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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


ý Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarter Ended September 30, 2009

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

Commission file number: 0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.



A Delaware Corporation I.R.S Employer Identification No. 04-3128178

82 Cambridge Street, Burlington, Massachusetts 01803
Registrant's telephone number, including area code: (781) 993-2300

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common Stock, $0.01 par value
Name of each exchange on which registered
NASDAQ -Global Select Market
 
Preferred Stock Purchase Rights

Securities registered pursuant to Section 12(g) of the Act:
 
None.

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes o  No  o

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

Large accelerated filer o   Accelerated filer ý    Non-accelerated filer o  Smaller reporting company o
                          (Do not check if a smaller
                reporting company)

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

The number of shares outstanding of the registrant's common stock as of the close of business on November 2, 2009 was 18,067,989.


Palomar Medical Technologies, Inc. and Subsidiaries

Table of Contents

Page No.
PART I - Financial Information
       
       
Item 1. Financial Statements
Unaudited Condensed Consolidated Balance Sheets as of September 30, 2009 and
December 31, 2008
3
Unaudited Condensed Consolidated Statements of Operations for the periods ended
September 30, 2009 and September 30, 2008
4
Unaudited Condensed Consolidated Statements of Cash Flows for the periods ended
September 30, 2009 and September 30, 2008
5
Notes to Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and the Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk 28
Item 4. Controls and Procedures 29
       
PART II - Other Information
       
Item 1. Legal Proceedings 29
Item 1A. Risk Factors 32
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Securities 45
Item 3. Defaults Upon Senior Securities 45
Item 4. Submission of Matters to a Vote of Security Holders 45
Item 5. Other Information 45
Item 6. Exhibits 45
SIGNATURES 46

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

September 30,
2009

December 31,
2008

                                                        Assets            
Current assets  
   Cash and cash equivalents   $ 109,359,977   $ 122,601,139  
   Accounts receivable, net    5,499,647    6,395,364  
   Inventories    12,454,618    16,045,725  
   Deferred tax assets    4,365,479    4,149,583  
   Other current assets    1,721,407    2,613,003  


    Total current assets    133,401,128    151,804,814  


Investments, at fair value    4,124,313    4,486,834  


Property and equipment, net    29,531,908    14,225,397  


Deferred tax assets    1,356,021    1,197,876  


Other assets    6,111    7,515  


Total assets   $ 168,419,481   $ 171,722,436  


                                         Liabilities and Stockholders' Equity  
Current liabilities  
   Note payable   $ --   $ 6,000,000  
   Accounts payable    6,674,096    3,247,051  
   Accrued liabilities    8,013,887    6,688,137  
   Deferred revenue    4,115,936    6,166,246  


    Total current liabilities    18,803,919    22,101,434  


   Accrued income taxes    2,830,699    2,815,577  


    Total liabilities   $ 21,634,618   $ 24,917,011  


Commitments and contingencies (Note 14)  
Stockholders' equity  
   Preferred stock, $0.01 par value-  
    Authorized - 1,500,000 shares  
    Issued - none    --    --  
   Common stock, $0.01 par value-  
    Authorized - 45,000,000 shares  
    Issued - 18,479,345 shares    184,794    184,794  
   Additional paid-in capital    206,759,047    205,306,957  
   Accumulated other comprehensive loss    (283,628 )  (542,443 )
   Accumulated deficit    (54,502,132 )  (52,547,173 )
   Treasury stock, at cost - 411,356 and 413,255 shares, respectively    (5,373,218 )  (5,596,710 )


    Total stockholders' equity   $ 146,784,863   $ 146,805,425  


Total liabilities and stockholders’ equity   $ 168,419,481   $ 171,722,436  


The accompanying notes to condensed consolidated financial statements.

3



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

Three Months Ended
September 30,
Nine Months Ended
September 30,
2009
2008
2009
2008
Revenues                    
    Product revenues   $ 11,229,156   $ 19,223,597   $ 34,823,566   $ 56,118,901  
    Royalty revenues    1,264,022    2,777,627    4,032,039    8,294,211  
    Funded product development revenues    806,482    954,907    1,636,082    1,949,944  
    Other revenues    1,250,000    1,250,000    3,750,000    3,997,625  




       Total revenues    14,549,660    24,206,131    44,241,687    70,360,681  




Costs and expenses  
    Cost of product revenues    4,775,259    6,764,284    15,266,663    19,689,284  
    Cost of royalty revenues    505,609    1,111,051    1,612,816    3,317,685  
    Research and development    3,305,311    4,219,677    10,125,279    14,153,284  
    Selling and marketing    4,062,930    5,946,025    13,464,732    18,371,742  
    General and administrative    2,451,496    5,952,934    7,566,053    17,284,595  




       Total costs and expenses    15,100,605    23,993,971    48,035,543    72,816,590  




       (Loss) income from operations    (550,945 )  212,160    (3,793,856 )  (2,455,909 )
    Interest income    218,169    798,522    551,817    3,058,056  
    Other income (expense)    156,941    (68,908 )  506,761    (61,164 )




       (Loss) income before income taxes    (175,835 )  941,774    (2,735,278 )  540,983  
    Provision for (benefit from) income taxes    120,752    345,300    (780,319 )  189,032  




        Net (loss) income   $ (296,587 ) $ 596,474   $ (1,954,959 ) $ 351,951  




Net (loss) income per share  
    Basic   $ (0.02 ) $ 0.03   $ (0.11 ) $ 0.02  




    Diluted   $ (0.02 ) $ 0.03   $ (0.11 ) $ 0.02  




Weighted average number of shares outstanding  
    Basic    18,065,655    18,091,419    18,058,246    18,175,772  




    Diluted    18,065,655    18,289,995    18,058,246    18,450,464  




Comprehensive (loss) income:  
    Net (loss) income   $ (296,587 ) $ 596,474   $ (1,954,959 ) $ 351,951  
    Unrealized (loss) gain from marketable securities    (24,138 )  67,949    142,645    (125,150 )
       net of taxes (benefit) of $14,279, $(43,736)  
       $(119,834) and $80,553, respectively  
    Foreign currency translation adjustment    (24,690 )  21,260    (115,680 )  17,139  




       Comprehensive (loss) income   $ (345,415 ) $ 685,683   $ (1,927,994 ) $ 243,940  





See accompanying notes to condensed consolidated financial statements.

4


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


Nine Months Ended
September 30,

2009
2008
Operating activities            
    Net (loss) income   $ (1,954,959 ) $ 351,951  
    Adjustments to reconcile net (loss) income to net cash from operating activities:  
      Depreciation and amortization    469,167    515,085  
      Stock-based compensation expense    2,573,483    5,104,338  
      Provision for bad debt    139,810    302,228  
      Inventory write-off    151,274    440,000  
      Change in deferred tax asset    (1,179,411 )  (2,104,833 )
      Tax benefit from the exercise of stock options    (264,100 )  (1,994,199 )
      Other non-cash items    178,000    17,139  
      Changes in assets and liabilities:  
        Accounts receivable    738,195    4,795,435  
        Inventories    3,690,047    (3,492,896 )
        Other current assets    894,688    123,622  
        Other assets    2,538    (8,494 )
        Accounts payable    2,947,087    2,359,232  
        Accrued liabilities    1,428,661    (2,452,065 )
        Accrued income taxes    15,122    --  
        Deferred revenue    (2,047,346 )  122,058  


          Net cash from operating activities    7,782,256    4,078,601  


Investing activities  
    Capital expenditures    (15,775,678 )  (889,904 )
    Purchases of investments    --    (1,250,000 )
    Proceeds from sale of investments    625,000    37,635,000  


          Net cash (used in) from investing activities    (15,150,678 )  35,495,096  


Financing activities  
    Proceeds from the exercise of stock options and warrants    117,415    429,509  
    Tax benefit from the exercise of stock options    264,100    1,994,199  
    Costs incurred related to issuance of common stock    --    (44,700 )
    Costs incurred related to purchase of stock for treasury    (258,491 )  (4,622,245 )
    Proceeds from borrowings on credit facility    14,000,000    --  
    Payments on credit facility    (20,000,000 )  --  


          Net cash used in financing activities    (5,876,976 )  (2,243,237 )


Effect of exchange rate changes on cash and cash equivalents    4,236    --  
     
Net (decrease) increase in cash and cash equivalents    (13,241,162 )  37,330,460  
Cash and cash equivalents, beginning of the period    122,601,139    90,460,350  


Cash and cash equivalents, end of the period   $ 109,359,977   $ 127,790,810  


Supplemental disclosure of cash flow information  
     Cash paid for income taxes   $ 36,493   $ 914,574  


Supplemental noncash investing activities  
    Unrealized gain on marketable securities, net of taxes   $ 142,645   $ (125,150 )


See accompanying notes to condensed consolidated financial statements.

5


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

Note 1 - Basis of presentation

        The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim information. The consolidated balance sheet at December 31, 2008 has been derived from the audited balance sheet at that date; however, the accompanying financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The results of operations for the interim periods shown in this report are not necessarily indicative of expected results for any future interim period or for the entire fiscal year. We believe that the quarterly information presented includes all adjustments (consisting of normal, recurring adjustments) necessary for a fair presentation in accordance with accounting principles generally accepted in the United States. The accompanying condensed consolidated financial statements and notes should be read in conjunction with our Form 10-K for the year ended December 31, 2008.

        In 2009, we reclassified certain balances within current assets. To be consistent with the 2009 presentation, we reclassified certain 2008 balances within current assets in the accompanying Condensed Consolidated Balance Sheets. The reclassifications had no impact on previously reported results of operations or cash flow related to operating activities.

        We are required to evaluate events occurring after September 30, 2009, the end of our third quarter, for recognition and disclosure in the unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2009. Events are evaluated based on whether they represent information existing as of September 30, 2009, which require recognition in the unaudited condensed consolidated financial statements or new events occurring after September 30, 2009, which do not require recognition, but require disclosure if the event is significant to the unaudited condensed consolidated financial statements. We evaluated events occurring subsequent to September 30, 2009 through November 5, 2009, the date of issuance of these financial statements. In Note 2, we disclose the stock option exchange and restricted stock award grant approved by the Board of Directors in October 2009. In Note 10, we disclose the termination of our Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc.

Note 2 – Stock-based compensation

        Our net loss increased by approximately $0.7 million and $1.9 million for the three and nine months ended September 30, 2009, respectively, as a result of stock-based compensation expense. Our net income decreased by $0.8 million and $3.3 million for the three and nine months ended September 30, 2008, as a result of stock-based compensation expense. The compensation expense for the three and nine months ended September 30, 2009 increased our net loss per share by $0.04 and $0.10. The compensation expense for the three and nine months ended September 30, 2008 decreased our basic and diluted earnings per share by $0.04 and $0.18, respectively. As of September 30, 2009, there was $6.0 million of unrecognized compensation expense related to non-vested share awards. The expense is expected to be recognized over a weighted-average period of 2.1 years.

6


         Stock Options

        During the three and nine months ended September 30, 2009, no options were granted.

        The following table summarizes our stock option activity since December 31, 2008:


Number of
Shares

Exercise Price
Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
Term
(in Years)

Aggregate
Intrinsic
Value

Outstanding, December 31, 2008 3,228,299  $0.90 - $26.00 $     15.81 6.88 $ 2,208,789





     Granted --  --  -- 
     Exercised (36,899) $1.97 - $  8.11 3.18
     Canceled (12,875) $13.31 - $16.53 $     13.56





Outstanding, September 30, 2009 3,178,525  $0.90 - $26.00 $     15.96 6.20 $6,627,629





Exercisable, September 30, 2009 2,784,776  $0.90 - $26.00 $     16.34 5.89 $5,485,756







        The total intrinsic value for stock options exercised during the nine months ended September 30, 2009 and 2008 was $0.3 million and $1.5 million, respectively.

