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Article by DailyStocks_admin    (03-03-08 02:56 AM)

The Daily Magic Formula Stock for 03/03/2008 is Palomar Medical Technologies Inc. According to the Magic Formula Investing Web Site, the ebit yield is 25% and the EBIT ROIC is >100 %.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


Dailystocks.com makes NO RECOMMENDATIONS whatsoever, and provides this for informational purpose only.

BUSINESS OVERVIEW

Introduction

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

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1996 we introduced the first high powered laser hair removal system
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1997 we obtained FDA clearance for the first high powered laser hair removal system
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1997 we were first to obtain FDA clearance for high power diode laser system
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1998 we were the first to obtain FDA clearance for permanent hair reduction
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1999 we were first to obtain FDA clearance for sub-zero cooled laser system
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2000 we were first to obtain FDA clearance for a super long pulse laser system
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2001 we introduced the cost effective and upgradeable Lux Platform
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2001 we introduced the Q-Yag5™ system for tattoo and pigmented lesion removal
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2003 we signed a Development and License Agreement with The Gillette Company to complete development and commercialize a patented home-use, light based hair removal device for women
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2004 we introduced the StarLux®Pulsed Light and Laser system which incorporates a single power supply system capable of operating both lasers and lamps
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2004 we were awarded a research contract by the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
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2004 we signed a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc., a Johnson & Johnson company (NYSE: JNJ), to develop, clinically test and potentially commercialize home-use, light based devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne
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2005 we were awarded additional funding and a one year extension for our research contract with the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
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2005 we began shipping the Lux 1064™ handpiece for use with the StarLux System for removal of leg veins and other conditions
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2005 we began shipping the Lux IR™ Fractional Infrared handpiece for use with the StarLux System for deep heating for pain relief and in 2006 we received FDA clearance for soft tissue coagulation
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2006 we were awarded additional funding and a five month extension for our research contract with the United States Department of the Army to develop a light based self-treatment device for Pseudofolliculitis Barbae
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2006 we began shipping the Lux1540™ Fractional Laser handpiece for use with the StarLux System for soft tissue coagulation and we are seeking FDA clearance for skin resurfacing
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2006 we received a 510(k) over-the-counter (OTC) clearance from the FDA for a new, patented, home use, light-based hair removal device
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2007 we introduced the StarLux®500 Laser and Pulsed Light System featuring 70% more power and increased functionality and speed of treatment
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2007 we introduced four new handpieces including:

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Lux1540-Z™ Fractional Laser handpiece allowing control of micro-beam density and focal depth as well as spot size
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LuxDeepIR™ Fractional handpiece, the second generation of the LuxIR™ Fractional handpiece, including advanced cooling, contact sensors and longer pulse duration
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LuxW™ Pulsed Light handpiece optimized for treatment of very light pigmented lesions, and
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LuxYs™ Pulsed Light handpiece for permanent reduction of lighter, finer hair

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2007 we expanded our Development and License Agreement with Gillette to allow for the development of an additional home-use, light based hair removal device for women
We are continuously researching, developing and testing new and exciting innovations for a variety of cosmetic applications, such as:

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skin rejuvenation, including tone and texture
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skin tightening, including laxity and lifting
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pigmented lesion removal, such as sun and age spots, freckles and melasma
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vascular lesion removal, such as spider veins, cherry angiomas and rosacea
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leg vein removal
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acne treatment
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scars, including acne scars, stretch marks and warts
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fat reduction, including cellulite

We were organized in 1987 to design, manufacture, market and sell lasers and other light based products and related disposable items and accessories for use in medical and cosmetic procedures. In December 1992, we filed our initial public offering. Subsequently, we pursued an acquisition program, acquiring companies in our core laser business as well as others, principally in the electronics industry, in order to spread risk and bolster operating assets. By the beginning of 1997, we had more than a dozen subsidiaries. At the same time, having obtained FDA clearance to market our EpiLaser® ruby laser hair removal system in March 1997, we were well positioned to focus on what we believed was the most promising product in our core laser business. Hence, under the direction of a new board and management team, we undertook a program in 1997, which was completed in May of 1998, of exiting from all non-core businesses and investments and focusing only on those businesses which we believed held the greatest promise for maximizing stockholder value. Our exclusive focus then became the use of lasers and other light based products in dermatology and cosmetic procedures.

