Obagi Medical Products, Inc (OMPI) - Description of business


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Company Description


Corporate information

Dr. Zein Obagi founded WorldWide Product Distribution, Inc. in 1988. OMP Acquisition Corporation was formed as a California corporation in October 1997 to purchase substantially all of the assets and to assume the accounts payable and related operating liabilities of WorldWide Product Distribution, Inc. and subsequently changed its name to Obagi Medical Products, Inc. in December 1997. OMP, Inc. was incorporated in Delaware in November 2000 and, in January 2001, Obagi Medical Products, Inc. was merged into OMP, Inc., with OMP, Inc. as the surviving corporation. In December 2004, the stockholders of OMP, Inc. exchanged their shares of OMP, Inc. for an equal number of shares in a newly formed holding company incorporated in Delaware, Obagi Medical Products, Inc., which became the parent holding company for all existing operations.

Our principal executive offices are located at 310 Golden Shore, Long Beach, California 90802 and our telephone number is (562) 628-1007. Our website address is http://www.obagi.com. Copies of our most recent Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q and our other reports filed with the Securities and Exchange Commission, or the SEC, can be obtained, free of charge as soon as reasonably practicable after such material is electronically filed with, or furnished to the SEC, by calling Ina McGuinness at Integrated Corporate Relations at (310) 954-1100, through the SEC’s website by clicking the SEC Filings link from the Investor Relations page on our website at www.obagi.com or directly from the SEC’s website at www.sec.gov. Our website and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.

Overview

We are a specialty pharmaceutical company focused on the aesthetic and therapeutic skin health markets. We develop and commercialize prescription-based, topical skin health systems that enable physicians to treat a range of skin conditions, including pre-mature aging, photo-damage, hyperpigmentation (irregular or patchy discoloration of the skin), acne and soft tissue deficits, such as fine lines and wrinkles. Our products are designed to improve the underlying health of patients’ skin, and our clinical studies have demonstrated that the use of our Obagi Nu-Derm System results in skin that looks and acts younger and healthier. We focus our research and development activities on improving the efficacy of

established prescription and over-the-counter, or OTC, therapeutic agents by enhancing the penetration of these agents across the skin barrier using proprietary technologies collectively known as Penetrating Therapeutics™. Through our own domestic sales force and foreign distribution partners, we market and sell physician-dispensed skin care systems directly to plastic surgeons, dermatologists and other physicians who are focused on aesthetic and therapeutic skin care. We are the market leader in the growing physician-dispensed skin care channel, according to an independent 2006 study by Kline & Co. Our net sales have grown from approximately $35.6 million in 2001 to approximately $78.0 million in 2006.

We currently market and sell a range of systems and related products for the enhancement of skin health. Our leading product line is our Obagi Nu-Derm System. This system was launched in 1988, and since that time, we have made substantial enhancements to the system through the application of our Penetrating Therapeutics technology. We believe that our Obagi Nu-Derm System is the only clinically proven, prescription-based topical skin health system on the market that has been shown to enhance the skin’s overall health by correcting photo-damage using drugs that, by definition, work at the cellular level, resulting in a reduction of the visible signs of aging. We have further leveraged our Penetrating Therapeutics technology through the systems that we market. In 2004, we launched the Obagi-C Rx System, which we believe is the only prescription-based system that reduces the early effects of sun damage and evens skin tones through the use of Vitamin C serum combined with 4% hydroquinone. We are the sole licensee of certain Avon patents relating to this technology. In 2005, we launched Professional-C, a series of high potency antioxidant Vitamin C serums that help to counteract the effects of ultraviolet radiation and other environmental influences. Professional-C represents an improved product line with more effective skin barrier penetration replacing our Vitamin C serum offerings marketed under the Cffectives and Obagi-C brands that we introduced in 2000. In July 2006, we launched Nu-Derm Condition and Enhance targeted for use with Botox. This system provides adjunctive therapy following Botox injections, which was designed to enhance aesthetic outcomes and improve overall patient satisfaction. In October 2006, we introduced the first product in the ELASTIderm™ product line, ELASTIderm™ Eye Cream, a nighttime eye cream for treatment of skin laxity around the eye. In February 2007, we launched a second product in the ELASTIderm line for daytime use, ELASTIderm™ Eye Gel, to use along with our ELASTIderm Eye Cream, as an eye therapy system. ELASTIderm products are formulated with a patent pending bi-mineral complex, which is clinically shown to help the body’s own natural ability to increase epidermal thickness, augment hypodermal fat and increase elastin levels. In February 2007, we launched CLENZIderm M.D.™, a system of products for acne treatment featuring a novel formulation of Benzoyl Peroxide, or BPO. Our clinical studies have shown that CLENZIderm M.D. penetrates more readily into the skin follicle than current creams or gels because it is in solution form (1/100 th  - 1/1000 th  of the size of current BPO particles). We believe that our solution-based acne system is a more effective treatment for acne because a greater amount of the active ingredient, BPO, will penetrate the hair follicle to more rapidly kill P. acne bacteria.

In addition, we offer tretinoin, a generic equivalent to Retin-A, which has been among the most widely used acne treatments for approximately 25 years. We currently distribute a Food and Drug Administration, or FDA, approved generic equivalent in the physician-dispensed channel under an exclusive license agreement with Triax Pharmaceuticals, LLC. We also sell the Obagi Blue Peel which has been cited by Kline & Co. as one of the most well known brands for use in physician-strength facial peel procedures. While the Obagi Blue Peel products are not dispensed for daily home use in a system and are therefore not a significant source of our revenue, they are used to aid the physician in skin peeling activities. Acceptance and awareness of the Obagi Blue Peel among physicians give it an intrinsic value as a marketing tool in driving new account growth.

We believe that our products have the potential to be used in a number of applications and procedures beyond their current use. For example, our Obagi Systems may complement and enhance commonly performed cosmetic procedures, such as Botox injections, as well as shorten healing times and

reduce the post-inflammatory hyperpigmentation that typically follow laser therapy and basal cell carcinoma excisions, and we are conducting clinical studies to evaluate the adjunctive use of our systems before and after these types of procedures. We expanded this initiative in 2005, and are working with physicians and physicians’ associations to evaluate the use of our Obagi Nu-Derm System in enhancing skin healing in ablative and non-ablative laser procedures. In late 2005 and through 2006, we conducted a study targeting more than 5,000 patients and supporting independent clinical research on our systems. The study entails physician and patient evaluations of skin quality on patients using our Obagi Nu-Derm System in conjunction with other cosmetic facial procedures. Based on the results of the clinical use study, in which patient outcomes have been documented for 2,697 patients, we launched new systems for use before and after commonly performed cosmetic procedures in July 2006. These systems are positioned under the Nu-Derm Condition and Enhance brand, with an initial focus on use in conjunction with Botox injections (Botox is a registered trademark of Allergan, Inc.). We are using this data to evaluate possible individual clinical studies on the use of Nu-Derm Condition and Enhance with  specific procedures. For example, in February 2007, we entered into an agreement with Syneron to perform a joint clinical use study of Nu-Derm Condition and Enhance system used as an adjunct therapy with Syneron’s energy based systems, with physicians who are experienced with Syneron’s systems, in order to evaluate the enhanced aesthetic outcomes and improved overall patient satisfaction. However, this study has not yet been undertaken and will require the cooperation of physicians not yet identified, and as such, there can be no assurance that the end results of this study will be positive. We plan to continue to build clinical support for the benefits of our systems in conditioning the skin and enhancing the outcomes of the most commonly performed cosmetic procedures, such as chemical peels, dermabrasion, and laser resurfacing, as well as the aesthetic and wound healing aspects of surgical procedures such as basal cell carcinoma excisions.

We engage in an active development program using our Penetrating Therapeutics technology to enhance the efficacy of established FDA-approved and OTC active ingredients. Positive findings from completed pilot studies of these new systems may not be duplicated in the larger studies that we are currently completing, or the incidence of side effects in these larger studies may force us to reformulate our products. We will continue to seek additional market opportunities where we believe we can improve the effectiveness of existing products through the application of our Penetrating Therapeutics technology to address conditions such as fungal infections, dermatitis, psoriasis, hair loss and hair removal.

We also advance our development objectives through product and license agreements with third parties. These agreements may include patent and technology licenses, product licenses and new product collaboration agreements. For example, we are developing products for the regeneration of elasticity in skin which are covered by claims contained in a patent application which we license from JR Chem LLC. The initial focus will be centered on products applied around the eyes, on the neck and on the back of the hands, where the break down in skin elasticity is most visible in aging skin. The first products to result from our collaboration with JR Chem are the products in our ELASTIderm product line. In addition, in December 2005, we entered into a product supply and collaboration agreements with Triax Pharmaceuticals, LLC for the supply of certain of its tretinoin products and to provide Obagi-branded tretinoin products in various concentrations.

In the United States, we sell our systems and related products directly to physicians through our internal sales force, which as of December 31, 2006 consisted of 109 sales, marketing and education specialists, including 96 direct sales representatives and managers. Physicians dispense our products in-office, directly to their patients, a distribution method commonly referred to as the “physician-dispensed” channel. We believe that the physician-dispensed distribution model ultimately results in higher patient satisfaction because it is better suited to the provision of system-based skin care than traditional drug distribution channels. Our physician customer base consists primarily of plastic surgeons and dermatologists, but also includes an increasing number of physicians from other practice areas, such as internal medicine and obstetrics and gynecology, or OBGYN, who are adding skin care to their practices.

As of December 31, 2006, we sold our products to approximately 4,400 accounts in the United States, which we believe represented over 6,000 individual practicing physicians. Based on a 2006 study by Kline & Co., an independent market research firm, we are the leading skin health company in the physician-dispensing channel, with an estimated 27% market share and nearly three times the market share of the next largest competitor. Outside the United States, we utilize distribution partners for the sale of our systems and related products. We currently have 12 distribution partners who sell our products through their own dedicated sales forces in approximately 35 countries.

We also compete in the Japanese retail skin care markets through a strategic licensing agreement with Rohto Pharmaceutical Co., Ltd., or Rohto. Rohto is a Japanese pharmaceutical manufacturer and distributor. Under our agreement, Rohto is licensed to manufacture and sell a series of OTC products under the Obagi brand name, including Obagi-C (a Vitamin C based topical serum in various concentrations), in the Japanese drug store channel and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto. We have other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel. Our net licensing revenue from skin health systems and products in Japan was approximately $4.1 million in 2006.

Background

Skin damage and disorders

The skin is the largest organ in the body, consisting primarily of two layers: the epidermis, a thin outer layer; and the dermis, a relatively thick inner layer. The epidermis is comprised of specialized cells such as keratinocytes and melanocytes. Keratinocytes are formed in the epidermis and travel to the skin’s surface and are exfoliated, or shed off, as they die in a maturation cycle which normally takes approximately six weeks. Buildup of excess keratinocytes can result in rough, thick or dry skin. Melanocytes produce melanin, the pigment that determines skin color and protects the body from ultraviolet radiation. The dermis is comprised largely of connective tissue fibers made of collagen and elastin. Collagen is a tough, fibrous protein that helps give skin its strength and resiliency. Elastin is a tissue that helps maintain healthy skin tension and gives skin its shape, but does not readily regenerate post-puberty and degrades over time. As the elastin degrades, skin tone and elasticity become diminished, resulting in loose, sagging skin.

The health and appearance of a person’s skin is impacted by a variety of intrinsic and extrinsic factors, including pre-mature aging, photo damage, hormones, stress, pollutants, diets and skin diseases. These factors cause newly created cells to be damaged which leads to an increase in the skin cell maturation cycle. The result is that skin cells are disorganized and pigment cell activity is increased. The damaged epidermal cells cause a wide variety of conditions such as mottled pigmentation (varied pigment density across the skin), melasma (skin discoloration often caused by hormonal changes such as those from pregnancy), age spots, fine lines and dry thickened sallow skin. In the dermis of extrinsic or intrinsic aged skin, the amount of new collagen and elastin produced decreases, resulting in fibers that do not support the structure and the dermis becoming thinner. As a result deep lines, wrinkles and sagging skin make the appearance of skin significantly worse. Skin health is also impacted by diseases such as acne, rosacea, dermatitis, and psoriasis. Imbalanced production of skin oils such as sebum encourages accelerated growth of microbes in the skin such as Propionibacterium acnes, or P.acne. The skin can also become host to viral or fungal infections.

While these conditions and diseases are not life-threatening, they are readily apparent, sometimes disfiguring, usually chronic and can be debilitating in terms of a person’s self image and confidence. As a result, people are often highly motivated to seek treatment programs to restore the look and feel of their skin.

The skin care market

In 2005, the global skin care market was estimated to be $36.2 billion, of which over 62% were facial skin care products, according to Global Industry Analysts, Inc., a market research firm. Additionally, the independent research firm, Kalorama Information, estimates that from 2005 to 2010, over 70 million people in the United States alone will receive cosmetic facial procedures for which they will pay over $60 billion. We believe this reflects a growing desire and acceptance among the aging population to seek aesthetic facial products and procedures from their physicians. A key driver of this trend is the aging of the “baby boomer” segment of the U.S. population. In addition, life expectancy in the United States has extended in recent years, leading to a further increase in the average age of the country’s population. Because healthcare needs, including the treatment of skin disorders, tend to increase with age, we expect the demand for dermatologic products to continue to increase over time. In particular, women tend to demonstrate a higher motivation than men to improve their personal appearances. The number of women between the ages of 35 and 65, the primary users of our products, was estimated by the U.S. Census Bureau to have grown 35% between 1990 and 2004. With this segment’s strong desire to reduce the signs of pre-mature aging, we expect the aging female population to continue to increase the market opportunity for skin care products.

Consumer demand for physician-dispensed skin care products and procedures has been steadily growing. We believe this growth is due to consumers realizing that many non-prescription consumer cosmetic products are unable to fully meet their needs. Consumers have increasingly turned to their physicians for products and simple in-office procedures that can provide better results than consumer cosmetics. For example, physician-directed cosmetic products and commonly performed cosmetic procedures such as Botox injections, laser hair removal and microdermabrasion (a cosmetic procedure that removes the outermost layer of the skin to promote skin rejuvenation), have experienced substantial growth as consumers learn that they can achieve positive cosmetic results with minimally invasive techniques. According to the American Society of Plastic Surgeons, or ASPS, the number of minimally-invasive cosmetic office procedures performed increased 72% from approximately 4.9 million in 2002 to approximately 8.4 million in 2005. This increase was led by facial procedures such as Botox, up 242% in 2005 compared to 2002, and injectable fillers, which were first measured by ASPS in 2003, and increased 990% in 2005 compared to 2003.

Beyond anti-aging and aesthetic treatments, there is significant market demand for effective treatments of skin diseases such as acne, rosacea, psoriasis, and eczema (dermatitis). While a number of therapies and treatments exist for such diseases, most treatments consist of either topical applications with efficacy that is limited by their inability to cross the skin barrier effectively, or systemic (oral) applications that carry significant potential side effects.

According to Kline & Co., in 2006, there were approximately 22,700 practicing dermatologists and plastic surgeons in the United States. Based on our experience with physicians who have opened accounts with us, we believe a growing number of general practice, family practice and OBGYN physicians are also dedicating resources in their practices to skin care. We believe that these physicians are responding to the rapid increase in consumer demand for non-invasive skin care treatments. Furthermore, many of these physicians are dispensing prescription and non-prescription skin care products directly to their patients. According to a 2006 Kline & Co. study, a combined number of approximately 10,100 physicians dispensed skin care products directly to their patients.

Outside the United States, the physician-dispensed skin care market varies by country due to cultural differences and regulatory variations. Cultural desires for skin with lighter and more even pigmentation have created large and growing aesthetic skin care demand across the Pacific Rim countries, particularly Japan, China and Korea. European and certain South American countries such as Brazil also present large skin care markets due to the complementary growth in cosmetic procedures and willingness on the part of

their consumers to spend discretionary income on aesthetic enhancements. We believe that the growth in major international markets will also be driven by cultural desires to remove skin darkening caused by exposure to sun, aging populations and a heightened awareness and acceptance of physician-dispensed products and procedures. Additionally, while physician dispensing is common in most countries, certain countries prohibit or limit the types of products that can by dispensed from the physician office, requiring physicians to either partner with a retail pharmacy or drug store, or to simply forgo dispensing.