        The following table summarizes information about stock options outstanding as of September 30, 2009:



Options Outstanding
Options Exercisable
Range of
Exercise Prices

Options
Outstanding

Weighted
Average
Remaining
Contractual Life

Weighted
Average
Exercise Price

Options
Exercisable

Weighted
Average
Exercise Price

 $0.90   - $10.72    208,367 2.35 years $ 2.41   208,367 $ 2.41
13.31   -   13.31 1,282,500 8.41 years 13.31   888,751   13.31
 13.66   -   16.53  1,033,158  4.60 years 16.49 1,033,158    16.49
23.61   -   26.00    654,500 5.60 years 24.64   654,500   24.64





$0.90   - $26.00 3,178,525   6.20 years $15.96   2,784,776   $16.34 







         In October 2009, our Board of Directors reviewed our outstanding equity compensation arrangements and determined to provide our management, employees and directors with appropriate incentives to achieve our business and financial goals while at the same time minimizing the accounting costs of these incentives and reducing the overhang caused by stock options that are significantly underwater. As a result of this review and determination, in October 2009, our Board approved a stock option exchange program for some of our significantly underwater options. As part of this program, during the fourth quarter of 2009 we expect to provide certain employees, officers and directors who were previously granted stock options for the purchase of a total of 650,500 shares of our common stock with exercise prices of $24.63 and $26.00 per share with the opportunity to amend these options to (i) reduce the number of shares that are the subject of these options based on a conversion ratio which will not create (or will minimize to the maximum extent possible) any incremental stock-based compensation expense on the date of amendment (the “Amendment Date”), (ii) reduce the exercise price to an amount equal to the closing price of our common stock on The Nasdaq Global Select Market on the Amendment Date and (iii) extend the expiration date until 10 years from the Amendment Date. In addition, certain participants in this program will be granted a number of fully vested shares of restricted common stock under our 2004 Stock Incentive Plan equal to the difference between the number of shares of common stock that was the subject of the stock option initially granted under the 2004 Stock Incentive Plan and the number of shares evidenced by the option following the amendment. We estimate we will incur a one-time stock-based compensation charge of between $4 million and $5 million in the fourth quarter of 2009 as a result of these restricted stock awards.

         Stock-Settled Stock Appreciation Rights

        The granted stock-settled stock appreciation rights (SARs) are awards that allow the recipient to receive an amount of our common stock equal to the appreciation (if any) in the fair market value of our common stock on the date of exercise over the initial SAR valuation set on the date of grant per share of common stock for the number of shares vested. Since 2007, stock-settled SARs were granted and the conversion price was set at 50 percent of the fair market value of our common stock on the date of grant, and the holder’s right to receive shares of common stock under these grants occurs automatically on the vesting date. The SARs become exercisable over a four-year period with one-third vesting on the second, third, and fourth anniversaries of the date of grant. The related compensation expense is being recognized over the four-year period on a straight-line basis. During the three and nine months ended September 30, 2009, there were 0 and 1,000 stock-settled SARs granted, respectively.

7


        On August 10, 2009, 143,184 SARs which were granted on August 10, 2007 vested. As the fair market value of our common stock on August 10, 2009 was less than the SARs’ conversion price, these SARs expired without any benefit to the grantees.

        The following table summarizes our stock-settled stock appreciation rights activity since December 31, 2008:


Number of
Shares

Weighted
Average
Conversion
Price

Weighted
Average
Remaining
Contractual
Term
(in Years)

Aggregate
Intrinsic Value

Outstanding, December 31, 2008 797,500     $     11.61    2.17        $1,240,814   




     Granted 1,000     5.60   
     Converted --     --           
     Canceled (186,784)    $     13.75   




Outstanding, September 30, 2009 611,716     $     10.95    1.67        $3,220,114   




Vested, September 30, 2009 --     --     --         --    





SARs Outstanding
Range of
Conversion Prices

SARs
Outstanding

Weighted Average
Remaining Contractual
Life

Weighted Average
Conversion Price

$5.44 - $7.97 325,400  1.88 years $ 7.91
14.40 - 14.40 286,316  1.36 years 14.40



$5.44 - $14.40 611,716  1.67 years $10.95



         Warrants

        The following table summarizes our warrant activity since December 31, 2008:


Number of
Shares

Exercise Price
Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
Term

Aggregate
Intrinsic Value

Outstanding, December 31, 2008 10,000  $     2.81 $2.81 1.43    $87,175 
     Granted --  --    --
     Exercised --  --    --
     Canceled --  --    --





Outstanding, September 30, 2009 10,000  $     2.81 $2.81 0.68    $133,975





Exercisable, September 30, 2009 10,000  $     2.81 $2.81 0.68    $133,975






        The total intrinsic value for warrants exercised for the nine months ended September 30, 2009 and 2008 were $0 and $815,000, respectively.

8


Note 3 – Inventories

        Inventories are valued at the lower of cost (first-in, first-out method) or market, and include material, labor and manufacturing overhead. At September 30, 2009 and December 31, 2008, inventories consisted of the following:

September 30,
2009

December 31,
2008

Raw materials $  4,887,576  $  7,757,417 
Work in process 1,625,027  1,517,400 
Finished goods 5,942,015  6,770,908 


     Total $12,454,618  $16,045,725 


Note 4 – Property and equipment

        Property and equipment are recorded at cost. Repairs and maintenance costs are expensed as incurred. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of property and equipment. Land and construction in progress assets are not depreciated. At September 30, 2009 and December 31, 2008, property and equipment consisted of the following:


September 30,
2009

December 31,
2008

Estimated
useful life

Land $   10,680,000   $   10,680,000  
Machinery and equipment    2,100,331      2,100,331   3-8 years
Furniture and fixtures 3,321,171   3,248,093   5 years
Leasehold improvements 537,648   537,648   Shorter of estimated useful
life or term of lease
Construction in progress 18,188,464    2,485,864  

34,827,614    19,051,936  
Accumulated depreciation   (5,295,706)    (4,826,539) 

            Total $   29,531,908   $   14,225,397  

        On November 19, 2008, we purchased land for $10.7 million on which we are building our new operational facility. Construction of the building is expected to be completed during the first quarter of 2010. We anticipate that capital expenditures related to the building for 2009 will be approximately $24 million. During the three and nine months ended September 30, 2009, we had $6.3 million and $15.7 million, respectively, of capital expenditures related to the building. The total cost of the building (exclusive of land) is expected to be approximately $25 million. We are financing this project by using cash on hand.

Note 5 – Warranty costs

        We typically offer a one year warranty on our base systems. Warranty coverage provided is for labor and parts necessary to repair the systems during the warranty period. We account for the estimated warranty cost of the standard warranty coverage as a charge to cost of revenue when revenue is recognized. The estimated warranty cost is based on units sold, historical product performance and the cost per repair. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.

9


        The following table provides the detail of the change in our product warranty accrual, which is a component of accrued liabilities on the Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008:


September 30,
2009

December 31,
2008

Warranty accrual, beginning of year     $ 856,158   $ 1,051,432  
Charges to cost and expenses relating to new sales    952,768    1,822,196  
Costs of product warranty claims    (1,255,584 )  (2,017,470 )


Warranty accrual, end of period   $ 553,342   $ 856,158  



  

Note 6 – Fair Value of Financial Instruments

         In September 2006, the FASB issued new guidance on fair value measurements.  This guidance defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements.  The guidance applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements.  This guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and we adopted on January 1, 2008.  In February 2008, the FASB issued an update to the fair value measurement guidance. This guidance permits the delayed application of the fair value measurement guidance for all non-recurring fair value measurements of non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008. The adoption of this guidance had no impact on the Company’s consolidated financial statements.

        We performed an analysis of our investments held at September 30, 2009 to determine the significance and character of all inputs to their fair value determination. The standard requires additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in fair value for each reporting period.

        The FASB’s fair value measurement guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into the following three broad categories.


  o Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

  o Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

  o Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

Fair Value on a Recurring Basis

        Assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations. The following table presents our assets measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008.


Assets
(In thousands)
Fair Value as of September 30, 2009
Level 1
Level 2
Level 3
Total
  Auction-rate preferred securities $    --  $     --  $2,622  $2,622 
  Auction-rate municipal securities     --      --  1,502  1,502 




Total $    --  $      --  $4,124  $4,124 





10


Assets
(In thousands)
Fair Value as of December 31, 2008
Level 1
Level 2
Level 3
Total
  Auction-rate preferred securities $    --  $    --  $3,166  $3,166 
  Auction-rate municipal securities --  --  1,321  1,321 




Total $    --  $    --  $4,487  $4,487 





        At September 30, 2009, the amortized cost basis of the auction-rate preferred securities and auction-rate municipal securities were $2.9 million and $1.6 million, respectively. At December 31, 2008, the amortized cost basis of the auction-rate preferred securities and auction-rate municipal securities were $3.5 million and $1.6 million, respectively. As described in more detail below, all of our auction-rate securities have unrealized temporary losses in accumulated other comprehensive income. We have no other-than-temporary impairments.

        There is no maturity date of the auction-rate preferred securities while the maturity date for our auction-rate municipal securities is in December 2045.

Level 3 Gains and Losses

        The table presented below summarizes the change in balance sheet carrying values associated with Level 3 financial instruments for the nine months ended September 30, 2009.


(In thousands)
Auction-rate
preferred securities

Auction-rate
municipal securities

Total
Balance at December 31, 2008     $ 3,166   $ 1,321   $ 4,487  
     Net payments, purchases and sales   (625 )  --   (625 )
     Net transfers in/(out)    --  --  --
     Gains/(losses)  
        Realized    --    --    --  
        Unrealized    81    181    262  



Balance at September 30, 2009   $ 2,622   $ 1,502   $ 4,124  




        All of the above auction-rate securities (“ARS”) have been in a continuous unrealized loss position for 12 months or longer. We continue to receive regular dividends from each of our ARS at current market rates.

        Historically, the ARS market was an active and liquid market where we could purchase and sell our ARS on a regular basis through auctions. As such, we classified our ARS as Level 1 investments in accordance with the FASB’s guidance at December 31, 2007. Subsequent to December 31, 2007, several of our ARS failed at auction due to a decline in liquidity in the ARS and other capital markets. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market. As approximately $4.1 million of our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current investments as of September 30, 2009.

         The fair value of our holdings of ARS at September 30, 2009 was $4.1 million. To value our ARS, we determined the present value of the ARS at the balance sheet date by discounting the estimated future cash flows based on a fair value rate of interest and an expected time horizon to liquidity. We also evaluated the credit rating of the issuer and found them all to be investment grade securities. There was no change in our valuation method during the three months ended September 30, 2009 as compared to prior reporting periods. Our valuation analysis showed that our ARS have no credit risk. The impairment is due to liquidity risk. Additionally, as of September 30, 2009, we do not intend to sell the ARS, it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity, and we expect to recover the full amortized cost basis of these securities. As a result of our valuation analysis, our investment strategy, reoccurring dividend stream from these investments, and our strong cash and cash equivalents position, we have determined that the fair value of our ARS was temporarily impaired as of September 30, 2009. For the three and nine months ended September 30, 2009, we marked to market our ARS and recorded an unrealized loss of $24,000 and an unrealized gain of $143,000, respectively, net of taxes in accumulated other comprehensive income in stockholders’ equity to reflect the cumulative temporary impairment of approximately $200,000, net of taxes, on our ARS as of September 30, 2009.

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        We continue to monitor the market for ARS and consider its impact, if any, on the fair value of our investments. If current market conditions deteriorate further, we may be required to record additional unrealized losses in accumulated other comprehensive (loss) income. If the credit rating of the security issuers deteriorates, the anticipated recovery in market values does not occur, or we stop receiving dividends, we may be required to adjust the carrying value of these investments through impairment charges in our Consolidated Statements of Operations.

