x		Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the Quarter Ended March 31, 2013

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

 

		Three Months Ended
		March 31,
		2013				2012
Revenues
Professional product revenues		$	17,326,502			$	11,897,174
Consumer product revenues			710,900				978,768
Service revenues			3,148,605				3,770,243
Royalty revenues			1,979,392				1,798,062
Other revenues			57,660				555,556
Total revenues			23,223,059				18,999,803
Costs and expenses
Cost of professional product revenues			7,308,169				4,901,098
Cost of consumer product revenues			668,339				834,383
Cost of service revenues			1,383,621				1,659,963
Cost of royalty revenues			791,757				719,225
Research and development			2,582,453				3,372,261
Selling and marketing			7,397,665				6,681,525
General and administrative			4,029,756				3,151,967
Total costs and expenses			24,161,760				21,320,422
Loss from operations			(938,701	)			(2,320,619	)
Interest income			76,593				89,003
Other (loss) income			(437,315	)			11,802
Loss before income taxes			(1,299,423	)			(2,219,814	)
(Benefit) provision for income taxes			(187,695	)			71,978
Net loss		$	(1,111,728	)		$	(2,291,792	)
Net loss per share
Basic		$	(0.06	)		$	(0.12	)
Diluted		$	(0.06	)		$	(0.12	)
Weighted average number of shares outstanding
Basic			18,963,788				18,858,464
Diluted			18,963,788				18,858,464
Comprehensive loss:
Net loss		$	(1,111,728	)		$	(2,291,792	)
Unrealized gain (loss) on marketable securities, net of taxes			18,092				(24,827	)
Foreign currency translation adjustment			276,412				(19,468	)
Comprehensive loss		$	(817,224	)		$	(2,336,087	)

Note 5 – Inventories

Inventories are valued at the lower of cost (first-in, first-out method) or market, and include material, labor and manufacturing overhead.  At March 31, 2013 and December 31, 2012, inventories consisted of the following:

 

		March 31,				December 31,
		2013				2012
Raw materials		$	6,670,780			$	8,475,918
Work in process			2,484,738				1,795,986
Finished goods			11,487,666				11,313,003
Total		$	20,643,184			$	21,584,907

 

Included in our finished goods inventory at March 31, 2013 and December 31, 2012, are $3.4 million and $3.2 million, respectively, of demonstration products that are used by our sales organization.

At March 31, 2013 and December 31, 2012, we had $0 and $0.3 million, respectively, of consumer product inventory held on consignment in finished goods.  Included in our consolidated inventory balances at March 31, 2013 and December 31, 2012 is approximately $0.1 million and $0.7 million, respectively, of consumer product inventory.

Note 6 – Property and equipment

At March 31, 2013 and December 31, 2012, property and equipment consisted of the following:

		March 31,				December 31,
		2013				2012			Estimated useful life
Land		$	10,680,000			$	10,680,000
Building			24,505,574				24,505,574		39 years
Machinery and equipment			3,507,047				3,496,347		3-7 years
Furniture and fixtures			6,269,995				6,210,158		7 years
Leasehold improvements			91,046				96,100		Shorter of estimated useful life or term of lease
		$	45,053,662			$	44,988,179
Accumulated depreciation			(9,469,432	)			(9,103,151	)
Total		$	35,584,230			$	35,885,028

 

Note 7 – Warranty costs

The following table provides the detail of the change in our product warranty accrual, which is a component of accrued liabilities on the Condensed Consolidated Balance Sheets as of March 31, 2013 and 2012:

 

 

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		For the three months ended March 31,
		2013				2012
Warranty accrual, beginning of period		$	985,572			$	785,412
Charges to cost and expenses relating to new sales			1,108,151				398,181
Costs of product warranty claims/change of estimate			(885,245	)			(290,673	)
Warranty accrual, end of period		$	1,208,478			$	892,920

Note 8 – Fair Value of Financial Instruments

We performed an analysis of our investments held at March 31, 2013 and December 31, 2012 to determine the significance and character of all inputs to their fair value determination. The FASB's fair value measurement guidance requires additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in fair value for each reporting period.

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

Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations.  The following table presents our assets measured at fair value on a recurring basis as of March 31, 2013 and December 31, 2012.

Assets		Fair Value as of March 31, 2013
(in thousands)		Level 1				Level 2				Level 3				Total
Cash and cash equivalents		$	57,823			$	-			$	-			$	57,823
Short-term investments*			29,010				-				-				29,010
Other investments*			13,061				-				-				13,061
Auction-rate municipal securities			-				-				925				925
Total		$	99,894			$	-			$	925			$	100,819

* The amortized cost of these investments approximates fair market value.

Assets		Fair Value as of December 31, 2012
(in thousands)		Level 1				Level 2				Level 3				Total
Cash and cash equivalents		$	55,116			$	-			$	-			$	55,116
Short-term investments*			33,058				-				-				33,058
Other investments*			10,536				-				-				10,536
Auction-rate municipal securities			-				-				997				997
Total		$	98,710			$	-			$	997			$	99,707

* The amortized cost of these investments approximates fair market value.

At March 31, 2013, we held $29.0 million of short-term investments classified as held-to-maturity, which included $10.0 million in U.S. commercial paper, $8.0 million in corporate bonds, $6.0 million in U.S. Treasury Notes, and $5.0 million for U.S. agency bonds.  As of March 31, 2013, the remaining maturity dates for commercial paper, corporate bonds, U.S. Treasury Notes, and U.S. agency bonds range from 2 days to 0.5 years, 5 days to 0.3 years, 0.3 to 0.5 years, and 0.2 to 0.7 years, respectively.  At December 31, 2012, we held $33.1 million of short-term investments classified as held-to-maturity, which included $10.1 million in corporate bonds, $9.0 million in commercial paper, $8.0 million in U.S. agency bonds, and $6.0 million in U.S. Treasury Notes.  As of December 31, 2012, the maturity dates for corporate bonds, commercial paper, U.S. agency bonds, and U.S. Treasury Notes range from 0.1 to 0.6 years, 0.1 to 0.5 years, 0.2 to 0.9 years, and 0.5 to 0.8 years, respectively.  The amortized cost of these investments approximates fair market value.

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At March 31, 2013, we had $13.1 million of other investments classified as held-to-maturity securities, which included $7.5 million in U.S. agency bonds, $4.5 million in U.S. Treasury Notes, and $1.0 million in corporate bonds.  These other investments are recorded at amortized cost.  As of March 31, 2013, the maturity dates for the U.S. agency bonds, U.S. Treasury Notes, and corporate bonds range from 1.1 to 1.5 years, 1.1 to 1.4 years, and 1.1 years, respectively.  At December 31, 2012, we had $10.5 million of other investments classified as held-to-maturity securities which included $6.0 million in U.S. agency bonds and $4.5 million in U.S. Treasury Notes.  These other investments are recorded at amortized cost.  As of December 31, 2012, the maturity dates for the U.S. agency bonds and U.S. Treasury Notes range from 1.4 to 1.8 years and 1.3 to 1.6 years, respectively.  The amortized cost of these investments approximates fair market value.

In addition to the other investments discussed above, at March 31, 2013 and December 31, 2012, the par value of the auction-rate municipal securities ("ARS") was $1.2 million and $1.3 million, respectively.  As described in more detail below, all of our ARS have unrealized losses, which have been recorded in accumulated other comprehensive income (loss).  The maturity date for our auction-rate municipal securities is in December 2045.

Level 3 Gains and Losses

The table presented below summarizes the change in balance sheet carrying values associated with Level 3 financial instruments for the three months ended March 31, 2013.

 

		Auction-rate
(in thousands)		municipal securities				Total
Balance at December 31, 2012		$	997			$	997
Purchases			-				-
Settlements (at par)			(100	)			(100	)
Transfers in/out of Level 3			-				-
Gains
Realized			-				-
Unrealized			28				28
Losses
Realized			-				-
Unrealized			-				-
Balance at March 31, 2013		$	925			$	925

All of the above ARS have been in a continuous unrealized loss position for 12 months or longer.  We continue to receive regular interest payments from each of our ARS at current market rates.

Historically, the ARS market was an active and liquid market where we could purchase and sell our ARS on a regular basis through auctions.  As such, we classified our ARS as Level 1 investments in accordance with the FASB's guidance at December 31, 2007.  Beginning in February 2008, several of our ARS failed at auction due to a decline in liquidity in the ARS and other capital markets.  We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market.  As all of our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current investments as of March 31, 2013 and December 31, 2012.

