UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

Mark One

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED ~~SEPTEMBER~~JUNE 30, ~~2005~~2006

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

Commission File Number: 000-50939

INTRALASE CORP.

(Exact name of registrant as specified in its charter)

DELAWARE

38-3380954

(State or other jurisdiction of

incorporation or organization)

(IRS Employer

Identification No.)

9701 Jeronimo Road, Irvine, CA		92618
(Address of principal executive offices)		(~~zip~~Zip code)

(949) 859-5230

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ~~Yes ¨ No x~~

~~Indicate~~Large byaccelerated ~~check~~filer Yes ¨ No ¨ Accelerated ~~mark whether the registrant is a shell company (as defined in Rule 12b~~filer Yes x No ¨ Non-2accelerated ~~of the Exchange Act).~~ filer Yes ¨ No x ¨

Indicate ~~the~~by ~~number~~check ofmark ~~shares~~whether ~~outstanding of each of~~ the ~~issuer’s classes~~registrant ofis ~~common~~a ~~stock,~~shell company (as ofdefined ~~the~~in ~~latest~~Rule ~~practicable~~12b-2 ~~date: 27,950,951 shares~~ of ~~common~~the ~~stock,~~Exchange $0Act).~~01 par value, outstanding as of November 4, 2005.~~

Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 28,573,362 shares of common stock, $0.01 par value, outstanding as of July 28, 2006.

INTRALASE CORP.

INDEX

		Page No
PART I	FINANCIAL INFORMATION
Item 1	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004	2
	Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005	2
	Condensed Consolidated Statements of Operations – Three and Nine Month Periods Ended September 30, 2005 and 2004	3
	Condensed Consolidated Statements of Operations – Three and Six Month Periods Ended June 30, 2006 and 2005	3
	Condensed Consolidated Statements of Cash Flows – Nine Month Periods Ended September 30, 2005 and 2004	4
	Condensed Consolidated Statements of Cash Flows – Six Month Periods Ended June 30, 2006 and 2005	4
	Notes to Condensed Consolidated Financial Statements	5
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	1314
Item 3	Quantitative and Qualitative Disclosures about Market Risk	3132
Item 4	Controls and Procedures	32
PART II	OTHER INFORMATION
Item 1	Legal Proceedings	3233
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	34
Item 1A	Risk Factors	35
Item 4	Submission of Matters to a Vote of Security Holders	34
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 6	Exhibits	35
Item 4	Submission of Matters to a Vote of Security Holders	35
	Signatures	36
Item 6	Exhibits	36
	Signatures	37

PART I FINANCIAL INFORMATION

Item 1 Financial Statements

IntraLase Corp.

Condensed Consolidated Balance Sheets

(unaudited)

