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Article by DailyStocks_admin    (05-23-08 07:19 AM)

The Daily Magic Formula Stock for 05/23/2008 is Obagi Medical Products Inc. According to the Magic Formula Investing Web Site, the ebit yield is 14% 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

Corporate information

Dr. Zein Obagi founded WorldWide Product Distribution, Inc. in 1988. OMP Acquisition Corporation was formed as a California corporation in October 1997 to purchase substantially all of the assets and to assume the accounts payable and related operating liabilities of WorldWide Product Distribution, Inc. and subsequently changed its name to Obagi Medical Products, Inc. in December 1997. OMP, Inc. was incorporated in Delaware in November 2000 and, in January 2001, Obagi Medical Products, Inc. was merged into OMP, Inc., with OMP, Inc. as the surviving corporation. In December 2004, the stockholders of OMP, Inc. exchanged their shares of OMP, Inc. for an equal number of shares in a newly formed holding company incorporated in Delaware, Obagi Medical Products, Inc., which became the parent holding company for all existing operations.

Our principal executive offices are located at 310 Golden Shore, Long Beach, California 90802 and our telephone number is (562) 628-1007. Our website address is http://www.obagi.com. Copies of our most recent Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q and our other reports filed with the Securities and Exchange Commission ("SEC"), can be obtained, free of charge as soon as reasonably practicable after such material is electronically filed with, or furnished to the SEC, by calling Ina McGuinness at Integrated Corporate Relations at (310) 954-1100, through the SEC's website by clicking the SEC Filings link from the Investor Relations page on our website at www.obagi.com or directly from the SEC's website at www.sec.gov. Our website and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.

Overview

We are a specialty pharmaceutical company focused on the aesthetic and therapeutic skin health markets. We develop and commercialize prescription-based, topical skin health systems that enable physicians to treat a range of skin conditions, including pre-mature aging, photo-damage, hyperpigmentation (irregular or patchy discoloration of the skin), acne and soft tissue deficits, such as fine lines and wrinkles. Our products are designed to improve the underlying health of patients' skin, and our clinical studies have demonstrated that the use of our Obagi Nu-Derm System results in skin that looks and acts younger and healthier. We focus our research and development activities on improving the efficacy of established prescription and over-the-counter ("OTC"), therapeutic agents by enhancing the penetration of these agents across the skin barrier using proprietary technologies collectively known as Penetrating Therapeutics. Through our own domestic sales force and foreign distribution partners, we market and sell physician-dispensed skin care systems directly to plastic surgeons, dermatologists and other physicians who are focused on aesthetic and therapeutic skin care. We are the market leader in the growing physician-dispensed skin care channel, according to an independent 2007 study by Kline & Co., an independent market research firm. Our net sales have grown from approximately $35.6 million in 2001 to approximately $78.0 million in 2006 to $102.6 million for the year ended December 31, 2007.

We currently market and sell a range of systems and related products for the enhancement of skin health. Our leading product line is our Obagi Nu-Derm System. This system was launched in 1988, and since that time, we have made substantial enhancements to the system through the application of our Penetrating Therapeutics technology. We believe that our Obagi Nu-Derm System is the only clinically proven, prescription-based topical skin health system on the market that has been shown to enhance the skin's overall health by correcting photo- damage using drugs that, by definition, work at the cellular level, resulting in a reduction of the visible signs of aging.

In 2004, we launched the Obagi-C Rx System, which we believe is the only prescription-based system that reduces the early effects of sun damage and evens skin tones through the use of Vitamin C serum combined with 4% hydroquinone. We are the sole licensee of certain Avon patents relating to this technology. In 2005, we launched Professional-C, a series of high potency antioxidant Vitamin C serums that help to counteract the effects of ultraviolet radiation and other environmental influences. Professional-C represents an improved product line with more effective skin barrier penetration replacing our Vitamin C serum offerings marketed under the Cffectives and Obagi-C brands that we introduced in 2000.

In July 2006, we launched Obagi Condition and Enhance targeted for use with Botox (Botox is a registered trademark of Allergan, Inc.). This system provides adjunctive therapy following Botox injections, and is designed to enhance aesthetic outcomes and improve overall patient satisfaction.

In October 2006, we introduced the first product in the Obagi ELASTIdermâ„¢ ("ELASTIderm") product line, ELASTIderm Eye Cream, a nighttime eye cream for treatment of skin laxity around the eye. In February 2007, we launched a second product in the ELASTIderm line for daytime use, ELASTIderm Eye Gel, to use along with our ELASTIderm Eye Cream, as an eye therapy system. ELASTIderm products are formulated with a patent pending bi-mineral complex, which is clinically shown to help the body's own natural ability to increase epidermal thickness, augment hypodermal fat and increase elastin levels.

In February 2007, we launched Obagi CLENZIderm M.D.â„¢ ("CLENZIderm") for normal to oily skin, a system of products for acne treatment, featuring a novel formulation of Benzoyl Peroxide ("BPO"). Our clinical studies have shown that CLENZIderm M.D. penetrates more readily into the skin follicle than current creams or gels because it is in solution form. We believe that our solution-based acne system is a more effective treatment for acne because a greater amount of the active ingredient, BPO, will penetrate the hair follicle to more rapidly kill P. acne bacteria. In July 2007, we launched CLENZIderm M.D. for normal to dry skin.

In addition, we offer tretinoin, a generic equivalent to Retin-A, which has been among the most widely used acne treatments for approximately 25 years. We currently distribute a Food and Drug Administration ("FDA"), approved generic equivalent in the physician-dispensed skin care channel under an exclusive license agreement with Triax Pharmaceuticals, LLC ("Triax"). We also sell the Obagi Blue Peel which has been cited by Kline & Co. as one of the most well known brands for use in physician-strength facial peel procedures. While the Obagi Blue Peel products are not dispensed for daily home use in a system and are therefore not a significant source of our revenue, they are used to aid the physician in skin peeling activities. Acceptance and awareness of the Obagi Blue Peel among physicians give it an intrinsic value as a marketing tool in driving new account growth.

We believe that our products have the potential to be used in a number of applications and procedures beyond their current use. For example, our Obagi Condition and Enhance Systems may complement and enhance patient outcomes in commonly performed cosmetic procedures, such as Botox injections, as well as improve wound appearance and reduce the post-inflammatory hyperpigmentation that typically follows laser therapy and basal cell carcinoma excisions, and we are conducting clinical studies to evaluate the adjunctive use of our systems before and after these types of procedures. We expanded this initiative in 2005, and are working with physicians and physicians' associations to evaluate the use of our Obagi Nu-Derm System in enhancing skin healing in ablative and non-ablative laser procedures. In 2005 and 2006, we conducted a study of physician and patient evaluations of skin quality on patients using our Obagi Nu-Derm System in conjunction with other cosmetic facial procedures. Based on the results of this clinical use study of over 2,600 patients, we launched the Obagi Condition and Enhance Systems. These systems are positioned under the Obagi Condition and Enhance brand, with an initial focus on use in conjunction with Botox injections. We are using this data to evaluate possible individual clinical studies on the use of Obagi Condition and Enhance with specific procedures. We plan to continue to build clinical support for the benefits of our systems in conditioning the skin and enhancing the outcomes of the most commonly performed cosmetic procedures, such as chemical peels, dermabrasion, and laser resurfacing, as well as the aesthetic and wound healing aspects of surgical procedures such as basal cell carcinoma excisions.

We are engaged in an active development program using our Penetrating Therapeutics technology to enhance the efficacy of established FDA-approved and OTC active ingredients. Positive findings from completed pilot studies of these new systems may not be duplicated in the larger studies that we are currently completing, or the incidence of side effects in these larger studies may force us to reformulate our products. We will continue to seek additional market opportunities where we believe we can improve the effectiveness of existing products through the application of our Penetrating Therapeutics technology to address conditions such as acne, skin elasticity, rosacea, fungal infections, dermatitis, psoriasis, hair loss and hair removal.

