Our XTRAC system combines the technology of an excimer laser, or "cold" laser system (already in use for a variety of medical and cosmetic treatments), with the use of ultraviolet light therapy. The XTRAC system applies a concentrated dose of UVB radiation directly to diseased skin at a higher intensity than traditional ultraviolet light therapy. Our XTRAC system utilizes a 308 nm308-nm light wavelength, which studies have shown to be the optimal wavelength to treat psoriasis effectively. Our XTRAC system consists of the laser, which is mobile, and a hand piece attached to the laser by a liquid light guide or by a fiber optic cable, which are designed to permit direct application of the ultraviolet light and an aiming beam to psoriasis-affected skin. The XTRAC comes optionally with an adjustable hand-piece that can decrease the spot size of the operating beam to permit precise, operator-controlled irradiation of tissue.

Between March 1998 and November 1999, we initiated five seminal clinical trials of our XTRAC system at Massachusetts General Hospital. Our objective in these clinical trials was to compare our XTRAC laser technology with standard ultraviolet light therapy in the treatment of psoriasis. In January 2000, we received a 510(k) clearance to market the XTRAC system from the FDA based on the clinical results from these trials. The Massachusetts General Hospital clinical trial, which involved 13 patients, concluded that our XTRAC laser made it possible to treat psoriasis effectively in one session with moderately long remission. The study also concluded that the number of treatments to remission depended largely on the intensity of the ultraviolet light used, finding that medium intensities seemed to provide the best results with a superior balance between quick clearing and patient comfort. We supported the clinical trials with research grants of approximately $954,000.

To support our commercialization strategy, we completed an additional clinical trial in 2000. The trial was designed to validate the results obtained in the Massachusetts General Hospital clinical study in mainstream dermatologists' offices. We established five Beta sites throughout the United States using our XTRAC system in a clinical trial of 124 persons. This study examined various aspects of excimer laser therapy, including the number of treatments necessary for clearing, the ultraviolet light intensity necessary for clearing and overall patient satisfaction. Our Beta-Site Clinical Study indicated that:

In the following year,years, we received clearance to market our XTRAC system for the treatment of vitiligo and atopic dermatitis, and in 2002 for the treatment of leukoderma. Overall, approximately 4449 clinical publications have validated the clinical efficacy of our phototherapy treatments for the cleared indications of use and have advanced the insurance reimbursement process.

Psoriasis is believed to be a non-contagious, autoimmune medical disorder and a chronic inflammatory skin disease diagnosed in more than 4.57 million adult Americans and between 1% and 3% of the world's population. There is no known cure for psoriasis. Although clinical symptoms and severity vary greatly between individuals over periods of time, psoriasis appears most commonly as inflamed swollen lesions covered with silvery white scales. Psoriasis patients often suffer from debilitating and painful swelling, itching, bleeding, cracking and burning, resulting in decreased mobility, depression and low self-esteem. The National Psoriasis Foundation, or NPF, estimates that, in the United States, dermatologists treat over 1.5 million psoriasis patients each year.

For the past five years, we have sought to clear the path of obstacles and barriers to a smooth and orderly roll-out of the XTRAC system in dermatology. In 2000, the technology, which was originally designed for cardiology applications, was found to have significant therapeutic advantages for psoriasis patients who were treated with the UVB light emitted from the excimer based laser system. For the first two years we invested in establishing the clinical efficacy of the product and mechanical reliability of the equipment. Starting in 2002, under the technical leadership of Jeffrey Levatter, Ph.D., our chief technical officer, we made numerous improvements and corrections to the design of the XTRAC laser system. In the last three years we pursued - and in a number of regions, have substantially achieved - widespread reimbursement commencing with obtaining newly created CPT reimbursement codes.

We believe, based on our analysis, that the XTRAC system should become a preferred treatment modality for patients afflicted with psoriasis. Although existing treatments provide some relief to psoriasis sufferers, they are inconvenient and may involve negative side effects. We believe that our patent-protected XTRAC system will enable more effective and convenient treatment with minimal side effects.

Treatment of psoriasis commonly follows a step approach with topical therapy as a first-step, phototherapy as second-step, and systemic medications reserved for when all other treatments fail. The clinical body of evidence developed by us and others supports the use of the 308-nm excimer laser as safe and effective for localized plaque-type psoriasis recalcitrant to other first-step therapies, such as topical creams and ointments. In addition, an economic analysis completed in December 2003 has demonstrated that the addition of excimer laser treatment results in no expected cost increase to the payer. Further, this analysis demonstrates the cost-effectiveness of the excimer laser is superior due to the increased number of expected disease-free days and remission days.

In the United States, we are commercializing our XTRAC system in a manner designed to provide a recurring revenue stream not only to us, but also to the attending dermatologist, who would otherwise refer the patient for alternative treatment and thereby forego associated revenues. WeAlthough on occasion we may sell the laser outright to a dermatologist, typically we place units in the offices of dermatologists with high-volume psoriasis practices at no up-front capital cost to the dermatologists. We own the equipment and charge the dermatologist on a per-treatmentfee-per-treatment basis for the use of the XTRAC system.

A dermatologist generally takes delivery of our XTRAC system under the terms of our standard usage agreement. Our agreements generally do not provide the dermatologist with any purchase options.options, but we may offer a purchase option when favorable economic conditions exist. Title to the lasers remains either in our name or in the name of a third-party who may hold title as a security devicecollateral within the context of an equipment financing transaction. There is generally no fixed amount that is to be paid over pre-set intervals of time by thea dermatologist. We reserve the right to remove the laser unit from a dermatologist’s office if the parties’ economic expectations from the onset of the placement are not borne out.

Our agreements do not require the purchasespurchase of disposable products or similar items from us. We make available various accessory products (e.g. canisters of xenon chloride gas, subject to a special, proprietary formula tied to the specifications of the XTRAC system), but do not require the purchase of set amounts of such items. However, we insistrequire that only our qualified technicians maintain the lasers and that the physicians observe the instructions for use for the laser.

The dermatologist has the right to purchase pre-paid treatments, which are generally ordered telephonically and added to the laser’s computer by way of a random access code obtained from us and input by the dermatologist. These purchased treatments may be used for multiple treatments for the same or different patients, for psoriasis, vitiligo, atopic dermatitis or leukoderma. A single treatment is then deducted from the laser’s computer upon patient treatment. Payment for access codes is usually set for 60 days. The agreement does not provide for delay in payment based on third-party reimbursement. The dermatologist retainsdermatologists retain any revenue received from patients or their medical insurance providers.

Generally, dermatologists who treat psoriasis patients refer their patients to independent treatment centers for ultraviolet light or write prescriptions for topical creams or systemic drugs. In such cases, the physician does not ordinarily share in any of the revenue generated from providing treatments to the patient. However, physicians using our XTRAC system will treat the patient in their own office and, therefore, will retain revenue that would otherwise be lost to outside providers. In addition, in most states, a trained technician, rather than the physician, may apply the treatment under the physician’s supervision, apply the treatment, thus allowing the dermatologist to continue treating other patients, while at the same time increasing revenue from treatments using our XTRAC system. We believe that this will create an attractive incentive for the dermatologists to use our XTRAC system. We designed the XTRAC system to make such delegations safe.

Our international dermatology equipment marketing plan is based on the sale of our XTRAC system and the newly developed VTRAC system through independent, exclusive distributors. We have relationships with distributors and end users in more than 30 countries in Europe, the Middle East, the Far East and Southeast Asia, and in Australia, South Africa and parts of Central and South America. We intend to expand our products in more countries in these markets. In some countries in the longer term, we anticipate developing relationships in some countries similar to those in the United States, whereby we, acting through our distributors, place a laser system in the doctor's office for free or at minimal cost and charge the doctor a per-procedureper-treatment fee.

On March 18, 2005, we completed the acquisition of ProCyte Corporation (“ProCyte”).ProCyte. ProCyte generates revenues from the sale of skin health, hair care and wound care products; the sale of copper peptide compound in bulk; and royalties on licenses for the patented copper peptide compound.

ProCyte’s focus since 1996 had been to bring unique products to selected markets, primarily based upon patented technologies such as GHK and AHK copper peptide, to selected markets.peptide. We currently sell products directly to the dermatology, plastic and cosmetic surgery, and spa markets. We have also expanded the use of our novel copper peptide technologies into the mass retail market for skin and hair care through specifically targeted technology licensing and supply agreements.

Our products address the growing demand for skin health and hair care products, including products designed to addressmitigate the effects aging has on the skin and hair and to enhance appearance. Our products are formulated, branded for and targeted atfor specific markets. Our initial products were developed to be dispensed by physicians in the dermatology, plastic and cosmetic surgery markets for use following various medical procedures. Anti-aging skin care products were added to form a comprehensive approach for a patients’ skin carepatient’s skincare regimen. Certain of these products incorporate our patented technologies, while others complement the product line such as our advanced sunscreen products that reduce the effects of sun damage and aging on the skin.

The markets for skin care,skincare, hair care and wound care products are global. There are numerous distinct markets where we have a presence through our own direct sales efforts or through agreements with others. These include dermatology, plastic and cosmetic surgery, spa, catalog, and direct mail. We sell our products to customers utilizing a direct sales force and also generate revenues from technology licensing.

We emphasize high-quality products and services, technical knowledge, and responsiveness to customer needs in our marketing activities. We educate our distributors, customers and prospective customers about our products through a series of detailed marketing brochures, technical bulletins and pamphlets, presentations, news releases and direct mail pieces. We also conduct a series of one-day educational symposia around the country to provide product updates and marketing ideas to current and potential physician customers. These activities are supplemented by advertising in industry publications, technical presentations, and exhibitions at over 30 local, national and international trade shows.