Note 7 – Geographic information

        North America product revenue was $7.1 million and $12.0 million for the three months ended September 30, 2009 and 2008, respectively. For the nine months ended September 30, 2009 and 2008, North America product revenue was $20.9 million and $37.8 million, respectively. International product revenue outside North America, consisting of revenue from our Australian subsidiary, distributors and our sales shipped directly to customers was $4.2 million and $7.2 million for the three months ended September 30, 2009 and 2008, respectively, while international product revenue for the nine months ended September 30, 2009 and 2008 was $13.9 million and $18.3 million, respectively. The following table represents the percentage of product revenue by geographic region for the three and nine months ended September 30, 2009 and 2008:


Three Months Ended
September 30,

Nine Months Ended
September 30,

2009
2008
2009
2008
North America 62.9% 62.6% 60.1% 67.4%
Europe 17.0% 18.4% 17.7% 15.1%
South and Central America 9.9% 10.1% 7.8% 8.6%
Asia/Pacific Rim 3.2% 3.9% 5.4% 4.7%
Australia 4.2% 1.7% 5.2% 1.2%
Middle East 2.8% 3.3% 3.8% 3.0%




Total 100.0% 100.0% 100.0% 100.0%





Note 8 – Net (loss) income per common share

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

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        A reconciliation of basic and diluted shares for the three and nine months ended September 30, 2009 and 2008, is as follows:


Three Months Ended
September 30,

Nine Months Ended
September 30,

2009
2008
2009
2008
Basic weighted average number of shares        
    outstanding 18,065,655  18,091,419  18,058,246  18,175,772 
Potential common shares pursuant to stock
    options, stock appreciation rights and warrants --  198,576  --  274,692 




Diluted weighted average number of shares        
    outstanding 18,065,655  18,289,995  18,058,246  18,450,464 





        For the three months ended September 30, 2009 and 2008, approximately 2.3 million and 4.1 million, respectively, weighted average options, stock-settled SARs, and warrants to purchase shares of our common stock were excluded from the computation of diluted earnings per share because the effect of including the options would have been antidilutive.

Note 9 – Development and License Agreement with The Gillette Company and License Agreement with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company)

        Effective as of February 14, 2003, we entered into a Development and License Agreement (the “Agreement”) with Gillette to complete the development and commercialize a home-use, light-based hair removal device for women. In October 2005, The Procter & Gamble Company (“P&G”) (NYSE: PG) completed its acquisition of Gillette. Under the Agreement, Procter & Gamble, as the acquiring party, assumed all of Gillette’s rights and obligations. The agreement provided for up to $7 million in support of research and development to be paid by Gillette over approximately 30 months. Effective as of June 28, 2004, we completed the initial phase of the Agreement and both parties decided to move onto the next phase. Accompanying this decision, we amended the Agreement, whereby, Gillette provided $2.1 million in additional development funding to further technical innovations over a 9-month extension of the development phase, which was completed on August 31, 2006 (the “Development Phase”).

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

        Gillette was to conduct approximately 12 months of commercial assessment tests with respect to the device. Based on the commercial assessment tests, Gillette was to decide by January 7, 2008 whether or not to continue with the project (the “Launch Decision”). On February 21, 2007, we announced an amendment to our agreement with Gillette to include the development and commercialization of an additional home-use, light-based hair removal device for women, and we also announced that we had executed an amended and restated joint development agreement to incorporate other amendments, including several new amendments to allow for more open collaboration through commercialization. With regard to the additional home-use, light-based hair removal device for women, we completed certain development activities in consultation with Gillette during an eleven month program. Gillette provided us with $1.2 million and an additional $300,000 upon the completion of certain deliverables which was recognized over an eleven month period as costs were incurred and services were provided.

        On December 21, 2007, we announced an agreement with Gillette to extend the Launch Decision until no later than February 29, 2008. During this extension period, we negotiated with Gillette and its parent company P&G for a new agreement to replace the existing one. On February 29, 2008, we entered into a License Agreement with P&G under which we granted a non-exclusive license to certain patents and technology to commercialize home-use, light-based hair removal devices for women. This License Agreement terminated and replaced the prior Development and License Agreement.

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        For the three months ended September 30, 2009 and 2008, we recognized $0 and $18,000 of funded product development revenues from P&G and Gillette under the Development and License Agreement and various other agreements. For the nine months ended September 30, 2009 and 2008, we recognized $0 and $216,000 of funded product development revenues from P&G and Gillette, respectively, under the Development and License agreement and various other agreements.

        Under the License Agreement, for each of the three months ended September 30, 2009 and 2008, we recognized $1.25 million of other revenues from P&G, respectively. In each of the nine months ended September 30, 2009 and 2008, we recognized $3.75 million of other revenues from P&G. The $1.25 million payments are quarterly technology transfer payments (“TTP Quarterly Payment” as defined in the License Agreement). TTP Quarterly Payments will be made by P&G during the term of the License Agreement up to and including the quarter in which P&G launches the first Licensed Product (as defined in the License Agreement). Thereafter, TTP and royalty payments will be based on product sales as set forth in the License Agreement. TTPs, including the TTP Quarterly Payments, are non-creditable and non-refundable and there is no right of offset. As of September 30, 2009 and December 31, 2008, there were $0 and $1.25 million of advance payments received from P&G for which services were not yet provided were included in deferred revenue, under the License Agreement.

        For more information, please see the License Agreement filed as Exhibit 10.1 to our Current Report on Form 8-K filed March 3, 2008, the Development and License Agreement and subsequent amendments filed as Exhibit 10.1 to our Current Report on Form 8-K filed on February 19, 2003, Exhibits 99.1, 99.2, and 99.3 to our Current Report on Form 8-K filed on June 28, 2004, Exhibit 10.30 to our Annual Report on Form 10-K filed on March 6, 2006, and Exhibits 10.1 and 10.2 to our Current Report on Form 8-K filed on February 21, 2007.

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

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

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

        On August 22, 2007 and June 29, 2009, we signed amendments to our agreement with Johnson & Johnson to provide for additional development funding for certain development activities. Johnson & Johnson will provide us with quarterly payments for these development activities. We will recognize this revenue as costs are incurred and services are provided.

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        On October 16, 2009, we announced the termination of our Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. Despite having met all of our deliverables under the agreement, Johnson & Johnson terminated the agreement referencing the current unfavorable economic conditions as the reason for its decision. With this decision, Johnson & Johnson avoids having to make a large commercialization payment to us and avoids having to commit to the significant level of funding required to successfully launch a new product into the consumer market. For more information, please see our press release filed as an Exhibit 99.1 to our Current Report on Form 8-K filed October 16, 2009.

        For the three months ended September 30, 2009 and 2008, we recognized approximately $806,000 and $937,000, respectively, of funded product development revenues from Johnson & Johnson. For the nine months ended September 30, 2009 and 2008, we recognized approximately $1.6 million and $1.7 million, respectively, of funded product development revenues from Johnson & Johnson. As of September 30, 2009 and December 31, 2008, $199,000 and $726,000, respectively, of advance payments received from Johnson & Johnson for which services were not yet provided were included in deferred revenue.

        For more information, please see the Joint Development and License Agreement and amendments filed as Exhibit 99.1 to our Current Report on Form 8-K filed on September 7, 2004, Exhibit 10.45 to our Quarterly Report on Form 10-Q filed on May 8, 2007, Exhibits 10.47 and 10.48 to our Quarterly Report on Form 10-Q filed on November 2, 2007, and Exhibit 10.71 to this Quarterly Report on Form 10-Q filed on August 5, 2009.

Note 11 – Notes Payable

        In December 2008, we secured access to a revolving note through December 17, 2013. Through December 16, 2010, we have access to $30 million. The credit limit is subsequently reduced to $26 million, $22 million, and $18 million on December 17, 2010, December 17, 2011, and December 17, 2012, respectively. Outstanding balances on the revolving note bear interest at a rate equal to the sum of the LIBOR Advantage rate plus 0.75% per annum. At September 30, 2009 and December 31, 2008, we had outstanding debt of $0 million and $6 million, respectively. The average interest rate at December 31, 2008 was 1.22%. The interest expense was capitalized into Construction in Progress which is a component of Property and Equipment on the consolidated balance sheets and was immaterial for the three and nine months ended September 30, 2009. Any outstanding debt is due on December 17, 2013. On January 2, 2009, we repaid the $6 million borrowed as of December 31, 2008. On July 1, 2009, we repaid the $12 million outstanding as of June 30, 2009. As of September 30, 2009, we had no debt outstanding.

        Our revolving note requires that we maintain certain financial covenants. In order to be in compliance with the covenants, unencumbered cash and marketable securities less outstanding debt must be greater than the credit limit. For all periods in which we had outstanding debt, we were in compliance with the financial covenants. If we were to default on our debt, the building would be used as collateral.

Note 12 – Income Taxes

        We provide for income taxes under the liability method in accordance with the FASB’s guidance on accounting for income taxes. Under this guidance, we can only recognize a deferred tax asset for future benefit of our tax loss, temporary differences and tax credit carry forwards to the extent that it is more likely than not that these assets will be realized. In 2008 and 2009, we either expect to, or have incurred operating losses in foreign jurisdictions. We believe that it is more likely than not that the associated tax asset will expire prior to utilization. Therefore, in 2008 and 2009, we established a full valuation allowance on this deferred tax asset.

        Each quarter we assess the likelihood that we will be able to recover our deferred tax assets. We consider available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Although we have determined that a valuation allowance is not required with respect to our remaining net short-term and long-term deferred tax assets totaling $5.7 million at September 30, 2009, their recovery is dependent on achieving future operating income. Failure to achieve future operating income targets or negative changes to expected trends may change the assessment regarding the recoverability of the net deferred tax assets and such change could result in a valuation allowance being recorded against some or all of the deferred tax assets. Any increase in a valuation allowance would result in additional income tax expense and could have a significant impact on our earnings in future periods.

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        Additionally, under the FASB’s stock-based compensation guidance, we decreased our deferred tax assets by $0.9 million in the quarter ended September 30, 2009 due to the expiration of stock appreciation rights. The adjustment did not impact income tax expense as it was realized through a decrease to stockholders’ equity.

        At September 30, 2009, we have $2.8 million of net unrecognized tax benefits, all of which would affect our effective tax rate if recognized.

        We establish reserves for uncertain tax positions based on management’s assessment of exposure associated with tax deductions, permanent tax differences and tax credits. The tax reserves are analyzed periodically and adjustments are made, as events occur to warrant adjustment to the reserve.

        We recognize interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2009, we had approximately $36,000 of accrued interest and penalties related to uncertain tax positions.

        The tax years 2006-2008 remain open to examination by the major taxing jurisdictions to which we are subject. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions.

Note 13 – Stock Repurchase Program

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

        The following table shows our stock repurchase activity since June 30, 2009:


Period
Total
number of
shares
purchased

Average
price paid
per share

Total number of
shares purchased
as part of
publicly
announced program

Maximum
number of
shares that
may yet be
purchased
under
program

July 1, 2009 through July 31, 2009 - - - 324,500 
August 1, 2009 through August 31, 2009 - - - 324,500 
September 1, 2009 through September 30, 2009 - - - 324,500 




Total - - - 324,500 





Note 14 – Contingencies

Candela Corporation, Massachusetts Litigation

        On August 9, 2006, we commenced an action for patent infringement against Candela Corporation in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleges Candela’s GentleYAG and GentleLASE systems, which use laser technology for hair removal willfully infringe U.S. Patent No. 5,735,844 (the “'844 patent”), which is exclusively licensed to us by the Massachusetts General Hospital. Candela answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent and U.S. Patent No. 5,595,568 (the “'568 patent”) are invalid and not infringed. We filed a reply denying the material allegations of the counterclaims.

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        We filed an amended complaint on February 16, 2007 to add the Massachusetts General Hospital as a plaintiff. In addition, we further alleged that Candela’s GentleMAX system willfully infringes the ‘844 patent and that Candela’s Light Station system willfully infringes both the ‘844 and ‘568 patents. On February 16, 2007, Candela filed an amended answer to our complaint adding allegations of inequitable conduct, double patenting and violation of Massachusetts General Laws Chapter 93A. On February 28, 2007, we filed a response to Candela’s amended complaint pointing out many weaknesses in Candela’s allegations. A claim construction hearing, sometimes called a “Markman Hearing”, was held August 2, 2007, and we received what we consider to be a favorable Markman ruling on November 9, 2007.

