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 March 31, 2004.

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). 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

i

Palomar Medical Technologies, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets
(Unaudited)

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

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Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Condensed Statements of Operations
(Unaudited)

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

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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

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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

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

Note 1 – Basis of presentation

        The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim information. 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 ( “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 Palomar’s Form 10-K for the year ended December 31, 2003. Certain prior-period amounts have been reclassified to conform with the current-period presentation.

Note 2– Stock based compensation

        Palomar follows the intrinsic value method for 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 SFAS No. 123, Accounting for Stock-Based Compensation. Under APB 25, when the exercise price of options granted under these plans equals the market price of the underlying stock on the date of grant, no compensation expense is required. In accordance with EITF 96-18, Palomar records compensation expense equal to the fair value of options and warrants granted to non-employees over the vesting period, which is generally the period of service.

        The following table illustrates the effect on net income and earnings per share if Palomar had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. Palomar has computed the pro forma disclosures required under SFAS No. 123 for all stock options granted to employees of Palomar for the three months ended March 31, 2004 and 2003, respectively, using the Black-Scholes option-pricing model prescribed by SFAS No. 123.

Pro forma disclosure

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

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

Note 3 – Cash equivalents

        Cash equivalents consist of short-term, highly liquid investments which are readily convertible into cash with maturities of three months or less when purchased.

Note 4 – Inventories

        Inventories are valued at the lower of standard cost, which approximates actual cost determined on a first-in, first-out basis or market. At March 31, 2004 and December 31, 2003, inventories consisted of the following:

Note 5 – Property and equipment

        Property and equipment are recorded at cost. Repairs and maintenance costs are expensed as incurred. Depreciation and amortization are provided using the straight-line method over the estimated useful lives. At March 31, 2004 and December 31, 2003, property and equipment consisted of the following:

Note 6 – Warranty costs

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

        The following table reflects the changes in Palomar’s accrued warranty during the three months ended March 31, 2004:

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

Note 7 – Segment information

        Product revenue from international sources were $3.1 million and $3.6 million for the three months ended March 31, 2004 and 2003, respectively. The following table represents the percentage of product revenue by geographic region from customers for the three months ended March 31, 2004 and 2003:

Note 8 – Net income per common share

        Basic net income per share was determined by dividing net income attributable to common stockholders by the weighted average common shares outstanding during the period. Diluted net income per share was determined by dividing net income 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.

        A reconciliation of basic and diluted shares is as follows:

Note 9 – Research and development arrangement with Massachusetts General Hospital

         In August 1995, Palomar entered into an agreement with The Massachusetts General Hospital Corporation whereby Massachusetts General Hospital agreed to conduct clinical trials on a laser treatment for hair removal/reduction developed at Wellman Laboratories of Photomedicine. In July 1999, Palomar further amended this agreement to extend the research agreement for an additional five years, with Palomar agreeing to pay Massachusetts General Hospital $475,000 on an annual basis, and to expand the research beyond photothermal hair removal into the fields of fat removal and acne treatment. Palomar has the right to exclusively license, on royalty terms to be negotiated, Palomar-funded inventions in the relevant fields. Palomar is in discussions with Massachusetts General Hospital for an extension of this agreement for clinical research beyond August 2004.

Note 10 – Development and license agreement with Gillette

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

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

        At the end of the 30-month period, or such later date as regulatory clearance is obtained for the device, Gillette will decide whether or not to continue with the project based on all the information known at that time. Upon Gillette deciding to continue, Gillette will be obligated to make a development completion payment to Palomar of $2.5 million. If Gillette decides not to continue, Palomar may proceed to develop and commercialize the device on its own or with a different party.

        After Gillette makes the development completion payment to Palomar of $2.5 million, Gillette will conduct approximately 12 months of commercial assessment tests with respect to the device. Based on the commercial assessment tests, Gillette will then decide whether or not to continue with the project. Upon deciding to continue, Gillette will be obligated to make a development completion payment to Palomar of $10 million. If Gillette decides not to continue to commercialize the device, Palomar may proceed to commercialize the device on its own or with a different party.

