10-K 1 form10k123112.htm FORM 10K 123112 form10k123112.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
     
(Mark One)
 
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
 
OR
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: 001-33204
OBAGI MEDICAL PRODUCTS, INC.
(Exact name of registrant as specified in its charter)

     
Delaware
 
22-3904668
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
3760 Kilroy Airport Way, Suite 500, Long Beach, CA 90806
(Address of principal executive offices)

(562) 628-1007
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of class
 
Name of each exchange on which registered
Common Stock, par value $0.001 per share
 
Nasdaq Global Market
 
Securities registered pursuant to Section 12(g) of the Act:
Not applicable

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o   No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes o   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 Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý   No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes ý   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. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company, as defined in Rule 12b-2 of the Exchange Act.
Large accelerated filer  o
Accelerated filer  ý
Non-accelerated filer  o
(Do not check if a smaller reporting company)
Smaller reporting company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o    No ý

The aggregate market value of the registrant’s common stock, $0.001 par value per share, held by non-affiliates of the registrant on June 30, 2012, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $285.7 million  (based on the closing sales price of the registrant’s common stock on that date).  Shares of the registrant’s common stock held by each officer, director and each person known to the registrant to own 10% or more of the outstanding common stock of the registrant have been excluded in that such persons may be deemed to be affiliates of the registrant.  This determination of affiliate status is not a determination for other purposes.  As of March 6, 2013, there were 17,434,138 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates information by reference from the definitive proxy statement for the registrant’s 2013 Annual Meeting of Stockholders.
 
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OBAGI MEDICAL PRODUCTS, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
OBAGI MEDICAL PRODUCTS, INC.
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
     
     
   
Page
 
PART I
 
Item 1.
Business
2
Item 1A.
Risk Factors
26
Item 1B.
Unresolved SEC Commen44ts
44
Item 2.
Properties
44
Item 3.
Legal Proceedings
41
Item 4.
Mine Safety Disclosures
45
     
 
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
46
Item 6.
Selected Financial Data
49
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
50
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
68
Item 8.
Financial Statements and Supplementary Data
68
Item 9.
Changes in Disagreements with Accountants on Accounting and Financial Disclosure
68
Item 9A.
Controls and Procedures
68
Item 9B.
Other Information
69
     
 
PART III
 
Item 10.
Directors, Executive Officers and Corporate Governance
71
Item 11.
Executive Compensation
71
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
71
Item 13.
Certain Relationships and Related Transactions, and Director Independence
71
Item 14.
Principal Accountant Fees and Services
71
     
 
PART IV
 
Item 15.
Exhibits and Financial Statement Schedules
728
     
 
Obagi®, Blue Peel®, Blue Peel RADIANCE® Condition & Enhance®, ELASTIderm®, ELASTILash®, Nu-Derm®, Obagi-C®, Obagi CLENZIderm®, Rosaclear®, SoluCLENZ®, Obagi Hydrate and Penetrating Therapeutics™ are among the trademarks of Obagi Medical Products, Inc. and/or its affiliates in the United States and certain other countries.  Botox® is a registered trademark of Allergan, Inc.  Refissa® is a trademark of Spear Pharmaceuticals Inc.  ReGenica® is a trademark of Histogen, Inc., exclusively licensed to Suneva Medical, Inc.  Any other trademarks or trade names mentioned are the property of their respective owners.

© 2013 Obagi Medical Products, Inc.  All rights reserved.


 
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Forward-looking Statements

We have made forward-looking statements in this Annual Report on Form 10-K (this “Report”), including the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations" and "Business,” that are based on our management’s beliefs and assumptions and information currently available to us.  Forward-looking statements include the information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, industry environment, potential growth opportunities, the effects of future regulations, litigation and competition.  Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate” or similar expressions.

Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict.  Therefore, our actual results may differ materially and adversely from those expressed in any forward-looking statement.  We do not have any intention to update forward-looking statements after this Report is filed.  You should understand that many important factors, in addition to those discussed under the section entitled “Risk Factors” in Item 1A and elsewhere in this Report, could cause our results to differ materially and adversely from those expressed in the forward-looking statements.
 
PART I
 
ITEM 1: BUSINESS

Corporate Information

The Company was founded as WorldWide Product Distribution, Inc. (“Worldwide”) in 1988.  OMP Acquisition Corporation was incorporated in California in October 1997 to purchase substantially all of the assets and to assume the accounts payable and related operating liabilities of WorldWide and subsequently changed its name to Obagi Medical Products, Inc. in December 1997.  OMP, Inc. (“OMP”) was incorporated in Delaware in November 2000; in January 2001 Obagi Medical Products, Inc. was merged into OMP, with OMP as the surviving corporation.  In December 2004, the stockholders of OMP exchanged their shares of OMP for an equal number of shares in a newly formed holding company incorporated in Delaware, Obagi Medical Products, Inc., which became the parent holding company for all existing operations of OMP.  Unless the context indicates otherwise, in this Report we use the terms “Obagi,” “we,” “us” and “our” to refer to Obagi Medical Products, Inc. and its subsidiaries on a consolidated basis.

Our principal executive offices are located at 3760 Kilroy Airport Way, Suite 500, Long Beach, California 90806, and our telephone number at that location is (562) 628-1007.  Our website address is www.obagi.com.  Copies of our most recent Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other filings with the Securities and Exchange Commission (“SEC”) can be obtained free of charge as soon as reasonably practicable after such materials are electronically filed with, or furnished to, the SEC by clicking the SEC Filings link from the Investor Relations page on our website at www.obagi.com.  Members of the public may also read and copy any materials we file with, or furnish to, the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549.  To obtain information on the operation of the Public Reference Room, please call the SEC at 1-800-SEC-0330.  The SEC also maintains an Internet site at www.sec.gov that contains the reports, proxy and information statements, and other information that we file electronically with the SEC.  Our website and the information contained thereon or connected thereto are not intended to be incorporated into this Report.

Our common stock trades on the Nasdaq Global Market under the symbol “OMPI.”

Overview

We are a specialty pharmaceutical company that develops, markets and sells, and are a leading provider of, proprietary topical aesthetic and therapeutic prescription-strength skin care systems and related products in the physician-dispensed market.  Obagi systems and products are designed to prevent or improve the most common and visible skin disorders in adult skin, including premature aging, photodamage, hyperpigmentation (irregular or patchy discoloration of the skin), acne, sun damage, facial redness, and soft tissue deficits, such as fine lines and wrinkles.  Our products have been developed to enhance the underlying health of patients’ skin, and clinical studies have demonstrated that the use of our systems results in skin that looks and acts younger and healthier.

 
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We sell our products through a direct sales force in the United States and internationally through distribution partners in approximately 46 countries across North America, Central America, Europe, the Middle East and Asia.  Our domestic sales force and foreign distributors predominantly sell our products directly to dermatologists, plastic surgeons and other physicians who are focused on aesthetic and therapeutic skin care.  These physicians then dispense our products in-office, directly to their patients.  We believe that we are the market leader in this growing physician-dispensed skin care channel, according to a 2012 study by Kline & Co., an independent market research firm.  Our net sales have grown from approximately $35.6 million in 2001 to $120.7 million for the year ended December 31, 2012. 

Over the years, we have developed numerous skin care products and systems for the enhancement of skin health.  Using our Penetrating Therapeutics technologies, our products are designed to improve the penetration of prescription, over-the-counter (“OTC”) and cosmetic agents across the skin barrier to address the most common and visible skin conditions in adult skin.  Our product portfolio, which includes cosmetic, OTC and prescription products, including 4% hydroquinone, is sold and promoted through physician offices and requires education by a physician on proper use.

Our leading product line, launched in 1988, is the Obagi Nu-Derm System.  We believe the Nu-Derm System is the leading clinically-proven, prescription-based topical skin health system on the market that has been shown to enhance the skin’s overall health by correcting photodamage using drugs that, by definition, work at the cellular level.  This results in a reduction of the visible signs of aging.  In addition, we offer several other skin care systems and related products, including: (i) the Obagi-C Rx System, introduced in 2004, a prescription-strength system that reduces the early effects of sun damage and evens skin tone through the use of a Vitamin C serum combined with 4% hydroquinone; (ii) our Professional-C series of products, introduced in 2005, which consist of high potency antioxidant Vitamin C serums that help minimize the appearance of the effects of ultraviolet radiation and other environmental influences; (iii) the Condition & Enhance System, launched in 2006, which was developed to enhance the results of physician-delivered surgical and non-surgical cosmetic procedures, such as Botox, injectable fillers, chemical peels, microdermabrasion and laser resurfacing treatments; (iv) the ELASTIderm family of products, first introduced in 2006, which includes treatments developed to restore skin elasticity and collagen production, and reduce fine lines and wrinkles, around the eyes and décolletage; (v) our CLENZIderm M.D. Acne Therapeutic Systems, introduced in 2007, featuring a solubilized formulation of benzoyl peroxide (“BPO”) to treat and prevent acne at its root; (vi) the Rosaclear System, launched in 2009, which is a complete prescription-based system developed specifically for the treatment and prevention of the signs and symptoms of facial redness; (vii) ELASTILash Eyelash Solution, a member of the ELASTIderm family launched in 2010, designed to help achieve the appearance of thicker, fuller-looking eyelashes; (viii) Blue Peel RADIANCE, launched in 2011, a gentle salicylic acid-based peel that utilizes a unique blend of acids and other soothing ingredients for a potent combination that exfoliates, evens out skin tone and improves overall complexion, with little-to-no downtime; (ix) ELASTIderm Complete Complex Eye Serum, launched in January 2012, that utilizes an innovative rollerball technology for application; and (x) Obagi Hydrate, a moisturizer launched in October 2012, that features the innovative ingredient Hydromanil and several moisturizing agents for long-lasting hydration.  We also offer: (i) tretinoin, a generic equivalent to Retin-A that is among the most widely used acne treatments, as well as Refissa, a 0.05% strength tretinoin, approved by the United States Food and Drug Administration (“FDA”), with an emollient base that has a broad indication for treatment of fine facial lines, hyperpigmentation and tactile roughness; (ii) metronidazole topical gel, a generic equivalent to Metrogel, for use in conjunction with our Rosaclear System; (iii) ReGenica Facial Rejuvenation Complex, containing a multipotent CCM complex composed of active growth factors and proteins to accelerate visible improvement in skin appearance post facial laser procedures; and (iv) Obagi Blue Peel Essential Kit, which has been cited by Kline & Co. as one of the most well-known brands for use in physician-strength facial peel procedures.

We also advance our development objectives through product and license agreements with third parties.  These agreements may include patent and technology licenses, product licenses and new product collaboration agreements.  We compete in the Japanese retail skin care markets through strategic licensing agreements with a Japanese pharmaceutical manufacturer and distributor that sells a series of OTC products under the Obagi brand name in the Japanese drug and variety store channels.  In addition, until December 31, 2011 we had other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand through the aesthetic spa channel.  Our net licensing revenue from skin health systems and products in Japan was approximately $4.5 million for the year ended December 31, 2012.

The Skin Care Market

According to the American Society of Plastic Surgeons, there were 14.6 million cosmetic procedures performed in the United States in 2012, representing a 5% increase over 2011 and a 98% increase over 2000.  We believe this reflects a growing desire and acceptance among the population to seek assistance from physicians to improve their

 
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appearance, including the appearance of their skin.  A key driver of this trend is the aging of the “baby boomer” segment of the U.S. population.  In addition, life expectancy in the United States has extended in recent years, leading to a further increase in the average age of the country’s population.  Because healthcare needs, including the treatment of skin disorders, tend to increase with age, we expect the demand for skin care products to continue to increase over time.  In particular, women tend to demonstrate a higher motivation than men to improve their personal appearances.  The number of women between the ages of 35 and 65, the primary users of our products, was estimated by the U.S. Census Bureau to have grown 44.7% between 1990 and 2010.  With this segment’s strong desire to reduce the signs of premature aging, we expect the aging female population to continue to increase the market opportunity for skin care products.

Most of the cosmetic skin care products available today are designed to mask the effects of aging and skin disorders, rather than treat the underlying health of the skin.  As a result, consumers may see temporary skin surface improvements, but underlying skin restoration often does not occur because the active agents in these products lack the ability to effectively penetrate the skin barrier.  In addition, most traditional approaches to skin care are not comprehensive programs designed to integrate complementary products.  Individual products, even those that are widely used by consumers (such as facial soaps or sunscreens), are not generally designed to work together, and therefore may cause unintended side effects or reduced effectiveness when used in combination.

For these reasons, consumers have increasingly turned to their physicians for products and simple in-office procedures that can provide better results than consumer cosmetics.  For example, physician-recommended cosmetic products and commonly performed cosmetic procedures such as Botox injections, injectable fillers, laser hair removal and microdermabrasion, have experienced substantial growth as consumers learn that they can achieve positive cosmetic results with minimally invasive techniques.  Beyond anti-aging and aesthetic treatments, there is also significant market demand for effective products that treat skin diseases such as acne, rosacea, psoriasis, and eczema (dermatitis), as well as for eyelash enhancement and effective sunscreen products.  While a number of therapies, treatments and products exist for such diseases or conditions, most treatments or products consist of either topical applications with limited efficacy, or systemic (oral) applications that carry significant potential side effects.

According to Kline & Co., in 2012, there were approximately 26,200 physicians practicing dermatology and plastic surgery in the United States, of which more than 12,100 dispensed skin care products directly to their patients.  Based on our experience with physicians who have opened accounts with us, we believe a growing number of general practice, family practice, internal medicine, dental and obstetrics and gynecology (“OBGYN”) physicians are also dedicating resources in their practices to skin care.  We believe that these physicians are responding to the rapid increase in consumer demand for non-invasive skin care treatments.  

Outside of the United States, the physician-dispensed skin care market varies by country due to cultural differences and regulatory requirements.  Cultural desires for skin with lighter and more even pigmentation have created large and growing aesthetic skin care demands throughout Asia, particularly Japan, China and Korea.  European and certain South American countries such as Brazil also present large skin care markets due to the complementary growth in cosmetic procedures and willingness on the part of their consumers to spend discretionary income on aesthetic enhancements.  We believe that the growth in major international markets will also be driven by cultural desires to lessen the appearance of skin darkening caused by exposure to sun, aging populations and a heightened awareness and availability of aesthetic products and procedures.  While physician dispensing is common in most countries, certain countries prohibit or limit the types of products that can be dispensed from a physician’s office, requiring physicians to either partner with a retail pharmacy or drug store, or to simply forgo dispensing.

Our Obagi Systems and Related Products

We believe the effects of aging and skin disorders are best addressed at a deeper level, where the skin’s natural cell regeneration processes occur, rather than at the surface of the skin.  Thus, a number of our systems and related products have been designed to improve the overall health of the skin by improving cellular processes such as collagen and elastin production, keratinocyte clearing, and melanocyte regulation, using drugs that, by definition, work at the cellular level.  We have developed comprehensive skin care systems and products that incorporate a range of individual prescription and non-prescription therapeutic agents, as well as cosmetic ingredients.  The individual components of each system and related products have been specifically formulated to complement one another, enhancing the effectiveness of a particular system as a whole and allowing the physician to tailor the treatment program to the specific needs of the patient.  The design of our systems and products is generally proprietary to us, and we are the sole licensee of both provisional and issued U.S. patents and have patent applications pending for the composition of many of these products.

 
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System and related products
 
Segment/product category
 
Description
 
Applications
 
Launch date
Obagi Nu-Derm System
 
Physician-dispensed/ Nu-Derm
 
Comprehensive system of six products including prescription and OTC drugs
 
Fine lines, wrinkles, acne, photo damage, hyperpigmentation, melasma, laxity, skin sallowness
 
1988
Obagi Condition & Enhance Systems
 
Physician-dispensed/ Nu-Derm
 
Line extension of Nu-Derm designed for use before and after surgical and non-surgical cosmetic procedures; prescription-based
 
Enhances patient outcomes and patient satisfaction
 
2006
Obagi-C Rx System
 
Physician-dispensed/ Vitamin C
 
Highly stable Vitamin C serum with 4% hydroquinone system; prescription-based
 
Fine lines, wrinkles, hyperpigmentation, skin sallowness
 
2004
Professional-C
 
Physician-dispensed/ Vitamin C
 
Highly stable Vitamin C serums; non-prescription
 
Antioxidant protection, fine lines, wrinkles, hyperpigmentation
 
2005
ELASTIderm Eye and Décolletage
 
Physician-dispensed/ Elasticity
 
System of skin health products built around a novel formulation of a bi-mineral complex; prescription and non-prescription based
 
Increase elasticity and skin tone of eyes, face, neckline and chest
 
2006/2008/
2012
ELASTILash Eyelash Solution
 
Physician-dispensed/ Elasticity
 
Eyelash enhancing solution; non-prescription
 
Enhance the appearance of thickness and fullness of eyelashes
 
2010
CLENZIderm M.D. Systems
 
Physician-dispensed/ Therapeutic
 
Systems for acne treatment built around a novel formulation of BPO; non-prescription
 
Acne
 
2007
Obagi Rosaclear System
 
Physician-dispensed/ Therapeutic
 
System for rosacea treatment that reduces redness and flushing, along with treating papules and pustules; prescription based
 
Rosacea
 
2009
Tretinoin
 
Physician-dispensed/ Other
 
Generic equivalent of Retin-A available in the United States; requires prescription
 
Acne
 
2002
Refissa
 
Physician-dispensed/ Other
 
Branded Retin-A available in the United States; requires prescription 
 
Fine facial lines, hyperpigmentation and tactile roughness
 
2009
Metronidazole
 
Physician-dispensed/ Other
 
Generic equivalent of Metrogel; requires prescription
 
Rosacea
 
2009
Obagi Blue Peel Essential Kit
 
Physician-dispensed/ Other
 
Topical system to aid in the application of TCA (trichloroacetic acid) chemical peels
 
Fine lines, wrinkles, hyperpigmentation
 
1988
Blue Peel RADIANCE
 
Physician-dispensed/ Other
 
Salicylic acid-based superficial chemical peel
 
Fine facial lines, hyperpigmentation and tactile roughness
 
2011
Obagi Hydrate
 
Physician-dispensed/ Nu-Derm
 
Moisturizer containing Hydromanil and several other moisturizing agents
 
Moisturizer
 
2012
ReGenica Facial Rejuvenation Complex
 
Physician-dispensed/ Other
 
Complex containing active growth factors and proteins to improve appearance and moisturization after laser procedures
 
Post-procedure dryness, redness and flaking
 
2013

We further differentiate our skin care systems and related products by supporting their safety and efficacy with randomized controlled and comparative clinical studies conducted by leading market experts.  We believe that these clinical studies provide added scientific credibility to our products in the physician-dispensed market.  We have initiated 148 clinical studies since 2003, involving patients in the areas of acne, aesthetics and elasticity to analyze the efficacy, side effects and tolerability of our systems and products, as well as to compare them to other commonly used regimens.  We currently intend to launch approximately 43 additional clinical studies in 2013 to assess other therapeutic indications for new and existing products.

 
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Obagi Nu-Derm System

Our Obagi Nu-Derm System was initially launched in 1988, and since that time, we have made substantial enhancements to the system through the application of our Penetrating Therapeutics technologies.  We believe that the Nu-Derm System is the leading clinically proven, prescription-based topical skin health system currently available that has been shown to enhance the skin’s overall health by correcting photodamage using ingredients including pharmaceutical agents that, by definition, work at the cellular level.

The Obagi Nu-Derm System consists of a combination of six prescription, OTC therapeutic agents and adjunctive cosmetic skin care products to treat visible skin conditions such as photodamage and hyperpigmentation resulting from extrinsic damage and intrinsic changes to the skin.  The Nu-Derm cosmetic skin care products include cleansers, exfoliating creams and a moisturizer.  Two products in the Nu-Derm System contain hydroquinone, in a 4% prescription concentration, which acts as a bleaching agent that is designed to correct skin pigmentation problems by normalizing the production of new melanin in the epidermis.  Physicians may also prescribe the drug tretinoin, in various concentrations, or Obagi Nu-Derm Sunfader, which also contains 4% hydroquinone, as a complement to the system, depending on the physician’s judgment of patient need.  We believe that the use of these prescription therapeutic agents, the ability of such agents to penetrate the skin’s surface and the order of application distinguishes our Nu-Derm System from other commonly prescribed regimens.  While we have designed the Nu-Derm System to include products that patients can use in a systematic treatment regimen, we also make the component products available for individual sale.  We believe that physicians who dispense the Obagi Nu-Derm System generally encourage their patients to use the component products together in a systematic treatment regimen.  However, we also believe that some patients elect to use the products that make up the system individually.  Products that are used individually at times include the sunscreen products, Obagi Hydrate moisturizer and Obagi Nu-Derm Clear, which physicians may dispense on occasion to address localized pigmentation problems.  Side effects from use of the products may include redness, mild to moderate irritation and/or excessive flaking or sloughing of the outer layers of the treated skin.  Side effects generally resolve after the first 10 days of use, or in cases with certain individuals with sensitive skin, in a few days upon discontinuance of use.

The Obagi Nu-Derm System, including the Obagi Condition & Enhance System (described below), accounted for approximately 52% and 53% of our consolidated net sales for the years ended December 31, 2012 and 2011, respectively.  Although the volume of sales for each individual product within the system varies, we believe the majority of our sales of each component product is due to the fact that they are sold as part of the system.

Obagi Condition & Enhance

To address the growing market for cosmetic procedures, in July 2006, we launched Obagi Condition & Enhance, a line extension of our Nu-Derm System targeted for use with surgical and non-surgical cosmetic procedures, such as Botox, injectable fillers, chemical peels, microdermabrasion and laser resurfacing treatments.  This system provides adjunctive therapy both before and after these procedures, and has been clinically proven to enhance aesthetic outcomes and improve overall patient satisfaction.

Like our Nu-Derm System, the Condition & Enhance System consists of a combination of six prescription and OTC therapeutic agents and adjunctive cosmetic skin care products to treat visible skin conditions such as photodamage and hyperpigmentation resulting from extrinsic damage and intrinsic changes to the skin.  Condition & Enhance cosmetic skin care products include cleansers and exfoliating creams.  Two of these products contain hydroquinone, in a 4% prescription concentration, which acts as a bleaching agent that is designed to correct skin pigmentation problems by normalizing the production of new melanin in the epidermis.  While we have designed Obagi Condition & Enhance to include products that patients can use in a systematic treatment regimen, we also make the component products available for individual sale.  We believe that physicians who dispense Obagi Condition & Enhance generally encourage their patients to use the component products together in a systematic treatment regimen.  Side effects from use of the products may include redness, mild to moderate irritation and/or excessive flaking or sloughing of the outer layers of the treated skin.  Side effects generally resolve after the first 10 days of use, or in cases with certain individuals with sensitive skin, in a few days upon discontinuance of use.

Obagi-C Rx Systems

The Obagi-C Rx Systems consist of a combination of five prescription and OTC drugs and adjunctive cosmetic skin care products to treat skin conditions resulting from sun damage and the oxidative damage of free radicals.  The central ingredients in the systems are hydroquinone, in a 4% concentration, and Vitamin C.  This combination distinguishes Obagi-C Rx from other Vitamin C based products available in the physician office, and Obagi-C Rx

 
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products have been shown in clinical studies to penetrate all levels of skin better than the leading Vitamin C competitor.  We are the sole licensee of certain patents of Avon Products, Inc. (“Avon”) relating to these products.  Two products in each of the Obagi-C Rx Systems contain hydroquinone, in a 4% concentration, which is designed to correct skin pigmentation problems by normalizing the production of new melanin in the epidermis.  The Obagi-C Rx Systems include cosmetic skin care cleansers and exfoliating lotions, as well as a sunscreen lotion.  When combined in a system, we believe hydroquinone, Vitamin C and a sunscreen provide correction of, and protection against, premature skin aging.  As with the Obagi Nu-Derm System, the products that make up the Obagi-C Rx Systems are generally used together in a coordinated regimen by the majority of patients.  Side effects from use of these products may include redness and/or mild to moderate irritation of the treated skin.  Side effects generally resolve after the first 10 days of use, or in cases with certain individuals with sensitive skin, in a few days upon discontinuance of use.

Obagi Professional-C

Obagi Professional-C products are a complete line of proprietary, non-prescription products, that consist of Vitamin C serums used to reduce the appearance of damage to the skin caused by ultraviolet radiation and other environmental influences.  Vitamin C (L-ascorbic acid) acts as a potent antioxidant.  The Professional-C line consists of a 5% serum for the area around the eyes and 10%, 15% and 20% serums for the face, neck and chest.  Obagi Professional-C products are sold individually and are used on their own, or in combination with other Obagi system products.  These products are classified as cosmetics and side effects are not generally associated with their use; however certain sensitive individuals may experience mild irritation of the skin where product is applied.  These products in 10% and 20% concentrations have been shown in clinical studies to penetrate all levels of skin better than the leading Vitamin C competitor.

ELASTIderm

As skin ages, it loses its elasticity and begins to sag, particularly around the eyes, on the neck and on the hands.  Our ELASTIderm product line includes products for the treatment of skin laxity featuring a proprietary bi-mineral complex that may help improve elasticity of the skin and skin tone.  Based on the results of our clinical studies, which showed significant improvements in measured collagen and elastin in under eye skin treated over an eight-week period, we launched an eye cream product under the Obagi ELASTIderm brand name in October 2006.  In February 2007, we launched an eye gel, which is the second product under the Obagi ELASTIderm brand, and in January 2012 we launched an eye serum product that utilizes an innovative roller ball technology for application.

In February 2008, we launched ELASTIderm Décolletage, a system to treat skin conditions resulting from sun damage and improve the elasticity and skin tone for the neck and chest area.  Side effects from use of these products may include redness and/or mild to moderate irritation of the treated skin.  Side effects generally resolve after the first 10 days of use, or in cases with certain individuals with sensitive skin, in a few days upon discontinuance of use.

In response to the growing market for eyelash enhancers, in 2010, we introduced ELASTILash Eyelash Solution, a member of the ELASTIderm family.  The ELASTILash Eyelash Solution contains a peptide (believed to achieve the appearance of visibly thicker, fuller-looking eyelashes) and other cosmetic ingredients, and does not require a prescription.  The product is dermatologist- and ophthalmologist-tested, non-allergenic and has not resulted in any eyelid darkening or changes in iris pigmentation.

We are continuing to evaluate the use of future ELASTIderm products on other areas of the body.  These areas may include the hands, full face, arms and other areas of the body.  However, we cannot assure you that additional products will be successfully developed in the future.

CLENZIderm M.D.

Current formulations of BPO are emulsions, comprised of large, highly insoluble particles that do not pass easily into the skin follicle to treat the underlying causes of acne.  As a result, the efficacy of existing formulations of currently marketed BPO products is limited.  We have developed a system of products for acne treatment featuring a novel formulation of BPO that our clinical studies show penetrates more readily into the skin follicle than current creams or gels because the solubilized particle size is substantially smaller than that of other brands.  We believe that our solution-based acne system is a more effective treatment for acne because a greater amount of the active ingredient, BPO, in a solubilized form will penetrate the hair follicle to act on propionibaceterium acne (“P. acne”).  We conducted several clinical studies that demonstrated that our novel BPO alone achieved greater intrafollicular and skin surface bactericidal activity (or kill) against P. acnes than both a prescription generic BPO formulation and a prescription

 
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BPO/antibiotic combination product.  We believe these studies show the efficacy of our novel BPO formulations in reducing acne and clearing visible acne lesions on the skin.  Based on the results of these studies, we launched the CLENZIderm M.D. System for normal to oily skin in February 2007 and for normal to dry skin in July 2007.  Side effects from use of these products may include redness and/or mild to moderate irritation of the treated skin.  Side effects generally resolve upon discontinuance of use.

Obagi Rosaclear

According to the National Rosacea Society, rosacea is a very common skin condition, affecting more than 16 million Americans.  Our Rosaclear System is the first complete prescription-based system developed specifically for treating the signs and symptoms of rosacea, or facial redness.  The all-in-one system is designed, and has been clinically proven, to effectively reduce redness and flushing, along with treating papules and pustules, to help rosacea patients achieve a clearer, calmer and more balanced-looking complexion.  The system consists of a gentle cleanser, metronidazole topical gel 0.75%, and a Hydrating Complex Corrector designed to protect and moisturize irritated skin as well as minimize redness and flushing.  A chemical-free, non-comedogenic Skin Balancing Sun Protection SPF 30 sunscreen was also developed for use in conjunction with the system.  This sunscreen was designed to provide broad-spectrum UVA/UVB protection and is tinted to help reduce the appearance of facial redness and irritation.  Side effects can include tearing of the eyes, burning, skin irritation, dryness, transient redness, metallic taste, tingling or numbness of the extremities and nausea in certain sensitive individuals.  If these effects occur, the medication should either be used less frequently or discontinued.

Metronidazole

Metronidazole, an antibiotic, is often used in a topical gel form for the treatment of rosacea in the United States.  Topical metronidazole helps to treat the inflammatory papules and pustules associated with rosacea.  While physicians can, and in many cases do, write a prescription for metronidazole to be filled by a pharmacy in conjunction with our Rosaclear System, we also offer a FDA-approved metronidazole topical gel 0.75% to provide physicians the option of dispensing metronidazole directly from the office along with the Rosaclear System.  Side effects can include tearing of the eyes, burning, skin irritation, dryness, transient redness, metallic taste, tingling or numbness of the extremities and nausea in certain sensitive individuals.  If these effects occur, the medication should either be used less frequently or discontinued.

