10-Q 1 form10q.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

ý	Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarter ended June 30, 2006

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

Commission file number: 0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.

A Delaware Corporation

I.R.S Employer Identification No. 04-3128178

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

Title of each class
Common Stock, $0.01 par value

Name of each exchange on which registered
NASDAQ - National Market

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

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

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

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

The number of shares of common stock outstanding at August 2, 2006, was 17,642,924

Palomar Medical Technologies, Inc. and Subsidiaries

Table of Contents

		Page No.
PART I - Financial Information

Item 1.	Financial Statements
	Unaudited Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005	2
	Unaudited Condensed Consolidated Statements of Income for the periods ending June 30, 2006 and June 30, 2005	3
	Unaudited Condensed Consolidated Statements of Cash Flows for the periods ending June 30, 2006 and June 30, 2005	4
	Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2.	Management's Discussion and Analysis of Financial Condition and the Results of Operations	13
	Cautionary Statements	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30
Item 4.	Controls and Procedures	31

PART II - Other Information

Item 1.	Legal Proceedings	31
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Securities	32
Item 3.	Defaults Upon Senior Securities	32
Item 4.	Submission of Matters to a Vote of Security Holders	32
Item 5.	Other Information	32
Item 6.	Exhibits and Reports on Form 8-K	32
SIGNATURES		34

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)

	June 30, 2006			December 31, 2005
Assets
Current assets
Cash and cash equivalents	$	18,000,129		$	10,536,144
Available-for-sale investments, at market value		55,657,793			38,757,575
Accounts receivable, net		10,720,931			8,686,227
Inventories		8,972,641			6,753,110
Other current assets		1,918,782			582,074

Total current assets		95,270,276			65,315,130

Property and equipment, net		1,032,721			909,676

Other assets		111,074			111,074

Total Assets	$	96,414,071		$	66,335,880

Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	1,718,279		$	1,278,823
Accrued liabilities		9,580,679			11,465,100
Deferred revenue		5,417,002			1,725,849

Total current liabilities		16,715,960			14,469,772

Commitments and Contingencies

Stockholders' equity
Preferred stock, $.01 par value-
Authorized - 1,500,000 shares
Issued - none		--			--
Common stock, $.01 par value-
Authorized - 45,000,000 shares
Issued and outstanding - 17,543,591 and 17,126,467 shares, respectively		175,436			171,265
Additional paid-in capital		181,875,121			177,658,135
Accumulated deficit		(102,352,446	)		(125,963,292	)

Total stockholders' equity		79,698,111			51,866,108

Total liabilities and stockholders’ equity	$	96,414,071		$	66,335,880

See accompanying notes to condensed consolidated financial statements.

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Income
(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2006			2005		2006		2005
Revenues
Product revenues	$	21,617,074		$	15,780,556	$	42,006,844	$	30,063,972
Royalty revenues		14,151,941			1,130,435		14,796,942		2,512,719
Funded product development revenues		887,583			1,311,827		2,307,357		2,691,431

Total revenues		36,656,598			18,222,818		59,111,143		35,268,122

Costs and expenses (income)
Cost of product revenues		6,337,968			5,236,389		11,653,451		9,757,185
Cost of royalty revenues		5,660,773			452,173		5,918,773		1,005,087
Research and development		3,804,722			2,870,050		7,484,067		6,056,214
Selling and marketing		5,750,802			4,352,348		11,221,467		8,176,990
General and administrative		(1,169,851	)		1,469,638		683,718		3,020,350

Total costs and expenses		20,384,414			14,380,598		36,961,476		28,015,826

Income from operations		16,272,184			3,842,220		22,149,667		7,252,296

Interest income		1,868,939			247,949		2,444,964		426,017

Income before income taxes		18,141,123			4,090,169		24,594,631		7,678,313

Provision for income taxes		774,046			81,803		983,785		153,566

Net income	$	17,367,077		$	4,008,366	$	23,610,846	$	7,524,747

Net income per share
Basic	$	1.00		$	0.24	$	1.36	$	0.45

Diluted	$	0.86		$	0.21	$	1.18	$	0.40

Weighted average number of shares
Basic		17,397,750			16,856,271		17,334,577		16,776,925

Diluted		20,171,377			18,832,447		20,037,545		19,037,599

See accompanying notes to condensed consolidated financial statements.

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)

	Six Months Ended June 30,
	2006			2005
Cash flows from operating activities
Net income	$	23,610,846		$	7,524,747
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		226,696			168,739
Stock-based compensation expense		341,763			--
Provision for bad debt		141,077			66,575
Inventory write-offs		376,165			--
Changes in assets and liabilities:
Accounts receivable		(2,175,781	)		(1,442,426	)
Inventories		(2,595,696	)		(529,291	)
Other current assets		(1,336,708	)		(323,177	)
Accounts payable		439,456			665,872
Accrued liabilities		(1,884,421	)		639,299
Deferred revenue		3,691,153			53,840

Net cash from operating activities		20,834,550			6,824,178

Cash flows used in investing activities
Purchases of property and equipment		(349,741	)		(121,327	)
Purchases of available-for-sale investments		(26,950,218	)		(10,400,000	)
Proceeds from sale of available-for-sale investments		10,050,000			3,700,162

Net cash used in investing activities		(17,249,959	)		(6,821,165	)

Cash flows from financing activities
Proceeds from the exercise of stock options		3,786,688			2,079,202
Tax benefit from the exercise of stock options		142,057			105,717
Costs incurred related to issuance of common stock		(49,351	)		(36,400	)

Net cash from financing activities		3,879,394			2,148,519

Net increase in cash and cash equivalents		7,463,985			2,151,532
Cash and cash equivalents, beginning of the period		10,536,144			7,508,856

Cash and cash equivalents, end of the period	$	18,000,129		$	9,660,388

Supplemental disclosure of cash flow information
Cash paid for income taxes	$	847,500		$	9,055

See accompanying notes to condensed consolidated financial statements.

