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 September 30, 2007

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 November 1, 2007 was 18,295,706.

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 September 30, 2007 and December 31, 2006	3
	Unaudited Condensed Consolidated Statements of Income for the periods ending September 30, 2007 and September 30, 2006	4
	Unaudited Condensed Consolidated Statements of Cash Flows for the periods ending September 30, 2007 and September 30, 2006	5
	Notes to Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and the Results of Operations	16
	Cautionary Statements	26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	36

PART II - Other Information

Item 1.	Legal Proceedings	37
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Securities	39
Item 3.	Defaults Upon Senior Securities	39
Item 4.	Submission of Matters to a Vote of Security Holders	39
Item 5.	Other Information	39
Item 6.	Exhibits	39
SIGNATURES		40

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

	September 30, 2007			December 31, 2006
Assets
Current assets
Cash and cash equivalents	$	65,040,540		$	36,817,257
Available-for-sale investments, at market value		55,000,000			67,351,822
Accounts receivable, net		21,708,037			15,443,053
Inventories		14,919,432			11,011,710
Deferred tax assets		3,744,559			7,595,000
Other current assets		1,188,111			1,702,263

Total current assets		161,600,679			139,921,105

Property and equipment, net		1,334,168			1,129,985

Other assets		111,074			111,074

Total assets	$	163,045,921		$	141,162,164

Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	2,631,254		$	2,263,029
Accrued liabilities		13,972,012			15,798,076
Deferred revenue		6,259,555			5,969,397

Total current liabilities		22,862,821			24,030,502

Commitments and contingencies

Stockholders' equity
Preferred stock, $0.01 par value-
Authorized - 1,500,000 shares
Issued - none		--			--
Common stock, $0.01 par value-
Authorized - 45,000,000 shares
Issued and outstanding - 18,295,706 and 18,063,103 shares, respectively		184,007			180,631
Additional paid-in capital		198,979,176			189,937,701
Accumulated deficit		(55,963,497	)		(72,986,670	)
Treasury stock, at cost - 105,000 shares		(3,016,586	)		--

Total stockholders' equity		140,183,100			117,131,662

Total liabilities and stockholders’ equity	$	163,045,921		$	141,162,164

See accompanying notes to condensed consolidated financial statements.

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

	Three Months Ended September 30,		Nine Months Ended September 30,
	2007	2006	2007	2006
Revenues
Product revenues	$23,073,461	$23,671,555	$78,752,659	$65,678,399
Royalty revenues	5,826,091	3,642,413	10,584,266	18,439,355
Funded product development revenues	1,585,202	707,814	5,434,500	3,015,171
Other revenues	894,189	--	894,189	--

Total revenues	31,378,943	28,021,782	95,665,614	87,132,925


Costs and expenses
Cost of product revenues	7,869,200	7,036,514	26,796,166	18,689,965
Cost of royalty revenues	2,330,436	1,456,969	4,233,706	7,375,742
Research and development	4,187,559	3,303,014	12,242,994	10,468,961
Selling and marketing	5,971,960	5,527,793	18,606,577	16,608,183
General and administrative	4,360,561	2,890,409	11,655,562	4,033,324

Total costs and expenses	24,719,716	20,214,699	73,535,005	57,176,175


Income from operations	6,659,227	7,807,083	22,130,609	29,956,750

Interest income	1,926,745	1,031,530	4,826,121	3,476,494
Other income	--	--	500,000	--

Income before income taxes	8,585,972	8,838,613	27,456,730	33,433,244

Provision for income taxes	3,262,669	470,948	10,433,557	1,454,733

Net income	$ 5,323,303	$ 8,367,665	$17,023,173	$31,978,511


Net income per share
Basic	$ 0.29	$ 0.47	$ 0.93	$ 1.83

Diluted	$ 0.28	$ 0.41	$ 0.88	$ 1.59


Weighted average number of shares outstanding
Basic	18,348,424	17,642,215	18,271,116	17,438,247

Diluted	19,325,562	20,244,414	19,383,122	20,109,935

See accompanying notes to condensed consolidated financial statements.

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

	Nine Months Ended September 30,
	2007			2006
Cash flows from operating activities:
Net income	$	17,023,173		$	31,978,511
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		430,166			345,573
Stock-based compensation expense		166,240			436,211
Provision for bad debt		907,040			434,857
Inventory write-off		489,169			844,454
Tax benefit from the exercise of stock options		(4,672,863	)		(225,797	)
Changes in assets and liabilities:
Accounts receivable		(7,172,024	)		(6,945,828	)
Inventories		(4,396,891	)		(4,274,395	)
Deferred tax asset		3,850,441			--
Other current assets		514,152			(2,486,388	)
Accounts payable		368,225			1,035,327
Accrued liabilities		2,846,799			2,182,073
Deferred revenue		290,158			2,971,917

Net cash from operating activities		10,643,785			26,296,515


Cash flows used in investing activities:
Purchases of property and equipment		(634,349	)		(455,072	)
Purchases of available-for-sale investments		(37,098,178	)		(35,077,811	)
Proceeds from sale of available-for-sale investments		49,450,000			15,075,000

Net cash from (used in) investing activities		11,717,473			(20,457,883	)


Cash flows from financing activities:
Proceeds from the exercise of stock options		4,252,948			5,859,037
Tax benefit from the exercise of stock options		4,672,863			225,797
Purchases of common stock		(3,016,586	)		--
Costs incurred related to issuance of common stock		(47,200	)		(66,839	)

Net cash from financing activities		5,862,025			6,017,995


Net increase in cash and cash equivalents		28,223,283			11,856,627
Cash and cash equivalents, beginning of the period		36,817,257			10,536,144

Cash and cash equivalents, end of the period	$	65,040,540		$	22,392,771


Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	3,264,780		$	972,271

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, 2006 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, 2006.

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 123(R)). 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 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.

During the three months ended September 30, 2007, we granted 482,500 stock-settled stock appreciation rights (“SARs”). The SARs granted to employees and directors become exercisable over a four year period with one-third vesting on the second, third, and fourth anniversaries of the date of grant.

Our income before taxes and net income were reduced by $180,200 and $166,200 for the three and nine months ended September 30, 2007 and $94,000 and $436,000 for the three and nine months ended September 30, 2006, as a result of SFAS 123(R) stock-based compensation expense. The compensation expense for the three and nine months ended September 30, 2007 decreased basic and diluted earnings per share by $0.01 while the compensation expense for the three months ended September 30, 2006 had no effect on basic and diluted earnings per share, but reduced basic and diluted earnings per share by $0.02 for the nine months ended September 30, 2006. As of September 30, 2007, there was $6.9 million of unrecognized compensation expense related to non-vested market-based share awards.

