Form 10 – Q

United States Securities and Exchange Commission

Washington, D.C. 20549

(Mark one)

[X] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934

For the Quarterly Period Ended June 30, 2002

Or

[ ] 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.
(Exact Name of Issuer as Specified in Its Charter)

82 Cambridge Street, Burlington, Massachusetts 01803
(Address of Principal Executive Offices)

(781) 993-2300
(Issuer’s Telephone Number, Including Area Code)

        Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 [X] No [_]

        As of July 31, 2002, 11,505,406 shares of common stock, $.01 par value per share, were outstanding.

        Transitional Small Business Disclosure Format (check one): Yes [_] No [X]

Palomar Medical Technologies, Inc. and Subsidiaries

Index

i

Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Condensed Balance Sheets

The accompanying notes are an integral part of these consolidated financial statements.

1

Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Condensed Statements of Operations
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

2

Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Equity
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

3

Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Statements of Cash Flow
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

4

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

1. BASIS OF PRESENTATION

        The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim information. Accordingly, they 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. Palomar Medical Technologies, Inc. and its subsidiaries (the “Company” or “Palomar”) believes 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 consolidated financial statements and notes should be read in conjunction with the Company’s Form 10-K for the year ended December 31, 2001.

2. CASH AND CASH EQUIVALENTS

        Cash equivalents consist principally of corporate notes, U.S. government-agency securities, commercial paper, money market funds, and other marketable securities purchased with an original maturity of three months or less. These investments are carried at cost, which approximates market value.

3. INVENTORIES

        Inventories are stated at lower of cost (first-in, first-out) or market and consist of the following:

4. PROPERTY AND EQUIPMENT

        Property and equipment consist of the following:

5. DEBENTURE

        On March 13, 1997, the Company issued a $500,000, 6% convertible debenture due March 13, 2002. The convertible debenture has a conversion price of $11.00. The debenture holder may convert no more than one-third of the debenture in any 30-day period. The Company accounted for this debenture at face value.

        During the six months ended, June 30, 2002, the Company entered into an agreement with the debenture holder to pay the $500,000 convertible debenture originally due March 13, 2002 in five equal monthly installments, beginning April 2002. As part of this agreement, the debenture holder no longer has the option to convert the debenture into common stock. As of June 30, 2002, the Company paid $300,000 plus all outstanding interest.

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

6. SEGMENT AND GEOGRAPHIC INFORMATION

        Product revenue from international sources were $1.0 million and $3.0 million for the three months ended June 30, 2001 and 2002, respectively, and $2.4 million and $4.3 million for the six months ended June 30, 2001 and 2002, respectively. The following table represents the percentage of product revenue by geographic region from customers for the three and six months ended June 30, 2001 and 2002:

7. STOCKHOLDERS’ EQUITY

        During the six months ended June 30, 2002, the Company granted options to purchase 190,000 shares of the Company’s common stock at an exercise price of $0.91 to $0.97. During the six months ended June 30, 2002, options to purchase 91,718 shares of the Company’s common stock were cancelled. During the six months ended June 30, 2002, no options were exercised and none had expired.

        During the six months ended June 30, 2002, no warrants were granted, exercised or cancelled.

        During the six months ended June 30, 2002, the Company converted 6,000 shares of its Series F Preferred Stock including $2,267,553 of accrued dividends and interest into 467,123 shares of the Company’s common stock.

        In connection with the settlement of litigation relating to Varljen v. H.J. Meyers, Inc., et. al, the Company delivered the balance owed under the settlement agreement and issued 358,547 shares of the Company’s common stock during the three months ended March 31, 2002.

        During the six months ended June 30, 2002, the Company issued 148,855 shares of its common stock held in treasury to the 401(k) Plan in satisfaction of the Company’s employer match for 2001 employee contributions.

8. NET INCOME (LOSS) PER COMMON SHARE

        Basic net income (loss) per share was determined by dividing net income (loss) by the weighted average common shares outstanding during the period. Diluted net income (loss) per share was determined by dividing net income (loss) by diluted weighted average shares outstanding. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options based on the treasury stock method and the assumed conversion of all debt obligations and convertible preferred stock and the elimination of related interest expense and preferred stock dividends

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

        The Company’s net income (loss) per share for the three and six months ended June 30, 2001 and 2002 is as follows:

        For the three and six months ended June 30, 2001 and 2002, 6,167,410 and 5,415,678 shares, respectively, of certain outstanding stock options, stock warrants, convertible debt and preferred stock were not included in the diluted weighted average shares outstanding as they were antidilutive.