We also advance our development objectives through product and license agreements with third parties. These agreements may include patent and technology licenses, product licenses and new product collaboration agreements. For example, we have developed and are continuing to develop products for the regeneration of elasticity in skin which are covered by claims contained in a patent application which we license from JR Chem LLC ("JR"). Our initial focus was centered on products applied around the eyes, and we will continue to focus on products applied on the neck and on the back of the hands, where the break down in skin elasticity is most visible in aging skin. The first products to result from our collaboration with JR are the products in our ELASTIderm product line. In addition, in December 2005, we entered into a product supply and collaboration agreement with Triax for the supply of certain of its tretinoin products and to provide Obagi-branded tretinoin products in various concentrations.

In the United States, we sell our systems and related products directly to physicians through our internal sales force, which as of December 31, 2007 consisted of 131 sales, marketing and education specialists, including 100 direct sales representatives and managers. Physicians dispense our products in-office, directly to their patients, a distribution method commonly referred to as the "physician-dispensed" channel. We believe that the physician-dispensed distribution model ultimately results in higher patient satisfaction because it is better suited to the provision of system-based skin care than traditional drug distribution channels. Our physician customer base consists primarily of plastic surgeons and dermatologists, but also includes an increasing number of physicians from other practice areas, such as internal medicine and obstetrics and gynecology ("OBGYN"), who are adding skin care to their practices.

As of December 31, 2007, we sold our products to approximately 5,200 accounts in the United States, which we believe represented over 8,000 individual practicing physicians. Based on a 2007 study by Kline & Co., we are the leading skin health company in the physician-dispensing channel, with an estimated 26.4% market share and nearly three times the market share of the next largest competitor. Outside the United States, we utilize distribution partners for the sale of our systems and related products. As of December 31, 2007, we currently have 13 distribution partners who sell our products through their own dedicated sales forces in approximately 36 countries.

We also compete in the Japanese retail skin care markets through a strategic licensing agreement with Rohto Pharmaceutical Co., Ltd. ("Rohto"). Rohto is a Japanese pharmaceutical manufacturer and distributor. Under our agreement, Rohto is licensed to manufacture and sell a series of OTC products under the Obagi brand name, including Obagi-C (a Vitamin C based topical serum in various concentrations), in the Japanese drug store channel and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto. We have other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel. Our net licensing revenue from skin health systems and products in Japan was approximately $4.7 million for the year ended December 31, 2007.

Background

Skin damage and disorders

The skin is the largest organ in the body, consisting primarily of two layers: the epidermis, a thin outer layer; and the dermis, a relatively thick inner layer. The epidermis is comprised of specialized cells such as keratinocytes and melanocytes. Keratinocytes are formed in the epidermis and travel to the skin's surface and are exfoliated, or shed off, as they die in a maturation cycle which normally takes approximately six weeks. Buildup of excess keratinocytes can result in rough, thick or dry skin. Melanocytes produce melanin, the pigment that determines skin color and protects the body from ultraviolet radiation. The dermis is comprised largely of connective tissue fibers made of collagen and elastin. Collagen is a tough, fibrous protein that helps give skin its strength and resiliency. Elastin is a tissue that helps maintain healthy skin tension and gives skin its shape, but does not readily regenerate post-puberty and degrades over time. As the elastin degrades, skin tone and elasticity become diminished, resulting in loose, sagging skin.

The health and appearance of a person's skin is impacted by a variety of intrinsic and extrinsic factors, including pre-mature aging, photo-damage, hormones, stress, pollutants, diets and skin diseases. These factors cause newly created cells to be damaged which leads to an increase in the skin cell maturation cycle. The result is that skin cells are disorganized and pigment cell activity is increased. The damaged epidermal cells cause a wide variety of conditions such as mottled pigmentation (varied pigment density across the skin), melasma (skin discoloration often caused by hormonal changes such as those from pregnancy), age spots, fine lines and dry thickened sallow skin. In the dermis of extrinsic or intrinsic aged skin, the amount of new collagen and elastin produced decreases, resulting in fibers that do not support the structure and the dermis becoming thinner. As a result deep lines, wrinkles and sagging skin make the appearance of skin significantly worse. Skin health is also impacted by diseases such as acne, rosacea, dermatitis, and psoriasis. Imbalanced production of skin oils such as sebum encourages accelerated growth of microbes in the skin such as Propionibacterium acnes ("P. acne"). The skin can also become host to viral or fungal infections.

While these conditions and diseases are not life-threatening, they are readily apparent, sometimes disfiguring, usually chronic, and can be debilitating in terms of a person's self image and confidence. As a result, people are often highly motivated to seek treatment programs to restore the look and feel of their skin.

The skin care market

In 2005, the global skin care market was estimated to be $36.2 billion, of which over 62% were facial skin care products, according to Global Industry Analysts, Inc., a market research firm. Additionally, the independent research firm, Kalorama Information, estimates that from 2005 to 2010, over 70 million people in the United States alone will receive cosmetic facial procedures for which they will pay over $60 billion. We believe this reflects a growing desire and acceptance among the aging population to seek aesthetic facial products and procedures from their physicians. A key driver of this trend is the aging of the "baby boomer" segment of the U.S. population. In addition, life expectancy in the United States has extended in recent years, leading to a further increase in the average age of the country's population. Because healthcare needs, including the treatment of skin disorders, tend to increase with age, we expect the demand for dermatologic products to continue to increase over time. In particular, women tend to demonstrate a higher motivation than men to improve their personal appearances. The number of women between the ages of 35 and 65, the primary users of our products, was estimated by the U.S. Census Bureau to have grown 30% between 1990 and 2006. With this segment's strong desire to reduce the signs of pre-mature aging, we expect the aging female population to continue to increase the market opportunity for skin care products.

Consumer demand for physician-dispensed skin care products and procedures has been steadily growing. We believe this growth is due to consumers realizing that many non-prescription consumer cosmetic products are unable to fully meet their needs. Consumers have increasingly turned to their physicians for products and simple in-office procedures that can provide better results than consumer cosmetics. For example, physician-directed cosmetic products and commonly performed cosmetic procedures such as Botox injections, laser hair removal and microdermabrasion (a cosmetic procedure that removes the outermost layer of the skin to promote skin rejuvenation), have experienced substantial growth as consumers learn that they can achieve positive cosmetic results with minimally invasive techniques. According to the American Society of Plastic Surgeons ("ASPS"), the number of minimally-invasive cosmetic office procedures performed increased 85% from approximately 4.9 million in 2002 to approximately 9.1 million in 2006. This increase was led by facial procedures such as Botox injections, up 264% in 2006 compared to 2002, and injectable fillers, increased 69% in 2006 compared to 2004.

Beyond anti-aging and aesthetic treatments, there is significant market demand for effective treatments of skin diseases such as acne, rosacea, psoriasis, and eczema (dermatitis). While a number of therapies and treatments exist for such diseases, most treatments consist of either topical applications with efficacy that is limited by their inability to cross the skin barrier effectively, or systemic (oral) applications that carry significant potential side effects.

According to Kline & Co., in 2007, there were approximately 45,000 physicians practicing dermatology and plastic surgery in the United States. Based on our experience with physicians who have opened accounts with us, we believe a growing number of general practice, family practice, and OBGYN physicians are continuing to dedicate resources in their practices to skin care. We believe that these physicians are responding to the rapid increase in consumer demand for non-invasive skin care treatments. Furthermore, many of these physicians are dispensing prescription and non-prescription skin care products directly to their patients. According to a 2007 Kline & Co. study, a combined number of approximately 11,200 of the physicians practicing dermatology and plastic surgery dispensed skin care products directly to their patients.