	September 30, 2005			December 31,2004
	June 30, 2006			December 31, 2005
Assets
Current assets:
Cash and cash equivalents	$	715,~~720~~426,~~296~~439		$	2611,~~014~~198,~~926~~665
Marketable securities		5047,~~000~~986,~~000~~775			6635,000,000
Accounts receivable—Net of allowance for doubtful accounts of $235,911 (September 30, 2005) and $151,604 (December 31, 2004)		11,642,678			7,186,163
Accounts receivable—Net of allowance for doubtful accounts of $323,135 (June 30, 2006) and $269,308 (December 31, 2005)		18,496,553			13,575,776
Inventories, Net		14,~~467~~047,~~871~~720			813,~~901~~471,~~684~~961
Prepaid expenses and other current assets		13,~~823~~398,~~642~~377			13,~~868~~190,~~186~~412
Total current assets		8599,~~654~~355,~~487~~864			~~109~~76,~~970~~436,~~959~~814
Marketable securities		3234,000,000			44,000,000
Property, plant and equipment—Net		1213,~~292~~466,~~484~~162			412,~~597~~422,~~546~~428
Equipment under operating leases—Net of accumulated depreciation of $1,048,470 (September 30, 2005) and $682,889 (December 31, 2004)		3,124,519			2,224,785
Equipment under operating leases—Net of accumulated depreciation of $1,595,628 (June 30, 2006) and $1,155,270 (December 31, 2005)		3,984,551			3,681,099
Other assets		15,~~395~~021,~~128~~239			13,~~418~~087,~~774~~216
Total	$	~~134~~155,~~466~~827,~~618~~816		$	~~118~~139,~~212~~627,~~064~~557
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	5,~~545~~950,~~799~~101		$	54,~~685~~830,~~565~~731
Accrued expenses (including $311,298 of deferred rent and lease incentives at September 30, 2005)		7,720,273			6,030,507
Accrued expenses (including deferred rent and lease incentives of $323,281 at June 30, 2006 and $311,298 at December 31, 2005)		8,295,317			7,805,567
Deferred revenues		4,~~448~~855,~~632~~981			3,~~232~~874,~~272~~335
Total current liabilities		1719,~~714~~101,~~704~~399			1416,~~948~~510,~~344~~633
Deferred rent and lease incentives		34,~~654~~117,~~067~~808			3,964,894
Deferred revenues		1721,~~164,413~~376			~~970~~1,~~115~~179,466
Total liabilities		2223,~~533~~940,~~184~~583			1521,~~918~~654,~~459~~993
Commitments and Contingencies (Note 6)
Stockholders’ Equity:
Preferred stock, $0.01 par value — 10,000,000 shares issued and authorized and no shares outstanding at September 30, 2005 and December 31, 2004
Preferred stock, $0.01 par value — 10,000,000 shares issued and authorized and no shares outstanding at June 30, 2006 and December 31, 2005
Common stock, $0.01 par value—45,000,000 shares authorized; 27,733,932 (September 30, 2005) and 26,769,185 (December 31, 2004) shares issued and outstanding		277,339			267,692
Common stock, $0.01 par value—45,000,000 shares authorized; 28,559,055 (June 30, 2006) and 28,073,627 (December 31, 2005) shares issued and outstanding		285,591			280,736
Additional paid-in capital		~~171~~177,~~158~~680,~~230~~049			~~170~~173,~~567~~941,~~316~~312
Deferred stock-based compensation		(1927,~~659,208~~933	)		(42,~~302~~235,~~631~~113	)
Receivable from sale of stock to officers and employees		(~~138~~64,~~747~~529	)		(~~838~~138,~~690~~747	)
Accumulated deficit		(5745,~~704~~085,~~180~~945	)		(6353,~~400~~875,~~082~~624	)
Total stockholders’ equity		~~111~~131,~~933~~887,~~434~~233			~~102~~117,~~293~~972,~~605~~564
Total	$	~~134~~155,~~466~~827,~~618~~816		$	~~118~~139,~~212~~627,~~064~~557

See accompanying notes to financial statements.

IntraLase Corp.

Condensed Consolidated Statements of Operations

(unaudited)

	Three Months Ended						~~Nine~~Six Months Ended
	September 30, 2005			September 30,2004			September 30, 2005			September 30,2004
	June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Revenues	$	2232,~~887~~170,~~794~~926		$	1523,~~493~~002,~~329~~969		$	6762,~~071~~233,~~736~~980		$	4044,~~805~~183,~~023~~942
Costs of goods sold (1)		1014,~~526~~395,~~099~~889			810,~~499~~944,~~532~~054			3127,~~492~~993,~~389~~075			2320,~~656~~966,~~255~~290
Gross margin		1217,~~361~~775,~~695~~037			612,~~993~~058,~~797~~915			3534,~~579~~240,~~347~~905			1723,~~148~~217,~~768~~652
Operating expenses:
Research and development (1)		23,~~792~~689,~~796~~339			3,~~771~~083,~~928~~344			87,~~391~~284,~~190~~704			95,~~003~~598,~~812~~394
Selling, general and administrative (1)		79,~~873~~381,~~064~~883			68,~~361~~289,~~217~~367			2319,~~410~~866,~~896~~054			15,~~259~~537,~~206~~832
Total operating expenses		1013,~~665~~071,~~860~~222			1011,~~133~~372,~~145~~711			3127,~~802~~150,~~086~~758			2421,~~263~~136,~~018~~226
Income (loss) from operations		1,695,835			(3,139,348	)		3,777,261			(7,114,250	)
Income from operations		4,703,815			686,204			7,090,147			2,081,426
Interest and other income (expense), Net
Interest and other income, net
Interest expense		(7964,~~255~~383	)		(5686,~~204~~698	)		(~~257~~146,~~903~~227	)		(~~123~~178,~~664~~648	)
Interest income		~~841~~1,~~769~~123,365			41749,~~206~~954			2,~~191~~119,~~052~~172			~~132~~1,~~457~~349,283
Other income		8,743			13,361			170,083			29,218
Other income (expense)		(1,212	)		822			17,154			161,340
Interest and other income (expense) , net		771,257			(1,637	)		2,103,232			38,011
Interest and other income, net		1,057,770			664,078			1,990,099			1,331,975
Income (loss) before provision for income taxes		2,467,092			(3,140,985	)		5,880,493			(7,076,239	)
Income before provision for income taxes		5,761,585			1,350,282			9,080,246			3,413,401
Provision for income taxes		77197,~~183~~644			740,~~500~~505			~~184~~290,~~591~~567			22107,~~500~~408
Net income (loss)		2,389,909			(3,148,485	)		5,695,902			(7,098,739	)
Net income	$	5,563,941		$	1,309,777		$	8,789,679		$	3,305,993
Accretion of preferred stock					(14,948	)					(44,845	)
Net income per share – basic	$	0.20		$	0.05		$	0.31		$	0.12
Net income (loss) applicable to common stockholders	$	2,389,909		$	(3,163,433	)	$	5,695,902		$	(7,143,584	)
Net income per share – diluted	$	0.18		$	0.04		$	0.28		$	0.11
Net income (loss) per share applicable to common stockholders – basic	$	0.09		$	(1.37	)	$	0.21		$	(3.15	)
Weighted average shares outstanding – basic		28,496,710			27,219,621			28,359,985			27,020,035
Net income (loss) per share applicable to common stockholders – diluted	$	0.08		$	(1.37	)	$	0.18		$	(3.15	)
Weighted average shares outstanding – diluted		31,196,889			31,045,535			31,125,925			31,105,344
Weighted average shares outstanding – basic		27,621,700			2,312,946			27,222,794			2,267,167
Weighted average shares outstanding – diluted		31,216,624			2,312,946			31,158,180			2,267,167
(1) Amounts include stock-based compensation expenses, as follows:
Costs of goods sold	$	23141,~~097~~275		$	7228,~~406~~256		$	86276,~~226~~215		$	~~145~~63,~~798~~129
Research and development		15223,~~286~~116			~~268~~274,~~758~~844			~~193~~722,~~415~~118			~~901~~178,~~592~~129
Selling, general and administrative		81878,~~581~~816			~~539~~841,~~196~~191			~~925~~1,~~829~~836,911			1844,~~355,428~~248
	$	~~119~~1,~~964~~243,207		$	~~880~~1,~~360~~144,291		$	12,~~205~~835,~~470~~244		$	21,~~402~~085,~~818~~506