Limitations of traditional products and procedures

Most of the cosmetic skin care products and procedures available today are designed to mask the effects of aging and skin disorders, rather than treat the underlying health of the skin. As a result of using these cosmetic skin care products, consumers may see temporary skin surface improvements, but underlying skin restoration often does not occur. We believe that the limitations of traditional products and procedures result primarily from the following causes:

·        The outer layer of human skin is a highly effective protective barrier against the entry of foreign particles into the body. The active agents in many competing topical products and procedures lack the ability to effectively penetrate the skin barrier, reducing their ability to improve the health of the skin at the stratum corneum, epidermis and dermis level. The most commonly used skin care products are cosmetics by definition under the U.S. Food, Drug and Cosmetic Act, or the FDCA, consisting largely of surface covers and moisturizers, which only add water to the cells on the surface of the skin, providing superficial and temporary improvement in the appearance of the skin. Moisturizers are not capable of causing the skin to generate healthy new cells to replace older, damaged ones that make up the epidermis.

·        Most traditional approaches to skin care are not comprehensive programs designed to integrate complementary products. As a result, individual products, even those that are widely used by consumers (such as facial soaps or sunscreens) are not generally designed to work together, and therefore may cause unintended side effects or reduced effectiveness when used in combination. Furthermore, the range of skin types in any given patient population is highly varied and different skin types respond differently to treatment, yet few products are capable of treating the specific needs of the individual patient’s overall skin health.

The Obagi Medical Products approach

We believe the effects of aging and skin disorders are best addressed not at the surface of the skin but at a deeper level, where the skin’s natural regeneration processes occur. Our Obagi Nu-Derm and Obagi-C Rx Systems improve the overall health of the skin by improving cellular processes such as collagen and elastin production, keratinocyte clearing, and melanocyte regulation, using drugs that, by definition, work at the cellular level. With improved underlying skin health, we believe a patient’s skin shows fewer signs of aging, is less susceptible to disease, and better able to combat exposure to the elements. We have developed skin care systems that we believe address the limitations of traditional skin care products and procedures, including the following:

·        Our Obagi Nu-Derm and Obagi-C Rx Systems are drug-based systems designed to penetrate below the skin’s surface to correct damage in all layers of the skin (the stratum corneum, the epidermis and the dermis) and accelerate cellular turnover. We have demonstrated in clinical studies that by enhancing the penetration of the intended active ingredient (tretinoin), more of this drug gets to the targeted tissue, improving patient outcomes. The increased penetration of a system of active ingredients triggers a therapeutic cascade that (i) pushes fresher cells to the surface faster, for smoother skin, reduced wrinkles and increased tolerance, (ii) corrects current hyperpigmentation (including freckles and age spots) and prevents the appearance of new hyperpigmentation,

(iii) promotes more uniform cells at the deepest layer for better skin structure and balanced, even skin tone, (iv) helps stimulate collagen and elastin for firmer, more resilient skin, and (v) helps increase natural hydration and circulation for supple, healthy-looking skin.

·        To achieve improved skin health, our Penetrating Therapeutics technology integrate proprietary formulations of existing prescription and non-prescription skin care products into treatment programs specially designed and physician-tailored to address the unique needs of each patient’s skin. The individual products within our systems are formulated to work synergistically using our proprietary Penetrating Therapeutics technology in formulations that enhance the stability and efficacy of what are often otherwise unstable molecules. When this system of products is applied within a physician directed protocol tailored to the patient’s skin health needs, overall penetration of the active ingredient to the appropriate layer of skin is achieved, resulting in greater efficacy and improved patient outcomes.

Our business strategy

Our objective is to become the leading specialty pharmaceutical company dedicated to developing and commercializing systems that enable physicians to improve skin health at the cellular level. Key elements of our strategy include:

·        Leveraging the strength of our physician-dispensed marketing and distribution channel to increase market share and introduce new Obagi products.    We believe that our market-leading position in the physician-dispensed channel presents us with the opportunity to increase the market share of our existing products and to launch a range of new Obagi Systems and products. We have built long-term relationships with skin health professionals based on the success of our products during the 18 years since the first Obagi Systems and products were launched. We will continue our sales and marketing efforts aimed at helping physicians understand how our systems’ products can meet growing patient demand for effective skin care treatments, thereby generating additional sources of revenue for physician practices. Furthermore, we believe that our systems’ product offerings, and our experienced sales force, uniquely position us to benefit from growth in the number of physicians who dispense skin care products directly to their patients. According to Kline & Co., in 2006 only about 43% of the approximately 22,700 practicing plastic surgeons and dermatologists in the United States dispense professional skin care products. According to the results of a study we sponsored by Wirthlin Worldwide Company, an additional 40% of non-dispensing surveyed physicians indicated that they are considering dispensing skin care products.

·        Continuing to develop and market new indications for Obagi Systems.   We believe a significant opportunity exists to use current Obagi Systems as non-invasive adjunctive therapies to improve certain current skin care procedures, resulting in overall better patient outcomes and satisfaction. Many cosmetic procedures are limited in their ability to provide healthier skin and an overall enhanced aesthetic outcome. For example, Botox injections for cosmetic wrinkles affect mostly the forehead and have no effect on the skin’s color, hyperpigmentation, age spots, acne or the overall health of the skin. We believe patients who are treated with our Obagi Systems following Botox injections will achieve greater overall aesthetic outcomes and satisfaction, and we are conducting clinical studies to evaluate the adjunctive use of our systems before and after these types of procedures. We expanded this initiative in 2005, including working with physicians and physicians’ associations to evaluate the use of our Obagi Nu-Derm System in conjunction with these types of procedures in more than 5,000 patients. Based on the results of the study, in which patient outcomes have been documented for 2,697 of the patients, we launched new systems for use before and after commonly performed cosmetic procedures in July 2006. The systems are positioned under the Nu-Derm Condition and Enhance brand, with an initial focus on use in conjunction with Botox injections. We plan to continue to build clinical support for the benefits of our systems in

conditioning the skin and enhancing the outcomes of the most commonly performed cosmetic procedures, such as chemical peels, dermabrasion, laser resurfacing and basal cell carcinoma excisions.

·        Creating additional clinically proven Obagi Systems that increase the efficacy of commonly prescribed dermatological agents in addressing new areas of skin disease.    We focus our research and development efforts on increasing the ability of FDA-allowed skin agents to penetrate the skin barrier, thereby increasing the effectiveness of such agents within the Generally Recognized As Safe, or GRAS, OTC or Drug Efficacy Study Indication, or DESI, classification as defined by the FDA. This approach accelerates the commercialization timeline and avoids the lengthy clinical development processes typically required to obtain new drug approvals. We intend to further differentiate our products and systems by supporting them with randomized and comparative clinical studies conducted by leading experts in the markets in which we are developing products. Supporting this strategy we initiated more than eighteen (18) clinical studies in 2005 and 2006 in the areas of acne and elasticity.

·        Establishing new strategic collaborations and relationships.   We intend to continue accessing new and complementary products through in-licensing, strategic collaborations and strategic acquisitions. We also intend to explore new product distribution partnerships in high growth channels such as the spa and salon channel, in which manufacturers’ sales of skin care products are estimated at over $460 million in 2006, according to Kline & Co. We plan to target new products and channels, which will expand the Obagi brand and System concept but will not compete directly with the physician-dispensed channel or products. We believe that skin health professionals will be receptive to new products we introduce under the Obagi brand name, and that the brand credibility that exists among skin health professionals will allow for more rapid trial and acceptance. This belief is supported by a 2003 study we sponsored by Wirthlin Worldwide Company of 1,000 medical professionals (primarily consisting of plastic surgeons, dermatologists, and medical skin care professionals), which found that the Obagi brand had the highest total awareness, at 97%, among leading physician-dispensed brands.

·        Continuing to expand intellectual property protection .   Our intellectual property protection is based on a combination of issued patents, patent applications, licensed patents, licensed product methods and technologies and trade secrets. As of December 31, 2006, we were the sole licensee of four patents, and have filed more than 37 additional U.S. provisional and non-provisional patent applications since the beginning of 2004. We will continue to pursue additional invention and method patents as we find new applications and improvements to our existing intellectual property. We also pursue an aggressive trademark registration policy as a means to increase brand recognition and product differentiation in the market.

Our Obagi Systems and related products

We currently market and sell our systems and related products to physicians for the treatment of age-related skin disorders, incorporating a range of individual prescription and non-prescription therapeutic agents, as well as cosmetic ingredients. The individual components of each system have been formulated to complement one another, enhancing the effectiveness of the system as a whole and allowing the physician to tailor the treatment program to the specific needs of the patient. The design of our systems is proprietary to us, and we are the sole licensee of U.S. patents and have patent applications for the composition of certain of the products.

System and
related products

Segment/product
category

Description

Applications

Launch
date

Obagi Nu-Derm System

 

Skin Health / Nu-Derm

 

Comprehensive system of six products including prescription and OTC drugs

 

Fine lines, wrinkles, acne, photo damage, hyperpigmentation, melasma, laxity, skin sallowness

 

1988

Obagi-C Rx System

 

Skin Health / Vitamin C

 

Highly stable Vitamin C serum with 4% hydroquinone system; prescription-based

 

Fine lines, wrinkles, hyperpigmentation, skin sallowness

 

2004

Professional-C and Cffectives

 

Skin Health / Vitamin C

 

Highly stable Vitamin C serums; non-prescription

 

Antioxidant protection, fine lines, wrinkles, hyperpigmentation

 

2005 (1)

ELASTIderm™ System

 

Skin Health / Skin laxity

 

System of skin health products built around a novel formulation of a mineral complex; non-prescription

 

Increase elasticity and skin tone of eyes and face

 

2006

CLENZIderm M.D.™ System

 

Skin Health / Other

 

System for acne treatment built around a novel formulation of Benzoyl Peroxide, or BPO

 

Acne

 

2007

Tretinoin

 

Skin Health / Other

 

Generic equivalent of Retin-A available in the United States through an exclusive license

 

Acne

 

2002

Obagi Blue Peel System

 

Skin Health / Other

 

Topical system to aid in the application of TCA (trichloroacetic acid) chemical peels

 

Fine lines, wrinkles, hyperpigmentation

 

1988



(1)              Professional-C includes improved formulations and higher concentrations of vitamin C, and replaces our Cffectives and   Obagi-C brands that were first introduced in 2000.

Obagi Nu-Derm System

Our Obagi Nu-Derm System consists of a combination of six prescription and OTC drugs and adjunctive cosmetic skin care products to treat visible skin conditions such as photo damage and hyperpigmentation resulting from extrinsic damage and intrinsic changes to the skin. The Obagi Nu-Derm cosmetic skin care products include cleansers and exfoliating creams. Three of these products contain the drug hydroquinone in a 4% prescription concentration, which acts as a bleaching agent that is designed to correct skin pigmentation problems by normalizing the production of new melanin in the epidermis. Physicians also prescribe the drug tretinoin as part of the system, in various concentrations, depending on the physician’s judgment of patient need. We believe that the use of these prescription drugs, the ability of the drugs to penetrate the skin’s surface and the order of application distinguishes our Obagi Nu-Derm

System from other commonly prescribed regimens. While we have designed our Obagi Nu-Derm System to include products that patients can use in a systematic treatment regimen, we also make the component products available for individual sale. We believe that physicians who dispense the Obagi Nu-Derm System generally encourage their patients to use the component products together in a systematic treatment regimen. However, we also believe that some patients elect to use the products that make up the system individually. Products that are used individually at times include the sun screen products and Obagi Nu-Derm Clear, which physicians may dispense on occasion to address localized pigmentation problems. Side effects from use of the products may include redness, mild to moderate irritation and/or excessive flaking or sloughing of the outer layers of the treated skin. Side effects generally resolve after the first 10 days of use, or in cases with certain sensitive individuals, in a few days upon discontinuance of use.

In 2003, we sponsored a 301-subject, six-month, randomized, controlled, two-center, clinical use study that was independently designed and conducted by Thomas J. Stephens & Associates to compare the efficacy, side effects and tolerability of our Obagi Nu-Derm System with other commonly prescribed regimens of tretinoin, hydroquinone and OTC moisturizer. One of our minority stockholders assisted in the preparation of the study. Improvements in perioral (around the mouth) and periocular (around the eyes) fine wrinkles, facial mottled hyperpigmentation, clarity, sallowness, laxity (the appearance of loose, sagging and/or excess skin), and tactile roughness were measured. After 24 weeks of treatment, the mean changes observed with our Obagi Nu-Derm System were consistently larger than, and statistically superior to, the changes produced with the other treatment regimens. Of particular note were the changes in the perioral fine wrinkles, mottled pigmentation and laxity. While treatment with all regimens was generally well tolerated, there was a higher level of both objective and subjective irritation with the Obagi Nu-Derm System that largely resolved by the end of the study.

The Obagi Nu-Derm System accounted for over 68% of our consolidated net revenues in 2006. We sell our Obagi Nu-Derm System primarily as a single-price bundle of component products. Although volumes of sales for each individual product within the system varies, we believe the majority of our sales of each component product is due to the fact that they are sold as part of the system.

Clinical Study Support; Our products are designed to improve the underlying health of patients’ skin. Clinical studies conducted with our Obagi Nu-Derm System that we have sponsored have demonstrated that the use of our Obagi Nu-Derm System results in skin that looks and acts younger and healthier. Those studies include a randomized clinical study comparing four treatment groups over a 24-week period, involving 387 women with moderate photodamage assessments. The study was completed by 301 of the participating women. The study compared usage of Obagi Nu-Derm System (Group 1) versus other commonly prescribed therapies using tretinoin alone (Group 2) and hydroquinone alone (Group 3), as well as a leading facial moisturizer (Group 4). The mean changes observed in Group 1 (Obagi Nu-Derm System) were statistically significant and were consistently larger than, and statistically superior to, the changes produced with the other treatment groups, particularly with respect to perioral fine wrinkles, mottled hyperpigmentation, and laxity.

Mean values for clinical grading parameters at weeks one, two, 12, 18, and 24, and ultrasound measurements at weeks 12 and 24 were compared with mean baseline values. Changes from baseline were compared among the four test groups using analysis of variance with paired comparisons. P values less than or equal to 0.05 were considered statistically significant. Mean percent change from baseline and the incidence of improvement were calculated for all attributes at each time point. Silicone replicas taken at baseline and weeks 12 and 24 and 24-week biopsy samples were referred to reference laboratories.

Our clinical results provide objective and subjective support that our Obagi Nu-Derm System contributes to skin that looks and acts younger and healthier, in that the improvement in attributes related to skin tone, tissue content, skin laxity and wrinkling, are directly consistent with attributes found in comparatively younger skin.

Obagi-C Rx System

The Obagi-C Rx System consists of a combination of four prescription and OTC drugs and adjunctive cosmetic skin care products to treat skin conditions resulting from sun damage and the oxidative damage of free radicals. The central ingredients in the system are 4% hydroquinone, a prescription drug and Vitamin C. This combination distinguishes Obagi-C Rx from other Vitamin C based products available in the physician office. Two Obagi-C Rx System products contain this concentration of hydroquinone, which is designed to correct skin pigmentation problems by normalizing the production of new melanin in the epidermis. The Obagi-C Rx System includes cosmetic skin care cleansers and exfoliating lotions. When combined in a system, we believe hydroquinone, Vitamin C and a sunscreen provide correction of, and protection against, premature skin aging. As with the Obagi Nu-Derm System, the products that make up the Obagi-C Rx System are generally used together in a coordinated regimen by the majority of patients. Side effects from use of these products may include redness and/or mild to moderate irritation of the treated skin. Side effects generally resolve after the first 10 days of use, or in cases with certain sensitive individuals, in a few days upon discontinuance of use. We sponsored an in vitro study at the University of California, Irvine in September 2003 to evaluate the percutaneous absorption and bioavailability of our patented 10% Vitamin C and 4% hydroquinone combination product compared with the leading Vitamin C competitor, SkinCeuticals 20 Vitamin C. Our product demonstrated, with statistical significance, more Vitamin C in all layers of the skin than SkinCeuticals 20 Vitamin C serum.

