UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2003.

Commission file number 0-22340

PALOMAR MEDICAL TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:  (781) 993-2300

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 is an accelerated filer (as defined by Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No ý

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Palomar Medical Technologies, Inc. and Subsidiaries

Table of Contents

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

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

1

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

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

2

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

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. 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 condensed consolidated financial statements and notes should be read in conjunction with the Company's Form 10-K for the year ended December 31, 2002.

2. Stock based compensation.

        The Company follows Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations, in accounting for its stock-based compensation plans, rather than the alternative fair value accounting method provided for under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. Under APB 25, when the exercise price of options granted under these plans equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is required. In accordance with Emerging Issues Task Force (EITF) 96-18, the Company records compensation expense equal to the fair value of options and warrants granted to non-employees over the vesting period.

        The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The Company has computed the pro forma disclosures required under SFAS No. 123 for all stock options granted to employees of the Company for the three-months and nine-months ended September 30, 2003 and 2002, respectively, using the Black-Scholes option-pricing model prescribed by SFAS No. 123.

        Pro forma disclosure. The pro forma effect on the Company of applying SFAS No. 123 for all options and warrants to purchase common stock of the Company would be as follows:

3. 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 when purchased with an original maturity of three months or less. These investments are carried at cost, which approximates market value.

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

4. Inventories

        Inventories consist of the following:

        During the quarter ended March 31, 2003, the Company wrote-off $250,000 of certain inventory related to the SLP 1000 product line to cost of product revenues.

5. Property and equipment

        Property and equipment consist of the following:

6. Segment information

        Product revenue from international sources were $4.0 million for both the three-months ended September 30, 2003 and 2002, and $11.6 million and $8.3 million for the nine-months ended September 30, 2003 and 2002, respectively. The following table represents the percentage of product revenue by geographic region from for the three and nine-months ended September 30, 2003 and 2002:

7. Guarantees

        The Company’s products generally carry a standard one-year warranty. The Company provides a reserve based on anticipated warranty claims at the time product revenue is recognized. In anticipation of actual warranty claims, the Company amortizes the reserve ratably over the life of the warranty thereby offsetting actual warranty claims incurred. Actual warranty claims incurred and charged to cost of product revenues during an interim period may be more or less than the amount of amortized warranty reserve allocated against them. Factors that affect the Company’s product warranty liability include the number of installed units, the anticipated cost of warranty repairs and historical and anticipated rates of warranty claims.

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

        During the three months ended September 30, 2002, the Company experienced unusually high warranty claims for one of its products due to issues related to a key component. Accordingly, the Company increased its warranty reserve by $250,000 in the third quarter of 2002. During 2003, the Company began replacing the key component that was causing the product failure. At September 30, 2003, the Company’s warranty reserve for this particular product failure was approximately $350,000. At this time, the Company believes that the replacement part will rectify the problem and, if so, the Company’s reserve may exceed its estimated warranty obligation. However, management’s assessment is that it is too early to adjust such reserve until the replacement part has operated satisfactorily for a longer period of time.

        The following table reflects the changes in the Company’s accrued warranty during the nine-months ended September 30, 2003:

8. Stockholders’ equity

        Options to purchase common stock. During the nine-months ended September 30, 2003, the Company granted options to purchase 432,000 shares of the Company’s common stock at exercise prices ranging from $1.51 to $8.23. During the nine-months ended September 30, 2003, 1,164,780 shares of the Company’s common stock were exercised at exercise prices ranging from $0.90 to $3.1875 per share. During the nine-months ended September 30, 2003, options to purchase 85,074 shares of the Company’s common stock were cancelled.

        Warrants to purchase common stock. During the nine-months ended September 30, 2003, no warrants were granted or exercised and warrants to purchase 1,515,691 shares of common stock were cancelled.

        Exchange of note payable for common stock. On March 14, 2003, a director surrendered the $1 million principal balance of a Promissory Note and was issued 293,255 shares of the Company’s common stock with no registration rights at a price of $3.41 per share. The price was calculated at 110% of the Company’s common stock trailing ten-day average closing price of $3.10 per share.