The estimated fair value of our holdings of ARS at March 31, 2013 was $0.9 million. To value our ARS, we determined the present value of the ARS at the balance sheet date by discounting the estimated future cash flows based on a fair value rate of interest and an expected time horizon to liquidity. We also evaluated the credit rating of the issuer and found them all to be investment grade securities. There was no change in our valuation method during the year ended March 31, 2013 as compared to prior reporting periods. Our valuation analysis showed that our ARS have nominal credit risk. The impairment is due to liquidity risk. Additionally, as of March 31, 2013, we do not intend to sell the ARS, it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity, and we expect to recover the full amortized cost basis of these securities. As a result of our valuation analysis and recurring dividend stream from these investments, we have determined that the fair value of our ARS was temporarily impaired as of March 31, 2013.

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

Note 9 – Net loss per common share

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

A reconciliation of basic and diluted shares for the three months ended March 31, 2013 and 2012 is as follows:

		Three Months Ended
		March 31,
		2013				2012
Basic weighted average number of shares outstanding			18,963,788				18,858,464
Potential common shares pursuant to stock options, SARS, and restricted stock awards			-				-
Diluted weighted average number of shares outstanding			18,963,788				18,858,464

For the three months ended March 31, 2013 and 2012, 2.2 million and 2.6 million, respectively, weighted average stock options, SARs, and RSAs to purchase shares of our common stock were excluded from the computation of diluted earnings per share because the effect of including the options, SARs, and RSAs would have been antidilutive.

Note 10 – Income Taxes

We provide for income taxes under the liability method in accordance with the FASB's guidance on accounting for income taxes.  Under this guidance, we only recognize a deferred tax asset for the future benefit of our tax losses, temporary differences and tax credit carry forwards to the extent that it is more likely than not that these assets will be realized. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance.

For the three months ended March 31, 2013 and 2012, our effective tax rate was 14.4% and (3.2%), respectively.  In 2013, our rate primarily consisted of a decrease in our uncertain liability reserves.  In 2012, our rate consists primarily of minimum state taxes and an increase in our uncertain liability reserves.

In 2013 and 2012, we have continued to record a valuation allowance against our U.S. deferred tax assets.  In evaluating the ability to recover our U.S. deferred tax assets, we considered all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies.  We do not believe it is more likely than not that the net deferred tax assets will be realized.

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We establish reserves for uncertain tax positions based on management's assessment of exposure associated with tax deductions, permanent tax differences, and tax credits. The tax reserves are analyzed periodically and adjustments are made as events occur to warrant adjustment to the reserve. At March 31, 2013 and December 31, 2012, we have $3.1 million and $3.3 million, respectively, of unrecognized tax benefits, including related accrued interest.

We recognize interest and penalties related to uncertain tax positions in income tax expense. As of March 31, 2013 and 2012, we had approximately $242,000 and $192,000 of accrued interest and penalties related to uncertain tax positions.

The tax years 2006 through 2012 remain open to examination by the major taxing jurisdictions to which we are subject. We file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions.

Note 11 – License Agreement with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company)

On December 9, 2010, we announced an amendment to the License Agreement with Procter & Gamble ("P&G") and Gillette. The amendment provided additional funding from each company to meet the common goal of a successful product launch. The amendment did not change the scope of P&G's non-exclusive license to Palomar's broad patent portfolio as well as its non-exclusive license to the extensive technology developed by Palomar prior to February 28, 2008 for home-use, light-based hair removal devices for women.  Under the amended License Agreement, the parties agreed to reduce pre-commercial launch quarterly technology transfer payments ("TTP Quarterly Payments" as defined in the License Agreement) from $1.25 million to $1.0 million for the calendar quarter ending December 31, 2010 and thereafter the TTP Quarterly Payments would be $2.0 million per year for an agreed period, after which the payments would return to $1.25 million per calendar quarter if no product has been launched. P&G was to apply the savings, together with agreed minimum overall program funding, to accelerating product readiness and commercialization while Palomar will be paid an increased percentage of sales after commercial launch.  The TTP Quarterly Payments under the amended license agreement were being recognized ratably through the expected launch term.

During the second quarter of 2012, P&G launched a light-based hair removal product and paid us an Additional TTP Quarterly Payment (as defined in the License Agreement) of $1.0 million.  Starting in the third quarter of 2012 and going forward, P&G has made and will continue to make post-launch technology transfer payments based on a percentage of net sales of its light-based hair removal product which will be recognized in the period received.

For the three months ended March 31, 2013 and 2012, we recognized $0.1 million and $0.6 million of other revenues from P&G, respectively.

As of March 31, 2013 and December 31, 2012, there were no advance payments received from P&G for which services were not yet provided and were included in deferred revenue.

Note 12 – Contingencies

The medical device market in which we participate is largely technology driven. As a result, intellectual property rights, particularly patents, play a significant role in product development and differentiation. However, intellectual property litigation is inherently complex and unpredictable. Furthermore, appellate courts can overturn lower court patent decisions.

In addition, competing parties may file suits to balance risk and exposure between the parties. Adverse outcomes in proceedings against us could limit our ability to sell certain products in certain jurisdictions, or reduce our operating margin on the sale of these products and could have a material adverse effect on our financial position, results of operations or liquidity.

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In addition, although monetary and injunctive relief is typically sought, remedies and restitution are generally not determined until the conclusion of the trial court proceedings and can be modified on appeal. Accordingly, the outcomes of individual cases are difficult to time, predict or quantify.

We are not insured with respect to intellectual property infringement and maintain an insurance policy providing limited coverage against securities claims and product liability claims. The absence of significant third-party insurance coverage increases our potential exposure to unanticipated claims or adverse decisions.

We continually assess litigation to determine if an unfavorable outcome would lead to a probable loss or reasonably possible loss, which could be estimated.  In accordance with the FASB's guidance on accounting for contingencies, we accrue for all direct costs associated with the estimated resolution of contingencies at the earliest date at which it is deemed probable that a liability has been incurred and the amount of such liability can be reasonably estimated.  If the estimate of a probable loss is a range and no amount within the range is more likely, we accrue the minimum amount of the range.  In the cases where we believe that a reasonably possible loss exists, we disclose the facts and circumstances of the litigation, including an estimable range, if possible.  In management's opinion, we are not currently involved in any legal proceedings, which, individually or in the aggregate, could have a material effect on our financial statements.  We believe that contingent losses associated with any of our current litigation were remote at the time of the filing and as such, we have not recorded or disclosed any material loss contingencies, or provided any disclosures, related to such litigation.

We expense patent defense costs, costs for pursuing patent infringements, and external legal costs related to intangible assets in the period in which they are incurred.

 

Note 13 – Changes in Accumulated Other Comprehensive Income by Component

						Unrealized gain (loss) on
(in thousands)		Foreign Currency				marketable securities*				Total
Balance at December 31, 2012		$	(67	)		$	(186	)		$	(253	)
Other comprehensive income			276				18				294
Balance at March 31, 2013		$	209			$	(168	)		$	41

* amounts shown net of tax

 

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

The following discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth previously under the caption "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on March 14, 2013 and those included in Item 1A below.  This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2012.

Critical accounting policies

 

Management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which are prepared in accordance with accounting principles that are generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, related disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We continually evaluate our estimates and judgments, the most critical of which are those related to revenue recognition, available for sale and marketable securities valuation, accounts receivable valuation, inventory valuation, warranty provision, stock-based compensation, fair value measurements, income tax valuation, and contingencies. We base our estimates and judgments on historical experience and other factors that we believe to be reasonable under the circumstances. Materially different results can occur as circumstances change and additional information becomes known. A discussion of our critical accounting policies and the related judgments and estimates affecting the preparation of our consolidated financial statements is included in our Annual Report on Form 10-K for the year ended December 31, 2012.  There have been no material changes to our critical accounting policies as of March 31, 2013.

Recently issued accounting standards

In June 2011, the Financial Accounting Standards Board ("FASB") issued Auditing Standards Update ("ASU") No. 2011-05, Presentation of Comprehensive Income.  In this ASU, the FASB amended its guidance on the presentation of comprehensive income in financial statements to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items that are recorded in other comprehensive income.  The new accounting guidance requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements.  The provisions of this new guidance are effective for interim and annual periods beginning after December 15, 2011.  We retroactively adopted this guidance during the third quarter of 2011 and the impact on our financial statements was not material.  ASU 2011-05 addresses the presentation of comprehensive income (loss) in consolidated financial statements and footnotes. The adoption impacts presentation only and had no effect on the Company's financial condition, results of operations and comprehensive (loss) income or cash flows. The Company did not adopt the provisions of the reclassification requirements, which were deferred by ASU 2011-12, Comprehensive Income: Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, in December 2011.