Tretinoin and Refissa

Tretinoin creams and related adjunctive acne care products are used for the topical treatment of acne in the United States.  Tretinoin, the active ingredient in the prescription acne drug Retin-A, is a Vitamin A derivative and has been the primary prescription acne therapy for approximately 25 years.  Topical tretinoin normalizes the growth rate of skin cells, disrupting the onset of acne.  We offer FDA-approved formulations of tretinoin through exclusive licenses in the physician-dispensed skin care channel.  Our tretinoin line is available in concentrations of 0.1%, 0.05% and 0.025%.  In September 2009, we also began offering Refissa, a FDA-approved 0.05% strength tretinoin with an emollient base that has a broad indication for treatment of fine facial lines, hyperpigmentation and tactile roughness.  These products are sold individually and are used by doctors as a single therapy, in combination with Obagi Nu-Derm and Condition & Enhance or in combination with other acne therapies.  Side effects include excessively red, edematous, blistered, or crusted skin for certain sensitive individuals.  If these effects occur, the medication should either be discontinued until the integrity of the skin is restored, or the medication should be adjusted to a level the patient can tolerate.  To date, adverse effects generally have been reversed upon discontinuation of therapy.

Obagi Blue Peel Essential Kit

Obagi Blue Peel Essential Kit is a topical system to aid in the application of trichloroacetic acid (“TCA”) chemical peels used to smooth the surface of skin, improve skin tone and color, diminish wrinkles and shrink pore sizes and is sold for professional use only.  While the Obagi Blue Peel Essential Kit is not dispensed for daily home use in a system and is therefore not a significant source of our revenue, it is used to aid physicians in skin peeling activities.  Chemical peels are in-office procedures performed either by a physician or a member of a physician’s staff, depending on the skin depth of the peel.  During the procedure, acidic solutions are combined in our delivery system and applied to the face to remove the thin surface layers of aged and damaged skin.  After removal, the body will naturally replace the removed skin layers with new, healthy skin cells.  The Obagi Blue Peel Essential Kit provides for an even application and slows the penetration of the solution into the skin, allowing physicians to more accurately monitor and control the depth of the peel.  This produces a more uniform and consistent application, which reduces the risk of

 
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complications.  We believe that the Obagi Blue Peel Essential Kit is especially effective as a complementary treatment to our Nu-Derm System.  The Obagi Blue Peel Essential Kit products have no known side effects in and of themselves.  Patients treated with Obagi Blue Peel Essential Kit products as part of an acid peel procedure can expect to experience side effects that are associated with such chemical peel procedures.  We do not manufacture, supply or recommend the source for the TCA generally used in these chemical peel procedures. 

Blue Peel RADIANCE

Blue Peel RADIANCE, launched in January 2011, is a salicylic-acid based superficial chemical peel product that is sold for professional use only.  The product consists of a unique blend of acids and other soothing ingredients for a potent combination that can be used to improve a variety of skin disorders, including acne scarring, photodamage and melasma (uneven pigmentation).  As compared to deeper TCA chemical peels, Blue Peel RADIANCE may be applied in an in-office procedure that takes a matter of minutes and offers little-to-no downtime.  However, because it is a more gentle peel product, generally a series of four to six peel procedures provides the best overall results.  During and after a peel procedure using Blue Peel RADIANCE, the following may be experienced: stinging, itching, burning, mild pain, tightness, peeling and scabbing of the superficial layers of the skin.  These sensations should gradually diminish over the course of a few weeks as the skin returns to normal.  However, some patients may react differently.  In unusual and severe cases, the skin may turn very red, blister, swell and later scab and crust.  The skin may be uncomfortable and look like a bad sunburn.  The peeling usually lasts about three to seven days, although it may last longer.  Following a peel procedure, adequate sunscreen should be used for at least a week to allow for proper healing of the skin.

ReGenica Facial Rejuvenation Complex
 
        In January 2013, we began offering ReGenica Facial Rejuvenation Complex, targeted for use after facial laser procedures.  The typical recovery time following a laser procedure is two to four weeks, with patients frequently experiencing redness, dryness, swelling and skin flaking.  ReGencia Facial Rejuvenation Complex contains a multipotent CCM complex (“CCM”), which includes active growth factors and proteins, and skin conditioning agents to relieve these post-procedure side effects.  CCM has been clinically proven to accelerate the return of healthy appearing skin after laser treatment compared to a vehicle control in two separate studies published in peer-reviewed journals.  This product is classified as a cosmetic and side effects are not generally associated with its use.

Areas of Future Growth

Penetrating Therapeutics

Our product development strategy is to enhance the efficacy of established, widely prescribed, FDA-approved dermatology products (both prescription and OTC) by developing mechanisms that significantly enhance the penetration of these agents across the skin’s protective barrier into the deeper layers of the skin, where therapeutic benefits are realized.  We describe this enabling technology as Penetrating Therapeutics, in which the individual chemical characteristics of both active and inactive agents are addressed and then combined in a systematic manner based on their pharmacokinetic properties.

We believe that our Penetrating Therapeutics technology may be applicable in other skin health areas.  We are currently evaluating additional therapeutic formulations in related areas, some of which could result in new product introductions.

We seek to demonstrate through clinical studies the improved efficacy of various topical agents when used as part of our systems.  We are conducting and plan to initiate numerous clinical studies to demonstrate the advantages of our products in blinded, randomized controlled studies as well as direct comparative studies that will provide both clinically and statistically significant results.  We will work with leading researchers and clinicians in their respective fields of applications and markets.  We intend to use these results in marketing our products.

e-Commerce Platform

We are in the process of developing and testing a web-based marketing and fulfillment operation.  We have designed this e-Commerce platform to enable patients to order Obagi products from their physicians’ virtual storefronts on our newly created website, www.buyobagi.com, and we will assist physicians by hosting and maintaining their virtual storefronts and fulfilling their patients’ orders.  In addition, consumers who do not have a physician participating in this program and who wish to purchase cosmetic or OTC Obagi products only will be able to can order them online directly
 
 
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from us.  We intend to initially launch the e-Commerce platform with a select group of physicians in a limited number of states and will not offer products directly to consumers during this initial launch stage.  Following such beta launch, we will eventually roll out the platform nationwide, other than in those states that have regulations limiting or prohibiting these activities, and will sell OTC and cosmetic products online directly to consumers.  We believe a robust e-Commerce platform will help build and strengthen the relationship between our physician customers and their patients by giving patients an efficient and easy way to order Obagi products from their physicians.

To broaden our internet presence, in addition to developing our e-Commerce platform, we have also entered into a Supply and Distribution Agreement (the “Distribution Agreement”) with Bella Brands, LLC (“Bella”), under which Bella is an authorized distributor of Obagi products solely through its www.bellarx.com website.  Bella’s website will be dedicated to the sale of Obagi products directly to consumers and in assisting consumers who do not yet have a prescription for Obagi products in obtaining such a prescription.
 
Having an e-Commerce platform, we believe, will enable us to capitalize on the interest in our products by directing consumers to one place to learn about and purchase our products, capture a portion of this new business for our physician customers and serve a larger population of potential patients.  However, we cannot assure you that our e-Commerce platform will actually expand our base of end-users or result in the growth of our business.  Moreover, we have already invested and continue to, invest significant capital and other resources in the creation and maintenance of this e-Commerce platform.  These activities may divert the attention of our management and other key employees from the operation of our core business, which could materially and adversely impact our business and results of operations in 2013.

Sales and Marketing

Domestic

In the United States, we sell our systems and related products directly to physicians through our internal sales force.  Physicians then dispense our products in-office, directly to their patients, a distribution method commonly referred to as the “physician-dispensed” channel.  We believe that the physician-dispensed distribution model ultimately results in higher patient satisfaction because it is better suited to the provision of system-based skin care than traditional drug distribution channels.  Our physician customer base consists primarily of plastic surgeons and dermatologists, but also includes physicians from other practice areas, such as general practice, family practice, internal medicine, dental and OBGYNs who are adding skin care to their practices.

Based on a 2012 study by Kline & Co., we are the leading skin health company in the physician-dispensed channel, with an estimated 27.7% market share, nearly two times the market share of the next largest competitor.  As of December 31, 2012, we had over 6,600 active accounts in the United States.  Each account has at least one licensed physician on-site and we estimate that there are over 12,600 physicians in total practicing under these active accounts.  This includes physicians on-site at a small but growing number of medical spas.

The U.S. market accounted for 82% and 83% of our net sales for the years ended December 31, 2012 and 2011, respectively.  As of December 31, 2012, we had 139 sales, marketing and education specialists, including 105 dedicated sales representatives and managers.  We believe that we have sufficient sales representation to enable us to effectively target the plastic surgeons, dermatologists and aesthetic skin care physicians who dispense skin care products in the United States.  In addition to effective systems, we also offer turn-key practice building programs and patient events that help these physicians grow their practices.  These resources help physicians improve their recurring patient visits and revenue streams.

Our marketing efforts have a dual focus.  First, we market directly to physicians in an attempt to create treatment awareness and encourage the use of our products by both new and existing physician clients.  To support this effort, we use medical journal advertising, sales aids, videos, CDs and slide demonstrations, physician-to-physician speaker presentations, trade shows, reminder items, educational and training support, internet resources, and telemarketing.  Second, we attempt to create and then build upon the relationships with our physician customers by marketing our products to their patients.  We accomplish this through in-office materials in our physician customers’ medical practices; consumer engagement through our website, beauty blogs and social media outlets; public relations efforts to create brand awareness; and product maintenance programs to increase patient loyalty.  In addition, we provide patient education booklets and videos, funding for cooperative advertising, training and direct assistance in patient seminars and other programs, continuous product education and public relations programs for patient referrals.

 
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In addition, our research and development staff is designing and directing clinical studies to support the application of our existing product lines for new markets and to enhance our current marketing efforts.  We have conducted numerous studies with the leading academic institutions and key experts in dermatology and aesthetic medicine, and will continue to expand our collaborations with leading dermatologists and institutions to coordinate additional clinical studies for new product applications and formulations.  We believe evidence from our clinical studies will validate the performance of our existing products and provide a platform for the development of new products and product applications.

International

International markets accounted for 18% and 17% of our net sales for the years ended December 31, 2012 and 2011, respectively.  We address international markets through 19 international distribution partners that have sales and marketing activities in approximately 46 countries outside of the United States, and a trademark and know-how license agreements and a license distribution agreement for the retail drug store channel in Japan.  We target distribution partners who are capable and willing to mirror our sales and distribution model in the United States and who have an established business and reputation with physicians.  The products that we sell internationally are generally the same formulations as those sold in the United States; however, in some instances, formulations have been modified to comply with the regulatory requirements of certain countries.

These distributors use a model similar to our business model in the United States, addressing their territories through direct sales representatives who sell to physicians, or through alternative distribution channels, depending on regulatory requirements and industry practices.  The sale of skin health and restoration products through physician offices is not as widely established internationally as it is in the United States.  Some of our more successful international distribution partners include our partners in Europe, Southeast Asia, the Middle East and North America (excluding the United States).  In many of these territories, our partners utilize Obagi-branded medical centers to employ trained physicians for patient sales, as well as a training center to provide product and sales training to regional physicians and their staff.  In addition, some of our distribution partners, such as our distributors in Mexico and Canada, leverage their existing complementary product offerings to gain rapid account penetration for Obagi Systems in their territories.  International sales are diversified, and our largest individual medical channel distribution partner purchased approximately $2.6 million of products from us during the year ended December 31, 2012.

We intend to continue expanding our international presence by entering into strategic relationships in key locations such as Asia and Europe.  We believe that there is potential for significant sales growth of our products in international markets due to cultural emphasis on overall skin health and appearance, and the continued development and acceptance of surgical and non-surgical cosmetic procedures throughout many countries of the world.  In 2013, we intend to continue to invest in efforts to assess international market opportunities and to review and optimize our current international markets.

Licensing

In areas where the physician-dispensed skin care channel is underdeveloped, we look for alternative models to build a presence and brand awareness for our products.  For example, in Japan we have pursued two separate distribution channels for our brand and product concepts.  In 2002, we launched our first formal long-term relationship in Japan by entering into a Trademark and Know-How License Agreement with Rohto Pharmaceutical Co., Ltd. (“Rohto”) to market and sell our Obagi-developed products in Japan.  Rohto is a Japanese pharmaceutical manufacturer and distributor.  Under our current agreement, Rohto is licensed to manufacture and sell a series of OTC products developed by it under the Obagi brand name in the Japanese drug store channel, for which it pays us a license fee. In 2008, we expanded that relationship to provide for collaboration on the development of new products and to pursue the higher end department store channel in Japan.  In addition, at the end of 2008 we entered into a License Distribution Agreement with Rohto for sales of products using our bi-mineral complex technology, for which we receive royalty payments on net sales.  Our strategic partner in Japan has engaged in aggressive direct-to-consumer advertising, which we believe has raised consumer demand in Japan, creating greater brand awareness in the physician channel to the benefit of our core prescription lines.  During the year ended December 31, 2012, our licensing partner in Japan generated approximately $4.5 million in license fees and royalties.
 
We will continue to look for credible partners to address new geographies, and to evaluate alternative channel opportunities in Japan and other countries to drive brand awareness and accelerate overall market penetration.

 
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Concentration of Market Risk

Prior to 2012, sales to any single customer had not amounted to 10% or more of our consolidated net sales.  However, for the year ended December 31, 2012 we had two affiliated customers, Dr. Dinh Hoai and Dr. Lieu Nguyen, which together accounted for 11% of our consolidated net sales during the year ended December 31, 2012.  The loss of these customers could materially and adversely affect our business, financial condition and results of operations.

Manufacturing

We believe our manufacturing processes provide us with a competitive advantage, which we have developed through years of experience formulating skin care products.  We maintain manufacturing scalability and flexibility by maintaining manufacturing with several qualified independent third-party contract manufacturers. Our main contract manufacturers during 2012 included Arizona Natural Resources, Inc., GS Cosmeceutical USA, Inc., Bay Cities Container Corporation, Denison Pharmaceuticals Inc., Ei, Inc., PureTek Corporation and Swiss-American Products Inc., and we continue to explore and establish relationships with additional third-party manufacturers.  For all of our proprietary product concepts, we believe we own the related manufacturing processes, methods and formulations.

We use FDA-compliant manufacturers who specialize in the manufacture of prescription and OTC pharmaceutical and/or cosmetic products.  These parties manufacture products pursuant to our specifications.  All of these manufacturers are required by law and by our manufacturing standards to comply with current Good Manufacturing Practice (“cGMP”).  We pre-qualify and continually monitor our manufacturers for quality and compliance.  We also require documentation of compliance and quality from those manufacturers for whom we act as representative in connection with the promotion and sale of their products.  For most of our key products, we have two or more qualified manufacturers.  Although certain products, including some of our sun protection products, are currently supplied by a single source, we intend to qualify additional manufacturers for such products.

In addition, while physicians can and in many cases do write a prescription to be filled by a pharmacy for tretinoin for use in conjunction with our Obagi Nu-Derm and Condition & Enhance Systems or for metronidazole for use in conjunction with our Rosaclear System, we also purchase such products directly from third parties in order to provide physicians the option of dispensing these products directly from the office along with Obagi products.  These products are currently purchased under exclusive product supply agreements with two manufacturers of tretinoin that both expire in 2014, and under a product supply agreement with one manufacturer of metronidazole that terminated in 2012.  We currently have a sufficient inventory of metronidazole to meet our needs for at least the next 12 months as we explore arrangements with other manufacturers.  While there are several other manufacturers of generic tretinoin and metronidazole, the termination of those agreements or any loss of services under those agreements could be difficult for us to replace.

Intellectual Property

Our success depends in part on our ability to obtain and maintain proprietary protection for our product candidates, technology and know-how, to operate without infringing the proprietary rights of others and to prevent others from infringing our proprietary rights.  Our policy is to seek to protect our proprietary position by, among other methods, filing United States and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business.  In connection with developing new products and product applications, we have filed, or have obtained an exclusive license to, 31 U.S. provisional and non-provisional patent applications since 2004.  We also rely on trade secrets, know-how, continuing technological innovation and in-licensing opportunities to develop and maintain our proprietary position.

We have pursued an aggressive trademark registration policy as a means to achieve brand recognition and product differentiation in the market.  We own various U.S. and foreign trademark registrations and applications and common law marks.  

We have licensed certain patent applications owned by JR Chem LLC (“JR”) covering our ELASTIderm, CLENZIderm and Rosaclear Systems (the “JR Patents”).  We have also relied on services provided by JR in the development of new products to address acne, skin elasticity and facial redness, under a five-year contract.  Although
 that consulting portion of the contract expired in September 2010, we believe the license and royalty obligations of the parties under the contract survived termination.  See “Certain Material Agreements – Jose Ramirez and JR” below.  In addition, we have licensed the rights to four patents owned by Avon, one of which expired in 2008 while the remaining three expire between 2013 and 2018, covering methods and formulations for stabilizing Vitamin C in a serum for facial


 
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skin benefits, which is in our Obagi-C Rx C-Clarifying serum, Professional-C 5% serum and Professional-C 10% serum.  We entered into the license agreement with Avon in June 2003, for an initial three-year term, which is renewed year to year thereafter, at our option, through the life of the last patent to expire.  The last patent will expire in September 2018.

We have also acquired rights to market, distribute, sell and, in some cases, make products pursuant to license agreements with other third parties.  Such agreements contain provisions that require us to meet certain specified requirements, such as quantity purchase and payment obligations, in order to maintain the rights granted under the agreements.

Certain Material Agreements

Obagi Agreements

Avon.  Under a license agreement with Avon, dated June 26, 2003, we have an exclusive worldwide license to manufacture and sell skin care products containing an ascorbic acid component directly to physicians and medical spas.  Under the terms of the agreement, we also have a non-exclusive license to manufacture and sell such products directly to drug stores outside of the United States.  We paid Avon a non-refundable license issue fee.  Additionally, we pay a non-refundable annual renewal fee.  The original term of the agreement expired in 2006 and we have continued to annually renew the agreement each year since that time.  Our annual option to renew the agreement survives until the last of the licensed patents expires on September 10, 2018.  Each party, at its option, may terminate the agreement upon prior written notice in the case of default in the performance of any obligation under the agreement by the other party and failure to take action to cure such a default within a specified period.  If we become bankrupt or insolvent, or file a petition for bankruptcy, or if our business is placed in the hands of a receiver, assignee or trustee from which we cannot extract ourselves within 120 days, or if we are liquidated or substantially all of our assets or shares are sold, exchanged or transferred, or in the event of a merger or consolidation to which we are a party and to which Avon reasonably objects, the agreement shall immediately terminate without notice.

DDN.  On July 1, 2009, we entered into a services agreement with DDN/Obergfel LLC (“DDN”) under which DDN has agreed to serve as our exclusive third-party logistics provider for Obagi products sold or distributed in states east of the Mississippi in the United States.  Under the agreement, DDN has agreed to receive, warehouse and ship on our behalf any Obagi products sold in such territories and to provide standard order fulfillment and other shipping information related to those products.  In return, we have agreed to pay DDN specified warehousing and distribution fees and, if we do not meet certain minimum billing requirements, an additional management fee.  We have also agreed to pay specified additional fees for certain order adjustments, processing and handling of returned goods, access to DDN’s information systems and account management services.  The agreement had an initial term of 36 months.  Upon expiration of the initial term, the agreement automatically renewed for a 12 month term and will automatically renew for successive 12-month terms unless written notice is provided by either party a specified period of time before the end of the current term.  Each party has the right to terminate the agreement upon prior written notice in the case of a breach of the agreement by the other party and failure to cure such a breach within a specified period.  In addition, we may terminate the agreement at any time upon prior written notice to DDN and payment of an early termination fee.  In the event that DDN raises its fee rates more than a certain amount, then we may terminate the agreement without payment of any early termination fee upon written notice to DDN provided within a specified period after receiving notice of the fee rate adjustment.

Jose Ramirez and JR.  Pursuant to a consultant services and confidentiality agreement with Jose Ramirez and JR (the “JR Agreement”), we hired JR to perform research and development activities including product formulation, product development and regulatory work, as detailed in various statements of work.  We agreed to pay JR a minimum annual fee of $0.1 million per year for five years, commencing on January 1, 2005, plus reasonable and customary expenses incurred at our request, in connection with the provision of such services.  We paid consulting fees and expenses totaling $0.9 million under the agreement for the year ended December 31, 2010.

We had a right of first refusal for the exclusive license of any and all of JR’s inventions that he introduced to us related to skin healthcare that were developed or reduced to practice by JR during the term of the agreement, subject to certain exceptions.  In the event that we exercised this right and obtained such an exclusive license, we agreed to pay a tiered royalty to JR.  We are entitled, however, to credit against such royalty payments a portion of the expenses we have incurred to develop and commercialize any product subject to the exclusive license.  We paid JR an aggregate of approximately $0.4 million in royalty fees under the agreement for each of the years ended December 31, 2012, 2011 and 2010.  To the extent that we sublicense any of our rights under an exclusive license in exchange for only a license


 
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fee, we have agreed to pay JR a portion of any such license fee that we receive, subject to an annual cap and to our ability to credit against any amounts due to JR a portion of the research and development expenses we incurred in connection with the sublicense.  Any such sublicense would be subject to JR’s prior approval, which approval may not be unreasonably withheld.  We have negotiated a separate royalty arrangement for sales of our bi-mineral complex with Rohto.  Pursuant to our arrangement with Rohto, in December 2008, we amended the JR Agreement to modify the royalty rates paid to JR based on Rohto’s sales of products containing the bi-mineral technology.

The term of the JR Agreement was for five years, which began in January 2005.  Between January 1, 2010 and April 2010, at which time we reached what we believed was an agreement in principle for amending the JR Agreement, we continued to operate under the original terms of the JR Agreement.  Although that amendment was never executed, the parties operated under the agreement, as amended, from June 2010 through September 2010.  The JR Agreement terminated in September 2010 with respect to services, and accordingly our obligations to JR, except for certain royalty obligations, ceased at that time.  However, many obligations of JR survived such termination in a manner in which we believe will not impact our rights to the technology.

We are currently in discussions with JR on a variety of matters.  We have been advised by JR that it believes that certain of our products, including the ELASTIderm line of products, and CLENZIderm and Rosaclear, are covered by both issued and pending patents which JR contends are owned by it and which it believes were licensed to us under the JR Agreement.  JR contends that such license and our right to continue to sell such products terminated when the JR Agreement terminated.  We disagree with JR’s position on this issue and are seeking to resolve this and other issues in our ongoing negotiations with JR. Should we fail to reach agreement with respect to these current discussions, we could end up in litigation with JR regarding the ownership rights to these technologies, and our business, results of operations and financial condition could be adversely affected.  See “Risk Factors – Risks Related to Intellectual Property - If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights and - We and our manufacturers and suppliers license certain technologies and patents from third parties.  If these licenses are breached, terminated or disputed, our ability to commercialize products dependent on these technologies and patents may be compromised” in Part I, Item 1A of this Report.

Rohto.  On September 13, 2002, we entered into a strategic licensing agreement with Rohto, a Japanese pharmaceutical manufacturer and distributor.  Under the agreement, Rohto is licensed to manufacture and sell a series of OTC products developed by it under the Obagi brand name, as well as Obagi-C products, in the Japanese drug and variety store channels and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto.

On December 4, 2008, we entered into an amendment (the “Rohto Amendment”) to the original agreement with Rohto.  The Rohto Amendment extends the term of agreement to December 4, 2017 and permits extension of the Territory (as defined in the agreement) to areas outside Japan, subject to separate written agreement(s).  The Channel (as defined in the agreement) has been expanded to include department stores if certain conditions are met.  To date, these conditions have not been met.  Rohto and Obagi have also agreed to work together to up-brand the Obagi products sold in the various channels and work cooperatively on messaging, branding and product imaging.  Under the Rohto Amendment, Obagi has also agreed to provide an exclusive royalty-bearing license to sell and/or manufacture certain products developed by Obagi, Rohto or jointly developed by Obagi and Rohto.

On December 4, 2008, we entered into a license and supply agreement with Rohto (the “Bi-mineral Agreement”) whereby we granted Rohto an exclusive right to manufacture, market and sell our bi-mineral collagen and elastin enhancing products in all channels (other than the aesthetic and spa channels) in Japan.  Rohto also has the right to develop improvements to such products or new products related to the products.  The initial term of the Bi-mineral Agreement is for five years, through December 4, 2013, with an optional five-year extension.  The Bi-mineral Agreement calls for certain annual sales volume and expense commitments on behalf of Rohto.  If such commitments are not met, we have the right to terminate such agreement or render it non-exclusive.  As consideration for the exclusive license, Rohto will pay a development fee to us in equal installments over a five-year period as well as quarterly royalty fees based on product sales.  If the Bi-Mineral Agreement should be terminated by either party before all five installments of the development fee have been paid or in the event of early termination, then any unpaid installments will become due and payable to us ten days before the effective termination date.  The royalty rate is scaled over the term of the agreement.
 
       Precision Dermatology.  Under a product supply agreement with Precision Dermatology, Inc. (which acquired the assets of Triax Pharmaceuticals, LLC in April 2012) (“PDI”), originally entered into on December 8, 2005 and subsequently amended and restated on August 24, 2009, we have exclusive rights to sell certain tretinoin products in   

 
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0.1%, 0.05% and 0.025% concentrations and, at our request, any other concentrations for which PDI receives abbreviated new drug application (“ANDA”) approvals from the FDA, in the physician-dispensed skin care channel in the United States (including all territories of the United States).  In addition, we have rights to sell such products on a non-exclusive basis outside of the United States.  If we do not purchase a minimum number of units of products each year in any combination of concentrations, we will lose our exclusive selling rights in the United States.  During the years ended December 31, 2012 and 2011, we met the minimum purchase requirements.  Under the terms of the agreement, we are required to pay PDI a fixed price for the products, subject to volume discounts we may receive if we purchase a certain volume of products and those products are sold to our customers within a specified period of time.  These volume discounts are based on calendar year performance and applied to cumulative quarterly purchases.  The initial term of the amended and restated agreement is five years, with an automatic renewal for a successive five-year term unless written notice is provided by either party at least 12 months before the end of the current term.  Each party has the right to terminate the agreement upon prior written notice in the case of material breach and failure to take action to cure such a breach within a specified period.  Each party also has the option to terminate the agreement by written notice if the other party ceases to carry on its business or becomes the subject of any proceeding under state or federal law for the relief of debtors or otherwise becomes insolvent, bankrupt or makes an assignment for the benefit of creditors, or upon the appointment of a receiver for the other party or the reorganization of the other party for the benefit of creditors.

OPO Agreements

e-Commerce.  In March 2012, OPO, Inc., our wholly-owned subsidiary established in January 2012 (which is a stand-alone entity that will conduct our online sales and fulfillment operations) (“OPO”), entered into a Software License, Development and Services Agreement (the “Software Agreement”) with Koogly, LLC (“Koogly”).  Under the Software Agreement, Koogly will develop, install, maintain and host software for OPO that will enable end users to acquire our products through the www.buyobagi.com website, or order Obagi products online from their physicians’ virtual storefronts on the website, including prescription-based products, allow us to track and manage online orders and provide warehouse management functionality.  OPO agreed to pay Koogly a one-time license fee of $1.4 million.  In addition, OPO has agreed to pay Koogly a royalty in an amount that is less than one percent of net sales of Obagi products that are sold through the Obagi website during the term of the Software Agreement.  The term of the Software Agreement is seven years.  Thereafter, the Software Agreement may be renewed upon mutual agreement of Koogly and OPO.  Either party has the right to terminate the Software Agreement upon prior written notice in the case of a breach of the agreement by the other party and failure to cure such breach within a specified period.  In addition, OPO may terminate the Software Agreement if Koogly has not delivered the software within 12 months or, if once delivered and used in a commercial environment, the software is unavailable for five consecutive days. In March 2013, we entered into an amendment of the Software Agreement with Koogly under which Koogly has agreed to provide OPO with additional programming services for a period of six months for a $175,000 fee.  OPO may choose to extend these services for an extra six month period for an additional $175,000 fee.  In addition, Koogly has agreed to provide certain debugging services to OPO for a fee not to exceed $50,000.

In conjunction with the execution of the Software Agreement, on March 6, 2012, OPO entered into the Distribution Agreement with Bella.  Under the Distribution Agreement, OPO has appointed Bella as an authorized distributor of Obagi products solely through its www.bellarx.com website and solely to end users in the United States.  Bella’s website will be dedicated only to the sale of Obagi products and to assisting end users who do not yet have a prescription for Obagi products in obtaining such a prescription.  The term of the Distribution Agreement is also seven years.  Thereafter, the Distribution Agreement may be renewed upon mutual agreement of Bella and OPO.  Either party has the right to terminate the Distribution Agreement upon prior written notice in the case of a breach of the agreement by the other party and failure to cure such breach within a specified period.  In addition, OPO may terminate the Distribution Agreement upon termination of the Software Agreement.

Both Koogly and Bella are affiliates of Phoenix Capital Management, LLC, which owns the website www.kwikmed.com.  
 
Competition

The market for skin health and restoration is highly competitive with many established manufacturers, suppliers and distributors engaged in all phases of the business.  We believe that we face strong competition.  Competitive factors in our market include:

·  
product efficacy and uniqueness;


 
16

 

·  
brand awareness and recognition;

·  
product quality, reliability of performance and convenience of use;

·  
cost-effectiveness;

·  
breadth of product offerings;

·  
sales and marketing capabilities and methods of distribution;

·  
resources devoted to product education and technical support; and

·  
speed of introducing new competitive products and existing product upgrades.

We face and will continue to face intense competition.  A number of our competitors have substantially greater research and development and marketing capabilities, more diverse distribution channels and greater financial resources than we do.  These competitors may have developed, or could in the future develop, new technologies that compete with our products or render our products obsolete.  We are also likely to encounter increased competition as we enter new markets, attempt to further penetrate existing markets and expand into new distribution channels.  Some of our competitors have in the past and may in the future compete by lowering prices on their products.  We may respond by lowering our prices, exiting the market, expanding into other markets, or investing in the development of new, improved products. 
 
We believe our direct competitors in the physician-dispensed skin care channel include various products from SkinCeuticals, a division of L’Oreal S.A., SkinMedica, Inc., a division of Allergan, Inc., Kinerase from Valeant Pharmaceuticals International, Vitamin C and various products from IS Clinical, Neova from PhotoMedex, Inc. and Jan Marini.