        Commencing 12 months after the $10 million development completion payment, Gillette will be obligated to pay Palomar annual collaboration payments of $10 million for as long as Gillette elects to have Palomar work exclusively with Gillette.

        After launch of the first device for females, Gillette will pay Palomar a percentage of net sales of the device, subject in certain instances to various reductions and offsets. Again, for as long as Gillette elects to have Palomar work exclusively with Gillette, Gillette will continue to be obligated to pay Palomar annual collaboration payments of $10 million, which will be offset against the net sales percentage payments.

        In addition to the amounts to be paid by Gillette to Palomar in connection with jointly developed products, Gillette is required to make certain lump sum and net sales based payments to Palomar in the event that Gillette launches independent light-based female hair removal products. Gillette also receives the right to enter into a separate agreement with Palomar for the development and commercialization of home-use, light-based hair removal devices for men.

Note 11 – Research contract with the Department of the Army

         In the first quarter of 2004, Palomar began providing services under a $2.5 million research contract with the Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby Palomar is reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered. This revenue is included in funded product development revenue in the accompanying statements of operations. Palomar has recognized approximately $261,000 to funded product development revenues during the three months ended March 31, 2004.

Note 12 – Product upgrade rights

        During the quarter ended March 31, 2004, Palomar introduced the StarLux Pulsed Light and Laser System, which is expected to be ready for general release by the end of the second quarter of 2004. In connection with this product introduction, Palomar offered certain customers an upgrade option to trade-in existing products for a new StarLux system for an upgrade fee. Palomar deferred approximately $585,000 of revenue during the quarter ended March 31, 2004 in connection with the upgrade right in accordance with the Emerging Issues Task Force issue No. 00-21.

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

Forward-looking statements

        This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than historical or current facts, including, without limitation, statements about our business strategy, plans and objectives of management and our future prospects, are forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from these expectations. Such risks and uncertainties include, without limitation, the following:

        These risks and uncertainties are beyond our control and, in many cases; we cannot predict the risks and uncertainties that could cause our actual results to differ materially from those indicated by the forward-looking statements. When used in this document, the words “believes,”“plans,”“expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “could,” “should,” “future,”“potential,”“estimate,” or the negative of such terms and similar expressions as they relate to us or our management are intended to identify forward-looking statements. Palomar undertakes no obligation to release publicly the result 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 following discussion should be read in conjunction with, and is qualified in its entirety by, the condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report and the condensed consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K filed with the SEC on March 17, 2004. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

Critical accounting policies

        The discussion and analysis of the Palomar’s financial condition and results of operations are based upon it’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 Palomar 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, Palomar evaluates its estimates, including those related to revenue recognition, bad debts, inventories, warranty obligations, contingencies, restructurings and income taxes. Palomar 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 Palomar’s critical accounting policies and the related judgments and estimates affecting the preparation of consolidated financial statements is included in Palomar’s Annual Report on Form 10-K for fiscal year 2003.

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Overview

        We are engaged in research, development, manufacturing and sale of proprietary light based systems for hair removal and other cosmetic treatments. Since our inception, we have been able to develop a differentiated product mix of light based systems for cosmetic treatments through our own research and development as well as through research with our partnerships with Massachusetts General Hospital’s Wellman Laboratories and other centers throughout the world. We are continually developing and testing new indications to further the advancement in cosmetic light based hair removal techniques, fat reduction, acne treatment, Pseudofolliculitis Barbae or PFB and skin rejuvenation.

        This Management’s Discussion and Analysis of Financial Condition and Results of Operations provide information that our management believes to be necessary to achieve a clear understanding of our financial statements and results of operations.

        Our management monitors and analyzes a number of key performance indicators in order to manage our business and evaluate our financial and operating performance. Those indicators include but are not limited to the following:

        We improved product gross margins by 80% due to a higher margin product mix and the effects of increased sales volume as compared to the same period in 2003. We also strengthened our balance sheet since the end of last year, including increasing our cash position by 23% and increasing stockholders' equity by 22%. The current ratio is now 3.2x, up from 2.9x at the end of 2003, and we have no long-term debt.