        Private placement purchase of common stock. On March 14, 2003, the Company completed a private placement with Craig Drill Capital, a private investment firm based in New York City, for the purchase of 1 million shares of the Company’s common stock with no registration rights at a price of $3.41 per share for an aggregate subscription price of $3.4 million. The price was calculated at 110% of the Company’s common stock trailing ten-day average closing price of $3.10 per share.

        Issuance of common stock for employee stock purchase plan. During the nine-months ended September 30, 2003, employees purchased 19,060 shares of the Company’s common stock for $24,000 pursuant to the Purchase Plan.

        Issuance of stock for 401(k) match. The Company issued 184,109 shares of its common stock to the 401(k) Plan in satisfaction of the Company’s employer match for 2002 employee contributions during the nine-months ended September 30, 2003.

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

9. Net income (loss) per common share

        Basic net income (loss) per share was determined by dividing net income (loss) attributable to common stockholders by the weighted average common shares outstanding during the period. Diluted net income (loss) per share was determined by dividing net income (loss) attributable to common stockholders by diluted weighted average shares outstanding. Diluted weighted average shares reflect the dilutive effect, if any, of common stock options and warrants 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.

        The Company’s reconciliation of basic and diluted weighted average shares outstanding is as follows:

        For the nine-months ended September 30, 2002, potential common shares of 118,749 of certain outstanding stock options and stock warrants were not included in the diluted weighted average shares outstanding as they were antidilutive.

10. Funded product development revenue

        As of February 14, 2003, the Company entered into a Development and License Agreement with the Gillette Company (NYSE: G) (“Gillette”) to complete development and commercialize a home-use, light-based, hair removal device for women. The device is protected by multiple patents within the Company’s patent portfolio. The agreement provides up to $7 million in initial development support funding to be paid by Gillette to the Company over approximately the first 30 months of the agreement, with $2.6 million to be provided during 2003.

        The Company accounts for funded product development revenue under the Gillette agreement ratably over the funding period. In September 2003, Gillette made a $700,000 payment to the Company to fund development for the fourth quarter of 2003. This amount is included in deferred revenue at September 30, 2003.

11. Income taxes

        During the three months ended June 30, 2003, the Company recognized a tax benefit of $470,000, which is associated with the recovery of carryback operating losses paid in prior years pursuant to the Economic Stimulus package of 2002. During the three months ended, September 30, 2003, the Company recognized a benefit from income taxes of $300,000, which is attributed to the reduction in deferred income tax accruals associated with certain tax deductions taken in the Company’s 1999 Federal Tax return. Offsetting these refund claims during each of these periods, the Company provided a 4% effective tax rate for both the three-months and nine-months ended September 30, 2003 for the anticipated federal alternative minimum taxes and minimum state income taxes due for 2003.

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

Overview

        We are a full service Company including research, development, manufacturing and selling of proprietary light based systems for hair removal and other cosmetic treatments; as well as, the first company to obtain clearance from the FDA using laser systems for “permanent hair reduction.” Palomar’s light based hair removal systems have been installed in physician practices worldwide. Through Palomar’s research partnerships with Massachusetts General Hospital’s Wellman Laboratories (“General”) 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.

        Broad market acceptance of light based hair and tattoo removal and other cosmetic applications and further acceptance of the Palomar MediLux™ lamp based system, the Palomar EsteLux™ lamp based system, the Palomar NeoLux™ lamp based system and the Palomar Q-Yag 5™ Q-Switched ND: Yag laser system are critical to the Company’s success. These four systems, all of which have FDA clearance, cover a wide spectrum of cosmetic applications. The Palomar MediLux system is a higher powered system than the Palomar EsteLux system, and also has a higher repetition rate (treatment rate) and quick connect handpiece connector. Both the Palomar MediLux and EsteLux systems are fast, compact and efficient lamp based systems for both temporary and permanent hair reduction and pigmented and vascular lesion removal. In addition, the Palomar MediLux and EsteLux systems are sold outside the United States for treatment of acne and Palomar is currently seeking FDA clearance for this application in the United States. The Palomar NeoLux is a fast, compact and efficient lamp based system for both temporary and permanent hair reduction and pigmented lesion removal. 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 and believes that the successful introduction and marketing of new products is critical to the Company’s long-term success.

        On February 14, 2003, the Company entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based hair removal device for women.

