $     30.65      | $     22.50
|Quarter ended June 30, 2005      | 27.91            | 20.56      
|Quarter ended September 30, 2005 | 30.22            | 22.53      
|Quarter ended December 31, 2005  | 39.15            | 22.54      

|As
of February 28, 2006, we had 3,520 holders of record of common stock.  This
does not include holdings in street or nominee names.


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.


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.
18






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

|                                                      | Years Ended December 31, |  |   |        | 
|----------------------------------------------------- | ------------------------ |  | - | ------ | 
|
|
|Consolidated Statements of Operations Data:           |                          |  |   |        | 
|                                                      |                          |  |   |        | 
|Revenues:                                             |                          | 
|Product revenues                                      |                          |  | $ | 65,824 | 
|Royalty revenues                                      |                          |  |   | 4,921  | 
|Funded product development                            |                          |  |   |        | 
|revenues                                              |                          |  |   | 5,409  | 
|                                                      |                          |  |   |        | 
|Total revenues                                        |                          |  |   | 76,154 | 
|                                                      |                          |  |   |        | 
|Costs and expenses:                                   |                          | 
|Cost of product revenues                              |                          |  |   | 20,952 | 
|Cost of royalty revenues                              |                          |  |   | 1,969  | 
|Research and development                              |                          |  |   | 12,782 | 
|Selling and marketing                                 |                          |  |   | 17,468 | 
|General and administrative                            |                          |  |   | 6,229  | 
|                                                      |                          |  |   |        | 
|Total cost and expenses                               |                          |  |   | 59,400 | 
|                                                      |                          |  |   |        | 
|Income (loss) from operations                         |                          |  |   | 16,754 | 
|                                                      |                          |  |   |        | 
|Other income, net                                     |                          |  |   | 1,172  | 
|                                                      |                          |  |   |        | 
|Income (loss) before income taxes                     |                          |  |   | 17,926 | 
|                                                      |                          |  |   |        | 
|Provision (benefit) for income taxes                  |                          |  |   | 473    | 
|                                                      |                          |  |   |        | 
|Net income (loss)                                     |                          |  | $ | 17,453 | 
|                                                      |                          |  |   |        | 
|Net income (loss) per common share:                   |                          | 
|Basic                                                 |                          |  | $ | 1.04   | 
|                                                      |                          |  |   |        | 
|Diluted                                               |                          |  | $ | 0.91   | 
|                                                      |                          |  |   |        | 
|Weighted average number of common shares outstanding: |                          | 
|                                                      |                          |  |   |        | 
|Basic                                                 |                          |  |   | 16,831 | 
|                                                      |                          |  |   |        | 
|Diluted                                               |                          |  |   | 19,158 | 
|                                                      |                          |  |   |        | 

|                                 | Years Ended December 31, |         |  |          | 
|-------------------------------- | ------------------------ | ------- |  | -------- | 
|
|Consolidated Balance Sheet Data: |                          |         |  |          | 
|                                 |                          |         |  |          | 
|Cash and cash equivalents        |                          | $10,536 |  | $  7,509 | 
|Available-for-sale investments,  |                         
|at market value                  |                          | 38,758  |  | 17,650   | 
|Working capital                  |                          | 50,845  |  | 28,163   | 
|Total assets                     |                          | 66,336  |  | 39,599   | 
|Total stockholders equity       |                          | 51,866  |  | 29,174   | 

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


Forward-looking statements


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

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

|19
|--

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

| |  | ° |  | other
risks indicated below under the caption Cautionary Statements.
| |  | - |  | ----------------------------------------------------------------------

|These
risks and uncertainties are beyond our control and, in many cases; we cannot predict the
risks and uncertainties that could cause our actual results to differ materially from
those indicated by the forward-looking statements. When used in this document, the words 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 sale is deferred until all criteria are met.  Provisions are made at
the time of revenue recognition for any applicable warranty costs expected to be incurred.


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


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


We
recognize royalty revenue from licensees upon receipt of cash payments since the royalty
amounts are not fixed and determinable at the end of a quarter. In general, licensees are
obligated to make payments 30 days after the end of each quarter.
20






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. Payments from both Gillette and Johnson
& Johnson Consumer Companies, Inc. are non refundable if the development is not
successful.


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 Pseudofolliculitis Barbae
or PFB.  The contract is a cost plus fee arrangement whereby we are reimbursed for the
expenses incurred in connection with PFB research plus an 8% fee.  Revenue is recognized
under the contract as the costs are incurred and the services are rendered.


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


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


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


Warranty
Provision. We typically offer a one-year warranty for all of our products. We
provide for the estimated cost of product warranties at the time product revenue is
recognized. Factors that affect our warranty reserves include the number of units sold,
historical and anticipated rates of warranty repairs and the cost per repair. While we
engage in extensive product quality programs and processes, including actively monitoring
and evaluating the quality of our component suppliers, our estimated warranty obligation
is affected by ongoing product failure rates, specific product class failures outside of
our baseline experience, material usage and service delivery costs incurred in correcting
a product failure. If actual product failure rates, material usage or service delivery
costs differ from our estimates, revisions to the estimated warranty liability would be
required. Assumptions and historical warranty experience are evaluated to determine the
appropriateness of such assumptions. We assess the adequacy of the warranty provision and
we may adjust this provision if necessary.
21






Income
taxes.   We currently 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, we have recorded a valuation
allowance against this deferred tax asset as there is significant uncertainty that we
will not be able to fully utilize the net operating losses. Should our assumptions
regarding the utilization of these net operating losses change, we may reduce some or all
of this valuation allowance, which would result in the recording of an income tax
benefit. In evaluating the potential exposure associated with the various tax filing
positions, we accrue charges for possible exposures. Based on the annual evaluations of
tax positions, we believe we have appropriately filed our tax returns and accrued for
possible exposures. To the extent we were to prevail in matters for which accruals have
been established or be required to pay amounts in excess of reserves, our effective tax
rate in a given financial period might be materially impacted.


Overview


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


During
2005, we improved product gross profits by 48% due to a higher margin product mix and the
effects of increased sales volume in comparison to the same period in 2004. We also
strengthened our balance sheet since the end of last year, including increasing our cash
and investment position by 96% and stockholders' equity by 78%. Our current ratio is now
4.5x, up from 3.7x at the end of 2004, and we have no debt.


Our
revenues for the year ended December 31, 2005, were $76.2 million, up from $54.4 million
for the year ended December 31, 2004. Gross profit from product sales increased to $44.8
million (68 percent of product revenues), up from $30.3 million (66 percent of product
revenues) in the year-earlier period. We also reported net income of $17.5 million, or
$0.91 per diluted share, for the year ended December 31, 2005, versus net income of $10.6
million, or $0.60 per diluted share, for the year ended December 31, 2004.


Sales
from our Lux family of products remained strong throughout 2005 and our product revenue
increased each quarter as compared to 2004.  The Lux line of products consists of the
StarLux Pulsed Light and Laser System, the MediLux, the EsteLux® and the NeoLux Pulsed
Light Systems and their complimentary suites of handpieces.  The Lux family of products
are 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 2005.


Results of operations



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):
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|22
|--

|                               | 2005 | 2004 | 2005 to 2004 |        |  | 
|------------------------------ | ---- | ---- | ------------ | ------ |  | 
|
|Revenues:                      |      |      |              |        |  | 
|Product revenues               |      |      | $            | 65,824 |  | 
|Royalty revenues               |      |      |              | 4,921  |  | 
|Funded product                 |      |      |              |        |  | 
|development revenues           |      |      |              | 5,409  |  | 
|                               |      |      |              |        |  | 
|Total revenues                 |      |      |              | 76,154 |  | 
|                               |      |      |              |        |  | 
|Cost and expenses:             |      |     
|Cost of product revenues       |      |      |              | 20,952 |  | 
|Cost of royalty revenues       |      |      |              | 1,968  |  | 
|Research & development         |      |      |              | 12,783 |  | 
|Selling & marketing            |      |      |              | 17,468 |  | 
|General & administrative       |      |      |              | 6,229  |  | 
|                               |      |      |              |        |  | 
|Total costs & expenses         |      |      |              | 59,400 |  | 
|                               |      |      |              |        |  | 
|Income from operations         |      |      |              | 16,754 |  | 
|Interest income                |      |      |              | 1,154  |  | 
|Interest expense               |      |      |              | --     |  | 
|Other income (expense)         |      |      |              | 18     |  | 
|                               |      |      |              |        |  | 
|Income before income taxes     |      |      |              | 17,926 |  | 
|Provision (benefit) for income |      |      |              | 473    |  | 
|taxes                          |      |     
|                               |      |      |              |        |  | 
|Net income                     |      |      | $            | 17,453 |  | 
|                               |      |      |              |        |  | 

|Product
revenues. Sales of StarLux Pulsed Light and Laser 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 Pulsed Light and Laser 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, EsteLux and NeoLux 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 the
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 hand pieces.  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 the 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 both Gillette and Johnson & Johnson
Consumer Companies, Inc. Palomar receives payments quarterly in accordance with the work
plans that were 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.
 Payments are not refundable if the development is not successful. 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.
23






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 total revenue to 28% in 2005 from 29% 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 Pulsed Light and
Laser 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.