Stock Options

The following table summarizes all of our stock option activity since December 31, 2006:

			Exercise Price	Weighted Average Exercise Price					Aggregate Intrinsic Value
Outstanding, December 31, 2006	3,822,367		$0.90 - $26.00	$	16	.07	7	.19	$	131,978,861

Granted	--		--			--
Exercised	(337,603	)	$0.97 - $26.00	$	12	.43
Canceled	(4,000	)	$4.50 - $16.53	$	7	.85

Outstanding, September 30, 2007	3,480,764		$0.90 - $26.00	$	16	.43	6	.50	$	41,960,671

Exercisable, September 30, 2007	2,115,764		$0.90 - $26.00	$	16	.37	6	.44	$	25,635,271

The total intrinsic value for stock options exercised during the nine months ended September 30, 2007 and 2006 was $10,386,284 and $14,600,328, respectively.

The following table summarizes information about stock options outstanding as of September 30, 2007:

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	224,361	3.91 years	$0.97	224,361	$0.97
1.97 - 2.19	39,500	2.48 years	1.98	39,500	1.98
3.19 - 4.50	49,930	2.81 years	3.53	49,930	3.53
5.05 - 7.28	75,382	5.81 years	5.07	75,382	5.07
8.11 - 10.72	4,433	6.18 years	10.09	4,433	10.09
13.66 - 16.00	16,333	6.67 years	14.22	16,333	14.22
16.53 - 16.53	2,415,325	6.61 years	16.53	1,050,325	16.53
23.61 - 26.00	655,500	7.60 years	24.64	655,500	24.64

$0.90-$26.00	3,480,764	6.50 years	$16.43	2,115,764	$16.37

We granted 1,440,000 performance based stock options in 2004 to employees and directors with exercise prices equal to fair market value on the date of grant of $16.53, and which expire ten years from the date of grant. 815,000 of these options vest upon Gillette making a “Launch Decision” (January 7, 2008), and the remaining 625,000 of these options vest twelve months after the Launch Decision (January 7, 2009). If made, the Launch Decision would indicate Gillette’s decision to continue commercialization of a patented home-use, light based hair removal device for women pursuant to our Amended and Restated Development and License Agreement with them, executed February 14, 2007, and effective as of February 14, 2003. As of September 30, 2007, 1,365,000 of the 1,440,000 performance based stock options were outstanding, consisting of 775,000 that will vest upon the Launch Decision, if made, and 590,000 that will vest twelve months after the Launch Decision. We will incur a stock-based payment expense upon the vesting of these performance based options of approximately $6,836,000 upon the Launch Decision and $5,204,000 twelve months after the Launch Decision.

Stock-Settled Stock Appreciation Rights

The stock-settled stock appreciation rights (“SARs”) granted since December 31, 2006 are awards that allow the recipient to receive an amount of our common stock equal to the appreciation (if any) in the fair market value of our common stock on the date of exercise over the initial SAR valuation set on the date of grant per share of common stock for the number of shares vested. For the stock-settled SARs granted since December 31, 2006, the initial SAR valuation per share of the common stock was set at less than the fair market value of our common stock on the date of grant, and the holder’s right to receive shares of common stock under these grants occurs automatically on the vesting date.

The following table summarizes our stock-settled stock appreciation rights activity since December 31, 2006:

	Number of Shares	Weighted Average Initial SAR Valuation	Weighted Average Remaining Contractual Term (in Years)	Aggregate Intrinsic Value
Outstanding, December 31, 2006	-	-	-	-

Granted	482,500	$14.40	3.82
Converted	-	-	-
Canceled	-	-	-

Outstanding, September 30, 2007	482,500	$14.40	3.82	$6,798,425

Vested, September 30, 2007	-	-	-	-

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 with a corresponding reduction to operating cash flows.

Note 3 – Inventories

Inventories are valued at the lower of cost (first-in, first-out method) or market, and include material, labor and manufacturing overhead. At September 30, 2007 and December 31, 2006, inventories consisted of the following:

	September 30, 2007	December 31, 2006
Raw materials	$ 6,632,410	$ 4,669,750
Work in process	2,034,870	1,998,420
Finished goods	6,252,152	4,343,540

Total	$14,919,432	$11,011,710

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 the estimated useful lives of property and equipment. At September 30, 2007 and December 31, 2006, property and equipment consisted of the following:

	September 30, 2007	December 31, 2006	Estimated useful life
Machinery and equipment	$ 1,880,860	$ 1,759,984	3-8 years
Furniture and fixtures	2,944,047	2,516,408	5 years
Leasehold improvements	480,164	394,330	Shorter of estimated useful life or term of lease

	5,305,071	4,670,722
Accumulated depreciation	(3,970,903)	(3,540,737)

Total	$ 1,334,168	$ 1,129,985

Note 5 – Warranty costs

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

The following table provides the detail of the change in our product warranty accrual, which is a component of accrued liabilities on the condensed consolidated balance sheets for the three and nine months ended September 30, 2007 and 2006:

	Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Warranty accrual, beginning of period	$	1,420,702		$	972,135		$	1,120,420		$	874,746
Charges to cost and expenses relating to new sales		397,413			561,738			1,709,350			1,542,176
Costs of product warranty claims		(817,216	)		(484,050	)		(1,828,871	)		(1,367,099	)

Warranty accrual, end of period	$	1,000,899		$	1,049,823		$	1,000,899		$	1,049,823

Note 6 – Geographic information

Product revenue from international sources was $9.8 million and $6.0 million for the three months ended September 30, 2007 and 2006, respectively, and $30.9 million and $15.6 million for the nine months ended September 30, 2007 and 2006, respectively. The following table represents the percentage of product revenue by geographic region from customers for the three and nine months ended September 30, 2007 and 2006:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
United States	57	.4%	74	.8%	60	.7%	76	.2%
Europe	17	.9%	5	.6%	13	.0%	5	.2%
Canada	8	.9%	8	.1%	9	.3%	6	.7%
South and Central America	6	.6%	1	.0%	4	.4%	2	.0%
Asia/Pacific Rim	3	.0%	5	.4%	4	.5%	3	.5%
Japan	2	.7%	3	.8%	3	.6%	4	.3%
Middle East	1	.9%	1	.2%	3	.4%	1	.2%
Australia	1	.6%	0	.1%	1	.1%	0	.9%

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 the diluted weighted average shares outstanding. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options, stock appreciation rights, and warrants based on the treasury stock method.

A reconciliation of basic and diluted shares is as follows:

	Three Months Ended September 30,		Nine Months Ended September 30,
	2007	2006	2007	2006
Basic weighted average number of shares outstanding	18,348,424	17,642,215	18,271,116	17,438,247

Potential common shares pursuant to stock options,
stock appreciation rights, and warrants	977,138	2,602,199	1,112,006	2,671,688

Diluted weighted average number of shares outstanding	19,325,562	20,244,414	19,383,122	20,109,935

Note 8 – Arrangements with Massachusetts General Hospital

Under the terms of a research agreement with the Massachusetts General Hospital Corporation, Massachusetts General Hospital conducted clinical and non-clinical research in the field of photo thermal removal or reduction of hair, using light. The Research Agreement had a term of three years and expired in August 2007. We provided 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 as a result of 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 and interest thereof 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 (the “Agreement”) with Gillette to complete the development and commercialize a home-use, light based hair removal device for women. In October 2005, Procter & Gamble Company (NYSE: PG) completed its acquisition of Gillette. Under the Agreement, Procter & Gamble, as the acquiring party, assumed all of Gillette’s rights and obligations. The agreement provided for up to $7 million in support of research and development to be paid by Gillette over approximately 30 months. Effective as of June 28, 2004, we completed the initial phase of the agreement and both parties decided to move onto the next phase. Accompanying this decision, we amended the original agreement, whereby, Gillette provided $2.1 million in additional development funding to further technical innovations over a 9-month extension of the development phase, which was completed on August 31, 2006 (the “Development Phase”).