Palomar Medical Technologies, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1 – Basis of presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim information. The consolidated balance sheet at December 31, 2005 has been derived from the audited balance sheet at that date; however, the accompanying financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The results of operations for the interim periods shown in this report are not necessarily indicative of expected results for any future interim period or for the entire fiscal year. We believe that the quarterly information presented includes all adjustments (consisting of normal, recurring adjustments) necessary for a fair presentation in accordance with accounting principles generally accepted in the United States. The accompanying condensed consolidated financial statements and notes should be read in conjunction with our Form 10-K for the year ended December 31, 2005.

Note 2 – Stock based compensation

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

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

Our income before taxes and net income was $167,000 and $341,000 lower for the three months and six months ended June 30, 2006, respectively, as a result of stock-based compensation expense as a result of the adoption of SFAS 123(R). As of June 30, 2006, there was $156,000 of unrecognized compensation expense related to non-vested market-based share awards that is expected to be recognized during the following quarters, September 30, 2006 $95,000, December 31, 2006 $45,000, March 31, 2007 $15,000 and June 30, 2007 $1,000.

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

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

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

	Three months ended June 30, 2005	Six months ended June 30, 2005
Net income, as reported	$ 4,008,366	$ 7,524,747
Less: Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of tax	(7,742,532)	(7,928,748)

Pro forma net loss	$(3,734,166)	$ (404,001)


Net income (loss) per share:
Basic - as reported	$ 0.24	$ 0.45
Basic - pro forma	$ (0.22)	$ (0.02)
Diluted - as reported	$ 0.21	$ 0.40
Diluted - pro forma	$ (0.22)	$ (0.02)

There were no options granted during the six months ended June 30, 2006. On May 11, 2005, we granted 645,000 options that were fully vested as of date of grant to employees and directors with exercise prices equal to fair market value on the date of grant, or $24.63 per share, and expire ten years from the date of grant.

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

	Six months ended June 30, 2005
Risk-free interest rate	3.57%
Expected dividend yield	--
Expected lives	2 years
Expected volatility	86%

The following table summarizes all of our stock option activity since December 31, 2005:

	Number of Shares	Exercise Price	Weighted Average Exercise Price	Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
Outstanding, December 31, 2005	4,749,965	$0.90 - $26.00	$ 15.20

Granted	--	--	--
Exercised	(362,124)	1.00 - 19.00	10.27
Canceled	(31,998)	6.31 - 10.72	14.72

Outstanding, June 30, 2006	4,355,843	$0.90 - $26.00	15.61	7.59	$129,916,423

Exercisable, June 30, 2006	2,835,534	$0.90 - $26.00	15.61	7.48	$84,573,589

The total intrinsic value for options exercised during the six months ended June 30, 2006 and 2005 was $10,675,016 and $13,480,047, respectively.

The following table summarizes information about stock options outstanding as of June 30, 2006:

Options Outstanding				Options Exercisable
Range of Exercise Prices	Options Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price	Options Exercisable	Weighted Average Exercise Price
$0.90-$1.00	253,861	5.15 years	$0.97	253,861	$0.97
1.51-2.19	62,233	3.87 years	1.97	62,233	1.97
2.68-3.19	146,092	2.98 years	3.17	146,092	3.17
4.08-5.22	215,194	7.03 years	4.97	119,709	4.89
6.22-8.23	42,599	7.26 years	6.70	19,936	6.60
9.93-14.31	37,964	7.75 years	12.04	23,801	12.48
16.00-23.61	2,882,900	7.86 years	16.55	1,494,902	16.56
24.06-26.00	715,000	8.82 years	24.71	715,000	24.71

$0.90-$26.00	4,355,843	7.59 years	$15.61	2,835,534	$15.61

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

Note 3 – Inventories

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

	June 30, 2006	December 31, 2005
Raw materials	$4,198,563	$2,485,550
Work in process	1,445,746	1,170,862
Finished goods	3,328,332	3,096,698

Total	$8,972,641	$6,753,110

Note 4 – Property and equipment

Property and equipment are recorded at cost. Repairs and maintenance costs are expensed as incurred. Depreciation and amortization are provided using the straight-line method over their estimated useful lives. Property and equipment consisted of the following:

	June 30, 2006	December 31, 2005	Estimated useful life
Machinery and equipment	$ 1,665,704	$ 1,536,879	3-8 years
Furniture and fixtures	2,307,538	2,146,247	5 years
Leasehold improvements	353,180	293,555	Shorter of estimated useful life or term of lease

	4,326,422	3,976,681
Accumulated depreciation	(3,293,701)	(3,067,005)

Total	$ 1,032,721	$ 909,676

Note 5 – Warranty costs

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

The following table provides the detail of the change in our product warranty accrual, which is a component of accrued liabilities on the condensed consolidated balance sheets for the three and six months ended June 30, 2006 and 2005:

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Warranty accrual, beginning of period	$	938,662			719,213		$	874,746			722,040
Charges to costs and expenses relating to new sales		483,813			332,000			980,438			685,000
Costs of product warranty claims		(450,340	)		(301,054	)		(883,049	)		(656,881	)

Warranty accrual, end of period	$	972,135			750,159		$	972,135			750,159

Note 6 – Geographic information

Product revenue from international sources was $4.8 million and $5.5 million for the three months ended June 30, 2006 and 2005, respectively, and $9.1 million and $9.8 million for the six months ended June 30, 2006 and 2005. The following table represents the percentage of product revenue by geographic region from customers for the three and six months ended June 30, 2006 and 2005:

	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
United States	78	.0%	65	.2%	78	.3%	67	.5%
Canada	7	.5%	6	.9%	6	.2%	7	.9%
Japan	3	.6%	7	.9%	3	.0%	8	.1%
Asia / Pacific Rim / Middle East	2	.8%	4	.0%	3	.5%	3	.9%
Europe	3	.5%	7	.8%	5	.0%	6	.3%
Australia	1	.5%	5	.2%	1	.3%	4	.0%
South and Central America	3	.1%	3	.0%	2	.7%	2	.3%

Total	100	.0%	100	.0%	100	.0%	100	.0%

Note 7 – Net income per common share

Basic net income per share was determined by dividing net income by the weighted average common shares outstanding during the period. Diluted net income per share was determined by dividing net income by diluted weighted average shares outstanding. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options and warrants based on the treasury stock method.