        On November 17, 2008, the Judge stayed the lawsuit pending the outcome of reexamination procedures requested by a third party on both the ‘844 and ‘568 patents in the United States Patent and Trademark Office (the “Patent Office”). On December 9, 2008, Candela also filed requests for reexamination of both patents. Generally, a reexamination proceeding is one which re-opens patent prosecution to ensure that the claims in an issued patent are valid over prior art references. On January 16, 2009, we filed a preliminary amendment to the ‘844 patent adding new claims 33-59 which depend from claim 32 and a preliminary amendment to the ‘568 patent adding new claims 23 and 24 which depend from claim 1. On June 9, 2009, the Patent Office issued an office action confirming the validity of all claims of the ‘844 patent except claims 12-14. Rejecting Candela’s and the other company’s arguments to the contrary, the Patent Office confirmed that claims 1-3, 6-8, 11, 17-20, 27, 28, 30, 32 of the ‘844 patent are valid and patentable. The Patent Office also confirmed new claims 33-59 as valid and patentable. The Patent Office rejected only independent claim 12 and related dependent claims 13-14 of the ‘844 patent as unpatentable. We cancelled claims 12-14 from the ‘844 patent in order to expedite the reexamination proceeding. Claims 4, 5, 9, 10, 15, 16, 21-26, 29 and 31 are not under reexamination. Consequently, all currently pending claims are valid. On July 13, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘844 patent which will close the reexamination proceeding on the ‘844 patent.

        On June 19, 2009, we filed a motion to lift the stay and reopen the lawsuit. Because Candela has discontinued products which infringe the ‘568 patent, we dropped our claims of infringement of the ‘568 patent from the lawsuit and we agreed to a covenant not to sue Candela for past infringement under the ‘568 patent. On July 13, 2009, Candela filed their opposition to our motion to lift the stay, and on July 17, 2009, we filed our response to their opposition. We are waiting for the Judge to rule on our motion.

        On August 10, 2006, Candela Corporation commenced an action for patent infringement against us in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that our StarLux System with the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne treatment, that our QYAG5 System willfully infringes U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions, and that our StarLux System with the LuxG handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle treatment. On October 25, 2006, Candela filed an amended complaint which did not include U.S. Patent No. 6,659,999. Consequently, Candela no longer alleges in this lawsuit that the StarLux System with LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is seeking to enjoin us from selling these products in the United States if we are found to infringe the patents, and to obtain compensatory and treble damages, reasonable costs and attorney’s fees, and other relief as the court deems just and proper. On October 30, 2006, we answered the complaint denying that our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that the asserted patents are invalid and not infringed. In addition, with regard to U.S. Patent No. 5,312,395, we filed a counterclaim of inequitable conduct.

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        In February 2008, we filed a request for reexamination and then an amended request for reexamination of Candela’s ‘222 patent with the United States Patent and Trademark Office (“Patent Office”). In our request, we argued that Candela’s ‘222 patent is unpatentable over our own United States Patent No. 6,605,080 alone or in combination with other prior art. About the same time, we filed a motion to stay all proceedings in this action related to the ‘222 patent pending resolution of the amended request for reexamination of the ‘222 patent. In March 2008, the Patent Office granted our request for reexamination of the ‘222 patent. On June 11, 2008, the Court ordered the parties to report back to the Court after the Patent Office makes its decision in the reexamination of the ‘222 patent, after which a claim construction hearing (i.e., a Markman Hearing) will be scheduled for both the ‘222 and ‘395 patents. On June 12, 2008, the parties informed the Court that the total time the reexamination will remain pending is not known. No trial date has yet been set. We are defending the action vigorously and believe that we have meritorious defenses of non-infringement, invalidity and inequitable conduct. However, litigation is unpredictable and we may not prevail in successfully defending or asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for future sales of products found to infringe in the United States. We could also be ordered to stop selling any products in the United States that are found to infringe.

Alma Lasers, Inc., Delaware Litigation

        On September 11, 2008, Alma Lasers, Inc. filed a complaint requesting a declaratory judgment that our fractional patent, U.S. Patent No. 6,997,923, is not infringed by Alma’s products and is invalid over prior art. Alma served this lawsuit on us on November 6, 2008, and on November 21, 2008, we filed an answer which denied Alma’s allegations that the patent is invalid and not infringed. We also filed a counterclaim accusing Alma’s Pixel C0(2) Omnifit Fractional C0(2) Handpiece and Pixel C0(2) Fractional C0(2) Skin Resurfacing System of infringing the patent. On December 16, 2008, upon the request of both parties, a mediation conference was scheduled for June 30, 2009 before Magistrate Judge Mary Pat Thynge. On December 18, 2008, upon the request of both parties, the Judge presiding over the lawsuit, stayed the lawsuit and later closed the lawsuit pending the outcome of the mediation. Due to unforeseen circumstances, the mediation scheduled for June 30, 2009 was postponed until October 13, 2009. Following our request, Magistrate Judge Mary Pat Thynge cancelled the mediation on October 6, 2009. By letter dated October 13, 2009, we asked Judge Farnan to re-open the case.

Syneron, Inc., Massachusetts Litigation

        On November 14, 2008, we commenced an action for patent infringement against Syneron, Inc. in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleges Syneron’s eLight, eMax, eLaser, Aurora DS, Polaris DS, Comet and Galaxy Systems, which use light-based technology for hair removal, willfully infringe U.S. Patent Nos. 5,595,568 and 5,735,844, which are exclusively licensed to us by the Massachusetts General Hospital. In March 2009, we served Syneron with this suit. On April 30, 2009, the parties filed a stipulation to stay the lawsuit pending the outcome of the reexaminations of U.S. Patent Nos. 5,595,568 and 5,735,844.

        On June 9, 2009, the Patent Office issued an office action confirming the validity of all claims of the ‘844 patent except claims 12-14. The Patent Office confirmed that claims 1-3, 6-8, 11, 17-20, 27, 28, 30, 32 of the ‘844 patent are valid and patentable. The Patent Office also confirmed new claims 33-59 as valid and patentable. The Patent Office rejected only independent claim 12 and related dependent claims 13-14 of the ‘844 patent as unpatentable. We cancelled claims 12-14 from the ‘844 patent in order to expedite the reexamination proceeding. Claims 4, 5, 9, 10, 15, 16, 21-26, 29 and 31 are not under reexamination. Consequently, all currently pending claims are valid. On July 13, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘844 patent which will close the reexamination proceeding on the ‘844 patent.

        On August 14, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘568 patent which will close the reexamination proceeding on the ‘568 patent. This notice confirmed the validity and patentability of all the claims of the ‘568 patent including new claims 23 and 24.

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        On September 23, 2009, we filed a motion to lift the stay and reopen the lawsuit. On October 6, 2009, Syneron filed their opposition to our motion to lift the stay, and on October 9, 2009, we filed our response to their opposition. We are waiting for the Judge to rule on our motion.

Tria Beauty, Inc., Massachusetts Litigation

        On June 24, 2009, we commenced an action for patent infringement against Tria Beauty, Inc. (previously named Spectragenics, Inc.), in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that the Tria System, which uses light-based technology for hair removal, willfully infringes U.S. Patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General Hospital. Tria answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent is not infringed, is invalid and not enforceable. We filed a reply denying the material allegations of the counterclaims. On September 21, 2009, following successful re-examination of U.S. Patent No. 5,595,568 (the ‘568 patent), we filed a motion to amend our complaint to add a claim for willful infringement of the ‘568 patent, which is also exclusively licensed to us by the Massachusetts General Hospital. Our motion also included adding the Massachusetts General Hospital as a plaintiff in the lawsuit. Tria did not oppose the motion and the Judge granted the motion on October 8, 2009.

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

        Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management. Our MD&A is presented in the following sections:


  o   Forward-looking statements
  o   Critical accounting policies
  o   Overview
  o   Results of operations
  o   Liquidity and capital resources
  o   Off-balance sheet arrangements
  o   Contractual obligations

Forward-looking statements

        The condensed consolidated financial statements of Palomar Medical Technologies, Inc. in this document present the Company’s balance sheet, statement of operations, and statement of cash flows, and should be read in conjunction with the following discussion and analysis. References to “we”, “us”, “our”, “Company”, and “Palomar” mean Palomar Medical Technologies, Inc. and its subsidiaries. This discussion includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in filings with the SEC, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like “expects”, “anticipates”, “intends”, “likely will result”, “estimates”, “projects”, or variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in Item 1A. Risk Factors in our Form 10-K for the year ended December 31, 2008 that was filed with the SEC on March 5, 2009 and in this Form 10-Q. In making these statements, we are not undertaking to address or update these factors in future filings or communications regarding our business or results. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this document might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward-looking statements.

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Critical accounting policies  

        The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, investments, warranty obligations, contingencies and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. A discussion of our critical accounting policies and the related judgments and estimates affecting the preparation of our consolidated financial statements is included in the Annual Report on our Form 10-K fiscal year 2008. There have been no material changes to our critical accounting policies as of September 30, 2009.

Recent Accounting Pronouncements

        In December 2007, the FASB ratified guidance on accounting for collaborative arrangements. This guidance focuses on defining a collaborative arrangement as well as the accounting for transactions between participants in a collaborative arrangement and between the participants in the arrangement and third parties. The EITF concluded that both types of transactions should be reported in each participant’s respective income statement. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and should be applied retrospectively to all prior periods presented for all collaborative arrangements existing as of the effective date.  We adopted this guidance on January 1, 2009. The adoption of this guidance has not materially impacted our consolidated financial statements nor do we currently expect a material impact on our future consolidated financial statements.

        In December 2007, the FASB issued new accounting guidance on business combinations. The new guidance retains the fundamental requirements of previous guidance, but requires the recognition of all assets acquired and liabilities assumed in a business combination at their fair values as of the acquisition date. It also requires the recognition of assets acquired and liabilities assumed arising from contractual contingencies at their acquisition date fair values. Additionally, the new guidance supersedes previous guidance which required research and development assets acquired in a business combination that had no alternative future use to be measured at their fair values and expensed at the acquisition date. The new guidance now requires that purchased research and development be recognized as an intangible asset. We adopted the new guidance on January 1, 2009. As we had no acquisitions in the three and nine months ended September 30, 2009, the adoption had no impact on our consolidated financial statements.

        In December 2007, the FASB issued new accounting guidance on noncontrolling interests in consolidated financial statements. This guidance clarifies the classification of noncontrolling interests in consolidated statements of financial position and the accounting for, and reporting of, transactions between the reporting entity and holders of such noncontrolling interests. Under this guidance, noncontrolling interests are considered equity and should be reported as an element of consolidated equity. Net income will encompass the total income of all consolidated subsidiaries, and there will be separate disclosure on the face of the statement of operations of the attribution of that income between the controlling and noncontrolling interests; increases and decreases in the noncontrolling ownership interest amount will be accounted for as equity transactions. This new guidance is effective for the first annual reporting period beginning on or after December 15, 2008, and earlier application is prohibited. The guidance is required to be adopted prospectively, except for reclassifying noncontrolling interests to equity, separate from the parent’s shareholders’ equity, in the consolidated balance sheets and recasting consolidated net income to include net income attributable to both the controlling and noncontrolling interests, both of which are required to be adopted retrospectively. We adopted the new guidance on January 1, 2009. As our subsidiaries are 100% owned, the adoption had no impact on our consolidated financial statements.

        In April 2009, the FASB issued new guidance on interim disclosures about the fair value of financial instruments. This guidance is effective for interim and annual periods ending after June 15, 2009. The staff position requires fair value disclosures of financial instruments on a quarterly basis, as well as new disclosures regarding the methodology and significant assumptions underlying the fair value measures and any changes to the methodology and assumptions during the reporting period. We have adopted this guidance and included the disclosures in our consolidated financial statements.

        In April 2009, the FASB issued new guidance on the recognition and presentation of other-than-temporary impairments. This guidance is effective for interim and annual periods ending after June 15, 2009. The new guidance incorporates impairment guidance for debt securities from various sources of authoritative literature and clarifies the interaction of the factors that should be considered when determining whether a debt security is other-than-temporarily impaired. The adoption of this guidance did not materially impact our consolidated financial statements.

        In April 2009, the FASB issued new guidance on the determination of fair value when the volume and level of activity for the asset or liability have significantly decreased and how to identify transactions that are not orderly. This guidance is effective for interim and annual periods ending after June 15, 2009. The guidance provides additional guidance for estimating fair value in accordance with the FASB’s previous fair value measurement guidance when the volume and level of activity for the asset or liability have significantly decreased. It also includes guidance on identifying circumstances that indicate if a transaction is not orderly (i.e., a forced liquidation or distressed sale). The adoption of this guidance did not materially impact our consolidated financial statements.