Obagi Professional-C

The Obagi Professional-C products are a complete line of proprietary, non-prescription products, which consist of Vitamin C serums used to reduce the appearance of damage to the skin caused by ultraviolet radiation and other environmental influences. Vitamin C (L-ascorbic acid) acts as a potent antioxidant. The Obagi Professional-C line consists of a 5% serum for the area around the eyes and 10%, 15% and 20% serums for the face, neck and chest. Professional-C represents an expanded line that replaced our 5% and 10% Vitamin C serum offerings marketed under the Cffectives brand domestically, and Obagi-C brand internationally, as introduced in 2000. Obagi Professional-C products are sold individually and are used on their own, or in combination with other Obagi system products. These products are classified as cosmetics and side effects are not generally associated with their use, however certain sensitive individuals may experience mild irritation of the skin where product is applied. In addition, the product has been shown in studies we sponsored at the University of California, Irvine in September 2003 and July 2005 to penetrate all levels of skin better than SkinCeuticals 20 Vitamin C serum.

Obagi ELASTIderm™

Our ELASTIderm product line consists of products for the treatment of skin laxity featuring novel mineral complexes which may help the body’s own natural ability to increase epidermal thickness, augment hypodermal fat and increase elastin levels by supplying increased local concentrations of natural mineral actives to the relevant tissue, thereby improving the elasticity and skin tone around the eyes. We believe this is the first clinically proven skin health system to aid in the regeneration of elastin, which we believe is a new and novel topical application for anti-aging. An eight-week treatment, randomized, double-blind clinical study was conducted with 33 subjects to determine the efficacy of our novel under eye elastin regeneration product. The primary endpoints were appearance in under eye skin elasticity, fine line wrinkles and moisturization. The treatment improved the appearance of the under eye skin. We believe that a more rapid improvement in elasticity is essential to earning customer compliance and repurchase. Based on clinically significant improvements in measured collagen and elastin in skin treated over the eight week period, we launched a single nighttime eye cream product under the Obagi ELASTIderm brand name in mid-October 2006. In February 2007, we launched a daytime eye gel which is the second product under the Obagi ELASTIderm brand.

Tretinoin

Tretinoin creams and related adjunctive acne care products are used for the topical treatment of acne in the United States. Tretinoin, the active ingredient in the prescription acne drug Retin-A, is a Vitamin A derivative and has been the primary prescription acne therapy for approximately 25 years. Topical tretinoin normalizes the growth rate of skin cells, disrupting the onset of acne. We offer FDA-approved formulations of tretinoin through an exclusive license in the physician-dispensed channel. Our Tretinoin cream line is available in concentrations of 0.1%, 0.05% and 0.025%. These products are sold individually and are used by doctors as a single therapy, in combination with Obagi Nu-Derm, or in combination with other acne therapies including but not limited to salicylic acid and clindamyacin. Side effects include excessively red, edematous, blistered, or crusted skin for certain sensitive individuals. If these effects occur, the medication should either be discontinued until the integrity of the skin is restored, or the medication should be adjusted to a level the patient can tolerate. To date, generally adverse effects have been reversible upon discontinuation of therapy.

Obagi Blue Peel

Obagi Blue Peel is a topical system to aid in the application of TCA chemical peels used to smooth the surface of skin, improve skin tone and color, diminish wrinkles and shrink pore sizes. Chemical peels are an in-office procedure performed either by a physician or a member of a physician’s staff, depending on the skin depth of the peel. During the procedure, acidic solutions are combined in our delivery system and applied to the face to remove the thin surface layers of aged and damaged skin. After removal, the body will naturally replace the removed skin layers with new, healthy skin cells. The Obagi Blue Peel provides for an even application and slows the penetration of the solution into the skin, allowing physicians to more accurately monitor the peel. This produces a more uniform and consistent application, which reduces the risk of complications. We believe that the Obagi Blue Peel is especially effective as a complementary treatment to our Obagi Nu-Derm System. The Obagi Blue Peel products have no known side effects in and of themselves. Patients receiving blue peel products as part of an acid peel procedure can expect to experience side effects that are associated with such procedures.

Expanded applications for existing products

We believe that many of our products have applications in areas beyond their current uses. For example, we are conducting studies to evaluate the adjunctive use of our systems with commonly performed cosmetic procedures such as laser therapy, Botox injections and basal cell carcinoma excisions. In July 2006, we launched our Nu-Derm Condition and Enhance System, for use primarily with Botox injections.

Nu-Derm

Market opportunity.    According to the American Society of Plastic Surgeons, or ASPS, the number of minimally-invasive cosmetic office procedures performed increased 72% from approximately 4.9 million in 2002 to approximately 8.4 million in 2005. This increase was led by facial procedures such as Botox, up 242% in 2005 compared to 2002, and injectable fillers, which were first measured by ASPS in 2003, and increased 990% in 2005 compared to 2003.

Our Obagi Nu-Derm System restores skin to a healthier state and helps regulate skin cell functions and improve circulation. This improves the skin’s ability to constantly renew itself, repair damage, and act as an effective barrier. It also restores the skin to an active and tolerant state so that it responds better to the trauma of surgical procedures, heals faster and is less likely to exhibit an undesirable post-procedure response. Anecdotal evidence provided to us by clinicians who use our products suggests a decreased recovery period, improved rate of healing and reduction in post-inflammatory hyperpigmentation. Another proposed advantage of pre-treating patients undergoing laser resurfacing with our Obagi Nu-Derm System is that priming collagen might enhance the response to laser resurfacing, thereby improving cosmetic results. Further, our Obagi Nu-Derm System, when used as adjunctive therapy following Botox injections, has indicated the possibility of enhanced aesthetic outcomes and improved overall patient satisfaction as suggested to us anecdotally by several dermatologists and plastic surgeons and supported by our physician use study.

Clinical development.    In January 2006, we initiated a large, multi-center, physician use study targeted for over 5,000 patients. This study will broadly assess the outcomes and practice patterns of our Obagi Nu-Derm System used as an adjunct therapy to a wide variety of commonly performed cosmetic procedures. To date, we have received procedure evaluations on over 2,697 of the patients. The results indicate enhanced patient outcomes and are achieved with several commonly performed cosmetic procedures including Botox and facial laser resurfacing.

Product line

Description

Applications

Launch
date/target
launch date

Obagi Nu-Derm Condition and Enhance for Botox

 

Line extension of Nu-Derm System designed for use after soft tissue filler injections

 

Enhances outcomes for Botox and other injectible procedures

 

2006

Obagi Nu-Derm Condition and Enhance for Laser

 

Line extension of Nu-Derm System designed for use before and after cosmetic laser procedures

 

Enhances outcomes for cosmetic laser procedures

 

2007*

Obagi Nu-Derm Condition and Enhance for Basal Cell Carcinoma (BCC)

 

Line extension of Nu-Derm System designed for use before and after BCC excision and cutterage

 

Enhances outcomes for BCC treatment procedures

 

2008*



*                     These target launch dates are forecasted on the assumption that results of our clinical studies will be favorable, which may not be the case.

Obagi Nu-Derm Condition and Enhance for Botox

According to ASPS, there were approximately 3.8 million Botox injections performed in 2005. Botox is a non-surgical, physician administered cosmetic treatment that can temporarily reduce moderate to severe frown lines between eye brows (glabellar lines associated with corrugator and/or procerus muscle activity) for up to four months. In order to maintain the results, a patient needs to be injected every three to four months. We are planning to conduct a 12-week multi-center, randomized, single-blind, post-market study comparing the aesthetic outcome of the application of Botox alone to the application of Botox with post treatment with our Obagi Nu-Derm System. The primary endpoints will be additive improvements in perioral and periocular fine wrinkles, facial mottled hyperpigmentation, clarity, sallowness, laxity, tactile roughness and overall patient satisfaction. We anticipate initiating this study by mid-2007 for completion prior to 2007 year-end.

Obagi Nu-Derm Condition and Enhance for Laser

We are evaluating and sponsoring studies to evaluate the use of Obagi Nu-Derm products in aiding skin healing in skin peel procedures and ablative laser procedures, which are procedures using lasers that work primarily by removing the top layer of the skin, while the subsequent layer is heated. These initiatives are based on anecdotal evidence, supplied by physicians who are experienced with our Obagi Nu-Derm System, that indicates the possibility of improved recovery and healing time when our Obagi Nu-Derm System is used with ablative laser procedures. We also agreed to work jointly with Syneron Medical Ltd. to conduct physician site studies using our Nu-Derm Condition and Enhance Systems in conjunction with their el ō s technology. However, these evaluations and studies have not yet been completed, and there can be no assurance that the end results will be positive.

Obagi Nu-Derm Condition and Enhance for Basal Cell Carcinoma

According to the American Society for Dermatologic Surgery, approximately 1.7 million procedures to treat skin cancer were performed in the United States in 2005. Basal cell carcinoma is the most common skin cancer. Electrodessication and curettage is a commonly employed treatment in which superficial skin cancers are scraped with a curette followed by electrocautery of the site in three successive cycles. Electrodessication and curettage usually leaves a scar and hypopigmented, firm, and demarcated skin. We have initiated a multi-center, randomized, single-blind, controlled study comparing the efficacy of pre-treatment and post-treatment with our Obagi Nu-Derm System with a commonly prescribed regimen of gentle cleanser and emollient on skin healing. The primary endpoint will include an improvement in healing rates, less scar formation and less hypopigmented, firm, demarcated skin.

New Products and Product Lines

ELASTIderm™— Anti-Aging

Market opportunity.    Elastin is a protein found in the dermis which allows the skin to resume its normal shape after stretching. As skin ages, it loses its elasticity and begins to sag, particularly around the eyes, on the neck and on the hands. According to Kline & Co., in 2006, the eye, hand and neck skin care market in the spa and salon channel was estimated at over $170 million per year, comprised of products that are primarily designed to improve skin appearance through added moisturization, or building collagen in the skin. We conducted a soft-launch of an eye cream product under the Obagi ELASTIderm brand name in mid-October 2006, limited to our aesthetic sales force and targeted for existing accounts. In February 2007, we announced the formal launch of an ELASTIderm Eye Therapy system, including both the eye cream and a new eye gel product.

We are also evaluating the use of future ELASTIderm products on other areas of the body which may help the body’s own natural ability to increase epidermal thickness, augment hypodermal fat and increase elastin levels by supplying increased local concentrations of natural mineral actives to the relevant tissue, thereby improving the elasticity and skin tone. These areas may include the neck, hands, full face, arms and other areas of the body. However, there can be no assurance that additional products will be successfully developed in the future. The commercial acceptance of the recently introduced product cannot yet be determined, and there can be no assurance that additional products will be successfully developed in the future.

Clinical development.    An eight-week treatment, single blind clinical study was conducted with 33 subjects to determine the efficacy of our ELASTIderm product which contains a bi-mineral complex known as “copper zinc manonate.” The primary endpoints were appearance in under eye skin elasticity (Cutometer® Evaluation), fine line wrinkles (Skin Replica Analysis) and moisturization (Corneometer® Evaluation). Twice daily application of this novel bi-mineral complex resulted in significant improvements in elasticity in as early as week 2. Improvements in elasticity increased with each successive visit, with a

peak 46% improvement relative to baseline at week 9. P values in each week of the study ranged from .01 to .001, and were considered statistically significant.

A significant reduction in the number of coarse periorbital (skin around the eyes) wrinkles was also evident, in objective measurements of wrinkles using soft silicone impressions, which showed a maximal reduction of 16% (p ≤ 0.05) at week nine. Subjective feedback further showed a 214% increase, from baseline, in the number of subjects that considered their periorbital wrinkles to be not perceptible or mild to barely noticeable at week nine. Moreover, standardized digital photography demonstrated visible improvements in the appearance of periorbital fine lines and wrinkles in as little as two weeks. Our clinical results provide objective and subjective support that our novel bi-mineral complex was effective at improving photodamaged (sun damaged) periorbital skin elasticity and fine lines and wrinkles. Previously mentioned quantitative measurements of elasticity were supported by subjective feedback that demonstrated a 75% increase, from baseline, in the number of subjects that considered the lax/loose appearance of their periorbital skin to be non-existent or mild to barely noticeable at week nine.

CLENZIderm M.D.™— Acne

Market opportunity.    Acne is an inflammatory disease of the skin that results from a blockage of follicles or pores, as a consequence of accumulating dead skin cells and sebum, together which create a perfect medium for bacteria. The bacterium, P.acne, is a gram positive anaerobic bacterium that colonizes the sebaceous follicles and is implicated in the pathogenesis of acne. The prescription topical anti-acne market primarily includes BPO as a single active ingredient, or monotherapy product, BPO combination products (with antibiotics), topical retinoids, such as Retin-A, and topical antibiotics. Kalorama projects that the global market for prescription acne and rosacea drugs, including BPO, retinoids, and antibiotics, will increase 13% from $1.6 billion to $1.8 billion over the five years from 2005 to 2010.

Current formulations of BPO are emulsions, comprised of large, highly insoluble particles which do not pass easily into the skin follicle to treat the underlying causes of acne. As a result, the efficacy of existing formulations of currently marketed BPO products is limited. We have developed proprietary technologies that we believe will increase the ability of BPO to penetrate the epidermis and compromised sebaceous follicle.

Obagi CLENZIderm M.D.    We have developed a system of products for acne treatment featuring a novel formulation of BPO which our clinical studies show to penetrate more readily into the skin follicle than current creams or gels because it is in solution form (1/100th—1/1000th of the size of current particles). We believe that our solution-based acne system will be a more effective treatment for acne because a greater amount of the active ingredient, BPO, will penetrate the hair follicle to act on P.acne bacteria.

Clinical development.    We conducted several clinical studies that demonstrated that our novel BPO alone achieved greater intrafollicular and skin surface bactericidal activity (or kill) against P. acnes than both a prescription generic BPO formulation and a prescription BPO/antibiotic combination product. We also conducted a randomized, 2 week split face study to evaluate the efficacy of our acne therapeutic system,  with our novel 5% BPO serum gel and 2% Salicylic Acid toner, compared to BenzaClin®, a commercial prescription BPO/antibiotic combination product. The primary efficacy endpoint measured changes in inflammatory and non inflammatory lesions from baseline and at week 2. Our acne therapeutic system resulted in faster reduction in acne lesions than the BPO combination product, as demonstrated in week 1 results; 23% lesion reduction versus 12% reduction in inflammatory lesions and 13% reduction in non inflammatory lesions versus 5%. After 2 weeks of treatment, our acne therapeutic system had achieved a greater reduction in non-inflammatory lesions (34%) than the prescription BPO/Clindamycin combination (21%) and a comparable reduction in inflammatory lesions (52% and 50%, respectively). The

expert assessments showed that 81% of the subjects improved from moderate or severe acne categories to mild, almost clear or clear.

Additionally, we conducted a 3 week, full-face, single center, investigator blinded, randomized study with 41 subjects to evaluate the efficacy and tolerability of our CLENZIderm M.D. System with 3 different dosing regimens. All 3 dosing regimens showed statistically significant (P values less than .001) reductions in inflammatory and non-inflammatory lesion counts; 62%, 68%, 73% respectively at day 21 for inflammatory lesions and 47%, 54%, 56% for non inflammatory lesions. There was no statistical difference in lesion reduction between the 3 dosing regimens. All treatment regimens were well tolerated with mean levels of erythema, dryness, itching and irritation less than mild throughout the study.

We believe these studies show the efficacy of our novel BPO formulations in reducing P.acnes and clearing visible acne lesions on the skin. Additionally, in mid-November 2006, we conducted under the CLENZIderm M.D. brand name, a controlled experience trial with select dermatologists who currently prescribe the existing Obagi systems. Based on the results of that trial, we began a full commercial launch of the CLENZIderm M.D. anti-acne system in February 2007.

Areas of future growth

We believe that our Penetrating Therapeutics technology may be applicable in other skin health areas. We are currently screening therapeutic candidates in related fungal infections, dermatitis/seborrhea, hair growth and topical hair removal. According to Kalorama, in 2005 these therapeutic areas represented markets ranging from $500 million to over $2.8 billion in size.