On September 29, 2006, in response to a first decision point in the Agreement, Gillette decided to continue with the project. On December 8, 2006, over-the-counter clearance was obtained from the United States Food and Drug Administration for the device and, per the Agreement, Gillette was obligated to make a development completion payment to us of $2.5 million, which was paid on December 26, 2006. The $2.5 million payment will be recorded as revenue over a 12 month period, as we are obligated to perform additional services to Gillette during that period in consideration for this payment.

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 by January 7, 2008 whether or not to continue with the project (the “Launch Decision”). Upon deciding to continue, Gillette will be obligated to make a development completion payment to us of $10 million. If Gillette decides not to continue to commercialize the device, we may proceed to commercialize the device on our own or with a different party.

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

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

In addition to the amounts to be paid by Gillette 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.

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

For the three months ended September 30, 2007 and 2006, we recognized $958,000 and $50,000 of funded product development revenues from Gillette, respectively. For the nine months ended September 30, 2007 and 2006, we recognized $3.0 million and $900,000 of funded product development revenues from Gillette, respectively. As of September 30, 2007 and 2006, $830,000 and $500,000, respectively, of advance payments received from Gillette for which services were not yet provided were included in deferred revenue.

For more information, please see the Development and License Agreement and subsequent amendments filed as Exhibit 10.1 to our Current Report on Form 8-K filed on February 19, 2003, Exhibits 99.1, 99.2, and 99.3 to our Current Report on Form 8-K filed on June 28, 2004, Exhibit 10.30 to our Annual Report on Form 10-K filed on March 6, 2006, and Exhibits 10.1 and 10.2 to our Current Report on Form 8-K filed on February 21, 2007.

Note 10 – Joint Development and License Agreement with Johnson & Johnson Consumer
Companies, Inc.

Effective as of September 1, 2004, we entered into a Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. Under the agreement, Johnson & Johnson funds our research and clinical studies during an initial proof-of-principle phase. At the end of the proof-of-principle phase, Johnson & Johnson will decide whether or not to continue with one or more of the devices in one or more of the fields into a development phase. If Johnson & Johnson decides to continue, Johnson & Johnson will be obligated to fund the development of the selected devices. If Johnson & Johnson Consumer Companies, Inc. decides not to continue, we may proceed in fields not selected by Johnson & Johnson to develop and commercialize these and other devices on 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. If Johnson & Johnson decides to commercialize one or more of the devices, Johnson & Johnson will make payments to us for each selected field. Upon commercial launch of the first device in each selected field, Johnson & Johnson will make a payment to us, and for all devices sold for use in each selected field, Johnson & Johnson shall pay us a percentage of sales of such devices and certain topical compounds. If Johnson & Johnson decides not to commercialize or fails to launch a device, we may proceed in fields not selected by Johnson & Johnson to develop and commercialize these and other devices on our own or with a different party.

On August 22, 2007, we signed an amendment to our agreement with Johnson & Johnson to provide for additional development funding for certain development activities. Johnson & Johnson will provide us with quarterly payments of $448,000 for these development activities. We will recognize this revenue as costs are incurred and services are provided.

For three months ended September 30, 2007 and 2006, we recognized $568,000 and $340,000, respectively, of funded product development revenues from Johnson & Johnson. For nine months ended September 30, 2007 and 2006, we recognized $2.1 million and $1.1 million, respectively, of funded product development revenues from Johnson & Johnson. As of September 30, 2007 and 2006, $448,000 and $340,000, respectively, of advance payments received from Johnson & Johnson for which services were not yet provided were included in deferred revenue.

For more information, please see the Joint Development and License Agreement and amendments filed as Exhibit 99.1 to our Current Report on Form 8-K filed on September 7, 2004, Exhibit 10.45 to our Quarterly Report on Form 10-Q filed on May 8, 2007, and Exhibits 10.47 and 10.48 to this Quarterly Report on Form 10-Q.

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 $3.4 million and a twelve month extension. On September 1, 2006, we were awarded additional funding of $440,000 for a total of $3.8 million and an additional five month extension until April 30, 2007. On February 26, 2007, the contract was extended for an additional five month extension until September 30, 2007 and on August 8, 2007, the contract was again extended for an additional three months until December 31, 2007. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Our revenue from the contract is subject to government audit.

For the three months ended September 30, 2007 and 2006, we recognized approximately $59,000 and $318,000, respectively, of funded product development revenues under this agreement. For the nine months ended September 30, 2007 and 2006, we recognized approximately $309,000 and $1.0 million, respectively, of funded product development revenues under this agreement.

Note 12 – Settlement of Cutera Litigation

On June 5, 2006, we announced the resolution of our patent infringement lawsuits against Cutera, Inc. through the execution of a Settlement Agreement and a Non-Exclusive Patent License Agreement. Under the License Agreement, we granted Cutera a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field which is exclusively licensed to the Gillette Company. Cutera admitted that their products infringe these patents and that these patents are valid and enforceable. In addition, Cutera agreed not to challenge the infringement, validity and enforceability of these patents in the future. Cutera paid us $22 million as an estimated payment for royalties on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2000 through March 31, 2006, interest and reimbursement of our legal costs. Cutera subsequently informed us that they believed the actual liability for past royalties, interest and legal costs was $19.6 million, versus the actual payment of $22 million. We recorded the difference of $2.4 million as deferred revenue at June 30, 2006 to be applied against future amounts owed. The final amounts due were subject to an audit by an independent accounting firm which was completed during the fourth quarter of 2006, resulting in an additional $648,000 of royalty and interest. Under our license agreement with the Massachusetts General Hospital, we pay to the Massachusetts General Hospital 40% of all royalty and interest payments from Cutera. In connection with the settlement, during the three and nine months ended September 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 Massachusetts General Hospital, $3.8 million as a reduction in general and administrative expense and $1.2 million in interest income. Starting on April 1, 2006, Cutera began paying us a royalty on sales of its existing light based hair removal systems, and Cutera will pay us a royalty on sales of its later developed light based hair removal systems.

For the nine months ended September 30, 2006, we recognized $13.6 million of back-owed royalty revenues related to the settlement of the Cutera litigation.

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

Note 13 – Laserscope Agreement

On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated the prior license agreement. Under the Patent License Agreement, we granted Laserscope a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field which is exclusively licensed to the Gillette Company. Under the new license agreement, Laserscope will pay us a royalty on sales of its current light based hair removal products, including the Lyra and Gemini Laser Systems and the Solis IPL System, as well as on sales of new light based hair removal systems developed in the future.