We believe our indirect competitors that generally sell skin care products directly to consumers consist primarily of large cosmetic companies, including, but not limited to BioMedic from La-Roche Posay, Dermalogica, The Estee Lauder Companies Inc., Helene Curtis Industries, Inc., L’Oreal S.A., Matrix Essentials, Inc., a division of L’Oreal, Procter & Gamble Company, Neutrogena, a division of Johnson & Johnson, Revlon, Inc. and Unilever N.V.

Our acne products compete with Triaz from Medicis Pharmaceutical Corporation, Benzaclin from Valeant Pharmaceuticals International, Inc., Brevoxyl and Duac from Stiefel, a GSK company, and Benzac from Galderma Laboratories, L.P.  Our acne products also indirectly compete with OTC anti-acne products.

Our elasticity products have demonstrated clinical evidence of aiding the restoration of elasticity and mature elastin in aged skin.  We currently know of no other products that have clinical evidence to support this claim.  However, there are several products that claim to enhance elastin.

Our products also compete with current and future medical devices, such as lasers, which are or will be positioned for a variety of skin enhancements such as facial rejuvenation, dermal thickening, acne and other uses.  Competitors in this market include Syneron Medical Ltd., CoolTouch Corporation, Cutera, Inc., Cynosure, Inc., Lumenis Ltd., Reliant Technologies, Inc. and Solta Medical, Inc.  However, we believe, when used as a pre/post treatment, our Obagi Systems are complementary to many of these procedures.
 
As we enter new distribution channels, such as the e-Commerce channel, we will face competition from large online storefronts, such as Amazon.com, auction sites, such as eBay, as well as numerous online sellers of Obagi and other skincare products, including several unauthorized resellers of our products as well as certain customers.

Government Regulation

Federal, state and local governmental authorities in the United States and other countries regulate, among other things, the testing, production, distribution, labeling, advertising, promotion and sale of prescription and OTC drugs and cosmetics.  In the United States, the FDA, acting under the Federal Food, Drug, and Cosmetic Act (“FDCA”), and other federal statutes (including the Public Health Service Act, Administrative Procedure Act, Federal Trade

 
 
17

 

 Commission Act, Fair Packaging and Labeling Act, Lanham Act and Homeland Security Act) and agencies implementing regulations, regulate our products primarily on the basis of their intended use, as determined by the labeling claims or other representations made for the product.

FDA regulation of cosmetics

The FDCA defines cosmetics as products and their components intended to be rubbed, poured, sprinkled, or sprayed on, introduced into, or otherwise applied to the human body or any part thereof for cleansing, beautifying, promoting attractiveness, or altering the appearance.  Cosmetic products are not subject to FDA pre-market approval authority, although the FDA can take enforcement action under the Code of Federal Regulations (“CFR”) for marketed cosmetic products that are adulterated or misbranded, including violations of product safety requirements, use and quantity of ingredients, labeling and promotion and methods of manufacture.  Additionally, the FDA monitors compliance of cosmetic products through random inspections of cosmetic company websites, importers, manufacturers and distributors.  The labeling of cosmetic products is subject to the requirements of the FDCA, the Fair Packaging and Labeling Act and other FDA regulations.
 
We believe that many of the products in the Obagi Nu-Derm, Condition & Enhance, Obagi-C Rx, Professional-C, ELASTIderm, CLENZIderm M.D. and Obagi Rosaclear Systems and other product lines, as labeled and intended for use, fall within the FDA definition of cosmetics and therefore do not require pre-market review and approval.  Cosmetics may be sold both OTC and through a physician’s office, subject to state laws governing the commercial practices of physicians.

FDA regulation of drug products

The FDCA defines drugs as products intended to cure, mitigate, treat or prevent a disease or to affect the structure or any function of the human body.  Drug products are subject to more comprehensive safety and efficacy requirements of the FDCA and its implementing regulations.  In general, products falling within the FDCA’s definition of “new drugs” require pre-marketing review and approval by the FDA.  Products falling within the FDCA’s definition of “drugs” that are not “new drugs” because they are generally recognized as “safe and effective” for the indication for which they are being marketed and have been used to a material extent and for a material time under those conditions generally do not require pre-market review and approval from the FDA.  In addition, certain other drugs that have been in existence for a specified period of time are not currently subject to FDA pre-market review and approval.  The official legal status of many of these drug products has often not been determined or finalized.  Others are marketed under the FDA's regulatory discretion. The FDA has established enforcement priorities for determining when the agency will take enforcement action against marketed unapproved drugs.  This enforcement policy is set forth in FDA Compliance Policy Guide (“CPG”) entitled “Marketed New Drugs Without Approved New Drug Applications.”  The CPG, however, does not confer any legal authority to market an unapproved drug.  The FDA has reserved the right to take enforcement action (e.g. seizure, injunction or criminal prosecution) against any marketed unapproved drug at any time.  Additionally, marketed unapproved drugs are subject to compliance with FDA regulations concerning manufacture, labeling, advertising, distribution, and recordkeeping for drug products.

Brief History of the Development of the FDCA

The original federal Pure Food and Drug Act was adopted in 1906 and prohibited the sale of adulterated or misbranded drugs, but did not require that drugs be approved by the FDA prior to marketing.  In 1938, Congress enacted the FDCA, which required that all “new drugs” be approved for safety through a New Drug Application (“NDA”).  Drugs that were on the market prior to the enactment of the FDCA were exempt from “new drug” status under a grandfather clause, and did not require an NDA.  If a new drug was approved by the FDA between 1938 and 1962, the FDA generally allowed identical, related or similar (“IRS”) drugs to be marketed without independent approval on the grounds that the active ingredient(s) was generally recognized as safe.  In 1962, Congress amended the FDCA to require that all “new drugs” be demonstrated to be effective as well as safe to obtain FDA approval.  However, under a grandfather clause in the 1962 amendment, a drug was exempt from the effectiveness requirement if, before the amendment was enacted, it was: (i) used or sold commercially in the United States; (ii) not considered a “new drug;” and (iii) not covered by an effective application.

The Drug Efficacy Study Implementation (“DESI”) was a program begun by FDA in 1962 after the amendments to the FDCA were adopted.  The DESI program was intended to classify all pre-1962 drugs that were already on the market and approved based on safety only as either effective, ineffective, or needing further study.  The DESI program evaluated over 3,000 separate products and over 16,000 therapeutic claims.  By 1984, final action had
 
 
18

 

been completed on 3,443 products; of these, 2,225 were found to be effective, 1,051 were found not effective, and 167 were pending.  The DESI program remains uncompleted because the FDA turned its regulatory priorities to more pressing regulatory matters (the OTC Drug Review (the “OTC Review”) in the 1970's, the generic drug scandal in the late 1980's, the so-called drug lag in the 1990's, and the backlog in applications for generic drugs since the turn of the century with the need for increased inspections for raw material suppliers and applicants). The interactions of these mixed programs and priorities have created gray legal areas for drug products that have been marketed for decades in accordance with the FDA's CPG.


Drugs that did not have pre-1962 approvals or that were not IRS to drugs with pre-1962 approvals were not subject to DESI.  Some of these products are not formally exempt from the FDA pre-marketing “new drug” approval today, but are being marketed and sold based on an assertion of being grandfathered or generally recognized as safe and effective.  They are subject to the enforcement priorities set forth in the CPG unless the FDA determines that a NDA must be filed or otherwise concludes that such product is not a new drug.  These drugs are sometimes called “DESI II” drugs because the FDA stated its intention in the 1980’s to review these drugs under a DESI-type program once the DESI program was finished, in order to determine the drugs’ regulatory status.  The FDA did not initiate the so-called DESI II program due to competing priorities, as noted above.

FDA regulation of “new drug” products

Today, the steps required before a “new drug” may be marketed in the United States include: (i) pre-clinical laboratory and animal testing; (ii) submission to the FDA of an Investigational New Drug (“IND”), application, which must become effective before clinical trials may commence; (iii) adequate and well controlled clinical trials to establish the safety and efficacy of the drug; (iv) submission to the FDA of a NDA; and (v) FDA approval of the NDA prior to any commercial sale or shipment of the drug. An ANDA is required to be submitted and approved when the drug product intended for commercialization is bioequivalent to an already approved NDA product; an ANDA application does not need to repeat the clinical trials that were required for approval of the NDA, or reference listed drug.  In addition to obtaining FDA approval for each product, each drug-manufacturing establishment must be registered with the FDA and drugs offered for sale must be listed with the FDA.  Drug product manufacturing establishments located in California also must be licensed by the State of California in compliance with separate regulatory requirements.

Pre-clinical testing is generally conducted on laboratory animals to evaluate the potential safety and the preliminary efficacy of a drug.  The results of these studies are submitted to the FDA as a part of an IND, which must become effective before clinical trials in humans can begin.  Typically, clinical evaluation involves a time consuming and costly three-phase process.  In Phase I, clinical trials are conducted with a small number of subjects to determine the early safety profile, the pattern of drug distribution and metabolism.  In Phase II, clinical trials are conducted with groups of patients afflicted with a specific disease to determine preliminary efficacy, optimal dosages and expanded evidence of safety.  In Phase III, large-scale, multi-center, comparative trials are conducted with patients afflicted with a target disease to provide sufficient data to demonstrate the efficacy and safety required by the FDA.  The FDA closely monitors the progress of each of the three phases of clinical trials and may, at its discretion, re-evaluate, alter, suspend or terminate the testing based upon the data that have been accumulated to that point and its assessment of the risk/benefit ratio to the patient.

We in-license three ANDA products, tretinoin, Refissa and metronidazole, all prescription drug product offerings.  Each of our suppliers for these products holds FDA approval of ANDAs for its respective products.
 
FDA Enforcement Discretion for Marketed Unapproved Drug Products

Products falling within the FDCA’s definition of “drugs” that are not “new drugs” because they are generally recognized as “safe and effective” for the indication for which they are being marketed or fall within the 1938 or 1962 grandfather clauses are not required to obtain pre-market review and approval from the FDA.

We market a number of products containing 4% hydroquinone (the “HQ Products”) that we believe are not “new drug” products subject to FDA pre-market approval or may be grandfathered because they are generally regarded as safe and effective and that are marketed subject to the enforcement priorities in the CPG.  The Obagi Nu-Derm Clear, Blender and Sunfader products and the Obagi-C Rx C-Clarifying Serum, C-Night Therapy Cream and ELASTIderm Décolletage Skin Lightening Complex products contain the active ingredient hydroquinone at a 4% concentration and are marketed as prescription drugs.  We believe these HQ Products must be administered under the supervision of a physician but are not currently subject to prior FDA approval when formulated and labeled in accordance with guidelines

 
 
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for prescriber information under direction of a physician because we believe they do not fall within the statutory definition of a “new drug.”

Hydroquinone, as a skin bleaching agent has been subject to FDA regulation as an OTC drug in certain concentrations since the initiation of the OTC Review in the early 1970's.  The OTC Review was modeled on the DESI Review, and evaluated the safety and effectiveness of the data available for the active ingredients (drugs) in the hundreds of thousands of OTC drug products that were on the market.  Drugs that are subject to the OTC Review are and have been in a regulatory safe harbor for the uses covered by that multi-step process pending completion of the monograph applicable to the intended use under the OTC Review and the CPG.

To date, the FDA has not required an NDA or other approval for the continued marketing of hydroquinone.  In August 2006, the FDA issued a proposed rule that stated that OTC skin bleaching products containing hydroquinone and currently marketed outside the physician channel at 2% concentrations or less, were not generally recognized as safe and effective, were misbranded, and are new drugs within the meaning of the FDCA.  The FDA proposed that because of the carcinogenic and ochronosis potential of hydroquinone, its use in skin bleaching drug products should be restricted to prescription use only, and users of such products should be closely monitored under medical supervision.  The FDA also withdrew a tentative proposed monograph that concluded that hydroquinone products with concentrations of 2% or less were generally recognized as safe and effective and stated its intent to require NDA approval for continued marketing of prescription hydroquinone products at the time of publication of the final rule.  In the proposed rule, the FDA recommended that additional studies be conducted to determine if there is a risk to humans from the use of hydroquinone.  The FDA nominated hydroquinone for further study by the National Toxicology Program (the “NTP”), and in December 2009 the NTP Board of Scientific Counselors approved the nomination.  As a result, the FDA has stated that it intends to conduct the following three NTP studies will be conducted:

·  
Comparative metabolism studies in rats and mice by oral and dermal routes;

·  
Reproductive toxicity study in rats and mice by oral route; and

·  
Dermal carcinogenicity studies of hydroquinone in mice and rats.

There are several more steps to the nomination process before the studies will commence, and the studies themselves can take two years or more to complete.  The FDA has noted that, in the interim, it believes that hydroquinone at concentrations of 2% or less should remain available as an OTC drug product.  At the conclusion of the NTP studies, if the FDA does change the status of hydroquinone products to require a NDA, and if the FDA does not allow us to continue to market our products while we attempt to comply with such new requirement as imposed, or if the FDA does not approve a NDA filed by us or a third party for hydroquinone products, then we will no longer be able to market our Obagi Nu-Derm, Obagi-C Rx and ELASTIderm Décolletage Systems containing 4% hydroquinone.  Additionally, we cannot rule out the possibility that the FDA could take enforcement action against our HQ Products prior to the completion of the NTP studies.  FDA approval of a hydroquinone product under a NDA filed by another party would make our HQ Products an “enforcement priority” under the CPG, thus increasing the risk that we will be required to exit the market.  Furthermore, if the NTP studies conclude that hydroquinone is a carcinogen, we may be required to cease sales of all our products that contain hydroquinone.  Should one of our contract manufacturers or any of its ingredient suppliers develop cGMP issues, our products could also become an enforcement priority subject to potential immediate action under the CPG.  Furthermore, the actions that were taken by the State of California and previously by the State of Texas related to our HQ Products could cause the FDA to investigate or reconsider the regulatory status of these products and should it do so, it may require us to obtain a NDA for such products and could require us to withdraw such products from the market pending such approval.  See “Risk Factors - Risks Related to Regulatory Matters,” in Part I, Item 1A of this Report.

State Regulation of Drug Products

In addition to the FDA, various states also regulate the advertisement, distribution and sale of prescription drug products.

Texas.  In November 2009, we received a letter from the Texas Department of State Health Services (the “Agency”) regarding shipping in Texas of products containing unapproved new drugs and, specifically, referencing certain retail businesses in Texas that were selling our products containing prescription drugs over the Internet.  Prior to this time, the Agency had detained products from three of our customers that sold products on the Internet based on a complaint from a third party.  In its letter, the Agency alleged that we were shipping unapproved drug articles to these

 
 
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establishments in violation of certain Texas statutes.  After a series of communications with the Agency, at the end of April 2011, we met with the Agency and the Texas Attorney General (the “AG”) at which time the AG stated it viewed us to be in violation of the Texas Food, Drug and Cosmetic Act and the Texas Deceptive Trade Practices Act arising from the sale in Texas of our HQ Products, which the state believed to be an unapproved new drug.

By letter dated February 29, 2012, the Agency notified the AG that it would be closing its pending investigation and enforcement action against us relating to our promotion, sales and distribution of HQ Products in Texas effective that date and withdrew its April 13, 2011 referral of the matter to the AG.  The Agency based its decision on: (i) a directive that the Agency set priorities for enforcement and allocate its resources and concentrate its efforts on cases that represent the greatest risk to public health and safety; (ii) a FDA Q&A document issued in 2010 wherein the FDA acknowledged the potential medical benefits of hydroquinone-containing products for a certain medical condition, the uncertainty of public health risks associated with the ingredient and its intent to conduct long-term studies through the NTP; and (iii) its acknowledgement of the relevance of the FDA’s CPG policy statement that the FDA has been using to guide its staff and industry concerning the FDA’s enforcement priorities for unapproved drug products.  The Agency also noted that it did not have sufficient evidence to conclude that there is an immediate risk to public health and safety from the topical use of products containing hydroquinone.  No monetary penalties or other administrative fees were levied against us as the result of the Agency’s investigation and no lawsuit was ever filed by the AG against us.  Beginning in April 2011, we voluntarily ceased selling any HQ Products into the state of Texas.  In addition, we implemented a plan that enabled our customers in Texas to return any of these products (that had not otherwise been detained) currently in their possession in exchange for a credit or refund.  Upon completion of the investigation and withdrawal of the complaint, we resumed selling our HQ Products into Texas in May 2012.

California. In February 2012 we received a Subpoena to Answer Interrogatories and Produce Documents from the Attorney General of the State of California (the “CAG”) in connection with an investigation of our business practices.  The subpoena seeks information and documents relating to our belief that our HQ Products are not new drugs that require pre-market review and marketing approval by the FDA.  The subpoena also requests information and documents concerning the methods by which we promote, market and sell our HQ Products, the identities of persons who dispense our HQ Products in California, the amount of HQ Products we sell in California, complaints we have received and adverse event reports concerning our HQ Products, communications to and from the FDA regarding the safety and effectiveness of our HQ Products, and certain other information regarding our HQ Products.

We have provided documents and information to the CAG pursuant to the subpoena and have had discussions with the CAG’s office in an attempt to better understand the concerns of the CAG’s investigation.  We expect to continue to have discussions with the CAG’s office and to cooperate fully with the CAG’s investigation.

Certain of our HQ Products have been continuously promoted, sold and distributed in the United States for more than 20 years.  To date, the side effects that have been reported for our HQ Products are redness, mild to moderate irritation and/or excessive flaking or sloughing of the outer layers of the treated skin.  These side effects generally resolve after the first 10 days of use, or in cases with certain individuals with sensitive skin, in a few days upon discontinuance of use.

We believe our HQ Products are not “new drug” products subject to FDA pre-market approval because they are generally recognized as safe and effective and therefore are commercialized under the FDA’s regulatory discretion pursuant to the CPG.
 
Additionally, we believe our HQ Products are considered DESI II products which are defined as products that are considered to be drugs that require physician prescription, have not been the subject of a New Drug Application filed with the FDA and have not been through the FDA’s Drug Efficacy Study Implementation program.  If a DESI II drug meets certain requirements, which we believe our HQ Products meet, it is our understanding that the FDA will generally defer enforcement action, provided that such drug product does not present a safety problem or trigger one of the CPG’s enforcement priorities.

The OTC Monograph System

While FDA approval is generally required before a new drug product may be marketed in the U.S., many OTC drugs are exempt from the FDA’s pre-marketing approval requirements.  In 1972, the FDA instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness of OTC drug ingredients in the market.  Through this process, the FDA issues monographs for therapeutic product categories that set forth the specific active ingredients, dosages,
 
21

 

strengths, indications for use, warnings and labeling statements for OTC drug ingredients that the FDA will consider generally recognized as safe and effective for OTC use and therefore not subject to pre-market approval.

For most categories of OTC drugs not yet subject to a final monograph, the FDA usually permits such drugs to continue to be marketed until a final monograph becomes effective, unless the drug will pose a potential health hazard to consumers.  The FDA’s policy also generally applies to prescription drugs containing the same active ingredients as a marketed OTC product for the same or similar uses as the OTC product.

Drugs subject to final monographs, as well as drugs that are subject only to proposed monographs, are subject to various FDA regulations concerning, for example, manufacturing in accordance with cGMPs, general and specific labeling requirements and prohibitions against promotion for conditions other than those stated in the labeling.  Drug manufacturing facilities are subject to FDA inspection, and failure to comply with applicable regulatory requirements may lead to administrative or judicially imposed penalties.  State agencies also may require registration, licensure and inspection of manufacturing or distribution facilities and may require reporting of promotional activities.

We market a number of OTC products under the following monographs: Sunscreen, Acne, Skin Bleaching, Skin Protectant, External Analgesic and Topical Antibiotic.  These products are regulated by the FDA as OTC drugs subject to a FDA final monograph but do not require FDA pre-market review or approval.

FDA Regulation of Our Products and Product Candidates

The following table summarizes the current status of the active ingredients in, FDA pre-marketing approval (if any) required for, FDA regulatory category of, and launch date for, our material products and product candidates: 

Product
 
Main Functioning or Active Ingredients(1)
 
FDA Pre-Marketing Approval Required
 
Product Status(2)
 
Date Launched
Obagi Nu-Derm Gentle Cleanser(3)
 
Mild Cleansers
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Foaming Gel(3)
 
Mild Cleansers
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Toner(3)
 
Hamamelis Virginiana (Witch Hazel) Distillate
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Clear(3)
 
Hydroquinone 4%
 
No
 
DESI II
 
1988
Obagi Nu-Derm Exfoderm(3)
 
Phytic Acid
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Exfoderm Forte(3)
 
Glycolic Acid, Lactic Acid
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Blender(3)
 
Hydroquinone 4%
 
No
 
DESI II
 
1988
Obagi Nu-Derm Sun Block SPF 32(3)
 
Zinc Oxide 18.5%
 
No
 
OTC
 
2004
Obagi Nu-Derm HSP SPF 35(3)
 
Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%
 
No
 
OTC
 
2002
Obagi Nu-Derm Sun Shield SPF 50(3)
 
10.5% zinc oxide and 7.5% octinoxate
 
No
 
OTC
 
2011
Obagi Nu-Derm Sunfader
 
Hydroquinone 4% Octyl Methoxycinnamate 7.5%, Oxybenzone 5.5%
 
No
 
DESI II/OTC
 
1984
Obagi Nu-Derm Skin Balancing Toner
 
Hamamelis Virginiana (Witch Hazel) Distillate
 
No
 
Cosmetic
 
2009
Obagi Nu-Derm Action
 
Moisturizer
 
No
 
Cosmetic
 
1988
Obagi Nu-Derm Blend Fx
 
Arbutin
 
No
 
Cosmetic
 
2009
Obagi Nu-Derm Clear Fx
 
Arbutin
 
No
 
Cosmetic
 
2009
Obagi Nu-Derm Eye Cream
 
Mild Moisturizers
 
No
 
Cosmetic
 
1984
Obagi Nu-Derm Tolereen
 
Hydrocortisone 0.5%
 
No
 
OTC
 
1988
 
Obagi Hydrate
 
Mild Moisturizer
 
No
 
Cosmetic
 
2012
Obagi-C Rx C-Cleansing Gel
 
Mild Cleansers
 
No
 
Cosmetic
 
2004
Obagi-C Rx C-Exfoliating Day Lotion
 
Glycolic Acid
 
No
 
Cosmetic
 
2004
Obagi-C Rx C-Clarifying Serum
 
Hydroquinone 4%
 
No
 
DESI II
 
2004
Obagi-C Rx C-Therapy Night Cream
 
Hydroquinone 4%
 
No
 
DESI II
 
2004
Obagi-C Rx C-Sunguard SPF 30
 
Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%
 
No
 
OTC
 
2004
Obagi-C Rx System C-Balancing Toner
 
Hamamelis Virginiana (Witch Hazel) Distillate
 
No
 
Cosmetic
 
2010
Obagi-C Rx System C-Clarifying Serum Normal to Oily skin
 
Hydroquinone 4%
 
No
 
DESI II
 
2009
Obagi-C Rx Sun Shield SPF 50
 
10.5% zinc oxide and 7.5% octinoxate
 
No
 
OTC
 
2012
Obagi Professional-C Serum
 
L Ascorbic Acid (Vitamin C) 5% to 20% concentrations
 
No
 
Cosmetic
 
2005
Obagi Tretinoin(4)
 
Tretinoin 0.025%, 0.05%, and 0.1%
 
Yes
 
ANDA
 
2006
Refissa Tretinoin
 
Tretinoin 0.05%
 
Yes
 
ANDA
 
2009
 
 
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Product
 
Main Functioning or Active Ingredients(1)
 
FDA Pre-Marketing Approval Required
 
Product Status(2)
 
Date Launched
Obagi CLENZIderm M.D. Daily Care Foaming Cleanser
 
Salicylic Acid 2%
 
No
 
OTC
 
2007
Obagi CLENZIderm M.D. Pore Therapy
 
Salicylic Acid 2%
 
No
 
OTC
 
2007
                 
Obagi CLENZIderm M.D. Therapeutic Lotion
 
Benzoyl Peroxide 5%
 
No
 
OTC
 
2007
Obagi CLENZIderm M.D. Therapeutic Moisturizer
 
Glyceryn 20% Dimethieme 1%
 
No
 
OTC
 
2007
 
Obagi CLENZIderm M.D. Daily Care Cream Cleanser
 
Mild Cleansers
 
No
 
Cosmetic
 
2007
                 
Obagi ELASTIderm Eye Cream
 
Mineral complexes
 
No
 
Cosmetic
 
2006
Obagi ELASTIderm Eye Gel
 
Mineral complexes
 
No
 
Cosmetic
 
2007
Obagi ELASTIderm Complete Complex Serum
 
 
Mineral complexes
 
No
 
Cosmetic
 
2012
Obagi ELASTILash Eyelash Solution
 
Peptide
 
No
 
Cosmetic
 
2010
Obagi ELASTIderm Décolletage Fx Wrinkle Reducing lotion
 
Mineral complexes
 
No
 
Cosmetic
 
2009
Obagi ELASTIderm Décolletage Fx Skin Lightening Complex
 
Arbutin
 
No
 
Cosmetic
 
2009
Obagi Décolletage Chest and Neck Skin Lightening Complex
 
Hydroquinone 4%
 
No
 
DESI II
 
2008
Obagi Décolletage Chest and Neck Wrinkle Reducing Lotion
 
Mineral complexes
 
No
 
Cosmetic
 
2008
Obagi Rosaclear Metronidazole(5)
 
Metronidazole Topical Gel USP, 0.75%
 
Yes
 
ANDA
 
2009
Obagi Rosaclear Hydrating Complexion Corrector
 
Titanium Dioxide
 
No
 
Cosmetic
 
2009
Obagi Rosaclear Gentle Cleanser
 
Mild Cleansers
 
No
 
Cosmetic
 
2009
Obagi Rosaclear Skin Balancing Sun Protection SPF 30
 
Zinc Oxide 15.5%, Titanium Dioxide 2.0%
 
No
 
OTC
 
2009
Blue Peel RADIANCE
 
Salicylic acid
 
No
 
Cosmetic
 
2011
ReGenica Facial Rejuvenation Complex
 
Growth factors and mild moisturizers
 
No
 
Cosmetic
 
2013


(1)  By definition, products classified as cosmetics do not have active ingredients.  For cosmetics, the main functioning ingredient is listed.

(2)  Product Status Definitions: OTC, or over-the-counter, products are defined as products that are considered drugs by the FDA, but that do not require physician prescription or oversight in order to be used safely and effectively by a layperson.

DESI II products are products that are considered drugs that require physician prescription, that have not been the subject of a NDA and that have not been through the DESI process.  These drugs may not be “new drugs” under the FDCA or may be grandfathered due to their history and the recognition in the medical community as “generally recognized as safe and effective.”  A company that first introduced a non-preapproved drug product that was on the market prior to November 13, 1984 must ensure that its basic features are the same as that used for a product that was on the market prior to November 13, 1984.  If so, the FDA will generally defer enforcement action, provided that it does not present a safety problem or trigger one of the CPG’s enforcement
 
priorities; each of our products are the chemical equivalent to a product first introduced in 1969 and is not the subject of any CPG enforcement priorities. 

ANDA products are defined as drugs that have received FDA approval under an abbreviated new drug application; our three ANDA products require physician prescription.

Cosmetic products are defined as products that are not considered drugs by the FDA, are not allowed to make drug claims, and do not require FDA pre-marketing approval or physician prescription or oversight.

(3)  These products are identical to the products included in our Obagi Condition & Enhance System, which was launched in 2006.

(4)  Obagi Nu-Derm branded tretinoin is manufactured by PDI under its ANDAs, and was launched under the Obagi brand in 2006; however, we have been selling tretinoin supplied by PDI’s predecessor, Triax
 
 
 
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Pharmaceuticals, since 2003, for which we do not make any drug claims.  We also began offering Refissa, a different formulation of tretinoin, manufactured by Spear, under its ANDA, in September 2009, for which we can make on-label drug claims for the treatment of fine lines, hyperpigmentation and tactile roughness consistent with the Spear ANDA.

(5)  Obagi Rosaclear branded metronidazole was manufactured by Tolmar under its ANDA and was launched under the Obagi brand in 2009.

FDA Regulation of Drug Manufacturing

We and the third-party manufacturers on which we rely for the manufacture of our products are subject to requirements under 21 CFR parts 210 and 211 that drugs be manufactured, packaged and labeled in conformity with cGMPs.  To comply with cGMPs, manufacturers must continue to spend time, money and effort to meet requirements relating to personnel, facilities, equipment, production and process, labeling and packaging, quality control, recordkeeping and other requirements.  The FDA, state agencies and foreign Ministries of Health periodically inspect drug manufacturing facilities to evaluate compliance with cGMPs.

Federal and State Regulation of Advertising and Promotion and Sales Incentives

The FDA regulates the advertisement of prescription drug products.  The U.S. Federal Trade Commission (“FTC”), Fair Packaging and Labeling Act, and state authorities regulate the advertising of OTC drugs and cosmetics, as well as exercise general authority to prevent unfair or deceptive trade practices.

In addition to FDA restrictions on marketing of prescription products, several other types of state and federal laws have been applied to restrict certain marketing practices in the pharmaceutical industry in recent years.  These laws include anti-kickback statutes and false claims statutes.  The federal healthcare program anti-kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under Medicare, Medicaid or other federally financed healthcare programs.  This statute has been interpreted to apply to arrangements between pharmaceutical manufacturers on the one hand and prescribers, purchasers and formulary managers on the other.  Violations of the anti-kickback statute are punishable by imprisonment, criminal fines, civil monetary penalties and exclusion from participation in federal healthcare programs.  Although there are a number of statutory exemptions and regulatory safe harbors protecting certain common activities from prosecution or other regulatory sanctions, the exemptions and safe harbors are drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe harbor.  Many states have also adopted anti-kickback statutes similar to the federal laws and such statutes are, in some instances, broader in their application as they apply to any direct or indirect remuneration for referring an individual to a person to obtain a healthcare item or service, whether it is reimbursable under federally financed healthcare programs or not.