        Our reported total revenues for the three months ended March 31, 2004, were $10.8 million, up from $6.8 million for the same period in 2003. Gross profit from product sales increased to $6.2 million (64% of product revenues), up from $3.5 million (57% of product revenues) for the same period in 2003. We also reported net income of $1.2 million, or $0.07 per diluted share, for the three months ended March 31, 2004, versus net income of $358,000, or $0.03 per diluted share, for the same period in 2003.

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        Over the last two years, most of our revenue has been from the Lux family of products with their complementary handpieces, which offer a suite of applications to the end user at a lower cost than other competing systems. Customers can invest in their first Lux system with one handpiece then purchase additional handpieces as their practice grows and upgrade into a more powerful Lux system when ready. Additionally, the Lux platform enables Palomar to custom tailor products to fit almost any professional medical office or spa location and provides our customers with the comfort that the system can grow with their practice. We have kept a commitment to continually provide value to customers who invest in our Lux system platform. We believe the Lux family of products are the most affordable and versatile cosmetic light-based systems on the market.

        Our quarterly product revenue has increased as compared to the same period in 2003 as a result of the increased product demand for our Lux family of products. Looking forward, we would expect as our installed base of Lux family of products continues to increase that the demand for replacement handpieces will increase resulting in additional product revenue.

        In February 2004, we introduced the newest addition to the Lux family of products: the StarLux™ Pulsed Light and Laser System. In comparison to other Lux products, the StarLux has increased power, a computer controlled touch screen, instant handpiece recognition, integrated cooling, the ability to operate the Lux Y, LuxG, LuxR, LuxRs, LuxV and the Lux1064™ handpieces. We expect to start commercial shipment of StarLux products at the end of the second quarter of 2004.

        On February 18, 2004, we were awarded a $2.5 million research contract by the Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The project is scheduled to last for nineteen months.

        We continue to focus on delivering innovative light based systems and products to our customers in order to drive revenue and earnings growth.

Recent developments

        On March 18, 2004, our common stock began trading on the Nasdaq National Market System. After meeting all the requirements for listing on the Nasdaq National Market, we upgraded from the Nasdaq Small Cap Market System while retaining the same ticker symbol, PMTI.

        On April 5, 2004, we received clearance from the U.S. Food and Drug Administration (FDA) to market the LuxV™ handpiece for the treatment of acne. The LuxV is a handpiece attachment for use with Palomar’s family of Lux Pulsed Light systems. The LuxV handpiece offers a long-term acne solution by treating the root cause of acne. The LuxV emits pulses of intense light that alter the structure and function of the sebaceous glands to reduce acne lesions without the many side effects common to drugs while offering longer remission times and improved efficacy rates when compared to other treatments. Acne treatment is the most rapidly growing therapeutic category in the dermatology sector and in the U.S. alone; more than $1.4 billion annually is spent on anti-acne medication and treatment.

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Results of operations

        The following table contains selected statement of operations information, which serves as the basis of the discussion of our results of operations for the three months ended March 31, 2004 and 2003, respectively (in thousands, except for percentages):

        Product revenues. Increases in unit sales and the average selling prices of the “Lux” family of products were the leading contributor to the increase in product revenues. Sales from the “Lux” family of products, consisting of the MediLux, EsteLux, NeoLux and related additional handpieces, increased by $3.7 million for the three months ended March 31, 2004 in comparison to the same period in 2003. Product revenues were unfavorably impacted by a decrease of $225,000 of sales related to our legacy product, the RD-1200, in comparison to the same period in 2003. Market acceptance of the “Lux” family of products has been increasing since its introduction in September 2001.

        International product revenue was 32% of total product revenue for the three months ended March 31, 2004 in comparison to 59% for the same period in 2003. This decrease as a percentage of revenues in international sales is directly attributed to the increase in domestic product sales and a decrease in sales to Japan.