See accompanying notes to financial statements.

IntraLase Corp.

Condensed Consolidated Statements of Cash Flows

(unaudited)

	Nine Months Ended
	Six Months Ended
	September 30,2005			September 30,2004
	June 30,2006			June 30,2005
Cash flows from operating activities:
Net income (loss)	$	5,695,902		$	(7,098,739	)
Net income	$	8,789,679		$	3,305,993
Adjustments to reconcile net loss to net cash used in operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,~~942~~212,~~568~~257			1,~~844~~778,~~935~~504
Loss on disposition of property, plant and equipment		19,354			~~2,304~~
Provision for bad debt expense		8453,~~306~~827			4548,~~097~~900
Amortization of debt discount					2,755
Stock-based compensation		2,835,244			1,085,506
Stock-based compensation		1,205,470			2,402,818
Amortization of technology license		185,200			144,456
Amortization of technology license		209,276			50,004
Changes in operating assets and liabilities:
Accounts receivable		(4,~~540~~974,~~821~~604	)		(35,~~995~~626,~~906~~969	)
Prepaid expenses and other current assets		44(207,~~545~~965	)		13(509,~~753~~664	)
Inventories		(5575,~~566,187~~759	)		(2,~~069~~909,~~522~~759	)
Other assets		(~~185~~2,~~631~~119,224	)		~~(53~~107,~~103~~019	)
Accounts payable		~~(220~~1,~~671~~119,370	)		4(256,~~348,862~~076	)
Deferred rent and lease incentives		3(28,~~965,365~~099	)		3,731,540
Accrued expenses		1670,~~378,468~~762			1393,~~546,042~~097
Deferred revenues		1523,~~410,658~~556			1,~~761~~507,~~545~~957
Net cash provided by (used in) operating activities		6,423,248			(1,199,155	)
Net cash provided by operating activities		8,503,598			2,800,504
Cash flows from investing activities:
Purchase of property, plant and equipment		(102,~~191~~554,~~019~~724	)		(17,~~323~~085,~~859~~664	)
Purchase of equipment under operating leases		(1,265,316	)		(341,642	)
Proceeds from disposition of property, plant and equipment		50,337			—
Purchase of technology license					(1,235,000	)
Purchase of equipment under operating leases		(1,074,410	)		(570,360	)
Purchase of marketable securities		(5925,~~896~~975,~~500~~108	)		(350,~~990~~296,~~892~~500	)
Proceeds from maturities of marketable securities		4322,~~896~~988,~~500~~333			634,~~980~~296,~~057~~500
Net cash provided by (used in) investing activities		(27,456,335	)		88,664
Net cash used in investing activities		(6,565,572	)		(23,656,024	)
Cash flows from financing activities:
Net proceeds from the exercise of stock options		1,~~384~~505,~~615~~947			~~143~~920,~~366~~041
Net proceeds from the issuance of stock under the employee stock purchase plan		~~671~~709,~~697~~583			671,697
Net proceeds from collection of receivable - sale of stock to officers and employees		~~699~~74,~~943~~218			536,943
Payments for issuance costs associated with 2004 common stock offering		~~(17,798~~	)		(117,~~398,662~~798	)
Proceeds from issuance of long-term debt					898,956
Net cash provided by financing activities		2,289,748			2,110,883
Principal payments on long-term debt					(371,608	)
Net increase (decrease) in cash and cash equivalents	$	4,227,774		$	(18,744,637	)
Net cash provided by (used in) financing activities		2,738,457			(727,948	)
Cash and cash equivalents—beginning of year		11,198,665			26,014,926
Net increase (decrease) in cash and cash equivalents	$	(18,294,630	)	$	(1,838,439	)
Cash and cash equivalents—end of period	$	15,426,439		$	7,270,289
Cash and cash equivalents—beginning of year		26,014,926			8,903,715
Cash and cash equivalents—end of period	$	7,720,296		$	7,065,276
Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	~~257~~146,~~903~~227		$	~~123~~178,~~664~~648
Cash paid during the year for income taxes	$	~~308~~75,~~514~~105		$	26221,~~260~~177