Critical Accounting Policies 

        The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s 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 the Company 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, the Company evaluates its estimates, including those related to revenue recognition, bad debts, inventories, warranty obligations, contingencies, restructurings and income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed 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 the Company’s critical accounting policies and the related judgments and estimates affecting the preparation of the Company’s consolidated financial statements is included in the Annual Report on Form 10-K of the Company for fiscal year 2002.

Results of Operations

        Product revenues. Product revenues increased to $8.3 million from $6.5 million during the three-month period ended September 30, 2003 and increased to $22.1 million from $15.3 million during the nine-month period ended September 30, 2003 in comparison to the same period in 2002. The leading contributor to these increases of $1.8 million or 28% and $6.8 million or 45% in product revenues for the three and nine months ended September 30, 2003, respectively, was the increase in unit sales of the family of “Lux” product lines which includes the MediLux, EsteLux, NeoLux and additional handpieces. During the three-month and nine-month periods ended September 30, 2003, the revenue generated by the sale of additional Lux handpiece increased substantially compared to the same periods in 2002.

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        Royalty revenues. Royalty revenues decreased to $180,000 from $859,000 for the three-months ended September 30, 2003 and 2002, respectively. Royalty revenues decreased to $648,000 from $2.7 million for the nine-months ended September 30, 2003 and 2002, respectively. These decreases in comparison to the same periods in 2002 are attributed to Lumenis Inc.‘s (Nasdaq: LUME) (“Lumenis”) failure to make its royalty payments starting in October 2002 (see “Legal Proceedings”).

        Funded product development revenues. For the three-months and nine-months ended September 30, 2003, funded product development revenue of $700,000 and $1.9 million, respectively, was for work performed in connection with payments made by Gillette. On February 14, 2003, the Company entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based hair removal device for women. In September 2003, Gillette made a $700,000 payment to the Company to fund development for the fourth quarter of 2003. This amount is included in deferred revenue at September 30, 2003.

        Cost of product revenues. Cost of product revenues increased to $3.5 million from $3.3 million for the three-months ended September 30, 2003 in comparison to the same period in 2002. The increase in cost of product revenues during 2003 as compared to 2002 is attributed to increased product sales volume. As a percentage of product revenues, cost of product revenues decreased to 42% for the three-months ended September 30, 2003 from 50% for the same period in 2002. Contributing to this decrease of the cost of product revenue as a percentage of product revenue is the efficient use of the Company’s fixed overhead costs with the increased volume associated with the growth in product revenues offset by additional warranty costs of $150,000, recognized in the third quarter of 2002, associated with issues related to some of the Company’s prior generation products.

        Cost of product revenues increased to $9.4 million from $8.1 million for the nine-months ended September 30, 2003 in comparison to the same period in 2002. The increase in cost of product revenues during 2003 as compared to 2002 is primarily attributed to increased product sales volume. As a percentage of product revenues, cost of product revenues decreased to 42% for the nine-months ended September 30, 2003 from 53% for the same period in 2002. Contributing to this decrease of the cost of product revenue as a percentage of product revenue is the efficient use of the Company’s fixed overhead costs with the increased volume associated with the growth in product revenues and the adjustment made to royalty reserves of approximately $332,000 to reflect royalty rates established with General. A portion of this decrease as a percentage of product revenues in 2003 was offset by additional warranty costs of $150,000 associated with issues related to some of the Company’s prior generation products and by the Company writing off $250,000 of certain inventory related to the SLP 1000 product line during the first quarter of 2003.

        Cost of royalty revenues. Cost of royalty revenues decreased to $72,000 from $344,000 for the three-month period ended September 30, 2003 and as a percentage of royalty revenues was consistent at 40%. Cost of royalty revenues decreased in dollars to $259,000 from $1.1 million for the nine-month period ended September 30, 2003 and as a percentage of royalty revenues was consistent at 40%. The decrease in royalty revenues is attributed to Lumenis’ failure to make its royalty payments resulting in a reduced cost of royalty due to General (see “Legal Proceedings”).