In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. Under this ASU, an entity is required to provide information about the amounts reclassified out of Accumulated Other Comprehensive Income ("AOCI") by component. In addition, an entity is required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of AOCI by the respective line items of net income, but only if the amount reclassified is required to be reclassified in its entirety in the same reporting period. For amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures that provide additional details about those amounts. ASU 2013-02 does not change the current requirements for reporting net income or other comprehensive income in the financial statements. ASU 2013-02 is effective for interim and annual periods beginning after December 15, 2012.  The adoption of this guidance did not materially impact our financial statements or disclosures.

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Overview

 We are a leading researcher and developer of innovative aesthetic light-based systems for hair removal and other cosmetic procedures, including both lasers and high powered lamps.  Since our inception, we have been able to develop a differentiated product mix of light-based systems for various treatments through our research and development as well as with our partnerships throughout the world. We are continually developing and testing new indications to further the advancement in light-based treatments.  We conduct business in two segments, professional medical and cosmetic products and services ("Professional Product segment") and consumer medical and cosmetic products ("Consumer Product segment").

Our corporate headquarters and United States operations are located in Burlington, Massachusetts, where we conduct our manufacturing, warehousing, research and development, regulatory, sales, customer service, marketing and administrative activities.  In the United States, Australia, Canada, Japan, Germany, and Spain, we market, sell, and service our products primarily through our direct sales force and customer service employees.  In the rest of the world, sales are generally made through our worldwide distribution network which encompasses over 70 countries.

On March 18, 2013, we and Cynosure, Inc. announced the execution of a definitive agreement, pursuant to which Cynosure have agreed to acquire Palomar and Palomar stockholders will receive $6.825 per Palomar share in cash and $6.825 per Palomar share in Cynosure common stock, subject to the adjustment and collar provisions described in the definitive agreement.

The transaction is subject to customary closing conditions, including Cynosure and Palomar shareholder approval.  Upon completion of the transaction, Cynosure shareholders will own approximately 77% and Palomar shareholders will own approximately 23% of the combined company.

Results of operations

Professional product revenues for the first quarter of 2013 were $17.3 million, a 46% increase over the $11.9 million reported in the first quarter of 2012.  Professional product gross margins were 58% and 59% in the first quarter of 2013 and 2012, respectively.  Loss from operations was $0.9 million, which included $1.2 million in expenses related to the Cynosure transaction, compared to the first quarter of 2012 loss from operations of $2.3 million.  As of March 31, 2013, we had $101 million in cash, cash equivalents, short-term investments, and marketable securities and other investments with no borrowings.

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The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the three months ended March 31, 2013 and 2012, respectively (in thousands, except for percentages):

 

		Three Months Ended March 31,
		2013								2012
						As a % of								As a % of
						Total								Total				Change
		Amount				Revenue				Amount				Revenue				$					%
Revenues
Professional product revenues		$	17,326				75	%		$	11,897				63	%		$	5,429				46	%
Consumer product revenues			711				3	%			979				5	%			(268	)			(27	%)
Service revenues			3,149				14	%			3,770				20	%			(621	)			(16	%)
Royalty revenues			1,979				9	%			1,798				9	%			181				10	%
Other revenues			58				0	%			556				3	%			(498	)			(90	%)
Total revenues			23,223				100	%			19,000				100	%			4,223				22	%
Costs and expenses
Cost of professional product revenues			7,308				31	%			4,902				26	%			2,406				49	%
Cost of consumer product revenues			668				3	%			834				4	%			(166	)			(20	%)
Cost of service revenues			1,384				6	%			1,660				9	%			(276	)			(17	%)
Cost of royalty revenues			792				3	%			719				4	%			73				10	%
Research and development			2,582				11	%			3,372				18	%			(790	)			(23	%)
Selling and marketing			7,398				32	%			6,682				35	%			716				11	%
General and administrative			4,030				17	%			3,152				17	%			878				28	%
Total costs and expenses			24,162				104	%			21,321				112	%			2,841				13	%
Loss from operations			(939	)			(4	%)			(2,321	)			(12	%)			1,382				60	%
Interest income			77				-	%			89				-	%			(12	)			13	%
Other (loss) income			(437	)			(2	%)			12				-	%			(449	)			3742	%
Loss before income taxes			(1,299	)			(6	%)			(2,220	)			(12	%)			921				41	%
(Benefit) provision for income taxes			(187	)			(1	%)			72				-	%			(259	)			360	%
Net loss		$	(1,112	)			(5	%)		$	(2,292	)			(12	%)		$	1,180				51	%

 

 

 

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		Three Months Ended
		March 31,
		2013				2012
North America			47	%			57	%
Europe			23	%			22	%
Asia/Pacific Rim			10	%			2	%
Middle East			9	%			6	%
Australia			4	%			1	%
Japan			4	%			5	%
South and Central America			3	%			7	%
Total			100	%			100	%

Consumer product revenues.  During the three months ended March 31, 2013 and 2012, we recognized $0.7 million and $1.0 million, respectively, of consumer product revenues.  We are now actively seeking to align ourselves with a worldwide consumer-based distributor.  We have engaged an investment banker to assist us in identifying and negotiating an arrangement with a distributor that has the network and skills to market and distribute our consumer technology. While we are seeking a consumer-based distributor, we will continue to sell the product to our existing channels. However, we substantially reduced our consumer selling and marketing expenses during the fourth quarter of 2012 and expect to continue to do so through 2013.  If we do not find a consumer-based distributor, we will be unable to achieve substantial revenue or continue to sell the PaloVia laser. As a result during the third quarter of 2012, we recognized a $3.8 million charge to reduce our consumer product inventory to its estimated net realizable amounts.

In the three month periods ended March 31, 2013 and 2012, 86% and 85%, respectively, of our Consumer Product segment revenues were derived from sales in the United States and 14% and 15%, respectively, were from Europe.

Service revenues.  Service revenues primarily comprised of revenue generated from our service organization to provide ongoing service, sales of replacement handpieces, sales of consumables and accessories, and billable repairs of our professional products.  During the three months ended March 31, 2013, service revenues decreased 16%, as compared to the corresponding period in the prior year.  The decrease in the three months ended March 31, 2013 was primarily due to lower sales from billable services and lower current period recognition of ongoing service contracts, partially offset by higher sales of ongoing service contracts to be recognized over future periods.

Royalty revenues.  Royalty revenues increased for the three months ended March 31, 2013 by 10%, as compared to the corresponding period in the prior year.  The increase for the comparable three month periods is a result of royalties from two new licensees since the first quarter of 2012 and higher on-going royalty payments from our other licensees.

Other revenues.  During the three months ended March 31, 2013, other revenues decreased 90%, as compared to the corresponding period in the prior year.

During the second quarter of 2012, P&G launched a light-based hair removal product and paid us an Additional TTP Quarterly Payment (as defined in our license agreement with P&G (the "License Agreement") of $1.0 million. This Additional TTP Quarterly Payment resulted in $0.7 million in other revenues during the second quarter of 2012 after being netted with the receivable from P&G as payments under the amended License Agreement were being recognized ratably through the expected launch term. Starting in the third quarter of 2012 and going forward, P&G has made and will continue to make post-launch technology transfer payments based on a percentage of net sales of its light-based hair removal product, which we will recognize in the period received. During the three months ended March 31, 2013, other revenues consisted of $0.1 million in post-launch TTPs. During the three months ended March 31, 2012, other revenues consisted of the recognition of the $0.6 million related to payments received under an amendment to the License Agreement with P&G which was signed in the fourth quarter of 2010.  The payments under the amended License Agreement were being recognized ratably through the expected launch term.

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 Cost of professional product revenues. The cost of professional product revenues increased by $2.4 million and as a percentage of professional product revenues to 42% for the three months ended March 31, 2013, from 41% for the three months ended March 31, 2012. The increase in absolute dollars was attributable to higher professional product revenues and the increase as a percentage of professional product revenues was due to geographical shift in professional product revenues toward international distributors where we typically sell at lower prices and away from North American sales where we sell our products at higher prices through a direct sales force.  Our cost of professional product revenues consists primarily of material, labor and manufacturing overhead expenses. Cost of professional product revenues also includes royalties incurred on certain products sold, warranty expenses, as well as payroll and payroll-related expenses, including stock-based compensation, and quality control.

Cost of consumer product revenues. The cost of consumer product revenues relates to the PaloVia^® Skin Renewing Laser^®.  For the three months ended March 31, 2013 and 2012, cost of consumer product revenues was $0.7 million and $1.0 million, respectively or 94% and 85% of consumer product revenues, respectively.  This decline was primarily due to less absorption of overhead during the quarter due to lower revenue volume.