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

Limitations of traditional products and procedures

Most of the cosmetic skin care products and procedures available today are designed to mask the effects of aging and skin disorders, rather than treat the underlying health of the skin. As a result of using these cosmetic skin care products, consumers may see temporary skin surface improvements, but underlying skin restoration often does not occur. We believe that the limitations of traditional products and procedures result primarily from the following causes:

•
The outer layer of human skin is a highly effective protective barrier against the entry of foreign particles into the body. The active agents in many competing topical products and procedures lack the ability to effectively penetrate the skin barrier, reducing their ability to improve the health of the skin at the stratum corneum, epidermis and dermis level. The most commonly used skin care products are cosmetics by definition under the U.S. Food, Drug and Cosmetic Act ("FDCA"), consisting largely of surface covers and moisturizers, which only add water to the cells on the surface of the skin, providing superficial and temporary improvement in the appearance of the skin. Moisturizers are not capable of causing the skin to generate healthy new cells to replace older, damaged ones that make up the epidermis.

•
Most traditional approaches to skin care are not comprehensive programs designed to integrate complementary products. As a result, individual products, even those that are widely used by consumers (such as facial soaps or sunscreens) are not generally designed to work together, and therefore may cause unintended side effects or reduced effectiveness when used in combination. Furthermore, the range of skin types in any given patient population is highly varied and different skin types respond differently to treatment, yet few products are capable of treating the specific needs of the individual patient's overall skin health.

The Obagi Medical Products approach

We believe the effects of aging and skin disorders are best addressed not at the surface of the skin but at a deeper level, where the skin's natural regeneration processes occur. Our Obagi Nu-Derm and Obagi-C Rx Systems improve the overall health of the skin by improving cellular processes such as collagen and elastin production, keratinocyte clearing, and melanocyte regulation, using drugs that, by definition, work at the cellular level. With improved underlying skin health, we believe a patient's skin shows fewer signs of aging, is less susceptible to disease, and is better able to combat exposure to the elements. We have developed skin care systems that we believe address the limitations of traditional skin care products and procedures, including the following:

•
Our Obagi Nu-Derm and Obagi-C Rx Systems are drug-based systems designed to penetrate below the skin's surface to correct damage in all layers of the skin (the stratum corneum, the epidermis and the dermis) and accelerate cellular turnover. We have demonstrated in clinical studies that by enhancing the penetration of the intended active ingredient (tretinoin), more of this drug gets to the targeted tissue, improving patient outcomes. The increased penetration of a
system of active ingredients triggers a therapeutic cascade that (i) pushes fresher cells to the surface faster, resulting in smoother skin, reduced wrinkles and increased tolerance, (ii) corrects current hyperpigmentation (including freckles and age spots) and prevents the appearance of new hyperpigmentation, (iii) promotes more uniform cells at the deepest layer for better skin structure and balanced, even skin tone, (iv) helps stimulate collagen and elastin for firmer, more resilient skin, and (v) helps increase natural hydration and circulation for supple, healthy-looking skin.

•
To achieve improved skin health, our Penetrating Therapeutics technology integrates proprietary formulations of existing prescription and non-prescription skin care products into treatment programs specially designed and physician-tailored to address the unique needs of each patient's skin. The individual products within our systems are formulated to work synergistically using our proprietary Penetrating Therapeutics technology in formulations that enhance the stability and efficacy of what are often otherwise unstable molecules. When this system of products is applied within a physician directed protocol tailored to the patient's skin health needs, overall penetration of the active ingredient to the appropriate layer of skin is achieved, resulting in greater efficacy and improved patient outcomes.

Our business strategy

Our objective is to become the leading specialty pharmaceutical company dedicated to developing and commercializing systems that enable physicians to improve skin health at the cellular level. Key elements of our strategy include:

•
Leveraging the strength of our physician-dispensed marketing and distribution channel to increase market share and introduce new Obagi products . We believe that our market-leading position in the physician-dispensed skin care channel presents us with the opportunity to increase the market share of our existing products and to launch a range of new Obagi Systems and products. We have built long-term relationships with skin health professionals based on the success of our products during the 20 years since the first Obagi Systems and products were launched. We will continue our sales and marketing efforts aimed at helping physicians understand how our systems' products can meet growing patient demand for effective skin care treatments, thereby generating additional sources of revenue for physician practices. Furthermore, we believe that our systems' product offerings and our experienced sales force uniquely position us to benefit from growth in the number of physicians who dispense skin care products directly to their patients. According to Kline & Co., in 2007 only about 25% of the approximately 45,000 physicians practicing plastic surgery and dermatology in the United States dispense professional skin care products. According to the results of a study we sponsored by Wirthlin Worldwide Company, an additional 40% of non-dispensing surveyed plastic surgeons and dermotologists indicated that they are considering dispensing skin care products. Based on our experience with physicians who have opened accounts with us, we believe a growing number of general practice, family practice, and OBGYN physicians are also dedicating resources in their practices to skin care. We believe that these physicians are responding to the rapid increase in consumer demand for non-invasive skin care treatments. Furthermore, many of these physicians are already dispensing prescription and non-prescription skin care products directly to their patients.

•
Continuing to develop and market new indications for Obagi Systems . We believe a significant opportunity exists to use current Obagi Systems as non-invasive adjunctive therapies to improve certain current skin care procedures, resulting in overall better patient outcomes and satisfaction. Many cosmetic procedures are limited in their ability to provide healthier skin and an overall enhanced aesthetic outcome. For example, Botox injections for reducing wrinkles have no effect on the skin's color, hyperpigmentation, age spots, acne or the overall health of the skin. We believe patients who are treated with our Obagi Systems following Botox injections will achieve greater overall aesthetic outcomes and satisfaction. We conducted a clinical study to evaluate the adjunctive use of our systems before and after these types of procedures, and based on outcomes for over 2,600 patients, we launched the Obagi Condition and Enhance Systems, which have an initial focus on use in conjunction with Botox injections. We plan to continue to build clinical support for the benefits of our systems in conditioning the skin and enhancing the outcomes of the most commonly performed cosmetic procedures, such as chemical peels, dermabrasion and laser resurfacing.

•
Creating additional clinically proven Obagi Systems that increase the efficacy of commonly prescribed dermatological agents in addressing new areas of skin disease . We focus our research and development efforts on increasing the ability of FDA-allowed skin agents to penetrate the skin barrier, thereby increasing the effectiveness of such agents within the Generally Recognized As Safe, ("GRAS"), OTC or Drug Efficacy Study Indication ("DESI"), classification as defined by the FDA. This approach accelerates the commercialization timeline and avoids the lengthy clinical development processes typically required to obtain new drug approvals. We intend to further differentiate our products and systems by supporting them with randomized and comparative clinical studies conducted by leading experts in the markets in which we are developing products. Supporting this strategy we initiated an aggregate of 18 clinical studies in 2005 and 2006 in the areas of acne and elasticity, and we initiated eight clinical studies in 2007 in the areas of acne and aesthetics.

•
Establishing new strategic collaborations and relationships . We intend to continue accessing new and complementary products through in-licensing, strategic collaborations and strategic acquisitions. We also intend to explore new product distribution partnerships in high growth channels such as the spa and salon channel, in which manufacturers' sales of skin care products are estimated at over $508 million in 2007, according to Kline & Co. We plan to target new products and channels, which will expand the Obagi brand and Obagi System concept but will not compete directly with the physician-dispensed skin care channel or products. We believe that skin health professionals will be receptive to new products we introduce under the Obagi brand name, and that the brand credibility that exists among skin health professionals will allow for more rapid trial and acceptance. This belief is supported by a 2003 study we sponsored by Wirthlin Worldwide Company of 1,000 medical professionals (primarily consisting of plastic surgeons, dermatologists, and medical skin care professionals), which found that the Obagi brand had the highest total awareness, at 97%, among leading physician-dispensed brands.