        Research and development expenses. Research and development expenses increased to $1.5 million (16% of total revenues) from $1.2 million (16% of total revenues) for the three-months ended September 30, 2003 and 2002, respectively. Research and development expenses increased to $4.2 million (17% of total revenues) from $3.3 million (18% of total revenues) for the nine-months ended September 30, 2003 and 2002, respectively. This increase in dollars is attributed to costs associated with the Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based hair removal device for women. Research and development costs as a percentage of total revenues remained consistent during the three-months ended September 30, 2003 as compared to the same period in 2002. Research and development costs as a percentage of total revenues decreased during the nine-months ended September 30, 2003 as compared to the same period in 2002, due to the increase in total revenues. The spending on research and development reflects the Company’s commitment to continuing dermatology research for a better understanding of various cosmetic and medical conditions and to continuing research and development of devices and delivery systems to better treat those various cosmetic and medical conditions. The research and development goals in the fields of light based hair removal and pigmented and vascular lesion removal are to design systems that (1) permit more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured at lower costs, to expand our current markets. Furthermore, the Company is developing products to address other dermatology and cosmetic conditions, including the fields of fat reduction, acne treatment and skin rejuvenation.

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        Selling and marketing expenses. Selling and marketing expenses increased to $2.4 million (26% of total revenues) from $1.6 million (22% of total revenues) for the three-months ended September 30, 2003 as compared to 2002. Selling and marketing expenses increased to $6.1 million (25% of total revenues) from $3.8 million (21% of total revenues) for the nine-months ended September 30, 2003 as compared to 2002. This increase in selling and marketing expenses is due to increased costs associated with the roll-out of the Company’s product lines and an expanded direct sales force and higher commissions.

        General and administrative expenses. General and administrative expenses increased to $1.1 million (12% of total revenues) from $833,000 (11% of total revenues) for the three-months ended September 30, 2003 as compared to 2002. General and administrative expenses increased to $3.2 million (13% of total revenues) from $2.2 million (13% of total revenues) for the nine-months ended September 30, 2003 as compared to 2002. The increase in general and administrative expense dollars and as a percentage of revenues is primarily related to additional legal expenses incurred as a result of enforcing the Company’s patent position against infringers, defending the opposition of a European Patent exclusively licensed to the Company by General and an increase in the incentive compensation accrual.

        Interest income. Interest income decreased to $19,000 from $22,000 for the three-months ended September 30, 2003 and 2002, respectively. Interest income decreased to $54,000 from $57,000 for the nine-months ended September 30, 2003 and 2002 as the higher levels of excess cash was offset by lower interest rates.

        Interest expense. Interest expense decreased to $2,000 from $29,000 for the three-months ended September 30, 2003 as compared to 2002. Interest expense decreased to $27,000 from $87,000 for the nine-months ended September 30, 2003 as compared to 2002. This decrease is attributable to the reduction of debt, on March 14, 2003, which a director surrendered a $1 million Promissory Note and was issued 293,255 shares of the Company’s Common Stock with no registration rights at a price of $3.41 per share. The price was calculated at 110% of the Company’s Common Stock trailing ten-day average closing price of $3.10 per share.

        Other income. Other income decreased to $58,000 from $168,000 for the nine-months ended September 30, 2003 as compared to 2002. Other income is attributable to payments received from a previously written-off equity investment and a partial payment of a note receivable that was written off in a prior year.

        Income Taxes. During the three months ended June 30, 2003, the Company recognized a tax benefit of $470,000, which is associated with the recovery of carryback operating losses paid in prior years pursuant to the Economic Stimulus package of 2002. During the three months ended, September 30, 2003, the Company recognized a benefit from income taxes of $300,000, which is attributed to the reduction in deferred income tax accruals associated with certain tax deductions taken in the Company’s 1999 Federal Tax return. Offsetting these refund claims during each of these periods, the Company provided a 4% effective tax rate for both the three-months and nine-months ended September 30, 2003 for the anticipated federal alternative minimum taxes and minimum state income taxes due for 2003.

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Liquidity and Capital Resources

        As of September 30, 2003, the Company had $9.2 million in cash and cash equivalents. The continued, successful sales of the Company’s current products and future products will be critical to the Company’s future liquidity.

        The Company believes that cash balances will be sufficient to meet anticipated cash requirements for the next twelve months.

