UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission file number: 0-22340

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

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

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

Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.01 par value

         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 |X|     No |_|

         Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |_|

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X|     No |_|

         The aggregate market value of the voting and non-voting common equity (based upon the closing price reported by Nasdaq on June 30, 2004) of Palomar Medical Technologies, Inc., held by nonaffiliates was $204,869,095. For purposes of this disclosure, shares of common stock held by entities and individuals who own 5% or more of the outstanding common stock and shares of common stock held by each officers and directors have been excluded in that such persons may be deemed to be "affiliates" as that term is defined under the rules and regulations of the Securities Exchange Act of 1934. This determination of affiliate status is not necessarily conclusive.

        As of March 9, 2005, 16,708,069 shares of common stock were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the registrant's definitive proxy statement to be filed prior to April 30, 2004, pursuant to Regulation 14A of the Securities Exchange Act of 1934, are incorporated by reference into Part III of this Form 10-K.

TABLE OF CONTENTS

PART I

Item 1. Business

Introduction

        Palomar Medical Technologies, Inc. (“Palomar”) is a leading researcher and developer of light based systems for hair removal and other cosmetic procedures. Throughout its history, Palomar has remained on the forefront of technology:

Palomar is continuously researching, developing and testing new and exciting innovations to further advance the hair removal market and other cosmetic applications, including fat reduction, acne treatment and skin rejuvenation. With its unique focus on both the professional and consumer markets, Palomar is positioned to capitalize on the ever expanding market for improving personal appearance.

        Palomar was organized in 1987 to design, manufacture, market and sell lasers and other light based products and related disposable items and accessories for use in medical and cosmetic procedures. In December 1992, Palomar filed its initial public offering. Subsequently, Palomar pursued an acquisition program, acquiring companies in its core laser business as well as others, principally in the electronics industry, in order to spread risk and bolster operating assets. By the beginning of 1997, Palomar had more than a dozen subsidiaries. At the same time, having obtained FDA clearance to market its EpiLaser® ruby laser hair removal system in March 1997, Palomar was well positioned to focus on what it believed was the most promising product in its core laser business. Hence, under the direction of a new board and management team, Palomar undertook a program in 1997, which was completed in May of 1998, of exiting from all non-core businesses and investments and focusing only on those businesses, which it believed, held the greatest promise for maximizing stockholder value. Palomar’s exclusive focus then became the use of lasers and other light based products in dermatology and cosmetic procedures.

        In December 1997 and January 1998, respectively, Palomar was the first company to receive FDA clearance for a diode laser for hair removal and for leg vein treatment, the LightSheer™ diode laser system manufactured by Star Medical Technologies, Inc. (“Star”), a former subsidiary of Palomar. The LightSheer was the first generation of high-powered diode lasers designed for hair removal, and like Palomar’s EpiLaser and other prior hair removal products, the LightSheer incorporated technology protected by patents licensed exclusively to Palomar from The Massachusetts General Hospital Corporation (“Massachusetts General Hospital”).

        On December 7, 1998, Palomar entered into an Agreement with Coherent, Inc. (Coherent Medical Group, a former subsidiary of Coherent, was subsequently sold to ESC Medical, now known as “Lumenis, Inc.” and hereinafter referred to as “Lumenis”) to sell all of the issued and outstanding common stock of Palomar’s subsidiary, Star. Palomar completed the sale of Star to Lumenis on April 27, 1999.

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        On February 14, 2003, Palomar entered into a Development and License Agreement with The Gillette Company to complete development and commercialize a home-use, light based hair removal device for women. Palomar believes that this device will be protected by multiple patents within its patent portfolio. (See Note 12, “Development and License Agreement with Gillette” and exhibit 10.14, “The Development and License Agreement with The Gillette Company effective February 14, 2003 with redacted exhibits.”) On June 28, 2004 Palomar and Gillette announced that they completed the initial phase of their agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations.

        On February 18, 2004, Palomar announced that it was 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, commonly known as “razor bumps.” Though the project was scheduled to last for nineteen months, Palomar now believes it will need several more months to complete the work.

        On September 1, 2004 Palomar entered into a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc (“JJCC”), a Johnson & Johnson company, to develop, clinically test and potentially commercialize home-use, light based devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. Palomar believes that these devices will be protected by multiple patents within its patent portfolio. (See Note 13, “Joint Development and License agreement with Johnson & Johnson Consumer Companies (“JJCC”), a Johnson & Johnson company” and exhibit 10.24, “Joint Development and License Agreement By and Between Palomar Medical Technologies and Johnson and Johnson Companies, Inc. dated September 1, 2004”).

        Palomar has one operating subsidiary, Palomar Medical Products, Inc. located at Palomar’s headquarters in Burlington, Massachusetts, which oversees the manufacture and sale of Palomar’s lamp and laser based systems currently on the market.

Financial Information About Industry Segments

        Palomar conducts business in one industry segment, medical and cosmetic products and services.

Principal Products

        Palomar researches, develops, manufactures, markets, sells and services light based products used to perform procedures addressing medical and cosmetic concerns. Palomar offers a comprehensive range of products based on proprietary technologies that include, but are not limited to:

        Market surveys report that the great majority of men and women in the United States, and many other parts of the world, employ one or more techniques to temporarily remove hair from various parts of the body, including waxing, depilatories, tweezing and shaving. Compared to these hair removal techniques, Palomar’s light based hair removal processes provide significantly longer-term cosmetic improvement. Compared to other light based hair removal devices, Palomar’s Lux platform is more versatile, treats larger areas in less time, are less painful and are more cost effective.

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        Lux Platform. With increasing market acceptance of light based treatments for new applications, Palomar recognized the need for a cost effective platform that could expand with the needs of customers. In 2001, Palomar announced the first product with the Lux Platform: the EsteLux® Pulsed Light System. The EsteLux was first sold with the LuxY™ handpiece for hair removal and treatment of pigmented lesions. In rapid succession, Palomar developed five additional handpieces: LuxG™, LuxR™, LuxRs™, LuxB™ and LuxV™, allowing customers to add additional applications to their treatment portfolio and provide specifically tailored procedures. In March 2003 at the American Academy of Dermatology tradeshow, Palomar introduced the higher priced MediLux™ Pulsed Light System with the same six handpieces, but also with higher power, faster repetition rate and a new snap-on connector for faster changes between handpieces. In October 2003, Palomar introduced the lower cost NeoLux™ Pulsed Light System with three handpieces, the LuxY, LuxR and LuxRs, specifically targeted at the beauty industry. In February 2004, Palomar enhanced the upgrade opportunities for its customers with the introduction of the StarLux™ Pulsed Light and Laser System with increased power, a computer controlled touch screen, instant handpiece recognition, active contact cooling, and a long pulse Nd:YAG laser handpiece, the Lux 1064. The StarLux began shipping in June of 2004. In January 2005, the Lux 1064 laser handpiece received FDA clearance, and in February 2005, Palomar introduced the VisiLux 1064™ handpiece with a digital camera and visualization screen for improved imaging and treatment. In February 2005, Palomar introduced a new infrared handpiece, the Lux IR.

        The Lux systems offer a suite of applications at a fraction of the cost of 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. The Lux platform enables Palomar to custom tailor products to fit almost any professional medical office or spa location and provides customers with the comfort that the system is able to grow with their practice. The StarLux, MediLux, EsteLux and NeoLux systems are affordable and versatile cosmetic light based systems.

        In addition to being cost effective and upgradeable, the platform includes many technological advances. For example, the platform includes Palomar’s Smooth Pulse technology which sets a new standard in safe and comfortable treatments. The Smooth Pulse technology spreads power evenly over the entire pulse of light allowing Palomar to provide ideal wavelengths for faster results in fewer treatments. By contrast, competitive systems deliver a power spike at the beginning of each pulse which can cause injury at the most effective wavelengths. The Smooth Pulse technology also extends the life of the light source allowing Palomar to offer one year, unlimited pulse count warranties or up to 100,000 pulses which ever occurs first on most lamp handpieces. Palomar sells replacement handpieces to existing customers providing a reoccurring revenue stream.