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        In May 2009, the FASB issued new guidance on subsequent events which provides guidance on events that occur after the balance sheet date but prior to the issuance of the financial statements. The guidance distinguishes events requiring recognition in the financial statements and those that may require disclosure in the financial statements. Furthermore, the guidance requires disclosure of the date through which subsequent events were evaluated. This guidance is effective for interim and annual periods after June 15, 2009. We have adopted this guidance and have evaluated subsequent events through November 5, 2009.

        In June 2009, the FASB issued new accounting guidance entitled, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162” (“ASC”), which identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. This new guidance is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of this guidance has changed how we reference various elements of GAAP when preparing our financial statement disclosures, but did not have an impact on our financial position, results of operations or cash flows.

        In September 2009, the FASB issued new accounting guidance entitled, Multiple-Deliverable Revenue Arrangements a consensus of the FASB Emerging Issues Task Force. It updates the existing multiple-element revenue arrangements guidance in Emerging Issues Task Force’s guidance entitled, Revenue Arrangements with Multiple Deliverables. The revised guidance primarily provides two significant changes: 1) eliminates the need for objective and reliable evidence of the fair value for the undelivered element in order for a delivered item to be treated as a separate unit of accounting, and 2) eliminates the residual method to allocate the arrangement consideration. In addition, the guidance also expands the disclosure requirements for revenue recognition. The update will be effective for the first annual reporting period beginning on or after June 15, 2010, with early adoption permitted provided that the revised guidance is retroactively applied to the beginning of the year of adoption. We are currently assessing the future impact of this new accounting update to our consolidated financial statements.

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Overview

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

        We generate our revenues through the sales of our products, royalties derived from sales by our licensees, and funded product development programs from other companies. Our total revenues for the three and nine month periods ended September 30, 2009, decreased by 40% and 37%, respectively, as compared to the same periods in 2008. The global economic downturn continues to negatively affect our business and the aesthetic device industry as a whole.

        At September 30, 2009, our balance sheet includes $109.4 million in cash and cash equivalents and no debt. During the three and nine months ended September 30, 2009, we had $3.6 million and $7.8 million, respectively, of positive cash flow from operations.

Results of operations

        The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the three and nine months ended September 30, 2009 and 2008, respectively (in thousands, except for percentages):


Three Months Ended September 30,
2009
2008
Change
Amount
As a % of
Total
Revenue

Amount
As a % of
Total
Revenue

$
%
Revenues                            
      Product revenues   $ 11,229    77 % $ 19,223    79 % $ (7,994 )  (42 %)
      Royalty revenues    1,264    9 %  2,778    12 %  (1,514 )  (54 %)
      Funded product development revenues    806    5 %  955    4 %  (149 )  (16 %)
      Other revenues    1,250    9 %  1,250    5 %  --    -- %





      Total revenues    14,549    100 %  24,206    100 %  (9,657 )  (40 %)





Cost and expenses  
      Cost of product revenues    4,775    33 %  6,764    28 %  (1,989 )  (29 %)
      Cost of royalty revenues    506    3 %  1,111    5 %  (605 )  (54 %)
      Research and development    3,305    23 %  4,220    17 %  (915 )  (22 %)
      Selling and marketing    4,063    28 %  5,946    25 %  (1,883 )  (32 %)
      General and administrative    2,451    17 %  5,953    24 %  (3,502 )  (59 %)





      Total cost and expenses    15,100    104 %  23,994    99 %  (8,894 )  (37 %)





      (Loss) income from operations    (551 )  (4 %)  212    1 %  (763 )  (360 %)
             
      Interest income    218    1 %  799    3 %  (581 )  (73 %)
      Other income (expense)     157    1 %  (69 )  -- %  226  328 %





(Loss) income before income taxes    (176 )  (1 %)  942    4 %  (1,118 )  (119 %)
             
Provision for income taxes    121  1 %  345    1 %  (224 )  (65 %)





Net (loss) income   $ (297 )  (2 %) $ 597    3 % $ (894 )  (150 %)






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Nine Months Ended September 30,
2009
2008
Change
Amount
As a % of
Total
Revenue

Amount
As a % of
Total
Revenue

$
%
Revenues                            
      Product revenues   $ 34,824    79 % $ 56,119    80 % $ (21,295 )  (38 %)
      Royalty revenues    4,032    9 %  8,294    12 %  (4,262 )  (51 %)
      Funded product development revenues    1,636    4 %  1,950    3 %  (314 )  (16 %)
      Other revenues    3,750    8 %  3,998    5 %  (248 )  (6 %)





      Total revenues    44,242    100 %  70,361    100 %  (26,119 )  (37 %)





Cost and expenses  
      Cost of product revenues    15,267    34 %  19,689    28 %  (4,422 )  (22 %)
      Cost of royalty revenues    1,613    4 %  3,318    5 %  (1,705 )  (51 %)
      Research and development    10,125    23 %  14,153    20 %  (4,028 )  (28 %)
      Selling and marketing    13,465    30 %  18,372    26 %  (4,907 )  (27 %)
      General and administrative    7,566    17 %  17,285    25 %  (9,719 )  (56 %)





      Total cost and expenses    48,036    108 %  72,817    103 %  (24,781 )  (34 %)





      Loss from operations    (3,794 )  (8 %)  (2,456 )  (3 %)  (1,338 )  54 %
             
      Interest income    552    1 %  3,058    4 %  (2,506 )  (82 %)
      Other income (loss)    507    1 %  (61 )  -- %  568    931 %





(Loss) income before income taxes    (2,735 )  (6 %)  541  1 %  (3,276 )  (606 %)
             
(Benefit from) provision for income taxes    (780 )  (2 %)  189  -- %  (969 )  (513 %)





Net (loss) income   $ (1,955 )  (4 %) $ 352  1 % $ (2,307 )  (655 %)






        Product revenues. Product revenues for the three and nine months ended September 30, 2009 decreased by approximately $8.0 million and $21.3 million, respectively, as compared to the same periods in 2008 due primarily from the global economic slowdown, a decrease in consumer confidence and additional tightening of available credit from lending facilities for our customers. For the three and nine months ended September 30, 2009, customer service revenue increased by 5% in both periods as compared to the same periods in 2008. Sales of the StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces and the Aspire body sculpting system were the leading contributors to our product revenues for the three and nine months ended September 30, 2009 and 2008.

        International product revenue, consisting of revenue from our Australian subsidiary as well as from distributors in Europe, Asia, the Pacific Rim, and South and Central America and our sales shipped directly to international customers, was 37% and 40%, respectively, of total product revenue for the three and nine months ended September 30, 2009 in comparison to 37% and 33%, respectively, for the same periods in 2008.

        Royalty revenues. Royalty revenues decreased for the three and nine months ended September 30, 2009 in comparison to the same periods in 2008. For the three months ended September 30, 2009, the decrease is attributed to lower on-going royalty payments from our licensees. For the nine months ended September 30, 2009, the decrease is attributed to lower on-going royalty payments from our licensees and the recognition in 2008 of $682,000 in back-owed royalties from a patent settlement agreement with Alma Lasers, Ltd. executed in 2007 as this amount was determinable based on the completion of an audit by an independent accounting firm during the first quarter of 2008.

        Funded product development revenues. Funded product development revenues decreased for the three and nine months ended September 30, 2009, in comparison to the same periods in 2008. Funded product development revenues were generated from the development agreements with Johnson & Johnson Consumer Companies, Inc. and Procter & Gamble (and its wholly owned subsidiary The Gillette Company).

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        For the three months ended September 30, 2009 and 2008, we recognized $0 and $18,000 of funded product development revenues from Procter & Gamble (and its wholly owned subsidiary The Gillette Company). For the nine months ended September 30, 2009 and 2008, we recognized $0 and $216,000, respectively, of funded product development revenues from Procter & Gamble (and its wholly owned subsidiary The Gillette Company). The decrease in funded product development revenue from Procter & Gamble is the result of the termination of the Development and License Agreement with Gillette in the first quarter of 2008.

        For the three months ended September 30, 2009 and 2008, we recognized $806,000 and $937,000 of funded product development revenues from Johnson & Johnson.  The funded product development revenues from Johnson & Johnson in the three and nine months ended September 30, 2009 and 2008 are provided for in several agreement amendments with Johnson & Johnson to provide for additional development funding for certain development activities and a study to test consumer perception of a home-use product which was completed in the third quarter of 2008. These payments will be recognized as revenue as costs are incurred and services are provided.  As of September 30, 2009 and December 31, 2008, $199,000 and $726,000, respectively, of advance payments received from Johnson & Johnson for which services were not yet provided were included in deferred revenue.  On October 16, 2009, we announced the termination of our Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. Despite having met all of our deliverables under the agreement, Johnson & Johnson terminated the agreement referencing the current unfavorable economic conditions as the reason for its decision. With this decision, Johnson & Johnson avoids having to make a large commercialization payment and avoids having to commit to the significant level of funding required to successfully launch a new product into the consumer market.

        Other revenues. For the three months ended September 30, 2009 and 2008, we recognized $1.25 million each period of other revenues, consisting of quarterly payments relating to a License Agreement with The Procter & Gamble Company (see Note 9). For the nine months ended September 30, 2009 and 2008, we recognized $3.75 million and $4.0 million, respectively, of other revenues, consisting primarily of quarterly payments relating to a License Agreement with The Procter & Gamble Company. Other revenues for the nine months ended September 30, 2008, also include the recognition of the remaining portion of trade dress infringement fees associated with the Alma Lasers, Ltd. settlement agreement of $250,000. As of September 30, 2009 and December 31, 2008, $0 and $1.25 million, respectively, of advance payments received from Procter & Gamble for which services were not yet provided were included in deferred revenue.

         Cost of product revenues. For the three months ended September 30, 2009 and 2008, the cost of product revenues as a percentage of total revenues was 33% and 28%, respectively. For the nine months ended September 30, 2009 and 2008, the cost of product revenues as a percentage of total revenues was 34% and 28%, respectively. The increase is due to lower product sales volume which resulted in lower overhead absorption and a shift in product sales to outside North America between the nine months ended September 30, 2009 and 2008, where we sell the majority of our products at fixed transfer prices to our distributors.

        Cost of royalty revenues. The cost of royalty revenues decreased for the three and nine months ended September 30, 2009 in comparison to the same periods in 2008. For the three months ended September 30, 2009, the decrease is attributed to lower on-going royalty payments from our licensees. For the nine months ended September 30, 2009, the decrease is attributed to lower on-going royalty payments from our licensees and the recognition in 2008 of $682,000 in back-owed royalties from a patent settlement agreement with Alma Lasers, Ltd. executed in 2007 as this amount was determinable based on the completion of an audit by an independent accounting firm during the first quarter of 2008. 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 2008.

        Research and development expense. Research and development expense is a direct result of our spending related to our continued commitment of introducing new technology as well as enhancing our current family of products.

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        Expenses relating to the Johnson & Johnson Joint Development and License Agreement (see Note 10) decreased during the three and nine months ended September 30, 2009 by $0.3 million and $1.0 million, respectively, as compared to the same periods in 2008. The decrease for the three months ended September 30, 2009 was mainly due to decreases of $122,000 for clinical expenses, $89,000 for payroll and payroll related expenses, $73,000 for general overhead expenses, and $35,000 for material costs. The decrease for the nine months ended September 30, 2009 was mainly due to decreases of $497,000 for payroll and payroll related expenses, $469,000 for material costs, offset by increases of $12,000 for clinical expenses and $10,000 for general 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 decreased by $0.6 million and $3.1 million for the three and nine months ended September 30, 2009 as compared to the same periods in 2008. The main drivers of the decrease in the three and nine months ended September 30, 2009 as compared to the same periods in 2008 are lower stock-based compensation expense and an overall reduction of expenses during the global economic slowdown.