Supplemental Disclosures of Noncash Transactions:

During the nine months ended Sep 30, 2004 the Company recorded accretion of $44,845 to the redemption value of redeemable convertible preferred stock.

See accompanying notes to financial statements.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~ June 30, ~~2004~~2006

(unaudited)

1.	Basis of Presentation

The information set forth in these financial statements as of ~~September~~June 30, ~~2005~~2006 and December 31, ~~2004~~2005 and for the three and ~~nine~~six months ended ~~September~~ June 30, ~~2005~~2006 and ~~2004~~2005, is unaudited and includes the accounts of IntraLase Corp. (the “Company”). The information reflects all adjustments consisting only of normal recurring entries that, in the opinion of management, are necessary to present fairly the financial position and results of operations of the Company for the periods indicated. Results of operations for the interim periods are not necessarily indicative of the results of operations for the full fiscal year.

Certain information in footnote disclosures normally included in annual financial statements has been condensed or omitted, in accordance with the rules and regulations of the Securities and Exchange Commission for interim financial statements.

The information contained in these interim financial statements should be read in conjunction with the Company’s audited financial statements as of and for the year ended December 31, ~~2004~~2005 contained in the Company’s Annual Report on Form 10-K.

2.	Significant Accounting Policies

Revenue Recognition— In the normal course of business, the Company generates revenue through the sale and rental of lasers, the sale of per procedure fees inclusive of a disposable patient interface and maintenance parts and services. Revenue related to sales of the Company’s products and services is recognized as follows:

Laser revenues: Revenues from the sale or lease of lasers are recognized at the time of sale or at the inception of the lease, as appropriate. For laser sales that require the Company to install the product at the customer location, revenue is recognized when the equipment has been delivered, installed and accepted at the customer location. For laser sales to a distributor whereby installation is the responsibility of the distributor, revenue is recognized when the laser is shipped and title has transferred to the distributor. For laser sales in the ~~second~~first quarter of ~~2005~~2006 that were sold prior to the availability of the Company’s 3060 kilohertz upgrade, the fair value of the upgrade was deferred and revenue ~~was~~will be subsequently recognized when the upgrade has ~~had~~ been delivered, installed and accepted at the customer location. ~~The~~This is consistent with the deferral of the fair value of the Company’s 30 kilohertz upgrade isin ~~not~~the second quarter of 2005, prior to availability. The upgrades are not required for laser functionality but ~~does~~do increase the speed of the procedure. The Company does not allow customers, including distributors, to return any products. Some customers finance the purchase or rental of the Company’s lasers over periods up to four years directly from the Company. These financing agreements are classified as either operating leases or sales-type leases as prescribed by SFAS No. 13, Accounting for Leases. Under sales-type lease agreements, where ownership is transferred to the lessee at the end of the lease term, laser revenues are recognized based on the net present value of the contractual lease payments upon installation and customer acceptance. Revenues from lasers under operating leases are recognized as earned over the lease term, ~~which~~commencing isimmediately ~~generally~~after onthe alaser ~~straight-line~~is ~~basis~~installed ~~over~~and 36accepted toby 39the ~~months~~customer.