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Continuing to expand intellectual property protection . Our intellectual property protection is based on a combination of issued patents, patent applications, licensed patents, licensed product methods and technologies and trade secrets. As of December 31, 2007, we were the sole licensee of four patents, and have filed 39 U.S. provisional and non-provisional patent applications since the beginning of 2004. We will continue to pursue additional invention and method patents as we find new applications and improvements to our existing intellectual property. We also pursue an aggressive trademark registration policy as a means to increase brand recognition and product differentiation in the market.

Our Obagi Systems and Related Products

We currently market and sell our systems and related products to physicians for the treatment of age-related skin disorders, incorporating a range of individual prescription and non-prescription therapeutic agents, as well as cosmetic ingredients. The individual components of each system have been formulated to complement one another, enhancing the effectiveness of the system as a whole and allowing the physician to tailor the treatment program to the specific needs of the patient.

COMPENSATION

Elements of Compensation

To achieve the compensation committee's objectives, our compensation plan must serve three primary purposes. First, it must be competitive. In 2008, competitive means targeting total compensation, in the aggregate (i.e., including base pay, short-term incentives, long-term incentives and benefits) in a manner that is in line with the sixty-fifth percentile of comparable executives in the peer groups as an initial benchmark. Individual targets are equitably set on the same basis, compared to both peers and internal benchmarks. Secondly, it should provide compensation that varies based on our Company's performance and the individual performance of each executive. Third, it should align each participant's interests with our stockholders. The principal components of executive compensation consist of the following elements:

Base Salary. Base salaries are provided to our executives to compensate them for services rendered during the fiscal year. Base salaries for our executives are established based on the scope of their responsibilities and their individual performance. Generally, we believe that executive base salaries should be in line with our compensation philosophy. Base salaries are reviewed annually, and adjusted from time to time to realign salaries after taking into account individual responsibilities, performance and experience. For 2007, this review occurred in the first quarter at which time the compensation committee approved a cost of living salary increase of five percent for each of our executive officers, except for David Goldstein, our Executive Vice President, Global Sales and Field Marketing, who received a cost of living and performance increase of 10%. In February 2008, our compensation committee approved an increase in the base salary of Mr. Carlson from $415,000 to $500,000. Our compensation committee increased Mr. Carlson's salary for fiscal 2008 after considering his individual performance and contributions, our overall financial performance and the relevant market data. In addition, in February 2008, our compensation committee granted Mr. Goldstein a four percent increase in his base compensation from $284,000 to $295,360 because it determined that his base salary was below the levels of comparable positions in companies comparable to our Company. Our compensation committee is currently working with the Compensation Venture Group to evaluate the base salaries of our executive officers using the same criteria as it used for Mr. Carlson. This evaluation may result in adjustments to our executive officers' salaries in 2008.

Annual Bonus. In August 2007, our compensation committee through a subcommittee approved the Obagi System 2007 Performance Incentive Plan, or the 2007 Plan, an incentive compensation program for fiscal year 2007 under our 2005 Stock Incentive Plan. The 2007 Plan was designed to motivate, retain and reward our employees based on the achievement of corporate revenue and adjusted EBIT (or earnings before interest and taxes adjusted to exclude the impact of non-cash charges relating to the issuance of equity instruments) objectives and individual objectives.

Eligible participants under the 2007 Plan were full-time employees, including executive officers, who did not participate in sales or other variable incentive pay plans and were employed by us on December 31, 2007 and on the date the amounts were paid under the 2007 Plan. The 2007 Plan superseded any bonus or incentive pay components in offer letters or employment agreements of 2007 Plan participants.

Our compensation committee established target revenue and adjusted EBIT objectives that were aggressive and were not fully met in fiscal 2007 and no bonuses were awarded to our executive officers under the 2007 Plan for fiscal 2007. If 100% achievement of such target revenue and adjusted EBIT objectives were met, the aggregate Plan pool would have been funded in the amount of $2,075,000. If the revenue and adjusted EBIT objectives were exceeded, an increased amount would have been funded to the 2007 Plan pool, up to 150% of the target 2007 Plan pool. Thirty percent of the Plan 2007 pool would have been related to the revenue objective and 70% of the 2007 Plan pool would have been related to the adjusted EBIT objective. For executives to have earned any bonuses under the 2007 Plan, we had to achieve at least 92.5% of the revenue objective and at least 92.5% of the adjusted EBIT objective.

In the event that the revenue and adjusted EBIT objectives were sufficiently achieved to fund the 2007 Plan pool, the 2007 Plan participants would have been eligible to receive individual incentive awards as established by our compensation committee based on achievement of individual and in some cases Company objectives and paid out of the 2007 Plan pool. Our compensation committee established individual target bonus amounts calculated as a percentage of the participant's base salary. Eligible participants under the 2007 Plan were full-time employees, including executive officers, who did not participate in sales or other variable incentive pay plans and were employed by us on December 31, 2007 and the date any amount would have been paid under the 2007 Plan. The 2007 Plan superseded any bonus or incentive pay components in offer letters or employment agreements of 2007 Plan participants.

In April 2008, our compensation committee approved the Obagi System 2008 Performance Incentive Plan, or the 2008 Plan, which is an incentive compensation program for fiscal year 2008 under the 2005 Stock Incentive Plan. It amends and restates and is the successor plan to the 2007 Plan. The 2008 Plan is also designed to motivate, retain and reward our employees based on the achievement of corporate revenue and adjusted EBIT objectives and individual objectives.

Our compensation committee will establish target revenue and adjusted EBIT objectives. Assuming 100% achievement of the target revenue and adjusted EBIT objectives, the aggregate 2008 Plan pool will be funded in the amount of $2,436,000, an increase from the 2007 Plan's target of $2,075,000. If the revenue and adjusted EBIT objectives are exceeded, an increased amount will be funded to the 2008 Plan pool, up to 150% of the 2008 target Plan pool. Thirty percent of the 2008 Plan pool will relate to the revenue objective and 70% of the 2008 Plan pool will relate to the adjusted EBIT objective. For the 2008 Plan to be funded for executives to earn any bonuses, we must achieve at least 92.5% of the revenue objective and at least 92.5% of the adjusted EBIT objective.

In the event that the revenue and adjusted EBIT objectives are sufficiently achieved to fund the 2008 Plan pool, the 2008 Plan participants may be eligible to receive individual incentive awards as established by our compensation committee based on achievement of individual and in some cases Company objectives. Such awards will be paid out of the 2008 Plan pool.

Eligible participants under the 2008 Plan are full-time employees, including executive officers, who do not participate in sales or other variable incentive pay plans and are employed by us on December 31, 2008 and on the date any amount is paid under the 2008 Plan, unless such participant is on a leave of absence, disable or deceased. The 2008 Plan supersedes the 2007 Plan and any bonus or incentive pay components in offer letters or employment agreements of 2008 Plan participants, unless otherwise explicitly set forth in the 2008 Plan participants' employment agreements.

Long-Term Incentive Program. We believe that positive long-term performance is achieved through an ownership culture that encourages such performance by our executive officers through the use of stock and stock-based awards. Our stock compensation plans have been established to provide certain of our employees, including our executive officers, with incentives to help align those employees' interests with the interests of stockholders and to retain our executives. Our compensation committee believes that the use of stock and stock-based awards offers the best approach to achieving our compensation goals. We have not adopted stock ownership guidelines and our stock compensation plans have provided the principal method for our executive officers to acquire equity or equity-linked interests in the Company.