Technology licensing generated $459,967, representing 1.6% percent of our total revenues in 2005. We are continuously seeking partners in the prestige, direct-to-consumer, specialty retail and home shopping categories. ProCyte’sOur skincare business strategy is to identify skin careskincare markets that would be best served by more established companies and then target a significant partner in each market to license our technology.

We have operated under a worldwide license agreement with Neutrogena Corporation, a Johnson & Johnson company (“Neutrogena”), for worldwide use of our patented copper peptide technology in products for skin health in the mass retail market. Our current license agreement has a two-year term remaining.continues until April 2010. Neutrogena develops, manufactures and markets skin and hair care products domestically and internationally. Neutrogena launched its two initial products using our technology under the brand name of Visibly Firm™ with Active Copper™ in April 2001. Since that time, it has continued to add new products using ProCyte’s patented copper peptide technology. Neutrogena began expanding the sale of these products into some of its international markets during 2003 and has indicated plans to continue such expansion. We receive royalty payments, based on product sales by Neutrogena and revenue from the sale of the copper peptide compound used in Neutrogena’s products.

We market lasers used in surgery in such venues as hospitals, surgi-centers and doctors offices under the trademark of SLT and, to a lesser degree, the trade name of Surgical Innovations & Services. We market many of our surgical laser products using a similar business model to the marketing of our excimer laser products by charging a per-procedure fee, thereby limiting the initial outlay to the customer for capital expenditure, while ensuring continued revenue flow to us. We offer a wide range of laser services in various specialties, including urology, gynecology, orthopedics and general surgery. We are currently marketing such services under the trade name PhotoMedex Surgical Services. We also provide products that we manufacture for use in our surgical services business.

We also engage in the development, manufacture and sale of surgical products, including proprietary Contact and free-beam Laser Systems for surgery and in the provision of surgical services on a turnkey procedural basis. We introduced Contact Laser™ surgery by combining proprietary Contact Laser Delivery Systems with an Nd:YAG laser unit to create a multi-specialty surgical instrument that can cut, coagulate or vaporize tissue. Our Contact Laser Delivery Systems can be used effectively with any wavelength of laser between 532nm and 1064nm, including the KTP laser (532nm), diode laser (various wavelengths) and Nd:YAG laser (1064nm). We are currently marketing such products under the trade name PhotoMedex Surgical Products.

Our proprietary Contact Laser probe and scalpel surface treatments provide the ability to alter selectively the temperature profile of tissue, replicating the clinical effect of many different types of lasers. Through our patented Contact Laser Delivery Systems, we are able to produce a wide range of temperature gradients, which address a broad range of surgical procedures within multiple specialties. Our multiple-specialty capability reduces a hospital’s need to purchase several lasers to meet its specialists’ varied requirements. These factors, coupled with the precision, hemostasis, tactile feedback and control that our Contact Laser Delivery Systems provide, are our primary competitive strengths in surgical products.

During 2001, we introduced the LaserProLaserPro® CTH holmium laser, a versatile and compact holmium laser for lithotripsy, or fragmentation of calculi of the genito-urinary tract, as well as a broad range of other surgical applications. We also introduced a line of fiber-optic laser delivery systems to be used with the holmium laser. This laser has been used in the provision of surgical services and has also been offered for sale. In 2004, we introduced our new CO2 laser system as well as our own diodeDiode laser system, which we anticipate over time will replacehas replaced the Nd:YAG laser.

Our surgical revenues will thus continue to be generated primarily from:

Our Contact Laser Delivery Systems consist of proprietary fiberoptic delivery systems which deliver the laser beam from our Diode (or Nd:YAG or diodeYAG) laser unit via an optical fiber to the tissue, either directly or through a proprietary Laser Probe or Laser Scalpel. These delivery systems can also be used with the laser systems of certain other manufacturers. Our holmium laser delivery systems consist of fiber-optic delivery systems, which deliver the laser beam from our CTH holmium laser unit to the surgical site. The CO2 laser system does not use a fiberoptic and therefore will have less of a recurrent revenue steam. However, we anticipate that in conjunction with sales of the CO2 laser, we will sell more of our CO2-related Unimax® accessories.

We provide our customers with the ability to utilize our laser systems, as well as those of other companies, on a per-procedure basis. We provide these services through field technicians, called clinical support specialists, for a variety of surgical procedures utilizing various laser technologies. The per-procedure prices we charge for surgical services vary based on the surgical procedure performed.

Our primary competitive strengths in surgical services are in the training we provide to our clinical service specialists, our adherence to quality standards and our ability to integrate products that we manufacture into the range of services we provide. These strengths allow us to provide multiple specialtymultiple-specialty capability on a cost-effective basis, which in turn reduces or eliminates a hospital’s need to purchase laser systems, associated delivery systems and clinical support to meet its professionals’ requirements.

Most of our operations in surgical services are in the southeastern states of the United States. We also have operations in the Milwaukee, Wisconsin, Baltimore-Washington DC and Philadelphia, Pennsylvania areas. We intend to continue to expand the territory where we provide such services and shall explore how we may expand the range of surgical procedures which we can support. We see surgical services as a business with favorable prospects for revenue growth. In 2006, we entered a services contract with a nationwide consortium of hospitals which provides for a staged roll-out over the various regions of the consortium; we have begun the roll-out and are currently providing our services in the first region designated under the roll-out.

The following is a summary of our major surgical products:

The LaserPro CO2 laser unit can provide up to 30 watts of power to tissue at a wavelength of 10,600-nm. Like the diode,Diode, the CO2 laser is readily transportable and has been designed for dependable use. This laser was also designed to work seamlessly with a line of premiere CO2 accessories, including the Unimax® micromanipulator, which we acquired from Reliant Technologies. As in the case of the diodeDiode laser, we have in the case of the CO2 laser undertaken discussions to supply the laser on an OEM basis to third parties.

We manufacture virtually all of our laser systems and laser delivery systems (other than those manufactured by other companies that are utilized in the provision of surgical services) at our Montgomeryville, Pennsylvania facility. The raw materials we use are generally available in adequate supply from multiple suppliers. We obtain all of our partially finished Laser Probes and Laser Scalpels from three suppliers in the United States. We perform materials processing and final assembly on the Laser Probes and Laser Scalpels using proprietary and patented treatment processes. We also manufacture the fiberoptic delivery systems, with and without handpieces. A domestic supplier manufactures our sterile gas and fluid cartridge systems on an exclusive basis in accordance with our specifications.

As of March 15, 2006,2007, our sales and marketing organization contains the followingconsists of 65 full-time positions. These have expanded significantlyOf the 65 direct sales personnel, they are directed to sales in the Dermatology and Surgical divisions by business segment as a result of the ProCyte acquisition:follows: Dermatology: A in Domestic XTRAC; B in Skin Care; C in International Dermatology Equipment; Surgical, E in Surgical Services and F in Surgical Products.

Our sales organization provides consultation and assistance to customers on the effective use of our products, whether in phototherapy or in surgery. The consultative sales effort varies depending on many factors, which includeincluding the nature of the specialty involved and complexity of the procedures. MaintainingWe believe that maintaining this consultative effort allows us to develop a long-term relationship with our customers.

The time between identifying a U.S. customer for the XTRAC system and placing a unit with the customer can be from one to several months. The length of the sales cycle for a laser unit, whether an excimer unit sold internationally or one of our surgical lasers, varies from one month to one year, with the average sale or placement requiring approximately six months. The length of the sales cycle for the provision of surgical services can range from immediate to several months depending on the services desired.

Our sale and post-sale support personnel includes regional managers and clinical support specialists and marketing and technical personnel. We train the regional managers and clinical support specialists in the utilization of our products and services, which allows them to provide clinical consultation regarding safety, efficacy and clinical protocols. Our marketing and technology personnel provide our link to the customer to create innovative solutions and identify new applications and product opportunities. In some areas of the United States, we use independent distributors to provide this support for surgical products.

We sell our surgical products and services to hospitals and surgery centers as well as to individual practitioners. We design our products to be cost-effective and, where applicable, to be accessible and easy to use with various other technologies or products. Our marketing efforts include activities designed to educate physicians and nurses in the use of our products and services.

We manufacture our phototherapy products at our new 8,000 sq. ft. facility in Carlsbad, California and our surgical products at our 42,000 sq. ft. facility in Montgomeryville, Pennsylvania. Our California and Pennsylvania facilities are ISO 13485 certified. We believe that our present manufacturing capacity at these facilities is sufficient to meet foreseeable demand for our products. We substantially outsource the manufacture of our Skin careCare products. Our facility in Redmond, Washington is the final assembly center and primary warehouse for our skin careskincare products, and likewise is operated in conformance with a quality system.

We manufacture most of our own components and utilize certain suppliers for the manufacture of selected standard components and subassemblies, which are manufactured, to our specifications. Most major components and raw materials, including optics and electro-optic devices, are available from a variety of sources. We conduct all final testing and inspection of our products. We have established a quality control program, including a set of standard manufacturing and documentation procedures intended to ensure that, where required, our instruments are manufactured in accordance with FDA Quality System Requirements and the comparable requirements of the European Community.

As of March 15, 2006,2007, our research and development team included four full-time research employees and 10nine engineers. We conduct research and development activities at all three of our facilities: Carlsbad, California, Redmond, Washington and Montgomeryville, Pennsylvania.facilities. Our research and development expenditures were approximately $1.0 million in 2006, $1.1 million in 2005 $1.8 million in 2004 and $1.8 million in 2003.2004.

Our research and development activities are focused on:

We intend to protect our proprietary rights from unauthorized use by third parties to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets.