Our product development strategy is to enhance the efficacy of established, widely prescribed, FDA-approved dermatology products (both prescription and OTC) by developing mechanisms that significantly enhance the penetration of these agents across the skin’s protective barrier into the deeper layers of the skin, where therapeutic benefits are realized. We describe this enabling technology as Penetrating Therapeutics, in which the individual chemical characteristics of both active and inactive agents are addressed and then combined in a systematic manner based on their pharmacokinetic properties.

We seek to demonstrate through clinical studies the improved efficacy of various topical agents when used as part of our systems. We are conducting and plan to initiate numerous clinical studies to demonstrate the advantages of our products in both blinded, randomized controlled studies and direct comparative studies. We will seek to conduct clinical studies that provide both clinically and statistically significant results. We will work with leading researchers and clinicians in their respective fields of applications and markets. We intend to use these results in marketing our products.

Sales and marketing

Domestic. We believe we are the market leader in the physician-dispensed skin care channel with a 27% share and nearly three times the market share of the next largest competitor, according to a 2006 study by Kline & Co. As of December 31, 2006, we had approximately 4,400 active accounts in the United States. Each account has at least one licensed physician on-site and we estimate that there are approximately 6,000 physicians in total practicing under these active accounts. This includes physicians on-site at a small but rapidly growing number of medical spas.

The U.S. market accounted for 82% of our net sales in 2006. In the United States, we focus our sales and marketing efforts primarily toward plastic surgeons, dermatologists and other physicians with an aesthetic skin care focus using our direct sales force. As of December 31, 2006, we had 109 sales, marketing and education specialists, including 96 dedicated sales representatives and managers. We believe that we have sufficient sales representation to enable us to effectively target the plastic surgeons, dermatologists and aesthetic skin care physicians who dispense skin care products in the United States. According to a 2006 Kline & Co. study, there were approximately 10,100 of these physicians in the United States.

In addition to effective systems, we also offer turn-key practice building programs and patient events that help the physicians grow their practices. These resources help each physician practice improve their recurring patient visits and revenue streams.

Our marketing efforts have a dual focus. First, we market directly to physicians in an attempt to both create treatment awareness and encourage the use of our products by both new and existing physician clients. To support this effort, we use medical journal advertising, direct mail, sales aids, video, CD and slide demonstrations, physician-to-physician speaker presentations, trade shows, reminder items, educational and training support, internet resources, and telemarketing. Second, we attempt to create and then build upon the relationships with our physician customers by marketing our products to their patients through their medical practices. To support this effort, we provide patient education booklets and videos, funding for cooperative advertising, training and direct assistance in patient seminars and other programs, continuous product education and direct to consumer advertising and public relations programs for patient referrals.

In addition, our research and development staff is designing and coordinating clinical studies to support the application of our existing product lines in new markets and to enhance our current marketing efforts. We have conducted numerous studies with the Department of Dermatology at the University of California, Irvine and Education and Research Foundation, Lynchburg, VA. In addition, we are currently in discussions with leading dermatologists associated with numerous reputable institutions, to coordinate additional clinical studies for new product applications and formulations. We believe evidence from our clinical studies may validate the performance of our existing products and provide a platform for the development of new products and product applications.

International. International markets accounted for 18% of net sales in 2006. We address international markets through 12 international distribution partners that have sales and marketing activities in approximately 35 countries outside of the United States, and two trademark and know-how license agreements for the drug store and aesthetic spa channel of Japan. We target distribution partners who are capable and willing to mirror our sales and distribution model in the United States and who have an established business and reputation in the physician channel. Much like our business model in the United States, these distributors address their territories through direct sales representatives selling to physicians, or through alternative distribution channels, depending on regulatory requirements and industry practices. The sale of skin health and restoration products through physician offices is not as widely established internationally as it is in the United States. For example, some of our more successful international distribution partners include our partners in the Southeast Asia, the Middle East and the Philippines. In these territories, our partners utilize Obagi-branded medical centers to employ trained physicians for patient sales, as well as a training center to provide product and sales training to regional physicians and their staff. Separately, some of our distribution partners, such as our partners for Mexico and Canada, leverage their existing complimentary product offerings to gain rapid account penetration for Obagi Systems in their territories. International sales are diversified, and our largest individual medical channel distribution partner purchased approximately $2.4 million from us during 2006.

We intend to continue expanding our international presence by entering into strategic relationships in key locations such as Asia, Europe and South America. We believe that there is potential for significant sales growth of our products in international markets due to cultural emphasis on overall skin health and appearance and the continued development and acceptance of surgical and non-surgical cosmetic procedures throughout many countries of the world.

Licensing. Where the physician-dispensed channel is underdeveloped we will look for alternative models to build a presence and brand awareness for our products. For example, in Japan we have pursued three separate distribution channels for our brand and product concepts. In 2002, we launched our first formal long-term relationship in Japan by entering into a 10-year trademark and know-how license

agreement with Rohto to market and sell our Obagi-developed products in Japan. Rohto is a Japanese pharmaceutical manufacturer and distributor. Under our agreement, Rohto is licensed to manufacture and sell a series of OTC products under the Obagi brand name, including Obagi-C (a vitamin C based topical serum in various concentrations) in the Japanese drug store channel. Rohto’s Obagi branded products achieved retail annual sales of over $57 million in 2006 through approximately 5,000 high-end drug stores. We have additional licensing arrangements in Japan as well to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit. Separately, in early 2004, we entered into a distribution agreement with Koken Ltd., granting Koken exclusive rights to distribute certain prescription based Obagi Systems in the physician-dispensed channel. Our strategic partners in Japan have engaged in aggressive direct to consumer advertising, which we believe has raised consumer demand in Japan which creates greater brand awareness in the physician channel to the benefit of our core prescription lines. In 2006, these separate distribution channels in Japan generated approximately $4.1 million in net sales for us.

We will continue to look for credible partners to address new geographies, and to evaluate mass market channel opportunities in countries where it make sense in order to drive brand awareness and more rapid overall market penetration.

Manufacturing

We believe our manufacturing processes are a competitive advantage, which we have developed through years of experience formulating skin care products. We maintain manufacturing scalability and flexibility by maintaining manufacturing with five qualified contract manufacturers. For all of our proprietary product concepts, we also own the related manufacturing processes, methods and formulations. In the fourth quarter of 2005, we invested in our own manufacturing facility in order to develop the ability to manage and protect the manufacturing process with respect to certain of our new product pipeline concepts. Currently, we plan to use this facility solely for the purpose of smaller scale product manufacturing in connection with new product technologies and smaller market introduction quantities. This facility will allow us to protect intellectual property related to our products in the initial stages unless and until we believe we can transfer such know-how to third-party manufacturers with full protection of related intellectual property.

We use only FDA compliant manufacturers who specialize in the manufacture of prescription and OTC pharmaceutical and/or cosmetic products. These parties manufacture products pursuant to our specifications. All of these manufacturers are required by law and by our manufacturing standards to comply with current Good Manufacturing Practice, or cGMP. We pre-qualify and continually monitor our manufacturers for quality and compliance. We also require documentation of compliance and quality from those manufacturers that we act as representative for in connection with the promotion and sale of their products. For most of our key products, we have two or more qualified manufacturers. Certain products, including some of our sun protection products, are supplied by a single source. We have one supplier for our Healthy Skin Protection and Sun Block sunscreen products. That supply arrangement can be terminated at any time, and there is no guarantee that we could replace the aesthetic qualities or exact formulation of those sun screen products.

In addition, while physicians can and in many cases do write a prescription for tretinoin to be fulfilled by a pharmacy in conjunction with our Obagi Nu-Derm System, we also purchase tretinoin directly from Triax Pharmaceuticals, LLC in order to provide physicians the option of dispensing tretinoin directly from the office along with the Obagi products. These products are currently purchased under a five-year product supply agreement, entered into in December 2005, which also provides Obagi with the right to develop Obagi branded product offerings.

Intellectual property

Our success depends in part on our ability to obtain and maintain proprietary protection for our product candidates, technology and know-how, to operate without infringing the proprietary rights of others and to prevent others from infringing our proprietary rights. Our policy is to seek to protect our proprietary position by, among other methods, filing United States and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. We also rely on trade secrets, know-how, continuing technological innovation and in-licensing opportunities to develop and maintain our proprietary position.

We have pursued an aggressive trademark registration policy as a means to achieve brand recognition and product differentiation in the market. We own various U.S. and foreign trademark registrations and applications and common law marks. In connection with developing new products and product applications, we have filed more than 37 U.S. provisional and non-provisional patent applications. We do not own any issued patents with claims covering any of our Obagi Nu-Derm products.

We have also licensed certain patent applications owned by JR Chem LLC. We have relied on services provided by JR Chem LLC in the development of new products to address acne and skin elasticity products, under a five-year contract. We also have licensed the rights to four patents owned by Avon Products, Inc., one of which expires in 2008 while the remaining three expire between 2013 and 2018, covering methods and formulations for stabilizing Vitamin C in a serum for facial skin benefits, which is in our Obagi-C Rx C-Clarifying serum, Professional-C 5% serum and Professional-C 10% serum. We entered into the license in June 2003, for an initial three-year term, and the license is renewed year to year thereafter, at our option, through the life of the last patent to expire.

We have acquired rights to market, distribute, sell and, in some cases, make products pursuant to license agreements with third parties. Such agreements contain provisions which require us to meet requirements under these agreements, such as payment or royalty obligations, in order to maintain the rights granted under the agreements.

Below is a table that includes the patents we license that are material to our business as of December 31, 2006:

Patent title

Country in which
patent is issued

Licensor

Expiration date of
patent/license

Cosmetic Preparation Incorporating Stabilized Ascorbic Acid

 

United States

 

Avon

 

January 8, 2008

Use of Ascorbic Acid to Reduce Irritation of Topically Applied Active Ingredients

 

United States

 

Avon

 

May 14, 2013

Ascorbic Acid Compositions for Reducing Irritation of Topically Applied Active Ingredients

 

United States

 

Avon

 

April 26, 2013

Stable Ascorbic Acid Preparation for Topical Use

 

United States

 

Avon

 

September 10, 2018



Certain Material Agreements

Triax Pharmaceuticals

Under a product supply agreement with Triax Pharmaceuticals, LLC, or Triax, entered into on December 8, 2005, we have exclusive rights to sell certain tretinoin products in 0.1%, 0.05% and 0.025% concentrations in the physician-dispensed channel in the United States (including all territories of the United States). If  we do not purchase a minimum of 100,000 units of products each year in any combination of concentrations, we will lose our exclusive selling rights in the United States. During the year ended December 31, 2006, we met the minimum purchase requirements. Under the terms of the

agreement, we are required to pay Triax Pharmaceuticals a fixed price for the products, subject to volume discounts we may receive if we purchase a certain number of products and those products are sold to our customers within 90 days. These volume discounts are based on calendar year performance and applied to cumulative quarterly purchases. The initial term of our agreement is five years, with an automatic renewal for a successive five year term unless written notice is provided by either party at least 120 days before the end of the current term. Each party has the right to terminate the agreement upon 30 days’ prior written notice in the case of material breach and failure to take action to cure such a breach within such 30 day period. Each party also has the option to terminate the agreement by written notice if the other party ceases to carry on its business or becomes the subject of any proceeding under state or federal law for the relief of debtors or otherwise becomes insolvent, bankrupt or makes an assignment for the benefit of creditors, or upon the appointment of a receiver for the other party or the reorganization of the other party for the benefit of creditors.

Jose Ramirez and JR Chem

Pursuant to a consultant services and confidentiality agreement with Jose Ramirez and JR Chem LLC, or JR, we have hired JR to perform research and development activities including product formulation, product development and regulatory work, as detailed in various statements of work. Under the terms of the agreement, JR must assign or license to us all rights, title and interests to any and all inventions made during JR’s engagement with us or during the one year period thereafter if such inventions involve or are related to our actual or anticipated research or development, or incorporate or are based on any of our confidential information or ideas. We agreed to pay JR a minimum fee of $100,000 per year for five years plus reasonable and customary expenses incurred at our request in connection with the provision of such services, commencing on January 1, 2005, for this product formulation, product development and regulatory work. We also agreed to pay a tiered royalty for successful commercialization of products developed or identified by JR based on annual net sales, with a maximum royalty paid per product, capped at $5.0 million per year. The tiered royalty payable for each new product will be 3% on annual net sales from $0 to $50 million; 4% on annual net sales from $50 million to $75 million; and 5% on annual net sales above $75 million.

We have a right of first refusal for the exclusive license of any and all of JR’s inventions related to skin healthcare that are developed or reduced to practice by JR during the term of the agreement, but not in connection with certain service activities documented in the agreement or certain various statements of work, that are not assignable to us under the terms of the agreement. We would pay a royalty fee for any such exclusive licenses.

The initial term of the agreement is five years, starting in the beginning of 2005, and may be extended for up to two, one-year renewable terms with the mutual written agreement of each party within 60 days prior to the expiration of the then-current term. We have the right to terminate the agreement at any time in our sole discretion with 30 days’ notice by exercising an option to buy-out JR’s remaining service obligation for the then-current term. In our sole discretion, we may pay for the buy-out option with our stock or a combination of stock and cash at a fair market valuation. We have the right to terminate the agreement, without triggering the buy-out option, upon 30 days’ notice for any violation by JR of this agreement, unless JR is able to cure such violation within such 30 day period. We also have the right to immediately terminate the agreement, without triggering the buy-out option, if JR is convicted of a felony or other crime involving material harm to our standing or reputation, for JR’s nonfeasance or willful misconduct, for conduct that brings us into public disgrace or disrepute, or for continuous inattentiveness to JR’s duties after written notice of the same. If we exercise our right to terminate the agreement, all of our obligations to JR, except for royalty obligations, shall cease immediately.

To date, pursuant to this agreement, we have licensed six pending patent applications that cover novel methods and formulations for the treatment of acne, which we plan on using as the basis for our new acne

system to be marketed under the CLENZIderm M.D.™ brand, including the first product launched in February 2007. We have also licensed three pending patent applications dealing with composition of matter, wound healing and method of anti-aging treatment, which we plan on using as the basis for our new ELASTIderm™ System, including the first product launched in October 2006 and the second product launched in February 2007.

Avon

Under a license agreement with Avon Products, Inc., dated June 26, 2003, we have an exclusive worldwide license to manufacture and sell skin care products containing an ascorbic acid component directly to physicians and medical spas. Under the terms of the agreement, we also have a non-exclusive license to manufacture and sell such products directly to drug stores outside of the United States. We have agreed to pay Avon a non-refundable license issue fee of $400,000, payable in three installments. Additionally, we pay a non-refundable annual renewal fee of $100,000. We have the option to renew the agreement annually until the last of the licensed patents expires on September 10, 2018. Each party, at its option, may terminate the agreement upon 45 days’ prior written notice in the case of default in the performance of any obligation under the agreement by the other party and failure to take action to cure such a default within such 45 day period. If we become bankrupt or insolvent, or file a petition for bankruptcy, or if our business is placed in the hands of a receiver, assignee or trustee from which we cannot extract ourselves within 120 days, or if we are liquidated or substantially all of our assets or shares are sold, exchanged or transferred, or in the event of a merger or consolidation to which we are a party and to which Avon reasonably objects, the agreement shall immediately terminate without notice.

Competition

The market for skin health and restoration is highly competitive with many established manufacturers, suppliers and distributors engaged in all phases of the business. We believe that we face strong competition. Competitive factors in our market include:

·        product efficacy and uniqueness;

·        brand awareness and recognition;

·        product quality, reliability of performance and convenience of use;

·        cost-effectiveness;

·        breadth of product offerings;

·        sales and marketing capabilities and methods of distribution;

·        resources devoted to product education and technical support; and

·        speed of introducing new competitive products and existing product upgrades.

We face and will continue to face intense competition. A number of our competitors have greater research and development and marketing capabilities and greater financial resources than we do. These competitors may have developed, or could in the future develop, new technologies that compete with our products or render our products obsolete. We are also likely to encounter increased competition as we enter new markets and as we attempt to further penetrate existing markets. Some of our competitors have in the past and may in the future compete by lowering prices on their products. We may respond by lowering our prices, exiting the market or competing by investing in the development of new, improved products.

We believe our direct competitors in the physician-dispensed channel include BioMedic from La-Roche Posay, TNS from Skin Medica, Inc., Kinerase from Valeant Pharmaceuticals International, various

products from SkinCeuticals, a division of L’Oreal S.A., M.D. Forté and PREVAGE from Allergan, Inc., Vitamin C and various products from IS Clinical, and Neova from PhotoMedex, Inc.