A reconciliation of basic and diluted shares is as follows:

	Three Months Ended June 30,		Six Months Ended June 30,
	2006	2005	2006	2005
Basic weighted average number of
shares outstanding	17,397,750	16,856,271	17,334,577	16,776,925
Potential common shares pursuant to
stock options and warrants	2,773,627	1,976,176	2,702,968	2,260,674

Diluted weighted average number of
shares outstanding	20,171,377	18,832,447	20,037,545	19,037,599

Diluted weighted average shares outstanding do not include options and warrants outstanding to purchase 441,484 and 50,000 common equivalent shares for the three and six months ended June 30, 2005, respectively.

Note 8 – Arrangements with Massachusetts General Hospital

Under the terms of a research agreement with the Massachusetts General Hospital Corporation, Massachusetts General Hospital conducts clinical and non-clinical research in the field of photo thermal removal or reduction of hair, using light (hereinafter referred to as “hair removal”). The Research Agreement has a term of three years, until August 2007, and we will provide Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct and indirect costs of the research. We have the right to exclusively license, on royalty terms to be negotiated, Palomar-funded inventions that are discovered during this research.

We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital on the sale of certain products as well as 40% of royalties received from third parties. During the three months ended March 31, 2006, the license was amended resulting in approximately $762,000 reduction in accrued royalties. The reduction in accrued royalties was recorded as a reduction in cost of product revenues in the three months ended March 31, 2006.

Note 9 – Development and license agreement with Gillette

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

Thirty days after the end of the Development Phase, which is expected to be September 30, 2006, Gillette will decide whether or not to continue with the project based on all the information known at that time. Upon Gillette deciding to continue and after regulatory clearance is obtained for the device, Gillette will be obligated to make a development completion payment to us of $2.5 million. If Gillette decides not to continue, we may proceed to develop and commercialize the device on our own or with a different party.

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

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

After launch of the first device for females, Gillette will pay us up to 6 percent of net sales of the device, subject in certain instances to various reductions and offsets. Again, for as long as Gillette elects to have us work exclusively with them, Gillette will continue to be obligated to pay us annual collaboration payments of $10 million, which will be offset against the net sales percentage payments.

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

For the three months ended June 30, 2006 and 2005, we recognized $150,000 and $700,000 of funded product development revenues from Gillette, respectively. For the six months ended June 30, 2006 and 2005, we recognized $850,000 and approximately $1.4 million of funded product development revenues from Gillette, respectively. As of June 30, 2006, $50,000 of advance payments received from Gillette for which services were not yet provided were included in deferred revenue.

Note 10 – Joint Development and License agreement with Johnson & Johnson Consumer Companies, a Johnson & Johnson company

Effective as of September 1, 2004 and as amended effective May 1, 2006, we entered into a Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc., a Johnson & Johnson company, to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. The agreement provides for Johnson & Johnson to fund our research and clinical studies during an initial proof-of-principle phase. At the end of the proof-of-principle phase, Johnson & Johnson will decide whether or not to continue with one or more of the devices in one or more of the fields into a development phase. Upon Johnson & Johnson deciding to continue, Johnson & Johnson will be obligated to fund the development of the selected devices. If Johnson & Johnson decides not to continue, we may proceed in fields not selected by Johnson & Johnson to develop and commercialize these and other devices on our own or with a different party.

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

For the three months ended June 30, 2006 and 2005, we recognized $375,000 of funded product development revenues from JJCC for each period. For the six months ended June 30, 2006 and 2005, we recognized $750,000 of funded product development revenues from JJCC for each period. As of June 30, 2006, $340,000 of advance payments received from JJCC for which services were not yet provided were included in deferred revenue.

Note 11 – Research contract with the United States Department of the Army

In the first quarter of 2004, we began providing services under a $2.5 million research contract with the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae or PFB. On October 25, 2005, we announced that we had been awarded additional funding of $888,000 for a total of $3,388,000 and a twelve month extension. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. This revenue is included in funded product development revenue in the accompanying statements of income. Our revenue from the contract is subject to government audit. We are unaware of any specific adjustments or open items that could result from any such audit.

For the three months ended June 30, 2006 and 2005, we recognized approximately $363,000 and $237,000 of funded product development revenues under this agreement, respectively. For the six months ended June 30, 2006 and 2005, we recognized approximately $707,000 and $523,000 of funded product development revenues under this agreement, respectively.

Note 12 – Settlement of Lumenis Litigation

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

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

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

For the three and six months ended June 30, 2006, Lumenis made payments of approximately $368,000 and $827,000, respectively, relating to the 5% royalty. For the three and six months ended June 30, 2005, Lumenis made payments of approximately $484,000 and $1.1 million, respectively, relating to the 5% royalty and $537,500 and $1.1 million, respectively, for back-owed royalties recorded as royalty revenue.

Note 13 – Settlement of Cutera Litigation

On June 5, 2006, we announced the resolution of our on-going patent infringement lawsuits against Cutera, Inc. Cutera admitted that their products infringe the Anderson Patents (U.S. Patent No.s 5,595,568 & 5,735,844) and that these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of the Anderson Patents in the future. Cutera paid us $22 million as an estimated payment for royalties of 8.5% due on past sales of their laser- and lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us that they believed the actual liability for past royalties, interest and legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue at June 30, 2006 to be applied against future amounts owed. The final amounts due to us are subject to audit by an independent accounting firm which is scheduled to be completed by the end of the third quarter. Following the audit, the amounts owed may be higher or lower than the estimated $19.6 million. Under our license agreement with the General Hospital Corporation, we pay to the General Hospital Corporation 40% of all royalty and interest payments from Cutera. In connection with the settlement, during the three and six months ended June 30, 2006, we recorded $13.6 million of royalty revenue and $5.4 million in cost of royalties. We also recorded, net of amounts owed to the General Hospital, $3.8 million as a reduction in general and administrative expense and $1.2 million in interest income. Beginning April 1, 2006, Cutera will pay us a 7.5% royalty on future sales of its existing and any new light-based hair removal systems later developed.