Patents and other proprietary rights are an element of our business. Our policy is to file patent applications and to protect technology, inventions and improvements to inventions that are commercially important to the development of our business. As patents expire and expose our inventions to public use, we seek to mitigate the impact of such expirations by improvements on the inventions embodied in the expiring patents. The patents in our Skin Care segment relate to use of our copper peptide-based technology for a variety of healthcare applications, and to the composition of certain biologically active, synthesized compounds. Our strategy has been to apply for patent protection for certain compounds and their discovered uses that are believed to have potential commercial value in countries that offer significant market potential. As of March 15, 2006,2007, we have more than 130120 domestic and foreign issued patents, which serve to help protect the technology of our businesses in phototherapy, skin health and hair care, and surgical products and services. To the same purpose, we have more than 7040 patent applications pending in the United States and abroad. We have retrenched some applications where we do not foresee meaningful value to us.

We have licensed certain of our proprietary technology in phototherapy to Komatsu, Ltd. in connection with its manufacture of semi-conductor lithography equipment, for which we are entitled to receive royalty fees. We have licensed our copper peptide technology to Neutrogena.Neutrogena, for which we currently receive royalties. Conversely, from time to time, we seek licenses from third parties for technology that can broaden our product and service offerings, as for example a license we secured from Massachusetts General Hospital relatedthe Mount Sinai School of Medicine granted us for exclusive rights to a patent covering the use of excimer lasers in the treatment of psoriasis.vitiligo.

We also rely on trade secrets, employee and third-party nondisclosure agreements and other protective measures to protect our intellectual property rights pertaining to our products and technology.

Many of our products and services are offered under trademarks and service marks, both registered and unregistered. We believe our trademarks encourage customer loyalty and aid in the differentiation of our products from competitors’ products, especially in our skin care products. Accordingly, we have registered in the United States 34more than 30 of our trademarks in the United States. We have other registrations for our skin careskincare products in foreign jurisdictions.

Our products and research and development activities are regulated by numerous governmental authorities, principally the Federal Food and Drug Administration or FDA and corresponding state and foreign regulatory agencies. Any device manufactured or distributed by us will be subject to pervasive and continuing regulation by the FDA. The Federal Food, Drug and Cosmetics Act and other federal and state laws and regulations govern the pre-clinical and clinical testing, design, manufacture, use and promotion of medical devices and drugs, including our XTRAC system, surgical lasers and other products currently under development by us. Product development and approval within this regulatory framework takes a number of years and involves the expenditure of substantial resources.

In the United States, medical devices are classified into three different classes, Class I, II and III, on the basis of controls deemed reasonably necessary to ensure the safety and effectiveness of the device. Class I devices are subject to general controls, such as labeling, pre-market notification and adherence to the FDA's good manufacturing practices, and quality system regulations. Class II devices are subject to general as well as special controls, such as performance standards, post marketpost-market surveillance, patient registries and FDA guidelines. Class III devices are those which must receive pre-market approval by the FDA to ensure their safety and effectiveness, such as life-sustaining, life-supporting and implantable devices, or new devices which have been found not to be substantially equivalent to legally marketed devices.

Before a new medical device can be marketed, marketing clearance must be obtained through a pre-market notification under Section 510(k) of the Food and Drug Modernization Act of 1997, or the FDA Act, or through a pre-market approval application under Section 515 of such FDA Act. The FDA will typically grant a 510(k) clearance if it can be established that the device is substantially equivalent to a predicate device that is a legally marketed Class I or II device or certain Class III devices. We have received FDA 510(k) clearance to market our XTRAC system for the treatment of psoriasis, vitiligo, atopic dermatitis and leukoderma. Additionally, the FDA has issued clearances to commercially market our Contact Laser System, including the laser unit, Laser Probes and Laser Scalpels and Fiberoptic Delivery System,Systems, in a variety of surgical specialties and procedures in gynecology, gastroenterology, urology, pulmonology, general and plastic surgery, cardio-thoracic surgery, ENT surgery, ophthalmology, neurosurgery and head and neck surgery. The FDA granted these clearances under Section 510(k) on the basis of substantial equivalence to other laser or electrosurgical cutting devices that had received prior clearances or were otherwise permitted to be used in such areas. The range of clearances for our Diode laser system is similar to the range of clearances for the CLMD Nd:YAG laser systems. We have also received FDA clearance under Section 510(k) to market our holmium laser system, including the laser unit and fiberoptic delivery systems, in a variety of surgical specialties and procedures in urology, otorhinolaryngology, discectomy and percutaneous laser disc decompression.

For any devices that are cleared through the 510(k) process, modifications or enhancements that could significantly affect the safety or effectiveness, or that constitute a major change in the intended use of the device, will require new 510(k) submissions. In August 2003, the FDA granted 510(k) clearance for modifications that had been made to the XTRAC laser, which we have marketed as the XTRAC XL Plus excimer laser system. In October 2004, the FDA granted clearance for the Ultra™ (AL 8000) excimer laser system. We also received in 2004, 510(k) marketing clearance for our diodeDiode and CO2 surgical laser systems.

A pre-market approval application may be required if a proposed device is not substantially equivalent to a legally marketed Class I or II device, or for certain Class III devices. A pre-market approval application must be supported by valid scientific evidence to demonstrate the safety and effectiveness of the device, typically including the results of clinical trials, bench tests and laboratory and animal studies. In addition, the submission must include the proposed labeling, advertising literature and any training materials. The pre-market approval process can be expensive, uncertain and lengthy, and a number of devices for which FDA approval has been sought by other companies have never been approved for marketing.

We are subject to routine inspection by the FDA and have to comply with a number of regulatory requirements that usually apply to medical devices marketed in the United States, including labeling regulation, good manufacturing process requirements, medical device reporting regulation (which requires a manufacturer to report to the FDA certain types of adverse events involving its products), and the FDA's prohibitions against promoting products for unapproved or off-label uses.

We are also subject to the Radiation Control for Health and Safety Act with laser radiation safety regulations administered by the Center for Devices and Radiological Health, or CDRH, of the FDA. These regulations require laser manufacturers to file new product reports and annual reports, to maintain quality control, product testing and sales records, to incorporate certain design and operating features in lasers sold to end users and to certify and label each laser sold, except those sold to private-label customers, as belonging to one of four classes, based on the level of radiation from the laser that is accessible to users. Various warning labels must be affixed and certain protective devices installed, depending on the class of product. The CDRH is empowered to seek fines and other remedies for violations of the regulatory requirements. To date, we have filed the documentation with the CDRH for our laser products requiring such filing, and have not experienced any difficulties or incurred significant costs in complying with such regulations.

We have received ISO 13485/EN46001 certification for our XTRAC system and our, Diode, holmium, CO2 and Nd:YAG holmium, diode and CO2 laser systems. This certification authorizes us to affix a CE Mark to our products as evidence that they meet all European Community, or EC, quality assurance standards and compliance with applicable European medical device directives for the production of medical devices. This will enable us to market our approved products in all of the member countries of the European Union, or EU. We also will be required to comply with additional individual national requirements that are outside the scope of those required by the EU. Our products have also met the discrete requirements for marketing in various other countries. Failure to comply with applicable regulatory requirements can result in fines, injunctions, civil penalties, recalls or seizures of products, total or partial suspensions of production, refusals by foreign governments to permit product sales and criminal prosecution.

As to our products in the Skin Care business segment, the Federal Food, Drug and Cosmetic Act, and the regulations promulgated thereunder, and other federal and state statutes govern the testing, manufacture, safety, labeling, storage, record-keeping, advertising and promotion of cosmetic products as well. Our products and product candidates in the Skin Care segment may be regulated by any of a number of divisions of the FDA and in other countries by similar health and regulatory authorities. The process of obtaining and maintaining regulatory approvals for the manufacturing or marketing of our existing and potential skin care products is costly and time-consuming and is subject to unanticipated delays. Regulatory requirements ultimately imposed could also adversely affect our ability to clinically test, manufacture or market products.

In the United States, products that do not seek to make effectiveness claims based on human clinical evaluation may be subject to review and regulation under the FDA’s cosmetic, drug or 510(k) medical device guidelines. Similar guidelines exist for such products in other countries. Such 510(k) products, which include wound care dressings and certain ointments and gels, must show safety and substantial equivalency with predicate products already cleared by the FDA to be marketed. There can be no assurance that product applications submitted to the FDA or similar agencies in other countries will receive clearance to be marketed, or that the labeling claims sought will be approved, or that, if cleared, such products will be commercially successful or free from third partythird-party claims relating to the effectiveness or safety of such products.

We are also or may become subject to various other federal, state, local and foreign laws, regulations and policies relating to, among other things, safe working conditions, good laboratory practices, and the use and disposal of hazardous or potentially hazardous substances used in connection with research and development. Failure to obtain regulatory approvals where appropriate for our product candidates or to attain or maintain compliance with quality system regulations or other manufacturing requirements would have a material adverse effect on our business, financial condition and results of operations.

Our ability to market our phototherapy products successfully will depend in large part on the extent to which various third parties are willing to reimburse patients or providers for the cost of medical procedures utilizing our treatment products. These third parties include government authorities, private health insurers and other organizations, such as health maintenance organizations. Third-party payers are systematically challenging the prices charged for medical products and services. They may deny reimbursement if they determine that a prescribed device is not used in accordance with cost-effective treatment methods as determined by the payer, or is experimental, unnecessary or inappropriate. Accordingly, if less costly drugs or other treatments are available, third-party payers may not authorize or may limit reimbursement for the use of our products, even if our products are safer or more effective than the alternatives. Additionally, they may require changes to our pricing structure and revenue model before authorizing reimbursement.