We believe our indirect competitors which generally sell skin care products directly to consumers consist of large cosmetic companies, including but not limited to The Estee Lauder Companies Inc., Helene Curtis Industries, Inc., L’Oreal S.A., Matrix Essentials, Inc., a division of L’Oreal, Procter & Gamble Company, Neutrogena, a division of Johnson & Johnson, Revlon, Inc. and Unilever N.V. Other companies use medical devices to treat facial aesthetics.

Our acne product will compete with Triaz from Medicis Pharmaceutical Corporation, Benzaclin from Dermik Laboratories, Inc., Brevoxyl and Duac from Stiefel Laboratories Inc., Benzac® from Galderma Laboratories, L.P. and ZoDerm from Bradley Pharmaceuticals, Inc. Our acne product will also indirectly compete with OTC anti-acne products.

Our elasticity system has demonstrated clinical evidence of aiding the restoration of elasticity and mature elastin in aged skin. We currently know of no products which have clinical evidence to support this claim. However, there are several products which claim to enhance elastin.

Our products also compete with current and future medical devices, such as lasers, which are or will be positioned for a variety of skin enhancements such as facial rejuvenation, dermal thickening, acne and other uses. However, we believe our Obagi Systems are complementary to many of these procedures.

Government regulation

Federal, state and local governmental authorities in the United States and other countries regulate, among other things, the testing, production, distribution and sale of prescription and over-the-counter drugs and cosmetics. In the United States, the FDA, acting under the FDCA and other federal statutes and Agency implementing regulations, regulates products primarily on the basis of their intended use, as determined by the labeling claims made for the product.

FDA regulation of cosmetics

The FDCA defines cosmetics as products and their components intended to be rubbed, poured, sprinkled, or sprayed on, introduced into, or otherwise applied to the human body or any part thereof for cleansing, beautifying, promoting attractiveness, or altering the appearance. Cosmetic products are not subject to FDA pre-market approval authority, although the FDA can take enforcement action for marketed cosmetic products that are adulterated or misbranded, including violations of product safety requirements, use and quantity of ingredients, labeling and promotion and methods of manufacture. Additionally, the FDA monitors compliance of cosmetic products through random inspections of cosmetic manufacturers and distributors. The labeling of cosmetic products is subject to the requirements of the FDCA, the Fair Packaging and Labeling Act and other FDA regulations.

We believe that many of our products in the Obagi Nu-Derm, Obagi-C Rx, Obagi Professional-C, ELASTIderm™, CLENZIderm M.D.™ and other product lines, as labeled and intended for use, fall within the FDA definition of cosmetics and therefore do not require pre-market review and approval. Cosmetics may be sold both over the counter and through a physician’s office, subject to state laws governing the commercial practices of physicians.

FDA regulation of drug products

The FDCA defines drugs as products intended to cure, mitigate, treat or prevent a disease or to affect the structure or any function of the human body. Drug products are subject to more comprehensive safety and effectiveness requirements of the FDCA and its implementing regulations. In general, products falling within the FDCA’s definition of “new drugs” require pre-marketing clearance by the FDA. Products falling within the FDCA’s definition of “drugs” that are not “new drugs” and that are generally recognized as

“safe and effective” for the indication for which they are being marketed generally do not require pre-market review and approval from the FDA. Such drug products are commonly commercialized under the FDA Compliance Policy Guide entitled Marketed New Drugs Without Approved New Drug Applications or Abbreviated New Drug Applications and are subject to compliance with FDA regulations concerning manufacture, labeling, distribution, and recordkeeping for drug products.

We market a number of sunscreen products that are regulated by the FDA as OTC drug products subject to an FDA final monograph but not requiring FDA pre-market review or approval. We also market a number of products containing 4% hydroquinone that we believe are not “new drug” products and that are generally recognized as safe and effective for the indications for which they are being marketed. We also market a number of products containing 4% hydroquinone that are currently not subject to FDA pre-market approval. In August 2006, the FDA issued a proposed rule that stated that OTC skin bleaching products containing hydroquinone and currently marketed outside the physician channel at 2% concentrations or less, were not generally recognized as safe and effective, were misbranded, and are new drugs within the meaning of the FDCA. The FDA proposed that because of the carcinogenic and ochronosis potential of hydroquinone, its use in skin bleaching drug products should be restricted to prescription use only, and users of such products should be closely monitored under medical supervision. The FDA also withdrew a tentative proposed monograph that concluded that hydroquinone products were generally recognized as safe and effective and stated its intent to require New Drug Application approval for continued marketing of prescription hydroquinone products at the time of publication of the final rule. The FDA is presently reviewing public comments received in response to the August 2006 Proposed Rule. Finally, our tretinoin prescription drug product offerings are licensed from and supplied by Triax Pharmaceuticals, LLC, which, through Spear Pharma, holds FDA approval of Abbreviated New Drug Applications, or ANDAs, for those products.

FDA regulation of “new drug” products

The steps required before a “new drug” may be marketed in the United States include (i) pre-clinical laboratory and animal testing, (ii) submission to the FDA of an Investigational New Drug, or IND, application which must become effective before clinical trials may commence, (iii) adequate and well-controlled clinical trials to establish the safety and efficacy of the drug, (iv) submission to the FDA of a New Drug Application, or NDA, and (v) FDA approval of the NDA prior to any commercial sale or shipment of the drug. An Abbreviated New Drug Application, or ANDA, is required to be submitted and approved when the drug product intended for commercialization is bioequivalent to an already approved NDA product; an ANDA application does not need to repeat the clinical trials that were required for approval of the NDA, or reference listed drug. In addition to obtaining FDA approval for each product, each domestic drug-manufacturing establishment must be registered with the FDA. Drug product manufacturing establishments located in California also must be licensed by the State of California in compliance with separate regulatory requirements.

Pre-clinical testing is generally conducted on laboratory animals to evaluate the potential safety and the efficacy of a drug. The results of these studies are submitted to the FDA as a part of an IND, which must be approved before clinical trials in humans can begin. Typically, clinical evaluation involves a time consuming and costly three-phase process. In Phase I, clinical trials are conducted with a small number of subjects to determine the early safety profile, the pattern of drug distribution and metabolism. In Phase II, clinical trials are conducted with groups of patients afflicted with a specific disease to determine preliminary efficacy, optimal dosages and expanded evidence of safety. In Phase III, large-scale, multi-center, comparative trials are conducted with patients afflicted with a target disease to provide sufficient data to demonstrate the efficacy and safety required by the FDA. The FDA closely monitors the progress of each of the three phases of clinical trials and may, at its discretion, re-evaluate, alter, suspend or terminate the testing based upon the data that have been accumulated to that point and its assessment of the risk/benefit ratio to the patient.

The OTC monograph system

While FDA approval is generally required before a new drug product may be marketed in the U.S., many OTC drugs are exempt from the FDA’s pre-marketing approval requirements. In 1972, the FDA instituted the ongoing OTC Drug Review to evaluate the safety and effectiveness of OTC drug ingredients in the market. Through this process, the FDA issues monographs for therapeutic product categories that set forth the specific active ingredients, dosages, strengths, indications for use, warnings and labeling statements for OTC drug ingredients that the FDA will consider generally recognized as safe and effective for OTC use and therefore not subject to pre-market approval.

OTC drug ingredients are classified by the FDA in one of three categories: Category I ingredients which are deemed generally recognized as “safe and effective and not misbranded” for OTC use; Category II ingredients which are deemed “not generally recognized as safe and effective or would result in misbranding” for OTC use; and Category III ingredients which are those for which “available data is insufficient” to classify them in Category I or II. Based upon the results of ongoing studies, the FDA may reclassify all Category III ingredients as Category I or Category II ingredients.

For most categories of OTC drugs not yet subject to a final monograph, the FDA usually permits such drugs to continue to be marketed until a final monograph becomes effective, unless the drug will pose a potential health hazard to consumers. The FDA’s policy also generally applies to prescription drugs containing the same active ingredients as a marketed OTC product for the same or similar uses as the OTC product.

Drugs subject to final monographs, as well as drugs that are subject only to proposed monographs, are subject to various FDA regulations concerning, for example, manufacturing in accordance with cGMPs, general and specific labeling requirements and prohibitions against promotion for conditions other than those stated in the labeling. Drug manufacturing facilities are subject to FDA inspection, and failure to comply with applicable regulatory requirements may lead to administrative or judicially imposed penalties.

The active ingredient in Tolereen, hydrocortisone, the active ingredient in Bacitracin, bacitracin zinc and the active ingredient in Sunblock, zinc oxide, are currently classified by the FDA as Category I ingredients. We currently market these products and must do so in accordance with FDA’s final monographs for their respective therapeutic categories.

FDA enforcement discretion for marketed unapproved drug products

The Obagi Nu-Derm Clear, Blender and Sunfader products and the Obagi-C Rx C-Clarifying Serum and C-Night Therapy products contain the active ingredient hydroquinone at a 4% concentration and are marketed as prescription drugs under the FDA Compliance Policy Guide, or CPG, entitled Marketed New Drugs Without Approved New Drug Applications or Abbreviated New Drug Applications. These hydroquinone products must be administered under the supervision of a physician but are not subject to prior FDA approval when formulated and labeled in accordance with guidelines for prescriber information under direction of a physician. 4% Hydroquinone is known as a DESI II drug, as its active ingredient was marketed prior to FDA’s 1962 institution of drug effectiveness requirements. To date, the FDA has not required NDA approval for the continued marketing of hydroquinone. In its August 2006 proposed rule, regarding OTC hydroquinone, the FDA indicated its intent to require NDA approval for prescription 4% hydroquinone products. See risks related to regulatory matters beginning on page 17, and FDA regulation of drug products on page 94. If the FDA does change the status of 4% hydroquinone to require an NDE, and if the FDA does not grant us time comply with such new requirement as imposed, or if the FDA does not approve an NDA filed by us or a third party for 4% hydroquinone drug product, then we will no longer be able to rely on the CPG to market our Obagi Nu-Derm and Obagi-C Rx Systems containing hydroquinone. FDA approval of a 4% hydroquinone drug product under an NDA may adversely affect our ability to continue to market our products under the CPG.

FDA regulation of drug manufacturing

We and the third-party manufacturers on which we rely for the manufacture of our products are subject to requirements that drugs be manufactured, packaged and labeled in conformity with cGMPs. To comply with cGMPs, manufacturers must continue to spend time, money and effort to meet requirements relating to personnel, facilities, equipment, production and process, labeling and packaging, quality control, recordkeeping and other requirements. The FDA periodically inspects drug manufacturing facilities to evaluate compliance with cGMPs.

FDA Regulation of Our Products and Product Candidates

The following table summarizes the current status of the active ingredients in, FDA pre-marketing approval (if any) required for, FDA regulatory category of, and launch date or expected launch date for our material products and product candidates:

Product

Main Functioning or Active
Ingredients(1)

FDA
Pre-Marketing
Approval
Required

Product
Status(1)

Date
Launched
/Expected
Launch Date

Obagi Nu-Derm Gentle Cleanser

 

Mild Cleansers

 

 

No

 

 

Cosmetic

 

1988

Obagi Nu-Derm Foaming Gel

 

Mild Cleansers

 

 

No

 

 

Cosmetic

 

1988

Obagi Nu-Derm Toner

 

Hamamelis Virginiana (Witch Hazel) Distillate

 

 

No

 

 

Cosmetic

 

1988

Obagi Nu-Derm Clear

 

Hydroquinone 4%

 

 

No

 

 

DESI II

 

1988

Obagi Nu-Derm Exfoderm

 

Phytic Acid

 

 

No

 

 

OTC

 

1988

Obagi Nu-Derm Exfoderm Forte

 

Glycolic Acid, Lactic Acid

 

 

No

 

 

Cosmetic

 

1988

Obagi Nu-Derm Blender

 

Hydroquinone 4%

 

 

No

 

 

DESI II

 

1988

Obagi Nu-Derm Sun Block SPF 32

 

zinc oxide 18.5%

 

 

No

 

 

OTC

 

2004

Obagi Nu-Derm HSP SPF 35

 

Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%;

 

 

No

 

 

OTC

 

2002

Obagi Nu-Derm Sunfader

 

Hydroquinone 4% Octyl Methoxycinnamate 7.5%, Oxybenzone 5.5%

 

 

No

 

 

DESI II

 

1984

Obagi Nu-Derm Eye Cream

 

Mild Moisturizers

 

 

No

 

 

Cosmetic

 

1984

Obagi-C Rx C-Cleansing Gel

 

Mild Cleansers

 

 

No

 

 

Cosmetic

 

2004

Obagi-C Rx C-Exfoliating Day Lotion

 

Glycolic Acid

 

 

No

 

 

OTC

 

2004

Obagi-C Rx C-Clarifying Serum

 

Hydroquinone 4%

 

 

No

 

 

DESI II

 

2004

Obagi-C Rx C-Therapy Night Cream

 

Hydroquinone 4%

 

 

No

 

 

DESI II

 

2004

Obagi-C Rx C-Sungaurd SPF 30

 

Octyl Methoxycinnamate 7.5%, Zinc Oxide 9.0%

 

 

No

 

 

OTC

 

2004

Obagi Professional-C Serum

 

L Ascorbic Acid (Vitamin C) 5% to 20% concentrations

 

 

No

 

 

Cosmetic

 

2005

Obagi Nu-Derm Tretinoin

 

Tretinoin 0.025% to 0.1%

 

 

Yes

 

 

ANDA

 

2006(3)

Obagi CLENZIderm M.D. Daily Care Foaming Cleanser

 

Salicylic Acid 2%

 

 

No

 

 

OTC

 

February 2007

Obagi CLENZIderm M.D. Pore Therapy

 

Salicylic Acid 2%

 

 

No

 

 

OTC

 

February 2007

Obagi CLENZIderm M.D. Serum Gel

 

Benzoyl Peroxide 5%

 

 

No

 

 

OTC

 

February 2007

Obagi ELASTIderm Eye Cream

 

Mineral complexes

 

 

No

 

 

Cosmetic

 

2006

Obagi ELASTIderm Eye Gel

 

Mineral complexes

 

 

No

 

 

Cosmetic

 

February 2007



(1)              By definition, products classified as cosmetics do not have active ingredients. For cosmetics, the main functioning ingredient is listed.

(2)              Product Status Definitions:

OTC, or Over-the-Counter, products are defined as products that are considered drugs by the FDA, but that do not require physician prescription or oversight.

DESI II products are defined as products that are considered drugs that require physician prescription, but are not subject to FDA pre-marketing approval as they are generally recognized as safe and effective for their intended uses and are commercialized under an FDA Compliance Policy Guide for marketed unapproved drugs, which includes Drug Efficacy Study Indication, or DESI drugs. ANDA products are defined as drugs that have received FDA approval under an abbreviated new drug application; our only ANDA product requires physician prescription.

Cosmetic products are defined as products which are not considered drugs by the FDA, are not allowed to make drug claims, and do not require FDA pre-marketing approval or physician prescription or oversight.

(3)              Obagi Nu-Derm Tretinoin is manufactured by Triax Pharmaceuticals, and was launched under the Obagi brand in 2006, however, we have been selling tretinoin supplied by Triax Pharmaceuticals under the Spear brand since 2003.

Federal regulation of advertising and promotion

The FDA regulates the advertisement of prescription drug products. The U.S. Federal Trade Commission, or FTC, and state authorities regulate the advertising of OTC drugs and cosmetics, as well as exercise general authority to prevent unfair or deceptive trade practices.

In addition to FDA restrictions on marketing of prescription products, several other types of state and federal laws have been applied to restrict certain marketing practices in the pharmaceutical industry in recent years. These laws include anti-kickback statutes and false claims statutes. The federal healthcare program anti-kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under Medicare, Medicaid or other federally financed healthcare programs. This statute has been interpreted to apply to arrangements between pharmaceutical manufacturers on the one hand and prescribers, purchasers and formulary managers on the other. Violations of the anti-kickback statute are punishable by imprisonment, criminal fines, civil monetary penalties and exclusion from participation in federal healthcare programs. Although there are a number of statutory exemptions and regulatory safe harbors protecting certain common activities from prosecution or other regulatory sanctions, the exemptions and safe harbors are drawn narrowly, and practices that involve remuneration intended to induce prescribing, purchases or recommendations may be subject to scrutiny if they do not qualify for an exemption or safe harbor.