Per Procedure Fees Inclusive of a Disposable Patient Interface revenues: Per procedure fees inclusive of a disposable patient interface revenue is recognized upon shipment to the customer and when the title has passed in accordance with sales terms. The Company does not allow customers to return product.

Maintenance revenues: Maintenance revenues are derived primarily from maintenance services on the Company’s laser systems sold to customers in the ~~US.~~United ~~Prepaid~~States ~~maintenance~~and ~~expenses~~some customers in international markets that are ~~deferred~~not serviced by distributors. Maintenance revenues also include sales of parts and ~~recognized~~tool onkits. aWhen ~~straight~~prepaid ~~line~~maintenance ~~basis~~funds ~~over~~are received the ~~term~~Company ofamortizes the ~~contracts,~~deferred ~~generally~~maintenance 12amounts ~~months~~over the maintenance period. A substantial portion of the Company’s products are sold with one year of maintenance services for which the Company defers an amount equal to its fair value. To the extent the Company determines revenues associated with a specific maintenance contract are not sufficient to recover the estimated costs to provide such maintenance services, the Company accrues for such excess costs upon identification of the associated embedded loss. To date, these embedded losses have been insignificant.

Revenue Recognition under Bundled Arrangements: The Company sells ~~most~~many of its products and services under bundled contract arrangements, which contain multiple deliverable elements. These contractual arrangements typically include the laser and maintenance for which the customer pays a single negotiated price for all elements with separate prices listed in the multiple element customer contracts. Such separate prices may not always be representative of the ~~fair values of those elements, because the prices of the different components of~~ the arrangement may be modified through customer negotiations, although the aggregate consideration may remain the same. Revenues under bundled arrangements are allocated based upon the residual method in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. The Company’s revenue allocation to the deliverables begins by allocating revenues to the maintenance service and 30 kilohertz upgrade, for the short period

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

~~during~~fair ~~which~~values of those elements, because the 30prices ~~kilohertz~~of ~~upgrade~~the ~~was~~different components of the arrangement may be modified through customer negotiations, although the aggregate consideration may remain the same. Revenues under bundled arrangements are allocated based upon the residual method in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. The Company’s revenue allocation to the deliverables begins by allocating revenues to the maintenance service and upgrades, for the short period during which the upgrades were not available, and lastly by allocating revenue to the laser. There is reliable third-party and entity-specific evidence of the fair value of the maintenance service and ~~30 kilohertz upgrade~~upgrades, and the residual method is used to allocate the arrangement consideration to the delivered item (the laser). Fair value evidence for maintenance consists of amounts charged for annual renewals of maintenance agreements by the Company, ~~which~~(as ~~are~~maintenance is required for the customer to ~~continue~~use ~~using~~ the laser), prices the Company’s third party distributors charge their customers and amounts charged for maintenance by excimer laser manufacturers, for which maintenance may be different than the maintenance on the Company’s lasers. Fair value evidence for the 30upgrades ~~kilohertz upgrade~~ is the average upgrade price received from the Company’s customers for previously installed ~~lasers~~or ordered upgrades.

Stock-Based Compensation—~~The~~In ~~Company~~December ~~accounts~~2004, the ~~for~~FASB ~~stock~~issued SFAS No. 123R (revised 2004), Share-~~based~~Based ~~awards~~Payment, or SFAS No. 123R. SFAS No. 123R requires that the compensation cost related to ~~employees~~share-based ~~using~~payment transactions, measured based on the ~~intrinsic~~fair value ~~method~~of the equity or liability instruments issued, be recognized in ~~accordance~~the ~~with~~financial ~~Accounting~~statements. ~~Principles~~The ~~Board~~adoption ~~(“APB”)~~of ~~Opinion~~SFAS No. 25123R is required in fiscal years beginning after June 15, ~~Accounting~~2005. ~~for~~Effective ~~Stock~~January 1, ~~Issued~~2006, tothe ~~Employees~~Company adopted SFAS No. 123R ~~The~~using ~~Company~~the ~~accounts~~modified prospective application method, which provides for only current and future period stock-based compensation awards to ~~nonemployees~~be ~~using~~measured ~~the~~and recognized at fair value. ~~method~~Refer into ~~accordance~~Footnote ~~with~~7 ~~SFAS~~– ~~No. 123, Accounting for~~ Stock-Based Compensation for additional discussion and disclosure.