9. COMPREHENSIVE INCOME (LOSS)

        The Company records unrealized gains or losses on available-for-sale securities in other comprehensive income. Components of other comprehensive income (loss) for the three and six months ended June 30, 2001 and 2002, respectively, consisted of the following:

10. REVENUE RECOGNITION

        The Company recognizes product revenues upon shipment and acceptance. Provisions are made at the time of revenue recognition for any applicable warranty costs expected to be incurred. Revenues from services are recognized in the period the services are provided. Royalty revenues are recognized upon receipts cash payments.

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

        We are a researcher and developer of proprietary light based systems for hair removal and other cosmetic treatments; as well as, the first company to obtain clearance using laser systems from the FDA for “permanent hair reduction.” Palomar’s light based hair removal systems have been installed in physician practices worldwide. Through Palomar’s research partnership with Massachusetts General Hospital’s Wellman Laboratories and other centers, new indications are being tested to further advance the hair removal market and other cosmetic light based applications including fat reduction, acne treatment and skin rejuvenation.

        The Company believes the successful introduction and marketing of new products will become critical to the Company’s long-term success. Broad market acceptance of light based hair removal and specific acceptance of the Palomar EsteLux™ light based system, the Palomar Q-Yag 5™ Q-Switched ND: Yag laser system and the Palomar SLP1000® diode laser system is critical to the Company’s success. The three systems, all of which have FDA clearance, cover a wide spectrum of cosmetic applications; the Palomar SLP1000® is the first diode laser system in the marketplace cleared for use on all skin types and has different hand pieces to be used in a variety of cosmetic applications including hair and vascular lesion removal; the Palomar EsteLux™ system is a fast, more compact and efficient light based system for hair removal and pigmented lesion removal and the Palomar Q-Yag 5™ is a laser system for tattoo and pigmented lesion removal. The Company has traditionally spent a significant amount of its resources in developing new technologies and products.

        The Company believes the following represent its critical accounting policies:

        Revenue Recognition.The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101), as amended by SAB 101A and 101B. SAB 101 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

        Product Warranties.Products sold are generally covered by a warranty for a period of one year. The Company accrues a warranty reserve for estimated costs to provide warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claim activity or increased costs associated with servicing those claims, its warranty accrual will increase resulting in decreased gross profit.

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

        For the three months ended June 30, 2002, the Company’s revenues increased to $6.4 million, as compared to $6.1 million for the three months ended June 30, 2001. The increase in the Company’s revenues of $300,000, or 5% from the three months ended June 30, 2001, was mainly due to an increase in product sales of $3.7 million from the EsteLux, an increase of $330,000 in product sales of the Q-Yag 5, offset by a decrease in sales of $25,000 associated with the RD1200, $206,000 associated with the E2000 and $1.8 million from shipments associated with the SLP 1000. Additionally, royalty revenues received by the Company decreased by $1.7 million in 2002 compared to 2001. This decrease in royalty revenue is attributed to a back-owed payment of $1.2 million, paid by one of the Company’s licensees in 2001, resulting from a royalty audit performed through the period ending December 31, 2000.

        Gross profit for the three months ended June 30, 2002 was $3.4 million, 53% of revenues, compared to $2.4 million, 40% of revenues, for the three months ended June 30, 2001. The EsteLux and Q-Yag 5 are lower cost and higher margin products. As a result, the shift in product mix to the EsteLux and Q-Yag 5 has directly contributed to the increase in gross profit and gross profit percentage for the three months ended June 30, 2002.

        Research and development costs decreased to $1.1 million for the three months ended June 30, 2002, as compared to $1.4 million for the three months ended June 30, 2001. Research and development expenses as a percentage of revenue totaled 17% for the three months ended June 30, 2002 and 24% for the three months ended June 30, 2001. This decrease of $300,000 is a result from the investment that the Company made in prior periods in the development of product platforms. These platforms allow the Company to introduce new applications by changing the specifications of these platforms rather than developing entirely new products. The continued spending on research and development reflects the Company’s commitment to research and development for devices and delivery systems for cosmetic and medical applications using a variety of light-based

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systems, while continuing dermatology research utilizing the Company’s platforms. The research and development goals in the fields of light-based hair removal are to design systems that (1) permit more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured at a lower cost, thus addressing broader markets. Further, the Company is aiming to address dermatology and cosmetic procedure markets other than hair, including the fields of fat reduction, acne treatment and skin rejuvenation.