Federal false claims laws prohibit any person from knowingly presenting, or causing to be presented, a false claim for payment to the federal government, or knowingly making, or causing to be made, a false statement to have a false claim paid. Recently, several pharmaceutical and other healthcare companies have been prosecuted under these laws for allegedly inflating drug prices they report to pricing services, which in turn are used by the government to set Medicare and Medicaid reimbursement rates, and for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product. In addition, certain marketing practices, including off-label promotion, may also violate false claims laws. The majority of states also have statutes or regulations similar to the federal anti-kickback law and false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payer.

Also, as part of the sales and marketing process, pharmaceutical companies frequently provide samples of approved drugs to physicians. This practice is overseen by the FDA and other governmental authorities under the Prescription Drug Marketing Act and regulations that include requirements concerning record keeping and control procedures.

Certain states, including California, have also recently begun regulating the promotion of prescription drug products and require compliance with annual certification and disclosure requirements regarding our policies for drug promotion and the amount of money we spend per prescribing physician on drug promotion. Compliance with changing federal and state laws and regulations on prescription product promotion requires a great deal of time and effort.

Other government regulation

We and our suppliers or third-party manufacturers may also be subject to regulations under other federal, state, and local laws, including the Occupational Safety and Health Act, the Environmental Protection Act, the Clean Air Act and import, export and customs regulations as well as the laws and regulations of other countries.

Employees

As of December 31, 2006, we had 153 employees, all of whom were located in the United States. Our employees include 109 in sales and marketing, 19 in product development, manufacturing and distribution and 25 in administrative functions. Our employees are all non-unionized, and we believe our relations with our employees are good.

ITEM 1A:        RISK FACTORS

An investment in our common stock involves a high degree of risk. You should consider carefully the following risks and other information contained in this Annual Report on Form 10-K before you decide whether to buy our common stock. If any of the events contemplated by the following discussion of risks should occur, our business, results of operations and financial condition could suffer significantly. As a result, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock.

Risks related to our business

Our revenues and financial results depend significantly on sales of our Obagi Nu-Derm System. If we are unable to manufacture or sell our Obagi Nu-Derm System in sufficient quantities and in a timely manner, or maintain physician and/or patient acceptance of our Obagi Nu-Derm System, our business will be materially and adversely impacted.

To date, substantially all of our revenues have resulted from sales of our principal product line, our Obagi Nu-Derm System and related products. Our Obagi Nu-Derm System and related products accounted for approximately 72%, 72% and 68% of our net sales for the year ended December 31, 2004, 2005 and  2006, respectively. Although we have introduced new products such as Obagi-C Rx, and intend to introduce additional products, we expect sales of our Obagi Nu-Derm System and related products to account for a significant majority of our sales for the foreseeable future. Because our business is highly dependent on our Obagi Nu-Derm System and related products, factors adversely affecting the pricing of, or demand for, these products could have a material and adverse effect on our business. Additionally, our commercial success depends in large part on our ability to sustain market acceptance of our Obagi Nu-Derm System. If existing users of our products determine that our products do not satisfy their requirements, or if our competitors develop a product that is perceived by patients or physicians to better satisfy their respective requirements, sales of our Obagi Nu-Derm System and related products may decline, and our total net sales may correspondingly decline. We cannot assure you that we will be able to continue to manufacture these products in commercial quantities at acceptable costs. Our inability to do so would adversely affect our operating results and cause our business to suffer.

We face intense competition, in some cases from companies that have significantly greater resources than we do, which could limit our ability to generate sales.

The market for aesthetic and therapeutic skin health products is highly competitive and we expect the intensity of competition to increase in the future. We also expect to encounter increased competition as we enter new markets and as we attempt to penetrate existing markets with new products. We may not be able to compete effectively in these markets, we may face significant pricing pressure from our competitors and

we may lose market share to our competitors. Our principal competitors are large, well-established companies in the fields of pharmaceuticals, medical devices, cosmetics and health care. Our direct competitors include La-Roche Posay, Skin Medica, Inc., Valeant Pharmaceuticals International, SkinCeuticals, a division of L’Oreal S.A., Allergan, Inc., IS Clinical, and PhotoMedex, Inc.

We believe our indirect competitors, who generally sell skin care products directly to consumers, consist of large cosmetic companies, including but not limited to, The Estee Lauder Companies Inc., Helene Curtis Industries, Inc., L’Oreal S.A., Matrix Essentials, Inc., a division of L’Oreal S.A, Procter & Gamble Company, Neutrogena, a division of Johnson & Johnson, Revlon, Inc. and Unilever N.V. We also face competition from medical device companies offering products used to enhance the skin’s appearance to physicians, such as Candela, Cool Touch, Cynosure, Lumenis, Reliant Technologies, Syneron and Thermage.

We may not be able to successfully expand the use of our current product lines or develop new products.

We are working to improve, extend and reformulate many of our existing products. Continued market acceptance of our products will depend on our ability to successfully develop additional applications of our existing products. The development of additional applications will require significant commitments of personnel and financial resources and we cannot assure you that they will be successful. If the attempted extensions of our product lines are not commercially successful, our business will be adversely affected.

We are also developing new product lines by applying our Penetrating Therapeutics technology to new agents. We also have acquired rights to certain patents covering additional methods and formulations. New products, in various stages of development, include acne and skin elasticity products and systems. These development activities, as well as clinical studies, which must be completed before these products can be marketed and sold, will require significant commitments of personnel and financial resources. We cannot assure you that we will be able to develop new products or technologies in a timely manner, or at all. Delays in the development or testing processes will cause a corresponding delay in revenue generation from those products. Regardless of whether such new products or technologies are ever released to the market, the expense of such processes, which may be considerable, will have already been incurred and we may not be able to recover such expenses.

We reevaluate our development efforts regularly to assess whether our efforts to develop a particular new product or technology are progressing at a rate that justifies our continued expenditures. On the basis of these reevaluations, we have abandoned in the past, and may abandon in the future, our efforts on a particular product or technology. New products that we develop may not be successfully commercialized. If we fail to take a product or technology from the development stage to market on a timely basis, we may incur significant expenses without a near-term financial return or any financial return.

Our failure to successfully in-license or acquire additional products and technologies would impair our ability to grow.

We intend to in-license, acquire, develop and market new products and technologies. Because we have limited internal research capabilities, our business model depends in part on our ability to license patents, products and/or technologies from third parties. The success of this strategy also depends upon our ability and the ability of our third-party formulators to formulate products under such licenses, as well as our ability to manufacture, market and sell such licensed products.

We may not be able to successfully identify any new products to in-license, acquire or internally develop. Moreover, negotiating and implementing an economically viable acquisition is a lengthy and complex process. Other companies, including those with substantially greater financial, marketing and sales resources, may compete with us for the acquisition of products. We may not be able to acquire or in-license the rights to such products on terms that we find acceptable, or at all. As a result, our ability to grow our business or increase our profits could be adversely impacted.

Our marketed products and our products under development could be rendered obsolete by technological or medical advances.

Our marketed products and our products under development may be rendered obsolete or uneconomical by the development of medical advances to treat the conditions that our products are designed to address. The treatment of skin conditions and the enhancement of the appearance of skin, which is what all of our products target, are the subjects of active research and development by many potential competitors, including major pharmaceutical companies, such as Johnson & Johnson and Galderma, specialized biotechnology firms, such as Allergan and Medicis, universities and other research institutions. Competitive advances may also include the potential development of new laser or radio frequency therapies being developed by manufacturers such as Candela, Syneron and Thermage, aimed at treating hyperpigmentation and photo-damaged skin. While we intend to expand our technological capabilities to remain competitive, research and development by others may render our technology or products obsolete or noncompetitive or result in treatments superior to any therapy we develop, as our competitors may develop and patent products which are better than ours, which could harm our competitive position.

If we lose key personnel or are unable to attract and retain other qualified personnel, we may be unable to execute our business plan and our business would be materially adversely affected.

As of December 31, 2006, we had 153 employees. Our success depends on our continued ability to attract, retain and motivate highly qualified management, business development, sales and marketing, product development and other personnel. In the future we may not be able to recruit and retain qualified personnel, particularly for senior sales and marketing and research and product development positions due to intense competition for personnel among businesses like ours, and the failure to do so could have a significant negative impact on our future product sales and business results. Our success depends in large part on the efforts and abilities of Steven Carlson, our Chief Executive Officer, Stephen Garcia, our Chief Financial Officer, Curtis Cluff, our Executive Vice President of Corporate Development, and David Goldstein, our Executive Vice President of Sales, as well as other members of our senior management and our scientific and technical personnel. Although we have agreements with certain of these officers that contain certain provisions related to severance and bonus payments, aside from Mr. Carlson, we have not entered into employment agreements with any of these officers. We may not be able to retain the services of our officers. In addition, we do not have “key person” insurance policies on any of our executive officers that would compensate us for the loss of their services. If we lose the services of one or more of these individuals, finding a replacement could be difficult, may take an extended period of time and could significantly impede the achievement of our business objectives. This may have a material adverse effect on our results of operations and financial condition.

To sustain our continued growth, we will need to increase the size of our organization, and we may encounter difficulties managing our growth, which could adversely affect our results of operations.

If we are able to successfully develop additional products and extend the use of our current products, we may experience growth in the number of our employees and the scope of our operations. To the extent that we acquire and launch additional products, the resulting growth and expansion of our sales force will place a significant demand on our financial, managerial and operational resources. Since many of the new products or systems we are working on may involve new technologies or entering new markets, we may not be able to accurately forecast the number of employees required, the timing of their hire or the associated cost. The extent of any expansion we may experience will be driven largely by the success of our new products and systems. As a result, management’s ability to project the size of any such expansion and its cost to the company is limited by the following uncertainties: (i) we will not have previously sold any of the new products and technologies and the ultimate success of these new products and technologies is

unknown; (ii) we will be entering new markets; and (iii) the costs associated with any expansion will be partially driven by factors that may not be fully in our control (e.g., timing of hire, market salary rates). Subject to these uncertainties, we believe that our current business plan may require us to hire between 30 and 40 new employees within the next 12 months at an incremental cost of between $3.0 million and $4.0 million. Due to the uncertainty surrounding the new product lines, this estimate may prove to be incorrect, and our costs could be significantly higher. Our success will also depend on the ability of our executive officers and senior management to continue to implement and improve our operational, information management and financial control systems, particularly in light of our status as a newly public company subject to the reporting requirements of the Securities Exchange Act of 1934, or the Exchange Act, and to expand, train and manage our employee base. Our inability to manage growth effectively could cause our operating costs to grow even faster than we are currently anticipating and adversely affect our results of operations.

Because we have limited research and development capabilities, we will be dependent on third parties to perform research and development for us.

We have limited internal research and development capabilities and currently outsource all of our product research and development to third-party research labs. In particular, we have licensed patents that may issue under certain patent applications filed by JR Chem LLC, and have relied heavily on services provided by JR Chem LLC in the development of new products to address acne and skin elasticity. We have received sufficient support from our third-party research labs to drive our current new product development, and we expect to continue to rely on third parties to research and develop new products.

There are a limited number of third-party research and development companies that specialize or have the expertise required to achieve our product development objectives. As a result, it may be difficult for us to engage research and development labs and personnel for our anticipated future needs. If we are unable to arrange for third-party research and development of our products, or to do so on commercially reasonable terms, we may not be able to develop new products or expand the application of our existing products.

Reliance on third-party research and development labs entails risks to which we would not be subject if we performed the research and development ourselves, including reliance on the third party for maintaining the confidentiality of the proprietary information relating to the product being developed and for maintaining quality assurance, the possibility of breach of the research and development agreement by the third party, and the possibility of termination or non-renewal of the agreement by the third party.

Dependence upon third parties for the research and development of our future products may limit our ability to commercialize and deliver products on a timely and competitive basis.

Because we currently have limited commercial manufacturing capabilities, we will continue to be dependent on third parties to manufacture products for us for some time.

We have limited commercial manufacturing experience and currently outsource all of our non-Benzoyl Peroxide product manufacturing to third-party contract manufacturers. Although we have received sufficient material from our manufacturers to meet our current needs, we do not have long-term contracts with most of these third parties. Triax Pharmaceuticals, LLC is our sole supplier and manufacturer of tretinoin pursuant to a contract that has an initial termination in 2010. The termination of that agreement or any loss of services under that agreement would be difficult for us to replace. We expect to continue to rely on third parties to produce materials required for clinical trials and for the commercial production of our products.

There are a limited number of third-party manufacturers that operate under the FDA’s current cGMPs, or cGMP, regulations and that have the necessary expertise and capacity to manufacture our products. As a result, it may be difficult for us to locate manufacturers for our anticipated future needs. If we are unable to arrange for third-party manufacturing of our products, or to do so on commercially reasonable terms, we may not be able to complete development of, market and sell our new products.

Reliance on third-party manufacturers entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the third party for regulatory compliance and quality assurance, the possibility of breach of the manufacturing agreement by the third party, and the possibility of termination or non-renewal of the agreement by the third party.

We have developed manufacturing dedicated to the production of our CLENZIderm M.D™ Serum Gel. We may expand the capabilities of that manufacturing site and may in the future elect to manufacture certain new products developed or certain existing products without the assistance of third parties. However, in order to make that election, we will need to invest substantial additional funds and recruit qualified personnel in order to operate our development manufacturing facility on a commercial basis. There can be no assurance that we will successfully manufacture our own products, and if we are not able to make or obtain adequate supplies of our products, it will be more difficult for us to launch CLENZIderm M.D.™, or other new products and compete effectively.

Dependence upon third parties for the manufacture of our products may reduce our profit margins, or the sale of our products and may limit our ability to develop and deliver products on a timely and competitive basis.

Our growth may suffer if an economic downturn in any of our major markets inhibits people from spending their disposable income on aesthetic and skin health products.

Our growth depends significantly on continued economic growth in the markets where we sell our products. Because many treatments in which our products are used are considered cosmetic in nature, they are typically paid directly by the patient out of disposable income and are not subject to reimbursement by third-party payers such as health insurance organizations. As a result, an economic downturn in any of our major markets, such as North America, the Pacific Rim and the Middle East, could have an adverse effect on the sales and profitability of our products.

Our products may cause undesirable side effects that could limit their use, require their removal from the market or prevent further development.

The most common side effects associated with our therapeutic products are temporary redness, stinging, burning sensation, skin peeling, flaking, acne flare-ups and photo-sensitivity normally experienced within approximately the first ten weeks of use. While these side effects generally are not severe, they may limit the use of our products, particularly if physicians or patients perceive that the risks or discomfort outweigh the benefits or if they perceive that the side effects of competitive products are less significant.

Undesirable side effects caused by our products could interrupt, delay or halt our development programs, including clinical trials, and could result in adverse regulatory action by the FDA or other regulatory authorities. More severe side effects associated with our products may be observed in the future. Even if we are able to complete the development of a new product and obtain any required regulatory approval, undesirable side effects could prevent us from achieving or maintaining market acceptance of the product or could substantially increase the costs and expenses of commercializing the product. Negative publicity concerning our products, whether accurate or inaccurate, could also reduce market or regulatory acceptance of our products, which could result in decreased product demand, removal from the market or an increased number of product liability claims, whether or not such claims have merit.

The FDA has issued a proposed rule which cites evidence that an active ingredient contained in some of our Obagi Nu-Derm and Obagi-C Rx Systems may have negative side effects.

In August 2006, the FDA issued a proposed rule which cites some evidence that hydroquinone may be a carcinogen, if orally administered, and may be related to a skin condition called ochronosis, which results in the darkening and thickening of the skin, and the appearance of small bumps and grayish-brown spots. Hydroquinone is an active ingredient contained in our Obagi Nu-Derm Clear, Obagi Nu-Derm Blender and Obagi Nu-Derm Sunfader products, which are part of our Obagi Nu-Derm System, and in our Obagi-C Rx C-Clarifying Serum and Obagi-C Rx C-Night Therapy products, which are part of our Obagi-C Rx System. The FDA also concluded that it could not rule out the potential carcinogenic risk from topically applied hydroquinone. After further review of the evidence cited in the notice, or information provided in the public comments on the proposed rule, or if additional evidence of cancer or ochronosis, or other side effects associated with any of our products were to be reported to or observed by the FDA or other regulatory authorities, we could be required to suspend the marketing of our products that contain hydroquinone, conduct additional safety tests and potentially cease the sale of affected products, which would harm our business. In addition, patients who experience side effects from our products may bring product liability claims against us.