InNet ~~December~~Income ~~2002,~~per ~~the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, Accounting for Stock-Based Compensation~~Share—~~Transition~~Basic ~~and~~net ~~Disclosure.~~income ~~SFAS~~per ~~No. 148~~share ~~amends~~is ~~SFAS~~computed ~~No. 123~~by todividing ~~provide~~net ~~alternative~~income ~~methods~~by ~~for voluntary transition to SFAS No. 123’s fair value method of accounting for stock~~the weighted-~~based~~average ~~employee compensation~~number ~~(“the fair value method”). SFAS No. 148 also requires disclosure~~ of ~~the~~shares ~~effects~~ of ancommon ~~entity’s accounting policy with respect to~~ stock~~-based~~ ~~employee~~outstanding ~~compensation~~for onthe ~~reported~~period. Diluted net income ~~(loss)~~per inshare ~~annual~~is ~~financial statements.~~computed ~~The~~giving ~~Company~~effect ~~is required~~ to ~~follow~~all ~~the~~common ~~prescribed~~stock, ~~disclosure~~including ~~format~~options, ~~and~~warrants, ~~has~~common ~~provided~~stock ~~the~~subject ~~additional~~to ~~disclosures~~repurchase ~~required by SFAS No. 148 for the three~~ and ~~nine~~redeemable ~~months~~convertible preferred ~~ended September 30~~stock, ~~2005~~if ~~and 2004 below~~dilutive.

SFAS No. 123 requires the disclosure of pro forma net income (loss) had the Company adopted the fair value method in accounting for employee stock-based awards. Under SFAS No. 123, the fair value of stock- based awards to employees is calculated through the use of option-pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock-option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company’s calculations were made using the Black-Scholes option-pricing model with the following weighted-average assumptions:


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
Numerator:
Net income	$	5,563,941	$	1,309,777	$	8,789,679	$	3,305,993

Denominator:
Basic net income per share – weighted average shares outstanding		28,496,710		27,219,621		28,359,985		27,020,035

Effect of dilutive securities:
Weighted average dilutive options outstanding		2,700,179		3,825,914		2,765,940		4,085,309

Total weighted-average number of shares used in computing net income (loss) per share applicable to common stockholder—diluted		31,196,889		31,045,535		31,125,925		31,105,344

	Three Months EndedSeptember 30,				Nine Months EndedSeptember 30,
	2005		2004		2005		2004
Expected life (1)	75 months		60 months		65 months		60 months
Risk free rate of return	4.0	%	3.2	%	4.0	%	3.2	%
Volatility (2)	52	%	0	%	58	%	0	%
Dividends	none		none		none		none

Comprehensive Income—There was no difference between comprehensive income and net income for the three and six months ended June 30, 2006 and 2005.

~~(1)~~Segment ~~Expected~~Reporting—SFAS ~~life~~No. 131, Disclosures about Segments of ~~six~~an ~~months~~Enterprise and Related Information, established standards for ~~employee~~reporting ~~stock~~information ~~purchase~~about ~~plan~~operating segments in ~~2005~~financial statements. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief decision maker or group, in deciding how to allocate resources and in assessing performance. The Company’s chief decision maker reviews the results of operations and requests for capital expenditures based on one industry segment: producing and selling products and procedures to improve people’s vision through laser vision correction. The Company’s entire revenue and profit stream is generated through this segment.

(2) 88 to 89% volatility for grants from June 2004 through September 2004

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

If the computed fair value of the awards had been amortized to expense over the vesting period of the awards, net income (loss) would have been as follows for the periods ended:

	Three Months EndedSeptember 30,						Nine Months EndedSeptember 30,
	2005			2004			2005			2004
Net income (loss) applicable to common stockholders as reported	$	2,389,909		$	(3,163,433	)	$	5,695,902		$	(7,143,584	)
Add: Stock—based employee compensation expense included in reported net loss		230,179			527,136			1,294,761			1,095,894
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(1,981,664	)		(821,261	)		(4,120,681	)		(1,571,935	)
Net income (loss) applicable to common stockholders	$	638,424		$	(3,457,558	)	$	2,869,982		$	(7,619,625	)
Pro forma net income (loss) per share applicable to common stockholders—basic	$	0.02		$	(1.49	)	$	0.11		$	(3.36	)
Pro forma net income (loss) per share applicable to common stockholders—diluted	$	0.02		$	(1.49	)	$	0.09		$	(3.36	)

Net Income (Loss) Applicable to Common Stockholders—Net loss applicable to common stockholders for the three and nine months ended September 30, 2004 has been calculated by adding to the net loss the accretion to the redemption value of redeemable convertible preferred stock.