        Cash provided by operating activities amounted to $403,000 for the nine months ended September 30, 2003, in comparison to cash used by operating activities in the amount of $730,000 for the same period one year earlier. This increase in cash provided by operating activities for the nine-month period ended September 30, 2003 compared to the same period a year earlier primarily reflects the effects of a net profit. Cash used by investing activities totaled $174,000 for the nine months ended September 30, 2003, compared to $89,000 for the same period in the prior year. These amounts reflect cash used for purchases of property and equipment. Cash provided by financing activities amounted to $4.5 million for the nine-month period ended September 30, 2003 in comparison to cash used by financing activities of $663,000 for the same period a year earlier. This increase in cash provided by financing activities for the nine months ended September 30, 2003, compared to the same period a year earlier primarily reflects proceeds from the sale of common stock and proceeds from the exercise of stock options and employee stock purchase plan offset by costs related to the issuance of common stock. For the nine-months ended September 30, 2002, the Company made payments on a convertible debenture and incurred costs related to the issuance of common stock.

        The Company anticipates that capital expenditures for the remainder of 2003 will total approximately $75,000, consisting primarily of machinery, equipment, computers and peripherals. The Company expects to finance these expenditures with cash on hand.

        Lumenis has failed to make the royalty payments due since October 30, 2002 for sales of their Lightsheer diode laser system. On February 14, 2003, the Company terminated its license agreement with Lumenis (see “Legal Proceedings”). During the second quarter of 2003, Carl Zeiss Meditec AG, parent company to Asclepion-Meditec AG, notified the Company that it had sold Asclepion to EL.EN and Quanta System and, consequently, terminated the sub-license agreement between Asclepion and the Company effective July 31, 2003. To date, Asclepion has only paid the Company a minimum royalty payment of fifty thousand dollars ($50,000) per year, prorated in the first and last years. The Company faces risks associated with pending litigation and there can be no assurance that these royalty amounts from other third parties will not decrease or that the Company will be able to collect all licensing royalties owed by current licensees or increase royalties by sub-licensing additional third parties.

        On February 14, 2003, the Company entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based, hair removal device for women. The agreement provides up to $7 million in initial development support funding to be paid by Gillette to Palomar over approximately the first 30 months of the agreement, with $2.6 million to be provided during 2003.

        On March 14, 2003, a director surrendered the $1 million principal balance of a Promissory Note and was issued 293,255 shares of the Company’s common stock with no registration rights at a price of $3.41 per share. The price was calculated at 110% of the Company’s common stock trailing ten-day average closing price of $3.10 per share.

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        On March 14, 2003, the Company completed a private placement with Craig Drill Capital, a private investment firm based in New York City, for the purchase of 1 million shares of the Company’s common stock with no registration rights at a price of $3.41 per share for an aggregate subscription price of $3.4 million. The price was calculated at 110% of the Company’s common stock trailing ten-day average closing price of $3.10 per share.

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 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 including but not limited to statements relating to new markets, development and introduction of new products, and financial projections that involve risk and uncertainties that may individually or mutually impact the matters herein, and cause actual results, events and performance to differ materially from such forward-looking statements. Our actual results could differ materially from those suggested in such forward-looking statements due to the cautionary statements identified below and other factors including, without limitation, risks concerning the timing of new product introductions, financing of future operations, manufacturing risks, variations in our quarterly results, the occurrence of unanticipated events and circumstances and general economic conditions, including stock market volatility, results of future operations, technological difficulties in developing or introducing new products, the results of future research, lack of product demand and market acceptance for current and future products, challenges in managing joint ventures and research with third-parties, the impact of competitive products and pricing, governmental regulations with respect to medical devices, including whether FDA clearance will be obtained for future products, the results of litigation, difficulties in collecting royalties, potential infringement of third-party intellectual property rights, and/or other factors, which are detailed from time to time in the Company’s SEC reports, including the report on Form 10-K for the year ended December 31, 2002 and the Company’s quarterly reports on Form 10-Q. 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,”, “would” and “potential” or similar words.

Cautionary Statements

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

        Light based technology is rapidly changing and improving. 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, enhance existing products, and 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. In addition, the market for professional hair removal light based devices may already be saturated. At present, broader market acceptance of light based hair removal is critical to our success and we intend to continue our goals of bringing light based hair removal devices to the mass consumer market. We also 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. 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.