As a result of a royalty audit of Laserscope’s product sales from January 1, 2001 through June 30, 2006, there was an increase in the third quarter of 2006 royalty revenue of $2.2 million for back-owed royalties, cost of royalty revenue of $864,000 and net income of $1.3 million.

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

For the nine months ended September 30, 2006, we recognized $2.3 million of back-owed royalty revenues as a result of the Laserscope agreement.

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

Note 14 – Cynosure Agreement

On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc. Under this Agreement, we granted to Cynosure a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field which is exclusively licensed to the Gillette Company. In return, Cynosure granted us a non-royalty bearing (fully paid up), non-exclusive license to eight Cynosure patents and patent applications, including counterparts. Cynosure also paid us $10 million on November 7, 2006 as a royalty on sales of their laser and lamp-based hair removal systems made before October 1, 2006. Beginning October 1, 2006, Cynosure will pay us a royalty on sales of light based hair removal systems as well as future developed hair removal systems.

For more information, please see the Non-Exclusive Patent License Agreement filed as Exhibit 99.2 to our Current Report on Form 8-K filed November 7, 2006.

Note 15 – Alma Agreement

On April 2, 2007, we announced the resolution of our patent infringement and trade dress lawsuit against Alma Lasers, Inc. through the execution of a Settlement Agreement, a Non-Exclusive Patent License Agreement and a Trade Dress Settlement Agreement. Under the Patent License Agreement, we granted Alma a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,735,844 and 5,595,568 and all corresponding foreign patents and patent applications in the professional field, excluding the consumer field which is exclusively licensed to the Gillette Company. Alma admitted that their products infringe these patents and that these patents are valid and enforceable. In addition, Alma agreed not to challenge the infringement, validity and enforceability of these patents in the future. Alma will pay for royalties and interest due on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2003 and a trade dress fee plus interest on past sales of their Harmony and Aria systems. The amounts due to us are being determined based on an audit by an independent accounting firm. We have begun to recognize royalty revenue as the amounts become determinable. Under our license agreement with the Massachusetts General Hospital, we pay to the Massachusetts General Hospital 40% of all patent royalty and interest thereof from Alma. Beginning March 30, 2007, Alma will pay us a royalty on future sales of its existing and any new light based hair removal systems later developed.

For the three and nine months ended September 30, 2007, we recognized $3.1 million of back-owed royalty revenues, $894,000 of other revenues for trade dress infringement, and $432,000 of interest on back-owed royalties. At September 30, 2007, we had deferred revenue of $1.6 million related to payments received from Alma.

For more information, please see the Settlement Agreement, the Non-Exclusive Patent License Agreement, the Trade Dress Settlement Agreement, the Consent Judgments and Stipulations of Dismissal filed as Exhibits 10.1, 10.2, 10.3, 10.4 and 10.5 to our Current Report on Form 8-K filed on April 2, 2007.

Note 16 – Income Taxes

We adopted the provisions of Financial Standards Accounting Board Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007. As a result of the implementation of FIN 48, we recognized no material adjustment in the liability for unrecognized income tax benefits. At the adoption date of January 1, 2007, we had $2.8 million of unrecognized tax benefits, all of which would affect our effective tax rate if recognized. At September 30, 2007, we have $2.8 million of unrecognized tax benefits.

We recognize interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2007, we had no accrued interest related to uncertain tax positions.

The tax years 2003-2006 remain open to examination by the major taxing jurisdictions to which we are subject. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions.

Our effective tax rate for the nine months ended September 30, 2007 and 2006 was 38% and 4%, respectively. The primary components of this provision, in 2006, were minimum federal and state taxes. However, our cash tax liabilities were partially offset with the tax benefit from the exercise of stock options and net operating losses (NOL). In 2007, our effective tax rate is the combined federal and state statutory rates.

Our deferred tax assets represent the tax effects of net operating loss carryforwards, tax credit carryforwards and temporary differences that will result in deductible amounts in future years if we have taxable income. A valuation allowance reduces deferred tax assets to estimated realizable value, based on estimates and certain tax planning strategies. The carrying value of our net deferred tax assets assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions to realize the net carrying value. The valuation allowance is reviewed quarterly and is maintained until sufficient positive evidence exists to support the reversal of the valuation allowance based upon current and preceding years’ results of operations and anticipated profit levels in future years. If these estimates and related assumptions change in the future, we may be required to adjust our valuation allowance against the deferred tax assets resulting in additional provision (benefit) to income tax expense.

During the fourth quarter of 2006, we determined, based on current and preceding years’ results of operations and anticipated profit levels in future periods, that it is more likely than not that our domestic deferred tax assets will be realized in the future and, accordingly, that it was appropriate to release the valuation allowance recorded against those deferred tax assets. In reaching this conclusion, we weighed both negative and positive evidence regarding the realizability of these deferred tax assets and considered the extent to which the evidence could be objectively verified. The primary factors we considered were that:

Although we operate in an industry which is competitive and experiences rapid technological change, we have operated successfully in this environment. During the last several years, we have expanded our product mix and our newest products have been driving our revenue growth. We have maintained profitability and achieved year-over-year revenue growth during the past years.

We have cumulative profits before income taxes of $75.7 million for the three-year period ended with the fourth quarter of 2006.

Based upon our recent results of operations, as well as our internal projections, we expect to utilize our NOL carryforwards and tax credit carryforwards prior to their expiration.

We have never had any expired federal operating loss carryforwards in our history, and after utilization of net operating losses against the fiscal year 2006 federal taxable income, the first federal NOL carryforward scheduled to expire is in the year 2012.

Although we have determined that a valuation allowance is no longer required with respect to our domestic net operating loss carryforwards, deferred expenses and tax credit carryforwards, recovery is dependent on achieving the forecast of future operating income over a protracted period of time. Failure to achieve future operating income targets or negative changes to expected trends may change the assessment regarding the recoverability of the net deferred tax assets and such change could result in a valuation allowance being recorded against some or all of the deferred tax assets. Any increase in a valuation allowance would result in additional income tax expense and could have a significant impact on our earnings in future periods.

Note 17 – Stock Repurchase Program

On August 13, 2007, our Board of Directors approved a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management’s discretion without prior notice.

During the three months ended September 30, 2007, we used $3.0 million to purchase 105,000 shares of our common stock at an average price of $28.73.

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 8, 2007. 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 2006. There have been no material changes to our critical accounting policies as of September 30, 2007, except as noted below:

Effective January 1, 2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”).

Recent Accounting Pronouncements

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

Overview

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

Our total revenues for the quarter ended September 30, 2007 were $31.4 million, of which $23.1 million were product revenues. Royalty revenues were $5.8 million, of which $3.1 million related to the recognition of a portion of the back-owed royalties associated with a settlement agreement with Alma Lasers, Inc. Funded development revenues were $1.6 million. Other revenues of $894,000 relate to the recognition of a portion of the trade dress infringement associated with the settlement agreement with Alma. Income before taxes for the third quarter ended September 30, 2007 was $8.6 million.