Options. Our 2005 Stock Incentive Plan authorizes us to grant options to purchase shares of common stock to our employees, directors and consultants. Our compensation committee is the administrator of the stock option plan. Our compensation committee reviews and approves stock option awards to executive officers based upon a review of competitive compensation data, its assessment of individual performance, a review of each executive's existing long-term incentives, and retention considerations. Periodic stock option grants are made at the discretion of the compensation committee to eligible employees and, in appropriate circumstances, the compensation committee considers the recommendations of members of management, such as Mr. Carlson. Stock option grants are also made at the commencement of employment and, occasionally, following a significant change in job responsibilities or to meet other special retention or performance objectives. Stock options granted by us have an exercise price equal to the fair market value of our common stock on the day of grant, typically vest 33% per annum based upon continued employment over a three-year period, and generally expire 10 years after the date of grant. Incentive stock options also include certain other terms necessary to assure compliance with the Internal Revenue Code of 1986, as amended.

In February 2008, our compensation committee, after considering the individual performance and contributions of Mr. Carlson, our overall financial performance and the relevant market data, approved a stock option grant to Mr. Carlson of 225,000 options at an exercise price of 125% of the fair market value of our common stock on the date of grant. Eleven percent of such options will vest on the first anniversary of the option grant date, 22% on the second anniversary, 33% on the third anniversary, 22% on the fourth anniversary and 12% on the fifth anniversary. The date of grant will be that date in 2008 on which a decision is made with respect to option grants to our senior executive team for their performance in 2007. These performance options are intended to be a long-term incentive for Mr. Carlson to increase stockholder value. It is our compensation committee's present intention that no additional performance option grants be awarded to Mr. Carlson within the next three years. In addition, in February 2008, our compensation committee granted Mr. Goldstein an option to purchase 20,000 shares of our common stock vesting ratably one third on each of the first, second and third anniversaries of the date of grant, at an exercise price of the fair market value of our common stock on the date of grant, because it determined that his equity compensation was below the levels of comparable positions in companies comparable to our Company.

Stock Appreciation Rights. Our 2005 Stock Incentive Plan authorizes us to grant stock appreciation rights, or SARs. A SAR represents a right to receive the appreciation in value, if any, of our common stock over the base value of the SAR. The base value of each SAR equals the value of our common stock on the date the SAR is granted. Upon surrender of each SAR, unless we elect to deliver common stock, we will pay an amount in cash equal to the value of our common stock on the date of delivery over the base price of the SAR. SARs typically vest based upon continued employment on a pro-rata basis over a three-year period, and generally expire ten years after the date of grant. Our compensation committee is the administrator of our stock appreciation rights plan. To date, no SARs have been awarded to any of our executive officers. We have the right to convert outstanding SARs into stock options.

Restricted Stock and Restricted Stock Units. Our 2005 Stock Incentive Plan authorizes the compensation committee to grant restricted stock and restricted stock units, subject to restrictions which lapse in installments or as our compensation committee deems appropriate. Shares of common stock that are subject to restrictions will be forfeited to and reacquired by us if the recipient's employment or service terminates.

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

We are a specialty pharmaceutical company focused on the aesthetic and therapeutic skin health markets. We develop and commercialize prescription-based, topical skin health systems that enable physicians to treat a range of skin conditions, including pre-mature aging, photo-damage, skin laxity, hyperpigmentation, acne and soft tissue deficits, such as fine lines and wrinkles.

Current products. Our primary product is the Obagi Nu-Derm System, which we believe is the only clinically proven, prescription-based, topical skin health system on the market that has been shown to enhance the skin's overall health by correcting photo-damage at the cellular level, resulting in a reduction of the visible signs of aging. The primary active ingredients in this system are 4% hydroquinone and OTC skin care agents. In April 2004, we introduced the Obagi-C Rx System consisting of a combination of prescription and OTC drugs and adjunctive cosmetic skin care products to treat skin conditions resulting from sun damage and the oxidative damage of free radicals. The central ingredients in this system are 4% hydroquinone and Vitamin C. In October 2005, we launched the Obagi Professional-C products, a complete line of proprietary, non-prescription products, which consists of Vitamin C serums used to reduce the appearance of damage to the skin caused by ultraviolet radiation and other environmental influences. In July 2006, we launched our Obagi Condition and Enhance System, for use in conjunction with commonly performed cosmetic procedures including Botox ® injections. In October 2006, we launched our first product in the ELASTIderm™ product line, an eye cream for improving the elasticity and skin tone around the eyes. We introduced the CLENZIderm M.D.™ system and a second product in the ELASTIderm™ system to address acne and skin elasticity, respectively, based on positive interim clinical results, in February 2007. In July 2007, we launched our second system in the CLENZIderm M.D. line, CLENZIderm M.D. System II, that is specifically formulated for normal to dry skin. In August 2007, we launched two new Nu-Derm Condition and Enhance Systems. One is designed specifically for use with non-surgical procedures while the other has been developed for use with surgical procedures. We also market tretinoin, used for the topical treatment of acne in the United States, and Obagi Blue Peel products, used to aid the physician in the application of skin peeling actives.

Future products. We focus our research and new product development activities on improving the efficacy of established prescription and OTC therapeutic agents by enhancing the penetration of these agents across the skin barrier using our proprietary technologies collectively known as Penetrating Therapeutics. There can be no assurance that we will be able to introduce any additional systems using these technologies.

U.S. distribution. We market all of our products through our direct sales force in the United States primarily to plastic surgeons, dermatologists and other physicians who are focused on aesthetic skin care.

Aesthetic skin care. As of December 31, 2007, we sold our products to over 5,200 physician-dispensing accounts in the United States, with no single customer accounting for more than 5% of our net sales. Our current products are not eligible for reimbursement by Medicare or other third-party payors. We generated U.S. net sales of $87.0 million and $63.9 million during the years ended December 31, 2007 and 2006, respectively.

International distribution. We market our products internationally through 13 international distribution partners that have sales and marketing activities in 36 countries outside of the United States. Much like our business model in the United States, these distributors sell our products through direct sales representatives to physicians, or through alternative distribution channels depending on regulatory requirements and industry practices. We generated international net sales of $11.0 million and $10.0 million during the years ended December 31, 2007 and 2006, respectively.

Licensing. We market our products in the Japanese retail markets through a trademark and know-how license agreement with Rohto. Under our agreement, Rohto is licensed to manufacture and sell a series of OTC products under the Obagi brand name in the Japanese drug store channel, and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto. Rohto's Obagi branded products are sold through approximately 5,000 high-end drug stores. We have other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel. We receive royalties based upon these arrangements. We generated licensing revenue of $4.7 million and $4.1 million during the years ended December 31, 2007 and 2006, respectively.

Sales growth. Our total net sales have grown from $78.0 million for the year ended December 31, 2006 to $102.6 million for the year ended December 31, 2007. Our sales growth has been driven primarily by:

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Our professional marketing efforts to physicians. Our professional sales force targets physicians who are providing aesthetic treatments and educates them on how to best provide our products to their patients. Our professional sales force also provides education to physicians, aestheticians, other staff and patients about the benefits of promoting skin health. We have increased our sales force from 96 employees as of January 1, 2006 to 118 employees as of December 31, 2007. We will continue to invest in expanding our sales force as warranted by the success of new product offerings and continued core product growth.

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Strong growth in the aesthetic skin care market. In 2005, the global skin care market was estimated to be $36.2 billion, of which over 62% were facial skin care products, according to Global Industry Analysts, Inc., a market research firm. Additionally, the independent research firm, Kalorama Information, estimates that from 2005 to 2010, over 70 million people in the United States will receive cosmetic facial procedures for which they will pay over $60 billion. We believe this reflects a growing desire and acceptance among the aging population to seek aesthetic facial products and procedures from their physicians. With our leading position in the physician-dispensed channel, the clinically proven aesthetic benefits of our products and the potential of our systems to enhance or complement many other facial procedures, we believe we are well positioned to meet this growing patient demand.