        Sales and marketing expenses were $1.4 million, or 22% of revenues for the three months ended June 30, 2002, compared to $1.1 million, or 19% of revenues for the three months ended June 30, 2001. This increase in sales and marketing expenses is attributable to the product launch of the EsteLux and Q-Yag 5 systems.

        General and administrative expenses were $789,000 or 12% of revenues for the three months ended June 30, 2002, as compared to $702,000, or 12% of revenues for the three months ended June 30, 2001. This increase in general and administrative expenses is attributable to an increase in legal expenses.

        Interest income decreased to $15,000 for the three months ended June 30, 2002, compared to $288,000 for the three months ended June 30, 2001. This decrease in interest income is attributable to the reduction in cash available for investment and a reduction in effective interest rates.

        Interest expense increased to $27,000 for the three months ended June 30, 2002, compared to $24,000 for the three months ended June 30, 2001. This increase in interest expense is attributable to higher average debt balances as a result of the note payable to related party.

        Other income was $110,000 for the three months ended June 30, 2002. This amount was a receipt of a partial payment of a note receivable that was written off in a prior year.

        For the six months ended June 30, 2002, the Company’s revenues increased to $10.6 million, as compared to $9.7 million for the six months ended June 30, 2001. This increase in the Company’s revenues of $944,000, or 10% from the six months ended June 30, 2001, was mainly due to an increase in product sales of $5.2 million from the EsteLux, an increase of $803,000 in product sales of the Q-Yag 5, an increase in sales of $125,000 associated with the RD1200 offset by a decrease of $388,000 from shipments associated with the E2000 and $2.9 million from shipments associated with the SLP 1000. Additionally, royalty revenues received by the Company decreased by $1.9 million in 2002 compared to 2001. This decrease in royalty revenue is attributed to a back-owed payment of $1.2 million, paid by one of the Company’s licensees in 2001, resulting from a royalty audit performed through the period ending December 31, 2000.

        Gross profit for the six months ended June 30, 2002 was $5.1 million, 48% of revenues, as compared $3.3 million, 35% of revenues for the six months ended June 30, 2001. The EsteLux and Q-Yag 5 are lower cost and higher margin products. As a result, the shift in product mix to the EsteLux and Q-Yag 5 has directly contributed to the increase in gross profit and gross profit percentage for the six months ended June 30, 2002.

        Research and development costs decreased to $2.1 million for the six months ended June 30, 2002, from $3.1 million for the six months ended June 30, 2001. Research and development expenses as a percentage of revenue totaled 20% for the six months ended June 30, 2002 and 32% for the six months ended June 30, 2001. This decrease of $1.0 million is a result from the investment that the Company has made over the past quarters into the development of product platforms. These platforms allow the Company to introduce new applications by changing the specifications of these platforms rather than developing entirely new products. The continued spending on research and development reflects the Company’s commitment to research and development for devices and delivery systems for cosmetic and medical applications using a variety of light-based systems, while

9

continuing dermatology research utilizing the Company’s platforms. The research and development goals in the fields of light-based hair removal are to design systems that (1) permit more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured at a lower cost, thus addressing broader markets. Further, the Company is aiming to address dermatology and cosmetic procedure markets other than hair, including the fields of fat reduction, acne treatment and skin rejuvenation.

        Sales and marketing expenses increased to $2.2 million or 20% of revenues for the six months ended June 30, 2002, from $1.9 million or 19% of revenues for the six months ended June 30, 2001. This increase in sales and marketing expenses is attributable to the product launch of the EsteLux and Q-Yag5.

        General and administrative expenses decreased to $1.4 million or 13% of revenues for the six months ended June 30, 2002, as compared to $1.6 million or 16% of revenues for the six months ended June 30, 2001. This decrease in general and administrative expenses is attributable to improved cost management.

        Interest income decreased to $35,000 for the six months ended June 30, 2002 as compared to $587,000 for the six months ended June 30, 2001. This decrease in interest income is attributable to the reduction in cash available for investment and a reduction in effective interest rates.