Federal false claims laws prohibit any person from knowingly presenting, or causing to be presented, a false claim for payment to the federal government, or knowingly making, or causing to be made, a false statement to have a false claim paid.  Recently, several pharmaceutical and other healthcare companies have been prosecuted under these laws for allegedly inflating drug prices they report to pricing services, which in turn are used by the government to set Medicare and Medicaid reimbursement rates, and for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product.  In addition, certain marketing practices, including off-label promotion, may also violate false claims laws.  The majority of states also have statutes or regulations similar to the federal anti-kickback law and false claims laws, which apply to items and services reimbursed under Medicaid and other state programs or, in several states, apply regardless of the payer.

Also, as part of the sales and marketing process, pharmaceutical companies frequently provide samples of approved drugs to physicians.  This practice is overseen by the FDA, state and other governmental authorities under the Prescription Drug Marketing Act and regulations that include requirements concerning record keeping and control procedures.

Many states have also recently begun regulating the promotion of prescription drug products and require compliance with annual certification and disclosure requirements regarding our policies for drug promotion and the amount of money we spend per prescribing physician on drug promotion.  Compliance with changing federal and state laws and regulations on prescription product promotion requires a great deal of time and effort.
 
 
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Other Government Regulation

We and our suppliers or third-party manufacturers may also be subject to regulations under other federal, state, and local laws, including the Occupational Safety and Health Act, the Environmental Protection Act, the Clean Air Act and import, export and customs regulations as well as the laws and regulations of other countries.

Employees

As of December 31, 2012, we had 203 employees.  Our employees include 139 in sales and marketing, 30 in product development, manufacturing and distribution and 34 in administrative functions.  Our employees are all non-unionized, and we believe our relations with our employees are good.


 
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ITEM 1A:    RISK FACTORS

An investment in our common stock involves a high degree of risk.  You should consider carefully the following risks and other information contained in this Report before you decide whether to buy, hold or sell our common stock.  If any of the events contemplated by the following discussion of risks, or any additional risk not presently known to us or that we currently deem immaterial, should occur, our business, results of operations and financial condition could suffer significantly.  As a result, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock.

Risks Related to Our Business

Our sales and profitability may suffer if ongoing economic uncertainties in any of our major markets inhibit people from spending their disposable income on aesthetic and skin health products.

Virtually all of our products are purchased based on consumer choice due to the fact that our products are considered cosmetic in nature.  As a result, they are typically paid directly by the patient out of disposable income and are not subject to reimbursement by third-party payors such as health insurance organizations.  Adverse changes in the economy, such as the recent recession or ongoing economic uncertainties could accordingly have a significant negative effect on consumer spending for these products.  If consumers reassess their spending choices, the demand for these products could decline significantly.  If demand declines significantly in our major markets, such as North America, Asia and the Middle East, it would have a material adverse effect on our sales and profitability and could lead to a decline in our stock price.

Furthermore, if we are unable to successfully sell our products against competitive products or if consumer preferences in the marketplace shift to less costly alternative treatments, we may experience a decline in demand for our products, which could also have a material adverse effect on our sales and profitability.

Recent economic trends could adversely affect our financial performance and stock price.

As widely reported, the global financial markets experienced extreme disruption in 2008 and the majority of 2009, including severely diminished liquidity and credit availability.  During the year ended December 31, 2009, we saw these unprecedented global economic conditions have a negative impact on our revenue growth performance.  Although we witnessed some modest signs of economic recovery over the last three years, it is unclear whether the economy will show sustained growth and/or stability.  While we experienced moderate improvement in revenue growth in 2010 and 2011 and somewhat more significant growth in 2012, we cannot assure you that such improvements will be sustainable.  While adverse economic conditions have not materially impacted our financial position as of December 31, 2012 or liquidity for the year ended December 31, 2012, we cannot predict the timing, strength or duration of any economic recovery, and our financial condition could be negatively impacted in the future if the economy fails to sustain its recovery or if there are new events that contribute to additional deterioration in financial markets and major global economies, such as an impasse on the federal budget debates or a crisis in the Eurozone.  Recent economic uncertainties also resulted in increased downward pressure on stock prices generally, including our own, which may be unrelated to financial performance.  

Our revenues and financial results depend significantly on sales of our Obagi Nu-Derm System.  If we are unable to manufacture or sell the Nu-Derm System in sufficient quantities and in a timely manner, or maintain physician and/or patient acceptance of the Nu-Derm System, our business will be materially and adversely impacted.

To date, the majority of our revenues have resulted from sales of our principal product line, the Obagi Nu-Derm System and related products.  The Nu-Derm System and related products accounted for approximately 52%, 53% and 52% of our net sales for the years ended December 31, 2012, 2011 and 2010, respectively.  Although we currently offer other products such as Obagi-C Rx, Professional-C, ELASTIderm, CLENZIderm, Rosaclear, ELASTILash and Blue Peel RADIANCE, and we intend to introduce additional new products, we still expect sales of our Obagi Nu-Derm System and related products to account for a majority of our sales for the foreseeable future.  Because our business is highly dependent on our Obagi Nu-Derm System and related products, factors adversely affecting the pricing of, or demand for, these products could have a material and adverse effect on our business.  Sales of our Obagi Nu-Derm Systems also experience seasonality.  We believe this is due to variability in patient compliance that relates to several factors such as a tendency to travel and/or engage in other disruptive activities during the summer months.  Additionally, our commercial success depends in large part on our ability to sustain market acceptance of the Nu-Derm System.  If

 
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existing users of our products determine that our products do not satisfy their requirements, if our competitors develop a product that is perceived by patients or physicians to better satisfy their respective requirements, or if state or federal regulations or enforcement actions prohibit further sales of the Nu-Derm System, individual products within the system, or any related products, sales of these products may decline, and our total net sales may correspondingly decline.  We cannot assure you that we will be able to continue to manufacture these products in commercial quantities at acceptable costs.  Our inability to do so would adversely affect our operating results and cause our business to suffer.

We are dependent on third parties to manufacture products for us.

We currently outsource all of our product manufacturing to third-party contract manufacturers.  Although we have received sufficient material from our manufacturers to meet our current needs, we do not have long-term contracts with some of these third parties.  We have two or more qualified manufacturers for some of our key products, however, certain products, including some of our sun protection products, are currently supplied by a single source.  In the event that such a sole source supplier or any of our other third-party manufacturers terminates its supply arrangement with us, experiences financial difficulties, encounters regulatory or quality assurance issues, experiences a significant disruption in supply of raw materials or components for our products or suffers any damage to its facilities, we may experience delays in securing sufficient amounts of our products, which could harm our business, reputation and relationships with customers.

PDI and Spear are our only suppliers and manufacturers of tretinoin.  We have contracts with PDI and Spear that have initial termination dates in 2014.  While there are several other manufacturers of generic tretinoin, the termination of those agreements or any loss of services under those agreements could be difficult for us to replace.  Refissa tretinoin manufactured by Spear is the only tretinoin currently permitted to be marketed for on-label use to treat fine lines and wrinkles.  If this agreement were terminated, it would currently be impossible for us to replace with another product that would allow us to make such claims.

We expect to continue to rely on third parties to produce materials required for clinical trials and for the commercial production of our products.  However, there are a limited number of third-party manufacturers that operate under the FDA’s current cGMP, regulations and that have the necessary expertise and capacity to manufacture our products.  As a result, it may be difficult for us to locate manufacturers for our anticipated future needs.  If we are unable to arrange for third-party manufacturing of our products, or to do so on commercially reasonable terms, we may not be able to complete development of, market and sell our new products.

Reliance on third-party manufacturers entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the third party for regulatory compliance and quality assurance.  To the extent that any of our third-party manufacturers fails to comply with regulatory requirements or encounters quality assurance issues, we may experience an interruption in the supply of products, which could impair our customer relationships and adversely affect our business, financial condition and results of operations.  In addition, reliance on third-party manufacturers subjects us to the possibility of breach of the manufacturing agreement by the third party, and the possibility of termination or non-renewal of the agreement by the third party.

Dependence upon third parties for the manufacture of our products may also reduce our profit margins or the sale of our products, and may limit our ability to develop and deliver products on a timely and competitive basis.

The loss of a significant customer could materially and adversely affect our business, financial condition and results of operations.

During fiscal 2012, we had two affiliated customers, Dr. Dinh Hoai and Dr. Lieu Nguyen, in the United States that together accounted for 11% of our consolidated net sales.  Accordingly, our future operating results may continue to depend on our ability to continue to sell products to these customers.

We face intense competition, in some cases from companies that have significantly greater resources than we do, which could limit our ability to generate sales and/or render our products obsolete.

The market for aesthetic and therapeutic skin health products is highly competitive and we expect the intensity of competition to increase in the future.  We also expect to encounter increased competition as we enter new markets, attempt to penetrate existing markets with new products and expand into new distribution channels.  We may not be able to compete effectively in these markets, may face significant pricing pressure from our competitors and may lose market share to our competitors.  Our principal competitors are large, well established companies in the fields of

 
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pharmaceuticals, cosmetics, medical devices and health care.  Our largest direct competitors generally include SkinCeuticals, a division of L’Oreal S.A., SkinMedica, Inc., a division of Allergan, Inc., Kinerase from Valeant Pharmaceuticals International, IS Clinical, PhotoMedex, Inc. and Jan Marini. 
 
Our indirect competitors, who generally sell skin care products directly to consumers, consist of large well known cosmetic companies, including but not limited to, La-Roche Posay, Dermalogica, The Estee Lauder Companies Inc., Helene Curtis Industries, Inc., L’Oreal S.A., Matrix Essentials, Inc., a division of L’Oreal S.A, Procter & Gamble Company, Neutrogena, a division of Johnson & Johnson, Revlon, Inc. and Unilever N.V.  We also face competition from medical device companies offering products to physicians that are used to enhance the skin’s appearance.
 
Many of these competitors have significantly greater resources than we have.  This enables them, among other things, to make greater research and development investments and spread their research and development costs, as well as their marketing and promotion costs, over a broader revenue base.  It is also possible that developments by our competitors could make our products or technologies less competitive or obsolete.  The treatment of skin conditions and the enhancement of the appearance of skin, which is what all of our products target, are the subjects of active research and development by many potential competitors, including major pharmaceutical companies and specialized biotechnology firms, such as those listed above, as well as universities and other research institutions.  Competitive advances may also include the potential development of new laser or radio frequency therapies to treat hyperpigmentation and photodamaged skin.  While we intend to expand our technological capabilities to remain competitive, research and development by others may result in the introduction of new products by competitors that represent substantial improvements over our existing products.  If that occurs, sales of our existing products could decline rapidly.  Similarly, if we fail to make sufficient investments in research and development programs, our current and planned products could be surpassed by more effective or advanced products developed by our competitors.

Our new online fulfillment strategy will require a significant investment in capital and other resources and we cannot assure you that it will be successfully implemented.

We have identified the elements necessary to establish a web-based fulfillment operation and are currently in the process of completing the development of this platform.  We believe that having an e-Commerce platform will enable us to capitalize on the current interest in our products on the Internet by directing consumers to one place to learn about and purchase our products, capture a portion of this new business for our physician customers and serve a larger population of potential patients.  However, we cannot assure you that our e-Commerce platform will actually expand our base of end-users or result in the growth of our business.  Moreover, the creation and maintenance of an e-Commerce platform will require a significant investment in capital and other resources, including $6.7 million invested in 2012 and between $4.0 million and $6.0 million in 2013, and may divert the attention of our management and other key employees from the operation of our core business, which could materially and adversely impact our business and results of operations.

To be successful, we will have to convince a substantial number of both physician customers and their patients to adopt this new distribution channel, and we cannot assure you that we will be able to achieve this.  In addition, as we enter this new channel we will face competition from large online storefronts, such as Amazon.com, auction sites, such as eBay, as well as numerous online sellers of Obagi and other skincare products, including several unauthorized resellers of our products as well as certain customers.  As a result of these factors, we may not realize the return on our investment in this strategy that we currently anticipate.  For instance, in the past we have invested significant capital and resources to enter into a new distribution channel that did not perform as expected.  In August 2008, we entered into the pharmacy channel for the first time with our SoluCLENZ Rx Gel, which was available by prescription only.  However, after closely monitoring the progress of the launch and weekly sales data, we determined that distribution of a single prescription product through the pharmacy channel and the ongoing investment required to support that channel was cost prohibitive.  Accordingly, in April 2009 we exited the pharmacy channel.  In connection with such exit, we recorded charges approximating $0.8 million and reserved approximately $0.4 million in inventory during the year ended December 31, 2009.  If we are unable to successfully implement our online pharmacy fulfillment strategy, we may incur significant expenses without realizing a near-term or any financial return.  In order to be successful in this new distribution channel we will need to comply with numerous federal and state laws and regulations and there can be no assurance we will be able to do so or that our compliance with such laws and regulations will allow us to operate this new distribution channel in a profitable manner.

 
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We are increasingly dependent on information technology systems and infrastructure; system inadequacies, operating failures, or security breaches could harm our business.

We rely to a large extent on sophisticated information technology systems and infrastructure.  The size and complexity of these systems make them potentially vulnerable to breakdown, malicious intrusion, and random attack.  Likewise, confidentiality or data privacy breaches by employees or others with permitted access to our systems may pose a risk that valuable trade secrets, personal information, or other sensitive data may be exposed to unauthorized persons or to the public.  Such information security breaches may be very difficult to detect.  While we have invested heavily in the protection of data and information technology, there can be no assurance that our efforts will prevent breakdowns or breaches in our systems that could adversely and materially affect our business.

We are also dependent on a third party, Koogly, to develop the customized software necessary to launch our e-Commerce platform and to build interfaces between this software and our existing systems.  Reliance on a third-party to develop our e-Commerce software entails risks to which we would not be subject if we developed the software ourselves or had bought or licensed available off the shelf software.  These risks include reliance on the third party for creating software with all of the required functionality and customization, detecting and correcting any bugs or defects in the software, testing the interfaces between the software and our existing systems, creating any required updates, enhancements or ad-ons, securing access to the software, maintaining security to protect the information provided by physicians and consumers using the e-Commerce platform, maintaining the confidentiality of the proprietary information relating to the software, and assuring that the software does not infringe on the intellectual property rights of others.  Dependence on Koogly to develop this software may limit our ability to control the timing of the launch of our e-Commerce platform, as once the software is delivered, we will undergo testing to ensure that it operates in the manner in which we expect it to.

We may not be able to successfully expand the use of our current product lines or develop new products.

We are working to improve, extend and reformulate many of our existing products.  Continued market acceptance of our products will depend on our ability to successfully develop additional applications of our existing products.  The development of additional applications will require significant commitments of personnel and financial resources and we cannot assure you that we will be successful.  If the attempted extensions of our product lines are not commercially successful, our business will be adversely affected.

We are also developing new product lines by applying our Penetrating Therapeutics technology to new agents.  In addition, we have acquired rights to technologies described in certain patent applications relating to additional methods and formulations.  We continue to search for new products and technologies to improve the appearance and health of skin with a focus on tone and texture.   These development activities, as well as clinical studies, which must be completed before these products can be marketed and sold, will require significant commitments of personnel and financial resources.  We cannot assure you that we will be able to develop new products or technologies in a timely manner, or at all.  Delays in the development or testing processes will cause a corresponding delay in revenue generation from those products.  Regardless of whether such new products or technologies are ever released to the market, the expense of such processes, which may be considerable, will have already been incurred and we may not be able to recover such expenses.

We reevaluate our development efforts regularly to assess whether our efforts to develop a particular new product or technology are progressing at a rate that justifies our continued expenditures.  On the basis of these reevaluations, we have abandoned in the past, and may abandon in the future, our efforts on a particular product or technology.  If we fail to take any product or technology from the development stage to market on a timely basis or fail to gain successful market adoption of such product, we may incur significant expenses without a near-term or any financial return.
 
Our failure to successfully in-license or acquire additional products and technologies would impair our ability to grow.

We intend to in-license, acquire, develop and market new products and technologies.  Because we have limited internal research capabilities, our business model depends in part on our ability to license patents, products and/or technologies from third parties.  The success of this strategy also depends upon our ability and the ability of our third-party formulators to formulate products under such licenses, as well as our ability to manufacture, market and sell such licensed products.

 
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We may not be able to successfully identify any new products to in-license, acquire or internally develop.  Moreover, negotiating and implementing an economically viable acquisition is a lengthy and complex process.  Other companies, including those with substantially greater financial, marketing and sales resources, may compete with us for the acquisition of products.  We may not be able to acquire or in-license the rights to such products on terms that we find acceptable, or at all.  As a result, our ability to grow our business or increase our profits could be adversely impacted.
 
If we lose key personnel or are unable to attract and retain other qualified personnel, we may be unable to execute our business plan and our business would be materially adversely affected.

As of December 31, 2012, we had 203 employees.  Our success depends on our continued ability to attract, retain and motivate highly qualified management, business development, sales and marketing, product development and other personnel.  We may have difficulty recruiting and retaining such qualified personnel due to the uncertainties created by the proxy contest in which we are currently engaged.  In addition,  we may not be able to recruit and retain qualified personnel, particularly for senior sales and marketing and research and product development positions due to intense competition for personnel among businesses like ours.  The failure to do so could have a significant negative impact on our future product sales and business results.  In addition, some options granted to employees have an option price greater than our current market price.  This may hinder our ability to retain qualified personnel.  Our success depends on the efforts and abilities of Albert Hummel, our President and Chief Executive Officer, Preston Romm, our Chief Financial Officer, and David Goldstein, our Executive Vice President of Global Sales and Field Marketing, as well as other members of our senior management team and our scientific and technical personnel.  We may not be able to retain the services of these individuals.  In addition, we do not have “key person” insurance policies on any of our executive officers that would compensate us for the loss of their services.  If we lose the services of one or more of these individuals, finding a replacement could be difficult, may take an extended period of time and could significantly impede the achievement of our business objectives.  This may have a material adverse effect on our results of operations and financial condition.

To grow, we will need to increase the size of our organization, and we may encounter difficulties managing our growth, which could adversely affect our results of operations.

If we are able to successfully develop additional products and extend the use of our current products and/or expand our existing distribution channels, we may experience growth in the number of our employees and the scope of our operations.  To the extent that we acquire and launch additional products, the resulting growth and expansion of our sales force will place a significant demand on our financial, managerial and operational resources.  Since many of the new products or systems we are working on may involve new technologies or entering new markets, we may not be able to accurately forecast the number of employees required and the timing of their hire or the associated costs.  The extent of any expansion we may experience will be driven largely by the success of our new products and systems and alternative distribution channels.  As a result, management’s ability to project the size of any such expansion and its cost to the company is limited by the following uncertainties: (i) we will not have previously sold any of the new products and technologies and the ultimate success of these new products and technologies is unknown; (ii) we will be entering new markets and/or distribution channels; and (iii) the costs associated with any expansion will be partially driven by factors that may not be fully in our control (e.g., timing of hire, market salary rates). Subject to these uncertainties, we believe that our current business plan may require us to hire between 10 and 15 new employees within the next 12 months at an incremental cost of between $1.5 million and $2.2 million.  Due to the uncertainty surrounding the timing of our strategic initiatives, new product lines or the stabilization of the global markets, our costs to hire significant numbers of new employees could be higher than anticipated.  Our success will also depend on the ability of our executive officers and senior management team to continue to implement and improve our operational, information management and financial control systems, and to expand, train and manage our employee base.  Our inability to manage growth effectively could cause our operating costs to grow even faster than we currently anticipate and adversely affect our results of operations.

Because we have limited research and development capabilities, we will be dependent on third parties to perform research and development and product formulation activities for us.

We have limited internal research and development capabilities and currently outsource all of our product research and development and formulation activities to third-party research labs.  In particular, in the past we have licensed technologies that may issue as patents under certain patent applications filed by JR, and have relied heavily on services provided by JR in the development of new products to address acne and skin elasticity.  Our current agreement with JR expired in September 2010 and since that time we have had to locate alternative third-party research and

 
 
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development companies to assist us; we have received sufficient support from other third-party research labs to drive our current new product development, but we cannot assure you that we will continue to be able to receive such support in the future.

There are a limited number of third-party research and development companies that specialize in or have the expertise required to achieve our product development objectives.  As a result, it may be difficult for us to engage research and development labs and personnel for our anticipated future needs.  If we are unable to arrange for third-party research and development of our products, or to do so on commercially reasonable terms, we may not be able to develop new products or expand the application of our existing products.

Reliance on third-party research and development labs entails risks to which we would not be subject if we performed the research and development ourselves.  These risks include reliance on the third party for maintaining the confidentiality of the proprietary information relating to the product being developed and for maintaining quality assurance (including adequate stability, safety and other data), the possibility of breach of the research and development agreement by the third party, and the possibility of termination or non-renewal of the agreement by the third party. 

Dependence upon third parties for the research and development of our future products may limit our ability to commercialize and deliver products on a timely and competitive basis and quality assurance issues encountered with these third parties may require us to postpone a product launch or discontinue product sales until appropriate formulation adjustments and testing are performed.

Our products may cause undesirable side effects that could limit their use, require their removal from the market or prevent further development.

The most common side effects associated with our therapeutic products are temporary redness, stinging, burning sensation, skin peeling, flaking, acne flare-ups and photo-sensitivity normally experienced within approximately the first ten weeks of use.  While these side effects generally are not severe, they may limit the use of our products, particularly if physicians or patients perceive that the risks or discomfort outweigh the benefits, or if they perceive that the side effects of competitive products are less significant.

Undesirable side effects caused by our products could interrupt, delay or halt our development programs, including clinical trials, and could result in adverse regulatory or enforcement action by the FDA or other regulatory authorities.  More severe side effects associated with our products may be observed in the future.  Even if we are able to complete the development of a new product and obtain any required regulatory approval, undesirable side effects could prevent us from achieving or maintaining market acceptance of the product or could substantially increase the costs and expenses of commercializing the product.  Negative publicity concerning our products, whether accurate or inaccurate, could also reduce market or regulatory acceptance of our products, which could result in decreased product demand, removal from the market or an increased number of product liability claims, whether or not such claims have merit. 

The FDA issued a proposed rule that cites evidence that an active ingredient contained in some of our Obagi Nu-Derm, Obagi-C Rx and ELASTIderm Décolletage Systems may have negative side effects.

In August 2006, the FDA issued a proposed rule that cites some evidence that hydroquinone may be a carcinogen, if orally administered, and may be related to a skin condition called ochronosis, which results in the darkening and thickening of the skin, and the appearance of small bumps and grayish-brown spots.  Hydroquinone is an active ingredient contained in our: (i) Obagi Clear, Obagi Blender and Obagi Sunfader products, which are part of our Nu-Derm and Condition & Enhance Systems; (ii) Obagi-C Rx C-Clarifying Serum and Obagi-C Rx C-Night Therapy Cream products, which are part of our Obagi-C Rx Systems; and (iii) Décolletage Skin Lightening Complex, which is in
the ELASTIderm product family.  The FDA also concluded that it could not rule out the potential carcinogenic risk from topically applied hydroquinone.  In the proposed rule, the FDA recommended that additional studies be conducted to determine if there is a risk to humans from the use of hydroquinone.  The FDA nominated hydroquinone for further study by the NTP, and in December 2009 the NTP Board of Scientific Counselors approved the nomination.  As a result, the following three NTP studies will be conducted:

·  
Comparative metabolism studies in rats and mice by oral and dermal routes;

·  
Reproductive toxicity study in rats and mice by oral route; and

·  
Dermal carcinogenicity studies of hydroquinone in mice and rats.

 
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There are several more steps to the nomination process before the studies will commence, and the studies themselves can take two years or more to complete.  The FDA has noted that, in the interim, it believes that hydroquinone at concentrations of 2% or less should remain available as an OTC drug product.  However, if the NTP studies eventually conclude that hydroquinone is a carcinogen, we could be required to suspend the marketing of our products that contain hydroquinone, conduct additional safety tests and potentially cease the sale of affected products, which would harm our business.  In addition, patients who experience side effects from our products may bring product liability claims against us.

All of our products that contain hydroquinone are prescription drugs.  The FDA was considering regulating all hydroquinone products, including prescription hydroquinone products, as new drugs, and may conclude that the continued use of prescription hydroquinone products will require the submission and approval of a NDA.  It is our understanding that the FDA is not intending to take any action with respect to regulation of HQ products until the NTP studies have been conducted.  However, we cannot rule out possibility of the FDA taking action before the NTP studies are completed.  If, at the conclusion of the NTP studies, the FDA requires us to submit a NDA for our prescription HQ Products, we believe that the FDA may allow us to continue to market these products while we are preparing, submitting and waiting for approval of such NDA.  However, there can be no assurance that we will be able to continue to market our products during the NDA process, and we may be required to suspend marketing of our prescription HQ Products until such time as a NDA is approved.  In addition, we cannot assure you that any NDA we submit for our prescription HQ Products will be approved.  If we are required to suspend or cease marketing of our prescription HQ Products, our business would be materially adversely affected.

Product liability lawsuits could divert our resources, result in substantial liabilities and reduce the commercial potential of our products.

Our business exposes us to the risk of product liability claims that are inherent to the development, clinical testing and marketing of aesthetic and skin health products.  These lawsuits may divert our management from pursuing our business strategy and may be costly to defend.  In addition, if we are held liable in any of these lawsuits, we may incur substantial liabilities and may be forced to limit or forgo further commercialization of those products.  Although we maintain general liability and product liability insurance in amounts that we believe are reasonably adequate to insulate us from potential claims, this insurance may not fully cover potential liabilities.  In addition, our inability to obtain or maintain sufficient insurance coverage at an acceptable cost or to otherwise protect against potential product liability claims could prevent or inhibit the commercial production and sale of our products, which would adversely affect our business.

We are subject to risks associated with doing business internationally.

Our international sales currently depend upon the marketing efforts of and sales by certain distributors and licensees, particularly Rohto, a licensee of certain of our trademarks and products for the retail drug store channel in Japan, from whom we receive royalties that accounted for approximately 4% of our net sales for both of the years ended December 31, 2012 and 2011 and 5% of our gross margin for both the years ended December 31, 2012 and 2011.  Because incremental costs associated with this agreement are minimal, a material decline in licensing revenues from or termination of this agreement would have a material adverse effect on our net income.  While no other international distribution or license partner accounted for more than 5% of our net sales for either of the years ended December 31, 2012 and 2011, we intend to continue to expand our presence in international markets and our business is and may increasingly be subject to certain risks inherent in international business, many of which are beyond our control.  These risks include:
 
·  
adverse changes in tariff and trade protection measures;

·  
unexpected changes or differences in foreign regulatory requirements;

·  
potentially negative consequences from changes in tax laws;

·  
the potential business failure of one or more of our distribution partners;

·  
changing economic conditions in countries where our products are sold or manufactured;
 
 
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·  
exchange rate risks;

·  
potential political unrest and hostilities;

·  
potential natural disasters in countries where our products are sold;

·  
differing degrees of protection for intellectual property; and

·  
difficulties in coordinating foreign distribution.

Any of these factors could adversely affect our business, financial condition and results of operations.  We cannot assure you that we can successfully manage these risks or avoid their effects.

During 2010, we entered into discussions with a non-performing international distributor in an attempt to renegotiate its distribution agreement and develop a payment schedule for the distributor’s outstanding accounts receivable balance due to us related to sales in prior periods.  We terminated the agreement with that distributor in November 2010, as we were unable to reach an agreement with respect to the distributor’s payment obligations and other matters.  In July 2012, we entered into a non-monetary settlement agreement with such distributor resolving all outstanding issues.    

Potential business combinations could require significant management attention and prove difficult to integrate with our business, which could distract our management, disrupt our business, dilute stockholder value and adversely affect our operating results.

If we become aware of potential business combination candidates that are complementary to our business, we may decide to combine with such businesses or acquire their assets in the future.  Business combinations generally involve a number of additional difficulties and risks to our business, including:

·  
failure to integrate management information systems, personnel, research and development and marketing, operations, sales and support;

·  
disruption of our ongoing business and diversion of management’s attention from other business matters;

·  
potential loss of the acquired company’s customers;

·  
failure to develop further the acquired company’s technology;

·  
unanticipated costs and liabilities; and

·  
other accounting consequences.

In addition, we may not realize benefits from any business combination that we undertake in the future.  If we fail to successfully integrate such businesses, or the technologies associated with such business combinations into our company, the revenue and operating results of the combined company could be adversely affected.  Any integration process would require significant time and resources, and we may not be able to manage the process successfully.  If our customers are uncertain about our ability to operate on a combined basis, they could delay or cancel orders for our products.  We may not successfully evaluate or utilize the acquired technology or accurately forecast the financial impact of a combination, including accounting charges or volatility in the stock price of the combined entity.  If we fail to successfully integrate other companies with which we may combine, our business could be adversely affected.

Our business could be negatively affected as a result of a proxy contest.
 
       In January 2013, we received a notice from a stockholder, Voce Capital LLC and certain of its affiliates, that it intended to nominate its own slate of seven individuals for election to our Board of Directors at our 2013 Annual Meeting of Stockholders to replace our current Board.  If this proxy contest continues, our business could be adversely affected because:

 
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·  
responding to proxy contests and other actions by activist shareholders can be costly and time-consuming, which could disrupt our operations and divert the attention of management and our employees;

·  
perceived uncertainties as to our future direction may result in the loss of potential business opportunities, and may make it more difficult for us to attract and retain qualified personnel and business partners; and

·  
if individuals are elected to our Board of Directors that have their own specific agenda, it may adversely affect our ability to effectively and timely implement our current strategic plan, or they may seek to pursue completely different strategic initiatives or goals.

Risks Related to Regulatory Matters

Our ability to commercially distribute our products and our business may be significantly harmed if the regulatory environment governing our products changes, if the FDA takes enforcement action against us or our competitors marketing similar products, if a third party obtains FDA approval of a NDA for a 4% hydroquinone product for the same uses for which we market our hydroquinone products, or if our contract manufacturers fail to comply with cGMPs.

The FDA and comparable agencies of other countries regulate our products.  In the United States, FDA regulations govern, among other things, the activities that we perform, including product development, product testing, product labeling, product storage, manufacturing, advertising, promotion, product sales, reporting of certain product adverse events and failures, and distribution.  Individual state regulations may also govern drug product manufacturing, distribution, advertising and promotion.