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Conducting clinical studies on our products. We have completed 37 clinical studies since 2003 to demonstrate the efficacy of our products. We believe that these clinical studies provide our products added scientific credibility in the physician-dispensed market. We are currently conducting four clinical studies on new and existing products and plan on initiating six additional clinical studies by December 31, 2008.

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International. We have formal distribution agreements with 13 distribution partners covering over 50 countries and a trademark and product know-how license agreement in the OTC market of Japan. Currently, those distributors have sales activities in approximately 36 countries, with growth in 2006 and 2007 coming primarily from the Middle East, Far East, Europe, and North America (excluding the United States).

Results of operations. We commenced operations in 1997, and as of December 31, 2007, we had an accumulated deficit of $6.0 million. The accumulated deficit arose when we paid a $63.1 million common stock dividend in February 2005. At December 31, 2004, we had accumulated earnings of $20.4 million. We reported net income of $15.2 million and $6.1 million for the years ended December 31, 2007 and December 31, 2006, respectively.

Seasonality. Sales of our products have historically been higher between September and March. We believe this is due to increased product use and patient compliance during these months. We believe this increased usage and compliance relates to several factors such as higher patient tendencies toward daily compliance inversely proportionate to their tendency to travel and/or engage in other disruptive activities during summer months. Patient travel and other disruptive activities that affect compliance are at their peak during July and August.

Economy. Many treatments in which our products are used are considered cosmetic in nature, are typically paid for by the patient out of disposable income and are not subject to reimbursement by third-party payers such as health insurance organizations. As a result, we believe that our future sales growth may to some extent be influenced by the economic conditions within the geographic markets we sell our products. Historically, we have not been able to quantify with any degree of certitude the impact, if any, economic conditions have had on our sales. We believe, however, that the aesthetic nature of our products, the desire to maintain a healthy and youthful appearance and the demographics of the patients that use our products should limit the negative impact on our sales assuming any such economic downturn is not severe.

Future growth. We believe that our future growth will be driven by increased direct sales coverage, ongoing marketing efforts to create increased awareness of the Obagi brand and the benefits of skin health and new product offerings. We plan to continue to invest significant resources on the commercialization of new applications of our current products, the continuing development of our pipeline products and the in-licensing or acquisition of new product opportunities. Our on-going profitability is primarily dependent upon the continued success of our current product offerings.

Critical accounting policies and use of estimates

Our discussion and analysis of our financial condition and results of operations is based upon our financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, sales and expenses, and disclosures of contingent assets and liabilities at the date of the financial statements. On a periodic basis, we evaluate our estimates, including those related to revenue recognition, sales return reserve, accounts receivable, inventory and goodwill and other intangible assets. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. By their nature, these estimates are subject to an inherent degree of uncertainty. As a result, we cannot assure you that actual results will not differ significantly from estimated results. Our significant accounting policies are further described in Note 2 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue recognition. We recognize revenues in accordance with Securities and Exchange Commission ("SEC") Staff Accounting Bulletin ("SAB") No. 104 ("SAB No. 104"), Revenue Recognition in Financial Statements, which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB No. 104 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies. We recognize revenue when (i) persuasive evidence of an arrangement exists, (ii) shipment of products has occurred or services have been rendered, (iii) the sales price charged is fixed or determinable and (iv) collection is reasonably assured. Our shipment terms are FOB shipping point as outlined in our sales agreements.

Our domestic sales agreements do not provide for rights of return or price protection. However, we may approve returns on a case-by-case basis at our discretion. Certain international distribution agreements do provide for rights of return and price protection. Generally, such return rights are for a period of not more than 90 days after the products have been shipped to the distributors. In accordance with SFAS No. 48, Revenue Recognition When Right of Return Exists, we continuously monitor and track product returns and record a provision for the estimated future amount of such future returns, based on historical experience and any notification we receive of pending returns. We do not grant any warranty provisions on our products. We provide for discounts and allowances based on historical experience at the time revenue is recognized as a reduction to revenue. To date such provisions have approximated management's estimates. Other than our provision for future returns, the only estimates that we have to make regarding revenue recognition pertain to the collectability of the resulting receivable, both of which are discussed below.

We grant price protection rights to certain international distributors. Such price protection rights require us to pay the distributor if there is a reduction in the list price of our products. Price protection payments would be required for the distributor's inventory on-hand or in-transit on the date of the price reduction, for a period not to exceed 90 days prior to the date of the price reduction. We have not recorded a liability in connection with such price protection rights as we have never reduced the list prices of our products.

In September 2002, we entered into a licensing agreement with Rohto (see Note 8 to our financial statements), a large Japan-based company that specializes in the distribution and marketing of OTC medical oriented products in the drug store and retail channels. In January 2006, we entered into a licensing agreement with Tokyo Beauty Center (see Note 8), a diversified Japanese consumer products and services company, which also owns and operates a large chain of aesthetic spas in Japan. Royalty revenue is recognized as earned and is based upon a predetermined rate within the respective licensing agreement.

Sales returns and allowances. When we sell our products, we reduce the amount of revenue recognized from such sales by an estimate of future product returns and other sales allowances. Sales allowances include cash discounts, rebates and sales incentives relating to products sold in the current period. Factors that are considered in our estimates regarding sales returns include the historical rate of returns and current market conditions. We maintain a return policy that allows our customers to return product within a specified period after shipment of the product has occurred. Factors that are considered in our estimates regarding sales allowances include quality of product and recent promotional activity. If actual future experience for product returns and other sales allowances exceed the estimates we made at the time of sale, our financial position, results of operations and cash flow would be negatively impacted. To date, such provisions have approximated management's estimates.

Accounts receivable. We perform periodic credit evaluations of our customers and adjust credit limits based upon payment history and the customer's current creditworthiness, as determined by our review of current credit information. We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. Receivables are charged to the allowance for doubtful accounts when an account is deemed to be uncollectible, taking into consideration the financial condition of the customer and the value of any collateral. Recoveries of receivables previously charged off as uncollectible are credited to the allowance. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments and this exceeds our estimates of the balance sheet date, we would need to charge additional receivables to our allowances, and our financial position, results of operation and cash flow would be negatively impacted. Our credit losses have historically been within our expectations and the allowance established.

Inventory. We state our inventories at the lower of cost or market, computed at actual cost on a first-in, first-out basis and market being determined as the lower of replacement cost or net realizable value. Inventory reserves are established when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory reserves are measured as the difference between the cost of inventory and estimated market value. Inventory reserves are charged to cost of sales and establish a lower cost basis for the inventory. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology, new product offerings and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins. To date, actual reserve requirements approximated management's estimates.

Goodwill and other intangible assets. Effective January 1, 2002, we adopted SFAS No. 142 ("SFAS No. 142"), Goodwill and Other Intangible Assets, which requires, among other things, the use of a nonamortization approach for purchased goodwill and certain intangibles. Under a nonamortization approach, goodwill and intangibles having an indefinite life are not amortized, but instead will be reviewed for impairment at least annually or if an event occurs or circumstances indicate the carrying amount may be impaired. Events or circumstances which could indicate an impairment include a significant change in the business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in our strategy or disposition of a reporting unit or a portion thereof. Goodwill impairment testing is performed at the reporting unit level.