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

Note 14 – Income Taxes

Our effective tax rate for the six months ended June 30, 2006 and 2005 was 4% and 2%, respectively. The primary components of this provision, in both 2006 and 2005, were minimum federal and state taxes. However, our cash tax liabilities were partially offset with the tax benefit from the exercise of stock options. We have fully reserved our otherwise recognizable deferred tax asset which is principally comprised of net operating loss carryforwards, as its realization is uncertain.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking statements

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

•

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

•

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

•

other risks are indicated below under the caption “Cautionary Statements”.

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

The following discussion should be read in conjunction with, and is qualified in its entirety by, the condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report and the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K filed with the SEC on March 6, 2006. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

Critical accounting policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, warranty obligations, contingencies and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A discussion of our critical accounting policies and the related judgments and estimates affecting the preparation of our consolidated financial statements is included in the Annual Report on our Form 10-K fiscal year 2005 There have been no material changes to our critical accounting policies as of June 30, 2006 except as noted below:

Effective January 1, 2006, Palomar adopted Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised), “Share-Based Payment” (“SFAS 123(R)”). With the adoption of SFAS 123(R), Palomar has added “Share-Based Compensation” as a critical accounting policy.

Share-Based Compensation

Among its provisions, SFAS 123(R) requires Palomar to recognize compensation expense for equity awards over the vesting period based on their grant-date fair value. The compensation expense is recognized only for share-based payments expected to vest and we estimate forfeitures at the date of grant based on the Palomar’s historical experience and future expectations.

Palomar uses the Black-Scholes-Merton option-valuation model to value stock options, which requires the input of subjective assumptions. These assumptions include the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Palomar’s stock price, risk-free interest rate, the expected dividend yield and stock price. The expected term of the options is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. The expected term determines the period for which the risk-free interest rate and volatility must be applied. The risk-free interest rate is based on the expected U.S. Treasury rate over the expected term. Expected stock price volatility is based on a combination of historical volatility of Palomar’s stock price and other factors.

Overview

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

Our total revenues for the quarter ended June 30, 2006 were $36.7 million including $13.6 million from the Cutera settlement, up from $18.2 million in the second quarter of 2005. Product revenues increased to $21.6 million from $15.8 million and gross profit from product revenues increased to $15.3 million or 71 percent, up from $10.5 million or 67 percent in the year-earlier quarter. We reported net income of $17.4 million, or $0.86 per diluted share, for the second quarter of this year, versus net income of $4.0 million, or $0.21 per diluted share, for the second quarter of last year.

We strengthened our balance sheet since the end of last year including increasing our cash, cash equivalents and available-for-sale investments by 49% and increasing stockholders’ equity by 54%. Our current ratio is 5.7x, up from 4.5x at the end of 2005, and we have no debt.

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

Results of operations

The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the three and six months ended June 30, 2006 and 2005, respectively (in thousands, except for percentages):

	Three Months Ended June 30,
	2006						2005					Change
	Amount			As a % of Total Revenue			Amount		As a % of Total Revenue			$			%
Revenues
Product revenues	$	21,617			59	%	$	15,781		87	%	$	5,836			37	%
Royalty revenues		14,152			39	%		1,130		6	%		13,022			1,152	%
Funded product development revenues		888			2	%		1,312		7	%		(424	)		(32	%)

Total revenues		36,657			100	%		18,223		100	%		18,434			101	%

Cost and expenses (income)
Cost of product revenues		6,338			17	%		5,236		29	%		1,102			21	%
Cost of royalty revenues		5,661			15	%		452		2	%		5,209			1,152	%
Research & development		3,805			10	%		2,870		16	%		935			33	%
Selling & marketing		5,751			16	%		4,353		24	%		1,398			32	%
General & administrative		(1,171	)		-3	%		1,470		8	%		(2,641	)		(180	%)

Total cost & expenses		20,384			56	%		14,381		79	%		6,003			42	%


Income from operations		16,273			44	%		3,842		21	%		12,431			324	%
Interest income		1,868			5	%		248		1	%		1,620			653	%


Income before income taxes		18,141			49	%		4,090		22	%		14,051			344	%
Provision for income taxes		774			2	%		82		0	%		692			844	%

Net income	$	17,367			47	%	$	4,008		22	%	$	13,359			333	%

	Six Months Ended June 30,
	2006					2005					Change
	Amount		As a % of Total Revenue			Amount		As a % of Total Revenue			$			%
Revenues
Product revenues	$	42,007		71	%	$	30,064		85	%	$	11,943			40	%
Royalty revenues		14,797		25	%		2,513		7	%		12,284			489	%
Funded product development revenues		2,307		4	%		2,691		8	%		(384	)		(14	%)

Total revenues		59,111		100	%		35,268		100	%		23,843			68	%

Cost and expenses
Cost of product revenues		11,653		20	%		9,757		28	%		1,896			19	%
Cost of royalty revenues		5,919		10	%		1,005		3	%		4,914			489	%
Research & development		7,484		13	%		6,057		17	%		1,427			24	%
Selling & marketing		11,221		19	%		8,177		23	%		3,044			37	%
General & administrative		684		1	%		3,020		9	%		(2,336	)		(77	%)

Total cost & expenses		36,961		63	%		28,016		79	%		8,945			32	%

Income from operations		22,150		37	%		7,252		21	%		14,898			205	%
Interest income		2,445		4	%		426		1	%		2,019			474	%

Income before income taxes		24,595		42	%		7,678		22	%		16,917			220	%
Provision for income taxes		984		2	%		153		0	%		831			543	%

Net income	$	23,611		40	%	$	7,525		21	%	$	16,086			214	%

Product revenues. Sales of the StarLux Pulsed Light and Laser System coupled with its additional handpieces were the leading contributor to our increase in product revenues for the three and six months ended, June 30, 2006 in comparison to the same period in 2005. Favorably impacting product revenues for the three months ended June 30, 2006, was an increase of 41% in sales related to the “Lux” family of products, which includes the StarLux, MediLux, EsteLux, NeoLux and additional handpieces as well as an increase of 37% in customer service revenue. Offsetting these increases was a reduction in sales of 20% relating to the Q-Yag 5 product line in comparison to the same period in 2005. For the six months ended June 30, 2006, favorably impacting product revenues was an increase of 42% in sales related to the “Lux” family of products, a 53% increase in sales relating to customer service offset by a decrease of 12% from sales related to the Q-Yag 5 product line in comparison to the same period in 2005.