        Interest expense increased to $57,000 for the six months ended June 30, 2002, from $48,000 for the six months ended June 30, 2001. This increase in interest expense is attributable to higher average debt balances as a result of the note payable to related party.

        Other income increased to $168,000 for the six months ended June 30, 2002, as compared to $127,000 for the six months ended June 30, 2001.

        As of June 30, 2002, the Company had $4.1 million in cash and cash equivalents. The successful sales and marketing of new products and an on-going royalty stream will be critical to future liquidity.

     The Company’s operating activities used cash of $1.2 million and $3.1 million for the six months ended June 30, 2002 and 2001, respectively. Net cash used during the six months ended June 30, 2002 consisted primarily of a net loss from operations, offset by depreciation and amortization, an increase in accounts receivable, deferred revenue and a decrease in inventories, other current assets, accounts payable and accrued liabilities. Net cash used during the six months ended June 30, 2001 consisted primarily of a net loss from operations, offset by depreciation and amortization, an increase in accounts receivable, inventories, accrued liabilities, deferred revenue and a decrease in other current assets, and accounts payable.

        Investing activities used cash of $89,000 and provided cash of $1.9 million during the six months ended June 30, 2002 and 2001, respectively. During the six months ended June 30, 2002, the principal uses were purchases of property and equipment offset by a decrease in other assets. During the six months ended June 30, 2001, the principal use was purchases of property and equipment and purchases of available-for-sale investments, offset by proceeds from sales of available-for-sale investments.

        Financing activities used cash of $407,000 and $1.0 million during the six months ended June 30, 2002 and 2001, respectively. During the six months ended June 30, 2002, cash used from financing activities was the result of costs incurred related to the issuance of common stock and payments made on a debenture offset by the proceeds from the issuance of stock pursuant to the employee stock purchase plan and 401K matching contributions. Financing activities used cash of $1.0 million during the six months ended June 30, 2001 due to costs incurred related to the issuance of common stock and payments made on Swiss Franc convertible debentures offset by the proceeds from the issuance of stock pursuant to the employee stock purchase plan and 401K matching contributions.

        The Company anticipates that capital expenditures for 2002 will total $200,000, consisting primarily of machinery, equipment, computers and peripherals. The Company expects to finance these expenditures with cash on hand and equipment leasing.

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Statement under the Private Securities Litigation Reform Act

        In addition to the other information in this Form 10-Q, the following cautionary statements should be considered carefully in evaluating the Company and its business. Statements contained in this Form 10-Q that are not historical facts and other information provided by the Company and its employees from time to time may contain certain forward-looking information, as defined by (i) the Private Securities Litigation Reform Act of 1995 (the “Reform Act”) and (ii) releases by the SEC. Our actual results could differ materially from those suggested in such forward-looking statements due to the risk factors identified below and other factors including, without limitation, risks concerning the timing of new product introductions, financing of future operations, the Company’s research partnership with MGH, manufacturing risks, variations in our quarterly results, enforcement of intellectual property rights by us and our competitors, the occurrence of unanticipated events and circumstances, and general economic conditions, including stock market volatility. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. The cautionary statements below are being made pursuant to the provisions of the Reform Act and with the intention of obtaining the benefits of safe harbor provisions of the Reform Act. Forward looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words.

RISK FACTORS

Our future revenue depends on our successfully developing and marketing new products.

        We face rapidly changing technology and continuing improvements in cosmetic light-based technology. In order to be successful, we must continue to make significant investments in research and development in order to develop in a timely and cost-effective manner new products that meet changing market demands, to enhance existing products, and to achieve market acceptance for such products. We have in the past experienced delays in developing and marketing new products and enhancing existing products. Furthermore, some of our new products under development are based on unproven technology and/or technology with which the Company has no previous experience. Since the sale of Star to Coherent, our revenues have almost entirely depended on sales of newly introduced products. In addition, the market for hair removal light-based devices may already be saturated. At present, broad market acceptance of light-based hair removal is critical to our success. We intend to continue to diversify our product line by developing cosmetic light-based products for uses other than hair and tattoo removal and treatment of pigmented and vascular lesions, but there can be no assurance that we will be able to successfully implement such strategy in a timely fashion or at all.