        Selling and marketing expense. For the three months ended September 30, 2009, selling and marketing expense decreased by $1.9 million over the comparable period in 2008. For the three months ended September 30, 2009, factors driving the decrease in selling and marketing expense were decreases of $1.0 million from commission expense, $562,000 from payroll and payroll related expenses, and $239,000 from general overhead expenses as compared to the same period in 2008. For the nine months ended September 30, 2009, selling and marketing expense decreased by $4.9 million over the comparable period in 2008. For the nine months ended September 30, 2009, factors driving the decrease in selling and marketing expense were decreases of $2.2 million from commission expense, $1.4 million from general overhead expenses, and $1.4 million from payroll and payroll related expenses as compared to the same period in 2008. The majority of these decreases in selling and marketing expenses directly correlate with the decreases we have experienced in our product revenues as well as our intention to reduce expenses during this difficult economic period. Expenses related to our foreign subsidiaries totaled approximately $0.4 million in each of the three months ended September 30, 2009 and 2008 and $0.9 million and $0.7 million, respectively, in the nine months ended September 30, 2009 and 2008.

        General and administrative expense. For the three months ended September 30, 2009, general and administrative expenses decreased by $3.5 million over the comparable period in 2008. For the quarter ended September 30, 2009, factors driving the decrease in general and administrative expense were decreases of $3.8 million from legal expenses mainly related to patent litigation, $576,000 in general overhead expenses, and a decrease in bad debt expense of $159,000, offset by an increase of $1.1 million from incentive compensation as compared to the same period in 2008. For the nine months ended September 30, 2009, general and administrative expenses decreased by $9.7 million over the comparable period in 2008. For the quarter ended September 30, 2009, factors driving the decrease in general and administrative expense were decreases of $9.9 million from legal expenses mainly related to patent litigation, $1.5 million from payroll and payroll related expenses which consists mainly of a decrease in stock-based compensation expense, $1.1 million in general overhead expenses, and a decrease in bad debt expense of $442,000, offset by an increase of $3.0 million from incentive compensation as compared to the same period in 2008.

        Interest income. Interest income decreased for the three and nine months ended September 30, 2009 over the comparable periods in 2008 due to lower cash, cash equivalents, and investments balances mainly due to the construction of our new operational facility, lower interest rates and a more conservative investment strategy. For the nine months ended September 30, 2009 and 2008, we received $0 and $52,000 of interest, respectively, on back-owed royalty revenues related to the new patent license agreement with Alma Lasers, Ltd.

        Other income. Other income for the three and nine months ended September 30, 2009 and 2008, includes the foreign exchange gain (loss) resulting from transactions in currencies other than the U.S. dollar.

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        Provision for (benefit from) income taxes.  We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. Effective January 1, 2007, the Company adopted FIN No. 48, Accounting for Uncertainty in Income Taxes. Our effective benefit tax rate for the nine months ended September 30, 2009 and 2008 was 29% and 35%, respectively. We booked an adjustment in the third quarter 2009 which decreased our research credits. This resulted in an increase to tax expense and decreased our effective tax benefit for the period ended September 30, 2009.

Liquidity and capital resources

        The following table sets forth, for the periods indicated, a year over year comparison of key components of our liquidity and capital resources (in thousands):


Nine months ended
September 30,
Change
2009
2008
$
%
Cash flows from operating activities     $ 7,782   $ 4,079    3,703    91 %
Cash flows (used in) from investing activities    (15,151 )  35,495    (50,646 )  (143 %)
Cash flows used in financing activities    (5,877 )  (2,243 )  3,634    162 %
Capital expenditures, including construction in  
   progress   $ 15,776   $ 890    14,886    1,673 %

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

September 30, December 31, Change
2009
2008
$
%
Cash and cash equivalents     $ 109,360   $ 122,601    (13,241 )  (11 %)
Accounts receivable, net    5,500    6,395    (895 )  (14 %)
Inventories, net    12,455    16,046    (3,591 )  (22 %)
Working capital    114,597    129,703    (15,106 )  (12 %)
Non-current investments, at fair value    4,124    4,487    (363 )  (8 %)
Notes payable    --    6,000    (6,000 )  (100 %)

         We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and other activities for at least the next twelve months. As of September 30, 2009, we had no debt outstanding. The $6.0 million of short-term debt outstanding on December 31, 2008 was repaid during 2009.

        At September 30, 2009, we held $4.1 million in auction-rate securities (ARS). The ARS we invest in are high quality securities, none of which are mortgage-backed. At December 31, 2007, because of the short-term nature of our investment in these securities, they were classified as available-for-sale and included in short-term investments on our consolidated balance sheets. Subsequent to December 31, 2007, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market. As our investments in ARS currently lack short-term liquidity, we have reclassified these investments as non-current as of September 30, 2009. In the nine months ended September 30, 2009, we sold $625,000 of the ARS held at December 31, 2008.

        We have determined that the fair value of our ARS was temporarily impaired as of September 30, 2009. For the three and nine months ended September 30, 2009, we marked to market our ARS and recorded an unrealized loss of $24,000 and an unrealized gain of $143,000, respectively, net of taxes in accumulated other comprehensive (loss) income in stockholder’s equity to reflect the temporary impairment of our ARS. The recovery of these investments is based upon market factors which are not within our control. As of September 30, 2009, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.

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         Cash flows from operating activities for the nine months ended September 30, 2009, increased compared to the same period in 2008. This increase in operating activity cash flows reflects a decrease in working capital requirements, offset by a decrease in profitability, a decrease in tax benefit from the exercise of stock options, and a decrease in stock compensation expense in the first nine months of 2009, compared to the same period in 2008. Cash flows related to investing activities decreased for the nine months ended September 30, 2009, compared to the same period in 2008. These amounts primarily reflect cash used for purchases of property and equipment, purchases of investments, offset by proceeds from the sale of investments. Cash flows used in financing activities increased for the nine month period ended September 30, 2009, compared to the same period in 2008. This increase was primarily due to an increase in net payments on outstanding credit facilities and a decrease in tax benefits from stock option exercises, offset by a decrease in the purchase of treasury shares.

        In December 2008, we secured access to a revolving note through December 17, 2013. Through December 16, 2010, we have access to $30 million. The credit limit is subsequently reduced to $26 million, $22 million, and $18 million on December 17, 2010, December 17, 2011, and December 17, 2012, respectively. Outstanding balances on the revolving note bear interest at a rate equal to the sum of the LIBOR Advantage rate plus 0.75% per annum. At September 30, 2009 and December 31, 2008, we had outstanding debt of $0 and $6 million. The average interest rate at December 30, 2008 was 1.22%. The interest expense was capitalized into Construction in Progress which is a component of Property and Equipment on the consolidated balance sheets and was immaterial for the three and nine months ended September 30, 2009. Any outstanding debt is due on December 17, 2013. On January 2, 2009, we repaid the $6 million borrowed as of December 31, 2008. On July 1, 2009, we repaid the $12 million outstanding as of June 30, 2009. As of September 30, 2009, we had no debt outstanding.

        Our revolving note requires that we maintain certain financial covenants. In order to be in compliance with the covenants, unencumbered cash and marketable securities less outstanding debt must be greater than the credit limit. For all periods in which we had outstanding debt, we were in compliance with the financial covenants. If we were to default on our debt, the building would be used as collateral.

        Excluding the construction of our new operational facility, as discussed below, we anticipate that capital expenditures relating to machinery and equipment, furniture and fixtures, and leasehold improvements for the remainder of 2009 will total approximately $200,000. We expect to finance these expenditures with cash on hand.

        On November 19, 2008, we purchased land for $10.7 million on which we are building our new operational facility. Construction of the building is expected to be completed during the first quarter of 2010. We anticipate that capital expenditures related to the building for 2009 will be approximately $24 million. During the three and nine months ended September 30, 2009, we had $6.3 million and $15.7 million of capital expenditures related to the building. The total cost of the building (exclusive of land) is expected to cost approximately $25 million. We are financing this project by using cash on hand and drawing down on our line of credit.

        On August 13, 2007, our Board of Directors approved a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management’s discretion without prior notice. During the nine months ended September 30, 2009, we used $258,000 to purchase 35,000 shares of our common stock at an average price of $7.39.

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Off-balance sheet arrangements

        We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as variable interest or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of September 30, 2009, we were not involved in any unconsolidated transactions.

Contractual obligations

        We are a party to three patent license agreements with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as a percentage of royalties received from third parties. Royalty expense for the three and nine months ended September 30, 2009 totaled approximately $0.6 million and $1.9 million, respectively.

        For more information, please see the Amended and Restated License Agreement (MGH Case Nos. 783, 912, 2100), the License Agreement (MGH Case No. 2057) and the License Agreement (MGH Case No. 1316) filed as Exhibits 10.1, 10.2, and 10.3 to our Current Report on Form 8-K filed on March 20, 2008.

        We have obligations related to the adoption of FIN 48. Further information about changes in these obligations can be found in Note 12.

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

        On July 30, 2007, we signed an amendment to our Burlington, Massachusetts lease to add an additional 13,600 square feet. The lease for this facility was to expire in August 2009. However, we have renegotiated a 12 month lease extension, expiring in August 2010, at an increase over our current rate to coordinate the timing between construction of our new facility and the expiration of our current facility lease. Rent expense, including these lease amendments, will be approximately $1.5 million in 2009.

        On November 19, 2008, we purchased land for $10.7 million on which we are building our new operational facility. For more information, please see the Purchase and Sale Agreement filed as Exhibit 10.1 to our Current Report on Form 8-K filed on September 16, 2008.

        The following table summarizes our estimated contractual cash obligations as of September 30, 2009, excluding construction in progress related to our new building, royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):


Payments due by period
Total
Less than
1 year

1 - 3
Years

4 - 5
Years

After 5
Years

Operating leases $1,491  $1,491  $     --  $      --  $      -- 
Purchase commitments 3,499  3,499  --  --  -- 





Total contractual cash obligations $4,990  $4,990  $     --  $      --  $      -- 






Item 3. Quantitative and qualitative disclosures about market risk

        Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange rates, interest rates and a decline in the stock market. The current turbulence in the U.S. and global financial markets has caused a decline in stock values across all industries. We are exposed to market risks related to changes in interest rates and foreign currency exchange rates.

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        Our investment portfolio of cash equivalents, corporate preferred securities, and municipal debt securities is subject to interest rate fluctuations, but we believe this risk is immaterial because of the historically short-term nature of these investments. At September 30, 2009, we held $4.1 million in auction-rate securities (ARS). The ARS we invest in are high quality securities, none of which are mortgage-backed. At December 31, 2007, because of the short-term nature of our investment in these securities, they were classified as available-for-sale and included in short-term investments on our consolidated balance sheets. Subsequent to December 31, 2007, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market. As our investments in ARS currently lack short-term liquidity, we have reclassified these investments as non-current as of September 30, 2009. In the nine months ended September 30, 2009, we sold $625,000 of the ARS held at December 31, 2008. The recovery of the remaining $4.1 million ARS held is based upon market factors which are not within our control.

        Our international subsidiaries in The Netherlands and Australia conduct business in both local and foreign currencies and therefore, we are exposed to foreign currency exchange risk resulting from fluctuations in foreign currencies. This risk could adversely impact our results and financial condition. We have not entered into any foreign currency exchange and option contracts to reduce our exposure to foreign currency exchange risk and the corresponding variability in operating results as a result of fluctuations in foreign currency exchange rates.

Item 4. Controls and procedures

        Under the direction of the principal executive officer and principal financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2009. Based on that evaluation, we have concluded that our disclosure controls and procedures were effective.

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

        There were no significant changes in our internal controls over financial reporting or in other factors that could significantly affect these controls during the quarter ended September 30, 2009, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – Other information

Item 1.    Legal proceedings

Candela Corporation, Massachusetts Litigation

        On August 9, 2006, we commenced an action for patent infringement against Candela Corporation in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleges Candela’s GentleYAG and GentleLASE systems, which use laser technology for hair removal willfully infringe U.S. Patent No. 5,735,844 (the “'844 patent”), which is exclusively licensed to us by the Massachusetts General Hospital. Candela answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent and U.S. Patent No. 5,595,568 (the “'568 patent”) are invalid and not infringed. We filed a reply denying the material allegations of the counterclaims.