During
2005, legal expenses relating to the prosecution of new patents increased by
approximately $708,000 in comparison to the same period in 2004. We are committed to
expanding our intellectual property rights to protect discoveries made through our
investment in research and development.


Expenses
relating to the introduction of new products, 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.


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


Selling
and marketing expense.  The increase in selling and marketing expense is primarily
comprised of   $1.6 million from payroll and payroll related expenses, approximately $2.4
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.
24






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,a decrease in our corporate
legal expenses of approximately $582,000 and an increase in payroll and payroll related
expenses and other infrastructure costs of approximately $142,000 as compared to the same
period in 2004.


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.


Other
income (expense).  Other income (expense), net, increased in comparison to the
same period in 2004.  This increase is attributable to a previously written-off note
receivable and equity investment. During 2004, we incurred costs of $380,000 related to a
non-recurring expense from the settlement of litigation relating to a previously owned
subsidiary's facility lease, offset by payments received from a previously written-off
note receivable and equity investment.


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 currently 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, we have recorded a valuation allowance against this deferred tax asset as
there is significant uncertainty  that we will be able to fully utilize the net operating
losses due to significant tax deductions associated with the exercise of stock options.
Should our assumptions regarding the utilization of these net operating losses change, we
may reduce some or all of this valuation allowance, which would result in the recording
of an income tax benefit.


Year 2004 Compared to Year 2003


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, 2004 and
2003, respectively (in thousands, except for percentages):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|                                        | 2004 | 2003 | 2004 to 2003 |        |   | 
|--------------------------------------- | ---- | ---- | ------------ | ------ | - | 
|
|Revenues:                               |      |      |              |        |   | 
|Product revenues                        |      |      | $            | 45,810 |   | 
|Royalty revenues                        |      |      |              | 4,052  |   | 
|Funded product development revenues     |      |      |              | 4,570  |   | 
|                                        |      |      |              |        |   | 
|Total revenues                          |      |      |              | 54,432 |   | 
|                                        |      |      |              |        |   | 
|Cost and expenses:                      |      |     
|Cost of product revenues                |      |      |              | 15,514 |   | 
|Cost of royalty revenues                |      |      |              | 1,621  |   | 
|Research & development                  |      |      |              | 10,296 |   | 
|Selling & marketing                     |      |      |              | 12,030 |   | 
|General & administrative                |      |      |              | 5,229  |   | 
|                                        |      |      |              |        |   | 
|Total costs & expenses                  |      |      |              | 44,690 |   | 
|                                        |      |      |              |        |   | 
|Income from operations                  |      |      |              | 9,742  |   | 
|Interest income                         |      |      |              | 256    |   | 
|Interest expense                        |      |      |              | (6     | ) | 
|Other income (expense)                  |      |      |              | (214   | ) | 
|                                        |      |      |              |        |   | 
|Income before benefit from income taxes |      |      |              | 9,778  |   | 
|Benefit from income taxes               |      |      |              | 855    |   | 
|                                        |      |      |              |        |   | 
|Net income                              |      |      | $            | 10,633 |   | 
|                                        |      |      |              |        |   | 
|                                        |      |      |              |        |   | 

|25






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


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


Royalty
revenues.  The increase in royalty revenue during 2004, in comparison to the same
period in 2003, is attributed to our settlement agreement with Lumenis.  Under the terms
of the settlement, Lumenis paid $868,000 in the second quarter of 2004 for back-owed
royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay
$3.225 million over the next six quarters, or $537,500 per quarter, for back-owed
royalties due on sales of the LightSheer made between July 1, 2002 and December 31, 2003.
 Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the
LightSheer and other professional laser hair removal devices and modules.  We agreed to
the reduction of our standard 7.5% royalty rate to 5% due in part to Lumenis grant to us
of a paid up license to a variety of Lumenis' patents for our light based devices. We
granted Lumenis a paid up license to the '568 and '844 patents for Lumenis' professional
lamp based devices. Both parties have agreed to the validity and enforceability of each
others patents and not to challenge such validity and enforceability in the future.
During 2004, Lumenis made payments of approximately $1.4 million relating to the 5%
royalty and approximately $1.9 million for back-owed royalties recorded as royalty
revenue.


Funded
product development revenues. Funded development revenue increased during 2004 as
compared to the same period in 2003.  Funded development revenue is generated from the
development agreements with Gillette and Johnson & Johnson Consumer Companies, Inc., as
well as the United States Department of the Army.  For both Gillette and Johnson & Johnson
Consumer Companies, Inc., Palomar receives payments quarterly in accordance with the work
plan that were 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.
 Payments are not refundable if the development is not successful. For the year ended
December 31, 2004, we recognized approximately $3.1 million and $318,000 of funded
product development revenue from Gillette and Johnson & Johnson Consumer Companies, Inc.,
respectively.


We
provide services under a 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 Palomar is reimbursed for the expenses incurred in connection with
PFB research plus an 8% fee.  Revenue is recognized under the contract as the costs are
incurred and the services are rendered.  For the year ended December 31, 2004, we
recognized approximately $1.1 million of funded product development revenues from the
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 total revenue to 29% in 2004 from 38% in 2003.  The
increase in absolute dollars is directly attributable to increased variable costs
associated with increased product sales. This cost decreased as a percentage of total
revenue primarily due to a shift in sales mix to the higher priced StarLux Pulsed Light
and Laser System and  the other Lux family of products from sales of higher cost to
produce legacy products such a the SLP1000 and RD1200.  The Lux family of products
carry lower manufacturing costs as a result of their modular design.  In addition,
increased sales volume has improved the absorption of fixed manufacturing overhead at our
manufacturing facility as approximately 70% of our manufacturing overhead cost is fixed
in nature and is spread over much higher sales volumes.


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


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.




26


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


Expenses
relating to the Army contract, which began in February 2004, totaled approximately $1.1
million for the year ended December 31, 2004.


Expenses
relating to the Johnson & Johnson Consumer Companies, Inc. agreement, which began in
October 2004, totaled approximately $300,000 for the year ended December 31, 2004.


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


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


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


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


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


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


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


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


27






Benefit
from income taxes. We recognized a benefit from income taxes of $856,000 in 2004
as a result of a $1.1 million reduction in deferred income tax accruals associated with
tax deductions in a 1999 state tax return which were no longer required. Offsetting these
benefits, we provided a 3% effective tax rate for anticipated federal alternative minimum
taxes and minimum state income taxes due for 2004. We recognized a benefit for income
taxes of $656,000 in 2003 as result of a $470,000 carryback claim pursuant to the
Economic Stimulus package of 2002 and a $300,000 reduction in deferred income tax
accruals associated with certain tax deductions taken in our 1999 federal tax return
which were no longer required. Offsetting these benefits, we provided a 4% effective tax
rate for anticipated federal alternative minimum taxes and minimum state income taxes due
for 2003. We currently 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, we have recorded a valuation
allowance against this deferred tax asset as there is significant uncertainty that we
will not be able to fully utilize the net operating losses due to significant tax
deductions associated with the exercise of stock options. Should our assumptions
regarding the utilization of these net operating losses change, we may reduce some or all
of this valuation allowance, which would result in the recording of an income tax benefit.


Liquidity and capital resources


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

|                          |  |  | 2005 to 2004 |        
|------------------------- |  |  | ------------ | -------
|
|Operating cash flows      |  |  | $            | 19,901 
|Investing cash flows      |  |  |              | (21,477
|Financing cash flows      |  |  |              | 4,603  
|Capital expenditures, net |  |  |              | 370    

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

|                                   |  |  | 2005 to 2004 |       
|---------------------------------- |  |  | ------------ | ------
|
|Cash and cash equivalents          |  |  | $            | 10,536
|Available-for-sale investments, at |  | 
|market value                       |  |  |              | 38,758
|Accounts receivable, net           |  |  |              | 8,686 
|Inventories, net                   |  |  |              | 6,753 
|Working capital                    |  |  |              | 50,845

|As
of December 31, 2005, we had $49.3 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, 2005, we had no borrowings or debt.