We strengthened our balance sheet since the end of last year including increasing our cash and available-for-sale investments by 15% and increasing stockholders’ equity by 20%. Our working capital increased 20% since the end of 2006 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 nine months ended September 30, 2007 and 2006, respectively (in thousands, except for percentages):

	Three Months Ended September 30,
	2007					2006					Change
	Amount		As a % of Total Revenue			Amount		As a % of Total Revenue			$			%
Revenues
Product revenues	$	23,074		73	%	$	23,672		84	%		($598	)	(3	%)
Royalty revenues		5,826		19	%		3,642		13	%		2,184		60	%
Funded product development revenues		1,585		5	%		708		3	%		877		124	%
Other revenues		894		3	%		--		--			894		N/	A

Total revenues		31,379		100	%		28,022		100	%		3,357		12	%

Cost and expenses
Cost of product revenues		7,869		25	%		7,037		25	%		832		12	%
Cost of royalty revenues		2,330		8	%		1,457		5	%		873		60	%
Research and development		4,188		13	%		3,303		12	%		885		27	%
Selling and marketing		5,972		19	%		5,528		20	%		444		8	%
General and administrative		4,361		14	%		2,890		10	%		1,471		51	%

Total cost and expenses		24,720		79	%		20,215		72	%		4,505		22	%

Income from operations		6,659		21	%		7,807		28	%		(1,148	)	(15	%)
Interest income		1,927		6	%		1,032		4	%		895		87	%

Income before income taxes		8,586		27	%		8,839		32	%		(253	)	(3	%)

Provision for income taxes		3,263		10	%		471		2	%		2,792		593	%

Net income		$5,323		17	%	$	8,368		30	%	$	(3,045	)	(36	%)

	Nine Months Ended September 30,
	2007					2006					Change
	Amount		As a % of Total Revenue			Amount		As a % of Total Revenue			$			%
Revenues
Product revenues	$	78,753		82	%	$	65,679		75	%		$13,074		20	%
Royalty revenues		10,584		11	%		18,439		21	%		(7,855	)	(43	%)
Funded product development revenues		5,435		6	%		3,015		4	%		2,420		80	%
Other revenues		894		1	%		--		--			894		N/	A

Total revenues		95,666		100	%		87,133		100	%		8,533		10	%

Cost and expenses
Cost of product revenues		26,796		28	%		18,690		21	%		8,106		43	%
Cost of royalty revenues		4,234		4	%		7,376		9	%		(3,142	)	(43	%)
Research and development		12,243		13	%		10,469		12	%		1,774		17	%
Selling and marketing		18,607		20	%		16,608		19	%		1,999		12	%
General and administrative		11,655		12	%		4,033		5	%		7,622		189	%

Total cost and expenses		73,535		77	%		57,176		66	%		16,359		29	%

Income from operations		22,131		23	%		29,957		34	%		(7,826	)	(26	%)
Interest income		4,826		5	%		3,476		4	%		1,350		39	%
Other income		500		1	%		--		--			500		N/	A

Income before income taxes		27,457		29	%		33,433		38	%		(5,976	)	(18	%)

Provision for income taxes		10,434		11	%		1,454		1	%		8,980		618	%

Net income		$17,023		18	%	$	31,979		37	%		($14,956	)	(47	%)

Product revenues. Sales of the StarLux 300 and 500 Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces were the leading contributor to our product revenues for the three and nine months ended September 30, 2007 and 2006. Product revenues for the three months ended September 30, 2007 decreased by approximately $600,000 as compared to the same period in 2006. This change was driven by a decrease of 12% in sales related to the “Lux” family of products, which includes the StarLux, MediLux, EsteLux and additional handpieces, offset by a 58% increase in the Q-Yag 5 product line and a 54% increase in customer service revenue in comparison to the same period in 2006. For the nine months ended September 30, 2007, product revenues increased by approximately $13.1 million as compared to the same period in 2006. Favorably impacting product revenues was an increase of 18% in sales related to the Lux family of products, a 48% increase in sales relating to customer service, offset by a decrease of 15% from sales related to the Q-Yag 5 product line in comparison to the same period in 2006.

Product revenue for the three and nine months ended September 30, 2007 consisted of 66% and 70%, respectively, to North American customers where we sell through a direct sales force and 34% and 30%, respectively, outside of North America where we sell through distributors. In comparison to the same three and nine month periods in 2006, in each period, product revenue consisted of 83% to North American customers and 17% outside of North America.

Royalty revenues. Royalty revenues increased for the three months ended September 30, 2007 in comparison to the same period in 2006. This increase is attributed to four new patent license agreements signed since the third quarter of 2006. Royalty revenues for the nine months ended September 30, 2007 decreased in comparison to the same period in 2006 mainly as a result of the $15.8 million received for back-owed royalties related to a patent settlement in the second quarter of 2006 as well as a new patent license agreement in the third quarter of 2006, offset by $3.1 million of back-owed royalties received in the third quarter of 2007 and four new patent license agreements signed since the third quarter of 2006. Excluding these back-owed royalties, in the nine months ended September 30, 2007, royalty revenues increased 181%.

Funded product development revenues. Funded product development revenue increased for the three and nine months ended September 30, 2007, in comparison to the same periods in 2006. Funded product development revenue is generated from the development agreements with The Gillette Company, Johnson & Johnson Consumer Companies, Inc., and the United States Department of the Army.

For the three months ended September 30, 2007 and 2006, we recognized $958,000 and $50,000, respectively of funded product development revenues from Gillette. For the nine months ended September 30, 2007 and 2006, we recognized $3.0 million and $900,000, respectively of funded product development revenues from Gillette. Funded product development revenue from Gillette increased over the same periods in 2006 due to a $2.5 million payment received December 8, 2006 being recognized over a twelve month period as we are obligated to perform additional services and remain exclusive to Gillette. In addition, funded product development revenues from Gillette increased due to an amendment to our agreement with Gillette to include the development of a second light based hair removal device for home use which resulted in a payment to be recognized over an eleven month period as costs are incurred and services are provided, ending January 13, 2008. As of September 30, 2007 and 2006, $830,000 and $500,000, respectively of advance payments received from Gillette for which services were not yet provided were included in deferred revenue.

For the three months ended September 30, 2007 and 2006, we recognized $568,000 and $340,000, respectively of funded product development revenues from Johnson & Johnson. For the nine months ended September 30, 2007 and 2006, we recognized $2.1 million and $1.1 million, respectively of funded product development revenues from Johnson & Johnson. The funded product development revenues from Johnson & Johnson increased over the same periods in 2006 due to an amendment to our agreement with Johnson & Johnson which resulted in revenue being recognized over a six month period which ended August 15, 2007 as costs are incurred and services are provided as well as another amendment which provided for additional development funding. This revenue will be recognized as costs are incurred and services are provided. As of September 30, 2007 and 2006, $448,000 and $340,000, respectively, of advance payments received from Johnson & Johnson for which services were not yet provided were included in deferred revenue.