The Obagi Nu-Derm, Obagi Condition & Enhance, Obagi-C Rx and ELASTIderm Décolletage Systems contain HQ Products and are marketed in the United States without a FDA-approved marketing application subject to the enforcement priorities in the CPG.  We believe that these products are not currently subject to FDA pre-market approval because they are generally regarded as safe and effective.  In August 2006, the FDA issued a proposed rule that, if adopted in its current form, would establish that OTC skin bleaching drug products containing hydroquinone, in 2% concentrations or less are not generally recognized as safe and effective are misbranded, and are new drugs within the meaning of the FDCA.  The FDA proposed that because of the carcinogenic and ochronosis potential of hydroquinone, its use in skin bleaching drug products should be restricted to prescription use only, and users of such products should be closely monitored under medical supervision.  The FDA indicated that upon adoption of the final rule it intended to consider all skin bleaching drug products containing hydroquinone, whether currently marketed on a prescription or OTC basis, to be new drugs requiring an approved NDA for continued marketing.  In the proposed rule, the FDA recommended that additional studies be conducted to determine if there is a risk to humans from the use of hydroquinone.  The FDA nominated hydroquinone for further study by the NTP, and in December 2009 the NTP Board of Scientific Counselors approved the nomination.  As a result, the NTP will conduct further studies on hydroquinone.  However, there are several more steps to the nomination process before the studies will commence, and the studies themselves can take two years or more to complete.  The FDA has noted that, in the interim, it believes that hydroquinone at concentrations of 2% or less should remain available as an OTC drug product.  It is our understanding that the FDA is no longer evaluating this proposal and is not intending to take any action with respect to regulation of hydroquinone products until the NTP studies have been conducted.  However, should the FDA reverse this position prior to the completion of the NTP studies, or decide upon conclusion of the NTP studies that all skin bleaching products containing hydroquinone are new drugs requiring an approved NDA, we may be required to withdraw certain products in the Nu-Derm, Condition & Enhance, Obagi-C Rx and ELASTIderm Décolletage Systems until required clinical trials are performed and new drug approvals are obtained, in effect foreclosing us from selling these products.  If we are required to seek new drug approval for these products, our attention and resources will be dedicated to the process of obtaining new drug approval, which may be time-consuming and expensive.  In addition, we may not successfully obtain such approval or may be delayed in obtaining such approval if one of our competitors obtains approval and non-patent marketing exclusivity for the same uses for which we seek approval.  Other manufacturers of 4% prescription hydroquinone include, among others, SkinMedica, Inc., a division of Allergan, Inc., Taro Pharmaceuticals Inc., Valeant Pharmaceuticals, Inc. and Stiefel Laboratories, Inc.  If we are unable to obtain such approval we would be prohibited from selling the Nu-Derm, Condition & Enhance and Obagi-C Rx Systems and ELASTIderm Décolletage Skin Lightening Complex, which would have a material adverse impact on our business.

As discussed above, the August 2006 proposed rule cites some evidence that hydroquinone may be a carcinogen and may be related to ochronosis.  If the NTP studies conclude that hydroquinone is a carcinogen and the FDA determines that such potential health risks warrant a ban on the sale of hydroquinone products, such determinations
 
 
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would have a material adverse effect on our sale of the Nu-Derm, Condition & Enhance, Obagi-C Rx and ELASTIderm Décolletage Systems.  The FDA’s proposed rulemaking itself, and the concerns expressed therein relating to the use of hydroquinone, could have an adverse impact on the sales of these products.  Certain of our competitors are attempting to use the FDA’s proposed rulemaking to convince physicians and patients not to use our products containing hydroquinone.  To date, these marketing efforts by our competitors have not had a negative impact on our sales levels.  However, we cannot assure you that such marketing efforts will not have a negative impact on our sales levels in the future.
 
Finally, the contract manufacturers of our HQ Products are also subject to regulation by the FDA, especially for compliance with cGMPs.  Should the FDA conclude that one of our contract manufacturers or any of its ingredient suppliers is not in compliance with cGMPs, it could allege that our HQ Products are adulterated under the FDCA and fall within one of the enforcement priorities of the CPG.  This would mean that our products could be subject to immediate FDA enforcement action for being an unapproved “new drug.”
 
FDA and FTC regulations limit the type of marketing claims we can make about our products.  If the FDA determines that any of our marketing claims are false or misleading, or suggest a clinical benefit that is not supported in the studies we have done, we may be required to cease making the challenged marketing claims, issue corrective communications, pay fines, or stop selling products until the incorrect claims have been corrected.  FDA or FTC enforcement actions regarding promotional claims, including warning letters, would also divert our management’s attention and create public relations issues for our customers and opportunities for our competitors.

We are also subject to review, periodic inspection and marketing surveillance by the FDA and comparable state agencies to determine our compliance with regulatory requirements.  Our manufacturing processes, any clinical trials that we perform, our distribution and our promotional activities are subject to ongoing regulatory compliance.  In addition, state agencies also may require registration, licensure and inspection of manufacturing or distribution facilities and may require reporting of promotional activities.  If the FDA or any state or comparable agency finds that we have failed to comply with these requirements or later discovers previously unknown problems with our products, including unanticipated adverse events of unanticipated severity or frequency, or any of our manufacturers or manufacturing processes, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

·  
fines, injunctions and civil penalties;

·  
recall or seizure of our products;

·  
restrictions on our products, manufacturing processes, or distribution systems, including operating restrictions, partial suspension or total shutdown of production;

·  
denial of requests for approvals of product candidates;

·  
withdrawal of approvals already granted;

·  
disgorgement of profits; and

·  
criminal prosecution.
 
Any of these enforcement actions could affect our ability to commercially distribute our products in the United States and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of these products, which would materially and adversely affect our business.

Further, in February 2012 we received a Subpoena to Answer Interrogatories and Produce Documents from the CAG in connection with an investigation of our business practices.  The subpoena seeks information and documents relating to our belief that our HQ Products are not new drugs that require pre-market review and marketing approval by the FDA.  The subpoena also requests information and documents concerning the methods by which we promote, market and sell our HQ Products, the identities of persons who dispense our HQ Products in California, the amount of HQ Products we sell in California, complaints we have received and adverse event reports concerning our HQ Products, communications to and from the FDA regarding the safety and effectiveness of our HQ Products, and certain other information regarding our HQ Products.

 
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Although we are in discussions with the CAG on this matter, no resolution has been reached and based upon the information and documents requested by the CAG it is possible that the CAG could seek to limit or prohibit sales of our HQ Products in or from California or force us to change the methods by which we promote, market, sell and distribute our HQ Products in or from California.  During each of our fiscal years 2012 and 2011, approximately 40%, of our aggregate net sales came from sales of our HQ Products.  In the event the CAG takes actions that cause us to limit or cease our sales of our HQ Products in or from California or require us to materially change the methods by which we promote, market, sell and distribute our HQ Products in or from California, it would have a material adverse effect on our results of operations and financial condition.

It is possible that after any NTP studies are completed the FDA may conclude that we are required to file an NDA for our HQ Products.  Furthermore, there is no assurance that the FDA will not require an NDA filing prior to the completion of the NTP studies.  The FDA could allow us to continue to sell our HQ Products while we seek to obtain approval of our NDA.  However, the FDA could limit or prohibit sales of our HQ Products until such time as we obtain approval of our NDA.  If we are required to file an NDA for our HQ Products, we cannot provide assurance that we will be able to complete the testing required to submit the NDA, that we will be able to submit the NDA on a timely basis, if at all, or that we will be able to obtain FDA approval of our NDA.

Furthermore, the current actions being taken by the State of California (and previously by the State of Texas) related to our HQ Products could cause the FDA or other states to investigate or reconsider the regulatory status of these products, and should the FDA do so, it may require us to obtain a NDA for such products and could require us to withdraw such products from the market pending such registration.

Regulations could prohibit physicians from dispensing our products directly or through our e-Commerce platform.

In our primary market, the United States, we market our products and systems directly to physicians to dispense in their offices.  Most of the products and systems we sell are dispensed by physicians directly to their patients in their offices, although some patients choose to have prescriptions for tretinoin and metronidazole products filled by pharmacies instead of the treating physician in order to obtain insurance coverage for such products.  Although several of our systems contain HQ Products, our products are not currently available by prescription in the pharmacy.  In the event state regulations change, or if such state regulations are interrupted by regulators, to limit or prohibit the ability of physicians to dispense our products directly to patients in their offices or change to limit or prevent our ability to distribute products directly through physicians, patients may be unable to obtain many of our products, as they are not currently available in pharmacies.  

In addition, our new e-Commerce platform is designed to enable allow physicians to dispense products to their patients through online sales and enable us to sell cosmetic and OTC products directly to consumers.  Several states have recently taken action against a number of our customers who already sell our products to patients over the Internet, questioning whether these practices are consistent with such states’ pharmacy licensure and physician dispensing rules.  An adverse outcome by any of these states against any of these customers may result in the inability of such customers (including other customers in the state) to continue selling our products over the internet or at all.  A limited number of states have also adopted broad anti-kickback laws that could be interpreted as applying to physicians who sell our products through our e-Commerce platform, and, therefore, physicians in those states will not be eligible to participate in our new platform.  While we intend to comply with such laws by not offering the e-Commerce platform where it would be unlawful to do so, the laws of the some states are unclear.  Certain enforcement authorities may interpret their laws differently from our interpretation which may result in sanctions against us or our customers and which could interfered with our efforts to implement our e-Commerce platform.  To the extent that state regulations or enforcement actions prevent us from implementing our e-Commerce platform in certain states, sales of our products through this platform may not materialize in the amounts that we anticipated.

In February 2012 we received a Subpoena to Answer Interrogatories and Produce Documents from the CAG in connection with an investigation of our business practices.  The subpoena sought information and documents relating to our belief that our HQ Products are not new drugs that require pre-market review and marketing approval by the FDA.  The subpoena also requested information and documents concerning the methods by which we promote, market and sell our HQ Products, the identities of persons who dispense our HQ Products in California, the amount of HQ Products we sell in California, complaints we have received and adverse event reports concerning our HQ Products, communications to and from the FDA regarding the safety and effectiveness of our HQ Products, and certain other information regarding our HQ Products.

 
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We have provided documents and information to the CAG pursuant to the subpoena and have had discussions with the CAG’s office in an attempt to better understand the concerns of the CAG’s investigation.  We have cooperated fully with the CAG’s investigation and have received no further communications from them since receipt of the original subpoena.

Although we are in discussions with the CAG on this matter, no resolution has been reached and based upon the information and documents requested by the CAG it is possible that the CAG could seek to limit or prohibit sales of our HQ Products in or from California or force us to change the methods by which we promote, market, sell and distribute our HQ Products in or from California.

If patients are unable to purchase our products directly from physicians or our customers are prohibited from selling our products in their current manner or at all in California or other states, it would have a material effect on our business and on both customers’ and patients’ ability to purchase HQ Products.

Failure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.

We market our products outside of the United States.  In order to market our products in many non-U.S. jurisdictions we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements.  In others, we do not have to obtain prior regulatory approval but do have to comply with other regulatory restrictions on the manufacture, marketing and sale of our products.  We may be unable to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market.  The approval procedure varies among countries and can involve additional testing and data review.  The time required to obtain approval in non-U.S. jurisdictions may differ from that required to obtain FDA approval.  The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval.  In addition, many countries from time to time evaluate the regulatory status of various products and ingredients.  For instance, in the last two years, Australia and Canada have reclassified hydroquinone from a cosmetic to a drug.  We may not obtain foreign regulatory approvals on a timely basis, if at all, or may choose not to implement a country’s labeling requirements if to do so would have a negative impact on our international or domestic operations.  If we get approval by the FDA, that does not ensure approval by regulatory agencies in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory agencies in other foreign countries or by the FDA.  The failure to obtain these approvals, or to agree to regulatory restrictions or labeling requirements (in which case would not sell the affected products in certain jurisdictions) could harm our business.
 
If we or any of our third-party manufacturers do not operate in accordance with cGMPs, we could be subject to FDA enforcement actions, including the seizure of our products and the halt of production of our products.

Third-party manufacturers that we currently rely on or will rely on in the future (including ingredient suppliers that these third party manufacturers purchase from) must continuously adhere to the cGMPs set forth in the FDA’s regulations and guidance documents.  In complying with cGMPs, we and our third-party manufacturers must expend significant time, money and effort in development, testing, production, record keeping and quality control to assure that our products meet applicable specifications and other regulatory requirements.  The failure to comply with these specifications and other requirements could result in an FDA enforcement action, including the seizure of products and shutting down of production.  Our third-party manufacturers may also be subject to comparable or more stringent regulations of foreign regulatory authorities.  If our third-party manufacturers (or their ingredient suppliers) or we are unable to comply with cGMPs and applicable foreign regulatory requirements, our ability to develop, produce and sell our products could be impaired.

Risks Related to Intellectual Property

If we are unable to protect our proprietary rights, we may not be able to compete effectively.

Our success depends significantly on our ability to protect our proprietary rights to the technologies used in our products.  We rely primarily on maintaining the confidentiality of our trade secrets and the protection of trade secret laws, as well as a combination of patent, copyright, and trademark (including common law trademark) laws, and nondisclosure, confidentiality and other contractual restrictions, to protect our proprietary technology.  However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage.  For example, our trade secrets may be misappropriated by current or former employees, contractors, or parties with whom we partner, or may be inadvertently disclosed or obtained by breach of a confidentiality agreement.  We have recently applied for several patents both in the United States and abroad.  These

 
 
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patent applications may not issue as patents at all, or the applications may not issue as a patent in a form that will be advantageous to us or may issue and be subsequently successfully challenged by others and invalidated or rendered unenforceable.  Both the patent application process and the process of managing patent disputes can be time-consuming and expensive.  Competitors may be able to design around our patents or develop products that provide outcomes comparable to ours even without misappropriating our trade secrets.  Although we have taken steps to protect our intellectual property and proprietary technology, including entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants and advisors, such agreements may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements.  Further, the parties with whom we enter into confidentiality and intellectual property assignment agreements could dispute the ownership of intellectual property developed under these agreements.  In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States.

 
If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.

In order to protect or enforce our intellectual property rights, we may initiate litigation.  In addition, others may initiate litigation related to intellectual property against us.  Companies against whom we might initiate litigation or who might initiate litigation against us may be better able to sustain the costs of litigation because they have substantially greater resources.  We may become subject to interference proceedings conducted in patent and trademark offices to determine the priority of inventions.  There are numerous issued and pending patents in the skin care product field.  The validity and breadth of such patents may involve complex legal and factual questions for which important legal principles may remain unresolved.  If third parties file oppositions to our patent applications in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of our filed foreign patent applications.  We also have worked with consultants in developing our intellectual property portfolio.  To the extent any of these consultants are engaged in litigation involving intellectual property related to us, we may also become a party to such actions or otherwise be adversely affected by virtue of our relationships with the consultants.  For example, JR, a consultant who helped us develop CLENZIderm, and has granted us a license under certain patent applications that cover CLENZIderm, was involved in a lawsuit in which a third party plaintiff claimed that the owner of JR misappropriated the plaintiff’s trade secrets.  A settlement has been reached between JR and the plaintiff, which they claim prohibits our ability to develop new delivery systems or products containing solubilized BPO, the active ingredient in the CLENZIderm products.

In January 2005, we entered into a Consulting Services and Confidentiality Agreement with JR, under which, among other things, we hired JR to perform research and development activities including product formulation, product development and regulatory work, as detailed in various statements of work.  The initial term of the JR Agreement was for five years; however, in April 2010, we reached what we believed was an agreement in principle for amending the JR Agreement.  Although that amendment was never executed, the parties operated under the terms of the agreement, as amended, from June 2010 to September 2010, at which time the JR Agreement terminated.  [We are currently in discussions with JR on a variety of matters.  We have been advised by JR that it believes that certain of our products, including the ELASTIderm line of products, CLENZIderm and Rosaclear, are covered by both issued and pending patents which JR contends are owned by it and which it believes were licensed to us under the JR Agreement.  JR contends that such license and our right to continue to sell such products terminated when the JR Agreement terminated.  We disagree with JR’s position on this issue and are seeking to resolve this and other issues in our current negotiations with JR.  Should we fail to reach agreement with respect to these current discussions, the parties could end up in litigation regarding the ownership rights to these technologies, and our business, results of operations and financial condition could be adversely effected.  During the years ended December 31, 2012, 2011 and 2010, approximately 15%, 14% and 15% of our net sales, respectively, were related to products that contained technologies covered by the JR Agreement.  See Part I, Item 1 “Business – Certain Material Agreements – Jose Ramirez and JR” in this Report for further information.

Litigation may be necessary for us to assert or defend against infringement claims, enforce our issued and licensed patents, protect our trade secrets or know-how or determine the enforceability, scope and validity of the proprietary rights of others.  Our involvement in intellectual property claims and litigation could:

·  
divert existing management, scientific and financial resources;

·  
subject us to significant liabilities;

 
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·  
result in a ruling that allows our competitors to market competitive products without obtaining a license from us;

·  
require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all; or

·  
force us to discontinue selling or modify our products, or to develop new products.

If any of these events occurs, our business will be materially and adversely affected.
 
We and our manufacturers and suppliers license certain technologies and patents from third parties.  If these licenses are breached, terminated or disputed, our ability to commercialize products dependent on these technologies and patents may be compromised.

We have licensed 19 patents, including patents related to our Vitamin C serums that we have licensed from Avon.  We entered into our license with Avon in June 2003, for an initial three-year term, and the license is renewed year to year thereafter, at our option through the life of the last patent to expire (which will be in 2018).  These licensed patents contain claims that cover our Obagi-C Rx C-Clarifying serums, Professional-C 5% serum and Professional-C 10% serum.  If one or more of our licenses with Avon or licenses that we have with other parties terminate, or if we violate the terms of our licenses or otherwise lose our rights to these patents, we may be unable to continue developing and selling our products that are covered by claims in these patents.  Our licensors or others may dispute the scope of our rights under any of these licenses.  The licensors under these licenses may breach the terms of their respective agreements or fail to prevent infringement of the licensed patents by third parties.  Loss of any of these licenses for any reason could materially and adversely affect our financial condition and operating results.  See “Risk Factors – Risks Related to Intellectual Property:  If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights” and Part I, Item 1, “Business – Certain Material Agreements – Jose Ramirez and JR” in this Report for a description of current negotiations with JR.

Further, we purchase products from manufacturers and suppliers who have licensed patent rights to use and sell these products from third-party licensors, and if any dispute arises as to these licensed rights, the third-party licensors may bring legal actions against us, our respective licensees, suppliers, customers or collaborators, and claim damages and seek to enjoin the manufacturing and marketing of such products.
 
In addition, if we determine that our products do not incorporate the patented technology that we have licensed from third parties, or that one or more of the patents that we have licensed are not valid, we may dispute our obligation to pay royalties to our licensors.  Any dispute with a licensor could be complex, expensive and time-consuming and an outcome adverse to us could materially and adversely affect our business and impair our ability to commercialize our patent-licensed products.

Risks Related to Our Capital Requirements and Finances

Litigation could materially impact our financial results.

Substantial, complex or extended litigation could cause us to incur large expenditures, distract our management and disrupt our business.  For example, in connection with our settlement of the lawsuit an related demand for arbitration initiated by Dr. Zein Obagi, ZO Skin Health, Inc. and related affiliates, we recorded $5.0 million for a one-time payment to the plaintiffs and $2.9 million in related litigation fees as components of “Selling, general and administrative expenses” during the year ended December 31, 2011.  See Part I, Item 3 of this Report, “Legal Proceedings” and see Note 10, “Litigation” in our Notes to Consolidated Financial Statements for information concerning this matter.

 
39

 
 
If we fail to generate sufficient cash flow from our operations, we will be unable to continue to develop and commercialize new products.

We expect capital and operating expenditures to increase over the next several years as we expand our infrastructure, distribution channels and our commercialization, clinical trial, research and development and manufacturing activities.  We believe that our net cash provided by operating activities and existing cash and cash equivalents will be sufficient to fund our operations for the foreseeable future.  However, our present and future funding requirements will depend on many factors, including, among other things:

·  
the level of research and development investment required to maintain and improve our competitive position;

·  
the success of our product sales and related collections;

·  
our need or decision to acquire or license complementary businesses, products or technologies;

·  
costs relating to the expansion of our distribution channels;
 
·  
costs relating to the expansion of the sales force, management and operational support;

·  
competing technological and market developments; and

·  
costs relating to changes in regulatory policies or laws that affect our operations.

In addition, our future liquidity may be impacted by other factors not related to the funding requirements described above.  For instance, in October 2010, we announced that our Board of Directors has given us authority to repurchase up to $45.0 million of our outstanding stock depending on market conditions and other factors.  Pursuant to such authority, in November 2010 we repurchased a total of 3,556,910 shares of our common stock from two former stockholders, the Stonington Capital Appreciation 1994 Fund, L.P. and the Zein and Samar Obagi Family Trust (the “selling stockholders”), for a total purchase price of $35.0 million in accordance with the provisions of the Stock Purchase Agreement, dated as of November 15, 2010, among such selling stockholders and us.  No repurchases were effected during the year ended December 31, 2011, leaving us with $10.0 million available for repurchases under the program.  On March 6, 2012, our Board authorized a $20.0 million increase to our stock repurchase program, resulting in the availability to repurchase to up to $30.0 million of our common stock as of such date.  During the year ended December 31, 2012, we purchased 1,500,000 shares of our outstanding stock on the open market for a cost of $19.8 million.  As of December 31, 2012, we had $10.2 million remaining available to repurchase our outstanding stock under the program.  This authorization does not obligate us to acquire any particular amount of common stock nor does it ensure that any shares will be repurchased, and it may be suspended at any time at our discretion.  Additional repurchases under this authorization may include repurchases made through open market or privately negotiated transactions.  

If our net cash provided by operating activities and existing cash and cash equivalents are not sufficient to fund our operations in the future, we may need to draw down on our revolving line of credit (the “Facility”) or term loans (“Term Loans”) with Comerica Bank or raise additional funds, and we cannot be certain that such funds will be available to us on acceptable terms when needed, if at all.  If we are required to draw down on our Facility and/or Term Loans, our ability to in-license new technologies, develop future products or expand our pipeline of products could all be negatively impacted, which would have an adverse effect on our ability to grow our business and remain competitive in our marketplace.  In addition, if we raise additional funds through collaboration, licensing or other similar arrangements, we may be required to relinquish potentially valuable rights to our future products or proprietary technologies, or grant licenses on terms that are not favorable to us.  If we cannot raise funds on acceptable terms, we may not be able to expand our operations, develop new products, take advantage of future opportunities or respond to competitive pressures or unanticipated customer requirements.

Our quarterly operating results are variable, which may cause our stock price to decline.

Our quarterly results of operations have varied in the past and are likely to vary significantly in the future due to a number of factors, many of which are outside of our control, including:

·  
demand for and market acceptance of our products;

 
40

 
 
·  
the development of new competitive products by others;

·  
changes in regulatory classifications of our products;

·  
changes in physician or patient acceptance of the use of physician-dispensed products;

·  
changes in treatment practices of physicians who currently prescribe our products;

·  
reduced demand for our products during the summer months due to variability of patient compliance resulting from travel and other disruptive activities, particularly during July and August;

·  
delays between our expenditures to acquire new product lines or businesses and the generation of revenues from those acquired products or businesses;

·  
capital investments and expenditures to support strategic initiatives;
 
·  
the timing, release and competitiveness of our products;

·  
increases in the cost of raw materials used to manufacture our products;

·  
the mix of products that we sell during any time period;

·  
increased price competition;

·  
legal costs and settlement expenses associated with litigation and related reimbursements from insurance carriers, if any;

·  
legal costs and potential penalties related to regulatory matters; and

·  
adverse changes in the level of economic activity in the United States and other major regions in which we do business.

Due to the factors summarized above, we do not believe that period-to-period comparisons of our results of operations are necessarily meaningful and should not necessarily be relied upon to predict future results of operations.  In addition, due to the reduced demand for our products during the summer months as discussed above, our results of operations for the third quarter have historically been lower than our results of operations for the second quarter.  We do not expect that this will change in the future.  It is also possible that in future periods, our results of operations will not meet the expectations of investors or analysts, or any published reports or analyses regarding our company.  In that event, the price of our common stock could decline, perhaps substantially.

Changes in, or interpretations of, accounting rules and regulations, could result in unfavorable accounting charges or require us to change our policies.

Changes to, or interpretations of, accounting methods or policies in the future may require us to reclassify, restate or otherwise change or revise our financial statements, including those contained in this Report.  For example, on January 1, 2007, we adopted authoritative guidance issued by the Financial Accounting Standards Board (“FASB”), included under the Accounting Standards Codification (“ASC”) 740, Income Taxes (“ASC 740”), for uncertainties in our tax positions.  We provide for uncertain tax positions when such tax positions do not meet the recognition thresholds or measurement standards prescribed by ASC 740.  Changes to uncertain tax positions, including related interest and penalties, impact our effective tax rate.  When particular tax matters arise, a number of years may elapse before such matters are audited and finally resolved.  Favorable resolution of such matters could be recognized as a reduction to our effective tax rate in the year of resolution.  Unfavorable resolution of any tax matter could increase the effective tax rate.  Any resolution of a tax issue may require the use of cash in the year of resolution.

 
41

 
 
Impairment of our significant intangible assets may reduce our profitability.

The costs of our goodwill, acquired product rights, distribution rights, and trademarks are recorded as intangible assets and all, except for goodwill, are amortized over the period that we expect to benefit from the applicable assets.  As of December 31, 2012, acquired net intangible assets and goodwill comprised approximately 9% of our total assets.  We evaluate periodically the recoverability and the amortization period of our intangible assets.  Some factors we consider important in assessing whether or not impairment exists include performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the assets or the strategy for our overall business, and significant negative industry or economic trends.  These factors, assumptions, and changes in them could result in an impairment of our long-lived assets.  Any impairment of our intangible assets may reduce our profitability and have a material adverse effect on our results of operations and financial condition.  During the years ended December 31, 2012 and 2011, we wrote off an impaired license and abandoned patents for approximately $0.1 million and $0.9 million, respectively.


Fluctuations in demand for our products could create inventory maintenance uncertainties and could adversely affect our business.

As a result of customer buying patterns, a substantial portion of our revenues has been recognized in the last month of each quarter and the last month of the year.  We schedule our inventory purchases to meet anticipated customer demand.  As a result, relatively small delays in the receipt of manufactured products by us could result in revenues being deferred or lost.  Our operating expenses are based upon anticipated sales levels, and a high percentage of our operating expenses are relatively fixed in the short term.  Consequently, variations in the timing of sales, or reductions in sales due to ongoing global economic uncertainties, could cause significant fluctuations in operating results from period to period and may result in unanticipated periodic earnings shortfalls or losses.

If we overestimate demand, we may be required to write-off inventories and increase our reserves for product returns.  If we underestimate demand, we may not have sufficient inventory of products to ship to our customers.  Our products have expiration dates that range from 24 to 36 months from the date of manufacture.  We establish reserves for potentially excess, dated or otherwise impaired inventories.  We may not be able to accurately estimate the reserve requirement that will be needed in the future.  Although our estimates are reviewed quarterly for reasonableness, our product return activity could differ significantly from our estimates.  Judgment is required in estimating these reserves and we rely on data from third parties, including, but not limited to, distributor forecasts and independent market research reports.  The actual amounts could be different from our estimates, and differences are accounted for in the period in which they become known.  If we determine that the actual amounts exceed our reserve amounts, we will record a charge to earnings to approximate the difference.  A material reduction in earnings resulting from a charge would have a material adverse effect on our net income, results of operations and financial condition.

The agreements governing our Facility and Term Loans impose restrictions on our business that may limit our business opportunities and hinder our ability to execute our business strategy.

In May 2011, we entered into an amendment to the Credit and Term Loan Agreement, dated as of November 3, 2010 (the “Credit and Term Loan Agreement”) with Comerica Bank.  The Credit and Term Loan Agreement, as amended, contains, and other agreements we may enter into in the future may contain, covenants imposing restrictions on our business, and requires us to maintain certain financial covenants.  These restrictions and covenants may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise.  These covenants place restrictions on our ability to, among other things, incur additional debt, create liens, make investments, enter into transactions with affiliates, sell assets, guarantee debt, declare or pay dividends, redeem common stock or make other distributions to stockholders, and consolidate or merge.  
 
Although we were in compliance with all of our non-financial and financial covenants under the Credit and Term Loan Agreement as of December 31, 2012, our future ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial, and industry conditions.  In the event we ever borrow under the Credit and Term Loan Agreement, an event of default under the Credit and Term Loan Agreement would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest.  If we were unable to repay any debt owed, the lenders could proceed against the collateral securing that debt.

 
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We are subject to the requirements of Section 404 of the Sarbanes-Oxley Act.  If we are unable to comply with Section 404 in a timely manner it may affect the reliability of our internal control over financial reporting.

We are subject to the requirements of Section 404 of the Sarbanes-Oxley Act and the SEC rules and regulations require an annual management report on our internal control over financial reporting, including, among other matters, management’s assessment of the effectiveness of our internal control over financial reporting, and an attestation report by our independent registered public accounting firm addressing the effectiveness of our internal control over financial reporting.  Although our independent registered public accounting firm did not identify material weaknesses in connection with its audit of our internal control over financial reporting as of December 31, 2012, we cannot assure you that we will maintain an effective system of internal controls in the future.  If we are not able to adequately comply with the requirements of Section 404 we may be subject to sanctions or investigation by regulatory authorities, including the SEC or the Nasdaq Global Market.  Moreover, if we are unable to assert that our internal control over financial reporting is effective in any future period (or if our independent registered public accounting firm is unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which may have an a material adverse effect on us.

Our Board of Directors can issue preferred stock without stockholder approval of the terms of such stock.