Cash
provided by operating activities increased for the twelve months ended December 31, 2005
compared to the same period in 2004. This increase primarily reflects the effects of an
increase in net profit and a decrease in working capital requirements. Cash used in
investing activities decreased during 2005 compared to the same period in 2004. 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, 2005 compared to the same period in 2004. This increase was primarily
due to an increase in exercises of stock options.


We
anticipate that capital expenditures for 2006 will total approximately $900,000
consisting primarily of leasehold improvements, machinery, equipment, computers and
peripherals.  We expect to finance these expenditures with cash on hand.


28






On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light based, hair removal device for
women.  The agreement provides up to $7 million in initial development support funding to
be paid by Gillette to us over approximately the first 30 months of the agreement. On
June 28, 2004, we announced with The Gillette Company that they completed the initial
phase of this agreement, and both parties moved into the next phase.  The original
agreement provided for $7 million in development funding from Gillette. Under this
amendment, Gillette will provide $2.1 million in additional development funding to
further technical innovations over a 9-month extension of the development phase, which is
now planned to be completed by August 31, 2006.  As of December 31, 2005, we have
recognized $8.5 million of funded product development revenues from Gillette.  Any
amounts received in advance of services performed are recorded as deferred revenue.
Payments are not refundable if the development is not successful.


In the first quarter of 2004, we began providing services under a $2.5 million research contract with
the United States Department of the Army to develop a light based self-treatment device for PFB. On October 25,
2005, Palomar announced that it had been awarded additional funding of $888,000 for a total of $3,388,000 and a
twelve month extension. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses
incurred in connection with PFB research plus an 8% fee.  Revenue is recognized under the contract as the costs
are incurred and the services are rendered.  This revenue is included in funded product development revenue in
the accompanying statements of operations.  As of December 31, 2005, we have recognized $2.2 million of funded
product development revenues from the Department of the Army.


On
June 17, 2004, we reached a settlement agreement with Lumenis resolving on-going
litigation concerning both patent infringement and contractual matters. Pursuant to the
settlement, the federal action in the Northern District of California and the state court
action in Massachusetts were dismissed with prejudice. Under the terms of the settlement,
Lumenis paid $868,000 in the second quarter of 2004 for back-owed royalties from sales of
the LightSheer made prior to July 1, 2002 and agreed to pay $3.225 million over the next
six quarters, or $537,500 per quarter, for back-owed royalties due on sales of the
LightSheer made between July 1, 2002 and December 31, 2003.  Beginning on January 1,
2004, Lumenis agreed to pay us a 5% royalty on sales of the LightSheer and other
professional laser hair removal devices and modules.  We agreed to the reduction of our
standard 7.5% royalty rate to 5% due in part to Lumenis grant to us of a paid up license
to a variety of Lumenis' patents for our light based devices.  We granted Lumenis a paid
up license to the '568 and '844 patents for Lumenis lamp based devices.  Both parties
have agreed to the validity and enforceability of each others patents and not to
challenge such validity and enforceability in the future. For the twelve months ended
December 31, 2005, Lumenis made payments of approximately $2.1 million relating to the 5%
royalty and approximately $2.2 million for back-owed royalties recorded as royalty
revenue. For the twelve months ended December 31, 2004, Lumenis made payments of
approximately $1.4 million relating to the 5% royalty and approximately $1.9 million for
back-owed royalties recorded as royalty revenue.  As of December 31, 2005, all back-owed
royalties relating to our settlement agreement with Lumenis were paid.


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. The
agreement provides for Johnson & Johnson Consumer Companies, Inc. to fund our research
and clinical studies during an initial proof-of-principle phase. At the end of the
proof-of-principle phase, Johnson & Johnson Consumer Companies, Inc. will decide whether
or not to continue with one or more of the devices in one or more of the fields into a
development phase. Upon Johnson & Johnson Consumer Companies, Inc. deciding to continue,
Johnson & Johnson Consumer Companies, Inc. 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 Consumer Companies,
Inc. to develop and commercialize these and other devices on our own or with a different
party.  At the end of the development phase, Johnson & Johnson Consumer Companies, Inc.
will decide whether or not to commercialize one or more of the devices in one or more
fields. Upon Johnson & Johnson Consumer Companies, Inc. deciding to commercialize one or
more of the devices, Johnson & Johnson Consumer Companies, Inc. will make payments to us
for each selected field.  Upon commercial launch of the first device in each selected
field, Johnson & Johnson Consumer Companies, Inc. will make a payment to us, and for all
devices sold for use in each selected field, Johnson & Johnson Consumer Companies, Inc.
 shall pay us a percentage of sales of such devices and certain topical compounds.  If
Johnson & Johnson Consumer Companies, Inc. decides not to commercialize or fails to launch
a device, we may proceed in fields not selected by Johnson & Johnson Consumer Companies,
Inc. to develop and commercialize these and other devices on our own or with a different
party.  As of December 31, 2005, we have recognized $1.9 million of funded product
development revenues from Johnson & Johnson Consumer Companies, Inc.  Any amounts
received in advance of services performed are recorded as deferred revenue. Payments are
not refundable if the development is not successful.

29






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 2005 totaled approximately $3.7 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,
2005, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing (000s omitted):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                   |   | Payments due by period |   |       |  
|---------------------------------- | - | ---------------------- | - | ----- | -
|
|Operating lease                    | $ | 4,273                  | $ | 1,165 | $
|Purchase commitments               |   | 6,912                  |   | 6,912 |  
|                                   |   |                        |   |       |  
|Total contractual cash obligations | $ | 11,185                 | $ | 8,077 | $
|                                   |   |                        |   |       |  

|Recently issued accounting
standards


In
December 2004, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (SFAS) 123(R), Share-Based Payment. SFAS 123(R) revises SFAS No.
123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, and its related
implementation guidance. SFAS 123(R) will require compensation costs related to
share-based payment transactions to be recognized in the financial statements (with
limited exceptions). The amount of compensation cost will be measured based on the
grant-date fair value of the equity or liability instruments issued. Compensation cost
will be recognized over the period that an employee provides service in exchange for the
award. On April 14, 2005, SFAS 123(R) was amended to allow companies to adopt the
standard at the beginning of the fiscal year that begins after June 15, 2005. We will
adopt the standard as of the effective date. Assuming we use the Black-Scholes option pricing model and no other share-based payments are granted in the
future, the adoption of SFAS 123(R) is estimated to increase 2006 and 2007 compensation expense by quarter as follows:
March 31, 2006 by $170,000, June 30, 2006 by $165,000, September 30, 2006 by $95,000, December 31, 2006 by
$45,000, March 31, 2007 by $15,000 and June 2007 by $1,000.


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.



30







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                                         | 32  
|                                                                                                |     
|Consolidated Balance Sheets  December 31, 2005 and 2004                                        | 33  
|                                                                                                |     
|Consolidated Statements of Income  Years ended December 31, 2005, 2004 and 2003                | 34  
|                                                                                                |     
|Consolidated Statements of Stockholders Equity  Years ended December 31, 2005,  2004 and 2003 | 35  
|                                                                                                |     
|Consolidated Statements of Cash Flows  Years ended December 31, 2005, 2004and 2003             | 36  
|                                                                                                |     
|Notes to Consolidated Financial Statements                                                      | 37  

|31







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, 2005 and 2004, and the related consolidated statements of income,
stockholders' equity, and cash flows for each of the three years in the period ended
December 31, 2005.  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,
2005 and 2004, and the consolidated results of its operations and its cash flows for each
of the three years in the period ended December 31, 2005, in conformity with U.S.
generally accepted accounting principles.