 Cost of service revenues.  For the three months ended March 31, 2013 and 2012, the cost of service revenues decreased in absolute dollars and remained consistent as a percentage of service revenues at 44%.  The decrease in absolute dollars was primarily due to lower sales from billable services.

Cost of royalty revenues.  Cost of royalty revenues increased for the three months ended March 31, 2013 by 10%, as compared to the corresponding period in the prior year.  The increase was a result of royalties from two new licensees since the first quarter of 2012 and higher on-going royalty payments from our other licensees.  As a percentage of royalty revenues, the cost of royalty revenues for both the three months ended March 31, 2013 and 2012 was 40%.

Research and development expense. Research and development expense decreased by $0.8 million and as a percentage of total revenues to 11% from 18% for the three months ended March 31, 2013 over the corresponding period in 2012.  The decrease in research and development expense was due to reorganizing these departments while maintaining our continued commitment to introducing new products and enhancing our current family of products through our continued substantial investment in research and development.

Research and development expenses relating to our Professional Product segment decreased by 19%, for the three months ended March 31, 2013, as compared to the corresponding period in 2012.  Research expenses relating to our Professional Product segment include internal research and development projects relating to the introduction of new professional products and enhancements to our current line of professional products.  Research and development expense relating to our Consumer Product segment decreased by 93%, for the three months ended March 31, 2013, as compared to the corresponding period in 2012.  The decrease in research and development expense related to our Consumer Product segment includes decreases in payroll and payroll related expenses, materials, consultants, and other overhead expenses related directly to our consumer products as compared to 2012.

 For each of the three months ended March 31, 2013 and 2012, research and development expense included $0.2 million of stock-based compensation expense.

Selling and marketing expense.  Selling and marketing expense increased by $0.7 million, but decreased as a percentage of total revenues to 32% from 35%, for the three months ended March 31, 2013 over the corresponding period in 2012.  Selling and marketing expenses relating to our Professional Product segment increased by $1.3 million during the three months ended March 31, 2013 as compared to corresponding period in 2012.  The increase for the three months ended March 31, 2013 was primarily driven by an increase of $0.7 million in payroll and payroll related expenses and a $0.3 million increase in commissions due to higher product sales.  Selling and marketing expenses related to our Consumer Product segment decreased by $0.6 million in the three months ended March 31, 2013 as compared to corresponding period in 2012.  We substantially reduced our consumer selling and marketing expenses during the fourth quarter of 2012 and expect to continue to do so throughout 2013 while we are seeking a consumer-based distributor for our PaloVia laser.

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For each of the three months ended March 31, 2013 and 2012, selling and marketing expense included $0.2 million of stock-based compensation expense.

General and administrative expense.  General and administrative expense increased by $0.9 million, but remained consistent as a percentage of total revenues at 17%, for the three months ended March 31, 2013 over the corresponding period in 2012.  The increase in general and administrative expense for the three months ended March 31, 2013 was primarily due to $1.2 million of expenses related to the Cynosure acquisition.

For the three months ended March 31, 2013 and 2012, general and administrative expense included $0.2 million and $0.1 million, respectively, of stock-based compensation expense.

Interest income. Interest income for the three months ended March 31, 2013 decreased by 13%, as compared to the corresponding period in 2012 as a result of lower average interest rates on our cash, cash equivalents, short-term investments, and marketable securities and other investments balances.

Other (loss) income .  Other (loss) income for the three months ended March 31, 2013 and 2012 included the foreign exchange transaction (losses) gains resulting from foreign currency remeasurements related to intercompany balances outstanding, mainly denominated in Japanese Yen and the Euro at our foreign subsidiaries.

Provision for income taxes.  Our effective tax rate for the three months ended March 31, 2013 and 2012 was 14.4% and (3.2%), respectively.  In 2013, our rate consisted of a decrease in uncertain liabilities reserves.  In 2012, our effective tax rate primarily consisted of state non-income taxes and additional reserves for uncertain tax positions. Our 2013 and 2012 effective tax rate was less than the statutory rate primarily due to the fact that we continue to maintain a full valuation allowance in all jurisdictions.

Liquidity and capital resources

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

 

		March 31,				March 31,				Change
		2013				2012				$					%
Cash flows from (used in) operating activities		$	1,134			$	(8,856	)			9,990				113	%
Cash flows from investing activities			1,496				5,719				(4,223	)			(74	%)
Cash flows from (used in) financing activities			123				(8	)			(131	)			(1,638	%)
Capital expenditures			80				31				49				158	%

 

Additionally, our cash and cash equivalents, short-term investments, accounts receivable, inventories, marketable securities and other investments, and working capital are shown below for the periods indicated (in thousands).

 

		March 31,				December 31,					Change
		2013				2012					$				%
Cash and cash equivalents		$	57,823			$	55,116				2,707				5	%
Short-term investments			29,010				33,058				(4,048	)			(12	%)
Accounts receivable, net			12,090				10,559				1,531				14	%
Inventories			20,643				21,585				(942	)			(4	%)
Marketable securities and other investments			13,986				11,533				2,453				21	%
Working capital			104,620				106,951				(2,331	)			(2	%)

 

 

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At March 31, 2013, we held $0.9 million in auction-rate securities ("ARS") all of which were preferred municipal securities. The ARS in which we have invested are high quality securities, none of which are mortgage-backed. Beginning in February 2008, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets.  We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market. As our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current as of  March 31, 2013.  During the three months ended March 31, 2013 and 2012, we sold $0.1 million and $0 of our ARS at par, respectively.

We have determined that the fair value of our ARS was temporarily impaired as of March 31, 2013 and 2012.  For the three months ended March 31, 2013 and 2012, we marked to market our ARS and recorded an unrealized gain of $18,000 and an unrealized loss of $23,000, respectively, net of taxes in accumulated other comprehensive income (loss) in stockholder's equity to reflect the temporary impairment of our ARS. The recovery of these investments is based upon market factors which are not within our control. As of March 31, 2013, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.

Cash from (used in) from operating activities increased $10.0 million for the period ended March 31, 2013 as compared to the corresponding period in 2012. This increase primarily reflects the effects of a smaller net loss position and lower working capital requirements. Cash from investing activities decreased $4.2 million during the period ended March 31, 2013 as compared to the corresponding period in 2012. These amounts primarily reflect more purchases of and less cash proceeds from the sale of short-term investments and marketable securities. Cash from (used in) financing activities increased $0.1 million for period ended March 31, 2013 as compared to the corresponding period in 2012. This change was primarily due to increases in the proceeds from the exercise of stock options.

We anticipate that capital expenditures for 2013 will total approximately $1.1 million, consisting primarily of expenditures for the purchase of information technology equipment, furniture and fixtures, software, and machinery. We expect to finance these expenditures with cash on hand.

On November 16, 2012, we announced the approval of a stock repurchase program under which our management is authorized to repurchase up to 1.5 million shares of our common stock.  This stock repurchase program expires the earlier of November 15, 2013 or a determination by the Board to discontinue such repurchases.  As of March 31, 2013, we had repurchased 160,407 shares of common stock at an average price of $8.70 per share under this program.  The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions.  Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management's discretion without prior notice.

Off-balance sheet arrangements

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

Contractual obligations

We are a party to three patent license agreements with Massachusetts General Hospital ("MGH") under which we are obligated to pay royalties to MGH for sales of certain products as well as a percentage of royalties received from third parties. Royalty expense for the three months ended March 31, 2013 totaled approximately $1.2 million. For more information, please see the Amended and Restated License Agreement (MGH Case Nos. 783, 912, 2100), the License Agreement (MGH Case No. 2057) and the License Agreement (MGH Case No. 1316) filed as Exhibits 10.1, 10.2, and 10.3 to our Current Report on Form 8-K filed on March 20, 2008.

 

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We have obligations related to the adoption of Accounting Standards Codification No. 740 regarding Income Taxes, specifically uncertain tax positions.  Further information about changes in these obligations can be found in Note 3 to our consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2012.

We are obligated to make future payments under various contracts, including non-cancelable inventory purchase commitments.

The following table summarizes our estimated contractual cash obligations as of March 31, 2013, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):

		Payments due by period
						Less than					1-3				3-5			More than
		Total				1 year				Years				Years				5 Years
Operating leases		$	239			$	233			$	6			$	-			$	-
Purchase commitments			7,396				7,396				-				-				-
Total contractual cash obligations		$	7,635			$	7,629			$	6			$	-			$	-

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

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

Our investment portfolio of cash equivalents and short-term investments is subject to interest rate fluctuations, but we believe this risk is immaterial because of the historically short-term nature of these investments and the low interest rates which are currently available. At March 31, 2013, we held $0.9 million in ARS. The ARS in which we have invested are high quality securities, none of which are mortgage-backed. Beginning in February 2008, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets.  We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market.  As our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current as of March 31, 2013 and December 31, 2012. During the three months ended March 31, 2013 and 2012, we sold $0.1 million and $0, respectively, of our ARS.  The recovery of the remaining $0.9 million ARS held is based upon market factors which are not within our control.