Reimbursement systems in international markets vary significantly by country and by region within some countries, and reimbursement approvals must be obtained on a country-by-country basis. Many international markets have government-managed healthcare systems that control reimbursement for new devices and procedures. In most markets, there are private insurance systems, as well as government-managed systems. Our XTRAC products remain substantially without approval for reimbursement in any international markets under either government or private reimbursement systems. Reimbursement for the products and services provided by our Surgical Services and Surgical Products segments has been generally well establishedwell-established and is not viewed as an obstacle to growth in those segments. Since the skin careskincare products are primarily for cosmetic applications, reimbursement is not a critical factor in growing revenues for this product segment.

In 2006, we continued our efforts onto secure private, third-party reimbursement in our domestic XTRAC business segment. InOur efforts began in February 2002 when the Current Procedural Terminology Editorial Board of the American Medical Association, or AMA, approved the request by the American Academy of Dermatology to issue reimbursement codes for laser therapies in the treatment of psoriasis and other inflammatory skin diseases, which would include laser therapy using our XTRAC system to treat such conditions. In December 2002, the Centers for Medicare and Medicaid Services, or CMS, published the relative values and national Medicare reimbursement rates for each of the CPT codes. These reimbursement rates were effective January 1, 2003. However, they could not be paid sooner than March 1, 2003. The designation for laser treatment for inflammatory skin disease (psoriasis) was broken into three distinct codes, based on the total skin surface area being treated:

The state rates will vary by overhead factors applicable to each state.

In addition to Medicare and Medicaid, consistent domestic private healthcare reimbursement is critical for significant growth in XTRAC system procedures. There were more than 89,000 XTRAC procedures in 2006, 60,000 XTRAC procedures in 2005 and more than 50,000 XTRAC procedures in 2004 with the majority being covered by third-party reimbursement. Historically, it has been our belief that a rapid increase in widespread adoption of private healthcare reimbursement was being thwarted by a perception that the XTRAC therapy, although widely publicized as clinically safe and efficacious, was not economically cost-effective compared to other existing therapies. We sponsored the completion of an economic and clinical study to review the clinical and economic effectiveness of the XTRAC laser as a second-step therapy for the treatment of psoriasis. The conclusions of the study are: there is no additional cost of adding XTRAC as second-line therapy in a managed care plan; XRAC is a cost-effective second-line treatment for mild-to-moderate plaque psoriasis; XTRAC provides the greatest number of treatment-free days in one year among all therapies, except for intralesional corticosteroid injections (“ICI”); XTRAC is the lowest cost per treatment-free-day with the exception of ICI; XTRAC has the lowerlowest cost per remission day among all phototherapies; and XTRAC has the highest number of remission days among all therapies. The results of this study were compiled in a data compendium and distributed to all the major health insurers; the results have also been published in a peer-review journal. In 2005 substantive progress was made in connection with obtaining approvals for covering medically necessary targeted UVB therapy for psoriasis. As a result of certain national insurers approving the XTRAC excimer laser therapy in the latter part of 2005, we initiatedinitiated– and have continued in 2006 – a direct-to-consumer advertising campaign in certain geographic regions.

The market for our XTRAC system is highly competitive. We compete with other products and methodologies used to treat the symptoms of psoriasis, vitiligo, atopic dermatitis and leukoderma, including topical treatments, systemic medications and other phototherapies. We believe that our XTRAC system will favorably compete with alternative treatments for these disorders primarily on the basis of its effectiveness, as well as on the basis of the lower out-of-pocket costs, as compared to costs associated with alternative treatments. Market acceptance of our XTRAC system treatment for these diseases is dependent on our ability to establish, with the medical and patient communities, the efficacy of our XTRAC system as a preferred treatment modality. In addition, all or a portion of patient costs for many of the alternative treatments are paid or are reimbursable by health insurance coverage or other third-party payers, such as Medicaid and Medicare. Patient costs for treatments utilizing our XTRAC system may not be initially eligible for health care coverage or reimbursement by third-party payers until such payers approve reimbursement. This may cause some patients or physicians to choose alternative treatments offered by our competitors.

We also face direct competition from other companies, including large pharmaceutical companies, engaged in the research, development and commercialization of treatments for psoriasis, atopic dermatitis, vitiligo and leukoderma. In some cases, those companies have already received FDA approval or commenced clinical trials for such treatments. Many of these companies have significantly greater financial resources and expertise in research and development, manufacturing, conducting pre-clinical studies and clinical trials, and marketing than we do.

Various other companies are now marketing laser-based phototherapy treatment products. One former competitor had received FDA clearance to market an excimer laser for the treatment of psoriasis in the United States, and another competitor has asserted that it has such clearance - an assertion we are disputing. AtThere have been at least three foreign-based companies are currently marketingwhich market an excimer laser for the treatment of skin disorders outside of the United States. Two others have developed pulse-dye lasers, which are being explored as treatments for psoriasis. Another company has announced FDA clearance for a standard UVB light basedlight-based system using a fiber-optic delivery system for the treatment of skin disorders. We expect that other devices will enter the market, too. All of these technologies will continue to evolve with time. We cannot say how much these technologies will impact on us, but we anticipate that competitors that enter the US market will predominantly not use a fee-per-procedure model but will use an outright sales model, and will likely sell not on claims of superior quality, but on claims of lower prices and better economic returns.

Competition in the wound care, skin health and hair care markets is intense. Our competitors include well-established pharmaceutical, cosmetic and healthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia,Pavonia, Declore and Murad. These competitors have substantially more financial and other resources, larger research and development staffs, and more experience and capabilities in researching, developing and testing products in clinical trials, in obtaining FDA and other regulatory approvals and in manufacturing, marketing and distribution than us.we do. In addition, a number of smaller companies are developing or marketing competitive products. Our competitors may succeed in developing and commercializing products or obtaining patent protection or other regulatory approvals for products more rapidly than us.we can. In addition, competitive products may be manufactured and marketed more successfully than our potential products. Such developments could render our existing or potential products less competitive or obsolete and could have a material adverse effect on our business, financial condition and results of operations.

With regard to surgical lasers, we face substantial competition from other manufacturers of surgical laser systems, whose identity varies depending on the medical application for which the surgical system is being used, and from traditional surgical methods. Other companies are developing competitive surgical systems and related technologies. Many of these companies are substantially larger and have substantially greater resources than we do. These efforts could result in additional competitive pressures on our operations.

In addition, we face competition from other surgical services companies and from product manufacturers who may offer their products through a similar per-procedure method. Additionally, we face substantial competition from well-established manufacturers of non-laser products. These well-established companies have substantially greater resources than we do and could exert considerable competitive pressure on us. We continue to monitor the concepts or products and services some companies have introduced into the market that draw on Contact Laser technology. We do not believe, however, that such concepts or products will have a significant impact on our sales.

In addition, our competitors compete with us in recruiting and retaining qualified scientific, management and marketing personnel.

As of March 15, 2006,2007, we had 180192 full-time employees, which consisted of 73 executive personnel (6 executive personnel at our Montgomeryville, Pennsylvania facility and 1 at our Carlsbad, California facility), 55officers, 11 other senior officers or managers, 60 sales and marketing staff, 8082 people engaged in manufacturing of lasers and laser-related products, 89 customer-field service personnel, 4 people engaged in research and development, 108 engineers and 1615 finance and administration staff. We intend to hire additional personnel as the development of our business makes such action appropriate. The loss of the services of key employees could have a material adverse effect on our business. Since there is intense competition for qualified personnel knowledgeable in our industry, no assurances can be given that we will be successful in retaining and recruiting needed personnel.

Our employees are not represented by a labor union nor covered by a collective bargaining agreement. We believe that we have good relations with our employees. We provide our employees with certain benefits, including health insurance.

Historically, we have incurred significant losses and have had negative cash flows from our phototherapy operations. Our surgical products and services business also has generated losses in recent years. To date, we have dedicated most of our financial resources to research and development and selling, general and administrative expenses. As of December 31, 2005,2006, our accumulated deficit was approximately $80.2 million.$87.7million.

Our future revenues and success depend significantly upon acceptance of our excimer laser systems for the treatment principally of psoriasis, but also of vitiligo, atopic dermatitis and leukoderma. Our XTRAC system for the treatment of these conditions generates revenues, but those revenues are presently insufficient to generate positive cash flows from our operations in the two XTRAC-related business segments. Our future revenues and success also dependsdepend on the continued revenue growth of the revenue from the skin health and hair care products of our skincare products and of our surgical services business and revenue stability within our surgical products business. Our ability to market our products and services successfully and the expected benefits to be obtained from our products and services may be adversely affected by a number of factors, such as unforeseen costs and expenses, technological changes, economic downturns, competitive factors or other events beyond our control.

We expect to incur losses as we move into fiscal 20062007 because we plan to spend substantial amounts on expanding, in controlled fashion, our operations in phototherapy.phototherapy, and particularly in increasing our customers’ effective utilization of the XTRAC system. We cannot assure you that we will market any products successfully, operate profitably in the future, or that we will not require significant additional financing in order to accomplish our business plan.

We have historically financed our activities through working capital provided from operations, the private placement of equity securities and from lines of credit. We believe that our cash balance, together with access to lease financing for capital expenditures and other existing financial resources, and revenues from sales, distribution, licensing and manufacturing relationships, should be sufficient to meet our operating and capital requirements intobeyond the second quarter of 2007.2008. However, we may have to raise substantial additional capital if:

While we have engaged in clinical studies for our psoriasis treatment, and based on these studies, we have gained FDA clearance, appropriate CPT reimbursement codes for treatment and suitable reimbursement rates from CMS for those codes, we may face other hurdles to market acceptance if, for example, practitioners in significant numbers wait to see longer-term studies or if it becomes necessary to conduct studies corroborating the role of the XTRAC system as a second-line therapy for treating psoriasis or if patients do not elect to undergo psoriasis treatment using the XTRAC system. We have not had sufficient time to observe the long-term effectiveness or potential side effects of our treatment system for psoriasis, vitiligo, atopic dermatitis or leukoderma nor to gauge what marketing and sales programs, if any, are effective in increasing patients’ demand for the treatment of psoriasis with the XTRAC system.