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        We filed an amended complaint on February 16, 2007 to add the Massachusetts General Hospital as a plaintiff. In addition, we further alleged that Candela’s GentleMAX system willfully infringes the ‘844 patent and that Candela’s Light Station system willfully infringes both the ‘844 and ‘568 patents. On February 16, 2007, Candela filed an amended answer to our complaint adding allegations of inequitable conduct, double patenting and violation of Massachusetts General Laws Chapter 93A. On February 28, 2007, we filed a response to Candela’s amended complaint pointing out many weaknesses in Candela’s allegations. A claim construction hearing, sometimes called a “Markman Hearing”, was held August 2, 2007, and we received what we consider to be a favorable Markman ruling on November 9, 2007.

        On November 17, 2008, the Judge stayed the lawsuit pending the outcome of reexamination procedures requested by a third party on both the ‘844 and ‘568 patents in the United States Patent and Trademark Office (the “Patent Office”). On December 9, 2008, Candela also filed requests for reexamination of both patents. Generally, a reexamination proceeding is one which re-opens patent prosecution to ensure that the claims in an issued patent are valid over prior art references. On January 16, 2009, we filed a preliminary amendment to the ‘844 patent adding new claims 33-59 which depend from claim 32 and a preliminary amendment to the ‘568 patent adding new claims 23 and 24 which depend from claim 1. On June 9, 2009, the Patent Office issued an office action confirming the validity of all claims of the ‘844 patent except claims 12-14. Rejecting Candela’s and the other company’s arguments to the contrary, the Patent Office confirmed that claims 1-3, 6-8, 11, 17-20, 27, 28, 30, 32 of the ‘844 patent are valid and patentable. The Patent Office also confirmed new claims 33-59 as valid and patentable. The Patent Office rejected only independent claim 12 and related dependent claims 13-14 of the ‘844 patent as unpatentable. We cancelled claims 12-14 from the ‘844 patent in order to expedite the reexamination proceeding. Claims 4, 5, 9, 10, 15, 16, 21-26, 29 and 31 are not under reexamination. Consequently, all currently pending claims are valid. On July 13, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘844 patent which will close the reexamination proceeding on the ‘844 patent.

        On June 19, 2009, we filed a motion to lift the stay and reopen the lawsuit. Because Candela has discontinued products which infringe the ‘568 patent, we dropped our claims of infringement of the ‘568 patent from the lawsuit and we agreed to a covenant not to sue Candela for past infringement under the ‘568 patent. On July 13, 2009, Candela filed their opposition to our motion to lift the stay, and on July 17, 2009, we filed our response to their opposition. We are waiting for the Judge to rule on our motion.

        On August 10, 2006, Candela Corporation commenced an action for patent infringement against us in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that our StarLux System with the LuxV handpiece willfully infringes U.S. Patent No. 6,743,222 which is directed to acne treatment, that our QYAG5 System willfully infringes U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions, and that our StarLux System with the LuxG handpiece willfully infringes U.S. Patent No. 6,659,999 which is directed to wrinkle treatment. On October 25, 2006, Candela filed an amended complaint which did not include U.S. Patent No. 6,659,999. Consequently, Candela no longer alleges in this lawsuit that the StarLux System with LuxG handpiece infringes its patents. With regard to the two remaining patents, Candela is seeking to enjoin us from selling these products in the United States if we are found to infringe the patents, and to obtain compensatory and treble damages, reasonable costs and attorney’s fees, and other relief as the court deems just and proper. On October 30, 2006, we answered the complaint denying that our products infringe the asserted patents and filing counterclaims seeking declaratory judgments that the asserted patents are invalid and not infringed. In addition, with regard to U.S. Patent No. 5,312,395, we filed a counterclaim of inequitable conduct.

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        In February 2008, we filed a request for reexamination and then an amended request for reexamination of Candela’s ‘222 patent with the United States Patent and Trademark Office (“Patent Office”). In our request, we argued that Candela’s ‘222 patent is unpatentable over our own United States Patent No. 6,605,080 alone or in combination with other prior art. About the same time, we filed a motion to stay all proceedings in this action related to the ‘222 patent pending resolution of the amended request for reexamination of the ‘222 patent. In March 2008, the Patent Office granted our request for reexamination of the ‘222 patent. On June 11, 2008, the Court ordered the parties to report back to the Court after the Patent Office makes its decision in the reexamination of the ‘222 patent, after which a claim construction hearing (i.e., a Markman Hearing) will be scheduled for both the ‘222 and ‘395 patents. On June 12, 2008, the parties informed the Court that the total time the reexamination will remain pending is not known. No trial date has yet been set. We are defending the action vigorously and believe that we have meritorious defenses of non-infringement, invalidity and inequitable conduct. However, litigation is unpredictable and we may not prevail in successfully defending or asserting our position. If we do not prevail, we may be ordered to pay substantial damages for past sales and an ongoing royalty for future sales of products found to infringe in the United States. We could also be ordered to stop selling any products in the United States that are found to infringe.

Alma Lasers, Inc., Delaware Litigation

        On September 11, 2008, Alma Lasers, Inc. filed a complaint requesting a declaratory judgment that our fractional patent, U.S. Patent No. 6,997,923, is not infringed by Alma’s products and is invalid over prior art. Alma served this lawsuit on us on November 6, 2008, and on November 21, 2008, we filed an answer which denied Alma’s allegations that the patent is invalid and not infringed. We also filed a counterclaim accusing Alma’s Pixel C0(2) Omnifit Fractional C0(2) Handpiece and Pixel C0(2) Fractional C0(2) Skin Resurfacing System of infringing the patent. On December 16, 2008, upon the request of both parties, a mediation conference was scheduled for June 30, 2009 before Magistrate Judge Mary Pat Thynge. On December 18, 2008, upon the request of both parties, the Judge presiding over the lawsuit, stayed the lawsuit and later closed the lawsuit pending the outcome of the mediation. Due to unforeseen circumstances, the mediation scheduled for June 30, 2009 was postponed until October 13, 2009. Following our request, Magistrate Judge Mary Pat Thynge cancelled the mediation on October 6, 2009. By letter dated October 13, 2009, we asked Judge Farnan to re-open the case.

Syneron, Inc., Massachusetts Litigation

        On November 14, 2008, we commenced an action for patent infringement against Syneron, Inc. in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleges Syneron’s eLight, eMax, eLaser, Aurora DS, Polaris DS, Comet and Galaxy Systems, which use light-based technology for hair removal, willfully infringe U.S. Patent Nos. 5,595,568 and 5,735,844, which are exclusively licensed to us by the Massachusetts General Hospital. In March 2009, we served Syneron with this suit. On April 30, 2009, the parties filed a stipulation to stay the lawsuit pending the outcome of the reexaminations of U.S. Patent Nos. 5,595,568 and 5,735,844.

        On June 9, 2009, the Patent Office issued an office action confirming the validity of all claims of the ‘844 patent except claims 12-14. The Patent Office confirmed that claims 1-3, 6-8, 11, 17-20, 27, 28, 30, 32 of the ‘844 patent are valid and patentable. The Patent Office also confirmed new claims 33-59 as valid and patentable. The Patent Office rejected only independent claim 12 and related dependent claims 13-14 of the ‘844 patent as unpatentable. We cancelled claims 12-14 from the ‘844 patent in order to expedite the reexamination proceeding. Claims 4, 5, 9, 10, 15, 16, 21-26, 29 and 31 are not under reexamination. Consequently, all currently pending claims are valid. On July 13, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘844 patent which will close the reexamination proceeding on the ‘844 patent.

        On August 14, 2009, the Patent Office issued a Notice of Intent to Issue Ex Parte Reexamination Certificate for the ‘568 patent which will close the reexamination proceeding on the ‘568 patent. This notice confirmed the validity and patentability of all the claims of the ‘568 patent including new claims 23 and 24.

        On September 23, 2009, we filed a motion to lift the stay and reopen the lawsuit. On October 6, 2009, Syneron filed their opposition to our motion to lift the stay, and on October 9, 2009, we filed our response to their opposition. We are waiting for the Judge to rule on our motion.

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Tria Beauty, Inc., Massachusetts Litigation

        On June 24, 2009, we commenced an action for patent infringement against Tria Beauty, Inc. (previously named Spectragenics, Inc.), in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that the Tria System, which uses light-based technology for hair removal, willfully infringes U.S. Patent No. 5,735,844, which is exclusively licensed to us by the Massachusetts General Hospital. Tria answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent is not infringed, is invalid and not enforceable. We filed a reply denying the material allegations of the counterclaims. On September 21, 2009, following successful re-examination of U.S. Patent No. 5,595,568 (the ‘568 patent), we filed a motion to amend our complaint to add a claim for willful infringement of the ‘568 patent, which is also exclusively licensed to us by the Massachusetts General Hospital. Our motion also included adding the Massachusetts General Hospital as a plaintiff in the lawsuit. Tria did not oppose the motion and the Judge granted the motion on October 8, 2009.

Item 1A.    Risk Factors

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

Recent disruptions in the global economy, the financial markets, and currency markets, as well as government responses to these disruptions, have adversely impacted our business and results of operations.

        Recent distress in the financial markets has had an adverse impact on the availability of credit and liquidity resources. Certain preferred lessors are exiting from our industry or declaring bankruptcy. Prior to selling to a new customer, we require proof of financing. Many of our customers or potential customers are facing issues gaining access to sufficient credit, which is resulting in an impairment of their ability to make timely payments to us or to get financing at all. Lack of availability of consumer credit, a decrease in consumer confidence, and the general economic downturn is adversely impacting the market in which we operate. These factors are causing some customers to postpone buying decisions until economic conditions improve. As a result of recent fluctuations in currency markets and the strong dollar relative to many other major currencies, our products priced in United States dollars have been more expensive relative to products of our foreign competitors, which has resulted in lower sales. In addition, the non-dollar denominated earnings of our foreign operations has been lower when reported by us in US dollars. A slowdown in economic activity caused by the recession has reduced worldwide demand for our products.

Our new Aspire System with SlimLipo handpiece requires the use of consumable treatment tips and fiber delivery assemblies. In the future, we may derive substantial revenue from sales of those consumable components. These products were recently introduced and could fail to generate significant revenue or achieve market acceptance.

        In April 2008, we launched the Aspire body sculpting system and SlimLipo handpiece. Shipments began in the third quarter of 2008. The SlimLipo handpiece is our first minimally invasive product and provides laser-assisted lipolysis. The SlimLipo handpiece requires the use of consumable, single-use treatment tips and a limited-use fiber delivery assembly. In the future, we could receive substantial revenue from sales of the Aspire system with SlimLipo handpiece as well as the consumable components. Our future success will depend on a number of factors, including our ability to increase and maintain sales of the Aspire system with SlimLipo handpiece as well as the consumable components. Several competing systems also require the use of consumable components, while others do not or their consumable components allow for more usage before needing to be replaced. Competing against such systems may be more difficult.

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If third parties are able to supply our customers with consumable treatment tips and fiber delivery assemblies for the Aspire system with SlimLipo handpiece, our business could be adversely impacted.

        To ensure the proper operation of our products, our consumable treatment tips and fiber delivery assemblies are protected by an encryption technology that is designed to authenticate that the tips are supplied by us or by a supplier authorized by us. It is possible that a third party may be able to find methods of circumventing our encryption technology and other technological requirements which ensure that only authorized tips are used with the Aspire system with SlimLipo handpiece. If a third party is able to supply consumable treatment tips and fibers to our customers, this could lead to a reduction in the safety or efficacy of treatments performed with the Aspire system and SlimLipo handpiece as we cannot control the quality or operation of such third party products. This could lead to an increase in product liability lawsuits, damage the Aspire brand, and result in loss of confidence in our products. In addition, such third party supply of consumable treatment tips and fibers to our customers could result in a reduction in the rate of sales and price of consumable treatment tips and fiber delivery assemblies.

We have limited experience manufacturing the Aspire system, SlimLipo handpiece and consumable treatment tips and fiber laser assemblies in commercial quantities, which could adversely impact our business.