We face intense competition from companies with superior financial, marketing and other resources.

        The light-based hair removal industry is highly competitive and companies frequently introduce new products. We compete in the development, manufacture, marketing and servicing of hair removal light-based devices with numerous other companies, some of which have substantially greater financial, marketing and other resources than we do. As a result, some of our competitors are able to sell hair removal light-based devices at prices significantly below the prices at which we sell our products. In addition, as a result of the Star sale to Coherent and its subsequent re-sale to Lumenis, Lumenis is now a stronger competitor and we have had to find new ways to distribute our products. Our products also face competition from alternative medical products and procedures, such as electrolysis and waxing, among others. We may not be able to differentiate our products from the products of our competitors, and customers may not consider our products to be superior to competing products or medical procedures, especially if competitive products and procedures are offered at lower prices. Our competitors may develop products or new technologies that make our products obsolete or less competitive.

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We may need to secure additional financing, and our former auditors have expressed doubt about our ability to continue as a going concern.

        We have a history of losses. As a result, the report of our former independent public accountants in connection with our Consolidated Balance Sheets as of December 31, 2000 and 2001, and the related Consolidated Statements of Operations, Stockholders’ Equity (Deficit) and Cash Flows for the three years ended December 31, 2001 includes an explanatory paragraph stating that our recurring losses, and cash flow from operations raises substantial doubts about our ability to continue as a going concern. We may have to secure additional financing to complete our research and development activities, commercialize our current and proposed cosmetic light-based products, and fund ongoing operations. However, there can be no assurance that such financing will be obtained. We may also determine, depending upon the opportunities available, to seek additional debt or equity financing to fund the costs of operations or expansion. Additionally, if we incur indebtedness to fund increased levels of accounts receivable, finance the acquisition of capital equipment, or if we issue debt securities in connection with any acquisition we will be subject to risks associated with incurring substantial additional indebtedness.

Our quarterly operating results are and may continue to be volatile, and that may hurt the price of our common stock.

        If our operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline.

We could be delisted from NASDAQ.

        For continued listing on The NASDAQ SmallCap Market, a company must maintain a minimum bid price of $1.00 per share. A company must also maintain a minimum requirement of net tangible assets of $2.5 million or market capitalization of $35 million or net income (in latest fiscal year or 2 of the last 3 fiscal years) of $500,000. We are currently in compliance with all of NASDAQ’s requirements for continued listing on The NASDAQ SmallCap Market. However, there can be no assurance that we will remain in compliance with NASDAQ’s criteria for continued listing or that we will remain listed on NASDAQ. The delisting of our common stock would likely reduce the liquidity of our common stock and our ability to raise capital. If our common stock is delisted from The NASDAQ SmallCap Market, it will likely be quoted on the “pink sheets” maintained by the National Quotation Bureau, Inc. or NASDAQ’s OTC Bulletin Board. These listings can make trading more difficult for stockholders.

We depend on a number of vendors for critical components in our current and future products.

        We develop light-based systems that incorporate third-party components. Some of these items are custom made or otherwise not readily available on the market. We purchase some of these components from small, specialized vendors that are not well capitalized. A disruption in the delivery of these key components could have an adverse effect on our business.

Our products are subject to numerous medical device regulations. Compliance is expensive and time-consuming. Our new products may not be able to obtain the necessary clearances in order to sell them.

        All of our current products are light-based medical 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 introduced into the market, we must obtain clearance from the FDA. Our products may also be subject to state regulations, which are, in many instances, in a state of flux. Changes in state regulations may enhance or impede sales. Our products are subject to similar regulations in our major international markets. Complying with these regulations is necessary for our strategy of expanding the markets for and sales of our products into these countries. Compliance with the regulatory clearance process in any country is expensive and time-consuming, and we may not be able to obtain such clearances in a timely fashion or at all. 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.

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        Federal regulation allows our products to be sold to and used by licensed practitioners as determined on a state-by-state basis. As a result in some states, non-physicians may operate our product. The purchase and use of our products by non-physicians may result in their misuse, which could harm our reputation and expose us to costly product liability litigation.

We are dependent on third-party researchers.