        During the three months ended March 31, 2004, we deferred approximately $585,000 of revenue relating to an upgrade program offered to selected customers. This upgrade program consists of a purchase of a MediLux Pulsed Light System with an upgrade option to purchase the new StarLux Pulsed Light and Laser System. We expect to start commercial shipment of StarLux products at the end of the second quarter of 2004.

        Royalty revenues. The decrease in royalty revenues for the three months ended March 31, 2004 in comparison to the same period in 2003 is attributed to the termination of the license agreement with Asclepion, one of the Palomar’s licensees in 2003, who had made no sales in the United States and was only paying the minimum required royalties under the license agreement.

        Funded product development revenues. We account for funded product development revenue under the Gillette agreement ratably over the funding period as payments are received. For the three months ended March 31, 2004, we received from Gillette $752,000 to fund development. To date, Palomar has received from Gillette approximately $3.4 million to fund development. Any amounts received in advance are recorded as deferred revenue. Payments are not refundable if the development is not successful.

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        For the cost reimbursement contract with a fixed fee awarded by the Department of the Army, we earn a fixed fee of 8% as costs are incurred or services are provided. The total value of the contract is $2.5 million. As of March 31, 2004, we billed the Department of the Army for approximately $242,000 plus a fixed fee of $19,000 totaling approximately $261,000.

        Cost of product revenues. The cost of product revenues decreased as a percentage of product revenue to 32% for the three months ended March 31, 2004 from 39% during the same period in 2003. This cost decreased as a percentage of product revenue primarily as a result of lower manufacturing costs associated with the “Lux” product lines. In addition, the increased sales volume and increased average selling prices of the Lux family of products has improved the absorption of manufacturing overhead at our manufacturing facility for each product line.

        Cost of royalty revenues. As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% for both periods. The decrease in the cost of royalty revenues is attributed to the termination of the license agreement with Aesclepion, one of Palomar’s licensees in 2003, who had made no sales in the United States and was only paying the minimum required royalties under the license agreement.

        Research and development expense. The increase in both dollars and as a percentage of revenue in research and development expense is a direct result of our spending related to the Gillette agreement, other expenses related to the Department of the Army contract, legal costs related to our increasing patent portfolio, our continued commitment to introducing new platforms and enhancing our current family of products.

        For the three months ended March 31, 2004 expenses relating to the Gillette agreement have increased by approximately $495,000 as compared to the same period in 2003. This increase in expenses relating to the Gillette agreement is directly attributed to Palomar incurring additional payroll and payroll related expenses as well as additional development costs.

        Expenses relating to the Army contract, which began in February of 2004, totaled approximately $242,000. The project is scheduled to last for nineteen months.

        For the three months ended March 31, 2004, legal expenses relating to the prosecution of new patents increased by approximately $90,000 in comparison to the same period in 2003. Palomar is committed to expanding its intellectual property rights necessary to protect discoveries made through its investment in research and development. Expenses relating to the introduction of new products such as the StarLux, enhancements made to Palomar’s current family of products and research and development overhead increased by approximately $311,000 in comparison to the same period in 2003.

        The spending on research and development reflects Palomar’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, pigmented and vascular lesion removal and acne treatment are to design systems that: (1) permit effective treatment and more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured at lower costs, to expand our current markets. Furthermore, we are developing products to address other dermatology and cosmetic conditions, including the fields of fat reduction, acne treatment and skin rejuvenation.

        Selling and marketing expense. The increase in selling and marketing expenses is directly associated with an increase in commissions of approximately $216,000, an increase of $655,000 in costs related to the doubling of our domestic sales force in October 2003, which includes salaries and wages, travel, demonstration materials and insurance increases, an increase of $189,000 in marketing and advertising costs and an increase in costs relating to tradeshows of approximately $75,000. These increases directly correlate with our increased revenues, upfront costs associated with both international and domestic sales force and distribution channel expansion.