We provide services under a $3.8 million research contract with the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae or PFB. On February 26, 2007, the contract was extended for an additional five month period, ending September 30, 2007 and on August 8, 2007, the contact was extended for an additional three month period, ending December 31, 2007. The contract is a cost plus fee arrangement whereby we are reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered. For the three months ended September 30, 2007 and 2006, we recognized approximately $59,000 and $318,000, respectively of funded product development revenues from the United States Department of the Army. For the nine months ended September 30, 2007 and 2006, we recognized approximately $309,000 and $1.0 million, respectively of funded product development revenues from the United States Department of the Army.

Other revenues. For the three and nine month periods ended September 30, 2007, we recognized $894,000 of other revenue as recognition of a portion of the trade dress infringement associated with the settlement of our lawsuit with Alma.

Cost of product revenues. For the three month periods ended September 30, 2007 and 2006, the cost of product revenues as a percentage of total revenues was 25%. For the nine month periods ended September 30, 2007 and 2006, the cost of product revenues as a percentage of total revenues were 28% and 21%, respectively. The nine month period in 2006 included a positive adjustment of approximately $762,000 in accrued royalties due to a license amendment, offset by a charge of approximately $145,000 related to an inventory write-down. The remaining increase as a percentage of total revenue for the nine months ended September 30, 2007 as compared to the same period in 2006 was attributed to expansion efforts outside North America, a decrease in average selling prices in the second quarter of 2007, an increase in trade-ups of StarLux 300s to StarLux 500s, and the sale of StarLux 300 demonstration units due to our recent introduction of the StarLux 500.

Cost of royalty revenues. The cost of royalty revenues increased for the three months ended September 30, 2007 in comparison to the same period in 2006. This increase is attributed to four new patent license agreements signed since the third quarter of 2006. The cost of royalty revenues for the nine months ended September 30, 2007 decreased in comparison to the same period in 2006 mainly as a result of the $15.8 million received for back-owed royalties related to the settlement of a patent infringement lawsuit in the second quarter of 2006 and a new patent license agreement in the third quarter of 2006, offset by $3.1 million of back-owed royalties received in the third quarter of 2007. 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 in comparison to the same periods in 2006.

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

For the three and nine months ended September 30, 2007, expenses relating to the Gillette agreement increased by $339,000 and $187,000, respectively, as compared to the same periods in 2006. The increase in the three months ended September 30, 2007 was mainly due to increases of $126,000 for payroll and payroll related expenses, $108,000 for clinical, consulting, and overhead expenses, and $105,000 for material costs. The increase in the nine months ended September 30, 2007 was mainly due to increases of $174,000 for payroll and payroll related expenses and $39,000 for material costs, offset by an increase of $26,000 for clinical, consulting and overhead expenses.

Expenses relating to the Johnson & Johnson agreement increased during the three and nine months ended September 30, 2007 by $296,000 and $778,000, respectively. The increase for the three months ended September 30, 2007 was mainly due to increases of $300,000 for material costs and $77,000 for payroll and payroll related expenses, offset by $85,000 for other clinical, consulting and overhead expenses as compared to the same period in 2006. The increase in the nine months ended September 30, 2007 was mainly due to an increase of $479,000 for material costs, $190,000 for payroll and payroll related expenses, and $88,000 from other clinical, consulting and overhead expenses as compared to the same period in 2006.

For the three and nine months ended September 30, 2007, expenses relating to the United States Department of the Army decreased by approximately $239,000 and $663,000, respectively, in comparison to the same periods in 2006. The decrease for the three months ended September 30, 2007 was mainly due to $158,000 less payroll and payroll related expenses, $58,000 less material costs, and a $23,000 reduction in other clinical, consulting and overhead expenses. The decrease for the nine months ended September 30, 2007 was mainly due to $436,000 less payroll and payroll related expenses, $96,000 less material costs, and a $130,000 reduction in other clinical, consulting and overhead expenses.

Expenses for internal research and development projects relating to the introduction of new products, enhancements made to the current family of products and research and development overhead increased by $489,000 and $1.5 million for the three and nine months ended September 30, 2007 as compared to the same period in 2006.

Selling and marketing expense. For the three months ended September 30, 2007, selling and marketing expense increased by $444,000, or 8%, over the comparable period in 2006. For the quarter ended September 30, 2007, selling and marketing increased by $211,000 from payroll and payroll related expenses, $178,000 from our new international office, $44,000 related to commission expense, and $33,000 related to tradeshow expenses as compared to the same period in 2006. For the nine months ended September 30, 2007, selling and marketing expense increased by $2.0 million, or 12%, over the comparable period in 2006 which includes a $230,000 write-off of demonstration inventory. For the nine month period ended September 30, 2007, selling and marketing increased by $439,000 from payroll and payroll related expenses, $307,000 related to commission expense, $222,000 related to tradeshow expenses, $457,000 from our new international office, and $260,000 related to consultants as compared to the same period in 2006. These increases directly correlate with our increased revenues and costs associated with our continued expansion.

General and administrative expense. For the three months ended September 30, 2007, general and administrative expenses increased by $1.5 million over the comparable period in 2006. For the quarter ended September 30, 2007, general and administrative expense increased $1.3 million from legal expenses related to patent litigation, $531,000 from bad debt write offs, $129,000 in other overhead expenses, and $126,000 from payroll and payroll related expenses, offset by a decrease of $650,000 from incentive compensation as compared to the same period in 2006. For the nine months ended September 30, 2007, general and administrative expense increased by $7.6 million over the comparable period in 2006. For the nine months ended September 30, 2007, general and administrative expenses increased $3.1 million from legal expenses related to patent litigation excluding the $3.8 million received in the second quarter of 2006 as a result of the Cutera settlement for legal expense reimbursement and the $275,000 received in the third quarter of 2007 related to a new patent license agreement, $472,000 from bad debt write offs, $224,000 from payroll and payroll related expenses, and $289,000 in other overhead expenses, offset by a decrease of $50,000 from incentive compensation as compared to the same period in 2006. These increases are mainly attributed to our continued focus on financial growth and our continued efforts regarding the ongoing patent infringement lawsuits.

Interest income. Interest income increased for the three and nine months ended September 30, 2007 over the comparable periods in 2006 due to $259,000 of interest received in 2007 on back-owed royalty revenues related to a new patent license agreement and an increase in cash balance, offset by $1.2 million of interest received in 2006 on back-owed royalty revenues.

Other income. Other income for the nine months ended September 30, 2007 includes cash received related to the expiration of a standstill agreement.

Provision for income taxes. We file income tax returns in the U.S. federal jurisdiction as well as various state and foreign jurisdictions. Effective January 1, 2007, the Company adopted FIN No. 48, “Accounting for Uncertainty in Income Taxes.” Our effective tax rate for the three months ended September 30, 2007 and 2006 was 38% and 5%, respectively. The primary components of this provision, in 2006, were minimum federal and state taxes. In 2006, our cash tax liabilities were partially offset with the tax benefit from the exercise of stock options and NOLs. In 2007, our effective tax rate is the combined federal and state statutory rates.