        The Lux pulsed light handpieces combine the latest technology with simple, streamlined engineering that is both effective and economical. Long pulse widths and SpectruMax™ filtering provide increased safety and efficacy. Efficacy is further improved through Palomar’s Photon Recycling process which increases the effective fluence by capturing light scattered out of the skin during treatments and redirecting it back into the treatment target. Offering the largest spot size on the market and high repetition rates allows for a fast coverage rate which is especially important when removing hair from large areas such as legs and backs. A back or a pair of legs can be treated in approximately thirty minutes, and a smaller area, such as the underarms, in even less time. The system’s simple operation opens its applications to a wider band of worldwide users.

    EsteLux. During 2001, Palomar received FDA clearance to market and sell the Palomar EsteLux™ Pulsed Light System. In 2002 and 2003, Palomar offered six handpieces for the EsteLux system: LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV. These handpieces emit pulses of intense light to treat unwanted hair, solar lentigo (sunspots), rosacea, actinic bronzing, spider veins, birthmarks, telangiectasias, acne and more. The LuxY handpiece is used for hair removal for large body areas and for pigmented lesion treatments. The LuxG handpiece delivers the RejuveLux™ process — photofacial treatments that remove pigmented and vascular lesions to improve skin tone and texture. The LuxR handpiece can be used to remove hair on all skin types, from the fairest to the darkest, including deep tans. Likewise, the LuxRs handpiece can be used to remove hair on all skin types, but it has concentrated power in each pulse resulting in permanent hair reduction in fewer treatments. The LuxB handpiece provides effective treatment of lighter pigmented lesions on fair skin as well as leg and spider veins, and the LuxV handpiece treats pigmented lesions and mild to moderate acne. With these complimentary handpieces, the Lux Platform is one of the most affordable and multifaceted systems in the market.

    MediLux. In March 2003, Palomar launched the Palomar MediLux™ Pulsed Light System with the six handpieces also available on the EsteLux. The MediLux provides increased power, a faster repetition rate and a new snap-on connector making it easier to switch among handpieces and provide treatments tailored to each individual being treated.

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    NeoLux. In October 2003, Palomar launched the Palomar NeoLux™ Pulsed Light System, a less complex and less expensive system. The NeoLux is designed for the spa and salon market. A three button control panel enables easy operation and training. The NeoLux operates with the LuxY, LuxR and LuxRs handpieces to treat pigmented lesions and provide for hair removal on all skin types.

    StarLux. In February 2004, Palomar launched the Palomar StarLux™ Pulsed Light System, and in June 2004, Palomar began shipping this system. The StarLux has a single power supply capable of operating both lasers and lamps. The StarLux includes increased power, integrated contact cooling and a full color touch screen for easy operation. Currently, the StarLux operates five of the EsteLux / MediLux handpieces, namely the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition, the increased power of the StarLux allows for the operation of a long pulse Nd:YAG laser handpiece, the Lux1064™. In January 2005, the Lux 1064 laser handpiece received FDA clearance for a variety of applications, including but not limited to removal of pigmented and vascular lesions, including visible leg veins, tattoo and hair removal, treatment of wrinkles, removal of red pigmentation in hypertrophic and keloid scars and treatment of pseudofolliculitis barbae. The Lux1064 is a high power laser handpiece to feature Smooth Pulse technology and Active Contact Cooling while also providing multiple spot sizes. Palomar’s patented Active Contact Cooling technology sends a chilled water supply through the handpieces, thus cooling the skin before, during, and after treatment. This unique feature ensures maximum safety and comfort during treatment. The StarLux’s high-powered treatments deliver long-lasting and even permanent results. For the lamp handpieces, fluences up to 50 J/cm², the largest available spot size (up to 16 x 46 mm), and a wide spectrum of optimal wavelengths (400-1400 nm), provide outstanding efficacy. With fluences up to 700 J/cm², the Lux 1064 provides visible leg vein removal. The StarLux full-color screen allows easy finger-touch operation and instant handpiece recognition while providing constant feedback on operating parameters. In February 2005, Palomar introduced the VisiLux 1064™ handpiece which includes a digital camera and a visualization screen to provide enhanced imaging and magnification of the area of skin to be treated to increase ease of use and improve treatment. In February 2005, Palomar also introduced a new infrared handpiece, the Lux IR, for deep tissue heating for relief of muscle and joint pain (pending FDA clearance). Palomar expects to seek further FDA clearances for the Lux IR including skin tightening, skin lifting and wrinkle removal.

        Q-YAG 5. During 2001, Palomar received FDA clearance to market and sell the Palomar Q-YAG 5™ system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5 is a Q-switched, frequency-doubled Neodymium laser. This laser system allows users to switch between a 1064-nm single-wavelength beam and a 1064/532-nm mixed-wavelength beam. The combination of wavelengths allows users to treat a full spectrum of colors and inks, and the system’s design lowers costs and allows broader use of the instrument. The single 1064-nm wavelength is ideal for treating darker tattoo inks and dermal-pigmented lesions, such as Nevi of Ota common in Japan and other Pacific Rim countries. The mixed 1064/532-nm wavelength is better suited for brighter colors and epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength permits brighter, more superficial and deeper and darker target areas to be treated simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it smaller and lighter than competitive systems, which is especially desirable for mobile and/or small physician offices. These attributes reduce the cost, increase the reliability of the system and eliminate costly optics and service problems that are common with other high power Q-Switched lasers.

        Legacy Products. Palomar no longer sells the EpiLaser™ or E2000™ hair removal laser systems, the RD-1200™ Q-switched ruby laser or SLP1000® Diode Laser System. However, Palomar continues to service these systems. During 1996, using Palomar’s core ruby laser technology, originally developed for tattoo removal and pigmented lesions, Palomar developed a long pulse ruby laser, the EpiLaser, that was specifically configured to allow the appropriate wavelength, energy level and pulse duration to be absorbed effectively by the hair follicle without being absorbed by the surrounding tissue. That, combined with a cooling handpiece, allowed for safe and effective hair removal. In March 1997, Palomar was the first company to receive FDA clearance to sell and market a ruby laser (the EpiLaser system) in the U.S. for hair removal. The Palomar EpiLaser was cleared by the FDA for permanent hair reduction in March 1998. During 1998, Palomar introduced its second-generation ruby laser, the Palomar E2000™ hair removal laser system; a product that was superior to hair removal lasers then available in a number of respects, including speed and efficacy. The FDA cleared the E2000 for permanent hair reduction. The RD-1200™ is a Q-switched ruby laser for tattoo removal and treating pigmented lesions. The SLP1000 is a high-powered diode laser that delivers energy over a relatively long time period using a technology called “Super Long Pulse Technology”. The SLP1000 is the first diode laser using Super Long Pulse Technology and interchangeable handpieces to provide hair removal and vascular lesion treatments to virtually all skin types. In addition, the SLP1000 is compact and easy to use.

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Sales, Marketing and Distribution

        As of December 31, 2004, Palomar’s sales and marketing organization consisted of 41 employees. Palomar’s direct sales representatives operate within their respective regions and engage customers directly and employ targeted lead generation programs such as regional seminars. Palomar also manages customer opportunities through Palomar’s strategic distribution relationships with exclusive distributors.

Direct Sales Force

        Palomar sells products in the U.S. primarily through its direct sales force to dermatologists, cosmetic surgeons and general practitioners as well as to other licensed practitioners. Palomar’s domestic direct sales force is organized into regions and each region is managed by a regional sales manager. Palomar’s direct relationships with its customers are generally governed either by customer purchase orders and Palomar’s acknowledgement of those orders or by purchase contracts.