        We are substantially 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 substantially dependent upon 3^rd party researchers to grant us licensing terms, which may or may not be favorable for products and technology, which they may develop. At present, our principal research partner is the Wellman Laboratories of Photomedicine at Massachusetts General Hospital. We provide research funding, laser technology and optics know-how in return for licensing rights with respect to specific medical applications and patents. Our success will be highly dependent upon the results of this research. We cannot be sure 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.

Our common stock could be further diluted as the result of outstanding, convertible securities, warrants and options.

        In the past, we have issued convertible securities, such as debentures, preferred stock and warrants, in order to raise money. We have also issued options and warrants as compensation for services and incentive compensation for our employees and directors. We have a substantial number of shares of common stock reserved for issuance upon the conversion and exercise of these securities. These outstanding convertible securities, options and warrants could dilute our stockholders, and could adversely affect the market price of our common stock.

Our proprietary technology has only limited protections.

        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, license and confidentiality agreements to protect our proprietary rights. We generally enter into non-disclosure agreements with our employees and third parties with which we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our technology. 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. Costly and time consuming lawsuits may be necessary to enforce 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. Our competitors also may independently develop technologies that are substantially equivalent or superior to our technology.

We could become subject to claims by third parties regarding intellectual property rights.

        In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. The medical laser / light-based industry in particular is characterized by the large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. Because 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. Although patent and intellectual property disputes in the laser / 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

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some of our products. This could have a material adverse effect on our business, results of operations and financial condition.

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

        Our Second Restated Certificate of Incorporation and our By-laws contain provisions that could discourage takeover attempts or make more difficult the acquisition of a substantial block of our common stock. Our By-laws require a stockholder to provide to the Secretary of the Company 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 the outstanding stock of the Company until the next stockholders’ meeting. In addition, the Board of Directors is authorized to issue shares of 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 the Company.

        The Company is also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits the Company 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 management of the Company, including transactions in which stockholders might otherwise receive a premium for their shares over the then current market prices.

As with any new products, there is substantial risk that the marketplace may not accept or be receptive to the potential benefits of our products.

        Market acceptance of our current and proposed products will depend, in large part, upon our or any marketing partner’s ability to demonstrate to the marketplace the advantages of our products over other types of products. There can be no assurance that the marketplace will accept applications or uses for our current and proposed products or that any of our current or proposed products will be able to compete effectively.

We may not be able to successfully collect licensing royalties.

        At present, material portions of our revenues consist of royalties from sub-licensing patents licensed to us on an exclusive basis by Massachusetts General Hospital. However, there can be no assurance that these royalty amounts will not decrease or that we will be able to collect all licensing royalties owed by current licensees or increase royalties by sub-licensing additional third parties.

We face risks associated with pending litigation.

        We are involved in disputes with third parties. Such disputes have resulted in litigation with such parties. We have incurred, and likely will continue to incur, legal expenses in connection with such matters. There can be no assurance that such litigation will result in favorable outcomes for us. Any adverse result in litigation could have a material adverse effect on our business, financial condition and results of operations.

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We may not be able to retain our key executives and research and development personnel.

        As a small company with less than 100 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.

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

        Our products are and will continue to be designed with numerous safety features, but it is possible that patients could be adversely affected by use of one of our products. Further, in the event that any of our products prove to be defective, we may be required to recall and redesign such products. Although we have not experienced any material losses due to product liability claims to date, there can be no assurance that we will not experience such losses in the future. We maintain general liability insurance in the amount of $1 million per occurrence and $2 million in the aggregate and maintain umbrella coverage in the aggregate amount of $25 million; however, there can be no assurance that such coverage will continue to be available on terms acceptable to us or that such coverage will be adequate for liabilities actually incurred. In the event we are found liable for damages in excess of the limits of our insurance coverage or if any claim or product recall results in significant adverse publicity against us, our business, financial condition and results of operations could be materially and adversely affected. In addition, although our products have been and will continue to be designed to operate in a safe manner, and although we attempt to educate customers with respect to the proper use of our products, misuse of our products by personnel over whom we cannot exert control may result in the filing of product liability claims or significant adverse publicity against us.

We face risks of obsolete inventory as a result of rapid changes in technology.

        We operate in an industry that is subject to rapid changes in technology and intense competition, which could make our light-based systems obsolete. If forecasted demand decreases, we could have excess inventories, which could obsolete certain product lines and result in a write-off of some or all of our inventory.

We face risks associated with revenues.