Net Income (Loss) per Share Applicable to Common Stockholders—Basic net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding for the period. Diluted net income (loss) per share is computed giving effect to all common stock, including options, warrants, common stock subject to repurchase and redeemable convertible preferred stock, if dilutive.

	Three Months EndedSeptember 30,					Nine Months Ended September 30,
	2005		2004			2005		2004
Numerator:
Net income (loss) applicable to common stockholders	$	2,389,909	$	(3,163,433	)	$	5,695,902	$	(7,143,584	)
Denominator:
Basic net income (loss) per share – weighted average shares outstanding		27,621,700		2,342,792			27,222,794		2,297,013
Less: weighted-average shares subject to repurchase				(29,846	)				(29,846	)
Total weighted-average number of shares used in computing net income (loss) per share applicable to common stockholder—basic		27,621,700		2,312,946			27,222,794		2,267,167
Effect of dilutive securities:
Weighted average dilutive options outstanding		3,594,924					3,935,386
Total weighted-average number of shares used in computing net income (loss) per share applicable to common stockholder—diluted		31,216,624		2,312,946			31,158,180		2,267,167

The Company had 5,660,839 outstanding options to purchase common stock, 16,797,103 shares of redeemable convertible preferred stock and 39,514 warrants that were excluded from the computation of diluted net loss per share for the three and nine months ended September 30, 2004 as they had an antidilutive effect.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

September 30, 2005

(unaudited)

Included in the calculation of net loss attributable to common stockholders is accretion to redemption value of $14,948 and $44,845 for the three and nine months ended September 30, 2004, respectively, related to the issuance of the Company’s redeemable convertible preferred stock.

Comprehensive Income (Loss)—There was no difference between comprehensive income (loss) and net income (loss) for the three and nine months ended September 30, 2005 and 2004.

Segment Reporting—SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, established standards for reporting information about operating segments in financial statements. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief decision maker or group, in deciding how to allocate resources and in assessing performance. The Company’s chief decision maker reviews the results of operations and requests for capital expenditures based on one industry segment: producing and selling products and procedures to improve people’s vision through laser vision correction. The Company’s entire revenue and profit stream is generated through this segment.

The following table summarizes revenues by geographic region:

Three months endedSeptember 30,

Nine months endedSeptember 30,

Three months endedJune 30,

Six months endedJune 30,

2005

2004

2005

2004

2006

2005

2006

2005

United States

1116,~~966~~838,~~404~~523

1114,~~130~~179,~~118~~866

3834,~~409~~922,~~799~~282

2926,~~653~~610,~~438~~078

Asia Pacific

6,~~280~~745,~~354~~982

15,~~779~~195,~~662~~983

1411,~~191~~980,~~597~~898

39,~~223~~800,~~036~~237

Europe

46,~~000~~826,~~458~~752

2,~~177~~215,~~625~~104

11,~~985~~916,~~558~~383

45,~~794~~930,~~157~~674

Other

~~640~~1,~~578~~759,669

~~405~~1,~~924~~412,016

23,~~484~~414,~~782~~417

31,~~134~~842,~~392~~953

2232,~~887~~170,~~794~~926

1523,~~493~~002,~~329~~969

6762,~~071~~233,~~736~~980

4044,~~805~~183,~~023~~942

Substantially all of the Company’s long-lived assets are located in the United States.

Recent Accounting Pronouncements— In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment. This statement replaces SFAS No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method under APB 25, Accounting for Stock Issued to Employees, and requires instead that such transactions be accounted for using a fair-value-based method. ~~The Company is currently evaluating~~ SFAS No. 123R towas ~~determine which fair-value-based model and transitional provision it will follow upon adoption. SFAS No. 123R will be~~ effective for the Company beginning in its first quarter of fiscal 2006. ~~Although~~and the Company ~~will~~uses ~~continue to evaluate~~ the modified prospective application ~~of SFAS No~~method. ~~123R,~~ ~~management~~Refer ~~expects adoption~~ to ~~have~~Footnote a7 ~~material~~– ~~impact~~Stock-Based onCompensation ~~its~~for ~~results~~additional ofdiscussion ~~operations~~and ~~in amounts not yet determinable~~disclosure.