Global Distribution

        In Palomar’s international sales and marketing efforts, Palomar employs a global network of strategic distributors. Palomar has established distribution relationships throughout Europe, Japan, Australia, South and Central America, the Far East, and the Middle East. As of December 31, 2004, Palomar utilized 35 distributors in 45 countries. Generally, Palomar’s distributors enter into a one to two year agreement not to sell our competitor’s products. Palomar’s sales strategy is to choose the most productive and practicable distribution channel within each of its geographic markets.

        The following table shows product revenue relating to Palomar’s international sales activities during each of the last three fiscal years by geographic region:

Customer Service and Support

        Palomar believes that a broad range of support services is essential to the successful deployment and ongoing support of its products. In most cases, Palomar’s customer service and support organization provides front line product support and is the problem resolution interface. Palomar firmly believes that quick and effective delivery of service is essential to Palomar’s customers. Palomar offers the following services: technical assistance, hardware repair and replacement, loaner equipment to minimize end user disruption, and professional and educational services.

        Palomar’s customer service center and depot repair facility is located at Palomar’s Burlington, Massachusetts headquarters. Certain independent distributors also maintain service centers and parts depots at their facilities and are required to attend Palomar’s formal training to become certified in the repair and maintenance of each of Palomar’s products.

        Product maintenance and repair following the warranty period provides an additional recurring source of revenue. Customers may elect to purchase a service contract or purchase service on a time-and-materials basis. Palomar’s service contracts vary by the type of system and the level of service desired by the customer and typically last for one year. Initial warranties on most products cover parts, service and shipping charges for twelve months. Customers have the option to purchase an extended warranty (beyond the normal one year coverage) as part of the purchase.

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        Palomar’s customer service center not only provides technical assistance for each product line but also provides the option to the end user to purchase additional service contracts, replacement Lux handpieces, end-user marketing materials, and other complementary accessory items. Palomar expects that as the Lux product installed base expands, product revenue generated from the sale of replacement Lux handpieces will increase.

Products Under Development

        Palomar is engaged in developing products for the dermatology and cosmetic market. Products under development include lasers, lamps and other light based products for the removal of unwanted hair, tattoos, pigmented lesions, leg vein and other vascular lesions, acne, fat, cellulite, and skin rejuvenation, including wrinkles and skin tone and texture. Palomar performs its own research as well as with partners, including The Massachusetts General Hospital Corporation (“Massachusetts General Hospital”). Product development is performed by scientists and engineers at Palomar’s headquarters. Palomar directs resources at both new products for existing markets such as the removal of unwanted hair, vascular and pigmented lesions and tattoos, acne and wrinkle removal, and other products for new markets, such as fat reduction, including treatment of cellulite.

        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. Palomar believes that this device will be protected by multiple patents within its patent portfolio. This consumer hair removal device is expected to be safe and effective for use on women’s legs, underarms, bikini line and other areas where a woman might find it necessary to shave, apply hair-removal creams, or undergo waxing, electrolysis, or laser or other light based professional treatments in a doctor’s office, clinic, spa or salon. The parties have completed the first phase and have decided to move into the next phase. The original agreement provided 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. Under a June 2004 amendment, Gillette agreed to provide $2.1 million in additional development funding over a 9-month extension of the development phase, which is now planned to be completed by August 31, 2006. In 2004, Gillette provided $3.1 million in funded product development. (See Note 12, “Development and License Agreement with Gillette” and exhibit 10.14, “The Development and License Agreement with The Gillette Company effective February 14, 2003 with redacted exhibits”)

        On February 18, 2004, Palomar announced that it was 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, commonly known as “razor bumps”. Though the project was scheduled to last for nineteen months, Palomar believes it will need several more months to complete the work. PFB is called “the most significant dermatologic disease in the US Army” in an article by Brauner GJ, Flaudesmeyer KL. entitled “Pseudofolliculitis barbae: Medical consequences of interracial friction in the US Army”, Cutis, 1979, 23:61-66. PFB affects combat readiness, unit cohesion, and individual morale of over 50% of African American and Hispanic military personnel according to an article by Perry PK, Cook-Bolden FE, et al. entitled “Defining pseudofolliculitis barbae in 2001", JAAD, 2002, 46:S113-S119. The importance of a solution to the PFB problem is increasing along with the changing demographics of the military. According to Semiannual Race/Ethnic/Gender Profile by Service/Rank, Sept. 2000 the percentage of African-Americans and Hispanics in the services is currently twice that in the civilian population and growing. Palomar believes that this device will be protected by multiple patents within its patent portfolio.

        As of September 1, 2004, Palomar entered into a Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. (“JJCC”), a Johnson & Johnson company, to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. The agreement provides for JJCC to fund Palomar's research and clinical studies during an initial proof-of-principle phase. At the end of the proof-of-principle phase, JJCC will decide whether or not to continue with one or more of the devices in one or more of the fields into a development phase. Upon JJCC deciding to continue, JJCC will be obligated to fund the development of the selected devices. If JJCC decides not to continue, Palomar may proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a different party. At the end of the development phase, JJCC will decide whether or not to commercialize one or more of the devices in one or more fields. Upon JJCC deciding to commercialize one or more of the devices, JJCC will make payments to Palomar for each selected field. Upon commercial launch of the first device in each selected field, JJCC will make a payment to Palomar, and for all devices sold for use in each selected field, JJCC shall pay Palomar a percentage of sales of such devices and certain topical compounds. If JJCC decides not to commercialize or fails to launch a device, Palomar may proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a different party. Palomar recognized $318,000 of funded product development revenues from JJCC during the twelve months ended December 31, 2004. Any amounts received in advance of services performed are recorded as deferred revenue. Payments are not refundable if the development is not successful. (See Note 13, “Joint Development and License agreement with Johnson & Johnson Consumer Companies (“JJCC”), a Johnson & Johnson company” and exhibit *10.27 “Joint Development and License Agreement by and between Palomar Medical Technologies, Inc. and Johnson and Johnson Companies, Inc.”, dated September 1, 2004 (filed as Exhibit 99.1 to our Current Report on Form 8-K, filed with the SEC on September 7, 2004, and incorporated herein by reference)

Production, Sources and Availability of Materials

        Palomar’s manufacturing operations are located in Burlington, Massachusetts. Palomar maintains control of and manufactures most key subassemblies in-house. Manufacturing consists of the assembly and testing of components purchased from outside suppliers and contract manufacturers. Each fully assembled system is subjected to a rigorous set of tests prior to shipment to the customer or distributor. Palomar has obtained ISO 9001, ISO 13485, CDN MDR, and Council Directive 93/42/EEC. Palomar is registered with the Federal Food and Drug Administration.

        Palomar depends and will depend upon a number of outside suppliers for components used in its manufacturing process. Most of Palomar’s components and raw materials are available from a number of qualified suppliers. If Palomar’s suppliers are unable to meet Palomar’s requirements on a timely basis, production could be interrupted until an alternative source of supply is obtained. In 2002 and early 2003, Palomar experienced significant failures and delays in a critical raw material component required for the SLP 1000. Although the component vendor has rectified the problem, there can be no assurance that this situation will not re-occur in the future. Palomar has not experienced any other delays in raw material for its products.

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Patents and Licenses

        Palomar’s success and ability to compete are dependent on its ability to develop and maintain proprietary technology and operate without infringing on the proprietary rights of others. Palomar relies on a combination of patents, trademarks, trade secret and copyright laws and contractual restrictions to protect its proprietary technology. These legal protections afford only limited protection for its technology. Palomar is presently the exclusive licensee of two United States patents and the non-exclusive licensee of three United States patents and corresponding foreign patents and pending applications owned by Massachusetts General Hospital, and Palomar is also the joint owner with and exclusive licensee of Massachusetts General Hospital of three other United States patents and corresponding foreign patent and pending applications. In addition, Palomar is the sole owner of nine United States patents and corresponding foreign patent and pending applications, and Palomar has rights to other patents under exclusive and non-exclusive licenses.