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 (in thousands):

	Nine months ended September 30,					Change
	2007		2006			$			%
Cash flows from operating activities	$	10,644	$	26,297		$	(15,653	)		(60	%)
Cash flows from (used in) investing activities		11,717		(20,458	)		32,175			157	%
Cash flows from financing activities		5,862		6,018			(156	)		(3	%)
Capital expenditures, net	$	634	$	455		$	179			39	%

Additionally, our cash and investment position, accounts receivable, inventories and working capital are shown below for the periods indicated (in thousands).

			Change
	September 30, 2007	December 31, 2006	$	%
Cash and cash equivalents	$ 65,041	$ 36,817	$ 28,224	77%

Available-for-sale investments, at market value	55,000	67,352	(12,352)	(18%)
Accounts receivable, net	21,708	15,443	6,265	41%
Inventories, net	14,919	11,012	3,907	35%
Working capital	138,738	115,891	22,847	20%

At September 30, 2007, we had $120 million in cash and cash equivalents and available-for-sale investments. We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and other activities for at least the next twelve months. As of September 30, 2007, we had no borrowings or debt.

Cash flows from operating activities for the nine months ended September 30, 2007, decreased compared to the same period in 2006 which includes the back-owed royalties received from Cutera. This decrease in operating activity cash flows reflects a decrease in net income, a decrease in stock compensation expense, an increase in tax benefit from stock option exercises, and a decrease in inventory write-offs, offset by a decrease in working capital requirements and an increase in bad debt provision in the third quarter of 2007. Cash flows related to investing activities increased for the nine months ended September 30, 2007, compared to the same period in 2006. 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 flows from financing activities decreased for the nine month period ended September 30, 2007, compared to the same period in 2006. This decrease was primarily due to a decrease in proceeds from stock option exercises and the repurchase of common stock, offset by an increase in tax benefits related to stock option exercises.

We anticipate that capital expenditures for the remainder of 2007 will total approximately $250,000, consisting primarily of leasehold improvements, machinery, equipment, computers and peripherals. We expect to finance these expenditures with cash on hand.

Effective as of February 14, 2003, we entered into a Development and License Agreement with Gillette to complete the development and commercialize a home-use, light based hair removal device for women. (See Note 9 for more information.)

In the first quarter of 2004, we began providing services under a research contract with the United States Department of the Army to develop a light based self-treatment device for PFB. (See Note 11 for more information.)

On October 18, 2006, we entered into a new Non-Exclusive Patent License Agreement with Laserscope and terminated our prior license agreement with them. (See Note 13 for more information.)

On November 7, 2006, we announced the execution of a Non-Exclusive Patent License Agreement with Cynosure, Inc. (See Note 14 for more information.)

Contractual obligations

On August 1, 2004, we entered into a new agreement with Massachusetts General Hospital whereby they agreed to conduct clinical and non-clinical research in the field of photo thermal removal or reduction of hair, using light. The agreement had a term of three years and expired August 2007. We provided 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 as a result of this research.

We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as 40% of royalties received from third parties. Royalty expense for the three and nine months ended September 30, 2007 totaled approximately $2.9 million and $6.1 million, respectively.

We have obligations related to the adoption of FIN 48. Further information about changes in these obligations can be found in Note 16.

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

On July 30, 2007, we signed an amendment to our lease to add an additional 13,600 square feet. Rent expense, including this new lease, will total approximately $1.3 million per year, expiring in August of 2009.

The following table summarizes our estimated contractual cash obligations as of September 30, 2007, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):

	Payments due by period
	Total	Less than 1 year	1 - 3 Years	4 - 5 Years	After 5 Years
Operating lease	$ 2,489	$ 1,301	$ 1,188	$ --	$ --
Purchase commitments	5,769	5,769	--	--	--

Total contractual cash obligations	$ 8,258	$ 7,070	$ 1,188	$ --	$ --

Cautionary statements

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

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

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

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

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

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

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

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 therefrom may be adversely affected. Medical devices may be marketed only for the indications for which they are approved or cleared, and if we are found to be marketing our products for off-label, or non-approved, uses we might be subject to FDA enforcement action or have other resulting liability.

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

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

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

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:

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

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

operating restrictions or partial suspension or total shutdown of production;

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

criminal prosecution.

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

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

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

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

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

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

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

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

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

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

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

Our effective income tax rate may vary significantly.

Unanticipated changes in our tax rates could affect our future results of operations. Our future effective tax rates could be unfavorably affected by changing interpretations of existing tax laws or regulations, changes in estimates of prior years’ items, changes in the valuation of our deferred tax assets, future levels of research and development spending, deductions for employee stock option exercises being different than what we projected, and changes in overall levels of income before taxes.

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

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

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

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

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

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

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

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

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

consumer awareness of procedures and treatments;

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

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

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

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

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

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

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

expand our manufacturing capacity and scale of production;

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

provide adequate training and supervision to maintain high quality standards.

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

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

We forecast sales to determine requirements for components and materials used in our products and if our forecasts are incorrect, we may experience either delays in shipments or increased inventory costs.

To manage our manufacturing operations with our suppliers, we forecast anticipated product orders and material requirements to predict our inventory needs and enter into purchase orders on the basis of these requirements. Our limited historical experience may not provide us with enough data to accurately predict future demand. If our business expands, our demand for components and materials would increase and our suppliers may be unable to meet our demand. If we overestimate our component and material requirements, we will have excess inventories, which would increase our expenses. If we underestimate our component and material requirements, we may have inadequate inventories, which could interrupt, delay, or prevent delivery of our products to our customers.

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.

We work with and conduct research with many third parties and disputes may arise with these third parties regarding the ownership or inventorship of intellectual property rights. Although there are generally contracts with third parties, it is difficult to predict how such disputes would be resolved.

In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how. We generally enter into agreements with our employees and third parties with whom we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information and define our intellectual property ownership rights. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our technology, proprietary information and know-how and we may not have adequate remedies for any such breach. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our technology, our ability to compete effectively could be harmed and the value of our technology and products could be adversely affected. Costly and time consuming lawsuits may be necessary to enforce and defend patents issued or licensed exclusively to us, to protect our trade secrets and/or know-how or to determine the enforceability, scope and validity of others’ intellectual property rights. Such lawsuits may result in patents issued or licensed exclusively to us to be found invalid and unenforceable. In addition, our trade secrets may otherwise become known or our competitors also may independently develop technologies that are substantially equivalent or superior to our technology and which do not infringe our patents.

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

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

Candela Corporation has filed two patent infringement lawsuits against us. (See Part II. Item 1 Legal Proceedings.) Litigation with Candela has been and is expected to continue to be expensive and protracted, and our intellectual property position may be weakened as a result of an adverse ruling or judgment. Whether or not we are successful in the pending lawsuits, litigation consumes substantial amounts of our financial resources and diverts management’s attention away from our core business. Public announcements concerning this litigation that are unfavorable to us may in the future result in significant declines in our stock price. An adverse ruling or judgment in this matter could cause our stock price to decline significantly.

We may not be able to successfully collect licensing royalties.

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

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

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

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

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

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

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

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

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

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

We face risks associated with product warranties.