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        General and administrative expense. The increase in general and administrative expense is mainly attributed to increases to incentive compensation of $166,000, related to our incentive compensation plan of 2004, as well as additional rental expenses of approximately $80,000. As of January 2004, Palomar terminated the sub-lease granted to a third party of approximately 4,000 square feet to allow Palomar to expand into this area and better maximize its manufacturing capabilities. In the past, rental income from the sub-lease was being offset to rental expense. As a result of terminating the sub-lease, Palomar incurred an increase in rental expense of approximately $42,000. Additionally, Palomar incurred an additional rental expense of approximately $38,000 relating to a one time charge from an increase in lease operating expenses.

        Interest income. Interest income increased due to higher levels of excess cash on hand for the three months ended March 31, 2004 in comparison to the same period in 2003.

        Interest expense. The interest expense decrease is attributable to our reduction of debt. On March 14, 2003, a director surrendered a $1 million Promissory Note in exchange for 293,255 unregistered shares of our Common Stock at a price of $3.41 per share.

        Other income. Other income is attributable to payments received from a previously written-off note receivable and equity investment.

        Provision for income taxes. We provided approximately a 4% effective tax rate for anticipated federal alternative minimum taxes and minimum state income taxes due for 2004. We recorded no tax provision in 2003 as we were able to fully offset minimum taxes with net operating loss carryforwards. We have fully reserved our otherwise recognizable deferred tax asset, as its realization is uncertain.

Liquidity and capital resources

        The following table sets forth, for the periods indicated, a year-over year comparison of key components of our liquidity and capital resources (000’s omitted except in current ratio calculation):

        As of March 31, 2004, we had $13.0 million in cash and cash equivalents. The sales of our current products and future products will be critical to our future liquidity. We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and other activities for at least the next 12 months. At March 31, 2004, we had no long-term debt.

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        Operating cash flows in the three months ended March 31, 2004 amounted to $829,225 compared to cash used in operating activities of $1,062,293 for the same period in 2003. This increase primarily reflects the increase of net profits with a decrease in accounts receivable. Net cash used in investing activities totaled $130,263 for the three months ended March 31, 2004 compared to $3,000 for the same period in 2003. These amounts reflect cash used in the purchases of capital equipment. Cash provided by financing activities totaled $1,701,579 for the three months ended March 321, 2004 compared to $3,555,173 for the same period in 2003. These increases were a result of sales of common stock, and exercises of stock options and purchases of common stock pursuant to the employee stock purchase plan offset by costs related to the issuance of common stock.

        We anticipate that capital expenditures for the remainder of 2004 will total approximately $400,000, consisting primarily of machinery, equipment, computers and peripherals. We expect to finance these expenditures with cash on hand.

        On February 14, 2003, Palomar 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. For the three months ended March 31, 2004, Palomar received from Gillette $752,000 to fund development. To date, Palomar has received from Gillette approximately $3.4 million to fund development. Any amounts received in advance are recorded as deferred revenue. Payments are not refundable if the development is not successful.

        In the first quarter of 2004, Palomar began providing services under a $2.5 million research contract with the Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby Palomar is reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue is recognized under the contract as the costs are incurred and the services are rendered. This revenue is included in funded development revenue in the accompanying statements of operations. As of March 31, 2004, Palomar has billed the Department of the Army for approximately $242,000 plus a fixed fee of $19,000 totaling approximately $261,000. This contract began on February 18, 2004 and is scheduled to last for nineteen months.

Contractual obligations

        It is not our usual business practice to enter into off-balance sheet arrangements, except for off-balance sheet arrangements related to inventory purchase commitments and operating lease commitments, as disclosed in the table of contractual obligations below. In addition, it is not our normal policy to issue guarantees to third parties.

        In August 1995, we entered into an agreement with Massachusetts General Hospital whereby Massachusetts General Hospital agreed to conduct clinical trials on a laser treatment for hair removal/reduction developed at Wellman Laboratories of Photomedicine. In July 1999, we further amended this agreement to extend its exclusive research agreement for an additional five years. In addition to laser hair removal, the agreement has been expanded to include research and development in the fields of fat removal and acne treatment. We have the right to exclusively license, on royalty terms to be negotiated, the Palomar-funded inventions in the relevant fields. Under the terms of this agreement, we have paid Massachusetts General Hospital $475,000 on an annual basis for clinical research through August 2004. Palomar is in discussions with Massachusetts General Hospital for an extension of this agreement for clinical research beyond August 2004. We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby Palomar is obligated to pay royalties to Massachusetts General Hospital. Royalty expense in 2004 totaled approximately $347,000.