        Palomar seeks to limit disclosure of its intellectual property by requiring employees, consultants and any third party with access to Palomar’s proprietary information to execute confidentiality agreements with Palomar and often agreements that include assignment of rights provisions to Palomar. Due to rapid changes in technology, Palomar believes that factors such as the technological and creative skills of its personnel, new product developments and enhancements to existing products are as important as the various legal protections of Palomar’s technology to establishing and maintaining a leadership position.

        Despite Palomar’s efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the products or to obtain and use information that Palomar regards as proprietary. Policing unauthorized use of Palomar’s products is difficult. Litigation may be necessary to enforce intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Any such resulting litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the business, operating results and financial condition. There can be no assurance that Palomar’s means of protecting proprietary rights will be adequate or that Palomar’s competitors will not independently develop similar technology. Any failure by Palomar to meaningfully protect Palomar’s proprietary rights could have a material adverse effect on its business, operating results and financial condition.

        Management believes that none of Palomar’s current products infringe upon valid claims of patents owned by third parties. However, there have been claims and there can be no assurance that third parties will not make further claims of infringement with respect to our current or future products. Any such claims, with or without merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. A successful claim of intellectual property infringement against us and our failure or inability to license the infringed technology or develop or license technology with comparable functionality could have a material adverse effect on our business, financial condition and operating results. (See “Cautionary Statements.”)

        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 technology for hair removal developed at Wellman Laboratories of Photomedicine (“Clinical Trial Agreement”). In July 1999, Palomar amended this agreement to extend its research relationship for an additional five years, until August 2004, and to cover the additional fields of non-invasive, electromagnetic targeting of subcutaneous fat, and treatment of sebaceous glands and related skin disorders (e.g., acne) using infrared light except when externally applied chromophores are used. On August 1, 2004 Palomar and Massachusetts General Hospital entered into a new agreement (the “Research Agreement”) whereby Massachusetts General Hospital agreed to conduct clinical and non-clinical research in the field of photo thermal removal or reduction of hair, using light (hereinafter referred to, as “hair removal,”). The Research Agreement has a term of three years, until August 2007, and Palomar will provide Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct and indirect costs of the research.

        Palomar also entered into a license agreement with Massachusetts General Hospital in August of 1995 (“License Agreement”) through which Palomar is the exclusive licensee of certain U.S. and foreign issued patents and pending patent applications in the field of hair removal, including U.S. Patent Nos. 5,595,568 and 5,735,844, European Patent Nos. 0 806 913 B1 and EP 1 230 900 B1 and Chinese Patent No. ZL96191751.2. At an opposition hearing held December 1, 2004, EP 0 806 913 B1 was revoked and such revocation is being appealed by Palomar and Massachusetts General Hospital. Under the Clinical Trial Agreement and a joint patent agreement many joint patent applications have been filed. Palomar is a joint owner of such joint patent applications On February 18, 2003, Palomar and Massachusetts General Hospital signed a fourth amendment to the License Agreement, providing Palomar with exclusive licenses in all fields to existing and future joint patents and applications provided Palomar meets certain due diligence obligations.

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        Palomar has the right to sublicense patents licensed to it under the License Agreement. Palomar pays Massachusetts General Hospital royalties on sales of Palomar’s products covered by these licensed patents and a percentage of the royalties Palomar receives from its sub-licensees. Palomar currently sublicenses certain competitors to U.S. Patent Nos. 5,595,568 and 5,735,844 and foreign counterparts. One of these licensees is Lumenis, Inc. On June 17, 2004, Palomar and Lumenis settled their on-going litigation concerning both patent infringement and contractual matters and Lumenis agreed to pay $4.09 million over the next six quarters for royalties due on sales of its LightSheer system made between July 1, 2002 and December 31, 2003. Beginning on January 1, 2004, Lumenis agreed to pay Palomar a 5% royalty on sales of the LightSheer and other professional laser hair removal devices and modules. In addition, Lumenis granted Palomar a paid up license to a variety of Lumenis’ patents for Palomar’s light based devices and Palomar granted Lumenis a paid up license to the ‘568 and ‘844 patents for Lumenis’ lamp based devices. Importantly, both parties have agreed to the validity and enforceability of each others patents and not to challenge such validity and enforceability in the future.

        Palomar also licenses Gillette, to U.S. Patent Nos. 5,595,568 and 5,735,844 and foreign counterparts and other patents for the development and commercialization of a home-use, light based hair removal device for women. Palomar licenses JJCC to other patents for the development and commercialization of home-use, light based devices for reducing fat including cellulite, reducing appearance of skin aging, and reducing or preventing acne.

Dependence on a Single Customer

        For the years ended December 31, 2004, 2003 and 2002, Palomar had two customers that accounted for 9%, 20% and 35% of net sales, respectively. At December 31, 2004, 2003 and 2002, these customers accounted for 6%, 20% and 27% of trade receivables outstanding, respectively.

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Backlog

        Palomar generally does not maintain a high level of backlog. As a result, Palomar does not believe that its backlog at any particular time is indicative of future sales levels.

Competition

        The market in which Palomar is engaged is subject to intense competition and rapid technological change. Some of Palomar’s competitors have greater financial, marketing, and technical resources than that of Palomar. Moreover, some competitors have developed, and others may attempt to develop, products with applications similar to that of Palomar. Palomar expects that there may be further consolidation of companies within the light based industry via acquisitions, partnering arrangements or joint ventures. Palomar competes primarily on the basis of technology, product performance, price, quality, reliability, distribution and customer service and support. To remain competitive, Palomar will be required to continue to develop new products and periodically enhance its existing products. (See “Cautionary Statements.”)

Food and Drug Administration Regulations

        All of Palomar’s 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, Palomar must obtain clearance from the FDA. The types of medical devices that we seek to market in the United States 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 three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer. To date, the FDA has deemed Palomar’s products eligible for the 510(k) clearance process. Palomar believes that most of its products in development will receive similar treatment. However, Palomar cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of future products, nor can Palomar be sure that 510(k) clearance or PMA approval will ever be obtained for any product it proposes to market and failure to do so could adversely affect Palomar’s ability to sell products.

Number of Employees

        As of December 31, 2004, Palomar employed 161 persons. Palomar is not subject to any collective bargaining agreements, has never experienced a work stoppage and considers its relations with its employees to be good.

SEC Filings Available on Website

        Palomar’s internet website address is www.palomarmedical.com. Palomar’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 are available free of charge through Palomar’s internet website as soon as reasonably practicable after Palomar files such material with, or furnish it to, the Securities and Exchange Commission.

Item 2. Properties

        Palomar occupies approximately 44,000 square feet of office, manufacturing and research space in Burlington, Massachusetts under a lease expiring in August 2009. Palomar believes that this facility is in good condition and is suitable and adequate for its current operations.

Item 3. Legal Proceedings

        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 was 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. On January 14, 2005, Cutera filed a motion for summary judgment that the patent claims being asserted are invalid and not infringed. Palomar and the Massachusetts General Hospital filed a response vigorously defending both the validity of the patent claims and the infringement of those claims by Cutera’s CoolGlide products. A trial date has not yet been set. (See “Cautionary Statements”)

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

Not applicable.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

        Palomar’s common stock is currently traded on the Nasdaq National Market (“Nasdaq”) under the symbol PMTI. The following table sets forth the high and low bid information on Nasdaq for the common stock for the periods indicated. Such quotations reflect inter-dealer prices, without retail markup, markdown or commission and do not necessarily represent actual transactions.

        As of February 28, 2005, Palomar had 3,943 holders of record of common stock. This does not include holdings in street or nominee names.

        Palomar has not paid dividends to its common stockholders since its inception and does not plan to pay dividends to its common stockholders in the foreseeable future. Palomar intends to retain substantially all earnings to finance the operations of the company. Palomar may buy back shares of its common stock on the open market from time to time.