        We began manufacturing our Aspire system, SlimLipo handpiece and consumable treatment tips and fiber delivery assemblies during the second half of 2008. Because we have only limited experience in manufacturing in commercial quantities, we may encounter unforeseen situations that would result in delays or shortfalls. We face significant challenges and risk in manufacturing the Aspire laser system, SlimLipo handpiece and consumable treatment tips and fibers, including that production processes may have to change to accommodate any significant future expansion of our manufacturing operations and growth; key components are currently provided by a single supplier or limited number of suppliers, and we do not maintain large inventory levels of these components; and we have limited experience manufacturing the Aspire system, SlimLipo handpiece and consumable treatment tips and fiber delivery assemblies in compliance with FDA’s Quality System Regulation. If we are unable to keep up with or generate demand for the Aspire system, SlimLipo handpiece and consumable components, our revenue could be impaired, market acceptance for the Aspire system, SlimLipo handpiece and consumable components could be adversely affected and our customers might instead purchase competitors’ products.

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

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

We may not be successful in commercializing home-use, light-based devices on our own or with third parties. Managing the development and launch of home-use, light-based devices on our own or with third parties diverts the attention of key technical personnel and management from the professional business.   If we are unsuccessful, it could have a material adverse impact on our business and our stock price could fall.

        One of our goals is to commercialize home-use, light-based devices on our own, and our future growth is largely dependent on our ability to do so. In the future, we could receive substantial revenue from sales of home-use, light-based devices as well as any consumable components sold for use therewith. Our success will depend on a number of factors, including our ability to successfully launch home-use, light-based devices, the timing of such commercial launches and the market acceptance of such consumer products. Our ability may be adversely affected by difficulties or delays in bringing home-use, light-based devices to market, the inability to obtain or enforce intellectual property protection, and market acceptance of our new products. Many of our competitors have publicly announced their intent to enter the consumer market. Competing against such systems may be difficult. Significant resources and the attention of key technical personnel and management have been and will likely continue to be directed to the development and commercialization of home-use devices.  There are no guarantees that any of our home-use products will prove to be commercially successful. If we are not successful, our business could be adversely impacted and the price of our common stock could fall.

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        Our past Development and License Agreement with The Gillette Company (now a wholly owned subsidiary of Procter & Gamble Company) was replaced by a non-exclusive License Agreement with Procter & Gamble in February 2008. During the term of the agreement, Procter & Gamble has the ability to choose not to continue and may terminate the non-exclusive License Agreement. If Procter & Gamble should terminate their non-exclusive License Agreement with us, we will not receive certain payments, including the TTP Quarterly Payments of $1.25 million, and the price of our common stock could fall significantly. If Procter & Gamble continues through commercialization of such devices, Procter & Gamble are to pay us a percentage of net sales of such devices. Certain of these percentages of net sales are only owed if the devices are covered by valid patents.  There can be no assurance that valid patents will cover the devices in any or all countries, in which the devices will be manufactured, used or sold. In addition, a certain portion of the proceeds received on such sales may be owed to Massachusetts General Hospital.  This could have a material adverse effect on our business, results of operations and financial condition.

        We cannot be sure that Procter & Gamble/Gillette or any future third party development partner will agree with our interpretation of the terms of the agreements, that the agreements will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreements.

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

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

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


  o   FDA, other regulatory authorities or an institutional review board may place a clinical trial on hold;
  o   patients may not enroll in clinical trials, or patient follow-up may not occur, at the rate we expect;
  o   patients may not comply with trial protocols;
  o   institutional review boards and third party clinical investigators may delay or reject our trial protocol;

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  o   third party clinical investigators may decline to participate in a trial or may not perform a trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;
  o   third party organizations may not perform data collection and analysis in a timely or accurate manner;
  o   regulatory inspections of our clinical trials or manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials, or invalidate our clinical trials;
  o   governmental regulations may change or administrative actions may occur that cause delays; and
  o   the interim or final results of the clinical trials may be inconclusive or unfavorable as to safety or effectiveness.

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

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

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

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

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

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

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


  o   letters, warning letters, fines, injunctions, consent decrees and civil penalties;
  o   repair, replacement, refunds, recall or seizure of our products; o operating restrictions or partial suspension or total shutdown of production;
  o   refusing or delaying our requests for 510(k) clearance or pre-market approval of new products or new intended uses; and
  o   criminal prosecution.

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

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

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

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

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

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

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

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

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

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

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

We purchased land and began construction of a new operational facility during the fourth quarter of 2008. We are in the process of coordinating the transition from the current facility to the new facility. During this process, our operations may be disrupted during the move to our new facility and our business and operating results could be harmed.

        In the fourth quarter of 2008, we closed on the purchase of land for $10.7 million and entered into a construction management agreement for construction of a new operational facility on that land at a guaranteed maximum price of $23.5 million. We began construction in the fourth quarter of 2008. The lease for this facility was to expire in August 2009. However, we have negotiated a 12 month lease extension, expiring in August 2010, at an increase over our current rate to coordinate the timing between the construction of our new facility and the expiration of our current facility lease. During this time, we may incur many issues which would negatively affect our business and operating results, including:


  o   higher rental expenses after the lease on our current operational facility expires;
  o   permitting difficulties for our new operational facility;
  o   construction cost overruns; and
  o   disruption of operations during the move from our current facility to our new operational facility.

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Our effective income tax rate may vary significantly.

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

We may not be able to realize our deferred tax assets.

        Although we have generated a profit in recent years, we incurred losses during 2008 and the first nine months of 2009. We have a history of losses. If we do not achieve a certain amount of profitability in the near future, it may be more likely than not that we will not be able to realize some or all of our deferred tax assets. If we are unable to realize some or all of our deferred tax assets, we could have a significant charge to our statement of operations which would affect our profitability.

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

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

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

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

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

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

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

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

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


  o   consumer awareness of and demand for procedures and treatments;
  o   the cost, safety and effectiveness of the procedure and of alternative treatments;
  o   the success of our and our customers' sales and marketing efforts to purchasers of these procedures; and
  o   consumer confidence, which may be affected by short-term or long-term economic and other conditions.

        If there is not sufficient demand for the procedures performed with our products, a weakening in the economy, or other factors, practitioner demand for our products may be reduced or buying decisions postponed, which would adversely affect our operating results.

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

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


  o   implement appropriate operational, financial and management controls, systems and procedures;
  o   change our manufacturing capacity and scale of production;
  o   change our sales, marketing and distribution infrastructure and capabilities; and
  o   provide adequate training and supervision to maintain high quality standards.

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

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

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

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

Our proprietary technology has only limited protections which may not prevent competitors from copying our new developments.  This may impair our ability to compete effectively.  We may expend significant resources enforcing our intellectual property rights to prevent such copying, and our intellectual property could be determined to be not infringed, invalid or unenforceable.

        Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We own and license a variety of patents and patent applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. Our pending and future patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued, patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. Changes in either patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection. 

        We have granted certain patent licenses to several competitors, and in return for those license grants, we receive a significant ongoing royalty revenue stream.  A few of these competitors entered into license agreements only after we sued them for patent infringement.  We are currently enforcing certain of our patents against Candela Corporation, Syneron, Inc., Tria Beauty, Inc. and Alma Lasers, Ltd. and intend to enforce against other competitors in the future.  We do not know how successful we will be in asserting our patents against Candela, Syneron, Tria, Alma or other suspected infringers.

         Whether or not we are successful in the pending lawsuits, litigation consumes substantial amounts of our financial resources and diverts management’s attention away from our core business. Public announcements concerning this litigation that are unfavorable to us may in the future result in significant declines in our stock price. An adverse ruling or judgment in this matter could result in a loss of our significant ongoing royalty revenue stream and could also have a material adverse effect on license agreements with other companies both of which could have a material adverse effect on our business and results of operation and cause our stock price to decline significantly.  (For more information about our patent litigation, see Part II, Item 1 Legal Proceedings.)

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

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

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

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

We may not be able to successfully collect licensing royalties.

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

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

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

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

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

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

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

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

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

We face risks associated with product warranties.              

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

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

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

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We are subject to fluctuations in the exchange rate of the U.S. dollar and foreign currencies.

        We do not actively hedge our exposure to currency rate fluctuations. While we transact business primarily in U.S. dollars, and a significant proportion of our revenue is denominated in U.S. dollars, a portion of our costs and revenue is denominated in other currencies, such as the Euro and Australian dollar. As a result, changes in the exchange rates of these currencies to the U.S. dollar will affect our net income.

To successfully grow our international presence, we must address many issues with which we have little or no experience. We may not be able to properly manage our foreign subsidiaries which may have an adverse effect on our business and operating results.

        We have two international subsidiaries which are located in The Netherlands and Australia. In managing foreign operations, we must address many issues with which we have little or no experience which exposes our business to additional risk. Our foreign operations redirect management’s time from other operating issues. We may not be successful in operating our foreign subsidiaries. If we are unsuccessful in managing our foreign subsidiaries, the foreign subsidiaries could be unprofitable and negatively impact our resources and financial position.

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

          Although we have generated a profit in recent years, we incurred losses during 2008 and the first nine months of 2009. We have a history of losses. We may not be able to regain, sustain or increase profitability on a quarterly or annual basis due to many factors including lower demand for our products by practitioners, including practitioners postponing their buying decisions due to the weakening economy, the tightening of the credit market, and other factors. If our operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline.

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

The liquidity and market value of our investments may decrease.

        As of September 30, 2009, we held approximately $4.1 million of auction-rate securities. Recently, there have been disruptions in the market for auction-rate securities related to liquidity which has caused substantially all auctions to fail. All of our securities held as of September 30, 2009 failed in their last auction. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until we sell the securities in a secondary market. In the event that we are unable to sell the underlying securities at or above par, these securities may not provide us a liquid source of cash in the future. At September 30, 2009, due to the uncertainty and illiquidity in this market, we have classified our auction-rate securities as non-current assets and have recorded a cumulative unrealized loss of $0.2 million, net of taxes in accumulated other comprehensive (loss) income. The recovery of these investments is based upon market factors which are not within our control. As of September 30, 2009, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.

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

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

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

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

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

        In April 1999, we adopted a shareholder rights agreement or “poison pill.” This is intended to protect shareholders from unfair or coercive takeover practices. On October 28, 2008, we amended and restated the April 1999 shareholder rights agreement to (i) extend the expiration date to October 28, 2018, (ii) increase the purchase price to $200.00, (iii) amend the definition of “Acquiring Person” to exclude a “Person” qualified to file Schedule 13G as provided in the definition, (iv) amend the recitals to take account of the “Recapitalization” that occurred May 7, 1999, and (v) make any other additional changes deemed necessary. For more information, please see the Amended and Restated Rights Agreement dated October 28, 2008 filed as an exhibit to our Current Report on Form 8-K filed October 31, 2008.

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

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

Our stock price may be volatile.

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


  o   acceptance and success of new products or technologies;
  o   the success of competitive products or technologies;
  o   regulatory developments in the United States and foreign countries;
  o   developments or disputes concerning patents or other foreign countries;
  o   the recruitment or departure of key personnel;
  o   variations in our financial results or those of companies that are perceived to be similar to us;
  o   market conditions in our industry and issuance of new or changed securities analyst's reports or recommendations; and
  o   general economic, industry and market conditions.

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



Period
Total
number of
shares
purchased

Average
price paid
per share

Total number of
shares purchased
as part of
publicly
announced
program *

Maximum number
of shares that
may yet be
purchased
under program *

July 1, 2009 through July 31, 2009 --  --  --  324,500 
August 1, 2009 through August 31, 2009 --  --  --  324,500 
September 1, 2009 through September 30, 2009 --  --  --  324,500 




Total --  --  --  324,500 





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

Item 3. Defaults upon senior securities

         None.

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

         None.

Item 5. Other information

         None.

Item 6. Exhibits 


10.72 Amendment to the Palomar Medical Technologies, Inc. 2007 Stock Incentive Plan

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

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

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

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

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Signatures

        Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Palomar Medical Technologies, Inc.
(Registrant)


Date: November 5, 2009  By:/s/ Joseph P. Caruso       
      Joseph P. Caruso
      President, Chief Executive Officer and Director

Date: November 5, 2009  By:/s/ Paul S. Weiner       
      Paul S. Weiner
      Vice President and Chief Financial Officer





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