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

        The following table summarizes our estimated contractual cash obligations as of March 31, 2004, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (000’s omitted):

Cautionary statements

Our future revenue may decrease if we are unable to successfully develop and market 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 we have 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 and our failure to do so could decrease our future revenue.

Our failure to respond to rapid changes in technology could make our products obsolete and we may be unable to compete with companies having superior financial, marketing and other resources.

        The light based cosmetic and dermatology industry is highly competitive and companies frequently introduce new products. We compete in the development, manufacture, marketing, sales and servicing of light based devices with numerous other companies, some of which have substantially greater financial, marketing and other resources than us. 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. If forecasted demand decreases, we could have excess inventories which may result in a write-off of some or all of our inventory.

We may need to secure additional financing and without such additional financing we may be unable to fund ongoing operations or grow the business.

        Although we have generated a profit in recent quarters, we have 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.

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

        We develop light based systems that incorporate third-party components. 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 prevent us from manufacturing product and result in a decrease in revenue. We depend on an acceptable level of reliability for purchased components. Reliability below expectations for key components could have an adverse affect on inventory and inventory reserves.

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

        All of our current products are light based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA. The types of medical devices that we seek to market in the U.S. generally must receive either "510(k) clearance" or "PMA approval" in advance from the U.S. Food and Drug Administration (FDA) pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA's 510(k) clearance process usually takes from four to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer. To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product we propose to market and our failure to do so could adversely affect our ability to sell our products.

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

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

        Any modification to one of our 510(k) cleared devices that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance. The FDA requires every manufacturer to make this determination in the first instance, but the FDA can review any such decision. We have modified some of our marketed devices, but we believe that new 510(k) clearances were not required. We cannot be certain that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

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

        Our products may also be subject to state regulations. Federal regulation allows our products to be sold to and used by licensed practitioners as determined on a state-by-state basis. As a result, in some states non-physicians may purchase and operate our product. However, a state could disagree with our decision to sell to a particular type of end user or change regulations preventing sales to particular types of end users. Thus, state regulations and changes to state regulations may decrease revenues or prevent growth of revenues. 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.

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

        We are subject to inspection and market surveillance by the FDA to determine compliance with regulatory requirements. The FDA's regulatory scheme is complex, especially the Quality System Regulation ("QSR"), which requires manufacturers to follow elaborate design, testing, control, documentation, and other quality assurance procedures. This complexity makes complete compliance difficult to achieve. Also, the determination as to whether a QSR violation has occurred is often subjective. If the FDA finds that we have failed to comply with the QSR or other applicable requirements, the agency can institute a wide variety of enforcement actions, including a public warning letter or other stronger remedies, such as fines, injunctions, and civil penalties, recall or seizure of our products, operating restrictions, partial suspension, or total shutdown of our production, refusing our requests for 510(k) clearance or PMA approval of new products, withdrawing product approvals already granted or criminal prosecution

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

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

Our common stock could be further diluted by the conversion 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 us. We have a substantial number of shares of common stock reserved for issuance upon the conversion and exercise of these securities. Such a conversion would dilute our stockholders and could adversely affect the market price of our common stock.

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Our proprietary technology has only limited protections which may not prevent competitors from copying our new developments. This may impair our ability to compete effectively, and we may expend significant resources enforcing our intellectual property rights to prevent such copying

        Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We 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.

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

        In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. The light based cosmetic and dermatology industry in particular is characterized by a large number of patents and related litigation regarding patents and other intellectual property rights. Because our resources are limited and patent applications are maintained in secrecy for a period of time, we can conduct only limited searches to determine whether our technology infringes any patents or patent applications. Any claims for patent infringement, regardless of merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause shipment delays, require us to develop non-infringing technology or to enter into royalty or licensing agreements. 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.