In 2003, we improved the reliability and functionality of the XTRAC system and upgraded such lasers both in the United States and overseas. In 2004, we obtained FDA 510(k) marketing clearance for a smaller, faster and fastermore powerful XTRAC system known as the Ultra.Ultra™. These efforts should help us gain market acceptance for the XTRAC system both in the United States and abroad, but do not guarantee such acceptance or that we may not encounter further problems in reliability. We have designed the XTRAC system to be user-friendly, such that a properly in-serviced medical technician in a physician’s office may, under the physician’s supervision, safely and effectively administer treatments to a patient. In fact, the CMS reimbursement rates are based on the lower labor rates achieved through such delegation. Nevertheless, whether a treatment may be delegated, and if so to whom and to what extent, are matters that may vary state by state, as these matters are within the province of the state medical boards. In states that may be more restrictive in such delegation, a physician may decline to adopt the XTRAC system into his or her practice, deeming it to be too much fraught with too many constraints and finding other outlets for the physician’s time and staff time to be more remunerative. There can be no assurance that we will be successful in persuading such medical boards that a liberal standard for delegation is appropriate for the XTRAC system, givenbased on its design for ease and safety of use. If we are not successful, we may find that even if a geographic region has wide insurance reimbursement, the region’s physicians may yet balk at adopting the XTRAC system into their practices.

Our success will depend, in part, on our ability to maintain and defend our patents. However, we cannot give you any assurances that the technologies and processes covered by all of our patents may not be found to be obvious or substantially similar to prior work, which could render these patents unenforceable. Moreover, as our patents expire, competitors may utilize the technology found in such patents to commercialize their own laser systems. In offset to the expiring patents, we endeavor to secure additional patents on critical, commercially desirable improvements to the inventions of the expiring patents. There can be no assurance that we will be successful in securing such additional patents, or that such additional patents will adequately offset the effect of the expiring patents.

A U.S. patent relating to a copper peptide compound manufactured and used in products distributed by Neutrogena under the Neutrogena license agreement expired on February 5, 2005. Upon expiration of this patent, the agreement specifies that lower royalty percentages from sales of such products be used for the remaining term, the impact of which is a reduction in the average effective royalty rate of approximately 50%.rate. The actual amount of royalty income recognized in future periods is dependent upon the royalty percentages in effect during the period and the actual applicable sales reported by Neutrogena, which can vary from quarter to quarter. The expiration of the patent would also allow others, including Neutrogena, to apply the technology covered by that patent in their products.

Trade secrets and other proprietary information which are not protected by patents are also critical to our business. We attempt to protect our trade secrets by entering into confidentiality agreements with third parties, employees and consultants. However, these agreements can be breached and, if they are and even if we are able to prove the breach or that our technology has been misappropriated under applicable state law, there may not be an adequate remedy available to us. In addition, it is costly and time-consuming litigation may be necessary to enforce and determine the scope of our proprietary rights, andrights; even ifshould we prevail in such litigation, the party we prevail over may have scant resources available to satisfy a judgment.

Further, our skin careskincare business seeks to establish customer loyalty, to in part, by means of our use of trademarks. It can be difficult and costly to defend trademarks from encroachment or misappropriation overseas. Third parties may also challenge the validity of certain of our trademarks. In either eventuality, our customers may become confused and direct their purchases to competitors.

Third parties may independently discover trade secrets and proprietary information that allow them to develop technologies and products that are substantially equivalent or superior to our own. Without the protection afforded by our patent, trade secret and proprietary information rights, we may face direct competition from others commercializing their products using our technology, which may have a material adverse effect on our business and our prospects.

We cannot be sure that the products, services, technologies and advertising we employ in our business do not or will not infringe valid patents, trademarks, copyrights or other intellectual property rights held by third parties. We may be subject in the ordinary course of our business to legal proceedings and claims from time to time relating to the intellectual property or derivative rights of others. Any legal action against us claiming damages or seeking to enjoin commercial activities relating to the affected products or our methods or processes could have a material adverse effect on our business and prospects by:

Our ability to market the XTRAC system and other treatment products successfully will depend in large part on the extent to which various third parties are willing to reimburse patients or providers for the costs of medical procedures utilizing such products. These third parties include government authorities, private health insurers and other organizations, such as health maintenance organizations. Third-party payers are systematically challenging the prices charged for medical products and services. They may deny reimbursement if they determine that a prescribed device is not used in accordance with cost-effective treatment methods as determined by the payer, or is experimental, unnecessary or inappropriate. Further, although third-parties may approve reimbursement, such approvals may be under terms and conditions that discourage use of the XTRAC laser system. Accordingly, if less costly drugs or other treatments are available, third-party payers may not authorize or may limit reimbursement for the use of its products, even if our products are safer or more effective than the alternatives.

Although we have received reimbursement approvals from an increased number of private healthcare plans, we cannot give assurance that private plans will continue to adopt or maintain favorable reimbursement policies or to accept the XTRAC system in its clinical role as a second-line therapy in the treatment of psoriasis. Additionally, third party payers may require further clinical studies or changes to our pricing structure and revenue model before authorizing reimbursement.

As of March 16, 2006,15, 2007, we estimate, based on published coverage policies and on payment practices of private and Medicare insurance plans, that more than 75%approximately 80% of the insured population in the United States areis covered by the insurance coverage or payment policies that reimburse physicians for using the XTRAC system for treatment of psoriasis. Based on these reports and estimates, we are continuing the implementation of a rolloutroll-out strategy for the XTRAC system in the United States in selected areas of the country where reimbursement is widely available. The success of the rolloutroll-out depends on increasing physician and patient demand for the treatment. We can give no assurance that health insurers will not adversely modify their reimbursement policies for the use of the XTRAC system in the future.

We intend to seek coverage and reimbursement for the use of the XTRAC system to treat other inflammatory skin disorders, after additional clinical studies are completed. There can be no assurances that we will be in position to expand coverage for vitiligo or to seek reimbursement for the use of the XTRAC system to treat atopic dermatitis or leukoderma, or, if we do, that any health insurers will agree to any reimbursement policy.

Cost containment measures instituted by healthcare providers and insurers and any general healthcare reform could affect our ability to receive revenue from the use of our XTRAC system or to market our skincare products, and surgical laser products, and may have a material adverse effect on us. We cannot predict the effect of future legislation or regulation concerning the healthcare industry and third-party coverage and reimbursement on our business. In addition, fundamental reforms in the healthcare industry in the United States and the EUEuropean Union continue to be considered, although we cannot predict whether or when any healthcare reform proposals will be adopted and what impact such proposals might have on demand for our products.

Our products may not be accepted if we do not produce clinical data supported by the independent efforts of clinicians. We received clearance from the FDA for the use of the XTRAC system to treat psoriasis based upon our study of a limited number of patients. Safety and efficacy data presented to the FDA for the XTRAC system was based on studies on these patients. For the treatment of vitiligo, atopic dermatitis and leukoderma, we have received clearance from the FDA for the use of the XTRAC system based primarily on equivalence of predicate devices; we may discover that physicians will expect clinical data on such treatments with the XTRAC system. We may find that data from longer-term psoriasis patient follow-up studies may be inconsistent with those indicated by our relatively short-term data. If longer-term patient studies or clinical experience indicate that treatment with the XTRAC system does not provide patients with sustained benefits or that treatment with our product is less effective or less safe than our current data suggests, our revenues could decline. We can give no assurance that we may find that our data is not substantiated in studies involving more patients; in such a case we may never achieve significant revenues or profitability.

It is important to the success of our marketing efforts to educate physicians and technicians in the techniques of using the XTRAC system. We rely on physicians to spend their time and money to attend our pre-sale educational sessions. Positive results using the XTRAC system are highly dependent upon proper physician and technician technique. If physicians and technicians use the XTRAC system suboptimally or improperly, they may have unsatisfactory patient outcomes or cause patient injury, which may give rise to negative publicity or lawsuits against us, any of which could have a material adverse effect on our reputation as a medical device company and our revenues and profitability.

Similarly, it is important to our success that we educate and persuade hospitals, surgery centers and practitioners of the clinical and economic benefits of our surgical products and services. If we fail to educate and persuade our customers, we may suffer adversely in our reputation and our revenues and our profitability.

Excluding niche marketing efforts, the Skin Care segment targets its sales in the USU.S. market to physicians, who then mark the products up for sale to their patients. No single practice in itself is generally responsible for a significant disproportion of our sales. However, a number of practices, specializing in hair transplants, are united under the management of a single group, and this group accounts for a disproportion of our hair care products aimed at the care of a scalp that has received a hair transplant. Revenues from this customer were $1,169,892 in 2006 and $811,223 in 2005. We find as well that a few physicians re-sell our products not just to their own patients, but also at discounted prices on the internet.

In the International XTRACDermatology Equipment segment (as well as in the Surgical Products segment), we depend in the international arena for a material portion of our sales on several key distributors, as for example our master distributor in the Pacific Rim. If we lose one of these distributors, our sales of phototherapy and surgical lasers are likely to suffer in the short term.

In the Surgical Services segment, we find that our model works best if we have several accounts in a territory that have sufficient volume to allow us to be efficient in the delivery of our services. If we lose one of these anchor accounts, then we may become less efficient and therefore less competitive.

We have acted as contract developer of a system designed to detect cancerous cells in human tissue and act as an OEM manufacturer of surgical lasers and/or delivery systems. Development work is fraughtrife with financial risk and technological uncertainties. OEM work is usually limited to a contracted period of time, at the end of which there may be no extension or renewal. In either case, our aim to create a strategic partnership may be frustrated.