Item 6. Selected Financial Data

        The following table sets forth selected consolidated financial data for each of the last five fiscal years. This data should be read in conjunction with the detailed information, financial statements and related notes, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere herein. The historical results are not necessarily indicative of the results of operations to be expected in the future.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking statements

        This Annual Report on Form 10-K 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:

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        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. We undertake 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 consolidated financial statements and notes thereto included in Item 8 of this Annual Report. 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

        Our policies are more fully described in Note 1 of our Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments.

        Revenue Recognition.  We recognize revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We recognize product revenues upon shipment. If a product sale does not meet all of the above criteria, the sale is deferred until all criteria are met. Provisions are made at the time of revenue recognition for any applicable warranty costs expected to be incurred.

        Periodically, we sell products together with a product upgrade option that requires that the customer pay an upgrade fee at the time of exercise, has no refund provisions and includes an expiration date on the upgrade option. In accordance with Emerging Issues Task Force Issue No. 00-21 (“EITF 00-21”), Accounting for Revenue Arrangements with Multiple Deliverables, we defer the fair value ascribed to the upgrade option until the expiration of the upgrade option or the exercise of the upgrade option and shipment of the product upgrade.

        Revenues from the sale of service contracts is deferred and recognized on a straight-line basis over the life of the service contract. Revenues from services administered by us that are not covered by a service contract are recognized as the services are provided. In certain instances, we sell products together with service contracts. We recognize revenue on such multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the relative fair market value of each element.

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        We recognize royalty revenue from licensees upon receipt of cash payments since the royalty amounts are not fixed and determinable at the end of a quarter. In general, licensees are obligated to make payments 30 days after the end of each quarter.

        We account for funded development revenue from Gillette and Johnson & Johnson Consumer Companies, Inc. (“JJCC”) in accordance with the work plan that was developed with both Gillette and JJCC. Revenue is recognized under the contracts as costs are incurred and services are rendered. Any amounts received in advance of costs incurred and services rendered from Gillette or JJCC are recorded as deferred revenue. Payments from both Gillette and JJCC are non refundable if the development is not successful.

        We provide services under a $2.5 million research contract with the United States Department of the Army to develop a self-treatment light based device for Pseudofolliculitis Barbae or PFB. The contract is a cost plus fee arrangement whereby we are 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.

        Accounts Receivable Reserves. Allowances for doubtful accounts are estimated based on estimates of losses related to customer receivable balances. In establishing the appropriate provisions for customer receivable balances, we make assumptions with respect to their future collectibility. Our assumptions are based on an individual assessment of a customer’s credit quality as well as subjective factors and trends, including the aging of receivable balances. Generally, these individual credit assessments occur prior to the inception of the credit exposure and at regular reviews during the life of the exposure and consider (a) a customer’s ability to meet and sustain their financial commitments; (b) a customer’s current and projected financial condition; (c) the positive or negative effects of the current and projected industry outlook; and (d) the economy in general. Once we consider all of these factors, a determination is made as to the probability of default. An appropriate provision is made, which takes into account the severity of the likely loss on the outstanding receivable balance based on our experience in collecting these amounts. Our level of reserves for our customer accounts receivable fluctuates depending upon all of the factors mentioned above. We provide a general reserve for doubtful accounts based on the aging of our accounts receivable balances, historical experiences of write-offs and defaults.

        We also record a provision for estimated sales returns and allowances on product and service related sales in the same period as the related revenues are recorded. These estimates are based on the specific facts and circumstances of particular order, analysis of credit memo data and other known factors. If the data we use to calculate these estimates do not properly reflect reserve requirements, then a change in the allowances would be made in the period in which such a determination is made and revenues in that period could be adversely affected.

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

        Warranty Provision. We typically offer a one-year warranty for all of our products. We provide for the estimated cost of product warranties at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs and the cost per repair. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our estimated warranty obligation is affected by ongoing product failure rates, specific product class failures outside of our baseline experience, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Assumptions and historical warranty experience are evaluated on at least a quarterly basis to determine the appropriateness of such assumptions. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.

        Income taxes. We currently have net operating loss (“NOL”) carryforwards that can be utilized to offset future income for federal and state tax purposes. These NOLs generate a significant deferred tax asset. However, we have recorded a valuation allowance against this deferred tax asset as we have determined that it is more likely than not that we will not be able to fully utilize the NOLs. Should our assumptions regarding the utilization of these NOLs change, we may reduce some or all of this valuation allowance, which would result in the recording of an income tax benefit. In evaluating the potential exposure associated with the various tax filing positions, we accrue charges for possible exposures. Based on the annual evaluations of tax positions, we believe we have appropriately filed our tax returns and accrued for possible exposures. To the extent we were to prevail in matters for which accruals have been established or be required to pay amounts in excess of reserves, our effective tax rate in a given financial period might be materially impacted.

Overview

        We are engaged in research, development, manufacturing and distribution 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 research and development as well as 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, cellulite reduction, acne treatment, Pseudofolliculitis Barbae (“PFB”) treatment and skin rejuvenation. During the year, we continued to build a strong relationship with the Gillette Company and forged new alliances with the Johnson & Johnson Consumer Company (“JJCC”) and the Department of the Army.

        During 2004, we improved product gross profits by 66% due to a higher margin product mix and the effects of increased sales volume in comparison to the same period in 2003. We also strengthened our balance sheet since the end of last year, including more than doubling our cash position and stockholders’ equity. The current ratio is now 3.7x, up substantially from 2.9x at the end of 2003, and we have no long-term debt.

        Our reported revenues for the year ended December 31, 2004, were $54.4 million, up from $34.8 million for the year ended December 31, 2003. Gross profit from product sales increased to $30.3 million (66 percent of revenues), up from $18.3 million (58 percent of revenues) in the year-earlier period. We also reported net income of $10.6 million, or $0.60 per diluted share, for the year ended December 31, 2004, versus net income of $3.4 million, or $0.21 per diluted share, for the year ended December 31, 2003.

        Over the last three years, most of our revenue has included the Lux family of products with their complementary handpieces, offering 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 if they prefer upgrade into more powerful Lux systems when ready. Additionally, the Lux platform enables us 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.

        The StarLux, with it’s suite of handpieces, can be used for permanent hair reduction, the treatment of pigmented lesions, vascular lesions, leg veins, acne, wrinkles and other cosmetic applications. The StarLux can operate the LuxY™, LuxG™, LuxR™, LuxRs™, and LuxV™ lamp handpieces as well as the Lux1064™ Nd:YAG laser handpiece. Incorporated into the StarLux is active contact cooling for safety, smooth pulse technology for comfort, AccuSpectrum™ technology for versatility, photon recycling for efficacy and a full-color touch screen for ease of use.

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        The StarLux is welcomed into the Lux family of products by the MediLux™, EsteLux® and NeoLux™ Pulsed Light Systems. The EsteLux was the first Lux Platform product introduced and can operate the LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV handpieces. The MediLux has more power than that of the EsteLux, a higher repetition rate and a snap-on connector for faster changes between handpieces. The MediLux can operate the same six handpieces as the EsteLux, which allows customers to add additional applications to their treatment portfolio and provide specifically tailored procedures to meet their demand. The lower priced NeoLux was developed specifically for the beauty industry. The NeoLux is a simple, three setting device that can operate the LuxY, LuxR and LuxRs handpieces.

        Our product revenue has increased each quarter during 2004 as compared to 2003 as a result of the increased product demand for the StarLux and Lux family of products. Due to this increased demand in the market place, we increased our domestic sales force throughout 2004. 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.

        During 2004, we continued to bolster our consumer device research and development programs. In September, we entered into a joint development and license agreement with Johnson & Johnson Consumer Companies (“JJCC”) to develop, clinically test and potentially commercialize home-use, light based devices for reducing or reshaping body fat including cellulite, reduce the appearance of skin aging and reducing or preventing acne. In June, we moved into the next phase of our agreement with The Gillette Company to develop and commercialize a home-use, light based hair removal device for woman. In addition, in February, we were awarded a $2.5 million research contract by the U.S. Department of the Army to develop a light based self-treatment device for the dermatologic disease Pseudofolliculitis Barbae or PFB, a disease that affects combat readiness, unit cohesion and individual moral of over 50% of African American and Hispanic military personnel.