In December 1997 and January 1998, respectively, we became the first company to receive FDA clearance for a diode laser for hair removal and for leg vein treatment, the LightSheer™ diode laser system manufactured by Star Medical Technologies, Inc., one of our former subsidiaries. The LightSheer was the first generation of high-powered diode lasers designed for hair removal, and like our EpiLaser and other prior hair removal products, the LightSheer incorporated technology protected by patents licensed exclusively to us from the General Hospital Corporation doing business as Massachusetts General Hospital.

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

On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light based hair removal device for women. We believe that this device will be protected by multiple patents within our patent portfolio. On June 28, 2004, we announced with Gillette that we completed the initial phase of our agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations. In September 2006, we announced that Gillette had made the decision to move into the next phase of our agreement. On December 8, 2006, we became the first company to receive a 510(k) over-the-counter (OTC) clearance from the FDA for a new, patented, home use, light-based hair removal device. OTC clearance allows the product to be marketed and sold directly to consumers without a prescription. Under our agreement, Gillette paid us $2.5 million following our receipt of the OTC clearance. In February 2007, we announced an amendment to our agreement with Gillette to include the development and commercialization of an additional light-based hair removal device for home use, and we also announced that we had executed an Amended and Restated Joint Development Agreement to incorporate other prior amendments and several new amendments to allow for more open collaboration through commercialization.

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

Financial Information About Industry Segments

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

Principal Products

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

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Hair removal
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Removal of vascular lesions such as rosacea, spider veins, port wine stains and hemangiomas
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Removal of leg veins
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Removal of benign pigmented lesions such as age and sun spots, freckles and melasma
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Tattoo removal
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Acne treatment
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Wrinkle removal
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Pseudofolliculitis Barbae or PFB treatment
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Treatment of red pigmentation in hypertrophic and keloid scars
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Treatment of verrucae, skin tags, seborrheic keratosis
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Skin tightening through soft tissue coagulation
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Scars, including acne scars, stretch marks and warts
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Soft tissue coagulation
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Other skin treatments

Market surveys report that the great majority of men and women in the United States, and many other parts of the world, employ one or more techniques to temporarily remove hair from various parts of the body, including waxing, depilatories, tweezing and shaving. Compared to these hair removal techniques, our light based hair removal processes provides significantly longer-term cosmetic improvement.

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

The Lux systems offer a suite of applications at less cost than competing systems. Customers can invest in their first Lux system with one handpiece then purchase additional handpieces as their practice grows and upgrade into a more powerful Lux system when ready. The Lux platform enables us to custom tailor products to fit almost any professional medical office or spa location and provide customers with the comfort that the system is able to grow with their practice.

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

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

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

MediLux. In March 2003, we launched the Palomar MediLux™ Pulsed Light System with the six handpieces also available on the EsteLux. The MediLux provides increased power, a faster repetition rate and a snap-on connector making it easier to switch among handpieces and provide treatments tailored to each individual being treated.

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

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

CEO BACKGROUND

LOUIS P. VALENTE. Mr. Valente has served as one of our directors since February 1, 1997. Mr. Valente currently serves as our Executive Chairman of the Board of Directors. From May 14, 1997 through May 15, 2002, he served as our Chief Executive Officer, and on September 15, 1997, he became our Chairman of the Board. From 1968 to 1995, Mr. Valente held numerous positions at Perkin Elmer, Inc. (formerly EG&G, Inc.), a provider of drug discovery, research and clinical screening products, services and technologies for the life science industry in addition to products for aerospace, chemical, environmental, medical, photography, security and other global arenas. In 1968, he began his career at EG&G, Inc. as an Assistant Controller and held executive positions, including Corporate Treasurer, before becoming Senior Vice President of EG&G, Inc., presiding over and negotiating acquisitions, mergers and investments. Mr. Valente serves as a director of Medical Information Technology, Inc., MKS Instruments, Inc. and SurgiLight, Inc., all publicly held companies, and several private companies. Mr. Valente is a Certified Public Accountant and a graduate of Bentley College.