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        The light based hair removal industry is highly competitive and companies frequently introduce new products. We compete in the development, manufacture, marketing, sales and servicing of light based hair removal devices with numerous other companies, some of which have substantially greater financial, marketing and other resources than the Company. Our products also face competition from medical products and cosmetic 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 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.

We may need to secure additional financing.

        Although the Company has generated a profit in recent quarters, the Company has a history of losses. We may have to secure additional financing to complete our research and development activities, commercialize our current and proposed 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 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. 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.

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 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. We have modified some of our products under letters to file. The FDA could retroactively decide that the modification require 510(k) or PMA clearance and may force us to cease marketing and/or recall the modified products. Our products may also be subject to state regulations, which are, in many instances, in 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 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. However, a state could disagree with our decision to sell to a particular type of end user or change regulations allowing sales to particular types of end users. Similar risks apply to our international markets. 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 dependent upon third-party researchers over whom we do not have absolute control to satisfactorily conduct and complete research on our behalf. We are also dependent upon third-party researchers to grant us licensing terms, which may or may not be favorable for products and technology, which they may develop. At present, our principal research partner is the Wellman Laboratories of Photomedicine at Massachusetts General Hospital. We provide research funding, light technology and optics know-how in return for licensing rights with respect to specific medical applications and patents. In return for certain exclusive license rights, the Company is 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 the Company’s 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.

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

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

Our 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 whom 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 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. Our competitors also may independently develop technologies that are substantially equivalent or superior to our technology and which do not infringe our patents.

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 light based hair removal 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 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. 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.

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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 price.

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.

        In past years, material portions of our revenues consisted of royalties from sub-licensing patents licensed to us on an exclusive basis by General.

        Lumenis failed to make the royalty payments due since October 30, 2002 for sales of their Lightsheer diode laser system. On February 14, 2003, the Company terminated its license agreement with Lumenis (see “Legal Proceedings”). This reduction and any other loss or reduction in the Company’s royalty revenues could have a material adverse effect on the business and financial condition, affect future liquidity and prevent the Company from maintaining profitability. The Company faces risks associated with pending litigation and there can be no assurance that these royalty amounts from other third parties will not decrease or that the Company will be able to collect all licensing royalties owed by current licensees or increase royalties by sub-licensing additional third parties.

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        We are involved in disputes with other third parties, including Altus Medical Inc. (“Altus”) (see part II, item 1, Legal Proceedings). 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.

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

        As a small company with less than 125 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 and manufactured with numerous safety features, but it is possible that consumers could be adversely affected by use of one of our products. 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. 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 for which 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.

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        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, legal and other expenses. As a result, we need to generate a significant amount of revenue to achieve and maintain profitability.

We face risks associated with selling approximately half of our products and services internationally.

        We sell approximately half of our products and services outside of the United States and expect that these 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. In particular, longer payment cycles common in foreign markets, credit risk and delays in obtaining necessary import or foreign regulating approvals for products may occur.

We face risks associated with managing a joint development and license agreement.

        On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and commercialize a home-use, light-based hair removal device for women. We believe that this represents a unique opportunity to bring light based devices to the mass market. Under the agreement, significant resources and the attention of key technical personnel and management will be directed to the development of such a device even though such device will not likely be commercialized for several years, if ever. In addition, we cannot be sure that Gillette will agree with our interpretation of the terms of the agreement, that the agreement will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreement. After the expiration of 12 months and at several points thereafter, Gillette has the ability to choose not to continue and may terminate the agreement. In such cases, we will not receive certain payments but may proceed to develop and commercialize the device on our own or with a third party. There can be no assurance that we will be able to successfully implement such a strategy. In addition, after commercialization of such device, Gillette is to pay us a percentage of net sales of such device. Certain of these percentages of net sales are only owed if the device is covered by valid patents. There can be no assurance that valid patents will cover the device in any or all countries in which the device will be manufactured, used or sold. This could have a material adverse effect on our business, results of operations and financial condition.

We face risks associated with Section 11 (a)(4) Securities Act of 1933.