        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

        In February 2005, we introduced the VisiLux 1064™ handpiece, the LuxIR™ and the DermaType ™ skinphotometer. The VisiLux1064 Laser handpiece features a built-in, high resolution camera which projects an image of the treatment area onto an LCD screen mounted on the handpiece. The LCD screen provides real-time digital imaging for clear evaluation and treatment of leg veins and other targets. The camera magnifies the treatment area to about 4.5 times the actual size and through a proprietary illumination system enhances the image by contrasting the target against its background, for example, to provide clear viewing of deep veins. This innovation offers unparalleled visibility, treatment precision and ease of use while offering an additional laser alternative to our specialized family of Lux handpieces. We plan to begin shipments of the VisiLux1064 handpiece by the end of 2005.

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        The LuxIR Infrared handpiece will be offered with the StarLux and delivers pulses of infrared light deep into the dermis to create carefully controlled areas of elevated temperature. This handpiece is pending FDA clearance for the temporary relief of muscle and joint pain, muscle relaxation and increased circulation. We intend to seek FDA clearance for creating a smoother, tighter skin appearance as the technology has been shown to trigger a biological response which leads to collagen remodeling in the dermis. Remodeled collagen can fill the skin to smooth out fine wrinkles and minor sagging, and can also stimulate increased collagen production to create visible long term results. This is our first handpiece to utilize infrared light for the treatment of skin rejuvenation. We plan to begin shipments of the LuxIR handpiece by the end of 2005.

        The DermaType Skinphotometer measures the melanin and blood content of skin in a matter of seconds. With this device, our customers will be able to quickly and accurately determine appropriate system settings for each patient to insure the safest and most accurate treatments are provided. The DermaType Skinphotometer can be used in conjunction with the StarLux, MediLux, EsteLux or NeoLux Systems, resulting in treatments perfectly tailored to the patient’s individual skin type. This device is not yet available for sale. We intend to seek FDA clearance for this device in the near future and begin shipments of the DermaType Skinphotometer this summer.

Results of operations

Year 2004 Compared to Year 2003

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

        Product revenues. Sales of the newly introduced StarLux Pulsed Light and Laser System coupled with its additional handpieces were the leading contributor to our increase in product revenues. In addition, product revenues were favorably impacted by an increase of 5% in sales related to the other “Lux” family of products, which includes the MediLux, EsteLux and NeoLux and their additional handpieces an increase of 26% in revenue related to customer service sales offset by a decrease of 12% from sales related to the Q-Yag 5 product line and a decrease of 90% of sales related to our legacy products (the SLP1000 and the RD1200) as compared to the same period in 2003.

        International product revenue, consisting of sales by our distributors in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America and our sales shipped directly to international customers was 37% of total product revenue for the year ended 2004 in comparison to 47% 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.

        Royalty revenues. The increase in royalty revenue during 2004, in comparison to the same period in 2003, is attributed to our settlement agreement with Lumenis. Under the terms of the settlement, Lumenis paid $868,000 in the second quarter of 2004 for back-owed royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay $3.225 million over the next six quarters, or $537,500 per quarter, for back-owed royalties due on sales of the LightSheer made between July 1, 2002 and December 31, 2003. Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the LightSheer and other professional laser hair removal devices and modules. In addition, Lumenis granted us a paid up license to a variety of Lumenis’ patents for our light based devices. We granted Lumenis a paid up license to the ‘568 and ‘844 patents for Lumenis’ professional lamp based devices. Both parties have agreed to the validity and enforceability of each others patents and not to challenge such validity and enforceability in the future. During 2004, Lumenis made payments of approximately $1.4 million relating to the 5% royalty and approximately $1.9 million for back-owed royalties recorded as royalty revenue. (See Note 16, “Settlement of Litigation.”)

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        Funded product development revenues. Funded development revenue increased during 2004 as compared to the same period in 2003. Funded development revenue is generated from the development agreements with Gillette and Johnson & Johnson Consumer Companies, Inc. (“JJCC”) as well as the United States Department of the Army. For both Gillette and JJCC, Palomar receives payments quarterly in accordance with the work plan that were developed with both Gillette and JJCC. Revenue is recognized under the contracts as costs are incurred and services are rendered. Any amounts received in advance of costs incurred and services rendered from Gillette or JJCC are recorded as deferred revenue. Payments are not refundable if the development is not successful. For the year ended December 31, 2004, we recognized approximately $3.1 million and $318,000 of funded product development revenue from Gillette and JJCC, respectively.

        We provide services under a $2.5 million research contract with the United States 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. For the year ended December 31, 2004, we recognized approximately $1.1 million of funded product development revenues from the Department of the Army.

        Cost of product revenues. The cost of product revenues increased in absolute dollars, but decreased as a percentage of total revenue to 29% in 2004 from 38% in 2003. The increase in absolute dollars is directly attributable to increased variable costs associated with increased product sales. This cost decreased as a percentage of total revenue primarily due to a shift in sales mix to the higher priced StarLux Pulsed Light and Laser System and the other “Lux” family of products from sales of higher cost to produce legacy products such a the SLP1000 and RD1200. The “Lux” family of products carry lower manufacturing costs as a result of their modular design. In addition, increased sales volume has improved the absorption of fixed manufacturing overhead at our manufacturing facility as approximately 70% of our manufacturing overhead cost is fixed in nature and is spread over much higher sales volumes.

        Cost of royalty revenues. As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% in accordance with our license agreement with Massachusetts General Hospital for each period in comparison to the same periods in 2003. The increase in the cost of royalty revenues in absolute dollars is attributed to our settlement agreement with Lumenis. (See Note 16, “Settlement of Litigation.”)

        Research and development expense. The increase in research and development expense is a direct result of our spending related to the Gillette agreement, the JJCC agreement and the research contract with the United States Department of the Army and our continued commitment to introducing new platforms and enhancing our current family of products.

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        For our research and development agreement with Gillette, costs related to payroll and payroll related expenses increased by $125,000, material costs increased by $313,000 and other clinical, consulting and overhead expenses increased by $776,000 as compared to the same period in 2003, The Gillette agreement began in February 2003.

        Expenses relating to the Army contract, which began in February 2004, totaled approximately $1.1 million for the year ended December 31, 2004. Though the project was scheduled to last for nineteen months, we believe we will need several more months to complete the work.

        Expenses relating to the JJCC agreement, which began in October 2004, totaled approximately $300,000 for the year ended December 31, 2004.

        Legal expenses relating to the prosecution of new patents increased by approximately $218,000 in comparison to the same period in 2003. We are committed to expanding our intellectual property rights to protect discoveries made through our investment in research and development.

        Expenses relating to the introduction of new products such as the StarLux, enhancements made to our current family of products and research and development overhead increased by $1.4 million for the twelve months ended December 31, 2004, in comparison to the same period in 2003.

        The spending on research and development reflects our 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 cellulite reduction and skin rejuvenation.

        Selling and marketing expense. The increase in selling and marketing expense is primarily comprised of $1.9 million from payroll and payroll related expenses, approximately $1.8 million relating to tradeshows, consultants and other sales and marketing infrastructure costs, $210,000 related to the write-off of certain third party demo inventory offset by a decrease of approximately $384,000 relating to commission expense in comparison to the same period in 2003. Domestic commission increased by approximately $678,000 correlating with our increased domestic product revenue, European commissions increased by $47,000, while Far East commissions decreased by approximately $1.1 million due to a change in our commission structure with one of our Far East distributors. The increases directly correlate with our increased revenues, upfront costs associated with both international and domestic sales force and distribution channel expansion as well as the introduction of our newest product, the StarLux Pulsed Light and Laser System.