The loss or reduction of business from any of our significant customers or strategic partners in that business segment, Neutrogena in particular, or the failure to develop new significant customers or strategic partners could have a material adverse effect on the results of operations and our overall financial condition.

Intellectual property law outside the United States is uncertain and in many countries is currently undergoing review and revision. The laws of some countries do not protect our intellectual property rights to the same extent as laws in the United States. The intellectual property rights we enjoy in one country or jurisdiction may be rejected in other countries or jurisdictions, or, if recognized there, the rights may be significantly diluted. It may be necessary or useful for us to participate in proceedings to determine the validity of our foreign intellectual property rights, or those of our competitors, which could result in substantial cost and divert our resources, efforts and attention from other aspects of our business. If we are unable to defend our intellectual property rights internationally, we may face increased competition outside the United States, which could materially and adversely affect our future business, prospects, operating results and financial results and financial condition.

Our laser products are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. In addition, certain of our skincare products and product candidates may be regulated by any of a number of divisions of the FDA and in other countries by similar health and regulatory authorities. Unless an exemption applies, each medical device that we wish to market in the United States and certain skincare products that we may wish to market must first receive either 510(k) clearance or pre-market approval from the FDA. Either process can be lengthy and expensive. The FDA's 510(k) clearance process may take from four to twelve months, or longer. The pre-market application approval process is much more costly, lengthy and uncertain. It may take one to three years or even longer. Delays in obtaining regulatory clearance or approval could adversely affect our revenues and profitability.

We have introduced our XTRAC system through our distributors and to end users into markets in more than 35 countries in Europe, the Middle East, the Far East and Southeast Asia, and in Australia, South Africa and parts of Central and South America. We intend to expand the number of countries in these markets where we distribute our products. We cannot be certain that our distributors will be successful in marketing XTRAC systems in these or other countries or that our distributors will purchase more than their contractual obligations or in accordance with our expectations.

Underlying our approvals in a number of countries are our quality systems. We are regularly audited on the compliance of our quality systems with applicable requirements, which can be extensive and complex and subject to change due to evolving interpretations and changing requirements. Adverse audit findings could negatively affect our ability to market our products.

Even if we obtain and maintain the necessary foreign regulatory registrations or approvals, market acceptance of our products in international markets may be dependent, in part, upon the availability of reimbursement within applicable healthcare payment systems. Reimbursement and healthcare payment systems in international markets vary significantly by country, and include both government-sponsored healthcare and private insurance. We may seek international reimbursement approvals for our products, but we cannot assure you that any such approvals will be obtained in a timely manner, if at all. Failure to receive international reimbursement approvals in any given market could have a material adverse effect on the acceptance or growth of our products in that market or others.

WeWhile we now have limitedgreater financial resources due to the private placement of our securities in November 2006, we must still use those resources prudently as we expand our marketing efforts. Our prudence is heavily influenced by our marketing experience, which is still relatively limited. To increase acceptance and limited marketing resources. However,utilization of our XTRA system, we expect that we willmay have to expand the number of our sales and marketing personnel in order to implement ourfor marketing programs and strategy so as to increase utilization of the XTRAC system in the United States. Different programs may call for different strategies and talents. While we may be able to draw on currently available personnel within our organization, we also expect that we will have to increase the number of representatives devoted to the sales and marketing programs and broaden, through such representatives, the talents we have at our disposal. In some cases, we may look outside our organization for assistance in marketing our products, as for example in a program to market our surgical diode laser through the internet. We cannot predict whether the anticipated sales and marketing programs will be successful, either in design or implementation.

In similar fashion, we cannot predict how successful we may be in expanding our skincare products or surgical services in the United States, nor can we predict the success of new skincare or surgical products that we may introduce. There are, for example, skincare products and diode and CO2 lasers already in the market against which our comparable products must compete. No assurance can be given that we will be successful in marketing and selling our skin health and hair care products or our diode and CO2 lasers.

Although we believe that our current manufacturing facilities are adequate to support our commercial manufacturing activities for the foreseeable future, we may be required to expand or restructure our manufacturing facilities to increase capacity substantially. If we are unable to provide customers with high-quality products in a timely manner, we may not be able to achieve market acceptance for our XTRAC system, to maintain the benefits of vertical integration in the delivery of our surgical services or to achieve market acceptance and growth for our skincare products. Our inability to manufacture or commercialize our devices successfully could have a material adverse effect on our revenue.

If additional private carriers approve favorable reimbursement policies for psoriasis and our marketing programs are successful in increasing utilization of the XTRAC system, we expect to experience growth in the number of our employees and customers and the scope of our operations. This growth may place a strain on our management and operations. Our ability to manage this growth will depend upon our ability to broaden our management team and our ability to attract, hire and retain skilled employees. We also expect that compliance with the requirements of governmental and quasi-governmental bodies will grow more complex and burdensome. Our success will also depend on the ability of our officers and key employees to continue to implement and improve our operational, financial and other systems, to manage multiple, concurrent customer relationships, to respond to increasing compliance requirements and to hire, train and manage our employees. Our future success is heavily dependent upon growth and acceptance of our products. If we cannot scale our business appropriately or otherwise adapt to anticipated growth and complexity and new product introductions, a key part of our strategy may not be successful.

In addition, we may acquire additional companies in the medical products and services industry. Accordingly, in the ordinary course of our business, we regularly consider, evaluate and enter into negotiations related to potential acquisition opportunities. We may pay for these acquisitions in cash or securities, including equity securities, or a combination of both. We cannot assure you that attractive acquisition targets will be available at reasonable prices, that we will have sufficient authorized but unissued securities available to effect an acquisition, or that we will be successful in any such transaction. Acquisitions involve a number of special risks, including:

Production of our XTRAC system requires specific component parts obtained from our suppliers. Production of our surgical laser systems requires some component parts that will become harder to procure, as the design of thea system ages. Similarly, our skin careskincare products may require compounds that can be efficiently produced only by a limited number of suppliers. In the event that our suppliers cannot meet our needs, we believe that we could find alternative suppliers. However, a change in suppliers or any significant delay in our ability to have access to such resources would have a material adverse effect on our delivery schedules, business, operating results and financial condition.

The medical devices industry is subject to rapid and substantial technological development and product innovations. To be successful, we must respond to new developments in technology, new applications of existing technology and new treatment methods. Our response may be stymiedthwarted if we require, but cannot secure, rights to essential third-party intellectual property. We compete against numerous companies offering alternative treatment systems to ours, some of which have greater financial, marketing and technical resources to utilize in pursuing technological development and new treatment methods. Our financial condition and operating results could be adversely affected if our medical devices fail to compete favorably with these technological developments, or if we fail to be responsive on a timely and effective basis to competitors’ new devices, applications, treatments or price strategies. The development of a cure for psoriasis, vitiligo, atopic dermatitis or leukoderma would eliminate the need for our XTRAC system for these diseases and would require us to focus on other uses of our technology, which would have a material adverse effect on our business or prospects.

In addition, competition in the skin health and hair care markets is intense. Our skincare competitors include well-established pharmaceutical, cosmetic and healthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia, Declore and Murad. These competitors have substantially more financial and other resources, larger research and development staffs, and more experience and capabilities in researching, developing and testing products in clinical trials, in obtaining FDA and other regulatory approvals and in manufacturing, marketing and distribution than we do. Further, a number of smaller companies are developing or marketing competitive products. Our skincare competitors may succeed in developing and commercializing products or obtaining patent protection or other regulatory approvals for products more rapidly than we can. Further, competitive products may be manufactured and marketed more successfully than our potential skincare products. Such developments could render our existing or potential skincare products less competitive or obsolete and could have a material adverse effect on our business, financial condition and results of operations.

As we develop new products or improve our existing products, we may accelerate the economic obsolescence of the existing, unimproved products, and their components. The obsolescent products and related components may have little to no resale value, leading to an increase in the reserves we have against our inventory. On the other side, there is a risk that the new products or improved existing products may not achieve market acceptance and therefore also lead to an increase in the reserves against our inventory.

One or more of our products may be found to be defective after they have been shipped in volume, and require product replacement. Product returns and the potential need to remedy defects or provide replacement products or parts could result in substantial costs and have a material adverse effect on our business and results of operations. The clinical testing, manufacturing, marketing and use of our products and procedures may also expose us to product liability claims. In addition, the fact that we train technicians whom we do not supervise in the use of our XTRAC system when patients are treated and that we train and provide our technicians as part of our surgical services business may expose us to third-party claims if those doing the training are accused of providing inadequate training or if a technician is accused of negligently applying such training. We presently maintain liability insurance with coverage limits of at least $5,000,000 per occurrence. ContinuingHowever, continuing insurance coverage may not be available at an acceptable cost, if at all. We thus may not be able to obtain insurance coverage that will be adequate to satisfy anya liability that may arise. Regardless of merit or eventual outcome, product liability claims may result in decreased demand for a product, injury to its reputation, withdrawal of clinical trial volunteers and loss of revenues. As a result, regardless of whether we are insured, a product liability claim or product recall may result in losses that could have a material adverse effect upon our business, financial condition and results of operations.

Our XTRAC system utilizes a xenon chloride gas mixture under high pressure, which is extremely corrosive. While methods for proper disposal and handling of this gas are well-known, we cannot completely eliminate the risk of accidental contamination, which could cause:

From time to time, customers return to us surgical products that appear not to have performed to specification. Such products must be decontaminated before being returned to us. If they are not, our employees may be exposed to dangerous diseases.

We believe that our growth and future success will depend in large part upon the skills of our management and technical team. The competition for qualified personnel in the laser industry is intense, and the loss of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business. We cannot assure you that we will be able to retain our existing key personnel or to attract additional qualified personnel. We do not have key-person life insurance on any of our employees.