Our international subsidiaries in The Netherlands, Australia, Japan, Germany, and Spain conduct business in both local and foreign currencies and therefore, we are exposed to foreign currency exchange risk resulting from fluctuations in foreign currencies. This risk could adversely impact our operating results and financial position.  We have not entered into any foreign currency exchange and option contracts to reduce our exposure to foreign currency exchange risk and the corresponding variability in operating results as a result of fluctuations in foreign currency exchange rates.  We sell inventory to our subsidiaries in U.S. dollars.  These amounts are recorded at our local subsidiaries in local currency rates in effect on the transaction date.  Therefore, we may be exposed to exchange rate fluctuations that occur while the intercompany balances are outstanding, which we recognize as unrealized transaction gains and losses in our statement of operations.  Upon settlement of these balances, we may record realized foreign exchange gains and losses in our statement of operations.  We may incur negative foreign currency translation gains and losses as a result of changes in currency exchange rates.

Item 4.  Controls and Procedures

Under the direction of the principal executive officer and principal financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of March 31, 2013. Based on that evaluation, we have concluded that our disclosure controls and procedures were effective.

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

There were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2013 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II – Other information

Item 1.    Legal Proceedings

On June 24, 2009, we commenced an action for patent infringement against Tria Beauty, Inc. (previously named Spectragenics, Inc.), in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that the Tria System, which uses light-based technology for hair removal, willfully infringes the '844 patent, which is exclusively licensed to us by MGH.  Tria answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent is not infringed, is invalid and not enforceable.  We filed a reply denying the material allegations of the counterclaims.  On September 21, 2009, following successful re-examination of the '568 patent, we filed a motion to amend our complaint to add a claim for willful infringement of the '568 patent, which is also exclusively licensed to us by MGH.  Our motion also included adding MGH as a plaintiff in the lawsuit.  A claim construction hearing (also known as a Markman hearing) was held on August 10, 2010, and we received what we consider to be a favorable ruling on October 13, 2010.  On January 25, 2011, Tria filed a second amended answer and counterclaim including another claim that the patents are unenforceable for inequitable conduct.  On April 12, 2013, Tria filed a motion for summary judgment of non-infringement.  We expect to file our response to Tria's motion for summary judgment by May 17, 2013.  The parties are in discovery.  No trial date has yet been set.

On May 22, 2012, we commenced an action for patent infringement against Tria Beauty, Inc. in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that the Tria System, which uses light-based technology for hair removal, willfully infringes U.S. Patent No. 8,182,473 (the "'473 patent").  On July 16, 2012, Tria answered the complaint denying that its products infringe valid claims of the '473 patent and filing counterclaims seeking a declaratory judgment that the asserted patent is not infringed, is invalid and not enforceable.  Tria's answer further included purported counterclaims of violation of Massachusetts General Laws Chapter 93A and abuse of process, seeking damages "in excess of $75,000, exclusive of interest and costs." We have filed a response to Tria's answer denying and asserting defenses to Tria's purported counterclaims.  On December 20, 2012, we filed a second amended complaint which further alleges that the Tria System infringes U.S. Patent Nos. 8,328,794 and 8,328,796.  On January 13, 2013, Tria answered the second amended complaint denying that its products infringe valid claims of the asserted patents and filing counterclaims seeking a declaratory judgment that the asserted patents are not infringed, are invalid and not enforceable.  On February 14, 2013, we filed a response to Tria's answer denying and asserting defenses to Tria's purported counterclaims.  The parties are in discovery.  No trial date has yet been set.

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On October 13, 2010, we commenced an action for patent infringement against Asclepion Laser Technologies GmbH in the District Court of Düsseldorf, Germany seeking both monetary damages and injunctive relief.  The complaint alleged that Asclepion's MeDioStar and RubyStar products infringe European Patent Number EP 0 806 913, which is the first issued European patent corresponding to U.S. Patent Numbers 5,595,568 and 5,735,844.  On October 29, 2010, Asclepion asked the court to stay its proceedings until a final decision is rendered by the Court of Rome in Italy (see Asclepion Laser Technologies GmbH, Italian Litigation below) and until a final decision in the opposition proceedings is rendered by the European Patent Office.  On December 16, 2010, Asclepion filed an intervention to the opposition appeal proceedings concerning patent EP 0 806 913 requesting that the patent be revoked in its entirety.  On January 20, 2011, we agreed to Asclepion's request for a stay of this lawsuit.  On January 31, 2011, the District Court of Düsseldorf stayed this lawsuit until a final decision is rendered by the Court of Rome in Italy.

On October 22, 2010, we were served with an International Summons for a lawsuit filed September 20, 2010 by Asclepion Laser Technologies GmbH in the Court of Rome in Italy.  In this suit, Asclepion asks the Italian court to declare that Asclepion's MedioStar and RubyStar products do not infringe either the Italian or German portions of EP 0 806 913 B1 or EP 1 230 900 B1, which are the first two issued European patents corresponding to U.S. Patent numbers 5,595,568 and 5,735,844.  We believe the Court of Rome lacks jurisdiction over the German claims of these European Patents and have filed a request to the Italian Supreme Court challenging the international jurisdiction of the Italian Courts for deciding infringement of the non-Italian parts of the European patents. A hearing before the Italian Supreme Court is scheduled for May 28, 2013.

On March 21, 2013, a putative stockholder class action complaint, captioned Calin v. Palomar Medical Technologies, Inc., et al., No. 13-1051 BLS (Superior Court, Suffolk County), was filed against Palomar, Palomar's directors, Cynosure, Inc. ("Cynosure") and Commander Acquisition Corp. (the "Merger Subsidiary") in the Business Litigation Session of the Suffolk County Superior Court of the Commonwealth of Massachusetts. The lawsuit alleges that the members of the Palomar board of directors breached their fiduciary duties in connection with the approval of the merger (the "Merger") contemplated by the agreement and plan of merger, dated as of March 17, 2013, among Palomar, Cynosure and the Merger Subsidiary and that Cynosure and the Merger Subsidiary aided and abetted the alleged breach of fiduciary duties. The complaint alleges that the directors breached their fiduciary duties in connection with the proposed transaction by, among other things, failing to maximize stockholder value and to obtain the best financial and other terms. The plaintiff seeks injunctive and other equitable relief, including a request to enjoin Palomar from consummating the Merger, in addition to unspecified damages, fees and costs.  Plaintiff moved to expedite the proceeding on May 1, 2013 and moved to consolidate the Massachusetts actions on May 1, 2013.

On April 9, 2013, a second putative stockholder class action complaint, captioned Vladimir Gusinsky Living Trust v. Palomar Medical Technologies, Inc., et al., No. 13-1328 BLS (Superior Court, Suffolk County), was filed against Palomar, Palomar's directors, and Cynosure in the Business Litigation Session of the Suffolk County Superior Court of the Commonwealth of Massachusetts. The lawsuit alleges that the members of the Palomar board of directors breached their fiduciary duties in connection with the approval of the Merger and that Cynosure aided and abetted the alleged breach of fiduciary duties. The complaint alleges that the directors breached their fiduciary duties in connection with the proposed transaction by, among other things, failing to maximize stockholder value and to obtain the best financial and other terms. The plaintiff seeks injunctive and other equitable relief, including a request to enjoin Palomar from consummating the merger, in addition to fees and costs.  Plaintiff moved to expedite the proceeding on May 1, 2013 and moved to consolidate the Massachusetts actions on May 1, 2013.

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On April 12, 2013, a third putative stockholder class action complaint, captioned Saffer v. Palomar Medical Technologies, Inc. et al., No. 13-1385 BLS1 (Superior Court, Suffolk County), was filed against Palomar, Palomar's directors, Cynosure, and the Merger Subsidiary in the Business Litigation Session of the Suffolk County Superior Court of the Commonwealth of Massachusetts.  The lawsuit alleges that the members of the Palomar board of directors breached their fiduciary duties in connection with the approval of the merger and that Palomar, Cynosure, and the Merger Subsidiary aided and abetted the alleged breach of fiduciary duties. The complaint alleges that the directors breached their fiduciary duties in connection with the proposed transaction by, among other things, placing their interests ahead of shareholders' and failing to maximize stockholder value and to obtain the best financial and other terms.  The plaintiff seeks injunctive and other equitable relief, including a request to enjoin Palomar from consummating the merger, in addition to fees and costs.  Plaintiff moved to expedite the proceeding on May 1, 2013 and moved to consolidate the Massachusetts actions on May 1, 2013.