All of our products which contain hydroquinone are prescription-based. The FDA is considering regulating all hydroquinone products, including prescription-based hydroquinone products, as new drugs, and may conclude that the continued use of prescription-based hydroquinone products will require the submission and approval of an NDA. If we are required to submit an NDA for our prescription-based hydroquinone products, we believe that the FDA may allow us to continue to market these products while we are preparing, submitting and waiting for approval of such NDA. However, there can be no assurance that we will be able to continue to market our products during the NDA process, and we may be required to suspend marketing of our prescription-based hydroquinone products until such time as an NDA is approved. In addition, there can be no assurance that any NDA we submit for our prescription-based hydroquinone products will be approved. If we are required to suspend or cease marketing of our prescription-based hydroquinone products, it would adversely affect our business.

Product liability lawsuits could divert our resources, result in substantial liabilities and reduce the commercial potential of our products.

Our business exposes us to the risk of product liability claims that are inherent to the development, clinical testing and marketing of aesthetic and skin health products. These lawsuits may divert our management from pursuing our business strategy and may be costly to defend. In addition, if we are held liable in any of these lawsuits, we may incur substantial liabilities and may be forced to limit or forgo further commercialization of those products. Although we maintain general liability and product liability insurance in an amount that we believe is reasonably adequate to insulate us from potential claims, this insurance may not fully cover potential liabilities. In addition, our inability to obtain or maintain sufficient insurance coverage at an acceptable cost or to otherwise protect against potential product liability claims could prevent or inhibit the commercial production and sale of our products, which could adversely affect our business.

We are subject to risks associated with doing business internationally.

Our international sales currently depend upon the marketing efforts of and sales by certain distributors and licensees, particularly Rohto Pharmaceuticals, a licensee of certain of our trademarks and products for the retail drug store channel in Japan, from whom we receive royalties that accounted for 4% of our net sales and 5% of our gross margin in 2006. Because incremental costs associated with this agreement are minimal, a material decline in licensing revenues from or termination of this agreement would have a material adverse effect on our net income. While no other international distribution or

license partner accounted for more than 4% of our net sales in 2006, our business is subject to certain risks inherent in international business, many of which are beyond our control. These risks include:

·        adverse changes in tariff and trade protection measures;

·        unexpected changes in foreign regulatory requirements;

·        potentially negative consequences from changes in tax laws;

·        the potential business failure of one or more of our distribution partners;

·        changing economic conditions in countries where our products are sold or manufactured in other countries;

·        exchange rate risks;

·        potential political unrest and hostilities;

·        differing degrees of protection for intellectual property; and

·        difficulties in coordinating foreign distribution.

Any of these factors could adversely affect our business, financial condition and results of operations. We cannot assure you that we can successfully manage these risks or avoid their effects.

Potential business combinations could require significant management attention and prove difficult to integrate with our business, which could distract our management, disrupt our business, dilute stockholder value and adversely affect our operating results.

If we become aware of potential business combination candidates that are complementary to our business, we may decide to combine with such businesses or acquire their assets in the future. Business combinations generally involve a number of additional difficulties and risks to our business, including:

·        failure to integrate management information systems, personnel, research and development and marketing, operations, sales and support;

·        disruption of our ongoing business and diversion of management’s attention from other business matters;

·        potential loss of the acquired company’s customers;

·        failure to develop further the acquired company’s technology successfully;

·        unanticipated costs and liabilities; and

·        other accounting consequences.

In addition, we may not realize benefits from any business combination we may undertake in the future. If we fail to successfully integrate such businesses, or the technologies associated with such business combinations into our Company, the revenue and operating results of the combined company could be adversely affected. Any integration process would require significant time and resources, and we may not be able to manage the process successfully. If our customers are uncertain about our ability to operate on a combined basis, they could delay or cancel orders for our products. We may not successfully evaluate or utilize the acquired technology or accurately forecast the financial impact of a combination, including accounting charges or volatility in the stock price of the combined entity. If we fail to successfully integrate other companies with which we may combine in the future, our business could be adversely affected.

Risks related to regulatory matters

Our ability to commercially distribute our products and our business may be significantly harmed if the regulatory environment governing our products changes, if the FDA takes enforcement action against us or our competitors marketing similar products, or if a third party obtains FDA approval of an NDA, for 4% hydroquinone for the same uses for which we market our hydroquinone products.

The FDA and comparable agencies of other countries regulate our products. In the United States, FDA regulations govern, among other things, the activities that we perform, including product development, product testing, product labeling, product storage, manufacturing, advertising, promotion, product sales, reporting of certain product adverse events and failures, and distribution.

In addition, the Obagi Nu-Derm and Obagi-C Rx Systems contain products that include 4% hydroquinone as an active ingredient and are marketed in the United States without an FDA-approved marketing application. We believe that these products are not currently subject to FDA pre-market approval. In August 2006, the FDA issued a proposed rule that, if adopted in its current form, would establish that OTC skin bleaching drug products, such as hydroquinone, are not generally recognized as safe and effective and are misbranded, and could seek to require NDAs for new products using skin bleaching drug products, including prescription skin bleaching drug products. The FDA has indicated that upon adoption of the final rule it intends to consider all skin bleaching drug products, whether currently marketed on a prescription or OTC basis, to be new drugs requiring an approved NDA for continued marketing. This may require us to withdraw the Obagi Nu-Derm and Obagi-C Rx Systems until required clinical trials are performed and new drug approvals are obtained, in effect foreclosing us from selling the Obagi Nu-Derm and Obagi-C Rx Systems. If we are required to seek new drug approval for these products, our attention and resources will be dedicated to the process of obtaining new drug approval, which may be time-consuming and expensive. In addition, we may not successfully obtain such approval. If we are unable to obtain such approval, we would be prohibited from selling the Obagi Nu-Derm and Obagi-C Rx Systems, which would have a material adverse impact on our business.

Finally, as discussed above, the August 2006 proposed rule cites some evidence that hydroquinone may be a carcinogen and may be related to ochronosis. If new studies are published that corroborate such evidence, or if based on further review of the current evidence, the FDA determines that such potential health risks warrant a ban on the sale of 4% hydroquinone, such determinations would have a material adverse effect on our sale of the Obagi Nu-Derm and Obagi-C Rx Systems. The FDA’s proposed rulemaking itself, and the concerns expressed therein relating to the use of hydroquinone, could have an adverse impact on the sales of our Obagi Nu-Derm and Obagi-C Rx Systems. Certain of our competitors are attempting to use the FDA’s proposed rulemaking in order to convince physicians and patients not to use our products containing hydroquinone. To date, these marketing efforts by our competitors have not had a negative impact on our sales levels. However, we cannot provide assurance that such marketing efforts will not have a negative impact on our sales levels in the future.

FDA and FTC regulations limit the type of marketing claims we can make about our products. If the FDA determines that any of our marketing claims are false or misleading, or suggest a clinical benefit that is not supported in the studies we have done, we may be required to cease making the challenged marketing claims, issue corrective communications, pay fines, or stop selling products until the incorrect claims have been corrected. FDA or FTC enforcement actions regarding promotional claims, including warning letters, would also divert management attention and create public relations issues for our customers and opportunities for our competitors.

We are also subject to review, periodic inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. Our manufacturing processes, any clinical trials that we perform, and our promotional activities are subject to ongoing regulatory obligations. If the FDA finds that we have failed to comply with these requirements or later discovers previously unknown

problems with our products, including unanticipated adverse events of unanticipated severity or frequency, or our manufacturer or manufacturing processes, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

·        fines, injunctions and civil penalties;

·        recall or seizure of our products;

·        restrictions on our products or manufacturing processes, including operating restrictions, partial suspension or total shutdown of production;

·        denial of requests for approvals of product candidates;

·        withdrawal of approvals already granted;

·        disgorgement of profits; and

·        criminal prosecution.

Any of these enforcement actions could affect our ability to commercially distribute our products in the United States and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of these products and could materially and adversely affect our business.

New regulations could prohibit physicians from dispensing our products directly.

In our primary market, the United States, we market our products and systems directly to physicians to dispense in their offices. Most of the products and systems we sell are dispensed by physicians directly to their patients in their offices, although some patients choose to have prescriptions for our products filled by pharmacies instead of the treating physician. In the event state regulations change to limit or prohibit the ability of physicians to dispense our products directly to patients in their offices, patients may be required to purchase our products in pharmacies, as opposed to directly from their physicians. If patients are unable to purchase our products directly from physicians, it could result in patients purchasing less of our product than they otherwise would, which would harm our business.

Failure to obtain regulatory approvals in foreign jurisdictions would prevent us from marketing our products internationally.

We market our products outside of the United States. In order to market our products in many non-U.S. jurisdictions we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. In others, we do not have to obtain prior regulatory approval but do have to comply with other regulatory restrictions on the manufacture, marketing and sale of our products. We may be unable to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. The approval procedure varies among countries and can involve additional testing and data review. The time required to obtain approval in non-U.S. jurisdictions may differ from that required to obtain FDA approval. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. If we get approval by the FDA, that does not ensure approval by regulatory agencies in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory agencies in other foreign countries or by the FDA. The failure to obtain these approvals could harm our business.

If any of our third-party manufacturers do not operate in accordance with current Good Manufacturing Practices, we could be subject to FDA enforcement actions, including the seizure of our products and the halt of our production.

Third-party manufacturers that we currently rely on or will rely on in the future must continuously adhere to the current cGMPs set forth in the FDA’s regulations and guidance documents. In complying with cGMPs, we and our third-party manufacturers must expend significant time, money and effort in development, testing, production, record keeping and quality control to assure that our products meet applicable specifications and other regulatory requirements. The failure to comply with these specifications and other requirements could result in an FDA enforcement action, including the seizure of products and shutting down of production. Our third-party manufacturers may also be subject to comparable or more stringent regulations of foreign regulatory authorities. If our third-party manufacturers are unable to comply with cGMPs and applicable foreign regulatory requirements, our ability to develop, produce and sell our products could be impaired.

Risks related to intellectual property

If we ar e unable to protect our proprietary rights, we may not be able to compete effectively.

Our success depends significantly on our ability to protect our proprietary rights to the technologies used in our products. We rely primarily on maintaining the confidentiality of our trade secrets and the protection of trade secret laws, as well as a combination of patent, copyright, and trademark (including common law trademark) laws, and nondisclosure, confidentiality and other contractual restrictions, to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our trade secrets may be misappropriated by current or former employees, contractors, or parties with whom we partner, or may be inadvertently disclosed or obtained by breach of a confidentiality agreement. We do not own any issued patents with claims covering any of our Obagi Nu-Derm products. We have recently applied for several patents both in the United States and abroad. These patent applications may not issue as patents at all, or the applications may not issue as a patent in a form that will be advantageous to us or may issue and be subsequently successfully challenged by others and invalidated or rendered unenforceable. Both the patent application process and the process of managing patent disputes can be time-consuming and expensive. Competitors may be able to design around our patents or develop products that provide outcomes comparable to ours even without misappropriating our trade secrets. Although we have taken steps to protect our intellectual property and proprietary technology, including entering into confidentiality agreements and intellectual property assignment agreements with our employees, consultants and advisors, such agreements may not be enforceable or may not provide meaningful protection for our trade secrets or other proprietary information in the event of unauthorized use or disclosure or other breaches of the agreements. Further, the parties with whom we enter into confidentiality and intellectual property assignment agreements could dispute the ownership of intellectual property developed under these agreements. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States.

If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.

In order to protect or enforce our patent rights, we may initiate patent litigation. In addition, others may initiate patent litigation against us. Companies against whom we might initiate litigation or who might initiate litigation against us may be better able to sustain the costs of litigation because they have substantially greater resources. We may become subject to interference proceedings conducted in patent and trademark offices to determine the priority of inventions. There are numerous issued and pending patents in the skin care product field. The validity and breadth of such patents may involve complex legal

and factual questions for which important legal principles may remain unresolved. If third parties file oppositions to our patent applications in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of our filed foreign patent applications.

Litigation may be necessary for us to assert or defend against infringement claims, enforce our issued and licensed patents, protect our trade secrets or know-how or determine the enforceability, scope and validity of the proprietary rights of others. Our involvement in intellectual property claims and litigation could:

·        divert existing management, scientific and financial resources;

·        subject us to significant liabilities;

·        result in a ruling that allows our competitors to market competitive products without obtaining a license from us;

·        require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all; or

·        force us to discontinue selling or modify our products, or to develop new products.

If any of these events occur, our business will be materially and adversely affected.

We and our manufacturers and suppliers license certain technologies and patents from third parties. If these licenses are breached, terminated or disputed, our ability to commercialize products dependent on these technologies and patents may be compromised.

We have licensed four patents, including patents related to our Vitamin C serums, from Avon. We entered into the license in June 2003, for an initial three-year term, and the license is renewed year to year thereafter, at our option through the life of the last patent to expire (which will be in 2018). These licensed patents contain claims that cover our Obagi-C Rx C-Clarifying serum, Professional-C 5% serum and Professional-C 10% serum. If one or more of our licenses with Avon or licenses we have with other parties terminate, if we violate the terms of our licenses or otherwise lose our rights to these patents, we may be unable to continue developing and selling our products that are covered by claims in the patents we license. Our licensors or others may dispute the scope of our rights under any of these licenses. The licensors under these licenses may breach the terms of their respective agreements or fail to prevent infringement of the licensed patents by third parties. Loss of any of these licenses for any reason could materially and adversely affect our financial condition and operating results.

Further, we purchase products from manufacturers and suppliers who have licensed patent rights to use and sell these products from third-party licensors, and if any dispute arises as to these licensed rights, the third-party licensors may bring legal actions against us, our respective licensees, suppliers, customers or collaborators, and claim damages and seek to enjoin the manufacturing and marketing of such products.

In addition, if we determine that our products do not incorporate the patented technology that we have licensed from third parties, or that one or more of the patents that we have licensed are not valid, we may dispute our obligation to pay royalties to our licensors. Any dispute with a licensor could be complex, expensive and time-consuming and an outcome adverse to us could materially and adversely affect our business and impair our ability to commercialize our patent-licensed products.

Risks related to our capital requirements and finances

If we fail to generate sufficient cash flow from our operations, we will be unable to continue to develop and commercialize new products.

We expect capital outlays and operating expenditures to increase over the next several years as we expand our infrastructure, and our commercialization, clinical trials, research and development and manufacturing activities. We believe that our net cash provided by operating activities and existing cash and cash equivalents will be sufficient to fund our operations for the foreseeable future. However, our present and future funding requirements will depend on many factors, including, among other things:

·        the level of research and development investment required to maintain and improve our competitive position;

·        the success of our product sales and related collections;

·        our need or decision to acquire or license complementary businesses, products or technologies or acquire complementary businesses;

·        costs relating to the expansion of the sales force, management and operational support;

·        competing technological and market developments; and

·        costs relating to changes in regulatory policies or laws that affect our operations.

As a result of these factors, we may need to raise additional funds, and we cannot be certain that such funds will be available to us on acceptable terms when needed, if at all. In addition, if we raise additional funds through collaboration, licensing or other similar arrangements, it may be necessary to relinquish potentially valuable rights to our future products or proprietary technologies, or grant licenses on terms that are not favorable to us. If we cannot raise funds on acceptable terms, we may not be able to expand our operations, develop new products, take advantage of future opportunities or respond to competitive pressures or unanticipated customer requirements.

Our quarterly operating results are variable, which may cause our stock price to decline.