Our success depends in part upon the continued service and performance of:

As a part of our strategy to grow our business, we seek to make strategic acquisitions of, or significant investments in, complementary companies, products or technologies, although no significant acquisition or investments are currently pending. We acquired ProCyte withmay not be successful in the following goalsfuture in mind:identifying companies that meet out acquisition criteria. The failure to identify such companies may limit the rate at which we are able to grow our business. Furthermore, any future acquisitions that we do undertake could be accompanied by risks such as:

While weWe have begun to realize each of these goals, we have not fully realized on some, but not all of the goals. We have recently engaged a new senior officer to direct the operations of the skincare business. For example,the time being, we are seekingshall concentrate less on the optimal balance and cross-integration of the ProCyteSkin Care sales and marketing personnel into the sales and marketing of the XTRAC system. If we fail to attain somesystem and more on focusing the Skin Care sales personnel on growth of the goals, our overall business and financial health could be materially and adversely affected.skincare sales.

Our results of operations are expected to fluctuate significantly from quarter-to-quarter, depending upon numerous factors, including:

Our quarter-to-quarter operating results could also be affected by the timing and usage of individual laser units in the treatment of patients, since our revenue model for the excimer laser system for the treatment of psoriasis patients and for our surgical services is based on a payment per usagepayment-per-usage plan.

The market price for our common stock could fluctuate due to various factors. These factors include:

In addition, the stock markets have, in recent years, experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Market fluctuations, as well as economic conditions, have adversely affected, and may continue to adversely affect, the market price of our common stock.

We do not expect to pay any cash dividends in the foreseeable future. We intend to retain earnings, if any, to provide funds for the expansion of our business.

Our certificate of incorporation provides, as permitted by governing Delaware law, that a director shall not be personally liable to us or our stockholders for monetary damages for breach of fiduciary duty as a director, with certain exceptions. These provisions may discourage stockholders from bringing suit against a director for breach of fiduciary duty and may reduce the likelihood of derivative litigation brought by stockholders on our behalf against a director. In addition, our certificate of incorporation and bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Delaware law. In addition, we have agreed to indemnify the past and present directors, officers and employees of ProCyte for certain matters, to the same extent such individuals are indemnified by ProCyte, for a period of six years following the effective date of the merger.

We lease an 8,000 sq. ft. facility consisting of office, manufacturing and warehousing space located at 2375 Camino Vida Roble, Suite B, Carlsbad, California 92009. The lease expires on June 15, 2012. We have however, a right to cancellation after 5 years, provided that we pay off any remaining obligation for tenant improvements. The base rent is $6,640 per month. Our Carlsbad facility houses the manufacturing and development operations for our excimer laser business.

In the matter brought by us against RA Medical Systems, Inc. and Dean Stewart Irwin in the United States District Court for the Southern District of California, a new magistrate judge appointed in 2005 to the case has ruled that discovery will continue to be stayed until the trial judge rules on the defendants’ motion fordeclined to issue to defendants summary judgment based on atheir theory of res judicata. NotwithstandingOn the abeyance ofother hand, the case, we have brought in March 2006 a motion fortrial judge declined to issue to us partial summary judgment for unfair competition, which had been based on a theorythe fact that defendantsRA Medical did not have not had, until January 2006, a licensethe requisite permission from the State of California to manufacture or market theirits medical devices,device. The declination of our claim for relief was based on reasons that we believe will not bar this claim for relief in the other pending Federal action, discussed in the paragraph below. The trial judge further declined to consolidate this Federal action brought by us with the Federal action brought by RA Medical and therefore have unfairly competed against us by unlawfully manufacturing, marketing and selling medical devicesMr. Irwin, discussed below. Pretrial is scheduled for the Spring of 2007, but no trial date has been set. In this action, there are no counterclaims that were misbranded.we must defend against.

In the matter brought in California Superior Court by RA Medical and Mr. Irwin against us againstfor unfair competition, we removed the State action to Federal court. Plaintiffs claim we did not have the requisite permission from the State of California to market our excimer medical device from our new facility in Carlsbad. We counterclaimed for, among other things, contractual interference, misappropriation of our technology and unfair competition under Federal and State statutes. The plaintiffs have brought a motion to dismiss the latter two counterclaims, based in part on an alleged bar under the applicable statutes of limitations. The trial judge has not ruled on the motion. Discovery has been stayed, pending the judge’s ruling. Among our claims of unfair competition is a claim based on RA Medical’s lack of requisite permission from the State of California to market its medical device.

In the matter brought for malicious prosecution in California Superior Court by RA Medical Systems Inc. and Dean StewartMr. Irwin in the Superior Court for San Diego County, California, we have elected in February 2006 to discontinue our motions and appeals in the matter, and thus bring closure to this action.

In June 2006, the insurance carrier that had undertaken to indemnify us in the Superiormalicious prosecution action, discussed in the paragraph above, and that had for 18 months been defending us, recanted its undertaking to indemnify us. The carrier recanted on two grounds: first, that malicious prosecution is an intentional tort and therefore is non-indemnifiable, and second, that the alleged tort occurred after the period of coverage of its underlying policy had expired. We notified the subsequent insurance carrier in whose coverage period the alleged tort occurred. That carrier has undertaken to defend us, but has denied its duty to indemnify us, based on the same ground that malicious tort is a non-indemnifiable tort. We have rejected this ground and brought an action in the U.S. District Court for San Diego County, Californiathe Eastern District of Pennsylvania for breach of contract and basedfor declaratory judgment on allegations that we and the other defendants had engaged inissue whether malicious prosecution in bringing and maintaining the action brought by PhotoMedex in April 2003. We and the other defendants filed a motion to strike the actions, based on California Code of Civil Procedure section 425.16, their, so-called SLAPP statute. Our motion to strike was denied; we appealed the denial. The appellate court heard oral argument on the matter on March 14, 2006, taking the matteris indemnifiable under advisement. We are being defended by our insurance carrier.

We are involved in certain other legal actions and claims arising in the ordinary course of business. We believe, based on discussions with legal counsel, that such litigation and claims will likely be resolved without a material effect on our consolidated financial position, results of operations or liquidity.

As of March 15, 2006,2007, we had 52,319,29462,536,054 shares of common stock issued and outstanding. Further, we hadThis included 860,000 shares of issued and outstanding restricted stock, options to purchase 6,176,6466,730,475 shares of common stock, of which 3,632,2204,368,516 were vested as of March 15, 2006,2007, and warrants to purchase up to 2,100,3094,746,657 shares of common stock.

Our common stock is listed on the Nasdaq National Market under the symbol "PHMD." The following table sets forth, for the periods indicated, the high and low closing sale prices of our common stock,

The following is a summary of all of our equity compensation plans, including plans that were assumed through acquisitions and individual arrangements that provide for the issuance of equity securities as compensation, as of December 31, 2005.2006. See Notes 1 and 1312 to the consolidated financial statements for additional discussion. The awards of restricted stock to Messrs. O’Donnell and McGrath were made on January 15, 2006 and therefore are not included in the table below.

As of January 1, 2006, no options will be granted to employees or consultants out of any plans except the 2005 Equity Compensation Plan. Options to our outside directors will be made from the 2000 Non-Employee Director Stock Option Plan; options under the 2005 Investment Plan may be made only to executive officers. Most warrants issued by us have been to investors or placement agents, and none of them, and nor was any of the warrants issued to GE Capital Corporation, have been issued pursuant to equity compensation plans. Additionally, virtually all outstanding options have beenwere granted as compensation for benefits inuring to us other than for benefits from capital-raising activities. With limited exceptions under Nasdaq membership requirements, we intend in the future to issue options pursuant to equity compensation plans which have already been approved by our stockholders without necessity of further, special approval by our stockholders.

On March 31, 2006, we issued to Stern Laser srl (“Stern”) 101,010 of our restricted common stock, pursuant to a Master Asset Purchase Agreement (the “Master Agreement”) dated September 7, 2004 with Stern Laser srl (“Stern”). We have issued to Stern in June and December 2005 248,395 and 126,582 shares, respectively, of our restricted common stock; asStern. As of December 31, 2005,2006, we have issued to Stern an aggregate 488,854589,864 shares of our restricted common stock in connection with the Master Agreement. We have also agreed to pay Stern up to an additional $450,000$250,000 based on the achievement of certain remaining milestones relating to the development and commercialization of certain licensed technology and the licensed products which may be developed under such arrangement and may have certain other obligations to Stern under these arrangements. We retain the right to pay all of these conditional sums in cash or in shares of its common stock, inat our discretion. To secure the latter alternative, we have reserved for issuance, and placed into escrow, 211,146110,136 shares of our unregistered stock. The per-share price of any future issued shares will be based on the closing price of our common stock during the 10 trading days ending on the date of achievement of a particular milestone under the terms of the Master Agreement. Stern also has served as the distributor of the XTRAC laser system in South Africa and Italy since 2000. The primary asset, which we have acquired from Stern, is a license, which was carried on our books at $942,422,$1,013,009, net as of December 31, 2005.2006. Amortization of this intangible is on a straight-line basis over 10 years, which began in January 2005. As Stern completes further milestones under the Master Agreement, we expect that the carrying value of the license will increase.

On March 30, 2006, we closed the transaction provided for in the Investment Agreement with AzurTec. We issued 200,000 restricted shares of our common stock in exchange for 6,855,141 shares of AzurTec common stock and 181,512 shares of AzurTec Class A preferred stock, which represent a 14% interest in AzurTec, on a fully diluted basis. In 2005,accordance with APB No. 18, and related interpretations, we account for our investment in AzurTec on the cost basis.