We also have audited, in accordance
with the standards of the Public Company Accounting Oversight Board (United States), the
effectiveness of Palomar Medical Technologies Inc.'s internal control over financial
reporting as of December 31, 2005, 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 2, 2006 expressed an
unqualified opinion thereon.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|                      |                      
|                      |                      
|Boston, Massachusetts |                      
|March 2, 2006         |                      

|32







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

|                                                                                 | December 31,
2005 | December 31,
2004
|-------------------------------------------------------------------------------- | ----------------- | -----------------
|Assets                                                                           |                   |                  
|Current assets:                                                                  |                   |                  
|Cash and cash equivalents                                                        |                   |                  
|Available-for-sale investments, at market value                                  |                   |                  
|Accounts receivable, net of allowance of $984,392 and $979,392,     respectively |                   |                  
|Inventories                                                                      |                   |                  
|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 8)                                           |                   |                  
|Stockholders' equity:                                                            |                   |                  
|Preferred stock, $.01 par value-                                                 |                   |                  
|Authorized - 1,500,000 shares                                                    |                   |                  
|Issued -  none                                                                   |                   |                  
|Common stock, $.01 par value-                                                    |                   |                  
|Authorized - 45,000,000 shares                                                   |                   |                  
|Issued - 17,126,467 and 16,231,502 shares, respectively                          |                   |                  
|Additional paid-in capital                                                       |                   |                  
|Accumulated deficit                                                              |                   |                  
|                                                                                 |                  
|Total stockholders' equity                                                       |                   |                  
|                                                                                 |                  
|Total liabilities and stockholders equity                                       |                   |                  
|                                                                                 |                  

|See accompanying notes to
consolidated financial statements.

33






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                                |                          |  |  
|Interest expense                               |                          |  |  
|Other income (expense), net                    |                          |  |  
|                                               |                          |  |  
|Income before income taxes                     |                          |  |  
|                                               |                          |  |  
|Provision (benefit) from 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.


34






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

|                                                                  | Common Stock |  |  |            |  |  
|----------------------------------------------------------------- | ------------ |  |  | ---------- |  | -
|
|Balance, December 31, 2002                                        |              |  |  | 11,538,706 |  |  
|                                                                  |              |  |  |            | 
|Net income                                                        |              |  |  | --         |  |  
|Issuance of stock for employee stock purchase plan                |              |  |  | 22,422     |  |  
|Issuance of stock for employer 401(k) matching contribution       |              |  |  | 184,109    |  |  
|Costs incurred related to the issuance of common stock            |              |  |  | --         |  |  
|Tax benefit from the exercise of stock options                    |              |  |  | --         |  |  
|Exercise of warrants                                              |              |  |  | 99,000     |  |  
|Exercise of stock options                                         |              |  |  | 1,416,915  |  |  
|Exchange of note payable from related party for common      stock |              |  |  | 293,255    |  |  
|Sale of common stock                                              |              |  |  | 1,000,000  |  |  
|                                                                  |              |  |  |            |  |  
|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 |  | $
|                                                                  |              |  |  |            | 

|See accompanying notes to
consolidated financial statements.


35






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                                                          |                          |  |  
|Provision for bad debt                                                                 |                          |  |  
|Inventory write-off                                                                    |                          |  |  
|Tax benefit from the exercise of stock options                                         |                          |  |  
|Changes in assets and liabilities:                                                     |                          | 
|Accounts receivable                                                                    |                          |  |  
|Inventories                                                                            |                          |  |  
|Other current assets                                                                   |                          |  |  
|Accounts payable                                                                       |                          |  |  
|Accrued liabilities                                                                    |                          |  |  
|Deferred income taxes                                                                  |                          |  |  
|Deferred revenue                                                                       |                          |  |  
|                                                                                       |                          |  |  
|Net cash 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                                   |                          |  |  
|Decrease in other assets                                                               |                          |  |  
|                                                                                       |                          |  |  
|Net cash used in investing activities                                                  |                          |  |  
|                                                                                       |                          |  |  
|                                                                                       |                          |  |  
|Cash flows from financing activities:                                                  |                          | 
|Proceeds from the exercise of stock options, warrants and                              |                          |  |  
|employee stock purchase plan                                                           |                          |  |  
|Costs incurred related to issuance of common stock                                     |                          |  |  
|Proceeds from sale 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                            |                          |  | $
|                                                                                       |                          |  |  
|                                                                                       |                          |  |  
|Exchange of note payable for common stock                                              |                          |  | $
|                                                                                       |                          |  |  
|                                                                                       |                          |  |  
|Exercise of warrants pursuant to net exercise provision                                |                          |  | $
|                                                                                       |                          |  |  

|See accompanying notes to
consolidated financial statements.

36






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


Note 1 - Summary of Significant
Accounting Policies


Business


Palomar
is engaged in research, development, manufacturing and distribution of proprietary 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.


Use of Estimates


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


Cash and Cash Equivalents


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


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.
Palomar invests 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 Palomars 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 2005, 2004 and 2003 were not material.


Accounts Receivable Allowance


Palomar
maintains an allowance for losses resulting from the inability of its customers to make
required payments.  Palomar regularly evaluates the collectibility of its trade
receivables based on a combination of factors, which may include dialogue with the
customer to determine the cause in delay of payments, the use of collection agencies, and
/ or the use of litigation. In the event that it is determined that the customer may not
be able to meet its full obligation to Palomar, Palomar records a specific allowance to
reduce the related receivable to the amount that Palomar expects to recover given all
information present. Palomar also records a provision for estimated sales returns and
allowances on product and service related sales in the same period as the related
revenues are recorded. These estimates are based on the specific facts and circumstances
of a particular order, analysis of credit memo data and other known factors. If the data
Palomar uses to calculate these estimates do not properly reflect reserve requirements,
then a change in the allowances would be made in the period in which such a determination
is made and revenues in that period could be affected.  Accounts receivable allowance
activity, including sales returns and allowances, consisted of the following for the
years ended December 31, 2005, 2004 and 2003, respectively.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,              | 2005 | 2004 | 2003
|---------------------------- | ---- | ---- | ----
|Balance at beginning of year |      |      | $   
|Additions                    |      |      |     
|Deductions                   |      |      |     
|                             |      |      |     
|Balance at end of year       |      |      | $   
|                             |      |      |     

|37






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, 2005 and 2004, inventories
consisted of the following:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31, | 2005 | 2004
|--------------- | ---- | ----
|Raw materials   |      |     
|Work in process |      |     
|Finished goods  |      |     
|                |      |     
|                |      |     
|                |      |     

|Palomars
policy is to establish inventory reserves when conditions exist that suggest that
inventory may be in excess of anticipated demand or is obsolete based upon assumptions
about future demand for products and market conditions.  Included in Palomars finished
goods inventory are $952,832 in 2005 and $504,545 in 2004 of demonstration products
that are used by Palomars sales organization. Palomar accounts for such products as they
do with any other finished goods item in Palomars inventory in accordance with the
review of Palomars entire inventory. Palomar regularly evaluates the ability to realize
the value of inventory based on a combination of factors including the following:
historical usage rates, forecasted sales or usage, product end of life dates, estimated
current and future market values and new product introductions. Assumptions used in
determining managements estimates of future product demand may prove to be incorrect; in
which case the provision required for excess and obsolete inventory would have to be
adjusted in the future. If inventory is determined to be overvalued, Palomar would be
required to recognize such costs as cost of goods sold at the time of such determination.
Although Palomar performs a detailed review of its forecasts of future product demand,
any significant unanticipated changes in demand could have a significant impact on the
value of Palomars inventory and Palomars reported operating results.


Property and Equipment


Property
and equipment are recorded at cost.  Repairs and maintenance costs are expensed as
incurred. Depreciation and amortization are provided using the straight-line method over
the estimated useful lives of property and equipment.  At December 31, 2005 and 2004,
property and equipment consist of the following:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2005        | 2004        | Estimated
useful life                            
|----------------------------- | ----------- | ----------- | -------------------------------------------------
|Machinery and equipment       | $1,536,879  | $1,376,668  | 3-8 years                                        
|Furniture and fixtures        | 2,146,247   | 1,936,779   | 5 years                                          
|Leasehold improvements        | 293,555     | 293,555     | Shorter of estimated useful life or term of lease
|                              | 3,976,681   | 3,607,003  
|Less accumulated depreciation | 3,067,005   | 2,707,635  
|                              |             |             |                                                  
|Total                         | $   909,676 | $   899,368
|                              |             |             |                                                  

|Revenue Recognition


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

38






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


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


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


Palomar
accounts for funded development revenue from Gillette and Johnson & Johnson Consumer
Companies, Inc. 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, 2005, Palomar has
deferred $375,000 relating to Johnson & Johnson Consumer Companies, Inc.  Payments are
not refundable if the development is not successful. During 2005, Palomar 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,
Palomar recognized approximately $3.1 million and $318,000 of funded product development
revenue from Gillette and Johnson & Johnson Consumer Companies, Inc., respectively.