Product revenue for the three and six months ended June 30, 2006 comprised of 86% and 85%, respectively, to North American customers where we sell through a direct sales force and 14% and 15%, respectively, outside of North America where we sell through distributors. In comparison to the same three and six month periods in 2005, product revenue consisted of 72% and 75%, respectively, to North American customers, and 28% and 25%, respectively, outside of North America.

Royalty revenues. Royalty revenue increased for the three and six months ended June 30, 2006, as compared to the same period in 2005. This increase is attributed to the settlement of our patent infringement lawsuits against Cutera, Inc. Based on an estimate by Cutera; we recognized approximately $13.6 million of back-owed royalties from Cutera and have recorded $2.4 million as deferred revenue to be applied against future amounts owed. The final amounts due to us are subject to an audit by an independent accounting firm which is scheduled to be completed by the end of the third quarter 2006.

Royalty revenue from our other licensees decreased by 10% and 18%, respectively, for the three and six months ended June 30, 2006, as compared to the same period in 2005. These decreases are attributed to Lumenis making its final installment for back-owed royalties during the fourth quarter in 2005 and a general softening in the aesthetic market from our licensees as compared to the same period in 2005.

Funded product development revenues. Funded product development revenue is generated from the development agreements with Gillette, Johnson & Johnson Consumer Companies, Inc. and the United States Department of the Army. For both Gillette and Johnson & Johnson, we receive payments quarterly in accordance with the work plans that were developed with both Gillette and Johnson & Johnson. Revenue is recognized under the contracts as costs are incurred and services are rendered. Any amounts received in advance of costs incurred and services rendered from Gillette or Johnson & Johnson are recorded as deferred revenue. Payments are not refundable if the development is not successful. For both the three and six months ended June 30, 2006, funded product development revenue from Johnson & Johnson remained consistent. Funded product revenue from Gillette decreased as compared to the same periods in 2005 as we approach the end of work plan established with Gillette.

We provide services under a $3.4 million research contract with the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered. For the three and six months ended June 30, 2006, funded product development revenues from the Department of the Army increased by approximately $126,000 and $184,000, respectively, as compared to the same periods in 2005.

Cost of product revenues. The cost of product revenues increased in absolute dollars, but decreased as a percentage of total revenue. The decrease as a percentage of total revenue for the three months ended June 30, 2006 as compared to the same period in 2005 was attributed to a shift in product mix to the higher priced StarLux Pulsed Light and Laser System. The decrease as a percentage of total revenue for the six months ended June 30, 2006 as compared to the same period in 2005 was attributed to a shift in product mix to the higher priced StarLux Pulsed Light and Laser System and a net decrease in product royalties owed to the General Hospital Corporation as a result of an amendment to our license agreement. During the quarter ended March 31, 2006, we recorded a net decrease of $617,000 in cost of product revenues as a result of a non-recurring adjustment made to product royalties offset by the write-off of certain customer service loaner inventory. In addition, increased sales volume has improved the absorption of fixed manufacturing overhead at our manufacturing facility as approximately 70% of our manufacturing overhead cost is fixed in nature and is spread over higher sales volumes.

Cost of royalty revenues. The cost of royalty revenues increased for the three and six months ended June 30, 2006, in comparison to the same periods in 2005. These increases are almost entirely attributed to the settlement of our patent infringement lawsuits against Cutera, offset by Lumenis making its final installment for back-owed royalties during the fourth quarter in 2005 and the general softening in the aesthetic market from our licensees, as compared to the same periods in 2005. As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% in accordance with our license agreement with Massachusetts General Hospital for each period in comparison to the same periods in 2005.

Research and development expense. The increase in research and development expense is a direct result of our spending related our continued commitment to introducing new technology and enhancing our current family of products.

For both the three and six months ended June 30, 2006 expenses relating to the Gillette agreement decreased as compared to the same periods in 2005. These decreases are attributed to the reduction of research and development expenses associated with the end of work plan established with Gillette.

Expenses relating to the JJCC agreement increased by $63,000 and $186,000, respectively, for the three and six months ended June 30, 2006 as compared to the same periods in 2005.

For the three and six months ended June 30, 2006, expenses relating to the United States Department of the Army decreased by approximately $137,000 and $105,000, respectively, in comparison to the same periods in 2005.

For the three and six months ended June 30, 2006, legal expenses relating to the prosecution of new patents decreased by approximately $157,000 and $476,000, respectively, in comparison to the same periods in 2005.

Expenses relating to the introduction of new products, enhancements made to the current family of products and research and development overhead increased by approximately $1.3 million and $2.1 million, respectively, for the three and six months ended June 30, 2006 in comparison to the same periods in 2005.

The spending on research and development reflects our commitment to continuing dermatology research for a better understanding of various cosmetic and medical conditions and to continuing research and development of devices and delivery systems to better treat those various cosmetic and medical conditions. The research and development goals in the fields of light based dermatology are to design systems that: (1) permit safe and effective treatment and more rapid and painless treatment, (2) have high gross margins, and (3) are manufactured at lower costs, to expand our current markets.

Selling and marketing expense. For the quarter ended June 30, 2006, selling and marketing increased by $424,000 from payroll and payroll related expenses, $551,000 related to tradeshow expenses and other costs and $424,000 related to commission expense in comparison to the same period in 2005. For the six months ended June 30, 2006, selling and marketing expenses increased by $999,000 from payroll and payroll related expenses, approximately $1.2 million related to tradeshow expenses and other costs and by approximately $822,000 relating to commission expense in comparison to the same period in 2005. These increases directly correlate with our increased revenues and costs associated with our expansion of our domestic sales force and product lines.