On April 19, 2013, a fourth putative stockholder class action complaint, captioned Gary Drabek v. Palomar Medical Technologies, Inc. et al., No. 8491, was filed against Palomar, Palomar's directors, Cynosure, and the Merger Subsidiary in the Court of Chancery of the State of Delaware.  The lawsuit alleges that the members of the Palomar board of directors breached their fiduciary duties in connection with the approval of the merger and that Cynosure and the Merger Subsidiary aided and abetted the directors' purported breaches.  The complaint alleges that the directors breached their fiduciary duties in connection with the proposed transaction by, among other things, failing to maximize stockholder value, failing to obtain the best financial and other terms, and causing a purportedly deficient proxy statement to be filed.  The plaintiff seeks injunctive and other equitable relief, including a request to enjoin Palomar from consummating the merger, in addition to fees and costs.  The plaintiff moved to expedite the proceedings on April 29, 2013, and the preliminary injunction hearing is scheduled for June 17, 2013.

We do not believe the outcome of any of the litigation described above will have a material adverse effect on our financial statements.

Item 1A.    Risk Factors

Investing in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below in addition to the other information included or incorporated by reference in this quarterly report. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall. Updated risk factors are set forth below.

Disruptions which began in 2008 in the global economy, the financial markets, and currency markets, as well as government responses to these disruptions, continue to adversely impact our business and results of operations.

A slowdown in economic activity caused by the recession has reduced worldwide demand for our products.  The general economic difficulties being experienced by our customers, reduced consumer demand for our procedures, the lack of availability of consumer credit for some of our customers, and the general reluctance of many of our current and prospective customers to spend significant amounts of money on capital equipment during these unstable economic times are adversely affecting the market in which we operate.  Our total revenues declined by 29%, 31%, and 22% from 2007 to 2008, 2008 to 2009, and 2011 to 2012 (revenues in 2011 includes $29.8 million of royalty revenues from the settlement of the Candela/Syneron litigation described in "Item 1. Legal Proceedings"), respectively. Our total revenues increased by 5% from 2009 to 2010 and 62% from 2010 to 2011 (revenues in 2011 includes $29.8 million of royalty revenues from the settlement of the Candela/Syneron litigation mentioned above), but they may not continue to increase in future years.

Distress in the financial markets has had an adverse impact on the availability of credit and liquidity resources.  Certain preferred lessors have exited from our industry or declared bankruptcy.  Many of our customers or potential customers are facing issues gaining access to sufficient credit, which is resulting or may result in an impairment of their ability to make timely payments to us or to get financing at all.  Lack of availability of consumer credit, a decrease in consumer confidence, and the general economic downturn is adversely impacting the market in which we operate.  These factors are causing some customers to postpone buying decisions until economic conditions improve.

The severity of the European sovereign debt crisis has caused the price of the euro to fluctuate widely over the past several years, and has volatility increased since 2011 due in part to concerns over the sovereign debt levels of certain European Union members (e.g. Greece, Ireland, Portugal) and the value of the euro.  Approximately 21% and 24% of our Professional Product segment's product revenues in 2012 and the first three months of 2013, respectively, were from European countries, most of them affected by the euro.  A continued crisis could adversely impact our business and results of operations.

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We may not be successful in commercializing home-use, light-based devices with third parties.  Managing the development, launch and direct sales to consumers of home-use, light-based devices with third parties diverts the attention of key personnel and management from our Professional Product segment.  We may stop selling the PaloVia^® Skin Renewing Laser^® and may also stop manufacturing the PaloVia laser.  If our commercialization efforts are unsuccessful or we stop manufacturing the PaloVia laser, it could have a material adverse impact on our business and our stock price could fall.

At the end of 2010, we launched the PaloVia laser -- the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes.  The commercialization of a home-use, light-based device was one of our goals for many years.  Over the past two years, we have tested our PaloVia fractional laser technology in the United States in limited channels.  However, we believe managing direct sales to the consumer market distracts management's attention and diverts corporate resources from our Professional Product segment.

In the fourth quarter of 2012, we substantially reduced our consumer selling and marketing expenses as we actively seek to align ourselves with a worldwide consumer-based distributor or multiple distributors.  We have engaged an investment banker to assist us in identifying and negotiating an arrangement with a distributor that has the network and skills to market and distribute our consumer technology. If we do not find a consumer-based distributor, we will be unable to achieve substantial revenue.

Even if we find a consumer-based distributor, our ability to achieve significant revenues may be adversely affected by difficulties or delays in bringing home-use, light-based devices to market and keeping them on the market, the inability to obtain or enforce intellectual property protection, market acceptance of our new products, adverse events, product changes and high rates of customer returns. In addition, we face significant competition, including from companies that are much larger and better funded than us.  Currently the PaloVia laser is the only product of its kind on the market in the United States, but other companies, namely Philips Electronics and Tria, sell similar products outside the United States and we believe are seeking FDA clearance to sell such products in the United States.  In addition, in July 2012, Cynosure received FDA clearance to market a similar product in the United States.  Cynosure developed this product with Unilever, a global consumer goods company, which is expected to commercially launch the product in 2013.  Competing against such systems will be difficult. Other competitors have publicly announced their intent to enter the consumer market.  Significant resources and the attention of key personnel and management have been and will likely continue to be directed to the development and commercialization of home-use devices.  There are no guarantees that the PaloVia laser or any future home-use products will prove to be commercially successful or that Palomar will continue to manufacture, sell or distribute such devices.

In addition, the consumer product market is known for high rates of product returns and we have experienced high rates of product returns since our entrance into the consumer product market.  The consumer product market is also known for product liability lawsuits.  While we have not yet been subject to such lawsuits, if we were to be sued, litigation is unpredictable and we may not prevail in successfully defending our position. If we do not prevail in such litigation, we may be ordered to pay substantial damages. In addition, following litigation loss or an increase in adverse events or other problems among consumers, we could also decide to stop manufacturing, selling or distributing such products.  Even if we prevail in litigation, significant legal costs and the distraction of management could negatively impact our business, results of operations and financial position.   

We began manufacturing our PaloVia laser and consumable PaloVia Gel during the second half of 2010. Because we have only limited experience in manufacturing in commercial quantities, we may encounter unforeseen situations that would result in delays or shortfalls. We face significant challenges and risk in manufacturing the PaloVia laser and consumable PaloVia Gel, including that production processes may have to change to accommodate any significant future expansion of our manufacturing operations and growth; key components are currently provided by single suppliers or a limited number of suppliers, and we do not maintain large inventory levels of these components; and we have limited experience manufacturing the PaloVia laser and consumable PaloVia Gel in compliance with FDA's Quality System Regulation.  In October of 2012, one such single supplier filed for bankruptcy.  We believe the remaining inventory level we have of the component provided by this supplier is sufficient to accommodate our manufacturing the PaloVia laser into late 2013.  In the future, if we are able to partner with a consumer-based distributor, we will need to find another supplier or re-design the PaloVia laser such that the component is no longer necessary.  Once we run out of inventory of this single source supplier component, we may not be able to continue to manufacture the PaloVia laser.  If we are unable to keep up with demand for the PaloVia laser and consumable PaloVia Gel, our revenue could be impaired, market acceptance for the PaloVia laser and consumable PaloVia Gel could be adversely affected and our customers might instead purchase competitors' products.

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We have limited experience in operating in the consumer medical device market, which could adversely impact our business.

We entered the consumer medical device market in the fourth quarter of 2010.  Our limited experience in operating in this market has resulted in losses to date and could continue to negatively impact our business.  We are selling our consumer medical device through new channels of distribution in which management does not have a significant amount of experience.  Additionally, we are actively seeking to align ourselves with a worldwide consumer-based distributor or multiple distributors.  We have engaged an investment banker to assist us in identifying and negotiating an arrangement with a distributor that has the network and skills to market and distribute our consumer technology.  In operating in the consumer medical device market, we may encounter actual or perceived product quality, safety, or reliability problems, significant changes in consumer demand, high levels of product returns, and product liability issues which would divert management's attention from our core business.  Entering the consumer medical device market has presented management with new accounting issues related to revenue recognition and estimating customer return rates at the end of each reporting period for future customer returns related to sales recorded prior to the end of the period.  These accounting issues have warranted considerable management attention and additional accounting issues related to the consumer medical device market could divert management's attention from our core business.

Our Aspire system with SlimLipo handpiece requires the use of consumable treatment tips and fiber delivery assemblies.  These products could fail to generate significant revenue or achieve market acceptance.