Palomar
provides 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 Pseudofolliculitis Barbae or PFB. The
contract is a cost plus fee arrangement whereby Palomar is reimbursed for the expenses
incurred in connection with PFB research plus an 8% fee.  Revenue is recognized under the
contract as the costs are incurred and the services are rendered.  During 2005 and 2004,
Palomar recognized approximately $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 $249,000, $208,000 and $99,000 of reimbursed shipping and handling costs
during 2005, 2004 and 2003, respectively.


Product Warranty Costs


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


The
following table provides the detail of the change in Palomars product warranty accrual,
which is a component of other accrued liabilities on the consolidated balance sheet for
the years ended December 31, 2005 and 2004.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                      | 2005 | 2004
|---------------------------------------------------- | ---- | ----
|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


Palomar
charges research and development expenses to operations as incurred.


39






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,                                       | 2005       | 2004       | 2003      
|----------------------------------------------------- | ---------- | ---------- | ----------
|Basic weighted average common shares outstanding      | 16,831,185 | 15,688,855 | 13,399,178
|Potential common shares pursuant to stock options and
|warrants                                              | 2,327,153  | 2,031,006  | 2,518,214 
|                                                      |            |            |           
|Diluted weighted average common shares outstanding    | 19,158,338 | 17,719,861 | 15,917,392
|                                                      |            |            |           

|For
the years ended 2005, 2004 and 2003, potential common shares related to 0, 14,672 and
408,968, respectively, of outstanding stock options and warrants 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) No. 123(R), Share-Based Payment. SFAS 123(R)
revises SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), and supersedes
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25), and its related implementation guidance. SFAS 123(R) will require
compensation costs related to share-based payment transactions to be recognized in the
financial statements (with limited exceptions). The amount of compensation cost will be
measured based on the grant-date fair value of the equity or liability instruments
issued. Compensation cost will be recognized over the period that an employee provides
service in exchange for the award. On April 14, 2005, SFAS No. 123R was amended to allow
companies to adopt the standard at the beginning of the fiscal year that begins after
June 15, 2005. Palomar will adopt the standard as of the effective date.


Through December 31, 2005, Palomar followed the intrinsic value method under (APB 25) and related
interpretations, in accounting for its stock-based compensation plans, rather than the alternative fair value
accounting method provided for under SFAS 123. Under APB 25, when the exercise price of options granted under
these plans equals the market price of the underlying stock on the date of grant, no compensation expense is
required. In accordance with EITF 96-18, Palomar records compensation expense equal to the fair value of options
and warrants granted to non-employees over the vesting period, which is generally the period of service.


As permitted by SFAS 123, Palomar currently accounts for share-based payments to employees using Opinion
25s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options.
Accordingly, the adoption of SFAS 123(R)s fair value method will have an impact on our results of operations,
although it will have no impact on our overall financial position.  As a result of the adoption of Statement
123(R), Palomar plans to minimize share-based compensation to employees in the future.  Assuming the Company uses
the Black-Scholes option pricing model and no other share-based payments are granted in the future, the adoption
of SFAS 123(R) is estimated to increase 2006 and 2007 compensation expense by quarter as follows: March 31, 2006
by $170,000, June 30, 2006 by $165,000, September 30, 2006 by $95,000, December 31, 2006 by $45,000, March 31,
2007 by $15,000 and June 2007 by $1,000. However, had Palomar adopted SFAS 123(R) in prior periods, the impact
of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net
income and earnings per share. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required
under current literature. This requirement will reduce net operating cash flows and increase net financing cash
flows in periods after adoption. Palomar cannot estimate what those amounts will be in the future (because they
depend on, among other things, when employees exercise stock options), the amount of operating cash flows
recognized in prior periods for such excess tax deductions were $180,065, $191,434 and $52,500 in 2005, 2004 and
2003, respectively.

40






The
following tables illustrate the assumptions used and the effect on net income and
earnings per share if Palomar had applied the fair value recognition provisions of SFAS
123 to stock-based employee compensation. Palomar has computed the pro forma disclosures
required under SFAS  123 for all stock options granted to employees of Palomar in the
years ended December 31, 2005, 2004 and 2003 using the Black-Scholes option-pricing model
prescribed by SFAS 123.


The
weighted average assumptions used to calculate the SFAS 123 pro forma disclosure and the
resulting grant date fair values for the years ended December 31, 2005, 2004 and 2003 for
Palomar are as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                            | 2005     | 2004     | 2003    
|---------------------------------------------------------- | -------- | -------- | --------
|Risk-free interest rate                                    | 3.57 %   | 2.55%    | 3.00%   
|Expected dividend yield                                    | --       | --       | --      
|Expected lives                                             | 2 years  | 2 years  | 4 years 
|Expected volatility                                        | 86 %     | 100%     | 111%    
|Grant date fair value of options granted during the period | $  11.73 | $   8.99 | $   3.96

|Pro Forma Disclosure


The
pro forma effect on Palomar of applying SFAS 123 for all options and warrants to purchase
common stock of Palomar would be as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,                                | 2005 | 2004 | 2003
|---------------------------------------------- | ---- | ---- | ----
|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                                      |      |      | $   

|On May 11, 2005, Palomar granted 645,000 options in 2005 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 Palomar granted these options with longer time-based
vesting, Palomar would have incurred significant stock-based payment expenses in future years upon adoption of
SFAS 123 (R).




Palomar 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 Palomar granted these options with longer time-based
vesting, Palomar would have incurred significant stock-based payment expenses in future years upon adoption of
SFAS 123(R).


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


Concentration of Credit Risk

41






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


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, 2005 and
2004, 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,
2005 and 2004.  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





Note 2 - Segment and Geographic
Information


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


The
following table represents percentages of product revenue by geographic destination for
2005, 2004 and 2003:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,           | 2005 | 2004 | 2003
|------------------------- | ---- | ---- | ----
|United States             |      | 71   | %   
|Japan                     |      | 7    |     
|Canada                    |      | 7    |     
|Europe                    |      | 6    |     
|Australia                 |      | 3    |     
|Asia/Pacific              |      | 4    |     
|South and Central America |      | 2    |     
|                          |      |      |     
|Total                     |      | 100  | %   
|                          |      |      |     

|Note 3 - Research and Development
Arrangement


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

42






Note 4 - Income Taxes


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

|At December 31, | 2005 | 2004 | 2003
|--------------- | ---- | ---- | ----
|Federal:        |      |      |     
|Current         |      |      | $   
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|State:          |      |     
|Current         |      |      |     
|Deferred        |      |      |     
|                |      |      |     
|                |      |      |     
|                |      |      |     
|                |      |      |     
|Total           |      |      | $   
|                |      |      |     

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

|At December 31,                                               | 2005 | 2004 | 2003
|------------------------------------------------------------- | ---- | ---- | ----
|Income tax provision at federal statutory rate                |      |      |     
|Increase (decrease) in tax resulting from-                    |      |     
|State income taxes, net of federal benefit                    |      |      |     
|Change in valuation allowance, net operating loss utilization |      |      |     
|Reduction in tax reserves                                     |      |      |     
|Other                                                         |      |      |     
|                                                              |      |      |     
|Provision (benefit) for income taxes                          |      |      |     
|                                                              |      |      |     

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

|At December 31,                   | 2005 | 2004
|--------------------------------- | ---- | ----
|Net operating loss carry forwards |      |     
|Nondeductible accruals            |      |     
|Nondeductible reserves            |      |     
|Tax credits                       |      |     
|                                  |      |     
|Deferred tax assets               |      |     
|Valuation allowance               |      |     
|                                  |      |     
|                                  |      |     
|                                  |      |     

|At
December 31, 2005, Palomar had available, subject to review and possible adjustment by
the Internal Revenue Service, federal net operating loss carry forwards and tax credit
carry forwards of approximately $105 million and $3.1 million, respectively, to be used
to offset future taxable income.  These net operating loss carry forwards will expire
through 2024. A portion of Palomars net operating losses were created by the excess tax
benefits associated with stock options and will be realized through increases to
stockholders equity when utilized. A portion of Palomars losses may be limited to
changes in ownership, as defined by the Internal Revenue Code.  Under Financial
Accounting Standards Board issued Statement of Financial Accounting Standard (SFAS) No.
109, Palomar can only recognize a deferred tax asset for future benefit of its tax loss
and tax credit carry forwards to the extent that it is more likely than not that these
assets will be realized. In determining the realizability of these assets, Palomar
considered numerous factors, including historical profitability, estimated future taxable
income and the industry in which it operates.  At this time we have fully reserved our
otherwise recognizable deferred tax asset, as its realization is uncertain.