JOSEPH P. CARUSO. Mr. Caruso has served as one of our directors since October 2001. Since May 2002, Mr. Caruso has served as our Chief Executive Officer and President. From May 2001 to May 2002, Mr. Caruso served as our President and Chief Operating Officer. From 1992 until May 2002, Mr. Caruso served as our Chief Financial Officer. From 1981 to 1992, Mr. Caruso was Chief Financial Officer for a private manufacturing company and a manager with an international public accounting firm. Mr. Caruso is a Certified Public Accountant and a graduate of Merrimack College.

JEANNE COHANE. Ms. Cohane has served as one of our directors since June 7, 2000. Ms. Cohane has over eighteen years of experience in the cosmetic business. Ms. Cohane has spent most of her career in the retail beauty market where she was a senior member of the Crabtree & Evelyn management team and served as Managing Director of their private label company. Crabtree & Evelyn, an international company, is well known and respected for its beauty products and consumer based market approach. Ms. Cohane has many years of experience in strategic planning, business development and product expansion, leadership and management of all areas of operations.

NICHOLAS P. ECONOMOU. Dr. Economou has served as one of our directors since November 13, 1997. Dr. Economou is the chief executive officer of ALIS Corporation, a Carl Zeiss SMT company, which is a developer and manufacturer of analytical equipment for the semiconductor, nanotechnology, life sciences and materials industries. Before joining ALIS, Dr. Economou was chief executive officer of Confluent Photonics Corporation, a manufacturer of photonic subsystems. Previously, Dr. Economou was chief operating officer of AXSUN Technologies, a manufacturer of photonic subsystems. Prior to AXSUN, he was chief operating officer of FEI Company (FEIC), a manufacturer of production and analytical equipment for the semiconductor and data storage industries. Prior to FEI, he was chairman, president and chief executive officer of Micrion Corporation (MICN), which merged with FEI in August 1999. In addition to serving on the Board of Palomar, he is also a director on the boards of several private companies. Dr. Economou received his B.A. in physics from Dartmouth College and his M.A. and Ph.D. in physics from Harvard University.

JAMES G. MARTIN. Dr. Martin has served as one of our directors since June 2, 1997. Since 1995, Dr. Martin has served as the Vice President at Carolinas HealthCare System. From 1993 until 2000, he was also Chairman of the Research Development Board of Carolinas Medical Center. From 1985 until 1993, Dr. Martin was the Governor of North Carolina and from 1973 through 1984, he served as a United States Congressman from North Carolina. Dr. Martin currently serves as a director for Family Dollar, Inc., and DesignLine, Inc. Dr. Martin has a B.S. in chemistry from Davidson College and a Ph.D. in chemistry from Princeton University.

NEIL PAPPALARDO. Mr. Pappalardo has served as one of our directors since June 1997. Since 1969 Mr. Pappalardo has been the founder and chief executive officer of Medical Information Technology, Inc., a provider of software systems to over 2000 hospitals in the United States, Canada and the United Kingdom. Mr. Pappalardo serves on the executive committee as well as various other operational and academic committees at M.I.T., and is a trustee of the New England Aquarium and the Boston Lyric Opera. Mr. Pappalardo received his B.S. in electrical engineering from M.I.T.

MANAGEMENT DISCUSSION FROM LATEST 10K

Critical accounting policies

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

MANAGEMENT DISCUSSION FOR LATEST QUARTER

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.

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.

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.

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