Our amended and restated certificate of incorporation authorizes our Board of Directors, without stockholder approval, to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the rights, preferences, privileges, and restrictions granted to or imposed upon the preferred stock, including voting rights, dividend rights, conversion rights, terms of redemption, liquidation preference, sinking fund terms, subscription rights, and the number of shares constituting any series or the designation of a series. Our Board of Directors can issue preferred stock with voting and conversion rights that could adversely affect the voting power of the holders of common stock, without stockholder approval.  As of December 31, 2012, no shares of preferred stock were outstanding and we have no present plan to issue any shares of preferred stock.

Risks Related to Owning our Stock

We expect that the price of our common stock will fluctuate substantially.

The market price for our common stock has been and will continue to be affected by a number of factors, some of which are beyond our control, including:

·  
downturns in the global financial markets;

·  
changes in earnings estimates, investors’ perceptions, recommendations by securities analysts or our failure to achieve analysts’ earnings estimates;

·  
quarterly variations in our or our competitors’ results of operations;

·  
the announcement of new products or service enhancements by us or our competitors;

·  
announcements related to litigation;

·  
developments in our industry; and

·  
general market conditions and other factors unrelated to our operating performance or the operating performance of our competitors.
 
Provisions in our charter documents and Delaware law could discourage a takeover you may consider favorable or could cause current management to become entrenched and difficult to replace.

Provisions in our amended and restated certificate of incorporation and our bylaws, as well as Delaware law, could make it more difficult for other companies to acquire us, even if doing so would benefit our stockholders. Our certificate of incorporation and bylaws contain the following provisions, among others, which may inhibit an acquisition of our company by a third party:

 
43

 
 
·  
advance notification procedures for matters to be brought before stockholder meetings;

·  
a limitation on who may call stockholder meetings;

·  
a prohibition on stockholder action by written consent; and

·  
the ability of our Board of Directors to issue up to 10 million shares of preferred stock without a stockholder vote.

We are also subject to provisions of Delaware law that prohibit us from engaging in any business combination with any “interested stockholder,” meaning generally that a stockholder who beneficially owns more than 15% of our stock cannot acquire us for a period of three years from the date this person became an interested stockholder unless various conditions are met, such as approval of the transaction by our Board of Directors.  Any of these restrictions could have the effect of delaying or preventing a change in control.

We do not have a history of paying cash dividends on our common stock.

While we do not have a history of paying dividends, our Board may in the future determine to pay dividends.  Any payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our Board of Directors at that time.


 
ITEM 1B:    UNRESOLVED SEC STAFF COMMENTS

None.

 
ITEM 2:    PROPERTIES

As of December 31, 2012, we leased the following facilities:

                   
Function
 
Location
   
Square feet
   
Lease expiration
Headquarters
 
Long Beach, CA
     
30,884
   
October 2018
CA Distribution Center
 
Carson, CA
     
26,959
   
October 2013
UT Distribution Center
 
South Jordan, UT
     
44,351
   
January 2020

On August 6, 2008, we entered into a lease agreement with Kilroy Realty, L.P. for the lease of office space located in Long Beach, California.  This facility consists of 30,884 rentable square feet and the term of the lease is for ten years with an option to extend the lease term for five years.  We took possession of the facility on July 1, 2008, and the lease term commenced in October 2008 when we took occupancy and relocated our corporate headquarters to the new facility.  We believe our facilities are adequate for their intended use and are sufficient for our current level of operations.
 
Our activities are initiated and coordinated from our Long Beach headquarters.  Our cGMP compliance training for distribution personnel and sales training for customer service representatives are provided in Long Beach.

Our California distribution center is strategically located for quick, convenient and reliable distribution with access to all major carriers in Southern California.  In April 2012, we entered into a lease for an additional distribution center in South Jordan, Utah to support the operations of OPO.  This new facility consists of 44,351 square feet, of which we sublease 8,185 square feet to Bella and one of its affiliates.  The term of the lease commenced on October 19, 2012 and goes through January 31, 2020 with an option to extend the lease term for five years.

 
ITEM 3:    LEGAL PROCEEDINGS

On January 7, 2010, ZO Skin Health, Inc., a California corporation, filed a complaint in the Superior Court of the State of California, County of Los Angeles: ZO Skin Health, Inc. vs. OMP, Inc. and Obagi Medical Products, Inc. and Does 1-25; Case No.  BC429414.  The complaint alleged claims against us and sought injunctive relief,
 
 
44

 
 
compensatory damages  and other damages in an unspecified amount, punitive damages and costs of suit including attorneys’ fees.  We answered the complaint and denied the allegations in that pleading.  In addition, we asserted counterclaims against the plaintiff.

In addition, on or about January 7, 2010, Zein Obagi and his spouse, Samar Obagi, and the Zein and Samar Obagi Family Trust and certain other entities allegedly affiliated with Zein Obagi sent us an arbitration demand before JAMS in Los Angeles, California in which the claimants claimed breaches of the 2006 Services Agreement and 2006 Separation and Release Agreement (see Note 9 to our Consolidated Financial Statements) between us and the claimants and various breaches of common law, California law, and federal law.  We filed an answer to the Demand for Arbitration denying the allegations and asserting various counterclaims.  In May 2010, the claimants in the arbitration proceeding filed an amended demand, again before JAMS in Los Angeles.

On May 2, 2011, we entered into the Settlement Agreement with the ZO Parties, including Zein E. Obagi, M.D., Zein E. Obagi, M.D., Inc., ZO Skin Health, Inc., Skin Health Properties, Inc., the Zein and Samar Obagi Trust, and Samar Obagi that resulted in the dismissal with prejudice of all claims and counterclaims in both the litigation and arbitration.  Under the Settlement Agreement, we and the ZO Parties have agreed to mutual releases.  The Settlement Agreement also provides for: (i) a one-time payment of $5.0 million from us to the ZO Parties; and (ii) the grant of a limited, non-exclusive license by us to the ZO Parties to use certain of our trademarks in up to three locations.  The other non-economic terms of the Settlement Agreement are confidential.  We recorded $5.0 million for the one-time payment and $2.9 million in related litigation fees during the year ended December 31, 2011.

During the three months ended March 31, 2011, we received a coverage letter from our primary general liability insurance carrier, agreeing to defend the lawsuit and arbitration described above, under a reservation of rights.  In May 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities.  In July 2011, we filed an answer and cross claim against the carrier and our previous primary general liability insurance carrier.

On October 23, 2012, we entered into a Confidential Settlement Agreement and Release (the “Insurance Settlement”) with our insurance carriers.  Pursuant to the Insurance Settlement, we released the insurance carriers of all claims we did assert and could have asserted in the motions filed by us against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties.  In consideration for the final disposition of the matter, the insurance carriers paid us $14.0 million in October 2012, at which time we recorded net proceeds of approximately $8.4 million after legal expense as a gain on legal settlement related to the matter.

From time to time, we are involved in other litigation and legal matters or disputes in the normal course of business.  Management does not believe that the outcome of any of these other matters at this time will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 
ITEM 4:    MINE SAFETY DISCLOSURES

Not applicable.

 
45

 


 
PART II
 
ITEM 5:    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is traded on the Nasdaq Global Market under the symbol “OMPI” and has been quoted since our initial public offering on December 13, 2006.  The initial public offering price of our common stock on December 14, 2006 was $11.00 per share.  The following table sets forth for the fiscal periods indicated the high and low sale prices for our common stock as reported by Nasdaq:


             
Fiscal 2012
 
High
   
Low
 
First Quarter 
  $ 13.65     $ 10.10  
Second Quarter 
  $ 15.27     $ 12.25  
Third Quarter 
  $ 17.15     $ 11.89  
Fourth Quarter
  $ 13.78     $ 11.94  
                 
Fiscal 2011
               
First Quarter 
  $ 12.60     $ 10.50  
Second Quarter 
  $ 13.00     $ 9.05  
Third Quarter 
  $ 10.70     $ 9.04  
Fourth Quarter
  $ 10.38     $ 8.84  
                 

Holders

The approximate number of holders of our common stock was 3,499 as of February 27, 2013.  Because many of the shares of our common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of beneficial owners represented by these stockholders of record.

Dividends

While we do not have a history of paying dividends, our Board of Directors may in the future decide to do so.  However, any future determination to declare cash dividends will be made at the discretion of our Board of Directors, subject to compliance with certain covenants under our Credit and Term Loan Agreement, which limit our ability to declare or pay dividends, and will depend on our financial condition, results of operations, capital requirements, general business conditions, and other factors that our Board of Directors may deem relevant at that time.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table sets forth information regarding outstanding options and rights and shares reserved for future issuance under our equity compensation plans as of December 31, 2012:

 
46

 

             
Plan Category
 
Number of securities to be issued upon exercise of outstanding options, warrants and rights
 
Weighted-average exercise price of outstanding options, warrants and rights
 
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
   
(a)
 
(b)
 
(c)
Equity compensation plans approved by security holders
 
1,559,337
 
$
11.78
 
761,163
Equity compensation plans not approved by security holders
 
   
 
Total
 
1,559,337
 
$
11.78
 
761,163
 
Issuer Purchases of Equity Securities

On October 26, 2010, we announced that our Board of Directors authorized us to repurchase up to $45.0 million of our common stock, depending on market conditions and other factors.  Share repurchases under this program have included the repurchase of $35.0 million of shares from certain selling stockholders following completion of the registered public offering of shares of our common stock by such stockholders in November 2010 (the “secondary offering”).   No repurchases were made during the year ended December 31, 2011.  Accordingly, as of December 31, 2011, $10.0 million was still authorized for the repurchase of shares.

As no repurchases were made subsequent to December 31, 2011 through March 6, 2012, the date on which our Board authorized a $20.0 million increase to our stock repurchase program, our availability to repurchase our common stock increased to $30.0 million of our common stock as of such date.  During the year ended December 31, 2012, we purchased 1,500,000 shares of our outstanding stock for a cost of $19.8 million.  As of December 31, 2012, we had $10.2 million remaining available to repurchase our outstanding stock under the program.

Future repurchases under the program may be made through open market or privately negotiated transactions in compliance with SEC Rule 10b-18, subject to market conditions, applicable legal requirements and other factors.  However, this authorization does not obligate us to acquire any particular amount of common stock nor does it ensure that any further shares will be repurchased, and it may be suspended at any time at our discretion.

Performance Graph

The following information is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to the liabilities of Section 18 of the Exchange Act, and shall not be deemed to be incorporated by reference into any prior or subsequent filing by us under the Securities Act or the Exchange Act, whether made on, before or after the date of this filing and irrespective of any general incorporation language in such filing.

The Performance Graph below represents a comparison of the total return of our common stock, the NASDAQ Market Index and the SIC—Pharmaceutical Preparations for the period between December 14, 2006 and December 31, 2012.  The graph assumes $100 was invested on December 14, 2006 in stock, or November 30, 2006 in the index and peer group, and that all dividends, if any, have been reinvested.  Prices and stockholder returns over the indicated periods should not be considered indicative of future stock prices or stockholder returns.
 

 
47

 


OMPI 2012 Performance Graph

 
48

 


 
ITEM 6:    SELECTED FINANCIAL DATA

The selected consolidated financial data set forth below are derived from our audited consolidated financial statements for the fiscal years ended December 31, 2012, 2011, 2010, 2009 and 2008.  The information in the following table should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this Report.

 

                   Year Ended December 31,              
   
2012
   
2011
   
2010
   
2009
   
2008
 
Consolidated statements of income and comprehensive income data:
                             
Net sales                                                    
  $ 120,678     $ 114,108     $ 112,763     $ 104,096     $ 104,593  
Net income
    16,638       10,020       9,491       11,333       12,588  
Net income and comprehensive income
    16,638       10,020       9,573       11,320       12,587  
Net income attributable to common shares
                                       
Basic                                                  
  $ 0.91     $ 0.54     $ 0.44     $ 0.52     $ 0.56  
Diluted                                                  
  $ 0.90     $ 0.54     $ 0.44     $ 0.51     $ 0.56  
                                         
                                         
 
December 31,
 
      2012       2011       2010       2009       2008  
Consolidated balance sheet data:
                                       
Total assets                                                    
  $ 82,109     $ 77,651     $ 62,707     $ 87,490     $ 72,259  
Long-term debt less current portion
    8       13                   18  

 
 
49

 
 
ITEM 7:    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and related notes appearing elsewhere in this Report.  Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business and related financing requirements, includes forward-looking statements that involve risks and uncertainties.  You should review the “Risk Factors” section of this Report for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

Overview
 
We are a specialty pharmaceutical company that develops, markets and sells, and are a leading provider of, proprietary topical aesthetic and therapeutic prescription-strength skin care systems in the physician-dispensed market.  Our products are designed to prevent or improve some of the most common and visible skin disorders in adult skin, including premature aging, photodamage, skin laxity, hyperpigmentation, acne, sun damage, facial redness and soft tissue deficits, such as fine lines and wrinkles.
 
Current products.  Our primary product line is the Obagi Nu-Derm System, which we believe is the leading clinically proven, prescription-based, topical skin health system on the market that has been shown to enhance the skin’s overall health by correcting photodamage at the cellular level, resulting in a reduction of the visible signs of aging.  The primary active ingredients in this system are 4% hydroquinone and OTC skin care agents.  In April 2004, we introduced the Obagi-C Rx System consisting of a combination of prescription and OTC drugs and adjunctive cosmetic skin care products to address skin conditions resulting from sun damage and the oxidative damage of free radicals.  The central ingredients in this system are 4% hydroquinone and Vitamin C.  In October 2005, we launched the Obagi Professional-C products, a complete line of proprietary, non-prescription products, which consists of Vitamin C serums used to reduce the appearance of damage to the skin caused by ultraviolet radiation and other environmental influences.  In July 2006, we launched our Obagi Condition & Enhance System, for use in conjunction with commonly performed surgical and non-surgical cosmetic procedures.  In October 2006, we launched our first product in the ELASTIderm product line, an eye cream for improving the elasticity and skin tone around the eyes.  We introduced the CLENZIderm M.D. System and a second product in the ELASTIderm product line to address acne and skin elasticity around the eye, respectively, based on positive interim clinical results, in February 2007.  In July 2007, we launched our second system in the CLENZIderm M.D. line, CLENZIderm M.D. System II, which is specifically formulated for normal to dry skin.  In August 2007, we launched two new Nu-Derm Condition & Enhance Systems.  One is designed specifically for use with non-surgical procedures while the other has been developed for use with surgical procedures.  In February 2008, we launched ELASTIderm Décolletage, a system targeted for skin conditions resulting from sun damage and designed to improve the elasticity and skin tone for the neck and chest area.  In January 2009, we launched Obagi Rosaclear, a system to treat the symptoms of rosacea.  In September 2009, we also began offering Refissa by Spear, a FDA-approved 0.05% strength tretinoin with an emollient base that has a broad indication for treatment of fine facial lines, hyperpigmentation and tactile roughness.  In October 2010, we launched ELASTILash Eyelash Solution, a peptide-based eyelash solution that can help achieve the appearance of thicker, fuller-looking eyelashes.  In January 2011, we launched Blue Peel RADIANCE, a gentle salicylic acid-based peel that utilizes a unique blend of acids and other soothing ingredients to exfoliate, even out skin tone and improve overall complexion, with little-to-no downtime.  In January 2012, we launched ELASTIderm Complete Complex Eye Serum that utilizes an innovative roller ball technology for application.  In October 2012 we launched Obagi Hydrate, a moisturizer that features the innovative ingredient Hydromanil and several moisturizing agents for long-lasting hydration.  In January 2013 we began offering ReGenica Facial Rejuvenation Complex, containing a multipotent CCM complex composed of active growth factors and proteins to accelerate visible improvement in skin appearance post facial laser procedures.  We also market tretinoin, used for the topical treatment of acne in the U.S., metronidazole, used for the treatment of facial rosacea in the U.S., and the Obagi Blue Peel Essential Kit, used to aid the physician in the application of skin peeling actives.

Future products.  We focus our research and new product development activities on improving the efficacy of established prescription and OTC therapeutic agents by enhancing the penetration of these agents across the skin barrier using our proprietary technologies collectively known as Penetrating Therapeutics.  However, we cannot assure you that we will be able to introduce any additional systems using these technologies.
  

 
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U.S. distribution.  We market all of our products through our direct sales force in the United States primarily to plastic surgeons, dermatologists and other physicians who are focused on aesthetic skin care.
 
Aesthetic skin care.  As of December 31, 2012, we sold our products to over 6,600 physician-dispensing accounts in the United States.  During the year ended December 31, 2012, we had two affiliated customers within our physician-dispensed segment that together accounted for $12.9 million of our consolidated net sales.  Aside from these affiliated customers, there was no other customer accounting for more than 10% of our net sales during the year ended December 31, 2012.  No customer accounted for over 10% of our total consolidated net sales during the years ended December 31, 2011 and 2010.  Our current products are not eligible for reimbursement from third-party payors such as health insurance organizations.  We generated U.S. net sales of $99.0 million and $94.8 million during the years ended December 31, 2012 and 2011, respectively.

International distribution.  We market our products internationally through 19 international distribution partners and beginning January 1, 2012, one licensing partner, all of which have sales and marketing activities in approximately 46 countries outside of the United States.  Our distributors use a model similar to our business model in the United States, selling our products through direct sales representatives to physicians, or through alternative distribution channels depending on regulatory requirements and industry practices.  We generated international net sales of $17.2 million and $14.8 million during the years ended December 31, 2012 and 2011, respectively.
 
Licensing.  We market our products in the Japanese retail markets through license agreements with Rohto.  Under our agreements, Rohto is licensed to manufacture and sell a series of OTC products developed by it under the Obagi brand name, as well as Obagi-C products, in the Japanese drug store channel, and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto.  Rohto’s Obagi branded products are sold through approximately 6,300 high-end drug stores.  Through December 2011, we had other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel.  We generated licensing revenue of $4.5 million and $4.4 million during the years ended December 31, 2012 and 2011, respectively.
 
E-Commerce and fulfillment platform.  We are in the process of developing and testing a web-based marketing and fulfillment operation.  This e-Commerce platform will enable patients to order Obagi products from their physicians’ virtual storefronts on our newly created website, www.buyobagi.com, and we will assist physicians by hosting and maintaining their virtual storefronts and fulfilling their patients’ orders.  In addition, consumers who do not have a physician participating in this program and who wish to purchase cosmetic or OTC Obagi products can order them online directly from us.  We intend to initially launch the e-Commerce platform with a select group of physicians in a limited number of states and will not offer products directly to consumers during this initial launch stage.  Following such beta launch, we will eventually roll out the platform nationwide, other than in those states that have regulations limiting or prohibiting these activities, and will sell cosmetic and OTC products online directly to consumers.  We believe a robust e-Commerce platform will help build and strengthen the relationship between our physician customers and their patients by giving patients an efficient and easy way to order Obagi products from their physicians.  Once fully developed and deployed our new national distribution system will allow us to deploy additional channel expansion strategies and protect our brand from internet discounters by implementing a track and trace mechanism to follow products’ pedigrees through the sales channel.

To broaden our internet presence, in addition to developing our e-Commerce platform, we have also entered into a Distribution Agreement with Bella, under which Bella is an authorized distributor of Obagi products solely through its www.bellarx.com website.  Bella’s website will be dedicated to the sale of Obagi products directly to consumers and in assisting consumers who do not yet have a prescription for Obagi products in obtaining such a prescription.  Bella began distributing our products in December 2012.
 
 
Having an e-Commerce platform, we believe, will enable us to capitalize on the interest in our products by directing consumers to one place to learn about and purchase our products, capture a portion of this new business for our physician customers and serve a larger population of potential patients.  However, we cannot assure you that our e-Commerce platform will actually expand our base of end-users or result in the growth of our business.  Moreover, we have already invested and continue to, invest significant capital and other resources in the creation and maintenance this e-Commerce platform.  These activities may divert the attention of our management and other key employees from the operation of our core business, which could materially and adversely impact our business and results of operations in 2013.  During the year ended December 31, 2012, we incurred $3.9 million in expenses and $2.8 million capital expenditures as of December 31, 2012, related to our e-Commerce fulfillment initiative.


 
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Impairment of license.  In 2004, we entered into a license agreement with a third-party licensor to market and sell products containing a specific range of Kinetin concentration in Japan (see Note 2 to our Consolidated Financial Statements).  We subsequently, sublicensed these rights to an international distributer in Japan.  During the three months ended March 31, 2011, our sublicensee discontinued the manufacture and sale of products containing the Kinetin concentration.  In addition, neither we nor the sublicensee has current plans to develop or distribute products containing the Kinetin concentration in the future.  As a result, we recorded an impairment charge of $0.5 million consisting of the unamortized net book value of the initial license fee and the obligation for additional payments for which there is no future benefit.  These charges were recorded as a component of “Selling, general and administrative expense.”

Litigation settlement and insurance coverage.  In January 2010, Dr. Zein Obagi, ZO Skin Health, Inc., and related parties filed a complaint and an arbitration demand against us.  We later filed counterclaims in both proceedings.  On May 2, 2011, the parties to those proceedings entered into a Settlement Agreement that required dismissal of all claims and counterclaims in both proceedings.  Pursuant to the Settlement Agreement, we made a one-time settlement payment of $5.0 million.  The Settlement Agreement also contains a number of non-economic terms.  See Note 10 to our Consolidated Financial Statements for further discussion on the litigation and the Settlement Agreement.  Since January 2010 through December 31, 2011, we incurred significant litigation and related fees, including the $5.0 million settlement, of $13.5 million.  During the three months ended March 31, 2011, we received a coverage letter from our primary general liability insurance carrier, agreeing to defend the lawsuit, under a reservation of rights.  On May 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities.  In July 2011, we filed an answer and cross claim against the carrier and our previous primary general liability insurance carrier.  In October 2012, we entered into the Insurance Settlement with our insurance carriers.  Pursuant to the Insurance Settlement, we released the insurance carriers of all claims we did assert and could have asserted in the motions filed by us against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties.  In consideration for the final disposition of the matter, the insurance carriers paid us $14.0 million in October 2012, at which time we recorded net proceeds of approximately $8.4 million after legal expense as a gain on insurance settlement related to the matter, which is included as a component of “Selling, general and administrative expenses” in the Consolidated Statements of Income and Comprehensive Income.

Texas regulatory matter.  In November 2009, we received a letter from the Agency regarding our shipping in Texas of products containing unapproved new drugs and, specifically, referencing certain retail businesses in Texas that were selling our products containing prescription drugs over the Internet.  Prior to this time, the Agency had detained products from three of our customers that sold products on the Internet as a result of a complaint received from a third party.  In its letter, the Agency alleged that we were shipping unapproved new drug articles to these establishments in violation of certain Texas statutes.  After a series of communications with the Agency, at the end of April 2011, we met with the Agency and the AG at which time the AG stated that it viewed us to be in violation of the Texas Food, Drug and Cosmetic Act and the Texas Deceptive Trade Practices Act arising from the sale in Texas of our HQ Products, which the state believes to be an unapproved new drug.  Beginning April 2011, we voluntarily ceased shipping any HQ  Products into the state of Texas.  In addition, we developed a plan that enabled our customers in Texas to return any of these products (that had not otherwise been detained) in their possession in exchange for a credit or refund.

By letter dated February 29, 2012 the Agency notified the AG that it would be closing its pending investigation and enforcement action against us relating to our promotion, sales and distribution of HQ Products in Texas effective that date and withdrew its April 13, 2011 referral of the matter to the AG.  The Agency based its decision on:  (i) a directive that the Agency set priorities for enforcement and allocate its resources and concentrate its efforts on cases that represent the greatest risk to public health and safety; (ii) a FDA Q&A document issued in 2010 wherein the FDA acknowledged the potential medical benefits of hydroquinone-containing products for a certain medical condition, the uncertainty of the public health risks associated with the ingredient and its intent to conduct long-term studies through the NTP; and (iii) its acknowledgment of the relevance of the FDA’s CPG policy statement that the FDA has been using to guide its staff and industry concerning the FDA’s enforcement priorities for unapproved drug products.  The Agency also noted that it did not have sufficient evidence to conclude that there is an immediate risk to public health and safety from the topical use of products containing hydroquinone.  No monetary penalties or other administrative fees were levied against us as the result of the Agency’s investigation and no lawsuit was ever filed by the AG against us.  Upon completion of the investigation and withdrawal of the complaint, we re-introduced our HQ Products into Texas in May 2012.

In light of the aforementioned events, we recorded a sales returns and allowances provision for product to be returned from our customers residing in Texas of $1.9 million, which was recorded as a component of “Accrued liabilities” as of March 31, 2011 and as an offset to “Net sales” during the three months ended March 31, 2011.  In addition, we recorded $0.3 million in estimated finished goods inventory to be returned as of March 31, 2011 and as an
 
 
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offset to “Cost of sales” during the three months ended March 31, 2011.  Our methodology for calculating the provision considered, by customer, the previous 12 months of sales history.

We engaged a third party to assist in the efforts to manage the return of product from our customers residing in Texas.  As a result of our efforts, during the second and third quarters of 2011, we processed credits and refunds of $1.7 million in returned or detained products.  As of December 31, 2012, we did not expect to receive any additional sales returns related to the matter.

Sales.  Our total net sales have grown from $114.1 million for the year ended December 31, 2011 to $120.7 million for the year ended December 31, 2012.  Factors contributing to our sales generation include:

·  
Our professional marketing efforts to physicians.  Our professional sales force targets physicians who are focused on aesthetic and therapeutic skin care and educates them on how to best provide our products to their patients.  Our professional sales force also provides education to physicians, aestheticians, other staff and patients about the benefits of promoting skin health.  We have increased our sales force from 96 employees as of January 1, 2006 to 126 employees as of December 31, 2012.  We will continue to invest in expanding our sales force as warranted by the success of new product offerings and continued core product growth.  We currently do not have plans to hire a substantial number of employees in 2013.

·  
Strong growth in the aesthetic skin care market.  We believe the market demand for cosmetic facial procedures reflects a growing desire and acceptance among the aging population to seek aesthetic facial products and procedures from their physicians.  With our leading position in the physician-dispensed channel, the clinically proven aesthetic benefits of our products and the potential of our systems to enhance or complement many other facial procedures, we believe we are well positioned to meet this growing patient demand.

·  
Conducting clinical studies on our products.  We have completed 148 clinical studies since 2003 to demonstrate the efficacy of our products.  We believe that these clinical studies provide our products added scientific credibility in the physician-dispensed market.  We currently plan to initiate approximately 43 additional clinical studies in 2013.

·  
International.  We have formal distribution agreements with 19 distributors and one licensing partner and a trademark and product know-how license agreement in the OTC market in Japan.  Currently, those distributors have sales activities in approximately 46 countries, with the most successful distributors in 2012 coming primarily from the Far East, Europe, the Americas.

Results of operations.  We commenced operations in 1997, and as of December 31, 2012, we had accumulated earnings of $54.0 million.  We reported net income of $16.6 million and $10.0 million for the years ended December 31, 2012 and December 31, 2011, respectively.

Seasonality.  Sales of our products have historically been higher between September and March.  We believe this is due to increased product use and patient compliance during these months.  We believe this increased usage and compliance relates to several factors such as higher patient tendencies toward daily compliance inversely proportionate to their tendency to travel and/or engage in other disruptive activities during summer months.  Patient travel and other disruptive activities that affect compliance are at their peak during July and August.  The effects of seasonality in the past have been offset by the launch of new products.  This trend was very pronounced during 2007 when we launched four new product offerings and rebranded two systems.  However, we cannot assure you that we will continue to be able to offset such seasonality in the future.
 
Economy.  Many treatments in which our products are used are considered cosmetic in nature, are typically paid for by the patient out of disposable income and are generally not subject to reimbursement by third-party payors such as health insurance organizations.  As a result, we believe that our current and future sales growth may be influenced by the economic conditions within the geographic markets in which we sell our products.  Although there are modest signs of economic recovery, it is unclear whether the economy will show sustained growth and/or stability.  Even with continued growth in many of our markets, if uncertain economic conditions are prolonged or worsen, our business may be adversely impacted causing a decline in demand for our products.  We do believe that some of the negative impact we could experience may be partially offset due to the following: (i) we are the leader in the physician-dispensed market; (ii) the aesthetic nature of our products; (iii) the lower price point of our products compared to other aesthetic products in our market; (iv) the desire to maintain a healthy and youthful appearance; and (v) the demographics of the patients who use our products.
 
 
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Future growth.  We believe that our future growth will be driven by ongoing marketing efforts to create increased awareness of the Obagi brand and the benefits of skin health, new product offerings, entry into new distribution channels and expansion and further penetration into international markets.  Although we have in recent history moderated our investments in our strategic initiatives as a result of the recent recession and uncertain economic conditions, we plan to increase our investment in initiatives that we believe will facilitate growth in the business.  In 2012, we began to invest significant capital and other resources into the creation and maintenance of an e-Commerce platform that we currently believe will expand our base of end-users.  However, we cannot assure you that the e-Commerce platform will result in the expected growth of our business.  In addition, as opportunities present themselves, we plan to look towards the commercialization of new applications of our current products, the continuing development of our pipeline of products and the in licensing or acquisition of new product opportunities.  Such future investments could involve significant resources to facilitate more rapid growth.  At present, we believe that our ongoing profitability is primarily dependent upon the continued success of our current product offerings and certain other strategic marketing initiatives.

Critical Accounting Policies and Use of Estimates
 
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, sales and expenses, and disclosures of contingent assets and liabilities at the date of the financial statements.  On a periodic basis, we evaluate our estimates, including those related to revenue recognition, sales returns and allowances, accounts receivable, inventory, goodwill, other intangible assets, stock-based compensation and uncertainty in income taxes.  We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates.  By their nature, these estimates are subject to an inherent degree of uncertainty.  As a result, it is possible that our actual results will differ significantly from these estimates.  Our significant accounting policies are further described in Note 2 of Notes to Consolidated Financial Statements included elsewhere in this Report.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.
 
Revenue recognition.  We recognize revenues for our physician-dispensed segment in accordance with ASC 605, Revenue Recognition (“ASC 605”), which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. ASC 605 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies.  We recognize revenue when: (i) persuasive evidence of an arrangement exists; (ii) delivery of products has occurred or services have been rendered; (iii) the sales price charged is fixed or determinable; and (iv) collection is reasonably assured.  Our shipment terms are FOB shipping point as outlined in our sales agreements.
 