Results of operations

The year ended December 31, 2007 compared the year ended December 31, 2006

Net sales increased by $24.6 million, or 32%, to $102.6 million during the year ended December 31, 2007, as compared to $78.0 million during the year ended December 31, 2006. During the year ended December 31, 2007, we experienced Nu-Derm sales growth of $8.3 million. In addition, we saw sales growth of $1.4 million and $2.6 million in the Vitamin C and Other categories, respectively. The two product categories formally launched in 2007, Skin laxity and Therapeutic, increased $6.1 million and $5.6 million, respectively. Licensing fees increased $0.6 million during the year ended December 31, 2007. Our sales growth was comprised of $23.1 million of growth in the United States and $1.5 million in growth from international markets. U.S. growth was fueled by the overall growth in the skin care market, the recent launch of two new product lines and the expansion of our sales force. Over 83% of the product category sales growth experienced was attributable to unit volume growth. The Nu-Derm product category growth was largely driven by the expansion of our sales force, the promotional and educational efforts of our professional sales force and the launch of Nu-Derm Condition and Enhance for Botox® in July 2006 and the launch of two Condition and Enhance Systems in August 2007, which on a combined basis contributed $9.1 million. The growth in the Vitamin C category was primarily driven by the strong sales performance by the Obagi-C Rx product line. The Skin laxity product category growth was due to a full year of sales of our ELASTIderm Eye Cream product during the year ended December 31, 2007 as compared to only 3 months during the year ended December 31, 2006 and the February 2007 launch of the second product in the category, ELASTIderm Eye Gel. The Therapeutic product category growth is attributable to the official launch of our CLENZIderm™ product line in February 2007 and the launch of the second CLENZIderm system in July 2007. The Other product category growth was driven by the continued success of our system approach concept launched in early 2005. The system approach is designed to educate physicians on the benefits of prescribing the complete Nu-Derm system as opposed to partial systems. International sales growth was primarily in the Skin laxity, Vitamin C and Therapeutic product lines and primarily came from four regions, $0.5 million from the Europe and Other region, $0.2 million from North America excluding the United States, $0.1 million from the Middle East, and $0.1 million from the Far East. Our licensing fees increased $0.6 million primarily due to fees received under our agreement with Rohto.

Gross margin percentage. Our gross margin percentage decreased to 82.4%, for the year ended December 31, 2007 compared to 82.7% for the year ended December 31, 2006, primarily as a result of: (i) the $5.6 million increase in Therapeutic sales, which solely consist of our CLENZIderm product line that has a lower gross margin compared to our other product line offerings; (ii) start up manufacturing costs for the BPO serum gel burden on the initial units produced and sold; and (iii) a decline in our Vitamin C margin due to a reserve for obsolete inventories arising from product reformulation of approximately $0.1 million. This was partially offset by improved margins on products in our Other product line due to new contract volume purchasing discounts with the manufacturer. Although we anticipate gaining efficiency in our manufacturing processes for CLENZIderm, we believe our margins will remain slightly lower in the near future as we ramp up the sales volume of our CLENZIderm product line. Cost of sales also consists of outbound shipping and handling, work order scrap, licensing and royalty fees related to licensed intellectual property, depreciation and amortization attributable to products sold, and an inventory reserve for shrinkage and write-downs.

Selling, general and administrative. Selling, general and administrative expense consists primarily of salaries and other personnel-related costs, professional fees, insurance costs, stock based compensation, depreciation and amortization not attributable to products sold, warehousing costs, advertising, travel expense and other selling expenses. Selling, general and administrative expenses increased $10.5 million to $51.4 million during the year ended December 31, 2007, as compared to $40.9 million for the year ended December 31, 2006. This increase is primarily due to the following: (i) a $5.5 million increase due to the hiring of additional employees, largely direct sales and administrative support personnel, during the year ended December 31, 2007, as compared to the year ended December 31, 2006; (ii) a $1.3 million increase in expenses for physician training, practice building and patient acquisition; (iii) $1.2 million increase primarily consisting of market research targeting physicians and patients and for product development; (iv) a $1.1 million increase in non-cash compensation expense due to the adoption of SFAS No. 123R on January 1, 2006; (v) a $1.1 million increase due to expenses related to the secondary offering completed in October 2007; (vi) a $0.7 million increase in insurance; (vii) a $0.5 million increase in volume driven activities; (viii) a $0.5 million increase in operational and manufacturing support activities; (ix) a $0.2 million increase in depreciation and amortization; and (x) a $0.1 million increase in advertising costs; offset by, (i) a $1.0 million decrease in expenses relating to operating as a public company; (ii) a $0.4 million decrease in management fees; and (iii) a $0.3 million decrease in professional fees. As a percentage of net sales, selling, general and administrative expenses in the year ended December 31, 2007 were 50% as compared to 52% in the year ended December 31, 2006. We expect to incur additional operating costs, such as professional fees and insurance costs, related to the growth of our business. However, we believe selling, general and administrative expenses will decrease as a percentage of net sales.

Research and development. Research and development expenses decreased $0.4 million to $5.5 million for the year ended December 31, 2007 as compared to $5.9 million for the year ended December 31, 2006. This decrease is primarily due to a one-time payment of $0.4 million to Dr. Zein Obagi, or Dr. Obagi, one of our principal stockholders and one of our former officers and directors, under a non compete agreement during the year ended December 31, 2006. There were no such payments made in 2007. As a percentage of net sales, research and development costs in the year ended December 31, 2007 were 5% as compared to 8% in the year ended December 31, 2006.

Interest income and Interest expense. Interest expense was $2.4 million during the year ended December 31, 2007, as compared to $8.2 million for the year ended December 31, 2006. The decline is primarily attributable to the prepayment of $35.0 million in debt with the net cash proceeds received in our initial public offering completed in December 2006. During the year ended December 31, 2007 we made $23.5 million in prepayments, $7.0 million of which came from the net proceeds received in our secondary public offering completed in October 2007, in addition to our regularly scheduled payments of $0.8 million and an excess cash payment of $1.3 million. The additional prepayments resulted in a complete paydown of our outstanding debt. Interest income increased $177,000 to $190,000 during the year ended December 31, 2007, as compared to $13,000 for the year ended December 31, 2006. The increase is primarily due to an increase in our average cash balance to $8.6 million during the year ended December 31, 2007, compared to $4.1 million during the year ended December 31, 2006.

Income taxes. Income tax expense increased $6.8 million to $10.3 million for year ended December 31, 2007, as compared to $3.5 million for the year ended December 31, 2006. Our effective tax rate increased 4% to 40% for the year ended December 31, 2007, compared to 36% for the year ended December 31, 2006. The increase is primarily due to the decrease in the tax benefit, as a percentage of net income, derived from the research and development credit and certain costs incurred during the secondary offering completed in October 2007 not being deductible for tax purposes during the year ended December 31, 2007.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of operations

The three months ended March 31, 2008 compared to the three months ended March 31, 2007