General and administrative expense. For the three and six months ended June 30, 2006, general and administrative expenses decreased as compared to the same periods in 2005. These decreases are mainly attributed to the settlement of our patent infringement lawsuits against Cutera where Cutera reimbursed us approximately $3.8 million (net of what was paid to the General Hospital Corporation) for legal expenses incurred during the patent infringement lawsuit. Offsetting these decreases in legal expenses for the three and six months ended June 30, 2006 were increases in patent litigation of approximately $827,000 and $642,000, respectively, increases in payroll and payroll related expenses of approximately $201,000 and $416,000, respectively, and increases in other over-head expenses of approximately $190,000 and $467,000, respectively, as compared to the same periods in 2005.

Interest income. Interest income increased for both the three and six months ended June 30, 2006 due to the settlement of our patent infringement lawsuits against Cutera where Cutera paid us approximately $1.2 million (net of what was paid to the General Hospital Corporation) in interest in comparison to the same periods in 2005.

Provision for income taxes. We provided income taxes at a 4% effective rate in 2006 and a 2% effective rate in 2005. The primary components of this provision, in both 2006 and 2005, were minimum federal and state taxes. However, our cash tax liabilities were partially offset with the tax benefit from the exercise of stock options. We have fully reserved our otherwise recognizable deferred tax asset which is principally comprised of our net operating loss carryforwards, as its realization is uncertain. We evaluate the realizability of otherwise recognizable deferred tax assets on a quarterly basis..

Liquidity and capital resources

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

	Six months ended, June 30,						Change
	2006			2005			$			%
Operating cash flows	$	20,835		$	6,824		$	14,011			205	%
Investing cash flows		(17,250	)		(6,821	)		(10,429	)		(153	%)
Financing cash flows		3,879			2,149			1,730			81	%
Capital expenditures	$	350		$	121		$	229			189	%

Additionally, our cash, cash equivalents, available-for-sale investments, accounts receivable, inventories and working capital are shown below for the periods indicated.

	June 30,		December 31,		Change
	2006		2005		$		%
Cash and cash equivalents	$	18,000	$	10,536	$	7,464		71	%
Available-for-sale investments, at
market value		55,658		38,758		16,900		44	%
Accounts receivable, net		10,721		8,686		2,035		23	%
Inventories		8,973		6,753		2,220		33	%
Working capital		78,554		50,845		27,709		55	%

We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and other activities for at least the next 12 months. As of June 30, 2006, we had no borrowings or debt.

Operating cash flows for the three months ended June 30, 2006, increased compared to the same period in 2005. This increase in operating cash flows reflects an increase in net profit, an increase in deferred revenue as a result of the Cutera settlement offset by an increase in working capital requirements. Cash used in investing activities decreased for the six months ended June 30, 2006, compared to the same period in 2005. These amounts primarily reflect cash used for purchases of property and equipment, purchases of available-for-sale investments offset by proceeds from the sale of available-for-sale investments. Cash provided by financing activities increased for the three month period ended June 30, 2006, compared to the same period in 2005. This increase was primarily due to an increase in exercises of stock options.

We anticipate that capital expenditures for the remainder of 2006 will total approximately $600,000, consisting primarily of machinery, equipment, computers and peripherals. We expect to finance these expenditures with cash on hand.

Contractual obligations

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

We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as 40% of royalties received from third parties.

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

The following table summarizes our estimated contractual cash obligations as of June 30, 2006, excluding amounts due Massachusetts General Hospital, royalty and employment obligations because they are variable and/or subject to uncertain timing (000‘s omitted):

	Payments due by period
	Total	Less than 1 year	1 -3 Years	4 - 5 Years	After 5 Years
Operating lease	$ 3,690	$1,165	$2,525	$ --	$ --
Purchase commitments	7,812	$7,812	--	--	--

Total contractual cash obligations	$11,502	$8,977	$2,525	$ --	$ --

Cautionary statements

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

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

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

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

All of our current products are light based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA. In the event that we do not obtain FDA clearances, our ability to market products in the United States and revenue derived there from may be adversely affected. The types of medical devices that we seek to market in the U.S. generally must receive either “510(k) clearance” or “PMA approval” in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process can be expensive and usually takes from four to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer from the time the pre-market approval application is submitted to the FDA until an approval is obtained.

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

•

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

•

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

•

patients may not comply with trial protocols;

•

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

•

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

•

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

•

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

•

changes in governmental regulations or administrative actions; and

•

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

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

To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product we propose to market and our failure to do so could adversely affect our ability to sell our products.

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

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

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

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

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

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untitled letters, warning letters, fines, injunctions, consent decrees and civil penalties;

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repair, replacement, refunds, recall or seizure of our products;

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operating restrictions or partial suspension or total shutdown of production;

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

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criminal prosecution.

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

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

Any modification to one of our 510(k) cleared devices that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance. We may be required to submit pre-clinical and clinical data depending on the nature of the changes. We may not be able to obtain additional 510(k) clearances or pre-market approvals for modifications to, or additional indications for, our existing products in a timely fashion, or at all. Delays in obtaining future clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our revenue and operating results. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any such decision. We have modified some of our marketed devices, but we believe that new 510(k) clearances are not required. We cannot be certain that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

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

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

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

Our products may also be subject to state regulations. Federal regulation allows our products to be sold to and used by licensed practitioners as determined on a state-by-state basis which complicates monitoring compliance. As a result, in some states non-physicians may purchase and operate our products. In most states, it is within a physician’s discretion who they can supervise in the operation of our products and the level of supervision. However, some states have specific regulations as to appropriate supervision and who may be supervised. A state could disagree with our decision to sell to a particular type of end user or change regulations preventing sales to particular types of end users or change regulations as to supervision. In several states these regulations are in flux. Thus, state regulations and changes to state regulations may decrease revenues or prevent growth of revenues.