        General and administrative expense. The increase in general and administrative dollars is mainly attributed to increases to incentive compensation of $695,000, related to our incentive compensation plan of 2004, an increase in costs related to corporate governance as a result of the Sarbanes-Oxley Act of 2002 of $230,000, an increase in our corporate legal expenses of approximately $505,000 and an increase in payroll and payroll related expenses and other infrastructure costs of approximately $60,000 as compared to the same period in 2003.

        Interest income. Interest income increased due to higher levels of excess cash on hand as well as higher interest rates in comparison to the same periods in 2003.

        Interest expense. The decrease in interest expense 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. The price was calculated at 110% of our Common Stock trailing ten-day average closing price of $3.10 per share.

        Other income (expense). Other income (expense), net, decreased in comparison to the same period in 2003. This decrease is attributable to costs of $380,000 related to a non-recurring expense from the settlement of litigation relating to a previously owned subsidiary’s facility lease offset by payments received from a previously written-off note receivable and equity investment.

        Benefit from income taxes. We recognized a benefit from income taxes of $856,000 in 2004 as a result of a $1.1 million reduction in deferred income tax accruals associated with tax deductions in a 1999 state tax return which were no longer required. Offsetting these benefits, we provided a 3% effective tax rate for anticipated federal alternative minimum taxes and minimum state income taxes due for 2004. We recognized a benefit for income taxes of $656,000 in 2003 as result of a $470,000 carryback claim pursuant to the Economic Stimulus package of 2002 and a $300,000 reduction in deferred income tax accruals associated with certain tax deductions taken in our 1999 federal tax return which were no longer required. Offsetting these benefits, we provided a 4% effective tax rate for anticipated federal alternative minimum taxes and minimum state income taxes due for 2003. Given our limited history of profitability, at this time we have fully reserved our otherwise recognizable deferred tax asset, as its realization is uncertain.

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Year 2003 Compared to Year 2002

        The following table contains selected statement of operations information, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2003 and 2002, 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. The “Lux” family of products, consisting of the MediLux, EsteLux, NeoLux and related additional handpieces increased 52% for the year ended 2003 in comparison to the same period in 2002. Product revenues were favorably impacted by an increase of 4% in sales related to the Q-Yag 5 product line and an increase of 45% in revenue related to customer service sales offset by a decrease of 28% of sales related to the SLP1000 and a decrease of 27% of sales related to the RD-1200 product line in comparison to the same period in 2002. Market acceptance of the “Lux” family of products has been increasing since its introduction in September 2001. We have discontinued the RD1200 product line and have begun the process of phasing out the SLP1000 product line.

        International product revenue, consisting of sales by our distributors in Japan, Europe, Australia, Asia\Pacific Rim and South and Central America and our sales shipped directly to international customers was 47% of total product revenue during 2003 in comparison to 54% for the same period in 2002. 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.

        Royalty revenues. The decrease in royalty revenues in comparison to the same period in 2002 is attributed to Lumenis Inc.‘s failure to make its royalty payments starting in October 2002. (See Note 16, “Settlement of Litigation.”)

        Funded product development revenues. For the year ended 2003, funded product development revenue of $2.6 million was for work performed in connection with payments made by Gillette. 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. (See Note 12, “Development and License Agreement with Gillette” and exhibit 10.14, “The Development and License Agreement with The Gillette Company effective February 14, 2003 with redacted exhibits”)

        Cost of product revenues. The cost of product revenues decreased as a percentage of product revenue to 42% in 2003 from 50% in 2002. This cost decreased as a percentage of product revenue primarily due to improved gross profit recognized on the “Lux” family of products as a result of lower manufacturing costs associated with the “Lux” product lines. In addition, the increased sales volume has improved the absorption of manufacturing overhead at our manufacturing facility for each product line.

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        In connection with our increased focus on the “Lux” product lines and a de-emphasis and discontinuation of certain other existing products, during the fourth quarter of 2003, we wrote off an additional $316,000 to cost of product revenues relating to the SLP1000 and RD 1200 product lines. Approximately $200,000 was written off in relation to the SLP1000 product line for prior generation and obsolete and excess inventory and $116,000 was written off in relation to the RD 1200 product line for excess inventories. While we have discontinued the active marketing of certain products, we remain committed to servicing both product lines and will maintain adequate service inventories for each.

        During 2002, we experienced unusually high warranty claims for the SLP1000 due to issues related to a key component. Accordingly, we increased our warranty reserve by $250,000 in the third quarter of 2002 bringing the total warranty reserve related to this key component to approximately $380,000. During 2003, we qualified a new vendor for the key component and began replacing this key component. As of the end of 2003, we believed that the replacement part had effectively rectified the problem and that the warranty reserve was significantly in excess of estimated requirements. Consequently, we decreased our warranty reserve and reduced cost of goods sold by approximately $336,000 in the fourth quarter of 2003.

        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 royalty revenues is attributed to Lumenis’ failure to make its royalty payments resulting in a reduced cost of royalty due to Massachusetts General Hospital. (See Note 16, “Settlement of Litigation.”)

        Research and development expense. The increase in research and development expense is a direct result of our spending related to the Gillette agreement and our continued commitment to introducing new platforms and enhancing our current family of products. For our research and development agreement with Gillette, we have increased our research and clinical staffing by 25%. This increase in staffing has increased our payroll and payroll related expenses by approximately $600,000. In addition to this increase in payroll and payroll related expenses, we have incurred costs of approximately $730,000 on materials and consultants for prototypes related to the Gillette agreement. The investment in the Lux platform has allowed us to use the same platforms to introduce new applications by developing new handpieces and other complimentary features as opposed to developing new systems for each application. We continue our development of product platform enhancements and additional platforms. The spending on research and development reflects the our 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 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 cellulite reduction, acne treatment and skin rejuvenation.

        Legal expenses relating to the prosecution of new patents increased by approximately $517,000 in comparison to the same period in 2002. We are committed to expanding intellectual property rights to protect discoveries made through our investment in research and development.

        Selling and marketing expense. The increase in selling and marketing expenses is associated with an increase in direct sales force commissions of approximately $472,000, an increase in international commissions of approximately $132,000, an increase in commissions related to our independent representatives of approximately $652,000 and a doubling of our domestic sales force in October 2003. These increases directly correlate with our increased revenues, upfront costs associated with both international and domestic sales force and distribution channel expansion as well as costs associated with regional and international trade show and other marketing expenses.

        General and administrative expense. The increase in general and administrative dollars is primarily related to increases to our incentive compensation plan of 2003 and an increase in general liability and directors and officer insurance premiums.

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        Interest income. Interest income remained consistent in 2003 and 2002. The increase in excess cash to invest in 2003 was offset by a reduction in interest rates.

        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. The price was calculated at 110% of our Common Stock trailing ten-day average closing price of $3.10 per share.

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

        Benefit from income taxes. We recognized a benefit from income taxes of $656,000 in 2003 as result of a $470,000 carryback claim pursuant to the Economic Stimulus package of 2002 and a $300,000 reduction in deferred income tax accruals associated with certain tax deductions taken in our 1999 federal tax return which were no longer required. Offsetting these benefits, we provided a 4% effective tax rate for anticipated federal alternative minimum taxes and minimum state income taxes due for 2003. We recorded no tax provision in 2002 as we only had $39,000 net income for the year and 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):

        Additionally, our cash position, working capital, accounts receivable, inventories, working capital and current ratio are shown below for the periods indicated.

        As of December 31, 2004, we had $25.2 million in cash and cash equivalents and available-for-sale investments. 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. As of December 31, 2004, we had no borrowings or long-term debt.