43






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


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


Note 5 - 401(k) Plan


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


During
2005, 2004 and 2003, Palomar matched in Palomar stock 50% of all employee contributions
by issuing 11,124, 50,156 and 184,109 shares of stock, respectively, to the 401(k) Plan
in satisfaction of its employer match for employee contributions.  The number of shares
of common stock reserved for issuance under the 401(k) Plan was initially 1,000,000
shares.  As of December 31, 2005, 289,805 shares of common stock remained available for
issuance there under.


Note 6 - Accrued Liabilities


At
December 31, 2005 and 2004, accrued liabilities consisted of the following:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,               | 2005 | 2004        
|----------------------------- | ---- | ------------
|Payroll and employee benefits |      | $  3,900,531
|Commissions                   |      | 1,093,340   
|Royalties                     |      | 3,981,670   
|Warranty                      |      | 874,746     
|Other                         |      | 1,614,813   
|                              |      |             
|Total                         |      | $11,465,100 
|                              |      |             

|Note 7 - Note Payable to Related
Party


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


Note 8 - Commitments and
Contingencies


Operating lease and purchase
commitments


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


On
January 18, 2006, Palomar signed an amendment to its 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,
2005, excluding royalty and employment obligations because they are variable and/or
subject to uncertain timing:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|At December 31,      | 2006      | 2007      | 2008      | 2009    | 2010 | Thereafter
|-------------------- | --------- | --------- | --------- | ------- | ---- | ----------
|Purchase commitments | 6,912,000 | --        | --        | --      | --   | --        
|Operating lease      | 1,165,000 | 1,165,000 | 1,165,000 | 777,000 | --   | --        
|                     |           |           |           |         |      |           
|Total                | 8,077,000 | 1,165,000 | 1,165,000 | 777,000 | --   | --        
|                     |           |           |           |         |      |           
|                     |           |           |           |         |      |           
|                    

|44






Palomar
incurred rent expense of $1,074,000, $1,053,000 and $948,000 for the years ended December
31, 2005, 2004 and 2003, respectively.  This rental expense was offset by $4,600 and
$166,000 in 2004, 2003, respectively, from a tenant subleasing from Palomar approximately
4,000 square feet of Palomars facility. As of January 31, 2004, the tenants sublease
was terminated and Palomar began utilizing this 4,000 square feet.


Research and development
arrangement


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


Royalties


Palomar
is a party to a license agreement, as amended, with Massachusetts General Hospital
whereby the Company is obligated to pay royalties to Massachusetts General Hospital for
sales of certain products as well as 40% of royalties received from third parties.  For
the years ended December 31, 2005, 2004 and 2003, approximately $3,690,000, $2,818,000
and $896,000 of royalty expense, respectively, was incurred under this agreement.


Litigation


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


On
February 15, 2002, Palomar commenced an action for patent infringement in the United
States District Court for the District of Massachusetts against Altus Medical, Inc., now
known as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint
alleges Cuteras CoolGlide and CoolGlide Excel laser systems willfully infringe U.S.
patent No. 5,735,844, which is exclusively licensed to Palomar by the Massachusetts
General Hospital. The Massachusetts General Hospital was added as a plaintiff in this
lawsuit. Cutera answered the complaint denying that its products infringe the asserted
patent and filed a counterclaim seeking a declaratory judgment that the asserted patent
is invalid and not infringed. Palomar and the Massachusetts General Hospital filed a
reply denying the material allegations of the counterclaims. Palomar and the
Massachusetts General Hospital have further alleged that Cuteras CoolGlide Vantage and
CoolGlide XEO laser systems also willfully infringe the asserted patent. On June 4, 2003,
Cutera amended their answer and asserted a counter claim alleging that the patent is
unenforceable due to inequitable conduct. Palomar and the Massachusetts General Hospital
believe that this claim is without merit and filed a reply denying the material
allegations of this counterclaim. A claim construction hearing (often referred to as a
Markman hearing) was held on June 12, 2003, and on February 27, 2004 the Judge issued her
ruling. Palomar believes the ruling largely embraced Palomars position and will have a
considerable impact on the case as it proceeds toward trial. On January 14, 2005, Cutera
filed a motion for summary judgment that the patent claims being asserted are invalid and
not infringed. A hearing was held March 17, 2005, and on December 12, 2005, the Judge
issued a ruling denying Cuteras motion for summary judgment and making several findings
in Palomars favor.  On October 6, 2005, Cutera filed a motion to modify construction of
the claim term Applicator, and on December 12, 2005 the judge issued a ruling denying
Cuteras motion.  A trial date has been set for May 30, 2006.

45






On
April 7, 2005, Palomar and the Massachusetts General Hospital commenced a second action
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 complaint alleges Cuteras products using pulsed light technology for hair removal
willfully infringe U.S. patent Nos. 5,595,568 and 5,735,844, which are exclusively
licensed to Palomar by the Massachusetts General Hospital. Cuteras products include the
Solera Opus product in the Solera Platform and other products using pulsed light and
light-based technology in Cuteras XEO platform. Cuteras PW 770 handpiece is utilized in
the Solera and XEO Platforms.  Instead of answering the complaint, Cutera filed a motion
to dismiss for lack of personal jurisdiction in Massachusetts, and Cutera then filed
identical lawsuits in California and Delaware seeking a declaratory judgment that the
5,595,568 and 5,735,844 patents are not infringed, are invalid, and that the patents are
unenforceable due to inequitable conduct. Palomar and Massachusetts General Hospital
believe Cutera is subject to personal jurisdiction in Massachusetts and have filed a
response opposing their motion.  The parties are waiting for the judge to issue a
ruling.


Employment Agreements


Palomar
has two-year employment agreements with certain officers.  These employment agreements
automatically renew for successive two-year periods absent notice of non-renewal by
either party.  In the event of termination by Palomar without cause, non-renewal by
Palomar or termination by Palomar for good reason without a change in control, these
employment agreements provide 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.


Note 9 - Stockholders Equity


Common Stock


During
1998, Palomar sold 1,457,142 shares of common stock to a group of investors for
$10,200,000.  In addition, Palomar issued callable warrants with a three-year term to
these investors to purchase 1,457,142 shares of common stock at an exercise price of
$21.00 per share, all of which are expired at December 31, 2003. Under the terms of this
private placement, Palomar is obligated to pay the investors a fee of 5% per annum
(payable quarterly) of the dollar value invested in Palomar as long as the investors
continue to hold their common stock in their name at Palomars transfer agent.  During
2005, 2004 and 2003, Palomar paid $59,049, $79,600 and $203,750, respectively, related to
this fee.  These amounts have been charged to additional paid-in capital.




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


Preferred Stock


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


Rights Agreement

46






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


Note 10 - Stock Option Plans and
Warrants


Stock Options


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


The
following table summarizes all stock option activity of Palomar for the years ended
December 31, 2003, 2004 and 2005:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               | Number of
Shares | Exercise Price | WeightedAverage
Exercise Price
|---------------------------------------------- | ---------------- | -------------- | ------------------------------
|Outstanding, December 31, 2002                 |                  |                |                               
|Granted                                        |                  |                |                               
|Exercised                                      |                  |                |                               
|Canceled                                       |                  |                |                               
|                                               |                  |                |                               
|Outstanding, December 31, 2003                 |                  |                |                               
|Granted                                        |                  |                |                               
|Exercised                                      |                  |                |                               
|Canceled                                       |                  |                |                               
|                                               |                  |                |                               
|Outstanding, December 31, 2004                 |                  |                |                               
|                                               |                  |                |                               
|Granted                                        |                  |                |                               
|Exercised                                      |                  |                |                               
|Canceled                                       |                  |                |                               
|                                               |                  |                |                               
|Outstanding, December 31, 2005                 |                  |                |                               
|                                               |                  |                |                               
|Exercisable, December 31, 2003                 |                  |                |                               
|                                               |                  |                |                               
|Exercisable, December 31, 2004                 |                  |                |                               
|                                               |                  |                |                               
|Exercisable, December 31, 2005                 |                  |                |                               
|                                               |                  |                |                               
|Available for future issuances under the plans |                  |                |                               
|as of December 31, 2005                        |                  |                |                               
|                                               |                  |                |                               