Our domestic sales agreements do not provide for rights of return or price protection.  However, we may approve returns on a case-by-case basis at our discretion.  Certain international distribution agreements do provide for rights of return and price protection.  Generally, such return rights are for a period of not more than 90 days after the products have been shipped to the distributors.  In accordance with ASC 605-15, Revenue Recognition - Products, we continuously monitor and track product returns and record a provision for the estimated amount of such returns, based on historical experience and any notification we receive of pending returns.  We do not grant any warranty provisions on our products.  We provide for discounts and allowances based on historical experience at the time revenue is recognized as a reduction to revenue.  To date, such provisions have approximated management’s estimates.  Other than our allowance for sales returns, the only estimates that we have to make regarding revenue recognition pertain to the collectability of the resulting receivable, both of which are discussed below.
 
We grant price protection rights to certain international distributors.  Such price protection rights require us to pay the distributor if there is a reduction in the list price of our products.  Price protection payments would be required for the distributor’s inventory on-hand or in-transit on the date of the price reduction, for a period not to exceed 90 days prior to the date of the price reduction.  We have not recorded a liability in connection with such price protection rights as we have never reduced the list prices of our products.
 
In September 2002, we entered into a licensing agreement, as amended in December 2008, with Rohto (see Note 8 of Notes to Consolidated Financial Statements), a large Japan-based company that specializes in the distribution
 
 
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and marketing of OTC medical oriented products in the drug store and retail channels.  In January 2006, we entered into a three-year licensing agreement, renewable by mutual agreement for additional one year periods, with Tokyo Beauty Center, a diversified Japanese consumer products and services company, which also owns and operates a large chain of aesthetic spas in Japan.  In January 2012, we did not exercise the option to renew this licensing arrangement.  Royalty revenue is recognized as earned and is based upon a predetermined rate within the respective licensing agreement.
 
Sales returns and allowances.  When we sell our products, we reduce the amount of revenue recognized from such sales by an estimate of future product returns and other sales allowances.  Sales allowances include cash discounts, rebates and sales incentives relating to products sold in the current period.  Factors that are considered in our estimates of sales returns include the historical rate of returns as a percentage of net product sales, excluding returns and allowances and shipping and handling revenue, historical aging of returns and the current market conditions.  Although our domestic sales agreements do not provide for a contractual right of return, we maintain a return policy that allows our customers to return product within a specified period after shipment of the product has occurred.  Factors that are considered in our estimates regarding sales allowances include quality of product and recent promotional activity.  

As discussed earlier, in April 2011, we were made aware of enforcement actions taken against certain of our customers by the Agency and the AG regarding the shipping of our HQ Products, into the state of Texas.  As a result of these actions, we had voluntarily ceased shipping any HQ Products in the state of Texas.  We developed a plan that enabled our customers residing in Texas to return any of these products (that had not otherwise been detained) in their possession in exchange for credit or refund.  During the three months ended March 31, 2011, we recorded a sales returns and allowances provision related to this matter of $1.9 million and we recorded $0.3 million in estimated finished goods inventory to be returned as of March 31, 2011.  Our methodology for calculating the provision considered, by customer, the previous 12 months of sales history.  During the second and third quarters of 2011, we processed credits and refunds of $1.7 million for returned or detained products related to the Texas matter.  As of December 31, 2012, we did not anticipate further sales returns related to the matter.

If actual future experience for product returns and other sales allowances exceeds the estimates we made at the time of sale, our financial position, results of operations and cash flow would be negatively impacted.  To date, such provisions have approximated management’s estimates.
 
Accounts receivable.  We perform periodic credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s current creditworthiness, as determined by our review of current credit information.  Receivables are generally due within 30 days.  For certain selected customers who we deem to be creditworthy based upon their prior payment history, we may extend our standard payment terms to net 60 days for selected product purchases made in connection with specific sales promotion programs.  Such extension does not represent a permanent change to the payment terms for such customers but, rather, is applicable only to those specified purchases made by such customers in connection with the related sales promotion.  We deem a receivable to be past due when it has not been paid in accordance with the terms of the applicable invoice (e.g., net 30 days or net 60 days) prepared at the time of sale.  Accounts receivable, net of allowance for doubtful accounts and sales returns, were $20.5 million and $21.0 million as of December 31, 2012 and 2011, respectively.  Of these amounts, 89.9% and 87.8%, were deemed current as of December 31, 2012 and 2011, respectively, which represented $18.4 million for both periods.  
 
We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical write-offs as a percentage of product sales, adjusted specifically for accounts that are past due, non-performing, in bankruptcy or otherwise identified as at risk for potential credit loss.  Receivables are charged to the allowance for doubtful accounts when an account is deemed to be uncollectible, taking into consideration the financial condition of the customer and the value of any collateral.  As of December 31, 2012 we decreased our allowance for doubtful accounts to $0.6 million, from $1.2 million at December 31, 2011.  The decrease was primarily related to an improvement in collections, reducing write-offs during the year ended December 31, 2012.  Our days’ sales outstanding (“DSO”), has remained flat at 60 days as of December 31, 2012 and 2011.  On an annual basis, customers with significant purchases are reviewed for their creditworthiness.  If the financial conditions of our customers deteriorate, resulting in an impairment of their ability to make payments, and if the uncollectible balances exceed our estimates as of the balance sheet date, we would need to charge additional receivables to our allowances, and our financial position, results of operation and cash flow would be negatively impacted.  Our credit losses have historically been within our expectations and the allowance established.
 
Inventory.  We state our inventories at the lower of cost or market, computed at standard cost on a first-in, first-out basis and market being determined as the lower of replacement cost or net realizable value.  Inventory reserves are established when conditions indicate that the selling price could be less than cost due to physical deterioration, usage,
 
 
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obsolescence, reductions in estimated future demand and reductions in selling prices.  Inventory reserves are measured as the difference between the cost of inventory and estimated market value.  Inventory reserves are charged to cost of sales and establish a lower cost basis for the inventory.  We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology, new product offerings and customer demand levels.  Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins.  Conversely, favorable changes in demand could result in higher gross margins.  To date, actual reserve requirements have approximated management’s estimates.
 
Goodwill and other intangible assets.  Effective January 1, 2002, we adopted authoritative guidance issued by the FASB, which requires, among other things, the use of a nonamortization approach for purchased goodwill and certain intangibles.  Under a nonamortization approach, goodwill and intangibles having an indefinite life are not amortized, but instead will be reviewed for impairment at least annually or earlier if an event occurs or circumstances indicate the carrying amount may be impaired.  Events or circumstances that could indicate impairment include a significant change in the business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in our strategy or disposition of a reporting unit or a portion thereof.  Goodwill impairment testing is performed at the reporting unit level.
 
In September 2011, the FASB issued authoritative guidance in ASC 350, Intangibles – Goodwill and Other (“ASC 350”), with respect to the annual goodwill impairment test that adds a qualitative assessment which allows companies to determine whether they need to perform the two-step impairment test.  We elected to adopt this accounting guidance early at the beginning of our third quarter of 2011 on a prospective basis for goodwill impairment tests.  The guidance under ASC 350 gives an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If, after assessing the totality of events or circumstances, an entity determines it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the guidance requires that goodwill be tested for impairment using a two-step process.  However, if an entity concludes otherwise, then it is not required to perform the two-step process.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.  If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired and the second step of the impairment test is unnecessary.  If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test must be performed to measure the amount of impairment loss, if any.  The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill.  The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination.  If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. 

Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to such reporting units, assignment of goodwill to such reporting units, and determination of the fair value of each reporting unit.  The fair value of each reporting unit is estimated using a discounted cash flow methodology.  This requires significant judgments including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital.  Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.
 
We have selected September 30 as the date on which we perform our annual goodwill impairment assessment.  We attribute the entire balance of our goodwill of $4.6 million to our physician-dispensed reporting unit.  Our determination of fair value of our goodwill considered the current and future economic, market, competitive conditions, and other relevant factors.  We evaluated the fair value of our goodwill using two approaches.  For the first approach, we derived valuation multiples from historical earnings data of guideline companies within our industry that compete in the physician-dispensed market, and then evaluated and adjusted the multiples based on our strengths and weaknesses relative to the guideline companies.  The derived multiples were then applied to our operating data to arrive at an indication of fair value.  Cash-free invested capital multiples, representing a marketable, minority interest, were calculated for the guideline companies as of September 30, 2012.  Revenue and earnings multiples were based on a valuation of the guideline companies’ profit margins, historical growth patterns, and a review of our own market factors, primarily related to our physician-dispensed business.  The second approach, the discounted cash flow method, focused on the expected cash flows of our physician-dispensed business.  We evaluated earnings projections through 2015, trending the growth down to 3% in the terminal year.  The discount rate for our physician-dispensed business was determined by utilizing a weighted average cost of capital analysis, which analyzed long-term government bonds, the Moody’s Seasoned Baa bond rate, the cost of equity of similar companies relative to our physician-dispensed business,
 
 
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as well as our capital structure.  Both methods were weighted at 50%.  The analyses concluded that the fair value of our physician-dispensed reporting unit significantly exceeded the carrying amount of our goodwill.  There were no impairment triggers during the year ended December 31, 2012.  Based on our analyses, no goodwill impairment charges were recognized for the years ended December 31, 2012, 2011 and 2010.

Other intangible assets consist of trademarks, distribution rights, covenants not-to-compete, patents, customer lists, licenses and proprietary formulations.  Other intangible assets are amortized over the expected period of benefit using the straight-line method over the following lives: trademarks (20 years); distribution rights (ten years); covenants not-to-compete (seven years); and other intangible assets (three to 17 years).  In accordance with ASC 350, long-lived assets (including intangible assets that are amortized) are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, such as a significant sustained change in the business climate, during the interim periods.  If an indicator of impairment exists for any grouping of assets, an estimate of undiscounted future cash flows is compared to the asset group’s carrying value.  If an asset is determined to be impaired, the loss is measured by the excess of the carrying amount of the asset over its fair value as determined by an estimate of discounted future cash flows.  

In April 2011, the sublicensee of our non-exclusive right to market and sell any and all products marked under the “Obagi” brand containing a specific range of Kinetin concentration in Japan, ceased the manufacture and distribution of products containing the Kinetin concentration in February 2011.  As a result, we recorded an impairment charge of $0.5 million during the three months ended March 31, 2011 related to the license.  In addition, during the years ended December 31, 2012 and 2011, we wrote off $0.1 million and $0.4 million in patents and trademarks that were abandoned, respectively.  These impairment charges were included as components of “Selling, general and administrative expenses” in the Consolidated Statements of Income and Comprehensive Income.

There were no other indicators of impairment noted during 2012; therefore no other tests were performed for long-lived assets.  Any unfavorable changes in market conditions or our product lines may result in the impairment of goodwill or an intangible asset, which could adversely impact our net income.
 
Stock-based compensation.  We account for stock-based compensation in accordance with the guidance under ASC 718, Compensation (“ASC 718”).  Determining the appropriate fair-value model and calculating the fair value of stock-based awards at the date of grant using any valuation model requires judgment.  We use the Black-Scholes option-pricing model, which requires the input of highly subjective assumptions.  These assumptions include estimating the length of time employees will retain their stock options before exercising them (“expected term”), the estimated volatility of our common stock price over the expected term and the number of options that will ultimately not complete their vesting requirements (“forfeitures”).  We estimated our options’ expected terms in accordance with ASC 718, using our best estimate of the period of time from the grant date that we expect the options to remain outstanding.  If we determine that another method to estimate expected volatility or expected term yields a more accurate estimate than our current methods, or if another method for calculating these input assumptions is prescribed by authoritative guidance, the fair value calculated for stock-based awards could change significantly.  Higher volatility and expected terms result in an increase to stock-based compensation determined at the date of grant.  The expected dividend rate and expected risk-free rate of return are not as significant to the calculation of fair value.
 
Uncertainty in Income Taxes. The provisions under ASC 740 prescribe a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of this interpretation.  The provisions also provide guidance on accounting for derecognition, interest and penalties, and classification and disclosure of matters related to uncertainty in income taxes.  As of December 31, 2012, the liability for unrecognized tax benefits was $0.3 million.
 
Results of Operations

The year ended December 31, 2012 compared the year ended December 31, 2011
 
Net sales.  The following table compares net sales by operating segment and by product line for the years ended December 31, 2012 and 2011:    

 
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Year Ended December 31,
       
   
2012
   
2011
   
Change
 
Net sales by operating segment
 
(in thousands)
       
Physician-dispensed
  $ 116,214       109,677       6 %
e-Commerce
                0 %
Licensing
    4,464       4,431       1 %
Total net sales
  $ 120,678     $ 114,108       6 %
                         
Net sales by product line
                       
Nu-Derm
  $ 62,671     $ 60,035       4 %
Vitamin C
    18,580       16,604       12 %
Elasticity
    13,163       11,313       16 %
Therapeutic
    7,075       6,491       9 %
Other
    14,725       15,234       -3 %
Total
    116,214       109,677       6 %
Licensing
    4,464       4,431       1 %
Total net sales
  $ 120,678     $ 114,108       6 %
                         
United States
    82 %     83 %        
International
    18 %     17 %        

 Net sales increased by $6.6 million to $120.7 million during the year ended December 31, 2012, as compared to $114.1 million during the year ended December 31, 2011.  Overall, our growth during the year ended December 31, 2012 was primarily due to: (i) growth in the international physician-dispensed market; (ii)  a decline of $1.7 million in the sales returns and allowances provision originally recorded during the year ended December 31, 2011, related to the actions brought by the Texas state regulatory bodies (see “Overview and Recent Developments” above for further discussion) in April 2011; and (iii) our re-introduction of prescription products into Texas in May 2012.  Net sales attributed to Texas increased as a percentage of our total net sales from 5% for the year ended December 31, 2011 to 6% for the year ended December 31, 2012.

Physician-dispensed sales increased $6.6 million to $116.2 million during the year ended December 31, 2012, as compared to $109.7 million during the year ended December 31, 2011.  We experienced net increases in the following product categories: (i) an increase in Nu-Derm of $2.6 million; (ii) a $2.0 million increase in Vitamin C sales; (iii) a $1.9 million increase in Elasticity sales, driven primarily by the launch of ELASTIderm Complete Complex Eye Serum in January 2012; and (iv) an increase of $0.6 million in Therapeutic sales.  The growth in our Nu-Derm sales was primarily due to: (i) $1.1 million in sales returns related to Texas recorded during the year ended December 31, 2011; and (ii) $1.0 million attributable to the launch of Obagi Hydrate in October 2012.  These product category increases were partially offset by a decrease of $0.5 million in the Other product category.  Licensing fees increased slightly to $4.5 million during the year ended December 31, 2012, as compared to $4.4 million during the year ended December 31, 2011.  As Bella began distributing our products directly to consumers in mid-December 2012, revenues related to this initiative are nominal for the year ended December 31, 2012.
 
Our aggregate sales growth was composed of $4.2 million in the U.S., and $2.4 million from our International markets.  The increase in International sales was primarily due to increases in the Nu-Derm, Vitamin C and Elasticity product categories and was principally a result of: (i) a $1.3 million increase in the Europe and Other regions; (ii) a $0.8 million increase in the Far East region; (iii) a $0.2 million increase in the Americas; and (iv) a $0.1 million increase from the Middle East.  The growth in our international markets can be partially attributed to the increased regional specific marketing and practice building support we provided to our international distributor partners during the year ended December 31, 2012.

Gross margin percentage.  Our gross margin percentage improved slightly to 79.2% during the year ended December 31, 2012, as compared to 78.9% during the year ended December 31, 2011.  The gross margin for our physician-dispensed segment slightly increased to 78.4% as compared to 78.1% for last year.  This increase was primarily a result of a change in sales mix among products, favoring our higher-margin products during the year ended December 31, 2012 as compared to the year ended December 31, 2011.  In addition we experienced a reduction in inventory reserves during the first quarter of 2012, as $0.3 million in inventory was reserved during the first quarter of
 
 
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2011 related to the Texas matter.  Our gross margin for our licensing segment increased slightly to 100.0% compared to 99.7% for last year.  The increase in our licensing segment gross margin is due to a decline in license amortization expense and royalties expense related to products containing a specific Kinetin concentration, during the year ended December 31, 2011 (see “Impairment of License” discussion under “Overview”), as compared to the prior year.  Cost of sales also includes outbound shipping and handling, work order scrap, licensing and royalty fees related to licensed intellectual property, depreciation and amortization attributable to products sold, and an inventory reserve for shrinkage and write-downs.
  
Selling, general and administrative.  Selling, general and administrative expenses consist primarily of salaries and other personnel-related costs, professional fees, insurance costs, stock-based compensation, depreciation and amortization not attributable to products sold, warehousing costs, marketing costs, travel expenses, general and administrative support expenses and other selling expenses.  Selling, general and administrative expenses decreased $5.8 million to $66.0 million during the year ended December 31, 2012, as compared to $71.9 million for the year ended December 31, 2011.  The decrease was primarily due to the following: (i) the receipt of net insurance proceeds of $8.4 million from our insurance carriers related to the Dr. Obagi litigation and settlement; (ii) a $7.9 million decrease in costs associated with the litigation and settlement of matters related to Dr. Obagi (see Notes 9 and 10 to our Consolidated Financial Statements); (iii) a decrease of $1.0 million in expenses associated with regulatory matters in Texas; (iv) a $1.0 million decrease in other marketing expenses as during the year ended December 31, 2011, we invested in extensive market research and consumer engagement initiatives to update and enhance our Internet presence; (v) a $0.5 million decrease in impairment charges (see “Impairment of License” discussion under “Overview and Recent Developments”); (vi) a $0.2 million decrease in product development expenses; (vii) a $0.2 million decrease in volume-driven expenses, primarily bad debt expense; and (viii) a $0.2 million decrease in depreciation and amortization expense.  These decreases were partially offset by: (i) $3.9 million in expenses directly related to the development and set-up of our e-Commerce platform; (ii) a $2.3 million increase in headcount-related expenses, primarily due to an increase accrued bonus during the year ended December 31, 2012 and an increase in operational and general and administrative headcount; (iii) $1.1 million in expenses associated with the regulatory matters in California; (iv) $1.1 million in research concerning the Japanese market; (v) a $0.9 million increase in promotions and training expenses; (vi) $0.8 million in corporate advisory expenses related to our review of alternatives to increase shareholder value; (vii) a $0.8 million increase in professional fees; (viii) a $0.7 million increase in non-cash compensation expense; (ix) a $0.7 million increase in advertising primarily due to increased advertising support for our international distributors; (x) a $0.6 million increase in other expenses, primarily related to lobbying activities; (xi) $0.5 million in expenses related to the establishment of a second source for certain of our products; and (xii) $0.2 million in expenses related to researching physician opportunities.   As a percentage of net sales, selling, general and administrative expenses in the year ended December 31, 2012 decreased to 55% as compared to 63% for the year ended December 31, 2011.  However, we anticipate operating costs to increase, due to our continuing investment in certain strategic initiatives.
 
Research and development.  Research and development expenses remained flat at $2.2 million for the year ended December 31, 2012, as compared to the year ended December 31, 2011.  During the year ended December 31, 2012, expenses related to the development of line extensions and reformulations of existing products increased $0.4 million.  This increase was offset by: (i) a $0.3 million decrease in impairment charges related to abandoned patents; and (ii) a $0.1 million decrease in expenses related to the development of new products during the year ended December 31, 2012.  The flat nature of our research and development costs is primarily due to the timing of our research and development activities and we have not reduced, nor do we intend to reduce, our long-term emphasis on research and development.  As a percentage of net sales, research and development costs were 2% in each of the years ended December 31, 2012 and 2011.
 
Interest income and Interest expense.  Interest income increased to $63,000 for the year ended December 31, 2012 from $35,000 for the year ended December 31, 2011.  We earn interest income from the investment of our cash balance into higher interest-yielding certificates of deposit.  The increase is due to an increase in our average cash and cash equivalents, including short-term investments, from $24.1 million for the year ended December 31, 2011 to $35.2 million for the year ended December 31, 2012, and an increase in our weighted average interest rate from 0.24% during the year ended December 31, 2011 to 0.25% during the year ended December 31, 2012.  Interest expense decreased to $77,000 during the year ended December 31, 2012, as compared to $143,000 for the year ended December 31, 2011.  Interest expense primarily consists of amortization of debt issuance costs and commitment fees related to our Credit and Term Loan Agreement.
 
Income taxes. Income tax expense increased $4.9 million to $10.8 million for the year ended December 31, 2012, as compared to $5.9 million for the year ended December 31, 2011.  Our effective tax rate was 39.3% for the year ended December 31, 2012 and 37.0% for the year ended December 31, 2011.  The difference is primarily due to the
 
 
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 impact of the 2011 research and development credit and an increase in our lobbying expenses.  The research and development tax credit for 2012 was not extended by Congress until subsequent to December 31, 2012.  As a result, the impact of the 2012 research and development tax credit will be recognized during the first quarter of 2013.

The year ended December 31, 2011 compared the year ended December 31, 2010
 
Net sales.  The following table compares net sales by operating segment and by product line for the years ended December 31, 2011 and 2010:    


                   
   
Year Ended December 31,
       
   
2011
   
2010
   
Change
 
Net sales by operating segment
 
(in thousands)
       
Physician-dispensed
  $ 109,677       108,362       1 %
e-Commerce
                0 %
Licensing
    4,431       4,401       1 %
Total net sales
  $ 114,108     $ 112,763       1 %
                         
Net sales by product line
                       
Nu-Derm
  $ 60,035     $ 59,166       1 %
Vitamin C
    16,604       16,413       1 %
Elasticity
    11,313       11,551       -2 %
Therapeutic
    6,491       7,261       -11 %
Other
    15,234       13,971       9 %
Total
    109,677       108,362       1 %
Licensing
    4,431       4,401       1 %
Total net sales
  $ 114,108     $ 112,763       1 %
                         
United States
    83 %     84 %        
International
    17 %     16 %        

 Net sales increased by $1.3 million to $114.1 million during the year ended December 31, 2011, as compared to $112.8 million during the year ended December 31, 2010.  Overall, we believe our net sales growth during the year ended December 31, 2011 was primarily due to the launch of new products, a larger base of active accounts and international physician-dispensed growth.  However, we believe this growth was offset by the Texas regulatory matter.

Physician-dispensed sales increased $1.3 million to $109.7 million during the year ended December 31, 2011, as compared to $108.4 million during the year ended December 31, 2010.  We experienced net increases in the following product categories: (i) an increase in the Other category of $1.3 million; (ii) a $0.9 million increase in Nu-Derm sales; and (iii) an increase in Vitamin C of $0.2 million.  The growth in the Other category was primarily attributable to the launch of Blue Peel RADIANCE in January 2011, which contributed $1.6 million, partially offset by $0.2 million in sales returns related to Texas.  The growth in our Nu-Derm sales was primarily due to the launch of Nu-Derm Sun Shield SPF 50 in January 2011, which contributed $2.6 million; partially offset by $1.1 million in sales returns related to Texas. These product category increases were partially offset by: (i) a decrease of $0.8 million in the Therapeutic category; and (ii) a decrease of $0.2 million in Elasticity sales.  The decline in the Therapeutic category was primarily due to a decline in sales of our CLENZIderm product line.  Licensing fees remained fairly flat at $4.4 million during the year ended December 31, 2011, as compared to the year ended December 31, 2010.
 
Our aggregate sales growth was composed of $0.3 million in the U.S., and a $1.0 million increase from our International markets.  The increase in International sales was primarily due to increases in the Vitamin C and Other product categories and was principally a result of: (i) a $0.7 million increase in the Far East region; (ii) a $0.1 million increase from the Europe and Other Regions; (iii) a $0.1 million increase in the Middle East; and (iv) a $0.1 million increase from the Americas.
 
Gross margin percentage.  Our gross margin percentage remained fairly flat at 78.9% during the year ended December 31, 2011, as compared to the year ended December 31, 2010.  The gross margin for our physician-dispensed

 
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segment slightly declined to 78.1% as compared to 78.3% for last year.  The decline in our physician-dispensed segment was primarily a result of an increase in our inventory reserve for expired product and for inventory returned related to the Texas regulatory matter, partially offset by a change in sales mix among products, favoring our higher-margin products during the year ended December 31, 2011 as compared to the year ended December 31, 2010.  Our gross margin for our licensing segment increased slightly to 99.7% compared to 96.9% for last year.  The increase in our licensing segment gross margin is due to a decline in license amortization expense and royalties expense related to products containing a specific Kinetin concentration, during the year ended December 31, 2011 (see “Impairment of License” discussion under “Overview”), as compared to the prior year.
  
Selling, general and administrative.  Selling, general and administrative expenses increased $2.5 million to $71.9 million during the year ended December 31, 2011, as compared to $69.4 million for the year ended December 31, 2010.  The increase was primarily due to the following: (i) a $1.9 million increase in costs associated with the litigation and settlement of matters related to Dr. Obagi (see Notes 9 and 10 to our Consolidated Financial Statements); (ii) a $1.4 million increase in professional fees primarily related to consultants for our operations group and towards the evaluation of strategic alternatives to grow the business; (iii) $1.0 million in expenses related to the Texas regulatory matter, which includes costs for coordinating the return of product from our customers residing in Texas, as well as legal and other related costs; (iv) a $0.9 million increase in other marketing principally due to increased efforts in market research and consumer engagement initiatives; (v) a $0.6 million increase in promotions and training expenses; (vi) $0.5 million in impairment charges (see Note 2 to our Consolidated Financial Statements);  (vii) a $0.1 million increase in non-cash compensation; and (viii) a $0.1 million increase in other expenses.  These increases were partially offset by: (i) a $1.7 million decrease in headcount-related expenses primarily due to a decrease in commissions and bonus; (ii) a $1.3 million decrease in bad debt expense, due to the provision on a non-performing international distributor of $0.5 million during the year ended December 31, 2010, and due to an improvement in collections, reducing the number of accounts written-off; (iii) a $0.8 million decrease in expenses related to the secondary offering completed in November 2010; (iv) a $0.1 million decrease in rent expense due to the termination of the Agreement with Dr. Obagi in September 2010; and (v) a $0.1 million decrease in depreciation and amortization.  As a percentage of net sales, selling, general and administrative expenses in the year ended December 31, 2011 increased to 63% as compared to 62% for the year ended December 31, 2010.  
 
Research and development.  Research and development expenses decreased $1.7 million to $2.2 million for the year ended December 31, 2011, as compared to $3.9 million for the year ended December 31, 2010.  The decrease was primarily due to: (i) a $1.1 million decrease in expenses related to the development of line extensions and reformulations of existing products; (ii) a $0.5 million decrease in accelerated advisory and related fees pursuant to the termination of the Agreement with Dr. Obagi in September 2010; and (iii) a $0.4 million decrease in expenses related to the development of new products.  These decreases were partially offset by a $0.3 million impairment charge related to abandoned patents.  The decline in our research and development costs is primarily due to the timing of our research and development activities and we have not reduced, nor do we intend to reduce, our long-term emphasis on research and development.  As a percentage of net sales, research and development costs in the year ended December 31, 2011 were 2% as compared to 3% in the year ended December 31, 2010.
 
Interest income and Interest expense.  Interest income declined to $35,000 for the year ended December 31, 2011 from $89,000 for the year ended December 31, 2010.  We earn interest income from the investment of our cash balance into higher interest-yielding certificates of deposit.  The decline is due to a decline in our average cash and cash equivalents, including short-term investments, from $36.9 million for the year ended December 31, 2010 to $24.1 million for the year ended December 31, 2011, and a decline in our weighted average interest rate from 0.30% during the year ended December 31, 2010 to 0.24% during the year ended December 31, 2011.  Interest expense increased to $143,000 during the year ended December 31, 2011, as compared to $71,000 for the year ended December 31, 2010.  Interest expense primarily consists of amortization of debt issuance costs and commitment fees related to our Credit and Term Loan Agreement.
 
Income taxes.  Income tax expense decreased $0.4 million to $5.9 million for the year ended December 31, 2011, as compared to $6.3 million for the year ended December 31, 2010.  Our effective tax rate was 37.0% for the year ended December 31, 2011 and 40.1% for the year ended December 31, 2010.  The difference is primarily due to the impact of the 2011 research and development credit and a decrease in our state tax expense as a result of the adoption for California purposes of single sales factor apportionment.  In addition certain costs incurred during the secondary offering and stock repurchase completed in November 2010 were not deductible for tax purposes during the year ended December 31, 2010.