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

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

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

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

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

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

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

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

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

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

Our charter documents, Delaware law and our shareholder rights plan may discourage potential takeover attempts.

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

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

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

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

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

Our stock price may be volatile.

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

the success of competitive products or technologies;

regulatory developments in the United States and foreign countries;

developments or disputes concerning patents or other foreign countries;

the recruitment or departure of key personnel;

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

market conditions in our industry and issuance of new or changed securities analyst’s reports or recommendations; and

general economic, industry and market conditions.

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 September 30, 2007. Based on that evaluation, the Company has concluded that its disclosure controls and procedures were effective.

The Company’s management, including the CEO and CFO, does not expect that the Company’s disclosure controls or internal controls over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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 September 30, 2007, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – Other information

Item 1. Legal proceedings

On July 7, 2006, we commenced an action for patent infringement against Alma Lasers, Inc. in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged 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 & 5,735,844, which are exclusively licensed to us by the Massachusetts General Hospital. On July 27, 2006, we filed an amended complaint including an additional claim against Alma for unfair competition due to infringement by Alma’s Harmony System of the distinctive trade dress of our products, including the unique, distinctive, and immediately recognizable design of our EsteLux, MediLux and StarLux Systems.

On April 2, 2007, we announced the resolution of our lawsuit against Alma Laser, Inc. through the execution of a Non-Exclusive Patent License Agreement, a Trade Dress Settlement Agreement, and a Settlement Agreement. Under the Patent License Agreement, we granted Alma a non-exclusive, royalty bearing license to U.S. Patent Nos. 5,595,568 & 5,735,844 & corresponding foreign patents and applications in the professional field, excluding the consumer field which is exclusively licensed to Gillette. Alma admitted that their products infringe these patents and that these patents are valid and enforceable. In addition, Alma agreed not to challenge the infringement, validity and enforceability of these patents in the future. Alma paid us an estimated payment for royalties due on past sales of their laser and lamp-based hair removal systems beginning with their initial sales in 2003 through the date of settlement, plus interest and reimbursement of our legal costs. Alma also paid us an estimated payment for trade dress fees on past sales of their Harmony and Aria Systems and interest, and Alma agreed to change the trade dress of the Harmony and Aria systems within the next six to nine months. The final amounts due to us are subject to an audit by an independent accounting firm which was completed in the third quarter of 2007. Alma is disputing some of the amounts owed under the audit. Starting on March 30, 2007, Alma began paying us a royalty on sales of its existing light based hair removal systems, and Alma will pay us a royalty on sales of its later developed light based hair removal systems.

For more information, please see the Settlement Agreement, the Non-Exclusive Patent License Agreement, the Trade Dress Settlement Agreement, the Consent Judgments and Stipulations of Dismissal filed as Exhibits 10.1, 10.2, 10.3, 10.4 and 10.5 to a Current Report on our Form 8-K filed April 2, 2007.

On August 9, 2006, we commenced an action for patent infringement against Candela Corporation in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleges Candela’s GentleYAG and GentleLASE systems which use laser technology for hair removal willfully infringe U.S. patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General Hospital. Candela answered the complaint denying that its products infringe valid claims of the asserted patents and filing a counterclaim seeking a declaratory judgment that the asserted patent and U.S. patent No. 5,595,568 are invalid and not infringed. We filed a reply denying the material allegations of the counterclaims. This lawsuit has been transferred to the judge who presided over Palomar v Cutera, Inc. We filed an amended complaint on February 16, 2007 to add the Massachusetts General Hospital as a plaintiff. In addition, we further alleged that Candela’s new GentleMAX system willfully infringes U.S. Patent No. 5,735,844 and that Candela’s new Light Station system willfully infringes both U.S. Patent Nos. 5,735,844 and 5,595,568. On February 16, 2007, Candela filed an amended answer to our complaint adding allegations of inequitable conduct, double patenting and violation of Massachusetts General Laws Chapter 93A. On February 28, 2007, we filed a response to Candela’s amended complaint pointing out many weaknesses in Candela’s new allegations. A claim construction hearing, sometimes called a “Markman Hearing”, was held August 2, 2007, and we are waiting on a ruling from the Judge. No trial date has yet been set.

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

On December 19, 2006, Candela Corporation commenced an action for patent infringement against us in the United States District Court for the Eastern District of Texas, seeking both monetary damages and injunctive relief. The complaint alleges that our StarLux System with the LuxY handpiece willfully infringes U.S. Patent No. 6,659,999 and that our StarLux System with the Lux1540 handpiece willfully infringes related U.S. Patent Nos. 5,810,801 and 6,120,497. The three asserted patents are directed to wrinkle treatment. Candela is seeking to enjoin us from selling these products in the United States if found to infringe the patents, and to obtain compensatory and treble damages, reasonable costs and attorney’s fees, and other relief as the court deems just and proper. On January 10, 2007, we answered the complaint denying that our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that the asserted patents are invalid and not infringed. On April 6, 2007, Candela filed their infringement contentions which modified their complaint to accuse the Lux1540, Lux1540-Z, LuxIR, LuxDeepIR, LuxB, LuxG and LuxY handpieces for use with the StarLux, StarLux 500, MediLux and EsteLux Systems of infringing the three asserted patents. On July 13, 2007, we filed an amended answer to Candela’s first amended complaint including counter claim of inequitable conduct. We are defending the action vigorously and believe that we have meritorious defenses of non-infringement and invalidity. However, litigation is unpredictable and we may not prevail in successfully defending or asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for future sales of products found to infringe in the United States. We could also be ordered to stop selling any products that are found to infringe in the United States. A claim construction hearing, sometimes called a “Markman Hearing”, is scheduled for November 13, 2007.

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

Period	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Program *
August 13 - September 30, 2007	105,000	$ 28.73	105,000

* On August 13, 2007, our Board of Directors approved a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management’s discretion without prior notice.

Item 3. Defaults upon senior securities

None.

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

None.

Item 5. Other information

None.

Item 6. Exhibits

10.46

Third Amendment to Lease for 80/82 Cambridge Street, Burlington, MA dated July 30, 2007.

10.47+

Third Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. dated August 15, 2007

10.48+

Fourth Amendment to Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. dated August 22, 2007

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.

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.

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 request 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: November 2, 2007	By:/s/ Joseph P. Caruso Joseph P. Caruso President, Chief Executive Officer and Director


Date: November 2, 2007	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 10 – Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc.

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

Note 12 – Settlement of Cutera Litigation

Note 13 – Laserscope Agreement

Note 14 – Cynosure Agreement

Note 15 – Alma Agreement

Note 16 – Income Taxes

Note 17 – Stock Repurchase Program

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.

Our stock price may be volatile.

Item 3. Quantitative and qualitative disclosures about market risk

Item 4. Controls and procedures

PART II – Other information

Item 1. Legal proceedings

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

Item 3. Defaults upon senior securities

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

Item 5. Other information

Item 6. Exhibits

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)

Note 10 – Joint Development and License Agreement with Johnson & Johnson Consumer
Companies, Inc.