|47






The
ranges of exercise prices for options outstanding and options exercisable at December 31,
2005 are as follows:
|---------------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable |            |              |           |             
|------------------- | ------------------- | ---------- | ------------ | --------- | ------------
|
|$0.90-$1.00         | 343,094             | 5.55 years | $       0.98 | 343,094   | $       0.98
|1.51-2.19           | 87,265              | 4.40 years | 1.95         | 82,267    | 1.98        
|2.68-3.19           | 147,492             | 3.49 years | 3.17         | 147,492   | 3.17        
|4.08-5.22           | 257,451             | 7.53 years | 4.97         | 146,488   | 4.97        
|6.22-8.23           | 53,499              | 7.77 years | 6.81         | 27,504    | 6.81        
|9.93-14.31          | 49,164              | 8.21 years | 11.94        | 24,170    | 12.48       
|16.00-23.61         | 3,087,000           | 8.36 years | 16.55        | 1,671,003 | 16.57       
|24.06-26.00         | 725,000             | 9.31 years | 24.70        | 725,000   | 24.70       
|                   
|$0.90-$26.00        | 4,749,965           | 8.02 years | $     15.20  | 3,167,018 | $     15.09 
|                   

|Warrants


The
following table summarizes all warrant activity of Palomar for the years ended December
31, 2003, 2004 and 2005:
|-------------------------------------------------------------------------------------------------------------------------------

|                               | Number of
Shares | Exercise Price | Weighted
Average
Exercise Price
|------------------------------ | ---------------- | -------------- | -------------------------------
|Outstanding, December 31, 2002 |                  |                |                                
|Exercised                      |                  |                |                                
|Canceled                       |                  |                |                                
|                               |                  |                |                                
|Outstanding, December 31, 2003 |                  |                |                                
|Exercised                      |                  |                |                                
|                               |                  |                |                                
|Outstanding, December 31, 2004 |                  |                |                                
|                               |                  |                |                                
|Exercised                      |                  |                |                                
|                               |                  |                |                                
|Outstanding, December 31, 2005 |                  |                |                                
|                               |                  |                |                                
|Exercisable, December 31, 2003 |                  |                |                                
|                               |                  |                |                                
|Exercisable, December 31, 2004 |                  |                |                                
|                               |                  |                |                                
|Exercisable, December 31, 2005 |                  |                |                                
|                               |                  |                |                                

|On
September 29, 2000, Palomar issued warrants to purchase 225,000 shares of Palomars
common stock at $3.50 per share.  The aggregate purchase price was $787,500 and the
warrants expired 5 years from the date of issuance. These warrants were issued to an
investment banking firm as partial payment for investment banking services. The closing
price of Palomars common stock on September 29, 2000 was $2.59 per share and the
warrants were appropriately valued and expensed using the Black-Scholes method in
accordance with Statement of SFAS 123.


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


The
ranges of exercise prices for warrants outstanding and exercisable at December 31, 2005
are as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Warrants Outstanding | Warrants Exercisable |            |            |         |           
|-------------------- | -------------------- | ---------- | ---------- | ------- | ----------
|
|$1.97 - $2.81        | 60,000               | 4.20 years | $     2.25 | 60,000  | $     2.25
|3.19                 | 70,000               | 3.41 years | 3.19       | 70,000  | 3.19      
|                     |                      |            |            |         |           
|$1.97-$3.18          | 130,000              | 3.78 years | $     2.75 | 180,000 | $     2.75
|                     |                      |            |            |         |           

|48






Reserved Shares


At
December 31, 2005, the Company has reserved shares of its common stock for the following:
|-----------------------------------------------------------------------------------------------------------------------

|At December 31,      |          
|-------------------- | ---------
|Stock option plans   | 4,781,667
|Warrants             | 130,000  
|Employee 401(k) plan | 289,805  
|                     |          
|Total                | 5,201,472
|                     |          
|                    

|Employee Stock Purchase Plan


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


Note 11 - Quarterly Results of
Operations (Unaudited)


The
following table presents a condensed summary of quarterly results of operations for the
years ended December 31, 2005 and 2004 (in thousands, except per share data).
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                      | 2004 |           |  |          
|--------------------- | ---- | --------- |  | ---------
|
|Revenues              |      | $10,834   |  | $13,230  
|Cost and expenses     |      | 9,675     |  | 11,200   
|                      |      |           |  |          
|Net income            |      | $  1,159  |  | $  2,030 
|                      |      |           |  |          
|Net income per share: |     
|Basic                 |      | $    0.08 |  | $    0.13
|Diluted               |      | $    0.07 |  | $    0.12

|                      | 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
|                      |      |           |  |          

|Note 12 - Development and License
Agreement with Gillette


Effective
as of February 14, 2003, Palomar entered into a Development and License Agreement with
Gillette to complete the development and commercialize a home-use, light based hair
removal device for women. In October 2005, Procter & Gamble Company (NYSE: PG) completed
its acquisition of Gillette.  Under the Development and License 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, Palomar and
Gillette completed the initial phase of the agreement and both parties decided to move
onto the next phase.  Accompanying this decision, Palomar and Gillette amended the
original agreement, whereby, Gillette will provide $2.1 million in additional development
funding to further technical innovations over a 9-month extension of the development
phase, which is now planned to be completed by August 31, 2006.

49






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


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


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


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


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


For
the year ended December 31, 2005, 2004 and 2003, Palomar recognized $2.8 million, $3.1
million and $2.6 million of funded product development revenues from Gillette,
respectively.


Note 13  Joint Development and
License agreement with Johnson & Johnson Consumer Companies, Inc.


Effective
as of September 1, 2004, Palomar 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.


The
agreement provides for Johnson & Johnson Consumer Companies, Inc. to fund Palomar's
research and clinical studies during an initial proof-of-principle phase. At the end of
the proof-of-principle phase, Johnson & Johnson Consumer Companies, Inc. will decide
whether or not to continue with one or more of the devices in one or more of the fields
into a development phase. Upon Johnson & Johnson Consumer Companies, Inc. deciding to
continue, Johnson & Johnson Consumer Companies, Inc. will be obligated to fund the
development of the selected devices.  If Johnson & Johnson Consumer Companies, Inc.
decides not to continue, Palomar may proceed in fields not selected by Johnson & Johnson
Consumer Companies, Inc. 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 Consumer Companies, Inc. will decide
whether or not to commercialize one or more of the devices in one or more fields. Upon
Johnson & Johnson Consumer Companies, Inc. deciding to commercialize one or more of the
devices, Johnson & Johnson Consumer Companies, Inc. will make payments to Palomar for
each selected field.  Upon commercial launch of the first device in each selected field,
Johnson & Johnson Consumer Companies, Inc. will make a payment to Palomar, and for all
devices sold for use in each selected field, Johnson & Johnson Consumer Companies, Inc.
shall pay Palomar a percentage of sales of such devices and certain topical compounds.
 If Johnson & Johnson Consumer Companies, Inc. decides not to commercialize or fails to
launch a device, Palomar may proceed in fields not selected by Johnson & Johnson Consumer
Companies, Inc. to develop and commercialize these and other devices on its own or with a
different party.

50






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


Note 14  Research contract with
the United States Department of the Army


In
the first quarter of 2004, Palomar 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, Palomar announced that it had
been awarded additional funding of $888,000 for a total of $3,388,000 and a twelve month
extension. The contract is a cost plus fee arrangement whereby Palomar is reimbursed for
the expenses incurred in connection with PFB research plus an 8% fee.  This revenue is
included in funded product development revenue in the accompanying statements of
operations.  Palomar has recognized $1.0 million and $1.1 million of funded product
development revenues from the United States Department of the Army for the year ended December 31, 2005
and 2004, respectively. Palomars revenue from the contract may be subject to government
audit.  Palomar is unaware of any specific adjustments or open items that could result
from any such audit.


Note 15  Product upgrade options


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


Note 16  Settlement of Litigation


On
June 17, 2004, Palomar and Lumenis Ltd. announced that both parties reached a settlement
resolving their on-going litigation concerning both patent infringement and contractual
matters. Pursuant to the settlement, the parties dismissed with prejudice both the
federal action in the Northern District of California as well as the state court action
in Massachusetts.


Under
the terms of the settlement, Lumenis paid $868,000 in the second quarter of 2004 for
back-owed royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to
pay $3.225 million over the next six quarters, or $537,500 per quarter, for back-owed
royalties due on sales of the LightSheer made between July 1, 2002 and December 31, 2003.
 Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the
LightSheer and other professional laser hair removal devices and modules.  We agreed to
the reduction of our standard 7.5% royalty rate to 5% due in part to Lumenis grant to us
of a paid up license to a variety of Lumenis' patents for our light based devices.


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


For
the twelve months ended December 31, 2005, Lumenis made payments of approximately $2.1
million relating to the 5% royalty and approximately $2.2 million for back-owed royalties
recorded as royalty revenue. For the twelve months ended December 31, 2004, Lumenis made
payments of approximately $1.4 million relating to the 5% royalty and approximately $1.9
million for back-owed royalties recorded as royalty revenue.