In 2009, we completed the launch of the Aspire body sculpting system and SlimLipo handpiece.  The SlimLipo handpiece is our first minimally invasive product and provides laser-assisted lipolysis.  The SlimLipo handpiece requires the use of consumable, single-use treatment tips and a limited-use fiber delivery assembly.  The future success of the Aspire system will depend on a number of factors, including our ability to increase and maintain sales of the Aspire system with SlimLipo handpiece as well as the consumable components.  Several competing systems also require the use of consumable components.  Other competing systems either do not require the use of consumable components or their consumable components allow for more usage before needing to be replaced.  Competing against such systems may be more difficult.

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

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

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

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

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

If our products are defectively designed, manufactured or labeled, contain defective components or are misused, we may become subject to substantial and costly litigation by our customers or their patients or clients.  Furthermore, in the event that any of our products prove to be defectively designed and manufactured, we may be required to recall and redesign such products. Misusing our products or failing to adhere to operating guidelines for our products can cause severe burns or other damage to the eyes, skin or other tissue. We are routinely involved in claims related to the use of our products. In the medical device industry there has been an increase in lawsuits filed against manufacturers where plaintiffs are alleging liability based on relatively new strategies.  For example, a lawsuit was filed against us alleging negligence based on our selling to entities and training individuals not permitted to purchase or use our products.  As another example, lawsuits have been filed against our competitors and may be filed against us for failure to sufficiently train in the use of products or training in off-label treatments not covered by the FDA clearance for such products, even where such training is provided by third parties.  In addition, a lawsuit has been filed against us and other lawsuits against competitors claiming involvement of sales representatives, other employees or consultants in the operation of the devices when the treatment was provided.  Our new product the Skintel™ Melanin Reader™ works with our Palomar Icon™ System and Vectus™ system to provide suggested test spot settings based on how much melanin is in an individual's skin.  Though this information is meant to assist clinicians and not to replace their judgment, plaintiffs may allege otherwise.  Thus, the launch of the Skintel Melanin Reader may increase the number of lawsuits filed against us.  Product liability claims could divert management's attention from our core business, be expensive to defend and result in sizable damage awards against us. Our current insurance coverage may not be sufficient to cover these claims. Moreover, in the future, we may not be able to obtain insurance in amount or scope sufficient to provide us with adequate coverage against potential liabilities. Any product liability claims brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing continuing coverage, could harm our reputation in the industry and reduce product sales. We would need to pay any product losses in excess of our insurance coverage out of cash reserves, harming our financial condition and adversely affecting our operating results.

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

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

·	FDA, other regulatory authorities or an institutional review board may place a clinical trial on hold;

·	patients may not enroll in clinical trials, or patient follow-up may not occur, at the rate we expect;

·	patients may not comply with trial protocols;

·	institutional review boards and third party clinical investigators may delay or reject our trial protocol;

·	third party clinical investigators may decline to participate in a trial or may not perform a trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;

·	third party organizations may not perform data collection and analysis in a timely or accurate manner;

·	regulatory inspections of our clinical trials or manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials, or invalidate our clinical trials;

·	governmental regulations may change or administrative actions may occur that cause delays; and

·	the interim or final results of the clinical trials may be inconclusive or unfavorable as to safety or effectiveness.

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

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

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

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

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

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

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

·	letters, warning letters, fines, injunctions, consent decrees and civil penalties;

·	repair, replacement, refunds, recall or seizure of our products;

·	operating restrictions or partial suspension or total shutdown of production;

·	refusing or delaying our requests for 510(k) clearance or pre-market approval of new products or new intended uses; and

·	criminal prosecution.

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

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

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

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

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

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

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

Healthcare policy changes, including healthcare reform legislation, may have an adverse effect on our business, results of operations, and cash flows.

The Patient Protection and Affordable Care Act and Health Care and Education Affordability Reconciliation Act of 2010 were enacted into law in the U.S. in March 2010.  As a U.S. headquartered company with significant sales in the U.S., this healthcare reform law may materially impact us. Certain provisions of the law will not be effective until 2014 and 2015 and there are many programs and requirements for which the details have not yet been fully established or consequences not fully understood. As currently enacted, the law imposes on medical device manufacturers an excise tax of 2.3% on U.S. sales of Class I, II and III medical devices beginning January 1, 2013. We are subject to this excise tax.  In fiscal 2012 and the first three months of 2013, U.S. product revenues accounted for 48% and 41%, respectively, of our professional product revenues and, therefore, this tax burden may have a material, negative impact on our results of operations and cash flows. Additionally, we cannot predict what healthcare programs and regulations will be ultimately implemented at the federal or state level, or the effect of any future legislation or regulation in the U.S. or internationally. However, any changes that increase the cost of selling medical devices could adversely affect our business, results of operations, and cash flows.

We may have exposure to additional tax liabilities, which could negatively impact our income tax provision, net loss, and cash flow.

The determination of our worldwide provision for income taxes and current and deferred tax assets and liabilities requires judgment and estimation. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are subject to regular review and audit by both domestic and foreign tax authorities and to the prospective and retrospective effects of changing tax regulations and legislation. Although we believe our tax estimates are reasonable, the ultimate tax outcome may materially differ from the tax amounts recorded in our Consolidated Financial Statements and may materially affect our income tax provision, net loss, and cash flows in the period in which such determination is made.

Deferred tax assets are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. A valuation allowance reduces deferred tax assets to estimated realizable value, which assumes that it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions to realize the net carrying value. We review our deferred tax assets and valuation allowance on a quarterly basis. As part of our review, we consider positive and negative evidence, including cumulative results in recent years. As a result of our review, since 2010, we provided for a full valuation allowance against our U.S. and foreign deferred tax assets.

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We anticipate we will continue to record a valuation allowance against the losses of certain jurisdictions, primarily federal and state, until such time as we are able to determine it is "more-likely-than-not" the deferred tax asset will be realized. Such position is dependent on whether there will be sufficient future taxable income to realize such deferred tax assets.  

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

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

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

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

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 work with third-party researchers over whom we do not have absolute control to satisfactorily conduct and complete research on our behalf.  When we work with third-party researchers we are also dependent upon them to grant us licensing terms, which may or may not be favorable, for products and technology they may develop. We provide research funding, light technology and optics know-how in return for licensing rights with respect to specific dermatologic and cosmetic applications and patents. In return for certain exclusive license rights, we have been and may in the future be 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. 

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

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

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

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

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

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

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

·	consumer awareness of and demand for procedures and treatments;

·	the cost, safety and effectiveness of the procedure and of alternative treatments;

·	the success of our and our customers' sales and marketing efforts to purchasers of these procedures; and

·	consumer confidence, which may be affected by short-term or long-term economic and other conditions.

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

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

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

·	implement appropriate operational, financial and management controls, systems and procedures;

·	change our manufacturing capacity and scale of production;

·	change our sales, marketing and distribution infrastructure and capabilities; and

·	provide adequate training and supervision to maintain high quality standards.

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Failure to receive shipments of critical components, some of which are from single suppliers, could reduce revenues and reduced reliability of critical components could increase expenses.

                We develop light-based systems that incorporate third-party components and we purchase some of these components from small, specialized vendors that are not well capitalized. We do not have long-term contracts with some of these third parties for the supply of parts.  With regard to single source suppliers, we use scanner subassemblies and diode laser subassemblies to manufacture our PaloVia^® Skin Renewing Laser^®, we use diode laser subassemblies to manufacture our Aspire^® body sculpting system with SlimLipo™ handpiece, and we use diode laser bars to manufacture our Vectus™ Laser.  We depend exclusively at this time on sole source suppliers for these components, and although alternative suppliers exist, they could take months to qualify and implement.  The scanner and diode laser subassemblies and laser diode bars are important to our business.  A disruption in the delivery of these key components, or our inability to obtain substitute components or subassemblies from alternate sources at acceptable prices in a timely manner, or our inability to obtain assembly or testing services could prevent us from manufacturing products and result in a decrease in revenue.  In October 2012, the supplier of the scanner subassembly for the PaloVia laser filed for bankruptcy.  We believe the remaining inventory level we have of the component provided by this supplier is sufficient to accommodate our manufacturing the PaloVia laser into late 2013.  In the future, if we are able to partner with a consumer-based distributor, we will need to find another supplier or re-design the PaloVia laser such that the component is no longer necessary.  Once we run out of inventory of this single source supplier component, we may not be able to continue to manufacture the PaloVia laser.  We depend on an acceptable level of reliability for purchased components.  Reliability below expectations for key components could have an adverse effect on inventory and inventory reserves.  Any extended interruption in our supplies of third-party components could materially harm our business.

New regulations related to "conflict minerals" may cause us to incur additional expenses and could limit the supply and increase the cost of certain metals used in manufacturing our products.