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

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

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

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

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

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

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

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

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

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

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

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

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

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consumer awareness of procedures and treatments;

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the cost, safety and effectiveness of the procedure and of alternative treatments;

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the success of our and our customers’ sales and marketing efforts to purchasers of these procedures; and

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

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

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

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

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implement appropriate operational, financial and management controls, systems and procedures;

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expand our manufacturing capacity and scale of production;

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expand our sales, marketing and distribution infrastructure and capabilities; and

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provide adequate training and supervision to maintain high quality standards.

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

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

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

Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We own and license a variety of patents and patent applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. To date, however, our patent estate has not stopped other companies from competing against us, and though we have licensed certain competitors to certain patents and are enforcing those same patents against other competitors and intend to enforce against others, we do not know how successful we will be in asserting our patents against suspected infringers. Our pending and future patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued, patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. Changes in either patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection. In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how. We generally enter into non-disclosure agreements with our employees and third parties with whom we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our technology, proprietary information and know-how and we may not have adequate remedies for any such breach. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete effectively could be harmed and the value of our technology and products could be adversely affected. Costly and time consuming lawsuits may be necessary to enforce and defend patents issued or licensed exclusively to us, to protect our trade secrets and/or know-how or to determine the enforceability, scope and validity of others’ intellectual property rights. Such lawsuits may result in patents issued or licensed exclusively to us to be found invalid and unenforceable. In addition, our trade secrets may otherwise become known or our competitors also may independently develop technologies that are substantially equivalent or superior to our technology and which do not infringe our patents.

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

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

We may not be able to successfully collect licensing royalties.

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

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

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

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

On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light based hair removal device for women. On June 28, 2004 Palomar and Gillette announced that they completed the initial phase of their agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations. We believe that this represents a unique opportunity to bring light based devices to the mass market. There can be no assurance that we will be able to meet all our development obligations under the agreement or receive a 510k clearance for an over-the-counter product that could be sold directly to consumers. Under the agreement, significant resources and the attention of key technical personnel and management continue to be directed to the development of such a device even though such device will not likely be commercialized for several years, if ever. In addition, we cannot be sure that Gillette will agree with our interpretation of the terms of the agreement, that the agreement will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreement. During the term of the agreement, Gillette has the ability to choose not to continue and may terminate the agreement. If Gillette terminates the agreement, the price of our common stock could fall significantly, and we will not receive certain payments. We may proceed to develop and commercialize the device on our own or with a third party. However, there can be no assurance that we will be able to successfully implement such a strategy. In addition, after commercialization of such device, Gillette is to pay us a percentage of net sales of such device. Certain of these percentages of net sales are only owed if the device is covered by valid patents. There can be no assurance that valid patents will cover the device in any or all countries, in which the device will be manufactured, used or sold. This could have a material adverse effect on our business, results of operations and financial condition.

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

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

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

On September 1, 2004, we entered into a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. We believe that this represents a unique opportunity to bring light based devices to the mass market. There can be no assurance that we will be able to meet all our development obligations under the agreement or receive a 510k clearance for over-the-counter products that could be sold directly to consumers. Under the agreement, significant resources and the attention of key technical personnel and management will be directed to the development of such devices even though such devices will not likely be commercialized for several years, if ever. In addition, we cannot be sure that Johnson & Johnson Consumer Companies, Inc. will agree with our interpretation of the terms of the agreement, that the agreement will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreement. During the term of the agreement, Johnson & Johnson Consumer Companies, Inc. has the ability to choose not to continue and may terminate the agreement. If Johnson & Johnson Consumer Companies, Inc. terminates the agreement, the price of our common stock could fall significantly, and we will not receive certain payments. We may proceed to develop and commercialize the devices on our own or with a third party. However, there can be no assurance that we will be able to successfully implement such a strategy. In addition, after commercialization of such device, Johnson & Johnson Consumer Companies, Inc. is to pay us a percentage of net sales of such device. Certain of these percentages of net sales are only owed if the device is covered by valid patents. There can be no assurance that valid patents will cover these devices in any or all countries, in which the devices will be manufactured, used or sold. This could have a material adverse effect on our business, results of operations and financial condition.

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

Beginning with our annual report for our fiscal year ended, December 31, 2004, Section 404 of the Sarbanes-Oxley Act of 2002 required us to include a report by our management on our internal controls over financial reporting. Such report must contain an assessment by management of the effectiveness of our internal controls over financial reporting as of the end of our fiscal year and a statement as to whether or not such internal controls are effective. Such report must also contain a statement that our independent auditors have issued an attestation report on management’s assessment of such internal controls.

Our efforts to comply with Section 404 have resulted in, and are likely to continue to result in, significant costs, the commitment of time and operational resources and the diversion of management’s attention. If our management identifies one or more material weaknesses in our internal controls over financial reporting, we will be unable to assert that such internal controls are effective. If we are unable to assert that our internal controls over financial reporting are effective our business may be harmed.

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

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

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

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

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

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

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

Our products are and will continue to be designed and manufactured with numerous safety features, but it is possible that consumers could be adversely affected by use of one of our products. Furthermore, in the event that any of our products prove to be defectively designed and manufactured, we may be required to recall and redesign such products. Product liability claims could divert management’s attention from our core business, be expensive to defend and result in sizable damage awards against us. Although we have not experienced any material losses due to product liability claims to date, there can be no assurance that we will not experience such losses in the future. We maintain general liability insurance and umbrella coverage; however, there can be no assurance that such coverage will continue to be available on terms acceptable to us or that such coverage will be adequate for liabilities actually incurred. In the event we are found liable for damages in excess of the limits of our insurance coverage or if any claim or product recall results in significant adverse publicity against us, our business, financial condition and results of operations could be materially and adversely affected. In addition, although our products have been and will continue to be designed to operate in a safe manner, and although we attempt to educate customers with respect to the proper use of our products, misuse of our products by personnel over whom we cannot exert control may result in the filing of product liability claims or significant adverse publicity against us. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing continuing coverage, could harm our reputation in the industry and reduce product sales. We would need to pay any product losses in excess of our insurance coverage out of cash reserves, harming our financial condition and adversely affecting our operating results.