        Cash provided by operating activities increased for the twelve months ended December 31, 2004 compared to the same period in 2003. This increase primarily reflects the effects of an increase in net profit and a decrease in working capital requirements. Cash used in investing activities decreased during 2004 compared to the same period in 2003. These amounts primarily reflect cash used for purchases of property and equipment, purchases of available-for-sale investments offset by proceeds from the sale of available-for-sale investments. Cash provided by financing activities decreased for the twelve month period ended December 31, 2004 compared to the same period in 2003. This decrease was primarily due to a decrease in sales of common stock offset partially due to an increase in exercises of stock options.

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        We anticipate that capital expenditures for 2005 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, 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. The agreement provides up to $7 million in initial development support funding to be paid by Gillette to us over approximately the first 30 months of the agreement. On June 28, 2004, Palomar and The Gillette Company announced that they completed the initial phase of this agreement, and both parties moved into the next phase. The original agreement provided for $7 million in development funding from Gillette. Under this amendment, Gillette will provide $2.1 million in additional development funding to further technical innovations over a 9-month extension of the development phase, which is now planned to be completed by August 31, 2006. We recognized $3.1 million of funded product development revenues from Gillette during the twelve months ended December 31, 2004. Any amounts received in advance of services performed are recorded as deferred revenue. Payments are not refundable if the development is not successful.

        In the first quarter of 2004, we 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 we are 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. Though the project was scheduled to last for nineteen months, we now believe it will need several more months to complete the work. We recognized $1.1 million of funded product development revenues from the Department of the Army during the twelve months ended December 31, 2004.

        On June 22, 2004, we announced that we had reached a settlement agreement with Lumenis resolving their on-going litigation concerning both patent infringement and contractual matters. Pursuant to the settlement, the federal action in the Northern District of California and the state court action in Massachusetts were dismissed with prejudice. Under the terms of the settlement, Lumenis paid $868,000 in the second quarter for back-owed royalties from sales of the LightSheer made prior to July 1, 2002 and agreed to pay $3.225 million over the next six quarters, or $537,500 per quarter, for back-owed royalties due on sales of the LightSheer made between July 1, 2002 and December 31, 2003. Beginning on January 1, 2004, Lumenis agreed to pay us a 5% royalty on sales of the LightSheer and other professional laser hair removal devices and modules. In addition, Lumenis granted us a paid up license to a variety of Lumenis’ patents for our light based devices. We granted Lumenis a paid up license to the ‘568 and ‘844 patents for Lumenis’ lamp based devices. Both parties have agreed to the validity and enforceability of each others patents and not to challenge such validity and enforceability in the future. For the twelve months ended December 31, 2004, Lumenis made payments of approximately $1.4 million relating to the 5% royalty and approximately $1.9 million for back-owed royalties recorded as royalty revenue.

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        Effective as of September 1, 2004, we entered into a Joint Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. (“JJCC”), a Johnson & Johnson company, to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. The agreement provides for JJCC to fund our research and clinical studies during an initial proof-of-principle phase. At the end of the proof-of-principle phase, JJCC will decide whether or not to continue with one or more of the devices in one or more of the fields into a development phase. Upon JJCC deciding to continue, JJCC will be obligated to fund the development of the selected devices.  If JJCC decides not to continue, we may proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a different party. At the end of the development phase, JJCC will decide whether or not to commercialize one or more of the devices in one or more fields. Upon JJCC deciding to commercialize one or more of the devices, JJCC will make payments to us for each selected field. Upon commercial launch of the first device in each selected field, JJCC will make a payment to us, and for all devices sold for use in each selected field, JJCC shall pay us a percentage of sales of such devices and certain topical compounds. If JJCC decides not to commercialize or fails to launch a device, we may proceed in fields not selected by JJCC to develop and commercialize these and other devices on our own or with a different party. We recognized $318,000 of funded product development revenues from JJCC during the twelve months ended December 31, 2004. Any amounts received in advance of services performed are recorded as deferred revenue. Payments are not refundable if the development is not successful.

Contractual obligations

        On August 1, 2004, we entered into a new agreement with Massachusetts General Hospital whereby it agreed to conduct clinical and non-clinical research in the field of photo thermal removal or reduction of hair, using light. The agreement has a term of three years, until August 2007, and we will provide Massachusetts General Hospital at least $230,000 on an annual basis to cover the direct and indirect costs of the research. We have the right to exclusively license, on royalty terms to be negotiated, the inventions we fund that are discovered during this research.

        We are a party to a license agreement, as amended, with Massachusetts General Hospital whereby we are obligated to pay royalties to Massachusetts General Hospital for sales of certain products as well as 40% of royalties received from third parties. Royalty expense in 2004 totaled approximately $2.8 million.

        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 December 31, 2004, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (000‘s omitted):

Recently issued accounting standards

        In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment”. SFAS No. 123(R) revises SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123(R) will require compensation costs related to share-based payment transactions to be recognized in the financial statements (with limited exceptions). The amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. This statement is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. We will adopt the standard as of the effective date. (See Note 1, “Stock based compensation for the effect on our financial statements.”)

        In November 2004, the FASB issued FASB Statement No. 151, “Inventory Costs”, an amendment of ARB No. 43, Chapter 4. The amendments made by Statement 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe there will be a material effect upon our financial condition or results of operations from the adoption of the provisions of SFAS 151.

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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, treatment of acne and wrinkles, 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, prescription drugs 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 years, 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.

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 products and result in a decrease in revenue. We depend on an acceptable level of reliability for purchased components. Reliability below expectations for key components could have an adverse affect on inventory and inventory reserves.

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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 are not required. We cannot be certain that the FDA would agree with any of our decisions not to seek 510(k) clearance. If the FDA requires us to seek 510(k) clearance for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain a new 510(k) clearance.

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.

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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.

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.

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        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 our management, including transactions in which stockholders might otherwise receive a premium for their shares over the then current market price. In April 1999, we adopted a shareholder rights plan. This is intended to protect shareholders from unfair or coercive takeover practices. In accordance with the shareholder 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.

We may not be able to successfully collect licensing royalties.

        In past years and now again following the settlement with Lumenis, material portions of our revenues consist of royalties from sub-licensing patents licensed to us on an exclusive basis by Massachusetts General Hospital.

        We have sued Cutera, Inc. (formerly Altus Medical Inc., See Legal Proceedings) for patent infringement, and we are involved in patent disputes with other third parties. Such other disputes may also result in litigation. 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 weaken the strength of the patents involved, and have a material adverse effect on our business, financial condition and results of operations.

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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 175 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.

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 a significant amount 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 37% of total product revenue for the year ended 2004, 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.

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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. On June 28, 2004 Palomar and Gillette announced that they completed the initial phase of their agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations. 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.

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 was scheduled to last for nineteen months, we now believe it will take several additional months to complete the work. 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.

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Managing our relationship with Johnson & Johnson Consumer Companies (“JJCC”) effectively may divert the attention of key technical personnel and management from the core business. If JJCC ends the relationship our stock price could fall, and we may be unable to bring to market home-use, devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.

        On September 1, 2004, we entered into a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc. (“JJCC”), a Johnson & Johnson company, to develop and commercialize home-use, light based devices in the fields of (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. 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 devices even though such devices will not likely be commercialized for several years, if ever. In addition, we cannot be sure that JJCC 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, JJCC has the ability to choose not to continue and may terminate the agreement. If JJCC 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 devices 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, JJCC 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 these devices in any or all countries, in which the devices will be manufactured, used or sold. This could have a material adverse effect on our business, results of operations and financial condition.

Item 7A. 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.

Item 8. Financial Statements and Supplementary Data.

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

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Palomar Medical Technologies, Inc.:

We have audited the accompanying consolidated balance sheets of Palomar Medical Technologies, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Palomar Medical Technologies, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Palomar Medical Technologies Inc.‘s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 7, 2005 expressed an unqualified opinion thereon.

Ernst & Young LLP
Boston, Massachusetts
March 7, 2005

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Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Balance Sheets

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

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Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Statements of Income

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

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Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

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

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Palomar Medical Technologies, Inc. and Subsidiaries

Consolidated Statements of Cash Flows