On August 22, 2012, the SEC adopted a new rule requiring disclosures by public companies of specified minerals, known as conflict minerals, that are necessary to the functionality or production of products manufactured or contracted to be manufactured. The new rule, which is effective for 2013 and requires a disclosure report to be filed by May 31, 2014, will require companies to perform due diligence, disclose and report whether or not such minerals originate from the Democratic Republic of Congo or an adjoining country. The new rule could affect sourcing at competitive prices and availability in sufficient quantities of certain minerals used in the manufacture of our products, including tantalum, tin, gold and tungsten. The number of suppliers who provide conflict-free minerals may be limited. In addition, there may be material costs associated with complying with the disclosure requirements, such as costs related to determining the source of certain minerals used in our products, as well as costs of possible changes to products, processes, or sources of supply as a consequence of such verification activities. Within our supply chain, we may not be able to sufficiently verify the origins of the relevant minerals used in our products through the due diligence procedures that we implement, which may harm our reputation.  We are currently investigating the use of conflict materials within our supply chain.

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

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

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

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

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

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We may not be able to successfully collect licensing royalties.

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

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

Our effective income tax rate may vary significantly.

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

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

               As a small company with approximately 250 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 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.

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

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

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

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

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

Although we have generated profits during the periods of 2002 to 2007, in the third quarter of 2011, the full year of 2011, and in the fourth quarter of 2012, we have incurred losses from 2008 through the second quarter of 2011, as well as in the fourth quarter of 2011, the full year of 2012, and the first quarter of 2013, and have a history of losses.  We may not be able to regain, sustain or increase profitability on a quarterly or annual basis due to many factors including lower demand for our products by practitioners, for example, due to the weakening economy, the tightening of the credit market, and other factors. If our operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline.

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

The liquidity and market value of our investments may decrease.

As of March 31, 2013, we held approximately $0.9 million of auction-rate securities ("ARS"). There have been disruptions in the market for auction-rate securities related to liquidity which has caused substantially all auctions to fail. All of our securities held as of March 31, 2013 failed in their last auction. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until we sell the securities in a secondary market. In the event that we are unable to sell the underlying securities at or above par, these securities may not provide us a liquid source of cash in the future. At March 31, 2013, due to the uncertainty and illiquidity in this market, we have classified our auction-rate securities as non-current assets and have recorded a cumulative unrealized loss of $0.2 million, net of taxes in accumulated other comprehensive income (loss). The recovery of these investments is based upon market factors which are not within our control. As of March 31, 2013, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.

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

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

Our business and operating results could be adversely affected if our third party data protection measures are not seen as adequate, there are breaches of our security measures, or unintended disclosures of our third party data.

As we conduct transactions online directly with customers and perform other processes necessary to operate our business, we may be the victim of fraudulent transactions, including credit card fraud, which presents a risk to our revenues and potentially disrupts service to our customers. In addition, we are collecting third party information, including personal information and credit card information. We take measures to protect and safeguard our third party data from unauthorized access or disclosure. Despite our best efforts, it is possible that our security controls over third party data may not prevent the improper access or disclosure of personally identifiable information. A security breach that leads to disclosure of third party information (including personally identifiable information) could harm our reputation, compel us to comply with disparate state breach notification laws and otherwise subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. A resulting perception that our company does not adequately protect the privacy of personal information could result in a loss of current or potential customers for our online offerings that require the collection of customer data. Our key business partners also face these same risks and we have no control over their security measures.  Any security breaches of these key business partners' systems could adversely impact our ability to offer our products and services through their platforms, resulting in a loss of meaningful revenues.

If we are unable to protect our information technology infrastructure against service interruptions, data corruption, cyber-based attacks or network security breaches, our business and operating results may suffer.

We rely on information technology networks and systems, including the Internet, to process and transmit sensitive electronic information and to manage or support a variety of business processes and activities, including procurement and supply chain, manufacturing, distribution, and invoicing and collection of payments for our products. We use enterprise information technology systems to record, process, and summarize financial information and results of operations for internal reporting purposes and to comply with regulatory financial reporting, legal, and tax requirements. Our information technology systems, some of which are managed by third-parties, may be susceptible to damage, disruptions or shutdowns due to failures during the process of upgrading or replacing software, databases or components thereof, power outages, hardware failures, computer viruses, attacks by computer hackers, telecommunication failures, user errors or catastrophic events.  If our information technology systems suffer severe damage, disruption or shutdown and we are unable to effectively resolve the issues in a timely manner, our business and operating results may suffer.

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

                Our Second Restated Certificate of Incorporation and our Second Amended and Restated 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 chairman of the board of directors, the affirmative vote of a majority of the board of directors or the chief executive officer. 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.

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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, Second Amended and Restated 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.

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

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

Our stock price may be volatile.

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

·	acceptance and success of new products or technologies;

·	the success of competitive products or technologies;

·	regulatory developments in the United States and foreign countries;

·	developments or disputes concerning patents or other foreign countries;

·	the recruitment or departure of key personnel;

·	variations in our financial results or those of companies that are perceived to be similar to us;

·	market conditions in our industry and issuance of new or changed securities analyst's reports or recommendations; and general economic, industry and market conditions.

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Uncertainty about our merger with Cynosure may adversely affect our relationships with our customers, suppliers and employees, whether or not the merger is completed.

In response to the announcement of our proposed merger with Cynosure, our existing or prospective customers or suppliers may:

Any such delays or changes to terms could seriously harm our business or, if the merger is completed, the business of the combined company.

In addition, as a result of the merger, current and prospective employees could experience uncertainty about their future with us or the combined company. These uncertainties may impair our ability to retain, recruit or motivate key personnel.

Any delay in the completion of the merger may significantly reduce the benefits expected to be obtained from the merger or could adversely affect the market price of the common stock of Palomar or the combined company or their future business and financial results.

The merger is subject to a number of conditions, including approvals of Cynosure stockholders and our stockholders, which are beyond the control of Cynosure and Palomar and which may prevent, delay or otherwise materially and adversely affect completion of the merger. We cannot predict whether and when these other conditions will be satisfied.

We would also remain liable for significant transaction costs, including legal, accounting and financial advisory fees.

In addition, the market price our common stock may reflect various market assumptions as to whether and when the merger will be completed. Consequently, the completion of, the failure to complete, or any delay in the completion of the merger could result in a significant change in the market price of our common stock.

 

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Diversion of management's attention could harm us or the combined company, whether or not the merger is completed.

Completion of the merger will require a significant amount of time and attention from our management. The diversion of management's attention away from ongoing operations could adversely affect our ongoing operations and business relationships and, if the merger is completed, those of the combined company.

Cynosure may be unable to integrate successfully our businesses and realize the anticipated benefits of the merger.

We will incur significant costs in connection with the merger.

We have incurred and will incur substantial expenses related to the merger, whether or not the merger is completed.  We estimate that we will incur direct transaction costs of approximately $4.8 million in connection with the merger, approximately $2.0 million of which is not contingent upon the completion of the merger. Moreover, in the event that the merger agreement is terminated, we may, under some circumstances, be required to pay Cynosure a termination fee of approximately $10.6 million.

We have not paid dividends to our common stockholders since our inception and do not plan to pay dividends to our common stockholders in the foreseeable future.  We intend to retain substantially all earnings to finance our operations.  On November 16, 2012, we announced the approval of a stock repurchase program under which our management is authorized to repurchase up to 1.5 million shares of our common stock.  This stock repurchase program expires the earlier of November 15, 2013 or a determination by the Board to discontinue such repurchases.  As of March 31, 2013, we had repurchased 160,407 shares of common stock at an average price of $8.70 per share under this program.  We may buy back additional shares of our common stock on the open market from time to time.

(1)	On November 16, 2012, we announced the approval of a stock repurchase program under which our management is authorized to repurchase up to 1.5 million shares of our common stock.

None.

None.

None.

 

 

 

 

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(1)	Schedules to this Exhibit have been omitted in reliance on Item 601(b)(2) of Regulation S-K. The Company will furnish copies of any such schedules to the SEC upon request.

 

 

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Attached as Exhibit 101 to this report are the following formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets at March 31, 2013 and December 31, 2012, (ii) Consolidated Statements of Operations and Comprehensive Loss for the three months ended March 31, 2013 and March 31, 2012, (iii) Consolidated Statements of Cash Flows for the three months ended March 31, 2013 and March 31, 2012, and (iv) Notes to Condensed Consolidated Financial Statements.

In accordance with Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to this Quarterly Report on Form 10-Q is deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act, is deemed not filed for purposes of section 18 of the Exchange Act, and otherwise is not subject to liability under these sections.

 

 

 

 

 

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Signatures

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

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