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


None.



51






Item 9A.  Controls and Procedures


Evaluation of disclosure controls
and procedures


Our management has evaluated the effectiveness of our disclosure controls and procedures as of the end
of the period covered by this report.  Based upon that evaluation, our chief executive officer and chief
financial officer concluded that our 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, 2005 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.


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, 2005. 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.
52







Report of Independent
Registered Public Accounting Firm


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


We
have audited managements assessment, included in the accompanying Managements Report on
Internal Control over Financial Reporting, that Palomar Medical Technologies, Inc.
maintained effective internal control over financial reporting as of December 31, 2005,
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, 2005, 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, 2005, 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, 2005 and 2004, and the related consolidated
statements of income, stockholders equity, and cash flows for each of the three years in
the period ended December 31, 2005 of Palomar Medical Technologies, Inc. and our report
dated March 2, 2006 expressed an unqualified opinion thereon.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|                      |                      
|--------------------- | ---------------------
|                      | /s/ Ernst & Young LLP
|                      |                      
|                      |                      
|Boston, Massachusetts |                      
|March 2, 2006         |                      

|53






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 captioned Executive
Officers, Election of Directors and Section 16(a) Beneficial Ownership Reporting
Compliance in our 2006 annual proxy statement.


Item 11.  Executive Compensation.


We
incorporate the information required by this item by reference to the section captioned Executive
Officer Compensation in our 2006 annual proxy statement.


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


We
incorporate the information required by this item by reference to the sections captioned Security
Ownership of Certain Beneficial Owners and Management and Equity Compensation Plan
Disclosure in our 2006 annual proxy statement.


Item 13.  Certain Relationships
and Related Transactions.


We
incorporate the information required by this item by reference to the section captioned Certain
Relationships and Related Transactions in our 2006 annual proxy statement.


Item 14.   Principal Accountant
Fees and Services.


We
incorporate the information required by this item by reference to the section captioned
"Independent Auditor Fees" in our 2006 annual proxy statement.

54
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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, 2005 and December 31, 2004
| | -------------------------------------------------------------------------

| | Consolidated
Statements of Income for the years ended December 31, 2005,        December 31, 2004 and
                 December 31, 2003
| | ----------------------------------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Stockholders Equity for the years ended December 31, 2005,         December
                 31, 2004 and December 31, 2003
| | -------------------------------------------------------------------------------------------------------------------------------------------------------

| | Consolidated
Statements of Cash Flows for the years ended December 31, 2005,        December 31, 2004
                 and December 31, 2003
| | --------------------------------------------------------------------------------------------------------------------------------------------

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

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

| | 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 |  | 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 
|      |                                                                    |  |                          
|4.2   | Form of rights certificate                                         |  | 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
|      |                                                                    |  |                          

|55
|--

|        |                                                                                           |   | Incorporated by Reference
|------- | ----------------------------------------------------------------------------------------- | - | -------------------------
|
|10.4*   | Second Amended 1996 Stock Option Plan                                                     |   | 10-Q                     
|        |                                                                                           |   |                          
|10.5*   | 1998 Incentive and Non-Qualified Stock Option Plan                                        |   | DEF 14A                  
|        |                                                                                           |   |                          
|10.6*   | 2004 Stock Incentive Plan                                                                 |   | DEF 14A                  
|        |                                                                                           |   |                          
|10.8*   | 401(k) Plan                                                                               |   | S-8                      
|        |                                                                                           |   |                          
|10.9*+  | 2006 Incentive Compensation Program with Louis P. Valente                                 | X |                          
|        |                                                                                           |   |                          
|10.10*+ | 2006 Incentive Compensation Program with Joseph P. Caruso                                 | X |                          
|        |                                                                                           |   |                          
|10.11*+ | 2006 Incentive Compensation Program with Paul S. Weiner                                   | X |                          
|        |                                                                                           |   |                          
|10.12*  | Employment Agreement with Louis P. Valente dated July 1, 2001                             |   | 10-K                     
|        |                                                                                           |   |                          
|10.13*  | Employment Agreement with Joseph P. Caruso dated July 1, 2001                             |   | 10-K                     
|        |                                                                                           |   |                          
|10.14*  | Employment Agreement with Paul S. Weiner dated July 1, 2001                               |   | 10-K                     
|        |                                                                                           |   |                          
|10.15   | Form of common stock purchase warrant                                                     |   | S-8                      
|        |                                                                                           |   |                          
|10.16   | Form of common stock purchase warrant                                                     |   | S-8                      
|        |                                                                                           |   |                          
|10.17   | Form of common stock purchase warrant                                                     |   | S-8                      
|        |                                                                                           |   |                          
|10.18   | Lease for 82 Cambridge Street, Burlington, MA dated June 17, 1999                         |   | 10-Q                     
|        |                                                                                           |   |                          
|10.19   | First Amendment to Lease for 82 Cambridge Street, Burlington, MA dated March 20, 2000     | X |                          
|        |                                                                                           |   |                          
|10.20   | Second Amendment to Lease for 82 Cambridge Street,  Burlington, MA dated January 18, 2006 | X |                          
|        |                                                                                           |   |                          
|10.21   | License Agreement with The General Hospital Corporation dated August 18, 1995             |   | 10-K                     
|        |                                                                                           |   |                          
|10.22   | First Amendment to License Agreement with The General Hospital Corporation                |   | 10-K                     
|        |                                                                                           |   |                          
|10.23   | Second Amendment to License Agreement with The General Hospital Corporation               |   | 10-K                     

|56
|--

|       |                                                                                                                                |   | Incorporated by Reference
|------ | ------------------------------------------------------------------------------------------------------------------------------ | - | -------------------------
|
|       |                                                                                                                                |   |                          
|10.24+ | Third and Fourth Amendments to License Agreement with The General Hospital Corporation                                         |   | 10-K                     
|       |                                                                                                                                |   |                          
|10.25+ | Research Agreement with The General Hospital Corporation dated August 1, 2004                                                  |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.26+ | The Development and License Agreement with The Gillette Company dated February 14, 2003                                        |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.27  | Amendment to the Development and License Agreement with The Gillette Company dated February 14, 2003                           |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.28  | Amendment to the Development and License Agreement with The Gillette Company dated October 2, 2003                             |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.29  | Second Amendment to the Development and License Agreement with The Gillette Company                                            |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.30+ | Third Amendment to the Development and License Agreement with The Gillette Company                                             | X |                          
|       |                                                                                                                                |   |                          
|10.31+ | Joint Development and License Agreement with Johnson &  Johnson Consumer Companies, Inc. dated September 1, 2004               |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.32  | Rights Agreement with American Stock Transfer & Trust Company  dated April 20, 1999                                            |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.33  | Settlement Agreement with The General Hospital Corporation,  Lumenis, Inc. and Lumenis, Ltd. dated June 17, 2004               |   | 8-K                      
|       |                                                                                                                                |   |                          
|10.34+ | Patent License Agreement with Lumenis, Inc. dated June 17, 2004                                                                |   | 8-K                      
|       |                                                                                                                                |   |                          
|21.1   | List of subsidiaries                                                                                                           | X |                          
|       |                                                                                                                                |   |                          
|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 |                          
|       |                                                                                                                                |   |                          
|+      | Filed under application for confidential treatment.                                                                            |   |                          
|       |                                                                                                                                |   |                          
|*      | Management contract or compensatory plan or arrangement.                                                                       |   |                          
|       |                                                                                                                                |   |                          

|57



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 6, 2006.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 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 6, 2006
|Louis P. Valente        
|                         |                                        |              
|/s/ Joseph P. Caruso     | President, Chief Executive Officer and | March 6, 2006
|Joseph P. Caruso         | Director                              
|                         |                                        |              
|/s/ Paul S. Weiner       | Chief Financial Officer                | March 6, 2006
|Paul S. Weiner          
|                         |                                        |              
|/s/ Nicholas P. Economou | Director                               | March 6, 2006
|Nicholas P. Economou    
|                         |                                        |              
|/s/ A. Neil Pappalardo   | Director                               | March 6, 2006
|A. Neil Pappalardo      
|                         |                                        |              
|/s/ James G. Martin      | Director                               | March 6, 2006
|James G. Martin         
|                         |                                        |              
|/s/ Jeanne Cohane        | Director                               | March 6, 2006
|Jeanne Cohane           

|58
|--