In 2006, we issued to GE Capital Corporation 14,714, 13,19120,545; 24,708;, 25,038; and 15,86032,057 warrants to purchase our common stock issued on March 29, 2006, June 28, 2005,30, 2006, September 26, 200529, 2006 and December 27, 2005,28, 2006, respectively, in connection with draws we made against a Master Lease Agreement.

We believe that all of the foregoing issuances of securities were made solely to accredited investors in transactions exempt from registration under Section 4(2) of the Securities Act.

You should read the following selected historical consolidated financial data in conjunction with our consolidated financial statements included elsewhere in this Report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” beginning in Item 7 below. The selected historical consolidated statementstatements of operations data for the five-year periodyears ended December 31, 2006, December 31, 2005 and December 31, 2004, and the selected historical consolidated balance sheet data as of December 31, 2001, 2002, 2003, 20042006 and December 31, 2005, have beenare derived from our audited consolidated financial statements:statements included in this Annual Report on Form 10-K. The selected historical consolidated statements of operations data for the years ended December 31, 2003 and December 31, 2002 and the selected historical consolidated balance sheet data as of December 31, 2004, December 31, 2003 and December 31, 2002 are derived from our audited consolidated financial statements not included in this Annual Report on Form 10-K. The historical results presented here are not necessarily indicative of future results.

International XTRAC sales of our excimerXTRAC and VTRAC laser systemsystems and related parts were $1,404,096$2,186,424 for the year ended December 31, 20052006 compared to $1,626,646$1,404,096 and $1,166,520$1,626,646 for the years ended December 31, 20042005 and 2003,2004, respectively. We sold 2646 laser systems in the year ended December 31, 20052006 compared to 26 and 18 laser systems in each of the years ended December 31, 20042005 and 2003, respectively.2004. Compared to the domestic business, the international XTRACdermatology equipment operations are more widely influenced by competition from similar laser technology from other manufacturers and from non-laser lamps which over time,lamps. Such competition has also servedcaused us to reduce the prices we charge to international distributorsdistributors. Furthermore, average selling prices for our excimer products. Whileinternational dermatology equipment are influenced by the average revenue per laser was less in the year ended December 31, 2005 than in the same period of 2004, the number of lasers sold was the same as in the prior period.following two factors:

The following table illustrates the key changes in the International XTRAC segment for the periods reflected below:

For the year ended December 31, 2005,2006, ProCyte revenues were $10,042,132.$12,646,910 compared to $10,042,132 for the year ended December 31, 2005. Inasmuch as ProCyte was acquired on March 18, 2005, the operating results of ProCyte for the year ended December 31, 2005 include activity from ProCyte from March 19, 2005 through December 31, 2005 and there are no corresponding revenues accruing to us for the yearsyear ended December 31, 2004 or 2003.2004. Skin Care revenues are generated from the sale of various skin and hair care products, from the sale of copper peptide compound and from royalties on licenses, mainly from Neutrogena. For the full year 2005, unaudited Skin care revenues were approximately $13 million compared to unaudited revenues of $13.3 million for 2004.

The following table illustrates the key changes in the Skin Care (ProCyte) segment for the periods reflected below:

In the years ended December 31, 2006, 2005 2004 and 2003,2004, surgical service revenues were $6,944,292, $7,719,529 and $7,826,519, respectively, representing a 10% decrease and $5,953,462, respectively. Revenues in surgical services stayed relatively flat fora 1.4% decrease from the comparable prior year ended December 31, 2005 comparedperiods. The 2006 decrease was primarily due to 2004. During 2005the six territories that we closed four geographic areassince January 1, 2005, the largest of business due to unacceptable operating profit, which we had revenueswas in 2004. In addition, we have sufferedthe fourth quarter of 2005, and business interruption due to hurricanes in New Orleans and Alabama from the hurricanes in August and September 2005. Two of our territories were closed on the western side of Florida due to the termination of a customer contract. We closed the other four territories for insufficient profitability. During the first quarter of 2006, we have begun to work with a regional hospital system in central Florida, which we believe will generate annual revenue exceeding the annual revenue lost in the third and fourth quarter of 2005. Revenues in surgical services grew for the year ended December 31, 2004 from 2003 by 31.5%, primarily due to growth in urological procedures performed with laser systems purchased from a third-party manufacturer. Such procedures included a charge for the usewestern side of the laser and the technician to operate it, as well as a charge for the third party’s proprietary fiber delivery system.state.

Surgical Products revenues include revenues derived from the sales of surgical laser systems together with sales of related laser fibers and laser disposables. Sales of laser systems create recurring sales of laser fibers and laser disposables that are more profitable than laser systems.

For the year ended December 31, 2006, surgical products revenues were $5,800,864 compared to $5,720,514 in the year ended December 31, 2005. The increase was almost entirely due to $207,000 in additional laser system revenues reflecting the increase in the number of systems sold (80 vs. 47), partially offset by a decline in the average price per laser sold. This was offset, in part, by a decrease in disposable and fiber sales of approximately 5%.

For the year ended December 31, 2005, surgical products revenues were $5,720,514 compared to $5,035,832$5,035,852 in the year ended December 31, 2004. The increase was almost entirely due to $685,000 in additional laser system revenues reflecting the increase in the number of systems sold (47 vs. 17), partially offset by a decline in the average price per laser sold.

For the year ended December 31, 2004, surgical products revenues were $5,035,832 compared to $5,873,787As set forth in the year ended December 31, 2003. The decrease was due to fewer laser systems sold (17 vs. 38) partially offset by an increase intable below, the average price per laser sold.

Disposables and fiber sales were relatively level betweendecreased approximately 5% from the comparable yearsyear ended December 31, 2005 and 2004.2005. We have expected that the disposables base may continue to erode over time as hospitals continue to seek outsourcing solutions instead of purchasing lasers and related disposables for their operating rooms. We have continued to seek to offset this erosion through expansion of our surgical services. Similarly, we believe there will be continuing pressure on laser system sales as hospitals continue to outsource their laser-assisted procedures to third parties, such as our surgical services business. With the introduction of our CO2 and diode surgical lasers in the second quarter of 2004, we hopehave sought to offset the decline in laser and disposables revenues.

The following table illustrates the key changes in the Surgical Products segment for the periods reflected below:

Cost of revenues divides into product cost of revenues and service cost of revenues.revenues . Within product costscost of revenues are the costs of products sold in the International XTRACDermatology Equipment segment, the Skin Care segment (with royalties being transferred over to the Servicesservices side), and the Surgical Products segment (with laser maintenance being transferred over to the services side). Within services cost of revenues are the costs associated with the Domestic XTRAC segment and the Surgical Services segment, as well as costs associated with the royalties and maintenance.

Product cost of revenues during the year ended December 31, 2006 were $8,628,651, compared to $7,219,504 for the year ended December 31, 2005. The $1,409,147 increase reflected the cost of sales for the domestic XTRAC laser sales of $128,840, an increase of $726,412 in costs for the ProCyte business acquired on March 18, 2005, and therefore the operating results of ProCyte for the year ended December 31, 2005 include activity from ProCyte from March 19, 2005 through December 31, 2005. Additionally there was an increase of $216,389 for surgical products, due to increased laser system sales and a $337,506 increase in costs associated with sales of XTRAC laser equipment sold outside the United States.

Product cost of revenues during the year ended December 31, 2005 were $7,219,504, compared to $3,324,564 for the year ended December 31, 2004. The $3,894,940 increase reflected the inclusion of $3,132,532 of costs for the ProCyte business acquired in 2005, andon March 18, 2005. Additionally there was an increase of $1,009,503$1,009,204 for surgical products, due to increased laser system sales, which was offset, in part by a $246,796 decrease in costs associated with sales of XTRAC laser equipment sold outside the United States.

Services cost of revenues was $9,843,199 and $8,456,001 in the years ended December 31, 2006 and 2005, respectively. Contributing to the $1,387,198 increase was primarily relateda $1,345,853 increase in the Domestic XTRAC business segment due to increased depreciation on the lasers of $629,000, an increase in salesexcess and obsolete inventory reserve and abnormal gas consumption, which has been corrected by software modifications. Additionally there was an increase of $41,345 in the cost of revenues for the year. Additionally, we implemented a planned quality upgrade of all units in the field during 2003. The impact of this upgrade served to reduce field service costs and warranty claims for 2004.Surgical Services business.

Services cost of revenues was $8,456,001 and $7,038,705 in the years ended December 31, 2005 and 2004, respectively. Contributing to the $1,417,296 increase was a $616,236 increase in the surgical servicesSurgical Services business associated with the increase in urological procedures performed with laser systems purchased from a third-party manufacturer, which carry a higher cost of sale due to the disposable fiber purchased from the third-party manufacturer than a fiber which we manufacture. In addition, cost of revenues in the Domestic XTRAC business segment increased $801,060 due to manufacturing inefficiencies, an increase in excess and obsolete inventory reserve and increased depreciation on the lasers compared to the same period in 2004.

Certain allocable XTRAC manufacturing overhead costs are charged against the XTRAC service revenues. The manufacturing facility in Carlsbad, California is used exclusively for the production of the XTRAC lasers, which are placed in physicians’ offices domestically or sold internationally.sold. The unabsorbed costs, relating to excess capacity, are allocated to the Domestic XTRAC and the International XTRACDermatology Equipment segments based on actual production of lasers for each segment. Included in these allocated manufacturing costs are unabsorbed labor and direct plant costs.

Gross margin increased to $12,709,001 during the year ended December 31, 2005 from $7,381,912 during the same period in 2004, primarily reflecting the impact of the ProCyte acquisition on March 18, 2005. As a percentage of revenues, the gross margins for the year ended December 31, 2005, increased to 44.8% compared to 41.6% for the same period in 2004, largely as a result of the ProCyte’s gross margin contribution which approximates 68.8%.