        There can be no certainty as to the severity or duration of the current economic downturn and its impact on our future revenues.

We face risks associated with product warranties.

        We could incur substantial costs as a result of product failures that the Company is responsible under warranty obligations.

We face risks associated with liquidity and capital resources.

        There can be no assurance that we will not require additional financing to fund our operations or that such additional funding, if needed, will be available on terms acceptable to us or at all.

We may be unable to generate sufficient revenues to achieve profitability.

        There can be no assurance that our revenues will increase or that we will generate sufficient revenues to achieve or sustain profitability. While we strive to minimize the Company’s business expenses, we will continue to have large fixed expenses and we expect to continue to incur significant sales and marketing, product development, customer support and service, administrative and other expenses. As a result, we need to generate significantly higher revenue to achieve and maintain profitability.

Terrorist acts and acts of war may seriously harm our business and revenues, costs and expenses and financial condition.

        Terrorist acts or acts of war (wherever located around the world) may cause damage or disruption to Palomar, our employees, facilities, partners, suppliers, distributors, resellers, or customers, which could significantly impact our revenues, costs and expenses and financial condition. The terrorist attacks that took place in the United States on September 11, 2001 were unprecedented events that have created many economic and political uncertainties, some of which may materially harm our business and results of operations. The long-term effects on our business of the September 11, 2001 attacks are unknown. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility have created many economic and political uncertainties, which could adversely affect our business and results of operations in ways that cannot presently be predicted.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

        SFAS No. 107 requires disclosure about fair value of financial instruments. Financial instruments consist of cash equivalents, accounts receivable, accounts payable and short-term debt obligations. The fair value of these financial instruments approximates their carrying amount as of June 30, 2002 due to their short-term nature. All of the Company’s investments are considered cash equivalent money market accounts and debt securities which are considered available-for-sale investments and are carried at market value, with the difference between cost and market value, net of related tax effects, recorded as a separate component of stockholders’ equity. Accordingly, the Company has no quantitative information concerning the market risk of participating in such investments.

        Under its current policies, the Company does not use derivative financial instruments, derivative commodity instruments or other financial instruments to manage its exposure to changes in interest rates, foreign currency exchange rates, commodity prices or equity prices.

        The Company’s primary market risk exposures are in the areas of interest rate risk. The Company’s investment portfolio of cash equivalents is subject to interest rate fluctuations, but the Company believes this risk is immaterial because of the short-term nature of these investments.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

        The Company is party to various legal proceedings incident to its business. Except as noted below, there are no legal proceedings pending or threatened against the Company that management believes are likely to have a material adverse effect on the Company's consolidated financial position.

        On February 15, 2002, the Company commenced action for patent infringement in the United States District Court of Massachusetts against Altus Medical Inc. (“Altus”) seeking both monetary damages and injunction relief. The complaint alleges Altus’ CoolGlide and CoolGlide Excel laser systems willfully infringe a U.S. patent exclusively licensed to the Company by The General Hospital Corporation (“General”). General has been added as a plaintiff in this lawsuit. Altus answered the complaint denying that its products infringe the asserted patent and filed a counterclaim seeking a declaratory judgment that the asserted patent is invalid and not infringed. The Company and General filed a reply denying the material allegations of the counterclaims. The Company and General have further alleged that Altus’ CoolGlide Vantage laser system also willfully infringes the asserted patent. A trial date has not yet been set.

Item 2. Changes in Securities

      Not applicable.

Item 3. Defaults upon Senior Securities

      Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

        The following table sets forth a brief description of each matter voted upon and the number of votes cast for or against, as well as the number of abstentions, as to each such matter, at the Company’s Annual Meeting of Stockholders held on May 15, 2002.

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Item 5. Other Information.

      Not applicable.

Item 6. Exhibits and Reports on Form 8-K.

      99.1––Certificate pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).

        A Form 8-K was filed on July 8, 2002 regarding Palomar’s announcement that its Board of Director’s, upon the recommendation of its Audit Committee, dismissed Arthur Andersen LLP who had previously acted as Palomar’s independent auditor. Palomar engaged Ernst & Young LLP as its new independent auditors to audit the financial statements of Palomar for the fiscal year ending December 31, 2002, as well as to perform a timely review of its second quarter results for fiscal 2002.

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SIGNATURES

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

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