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 our Secretary advance notice of director nominations and business to be brought by such stockholder before any annual or special meeting of stockholders, as well as certain information regarding such nomination and/or business, the stockholder and others known to support such proposal and any material interest they may have in the proposed business. They also provide that a special meeting of stockholders may be called only by the affirmative vote of a majority of the board of directors. These provisions could delay any stockholder actions that are favored by the holders of a majority of our outstanding stock until the next stockholders’ meeting. In addition, the board of directors is authorized to issue shares of our common stock and preferred stock that, if issued, could dilute and adversely affect various rights of the holders of common stock and, in addition, could be used to discourage an unsolicited attempt to acquire control of us. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person becomes an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 may limit the ability of stockholders to approve a transaction that they may deem to be in their best interests. These provisions of our Second Restated Certificate of Incorporation, By-laws and the Delaware General Corporation Law could deter certain takeovers or tender offers or could delay or prevent certain changes in control or management of us, including transactions in which stockholders might otherwise receive a premium for their shares over the then current market price. In April 1999, we adopted a shareholder rights plan (“Rights Plan”). The Rights Plan is intended to protect shareholders from unfair or coercive takeover practices. In accordance with the Rights Plan, the Board of Directors declared a dividend distribution of Series A right for each share of common stock outstanding until the rights become exercisable. (See exhibit 10.15, “Rights Agreement with American Stock Transfer and Trust Company dated April 21, 1999”)

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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 Massachusetts General Hospital.

        Lumenis failed to make the royalty payments due since October 30, 2002 for sales of their Lightsheer diode laser system. On February 14, 2003, we terminated our license agreement with Lumenis. (See “Legal Proceedings”) This reduction and any other loss or reduction in our royalty revenues could have a material adverse effect on the business and financial condition, affect future liquidity and prevent us from maintaining profitability. We face risks associated with pending litigation and there can be no assurance that the royalty amounts from other third parties 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 are involved in disputes with other third parties, including Cutera, Inc. (formerly Altus Medical Inc., See 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 be unable to attract and retain key executives and research and development personnel that we need to succeed.

        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. Our future success will depend in large part upon our ability to attract, retain, and motivate highly skilled employees. We cannot be certain that we will be able to do so.

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 and umbrella coverage; 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.

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

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

We face risks associated with product warranties.

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

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

        We sell approximately half of our products and services outside the U.S. International product revenue, consisting of sales from our distributors in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America and sales shipped directly to international locations from the United States was 49% of total product revenue for the year ended 2003, and we expect that international sales will continue to be significant. As a result, a major part of our revenues and operating results could be adversely affected by risks associated with international sales. In particular, longer payment cycles common in foreign markets, credit risk and delays in obtaining necessary import or foreign regulatory approvals for products may occur. In addition, significant fluctuations in the exchange rates between the U.S. dollar and foreign currencies could cause us to lower our prices and thus reduce our profitability, or could cause prospective customers to push out orders to later dates because of the increased relative cost of our products in the aftermath of a currency devaluation or currency fluctuation.

Managing our relationship with Gillette effectively may divert the attention of key technical personnel and management from the core business. If Gillette ends the relationship our stock price could fall, and we may be unable to bring a home use hair removal device for women to the market.

        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. During the term of the agreement, Gillette has the ability to choose not to continue and may terminate the agreement. If Gillette terminates the agreement, the price of our common stock could fall significantly, and we will not receive certain payments. We may proceed to develop and commercialize the device on our own or with a third party. However, 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. (See exhibit 10.14, “The Development and License Agreement with The Gillette Company effective February 14, 2003 with redacted exhibits”)

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Managing our contract with the Army effectively may divert the attention of key technical personnel and management from the core business. We may be unable to complete the project within the time period which may impact our ability to receive future government contracts.

        On February 18, 2004, we announced that we were awarded a $2.5 million research contract by the Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. We believe this represents a unique opportunity to address PFB. Although the project is scheduled to last for nineteen months, there can be no assurance that we will be able to complete the project within that time period which may impact our ability to receive future government contracts. 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 ready for military use for several years, if ever.