        Prior to June 28, 2002, Arthur Andersen LLP served as the Company’s independent auditors. On March 14, 2002, Arthur Andersen was indicted on federal obstruction of justice charges arising from the government’s investigation of Enron Corporation and on June 15, 2002, Arthur Andersen was found guilty. Arthur Andersen informed the SEC that it would cease practicing before the SEC by August 31, 2002, unless the SEC determined that another date was appropriate. On June 28, 2002, the Company dismissed Arthur Andersen and retained Ernst & Young LLP as its independent auditors for its fiscal year ended December 31, 2002. SEC rules require the Company to present historical audited financial statements in various SEC filings, such as registration statements, along with Arthur Andersen’s consent to the Company’s inclusion of Arthur Andersen’s audit report in those filings. Since Arthur Andersen no longer practices public accounting, the Company will not be able to obtain the consent of Arthur Andersen to the inclusion of Arthur Andersen’s audit report in the Company’s relevant current and future filings. The SEC recently has provided regulatory relief designed to allow companies that file reports with the SEC to dispense with the requirement to file a consent of Arthur Andersen in certain circumstances, but purchasers of securities sold under the Company’s registration statements, which were not filed with the consent of Arthur Andersen to the inclusion of Arthur Andersen’s audit report will not be able to sue Arthur Andersen pursuant to Section 11(a)(4) of the Securities Act of 1933 and therefore the purchasers’ right of recovery under that section may be limited as a result of the lack of the Company’s ability to obtain Arthur Andersen’s consent.

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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 the Company, 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 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.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments.

        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 September 30, 2003 due to their short-term nature. All of the Company’s investments are considered cash equivalent money market accounts and debt securities which are carried at cost, which approximates market value. 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.

Primary Market Risk Exposures

        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. The Company’s currency exchange rate fluctuations have been and are expected to continue to be modest since the Company sells its products in United States currency.

Item 4. Controls and Procedures

(a)        Evaluation of disclosure controls and procedures.

        Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report the information we must disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, within the time periods specified in the SEC's rules and forms. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were reasonably effective.

(b)        Changes in internal controls.

        During the three month period ended September 30, 2003, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II – Other Information

Item 1. Legal Proceedings

        The Company is a 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.

        The Company is the exclusive licensee of U.S. Patent Nos. 5,595,568 and 5,735,844 (“the ‘568 and ‘844 patents”) from The General Hospital Corporation (“General”). Pursuant to a Patent License Agreement dated December 7, 1998, Lumenis paid the Company a 7.5% royalty on net sales of the LightSheer diode laser system. As of the quarter ended September 30, 2002, the Company received approximately $3.6 million dollars in royalties from Lumenis for sales of the LightSheer system. On October 24, 2002, Lumenis told the Company that it would no longer pay royalties for sales of the LightSheer system and filed a complaint in the United States District Court for the Northern District of California seeking a declaratory judgment that the ‘568 and ‘844 patents are invalid and/or unenforceable and not infringed by any Lumenis products. The Company believes that Lumenis’ claims are without merit, and on October 29, 2002, the Company filed a complaint in the Middlesex County Superior Court in Massachusetts against Lumenis for breach of contract, breach of the implied covenant of good faith and fair dealing, and violation of Massachusetts General Laws Chapter 93A. The Company has also answered Lumenis’ Federal Court compliant in California with similar counter claims. On February 14, 2003, the Company terminated the Patent License Agreement. The parties are in negotiations in an attempt to settle the matter as an alternative to litigation.

        On February 15, 2002, the Company commenced an action for patent infringement in the United States District Court for the District of Massachusetts against Altus seeking both monetary damages and injunctive relief. The complaint alleges Altus’ CoolGlide and CoolGlide Excel laser systems willfully infringe U.S. patent No. 5,735,844 (“the ‘844 patent”), which is exclusively licensed to the Company by 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 and CoolGlide XEO laser systems also willfully infringe the asserted patent. On June 4, 2003, Altus amended their answer and asserted a counter claim alleging that the ‘844 patent is unenforceable due to inequitable conduct. The Company and General believe that this claim is without merit and filed a reply denying the material allegations of this counterclaim. A claim construction (Markman) hearing on claim construction was held June 12, 2003. The Judge has not yet issued a ruling. 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

      Not applicable.

Item 5. Other Information.

      Not Applicable.

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

(a)      Exhibits

(b)      Reports on Form 8-K

      Current Report on Form 8-K filed with the Securities and Exchange Commission on July 24, 2003.

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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.

Palomar Medical Technologies, Inc.
(Registrant)

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Index to Exhibits

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