We face risks associated with product warranties.

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

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

We sell a significant amount of our products and services outside the U.S. International product revenue, consisting of sales from our distributors in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America and sales shipped directly to international locations from the United States, and we expect that international sales will continue to be significant. As a result, a major part of our revenues and operating results could be adversely affected by risks associated with international sales, including but not limited to political and economic instability and difficulties in managing our foreign operations. In particular, longer payment cycles common in foreign markets, credit risk and delays in obtaining necessary import or foreign certification or regulatory approvals for products may occur. In addition, significant fluctuations in the exchange rates between the U.S. dollar and foreign currencies could cause us to lower our prices and thus reduce our profitability, or could cause prospective customers to push out orders to later dates because of the increased relative cost of our products in the aftermath of a currency devaluation or currency fluctuation.

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

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

We may seek additional financing to grow the business.

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

We may determine, depending upon the opportunities available, to seek additional debt or equity financing to fund the costs of expansion. Additionally, if we incur indebtedness to fund increased levels of accounts receivable, finance the acquisition of capital equipment, or if we issue debt securities in connection with any acquisition we will be subject to risks associated with incurring substantial additional indebtedness.

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

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

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

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

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

Item 3. Quantitative and qualitative disclosures about market risk

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

Item 4. Controls and procedures

Under the direction of the principal executive officer and principal financial officer, the Company has evaluated the effectiveness of its disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of June 30, 2006. Based on that evaluation, the Company has concluded that its disclosure controls and procedures were effective in providing reasonable assurance that material information required to be disclosed is included on a timely basis in the reports filed with the Securities and Exchange Commission.

There were no significant changes in the Company’s internal controls over financial reporting or in other factors that could significantly affect these controls during the quarter ended June 30, 2006, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – Other information

Item 1. Legal proceedings

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

On July 7, 2006, we filed a complaint for patent infringement in the United States District Court for the District of Massachusetts against Alma Lasers, Inc. seeking both monetary damages and injunctive relief. The complaint alleges Alma’s Harmony, Soprano and Sonata Systems which use pulsed light and laser technology for hair removal willfully infringe U.S. patent Nos. 5,595,568 and 5,735,844 (the “Anderson Patents”). We have an exclusive license to these patents from the General Hospital Corporation. On July 27, 2006, we filed an amended complaint including an additional claim against Alma for unfair competition due to infringement by Alma’s Harmony System of the distinctive trade dress of our products, including the unique, distinctive, and immediately recognizable design of our Palomar EsteLux, MediLux and StarLux Systems. We are seeking both monetary and injunctive relief on the new claim. Alma has not yet responded to these charges.

Item 2. Changes in securities, use of proceeds and issuer purchases of securities.

None.

Item 3. Defaults upon senior securities

None.

Item 4. Submission of matters to a vote of security holders

Palomar’s Annual Meeting of Shareholders was held on May 10, 2006 (the “Annual Meeting”). At the Annual Meeting, stockholders voted on three matters: the election of directors for a term of one year, the ratification of the appointment of Ernst & Young LLP as the Company’s registered public accounting firm and the approval of the 2006 stock incentive plan. The stockholders elected management’s nominees as directors in an uncontested election, ratified the appointment of the registered public accounting firm and did not approve the 2006 stock incentive plan by the following votes, respectively:

Matter	Votes For	Withheld

Proposal #1: The Election of Directors

Joseph P. Caruso	12,678,302	2,863,252
Jeanne Cohane	15,148,653	392,901
Nicolas P. Economou	15,285,217	256,337
James Martin	15,138,568	402,986
A. Neil Pappalardo	13,333,982	2,207,572
Louis (Dan) Valente	11,848,255	3,693,301

Matter	Votes For	Votes Against	Abstained

Proposal #2: The Ratification of Ernst & Young LLP as the Company's Auditors

Ernst & Young LLP	15,502,763	27,152	11,640

Matter	Votes For	Votes Against	Abstained

Proposal #3: To Approve 2006 Stock Incentive Plan

	3,892,750	7,512,685	53,471

Item 5. Other information.

None.

Item 6. Exhibits and reports on Form 8-K

(a) Exhibits


	10.36+	First Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. dated May 1, 2006


	31.1	Certification of Joseph P. Caruso, President and Chief Executive Officer of the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.


	31.2	Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.


	32	Certification of Joseph P. Caruso, President and Chief Executive Officer of the Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


	32	Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


	+	Filed under application for confidential treatment.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant certifies that it has caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

Palomar Medical Technologies, Inc.
(Registrant)


Date: August 8, 2006	By:/s/ Joseph P. Caruso Joseph P. Caruso President, Chief Executive Officer and Director


Date: August 8, 2006	By:/s/ Paul S. Weiner Paul S. Weiner Vice President and Chief Financial Officer

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549

FORM 10-Q

Palomar Medical Technologies, Inc. and Subsidiaries

Palomar Medical Technologies, Inc. and Subsidiaries Condensed Consolidated Balance Sheets (Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries Condensed Consolidated Statements of Income (Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 – Basis of presentation

Note 2 – Stock based compensation

Note 3 – Inventories

Note 4 – Property and equipment

Note 5 – Warranty costs

Note 6 – Geographic information

Note 7 – Net income per common share

Note 8 – Arrangements with Massachusetts General Hospital

Note 9 – Development and license agreement with Gillette

Note 11 – Research contract with the United States Department of the Army

Note 12 – Settlement of Lumenis Litigation

Note 13 – Settlement of Cutera Litigation

Note 14 – Income Taxes

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking statements

Overview

Results of operations

Liquidity and capital resources

Contractual obligations

Cautionary statements

We may not be able to successfully collect licensing royalties.

We may seek additional financing to grow the business.

Item 3. Quantitative and qualitative disclosures about market risk

Item 4. Controls and procedures

PART II – Other information

Item 1. Legal proceedings

Item 3. Defaults upon senior securities

Item 4. Submission of matters to a vote of security holders

Item 5. Other information.

Item 6. Exhibits and reports on Form 8-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Income
(Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)

Palomar Medical Technologies, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)