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

        Prior to June 28, 2002, Arthur Andersen LLP served as our 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 ceased practicing before the SEC by August 31, 2002. On June 28, 2002, we dismissed Arthur Andersen and retained Ernst & Young LLP as its independent auditors for its fiscal year ended December 31, 2002. SEC rules require us to present historical audited financial statements in various SEC filings, such as registration statements, along with Arthur Andersen’s consent to our inclusion of Arthur Andersen's audit report in those filings. Since Arthur Andersen no longer practices public accounting, we will not be able to obtain the consent of Arthur Andersen to the inclusion of Arthur Andersen’s audit report in our relevant current and future filings. The SEC 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 our 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 our ability to obtain Arthur Andersen's consent.

Item 3.        Quantitative and qualitative disclosures about market risk

        Our primary market risk exposures are in the areas of interest rate risk. Our investment portfolio of cash equivalents and debt securities is subject to interest rate fluctuations, but we believe this risk is immaterial because of the short-term nature of these investments.

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Item 4.        Controls and procedures

PART II – Other information

Item 1.        Legal proceedings

        Palomar is the exclusive licensee of U.S. Patent Nos. 5,595,568 and 5,735,844 from The Massachusetts General Hospital Corporation. Pursuant to a Patent License Agreement dated December 7, 1998, Lumenis paid Palomar a 7.5% royalty on net sales of the LightSheer diode laser system. As of the quarter ended September 30, 2002, Palomar received approximately $3.6 million dollars in cumulative royalties from Lumenis for sales of the LightSheer system. On October 24, 2002, Lumenis told Palomar 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 patents are invalid and/or unenforceable and not infringed by any Lumenis products. Palomar believes that Lumenis’ claims are without merit, and on October 29, 2002, Palomar 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. Palomar has also answered Lumenis’ federal court complaint in California with similar counter claims. On February 14, 2003, Palomar terminated the Patent License Agreement and added counter claims of patent infringement to Lumenis’ Federal Court complaint in California. The Massachusetts state court action has been stayed pending the outcome of the Federal Court action. A claim construction hearing (often referred to as a Markman hearing) was held March 29, 2004. Following a Markman hearing, a judge will rule on the meaning of disputed claim terms (often referred to as a Markman ruling), that is, the judge will construe the disputed claim terms. On April 20, 2004, the Judge issued his Markman ruling. Palomar believes the ruling largely embraced Palomar’s position and will have a considerable impact on the case as it proceeds toward trial. A trial date has been set for March 21, 2005.

        On February 15, 2002, Palomar commenced an action for patent infringement in the United States District Court for the District of Massachusetts against Altus Medical, Inc., now known as Cutera, Inc., seeking both monetary damages and injunctive relief. The complaint alleges Cutera’s CoolGlide and CoolGlide Excel laser systems willfully infringe U.S. patent No. 5,735,844, which is exclusively licensed to Palomar by the Massachusetts General Hospital. The Massachusetts General Hospital has been added as a plaintiff in this lawsuit. Cutera 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. Palomar and the Massachusetts General Hospital filed a reply denying the material allegations of the counterclaims. Palomar and the Massachusetts General Hospital have further alleged that Cutera’s CoolGlide Vantage and CoolGlide XEO laser systems also willfully infringe the asserted patent. On June 4, 2003, Cutera amended their answer and asserted a counter claim alleging that the patent is unenforceable due to inequitable conduct. Palomar and the Massachusetts General Hospital believe that this claim is without merit and filed a reply denying the material allegations of this counterclaim. A claim construction hearing (often referred to as a Markman hearing) was held on June 12, 2003, and on February 27, 2004 the Judge issued her ruling. Palomar believes the ruling largely embraced Palomar’s position and will have a considerable impact on the case as it proceeds toward trial. A trial date has not yet been set. (See “Cautionary Statements”)

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

Item 6. Exhibits and reports on Form 8-K

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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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