Our quarterly results of operations have varied in the past and are likely to vary significantly in the future due to a number of factors, many of which are outside of our control, including:

·        demand for and market acceptance of our products;

·        the development of new competitive products by others;

·        changes in regulatory classifications of our products;

·        changes in physician or patient acceptance of the use of physician-dispensed products;

·        changes in treatment practices of physicians who currently prescribe our products;

·        delays between our expenditures to acquire new product lines or businesses and the generation of revenues from those acquired products or businesses;

·        the timing, release and competitiveness of our products;

·        increases in the cost of raw materials used to manufacture our products;

·        the mix of products that we sell during any time period;

·        increased price competition; and

·        adverse changes in the level of economic activity in the United States and other major regions in which we do business.

Due to the factors summarized above, we do not believe that period-to-period comparisons of our results of operations are necessarily meaningful and should not necessarily be relied upon to predict future results of operations. It is also possible that in future periods, our results of operations will not meet the expectations of investors or analysts, or any published reports or analyses regarding our company. In that event, the price of our common stock could decline, perhaps substantially.

Changes in, or interpretations of, accounting rules and regulations, such as expensing of stock options, could result in unfavorable accounting charges or require us to change our compensation policies.

Changes to, or interpretations of, accounting methods or policies in the future may require us to reclassify, restate or otherwise change or revise our financial statements, including those contained in this Annual Report on Form 10-K. For example, the Financial Accounting Standards Board, or FASB has adopted a new accounting pronouncement requiring the recording of expense for the fair value of stock options granted. Beginning January 1, 2006, we have adopted Statement of Financial Accounting Standards, or SFAS, No. 123R, Share-Based Payment , which required us to change our accounting policy to record expense for the fair value of stock options granted, and as a result, our operating expenses will increase. We rely on stock options to motivate current employees and attract new employees. As a result of the requirement to expense stock options, we may choose to reduce our reliance on stock options as a recruitment or motivation tool. If we reduce our use of stock options, it may be more difficult for us to attract and retain qualified employees. However, if we do not reduce our reliance on stock options, our operating expenses may increase.

Impairment of our significant intangible assets may reduce our profitability.

The costs of our goodwill, acquired product rights, distribution rights, and trademark are recorded as intangible assets and all, except for goodwill, are amortized over the period that we expect to benefit from the assets. As of December 31, 2006, acquired net intangible assets and goodwill comprised approximately 21% of our total assets. We evaluate periodically the recoverability and the amortization period of our intangible assets. Some factors we consider important in assessing whether or not impairment exists include performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the assets or the strategy for our overall business, and significant negative industry or economic trends. These factors, assumptions, and changes in them could result in an impairment of our long-lived assets. Any impairment of our intangible assets may reduce our profitability and have a material adverse effect on our results of operations and financial condition.

Fluctuations in demand f o r our products could create inventory maintenance uncertainties and could adversely affect our business.

As a result of customer buying patterns, a substantial portion of our revenues has been recognized in the last month of each quarter and the last month of the year. We schedule our inventory purchases to meet anticipated customer demand. As a result, relatively small delays in the receipt of manufactured products by us could result in revenues being deferred or lost. Our operating expenses are based upon anticipated sales levels, and a high percentage of our operating expenses are relatively fixed in the short term. Consequently, variations in the timing of sales could cause significant fluctuations in operating results from period to period and may result in unanticipated periodic earnings shortfalls or losses.

If we overestimate demand, we may be required to write off inventories and increase our reserves for product returns. If we underestimate demand, we may not have sufficient inventory of products to ship to our customers. Our products have expiration dates that range from 24 to 36 months from the date of

manufacture. We establish reserves for potentially excess, dated or otherwise impaired inventories. We may not be able to accurately estimate the reserve requirement that will be needed in the future. Although our estimates are reviewed quarterly for reasonableness, our product return, rebate or chargeback activity could differ significantly from our estimates. Judgment is required in estimating these reserves and we rely on data from third parties, including, but not limited to, distributor forecasts and independent market research reports. The actual amounts could be different from our estimates, and differences are accounted for in the period in which they become known. If we determine that the actual amounts exceed our reserve amounts, we will record a charge to earnings to approximate the difference. A material reduction in earnings resulting from a charge could have a material adverse effect on our net income, results of operations and financial condition.

We may be sued by the estate of Austin McNamara, our former Chairman and Chief Executive Officer, and certain trusts established by Mr. McNamara.

An Investor’s Rights Agreement between us and Mr. McNamara and trusts established by Mr. McNamara contained a repurchase obligation under which we were required, upon exercise of the repurchase right contained in the Investor’s Rights Agreement, to repurchase shares held by the trusts. Mr. McNamara died in December 2006. Our repurchase obligation was to be subordinated to our Credit Agreement, which restricts payments on the liability for shares subject to repurchase to a maximum of $1.5 million in any fiscal year, not to exceed $5.0 million in the aggregate while the Credit Agreement is in place. On November 17, 2006, we tendered promissory notes in the aggregate principal amount of $28.2 million, and a cash payment of $1.5 million as a partial prepayment of the notes, to the trusts established by Mr. McNamara in order to close on our repurchase of the shares held by the trusts in accordance with the terms of the Investor’s Rights Agreement described above. The trusts refused to accept our tender of these payments and refused to tender their shares and close on our repurchase of the shares that they hold. As a result, we believe that Mr. McNamara and the trusts are in material breach of their obligations under the Investor’s Rights Agreement.

As a further result of this material breach and for other reasons, we believe that we are no longer required to repurchase the shares held by such trusts pursuant to the Investor’s Rights Agreement and that the right of the trusts to require us to repurchase the shares held by the trusts pursuant to the Investor’s Rights Agreement has expired and can no longer be enforced against us. Mr. McNamara’s estate and the trusts have claimed that we have materially breached our obligation in the Investor’s Rights Agreement to repurchase the shares held by the trusts. It is our understanding that the primary claim asserted by Mr. McNamara’s estate and the trusts to support their assertion of our breach is that the form of note we tendered did not comply with the terms of the Investor’s Rights Agreement. We believe that the form of note complied with the terms of the Investor’s Rights Agreement and that we have complied with all of our obligations to the trusts under the Investor’s Rights Agreement. It is our position that the trusts are bound by the subordination provisions of the Investor’s Rights Agreement and by a subsequent subordination agreement entered into by them with respect to the Credit Agreement.

The trusts have agreed to be subordinated to the loans represented by the Credit Agreement, which limits payments to the trusts to a maximum of $1.5 million in any fiscal year, not to exceed $5.0 million in the aggregate while the Credit Agreement is in place. The Investor’s Rights Agreement contains no exclusive requirements with respect to the terms of the note to be granted thereunder, but does refer generally to principal, interest, prepayment and subordination and that the note be unsecured. The subordinated promissory notes tendered to the trusts were negotiated with and approved by the lenders party to the Credit Agreement and it is our position that these subordinated promissory notes included payment provisions consistent with the terms of the Credit Agreement. We have been advised by the attorney representing the trusts that, among other unspecified objections, the trusts object to the form of note tendered because it includes a provision providing for tax withholding and offset with respect to taxes

that may be due in connection with payments under the notes or upon the exercise of the options underlying the shares to have been repurchased. In addition, the trusts object to a provision prohibiting the trusts from prosecuting any claim challenging the enforceability or priority of the senior indebtedness.

We can make no assurances that Mr. McNamara’s estate and the trusts will not sue us in order to assert the foregoing claims and additional claims against us for breach of our obligations under the Investor’s Rights Agreement relating to the repurchase of the shares held by the trusts. There can be no assurance that we will be able to successfully defend these claims or any other claims Mr. McNamara’s estate and the trusts may bring against us, including employment related claims. If Mr. McNamara’s estate and the trusts were able to obtain a judgment against us, such judgment could require us to make significant cash payments, which we may not have the funds to pay, and may require us to make payments in a manner that may cause us to be in default under our Credit Agreement, which would adversely affect our financial condition.

We have debt and have the ability to incur substantial additional debt. The principal and interest payment obligations of such debt may restrict our operations and adversely affect our business.

As of December 31, 2006, we have approximately $25.8 million of outstanding indebtedness. In addition, the covenants governing our credit facilities permit us to incur additional debt under certain circumstances.

The incurrence of substantial amounts of debt may:

·        make it more difficult for us to satisfy our financial obligations;

·        require us to dedicate a substantial portion of any cash flow from operations to the payment of interest and principal due under our debt, which will reduce funds available for other business purposes;

·        increase our vulnerability to general adverse economic and industry conditions;

·        limit our flexibility in planning for, or reacting to, changes in our business and the industries in which we operate;

·        place us at a competitive disadvantage compared with some of our competitors that have less debt; and

·        limit our ability to obtain additional financing required to fund working capital and capital expenditures and for other general corporate purposes.

Our ability to satisfy our obligations and to reduce our total debt depends on our future operating performance and on economic, financial, competitive and other factors, many of which are beyond our control. Our business may not generate sufficient cash flow, and future financings may not be available to provide sufficient net proceeds to meet these obligations or to successfully execute our business strategy.

The agreements governing our credit facilities impose restrictions on our business that may limit our business opportunities and hinder our ability to execute our business strategy.

Our senior secured credit facilities contain, and other agreements we may enter into in the future may contain, covenants imposing significant restrictions on our business. These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. These covenants place restrictions on our ability to, among other things, incur additional debt, create liens, make investments, enter into transactions with affiliates, sell assets, guarantee debt, declare or pay dividends, redeem common stock or make other distributions to stockholders, and consolidate or merge.

Our ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial, and industry conditions. An event of default under our debt agreements would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest. If we were unable to repay debt to our senior lenders, these lenders could proceed against the collateral securing that debt.

We will be subject to the requirements of Section 404 of the Sarbanes-Oxley Act. If we are unable to comply with Section 404 in a timely manner it may affect the reliability of our internal control over financial reporting.

Assessing our staffing and training procedures to improve our internal control over financial reporting is an ongoing process. For the year ending December 31, 2007, pursuant to Section 404 of the Sarbanes-Oxley Act, management will be required to deliver a report that assesses the effectiveness of our internal control over financial reporting. Our auditors will be required to deliver an attestation report on management’s assessment of, and the operating effectiveness of, our internal control over financial reporting beginning either with the year ended December 31, 2007 or the year ending December 31, 2008 depending upon whether we are an accelerated or non-accelerated filer. We will not be able to determine if we are an accelerated filer until June 30, 2007. We have a substantial effort ahead of us to implement appropriate processes, document the system of internal control over key processes, assess their design, remediate any deficiencies identified and test their operation. In the past, we have identified several material weaknesses in our internal controls over financial reporting. We have remediated these identified material weaknesses, but we cannot give any assurances that all material weaknesses have been identified or that additional material weaknesses will not be identified in the future in connection with our compliance with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 beginning in the year ending December 31, 2007. The existence of one or more material weaknesses would preclude a conclusion by management that we maintained effective internal control over financial reporting.

We cannot be certain at this time that we will be able to successfully complete the procedures, certification and attestation requirements of Section 404 or that we or our independent registered public accounting firm will not identify additional material weaknesses in our internal control over financial reporting. If we fail to comply with the requirements of Section 404 or if we or our independent registered public accounting firm identify and report a material weakness, it may affect the reliability of our internal control over financial reporting.

We will incur increased costs as a result of being a public company.

As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. We will incur costs associated with our public company reporting requirements. We also anticipate that we will incur costs associated with recently adopted corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002. We expect these rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. While we have taken steps to improve our financial accounting organization and processes to date, we may still need to make additional changes, including adding staff in the areas of, internal controls and internal audit. We may also need to adopt and implement additional policies and procedures to further strengthen our financial reporting capability. However, the process of designing and implementing an effective financial reporting system is a continuous effort that will require us to anticipate and react to changes in our business and the economic and regulatory environments. All of this will also require us to expend significant resources. We also expect these rules and regulations may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. We are currently evaluating these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

Our board of directors can issue preferred stock without stockholder approval of the terms of such stock.

Our amended and restated certificate of incorporation authorizes our board of directors, without stockholder approval, to issue up to 10,000,000 shares of preferred stock in one or more series and to fix the rights, preferences, privileges, and restrictions granted to or imposed upon the preferred stock, including voting rights, dividend rights, conversion rights, terms of redemption, liquidation preference, sinking fund terms, subscription rights, and the number of shares constituting any series or the designation of a series. Our board of directors can issue preferred stock with voting and conversion rights that could adversely affect the voting power of the holders of common stock, without stockholder approval. As of December 31, 2006, no shares of preferred stock were outstanding and we have no present plan to issue any shares of preferred stock.

Risks related to our common stock

The interests of our controlling stockholder may conflict with the interests of our other stockholders.

As of December 31, 2006, Stonington Capital Appreciation 1994 Fund, L.P., or Stonington, beneficially owned approximately 45.3% of the outstanding shares of our voting capital stock, without giving effect to the exercise of outstanding options. As a result, Stonington has significant influence over the outcome of matters requiring stockholder approval, including:

·        the election and removal of our directors; and

·        the approval of mergers, consolidations or the sale of all or substantially all of our assets.

Currently, John A. Bartholdson, Albert J. Fitzgibbons III and Bradley J. Hoecker, all of whom serve on our board of directors, are employees of Stonington and serve on the board of directors of Stonington’s general partner. This concentration of stock ownership could limit the ability of our other stockholders to influence corporate matters and could have the effect of delaying, deferring or preventing a change in control of the company, or impeding a merger or consolidation, takeover or other business combination or a sale of all or substantially all of our assets. In addition, the significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise.

Future sales of our common stock, or the perception in the public markets that these sales may occur, could depress our stock price.

Sales of substantial amounts of our common stock in the public market, or the perception in the public markets that these sales may occur, could cause the market price of our common stock to decline. This could also impair our ability to raise additional capital through the sale of our equity securities. As of December 31, 2006, we had 21,801,961 shares of our common stock outstanding. In addition, we had outstanding options to purchase a total of 1,285,116 shares under our 2000 Stock Option/Stock Issuance Plan and 2005 Stock Incentive Plan of which 214,277 were vested. In February 2007, we filed a Form S-8 registration statement to register all the shares of common stock issuable under our equity incentive plans, including the 2005 Stock Incentive Plan. Approximately 16,431,898 shares of our common stock, on a fully-diluted basis assuming exercise of all outstanding options, were subject to a 180-day “lock-up” period following our initial public offering. Following the expiration of the 180-day “lock-up” period, the holders of those shares will generally be entitled to freely transfer those shares. Moreover, JPMorgan Securities Inc. may, in its sole discretion and at any time without notice, release those holders from the sale restrictions on their shares. In addition to the adverse effect a price decline could have on holders of our common stock, such a decline could impede our ability to raise capital or to make acquisitions through the issuance of additional shares of our common stock or other equity securities. Trusts established by Austin McNamara, which own approximately 1,875,001 shares of our common stock, have not signed lock-up

agreements with the underwriters. They are subject to a 180 day lock-up agreement under the terms of the Investor’s Rights Agreement with us. We have been advised by the trusts that they do not believe such lock-up agreement is enforceable. We believe it is enforceable, but we cannot provide assurance that the trusts will not seek to have a court declare such lock-up agreement to be unenforceable. If they are successful, the trusts may be able to sell their shares prior to the expiration of the 180 day lock-up period and claim damages against us resulting from our refusal to allow a sale of their shares prior to the end of the lock-up period.

Each of Stonington, the holder of approximately 9,867,285 shares of our common stock, the Zein and Samar Obagi Family Trust, the holder of approximately 4,064,167 shares of our common stock, the McNamara Family Irrevocable Trust, the holder of approximately 416,667 shares of our common stock, and the McNamara Family Trust, the holder of approximately 1,458,334 shares of our common stock, has rights to demand the registration of their shares or include their shares in registration statements that we may file on our behalf or on behalf of other stockholders.

The partnership through which Stonington holds its shares has a termination date of March 29, 2007. Although Stonington may return the investment through a distribution of shares to the fund’s investors, Stonington has also exited its investments in publicly traded companies through a combination of sales under Rule 144, registered secondary offerings, and the distribution of shares to the fund’s investors. By exercising its registration rights and selling a large number of shares, Stonington could cause the price of our common stock to decline, which could impede our ability to make acquisitions through the issuance of additional shares of our common stock. Furthermore, if we file a registration statement to offer additional shares of our common stock and have to include shares held by Stonington or other holders of registration rights, it could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

ITEM 1B:  UNRESOLVED SEC STAFF COMMENTS

None.


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