 
 
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Liquidity and Capital Resources

Trends and uncertainties affecting liquidity
 
Our primary sources of liquidity are our cash generated by operations and availability under our Credit and Term Loan Agreement.  As of December 31, 2012 we had approximately $34.6 million in cash and cash equivalents and $35.0 million available under the Facility and Term Loans.  We believe that our existing cash balances and cash generated by operations, together with our available credit capacity, will enable us to meet foreseeable liquidity requirements.  The following has or is expected to impact liquidity:

·  
On March 6, 2012, our Board authorized a $20.0 million increase to our stock repurchase program, resulting in the availability to repurchase up to $30.0 million of our common stock as of such date.  During the year ended December 31, 2012, we purchased 1,500,000 shares of our outstanding stock at a cost of $19.8 million.  As of December 31, 2012, we had $10.2 million remaining available to repurchase our outstanding stock under the program;

·  
The legal costs and related settlement expense related to the litigation and arbitration involving us and Dr. Obagi were material.  During the year ended December 31, 2011, we recorded $5.0 million for the one-time settlement payment and $2.9 million in litigation fees related to this matter.  In October 2012, we entered into an Insurance Settlement with our insurance carriers.  Pursuant to the Insurance Settlement, we released the insurance carriers of all claims we did assert and could have asserted in the motions filed by us against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties.  In consideration for the final disposition of the matter, the insurance carriers paid us $14.0 million in October 2012, at which time we recorded net proceeds of approximately $8.4 million after legal expense as a gain on legal settlement related to the matter;

·  
During the year ended December 31, 2011, we recorded $1.7 million in sales returns for products returned from customers residing in the state of Texas.  We voluntarily ceased shipment of certain of our HQ Products into the state of Texas from April 2011 to May 2012.  Although we resumed shipping HQ products in Texas in May 2012, we cannot assure you that our sales of such products in that state will return to historical levels.  Texas net sales, including products containing hydroquinone, represented approximately 6% and 5% of our total net sales during the year ended December 31, 2012 and 2011, respectively;

·  
Although no enforcement action has been instituted against us for the California regulatory matter to date, it is possible that we will incur significant legal costs and potential penalties may be assessed (see Government Regulations in Item I of Part I of this Report).  If the ultimate expenses, penalties and/or restrictions are material, this matter could have a material adverse effect on our consolidated financial position, results of operations and cash flows;

·  
We plan to continue to invest significant capital and other resources in 2013 of between $4.0 million and $6.0 million into the creation and maintenance of an e-Commerce platform and fulfillment center.  We cannot assure you that the e-Commerce platform will result in the growth of our business.  Investment in this initiative could have a material adverse effect on our consolidated financial position, results of operations and cash flows.  During the year ended December 31, 2012, we recorded $3.9 million and $2.8 million in expenses and capital expenditures, respectively, related to this strategic initiative; and

·  
In January 2013, we received a notice from a stockholder informing us that it intends to nominate a slate of candidates to replace our current Board of Directors at our 2013 Annual Meeting of Stockholders.  The Board is actively engaged in overseeing management's execution of our strategic plan, which includes further penetrating our existing physician channel, launching our e-Commerce platform and expanding in international markets.  Our Board believes that this strategy will result in significant value for all stockholders.  We will provide stockholders with proxy materials, including a proxy card, in connection with the 2013 Annual Meeting of Stockholders in due course.  We expect this effort will require legal and proxy solicitation services, as well as printing and other related expenses, of  between $0.5 million and $1.5 million during the year ended December 31, 2013.  During the year ended December 31, 2012, we incurred $0.8 million related to this matter and other advisory services

 
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We are operating in an uncertain and volatile economic environment, which could have unanticipated adverse effects on our business.  The pharmaceutical industry has been impacted by the volatility in the financial markets, including declines in stock prices, and by uncertain economic conditions.  Increases in food and fuel prices, changes in the availability of consumer credit and housing markets, actual and potential job losses among many sectors of the economy, significant declines in the stock market resulting in large losses to consumer retirement and investment accounts, and uncertainty regarding future federal tax and economic policies have all added to declines in consumer confidence and curtailed consumer spending.
 
In order to remain competitive in the marketplace, for certain selected customers who we deemed to be creditworthy based upon their prior payment history, we extended our standard payment terms from net 30 days to net 60 days for selected product purchases made in connection with certain sales promotion programs.  Such extension does not represent a permanent change to the payment terms for such customers but, rather, was applicable only to specified purchases made by such customers in connection with the applicable sales promotion program.  Sales of products having net 60 day payment terms represented 50% and 53% of our net sales for the year ended December 31, 2012 and 2011, respectively.  Our DSO has remained flat at 60 days as of December 31, 2012 and 2011.
 
It is unclear how long the current economic environment will continue, whether there will be new events that could contribute to additional deterioration, and if so, what effect such events could have on our business in 2013.  As noted above, to facilitate more rapid growth, we plan to invest in a new e-Commerce platform and fulfillment center and, as the opportunities arise, the commercialization of new application of our current products, the continuing development of our pipeline of products and the in licensing or acquisition of new product opportunities, and expansion and further penetration in international markets.  While we plan to increase our investments in these initiatives, we expect to continue to generate positive cash flow through our operations. 

As of December 31, 2012, we had no outstanding balance on the Facility or Term Loans.  We were in compliance with all financial and non-financial covenants under the Credit and Term Loan Agreement as of December 31, 2012.  We expect to be in compliance with both our non-financial and financial covenants during 2013; however, economic conditions or the occurrence of any of the significant events discussed above under “Risk Factors” could cause noncompliance with our financial covenants.
 
We expect to be able to manage our working capital levels and capital expenditure amounts to maintain sufficient levels of liquidity.  As of December 31, 2012 and 2011, we had approximately $47.4 million and $52.4 million, respectively, in working capital.  We invested approximately $ 3.2 million in capital expenditures during the year ended December 31, 2012, which largely consisted of software and IT upgrades.  In 2013, we expect to spend approximately $2.6 million in capital expenditures, primarily related to software and IT upgrades and our e-Commerce platform and fulfillment center.  

Cash requirements for our business

Historically, we have generated cash from operations in excess of working capital requirements and through private and public sales of common stock.  We currently invest our cash and cash equivalents in large money market funds.  As of December 31, 2012 and 2011, we had approximately $34.6 million and $35.0 million, respectively, of cash and cash equivalents.
 
On April 17, 2012, we entered into an amendment (the “Amendment”) to the Credit and Term Loan Agreement, dated as of November 3, 2010, as amended.  The Amendment was retroactively effective as of March 30, 2012.  Pursuant to the terms of the Amendment, we have access to: (i) up to $20.0 million in a revolving credit facility; and (ii) one or more term loans in an aggregate amount of up to $15.0 million.

The Amendment, among other things, extended the eligible draw period of the Term Loans until the earliest to occur of: (i) the date the aggregate outstanding principal balance of the Term Loans equals $15.0 million; (ii) July 1, 2013; or (iii) the date we request to close out the Term Loans.  In addition, the Facility will terminate, and any amounts outstanding under the Facility will be due on July 1, 2014 and all amounts outstanding under the Term Loans will be due five years after the last day we request to close out the Term Loans, unless terminated earlier in accordance with the provisions of the Credit and Term Loan Agreement.  The Amendment also allows intercompany loans or intercompany investments in our subsidiary created for the e-Commerce initiative, OPO, in an aggregate not to exceed $12.0 million and exempts OPO from the subsidiary requirements of the Credit and Term Loan Agreement.  As of the date of the Amendment, we had no outstanding balance on the Facility or the Term Loans. 

 
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Any borrowings under the Credit and Term Loan Agreement will bear variable interest based on a margin, at our option, over prime rate or LIBOR as defined in the Credit and Term Loan Agreement.  All amounts borrowed under the Credit and Term Loan Agreement are secured by a first priority security interest in all of our tangible and intangible assets.  The Credit and Term Loan Agreement contains certain financial and non-financial covenants.  Non-financial covenants include, among other things, monthly and quarterly reporting of a listing of our intellectual property.  Financial covenants include requirements for maintaining: (i) a minimum quick ratio; (ii) a maximum ratio of total liabilities to tangible effective net worth; and (iii) a minimum adjusted EBITDA amount; as well as limitations on (a) annual capital expenditures, (b) asset- or equity-based investments, (c) stock repurchases, which may not exceed $70.3 million, (d) dividend distributions, which may not exceed 25% of net income for the preceding fiscal year, and (e) joint venture investments, which may not exceed $2.0 million.  See below for covenant compliance:

           
   
As of December 31, 2012
 
Requirement
 
Facility Covenants
         
Minimum quick ratio
 
3.0
 
1.0
 
Maximum ratio of total liabilities to tangible effective net worth
 
0.29
 
2.00
 
Minimum adjusted EBITDA
 
$31.1 million
 
$12.0 million
 
Maximum stock repurchase
 
$60.1 million
 
$70.3 million
 
Maximum dividend distribution
 
$0
 
$2.37 million
 
Maximum capital expenditures
 
$0.4 million
 
$3.0 million
 

As of December 31, 2012, we had no outstanding balance on the Facility or Term Loans.  We were in compliance with all financial and non-financial debt covenants under the Credit and Term Loan Agreement, as amended, as of December 31, 2012.   

On October 26, 2010, we announced that our Board of Directors authorized us to repurchase up to $45.0 million of our common stock, depending on market conditions and other factors.  Share repurchases could include the repurchase of shares from the selling stockholders in connection with the secondary offering of our common stock completed in November 2010, as well as repurchases made through open market or privately negotiated transactions in compliance with SEC Rule 10b-18, subject to market conditions, applicable legal requirements and other factors.  During the fourth quarter ended December 31, 2010, we repurchased 3,556,910 shares of our outstanding common stock for a cost of $35.0 million.  No repurchases were effected during the year ended December 31, 2011, leaving us with $10.0 million available for repurchases under the program.  On March 6, 2012, our Board authorized a $20.0 million increase to our stock repurchase program, resulting in the availability to repurchase up to $30.0 million of our common stock as of such date.  During the year ended December 31, 2012, we purchased 1,500,000 shares of our outstanding stock for a cost of $19.8 million.  As of December 31, 2012, we had $10.2 million available for repurchases under the program.  This authorization does not obligate us to acquire any particular amount of common stock nor does it ensure that any shares will be repurchased, and it may be suspended at any time at our discretion.

We continually evaluate new opportunities for products or therapeutic systems and, if and when appropriate, intend to pursue such opportunities through the acquisitions of companies, products or technologies and our own development activities.  Our ability to execute on such opportunities in some circumstances may be dependent, in part, upon our ability to raise additional capital on commercially reasonable terms.  There can be no assurance that funds from these sources will be available when needed or on terms favorable to us or our stockholders.  If additional funds are raised by issuing equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock.

Inflation

Although at reduced levels in recent years, inflation continues to apply upward pressure on the cost of goods and services that we use.  The competitive environments in many markets substantially limit our ability to fully recover these higher costs through increased selling prices.  We continually seek to mitigate the adverse effects of inflation through cost containment and improved productivity and manufacturing processes.

Foreign Currency Fluctuations
 
Approximately 4% of our net sales in 2012 were derived from operations outside the United States and were denominated in Japanese Yen.  None of our international cost structure is denominated in currencies other than the U.S.
 
 
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dollar.  As a result, we are subject to fluctuations in sales and earnings reported in U.S. dollars due to changing currency exchange rates.  We do not believe, however, that we currently have significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies.
 
Cash Flow

Year ended December 31, 2012. For the year ended December 31, 2012, net cash provided by operating activities was $20.4 million.  The primary sources of cash were $16.6 million in net income, including the effect of: (i) adjusting for non-cash items; (ii) an increase in accounts payable and accrued liabilities through timing of payments for operational, promotional and inventory purchases; (iii) an increase in income taxes payable; (iv) a decrease in income taxes receivable; and (v) a decrease in accounts receivable; which were partially offset by: (i) an increase in inventory through a decrease in our inventory turn ratio from 5.2 to 4.5; and (ii) an increase in prepaids and other assets.

Net cash used in investing activities was $3.2 million for the year ended December 31, 2012.  This was primarily due to costs associated with software and IT upgrades and investments in licenses and patent-related intellectual property during the year ended December 31, 2012.  We anticipate spending approximately $2.6 million for total capital expenditures in 2013 primarily for planned investments in software and IT upgrades and our e-Commerce platform and fulfillment center.

Net cash used in financing activities was $17.7 million for the year ended December 31, 2012.  This was primarily due to the repurchase of 1,500,000 shares of our outstanding stock for a cost of $19.8 million, which was partially offset by proceeds received from the exercise of stock options during the year ended December 31, 2012.

Year ended December 31, 2011.  For the year ended December 31, 2011, net cash provided by operating activities was $19.4 million.  The primary sources of cash were $10.0 million in net income, including the effect of: (i) adjusting for non-cash items; (ii) an increase in accounts payable and accrued liabilities through timing of payments for operational, promotional and inventory purchases; (iii) a decrease in accounts receivable through improvement in our DSO from 72 days to 65 days; (iv) a decrease in income taxes receivable; and (v) a decrease in inventory through an increase in our inventory turn ratio from 4.2 to 5.2.

Net cash used in investing activities was $0.8 million for the year ended December 31, 2011.  This was due to costs associated with software and IT upgrades and investments in licenses and patent-related intellectual property during the year ended December 31, 2011.  

Net cash provided by financing activities was $1.3 million for the year ended December 31, 2011.  This was primarily due to proceeds received from the exercise of stock options, which was partially offset by the principal payments made on our capital lease obligations during the year ended December 31, 2011.

Off-balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Related Party Transactions

Cobrek Pharmaceuticals, Inc.

From November 2010 through March 2011, we entered into consulting arrangements with certain individuals affiliated with Cobrek Pharmaceuticals, Inc. (“Cobrek”) to provide consulting services to us.  These individuals include: (i) Cobrek’s Vice President of Regulatory Affairs and Quality Assurance; (ii) the Chairman of the board of directors of Cobrek; (iii) a member of the board of directors of Cobrek; and (iv) a senior consultant to Cobrek.  For both of the years ended December 31, 2012 and 2011, we recorded $0.9 million in aggregate fees and related expenses for consulting services provided by these four consultants.  As of December 31, 2012 and 2011, amounts due to the four consultants aggregated $40,000 and $0.1 million, respectively, and are included in “Amounts due to related parties” in the Consolidated Balance Sheets.
 
       In addition to the four consultants mentioned above, Albert F. Hummel, our President and Chief Executive Officer and member of our Board of Directors, was also the Chief Executive Officer, a member of the board of directors and a holder of more than 10% of the outstanding stock of Cobrek.  For the year ended December 31, 2011, we recorded $0.2 million in fees and related expenses for consulting services provided by Mr. Hummel prior to entering into an

 
 
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employment arrangement and subsequent employment agreement with him.  These expenses were recorded as a component of “Selling, general and administrative expenses.”  See Note 10, “Albert F. Hummel Employment Agreement” in our Notes to Consolidated Financial Statements for further information.

In December 2012, Cobrek was acquired by Perrigo Company, and since the acquisition, neither Mr. Hummel nor the consultants who provided services to us have any relationship with Cobrek.

Stock Purchase Agreement

On November 15, 2010, we entered into a Stock Purchase Agreement with the selling stockholders, under which we were obligated to purchase from the selling stockholders $35.0 million worth of our common stock, subject to certain conditions.  The purchase price per share to be paid to the selling stockholders was to be the same price paid by the underwriter to purchase shares from the selling stockholders in the secondary offering completed in November 2010.  However, if the purchase price to be paid was greater than $13.00, we would not purchase any shares from the selling stockholders.  In addition, the purchase of the shares by us was conditioned on the sale of shares in the secondary offering.

Following the completion of the secondary offering of 2,690,244 shares on November 24, 2010, we repurchased 3,556,910 shares from the selling stockholders at a price of $9.84 per share, which was equal to the public offering price of $10.25 per share less the applicable underwriter’s discount, on November 30, 2010.  Upon completion of both transactions the selling stockholders ceased to own any shares of our common stock.

Termination of 2006 Services Agreement

On September 2, 2010, we exercised our right to terminate the 2006 Agreement with Zein E. Obagi, MD Inc. (“Obagi Inc.”), Zein Obagi (“Dr. Obagi” and, together with Obagi Inc., the “Obagi Entities”), Samar Obagi, the Zein and Samar Obagi Family Trust and Skin Health Properties, Inc. (“the Marketer”) (collectively, the “Dr. Obagi Parties”), effective as of October 4, 2010.  In connection with the termination of the 2006 Agreement, we accelerated the payment of $0.5 million in certain fees and expenses (included within “Research and development expenses”) during the third quarter 2010, that otherwise would have been paid during the remainder of the original term, which was for five years and would have otherwise ended on June 29, 2011.  No additional amounts were paid to the Dr. Obagi Parties as a result of the termination.  In addition, as a result of the termination, we determined that our leasehold improvements in connection with a lease with the Marketer was impaired, resulting in the write-off of $0.3 million in leasehold improvements at the Beverly Hills property and $0.2 million in prepaid rent (included within “Selling, general and administrative expenses”).

Termination of the 2006 Agreement does not relieve the Dr. Obagi Parties from their obligations to comply with certain provisions of the 2006 Agreement, particularly as they relate to a limited trademark license to Obagi Inc. and/or the Marketer, the grant to us of a license to have access to and utilize accounts, customer lists and other customer information and data developed in connection with the 2006 Agreement, the protection of our intellectual property rights and other additional confidential information related to us, nor does it affect our ownership of trademarks and other intellectual property rights.

We entered into a Settlement and Release Agreement with Zein E. Obagi, M.D., Zein E. Obagi, M.D., Inc., ZO Skin Health, Inc., Skin Health Properties, Inc., the Zein and Samar Obagi Trust, and Samar Obagi (the “Settlement Agreement”) during the year ended December 31, 2011.  See Note 10, “Litigation” in our Notes to Consolidated Financial Statements for information concerning this matter.

Commitments and Contractual Obligations

Our major outstanding contractual obligations relate to operating leases and capital leases.  These contractual obligations as of December 31, 2012 were as follows:



 
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Payments due by period
 
 
Total
 
Less than 1 year
 
1-3 years
 
3-5 years
 
More than 5 years
 
Contractual Obligations
                             
Capital lease obligations
  $ 20     $ 12     $ 6     $ 2     $  
Operating lease obligations
    9,437       1,996       3,006       2,878       1,557  
Total
  $ 9,457     $ 2,008     $ 3,012     $ 2,880     $ 1,557  
                                         
 
Capital leases.  We lease certain office equipment for use in our operations that are classified under capital leases.  Our payment obligations under capital leases represent both principal and interest at implied fixed rates.  The leases expire through May 2014.

Operating leases.  We lease our corporate offices in Long Beach, California and distribution center in Carson, California under separate leases expiring in October 2018 and October 2013, respectively. In June 2012, we entered into a lease for space for our e-Commerce fulfillment center in South Jordan, Utah which expires in January 2020.  In addition, we lease automobiles for our sales representatives and other office equipment generally under 36-month contracts.
 
Uncertainty in Taxes.  In connection with provisions under ASC 740, at December 31, 2012, we had approximately $0.3 million of long-term liabilities, associated with uncertain tax positions.  The table above does not reflect our uncertain tax liability as the resolution of the balance, including the timing of payments, is contingent upon various unknown factors, and cannot be reasonably estimated.  Refer to Note 6 to the Consolidated Financial Statements for further information on unrecognized tax benefits.

Recent Accounting Pronouncements

New Accounting Standards
 
In February 2013, the FASB issued Accounting Standards Update (“ASU”) 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.  This update requires entities to disclose items reclassified out of accumulated other comprehensive income and into net income in a single location within the financial statements.  This new guidance is effective for us beginning January 1, 2013, with early adoption permitted.  We adopted this new guidance beginning the year ended December 31, 2012, and applied it retrospectively.  The adoption of this guidance did not have a significant impact on our consolidated financial statements.

In August 2012, the FASB issued ASU 2012-03, Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB Accounting Standards Update 2010-22 (SEC Update) (“ASU 2012-03”).  This update amends various SEC paragraphs pursuant to the issuance of Staff Accounting Bulletin No. 114.  The adoption of ASU 2012-03 did not expect have a material impact on our consolidated financial statements.

In June 2011, the FASB issued authoritative guidance in ASC 220, Comprehensive Income, on the presentation of other comprehensive income.  The new guidance eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity and requires an entity to present either one continuous statement of net income and other comprehensive income or two separate, but consecutive statements.  Further, the guidance requires reclassification adjustments from other comprehensive income to net income to be presented on the face of the financial statements.  However, in December 2011, the FASB issued follow-up guidance to defer the requirement to present reclassification adjustments from other comprehensive income on the face of the financial statements and allow entities to continue to report reclassifications out of accumulated other comprehensive income.  While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance.  We adopted this new guidance beginning January 1, 2012, and applied it retrospectively.  The adoption of this guidance did not have a significant impact on our consolidated financial statements.

 
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ITEM 7A:    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest our excess cash primarily in large money market funds and certificates of deposit with maturity dates no greater than one year.  We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion.  Accordingly, we believe that we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments.
 
Although substantially all of our sales and purchases are denominated in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the price competitiveness of our products outside the U.S.  We do not believe, however, that we currently have significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies.
 
Interest Rate Risk
 
Our interest income and expense is more sensitive to fluctuations in the general level of U.S. prime rate and LIBOR interest rates than to changes in rates in other markets.  Changes in U.S. LIBOR interest rates affect the interest earned on our cash and cash equivalents.  At December 31, 2012, we had approximately $34.6 million of cash and cash equivalents.  If the interest rates on our cash and cash equivalents were to increase or decrease by 1% for the year, annual interest income would increase or decrease by approximately $0.3 million.
 
Other Risks
 
The negative downturn in the economy in recent years has had an adverse impact on the financial services industry, including insurance companies, some of whom provide insurance coverage to us.  To the extent we have any claims in the future and such insurance providers are unable, due to their financial condition, to pay covered claims, we could experience adverse impacts on our cash flow and cash reserves.  We have no way of knowing whether or not any insurance providers that are financially stable at this time will experience financial difficulties in the future that could impact their ability to pay covered claims.
  
 
ITEM 8:    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this Item is incorporated herein by reference to the financial statements set forth in Item 15(a) of Part IV of this Report.
 
 
ITEM 9:    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

Not applicable.

 
ITEM 9A:    CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As of the end of the period covered by this Report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act).  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in providing reasonable assurance that information is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules, regulations and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and the Chief Financial Officer as appropriate, to allow timely decisions regarding required disclosure.

 
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Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15(d)-15(f) of the Exchange Act).  Under the supervision and with the participation of management, including our Chief Executive Officer and the Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based upon the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on that evaluation, our management concluded that Obagi’s internal control over financial reporting was effective as of December 31, 2012.
 
The effectiveness of our internal control over financial reporting as of December 31, 2012 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in its Report of Independent Registered Public Accounting Firm under Part IV, Item 15 of this Report.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 
ITEM 9B:    OTHER INFORMATION

Adoption of 2013 Performance Incentive Plan

On March 11, 2013, the Compensation Committee of our Board of Directors approved and adopted the Obagi 2013 Performance Incentive Plan (the “2013 Plan”), which was designed to motivate, retain and reward our employees, including our executives, based upon the achievement of corporate revenue and adjusted EBIT objectives, as well as individual objectives in certain cases.  Assuming 100% achievement of the target revenue and adjusted EBIT objectives, the aggregate 2013 Plan pool will be funded in the amount of $2.48 million, a slight increase from the target pool of $2.47 million under our 2012 Performance Incentive Plan.  For the 2013 Plan pool to be funded for executive officers and other participants to earn any bonuses, we must achieve at least 80% of the revenue objective and at least 80% of the adjusted EBIT objective.  If the revenue and adjusted EBIT objectives are exceeded, an increased amount will be funded to the 2013 Plan pool, up to 150% of the target pool.  If we achieve between the minimum required 80% and the target 100% of each objective, then the potential bonus amount for each executive officer and non-executive employee will be reduced by 5% and 3%, respectively, for each 1% that we are below the target objective, and the bonus pool will be reduced accordingly.  Thirty percent of the 2013 Plan pool will relate to the revenue objective, and 70% of the pool will relate to the adjusted EBIT objective.
 
 
In the event that the revenue and adjusted EBIT objectives are sufficiently achieved to fund the 2013 Plan pool, the participants in the 2013 Plan may be eligible to receive individual incentive awards as established by our Compensation Committee based on achievement of individual performance objectives, the corporate financial objectives (in certain cases) and/or certain company performance objectives. Our Compensation Committee has established the following individual target bonus amounts calculated as a percentage of the participant’s current base salary for our executive officers:
             
Name and Title
 
Target as a Percentage of Base Salary
   
Target Bonus Amount
 
Albert F. Hummel, Chief Executive Officer and President
    75 %   $ 386,250  
Preston S. Romm, Chief Financial Officer and Executive Vice President, Finance, Operations and Administration  
    60 %   $ 201,000  
David S. Goldstein, Executive Vice President, Global Sales and Field Marketing   
    50 %   $ 155,000  
Laura B. Hunter, Vice President, General Counsel and Secretary
    50 %   $ 137,500  
Mark T, Taylor, Senior Vice President, Corporate Development and Investor Relations
    50 %   $ 135,000  

The Compensation Committee may, if permitted by law, make retroactive adjustments to any awards made under the 2013 Plan paid to our executive officers where the payment was predicated upon the achievement of specified

 
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financial results that were the subject of a subsequent restatement.  Where applicable, we will seek to recover any amount determined to have been inappropriately received by the individual executive officer.

Eligible participants under the 2013 Plan are full-time employees, including executives, who do not participate in sales or other variable incentive pay plans and are employed by us on December 31, 2013.
 
 
Adoption of Amendments to the 2005 Stock Incentive Plan

On March 11, 2013 our Board of Directors approved an amendment to our 2005 Stock Incentive Plan, as amended, to provide that the Compensation Committee may make retroactive adjustments to any performance based award (cash or equity-based) made under the plan to executive officers who are subject to Section 16 of the Exchange Act and other designated executives where the payment was predicated upon the achievement of specified financial results that were the subject of a subsequent restatement.  Where applicable, the Compensation Committee will seek to recover any amount determined to have been inappropriately received by the individual executive.

Amendments to Certain Executive Employment Agreements

On March 11, 2013 (the “Amendment Date”), our compensation committee approved amendments to the Amended and Restated Executive Employment Agreements with each of the following executive officers: Mr. Preston Romm, our Chief Financial Officer and Executive Vice President, Finance, Operations and Administration, Mr. David Goldstein, our Executive Vice President, Global Sales and Field Marketing, Ms. Laura Hunter, our Vice President, General Counsel and Secretary, and an amendment to the Executive Employment Agreement with Mr. Mark Taylor, our Senior Vice President, Corporate Development and Investor Relations (collectively, the “Executive Amendments”).  Prior to the Executive Amendments, in the event of a change in control in which the consideration that was paid was solely cash, all options and restricted stock units held by the executive would accelerate and vest in full, and all options would become exercisable immediately prior to such change in control, regardless of the executive’s continued employment status.
 
       Under the Executive Amendments, any options or RSUs granted to the executive after the Amendment Date will, in the event of termination of the executive’s employment for good reason following a change in control, vest in full and all such options will become immediately exercisable.  With respect to options granted to an executive prior to the Amendment Date (“Current Options”), such options will continue to vest in full and become exercisable in the event of a change in control in which the consideration that is paid is solely cash, regardless of the executive’s continued employment status.  In the event of a change in control in which the consideration paid is stock or a combination of stock and cash, the Current Options will continue to be governed by the terms of the existing agreements for such options, provided, however, that if the executive’s employment is terminated following the change of control for good reason, then such Current Options will vest in full and become immediately exercisable on the date of termination.

Amendment of Software Agreement with Koogly

On March 11, 2013, OPO entered into an amendment of the Software Agreement dated March 6, 2012 by and between OPO and Koogly (the “Original Software Agreement”).  Under the terms of the Original Software Agreement, OPO agreed to pay Koogly a one-time license fee of $1.4 million, payable in two installments as follows: (i) half of the fee was payable upon execution of the Original Software Agreement and (ii) the second half was due after OPO received the software that Koogly was developing for and had had the opportunity to test and use it for a 90 day period, which period could be extended to correct and retest any defects in the software.  Under the amendment, the remaining half of the license fee is now payable as follows: (i) $337,500 was due upon execution of the amendment; (ii) $168,750 will be due and payable upon initial delivery of the software and determination by OPO, after testing, that such software is sufficiently functional to launch OPO’s online business in a beta environment and; (iii) the remaining $168,750 will be due and payable after delivery by Koogly to OPO of the warehouse management system portion of the software and OPO’s determination, after testing, that such system has no material defects.  In addition, under the amendment, Koogly has agreed to provide OPO with additional programming services for a period of six months for a $175,000 fee.  OPO may choose to extend these services for an extra six month period for an additional $175,000 fee.  In addition, Koogly has agreed to provide certain debugging services to OPO for a fee not to exceed $50,000. 
 
 
 
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PART III
 
ITEM 10:    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item is incorporated into this Report by reference to the definitive proxy statement for our 2013 Annual Meeting of Stockholders (the “Proxy Statement”).

 
ITEM 11:    EXECUTIVE COMPENSATION

The information required by this item is incorporated into this Report by reference to the Proxy Statement.

 
ITEM 12:    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is incorporated into this Report by reference to the Proxy Statement.

 
ITEM 13:    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this item is incorporated into this Report by reference to the Proxy Statement.  

 
ITEM 14:    PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by this item is incorporated into this Report by reference to the Proxy Statement.



 
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PART IV
 
ITEM 15:    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)1. Consolidated Financial Statements and Supplementary Data:
 
The following financial statements are included as a separate section of this report commencing on page F-1:

   
Report of Independent Registered Public Accounting Firm
F-1
Consolidated Balance Sheets as of December 31, 2012 and 2011
F-2
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2012, 2011 and 2010
F-3
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010
F-4
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010
F-5
Notes to Consolidated Financial Statements
F-6
   

(a)2. Financial Statement Schedules:

Schedule II—Valuation and Qualifying Accounts

Other than as set forth below, all other schedules have been omitted for the reason that the required information is presented in financial statements or notes thereto, the amounts involved are not significant or the schedules are not applicable.


                               
                               
(in thousands)
 
Balance at
 Beginning of
Period
   
Charged (Credited) to
 Cost and
Expense
   
Charged to Contra-
Revenue
   
Deductions
   
Balance at
 End of
Period
 
Year ended December 31, 2010
                             
Allowance for doubtful accounts
  $ 1,532     $ 1,531     $     $ (883 )   $ 2,180  
Allowance for sales returns
    492             (225 )           267  
Reserve for inventories
    598       1,031             (1,029 )     600  
Valuation allowance for deferred tax assets
    47                   (47 )      
Year ended December 31, 2011
                                       
Allowance for doubtful accounts
  $ 2,180     $ 74     $     $ (1,084 )   $ 1,170  
Allowance for sales returns
    267             35             302  
Reserve for inventories
    600       790             (925 )     465  
Year ended December 31, 2012
                                       
Allowance for doubtful accounts
  $ 1,170     $ (223 )   $     $ (359 )   $ 588  
Allowance for sales returns
    302             74             376  
Reserve for inventories
    465       181             (96 )     550  
                                         


 
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(a)3. Exhibits:
 
       
Where Located
Exhibit
 
Exhibit title
 
Form
Exhibit No.
Filing Date
Filed Herewith
</