Net sales increased by $2.3 million, or 10%, to $25.4 million during the three months ended March 31, 2008, as compared to $23.0 million during the three months ended March 31, 2007. Overall, the economic conditions within the United States (U.S.) had a negative impact on our revenue growth performance during the three months ended March 31, 2008, which we believe is attributable to reduced patient visits, reduced aesthetic procedures being performed and reduced patient disposable income. The effect was more pronounced in our larger customers. Our smaller U.S. customer sales have also been impacted but to a lesser degree. The perceived U.S. economic slow down effect was seen in all product categories but was more pronounced within the Nu-Derm product line. During the three months ended March 31, 2008, we experienced Nu-Derm sales decline of $1.1 million. We saw a combined sales growth of $0.6 million in the Vitamin C and Other product categories. We had a total of $2.4 million increase in Elasticity sales resulting from the launch of our ELASTIderm™ Décolletage product and $0.1 million from the CLENZIderm ™ product within the Therapeutic product category. Licensing fees increased by $0.4 million. This aggregate sales growth was comprised of $1.8 million in the United States and $0.5 million from international markets. U.S. growth was fueled by the recent launch of two new product lines. Over 34% of the core product category sales growth experienced was attributable to an increase in our unit volumes. The Nu-Derm product category decline was largely driven by the current perceived U.S. economic slow down and the focusing of our sales force on the launch ELASTIderm™ Décolletage. The growth in the Vitamin C category was primarily due to strong sales performance by the Professional-C product line. The Elasticity product category growth was driven by the launch of Décolletage, our new system within the ELASTIderm product line, in January 2008 that focuses on restoring the elasticity of the neck and chest area. CLENZIderm, the primary product in our Therapeutic product category, was launched in February 2007, with a second system launched in July 2008. The Therapeutic category increased by $0.1 million due to the effect of the perceived U.S economic slow down and being compared to a launch period, which would include higher levels of initial stocking order volume. The Other product category growth was driven by a sales focused system approach. The system approach is designed to educate physicians on the benefits of prescribing the complete Nu-Derm system as opposed to partial systems. International sales growth was primarily in the Elasticity and Therapeutic categories and primarily came from two regions; $0.3 million from the Middle East and $0.1 million from North America excluding the United States. This growth was offset by a decline in the Far East region of $0.3 million. Our licensing fees increased $0.4 million due to the launch of rebranded Vitamin C products by our Japan partner Rohto. We believe, depending upon its duration and severity, that a continued U.S. economic slow down may negatively impact our future net sales.

Gross margin percentage. Our gross margin percentage decreased to 81.4%, for the three months ended March 31, 2008 compared to 82.8% for the three months ended March 31, 2007, primarily as a result of: (i) promotional incentives associated with the launch of ELASTIderm Décolletage; (ii) change in our product mix, which has historically been dominated by our Nu-Derm product line; and (iii) an $0.1 million increase in product costs related to our "purchase with purchase" promotion during the three months ended March 31, 2008. These were partially offset, by an increase in licensing fees, which have the highest margins. We believe our margins will increase slightly during the remaining three quarters of the year as (i) we expect to gain efficiencies in our new product line offerings; and (ii) our promotions associated with the launch of ELASTIderm Décolletage were only in effect during the three months ended March 31, 2008; and (iii) the sales force returns to a more balanced focus across all product lines. Cost of sales also consists of outbound shipping and handling, work order scrap, licensing and royalty fees related to licensed intellectual property, depreciation and amortization attributable to products sold, and an inventory reserve for shrinkage and write-downs.

Selling, general and administrative. Selling, general and administrative expenses consist primarily of salaries and other personnel-related costs, professional fees, insurance costs, stock-based compensation, depreciation and amortization not attributable to products sold, warehousing costs, advertising, travel expense and other selling expenses. Selling, general and administrative expenses increased $2.0 million to $14.3 million during the three months ended March 31, 2008, as compared to $12.3 million for the three months ended March 31, 2007. This increase is primarily due to the following: (i) a $1.3 million increase due to an increase in headcount, largely direct sales, marketing and operational personnel; (ii) a $0.2 million increase in expenses for physician training, practice building and patient acquisition; (iii) a $0.2 million increase in marketing and promotional activities for new product development; (iv) a $0.1 million increase in insurance; (v) a $0.1 million increase in non-cash compensation primarily due to restricted stock units granted in February 2008; and (vi) a $0.1 million increase in other expenses. As a percentage of net sales, selling, general and administrative expenses in the three months ended March 31, 2008 were 56% as compared to 53% for the three months ended March 31, 2007. We expect to incur additional operating costs, such as professional fees and insurance costs, related to the growth of our business. However, since a significant portion of our public reporting costs are incurred during the three months ended March 31, we believe selling, general and administrative expenses will decrease as a percentage of net sales for the remaining three quarters of the year.

Research and development. Research and development expenses increased $0.2 million to $1.4 million for the three months ended March 31, 2008 as compared to $1.2 million for the three months ended March 31, 2007. The increase is primarily due to the following: $0.3 million increase in development costs related to the development of new products; offset by a $0.1 million decrease in salaries and related benefits during the three months ended March 31, 2008 as compared to the three months ended March 31, 2007 due to a decrease in headcount. As a percentage of net sales, research and development costs in the three months ended March 31, 2008 were 6% as compared to 5% in the three months ended March 31, 2007. We believe that research and development costs as a percentage of sales will remain fairly consistent for the remaining three quarters of the year.

Interest income and Interest expense. Interest income was $0.1 million for the three months ended March 31, 2008, as compared to $44,000 for the three months ended March 31, 2007. The increase is primarily due to the investment of the majority of our cash balance into a higher interest rate yielding money market account and an increase in our average cash balance from $11.9 million for the three months ended March 31, 2007 to $18.1 million for the three months ended March 31, 2008. Interest expense was $37,000 during the three months ended March 31, 2008, as compared to $0.7 million for the three months ended March 31, 2007. The decline is attributable to the complete paydown of our debt during the year ended December 31, 2007.

Income taxes. Income tax expense increased $0.1 million to $2.0 million for three months ended March 31, 2008, as compared to $1.9 million for the three months ended March 31, 2007. Our effective tax rate was 40% for both the three months ended March 31, 2008 and for the three months ended March 31, 2007. The increase in income tax expense is primarily due to the increase in income before provision for income taxes by $0.2 million.

Liquidity and capital resources

Management assesses our liquidity by our ability to generate cash to fund our operations. Significant factors in the management of liquidity are: funds generated by operations; levels of accounts receivable, inventories, accounts payable and capital expenditures; funds required for acquisitions; borrowing capacity under credit facilities; and financial flexibility to attract long-term capital on satisfactory terms. As of March 31, 2008, our accumulated deficit was $3.0 million. We currently invest our cash and cash equivalents in large money market funds and high-quality corporate issuers. Historically, we have generated cash from operations in excess of working capital requirements and through private and public sales of common stock. We had $10.0 million available on our revolving line of credit on March 31, 2008 and December 31, 2007. As of March 31, 2008, we had no outstanding debt under our credit agreement with Merrill Lynch Capital (the "Credit Agreement"). Borrowings under the Credit Agreement are subject to certain financial and operating covenants that include, among other provisions, maintaining a maximum Debt to EBITDA Ratio and minimum EBITDA levels and restrictions on our ability to pay dividends. Certain covenants also limit annual capital expenditures and use of proceeds from the issuance of debt and equity securities. We were in compliance with all financial and non-financial covenants as of March 31, 2008 and December 31, 2007.

We expect to increase our selling, marketing and administrative expenses and our research and development expenses. We anticipate our selling and marketing expenses to increase as we seek to: (i) expand our professional sales force; (ii) increase our efforts towards physician training and patient awareness; (iii) support the launch of new products or the expanded application of existing products; and (iv) expand our distribution to new physician specialties. We anticipate that our administrative expenses will increase (i) to support our current growth plans (ii) construct and relocate to our new corporate facility; (iii) implement a new enterprise resource planning software system; and (iv) compliance with our obligations as a public company. Our research and development expenses will likely increase as a result of our current plans to (i) research and develop new products and (ii) expand the application of current products. We believe that our cash outflows related to acquiring products and entering into licensing agreements may increase as we seek to expand our product portfolio. Additionally, if sales of our current products continue to increase and/or we increase the number of products in our portfolio, we may find it necessary to consider alternative manufacturing relationships, which may include the acquisition of our own manufacturing facilities or additional capital expenditures for facilities and equipment of third-party manufacturers that are dedicated to our products.

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

We have maintained a positive operating cash flow in each year since 2001, and we believe that the net cash provided by operating activities and existing cash and equivalents will provide us with sufficient resources to meet our expected working capital requirements, debt service and other cash needs for the foreseeable future.

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