In ~~December~~November 2004, the FASB issued SFAS No. ~~153~~151, ~~“Exchanges~~Inventory ~~of Nonmonetary~~Costs. ~~Assets~~SFAS –No. 151 Anclarifies ~~amendment~~the ofaccounting ~~APB 29, Accounting~~ for ~~Nonmonetary~~abnormal ~~Transactions”.~~amounts ~~This~~of ~~statement~~idle ~~amends~~facility ~~APB~~expense, ~~Opinion~~freight, ~~No. 29~~handling tocosts ~~eliminate~~and ~~the~~wasted ~~exception~~material ~~for~~(spoilage) ~~nonmonetary~~to ~~exchanges~~be ofexpensed ~~similar~~as ~~productive~~incurred ~~assets~~ and ~~replaces~~not itincluded ~~with~~in aoverhead. ~~general~~Further, ~~exception~~SFAS ~~for~~No. 151 ~~exchanges~~requires ofthat ~~nonmonetary~~allocation ~~assets~~of ~~that~~fixed doproduction ~~not~~overheads ~~have~~to ~~commercial~~conversion ~~substance.~~costs Ashould ~~nonmonetary~~be ~~exchange~~based ~~has~~on ~~commercial~~normal ~~substance~~capacity ifof the ~~future~~production ~~cash~~facilities. ~~flows~~The provisions of ~~the~~SFAS ~~entity~~No. 151 are ~~expected~~effective tofor ~~change~~inventory ~~significantly~~costs asincurred during afiscal ~~result~~years ofbeginning ~~the~~after ~~exchange~~June 15, 2005. The Company’s ~~will~~current ~~evaluate~~accounting policies are consistent with the ~~effect~~accounting required by SFAS No. 151 and, ifas ~~any~~such, the adoption of ~~adopting~~this ~~SFAS~~statement Nohad no effect on its financial statements. ~~153.~~

In ~~November~~May ~~2004~~2005, the FASB issued SFAS No. ~~151~~154, ~~“Inventory~~Accounting ~~Costs”~~Changes and Error Corrections, which replaces APB Opinion No. 120, Accounting Changes and SFAS No. ~~151~~3, ~~clarifies~~Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 changes the ~~accounting~~requirements for ~~abnormal~~accounting ~~amounts~~and ofreporting ~~idle~~a ~~facility~~change ~~expense,~~in ~~freight~~accounting principle, ~~handling~~and ~~costs~~applies to ~~and~~all ~~wasted~~voluntary ~~material (spoilage)~~changes toin beaccounting ~~expensed~~principles, as ~~incurred~~well ~~and~~as ~~not~~changes ~~included~~required by an accounting pronouncement in ~~overhead~~the unusual instance it does not include specific transition provisions. ~~Further~~Specifically, ~~Statement~~SFAS No. ~~151~~154 requires ~~that~~retrospective application ~~allocation~~to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects or the cumulative effect of ~~fixed~~the ~~production~~change. ~~overheads~~When it is impracticable to ~~conversion~~determine ~~costs~~the ~~should~~effects of the change, the new accounting principle must be ~~based~~applied onto ~~normal~~the ~~capacity~~balances of assets and liabilities as of the ~~production~~beginning ~~facilities.~~of ~~The~~the earliest period for which retrospective application is practicable and a corresponding adjustment must be made to the opening balance of retained earnings ~~provisions~~for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of the change the new principle must be applied as if it were adopted prospectively from the earliest date practicable. SFAS No. ~~151~~154 ~~are~~is effective for ~~inventory~~accounting ~~costs~~changes ~~incurred~~and ~~during~~corrections of errors made in fiscal years beginning after ~~June~~December 15, 2005. ~~The~~SFAS ~~Company’s~~No. 154 ~~current~~does ~~accounting~~not ~~policies~~change ~~are~~the ~~consistent~~transition ~~with~~provisions ~~the~~of ~~accounting~~any ~~required~~existing bypronouncements. The Company has evaluated the impact of SFAS No. ~~151~~154 and~~, as~~ ~~such,~~does not expect the adoption of this ~~statement~~Statement ~~will~~to have noa ~~effect~~significant impact on its financial statements. The Company will apply SFAS No. 154 in future periods, when applicable.

8In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 are effective for reporting periods beginning after December 15, 2006. The Company is currently assessing the impact of the adoption of FIN 48 and its impact on the Company’s condensed consolidated financial statements.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

3.	Cash, Cash Equivalents and Marketable Securities

The Company’s portfolio of cash, cash equivalents and marketable securities are as follows:

	September 30,2005		December 31,2004
	June 30,2006		December 31,2005
Cash and money market funds	$	715,~~720~~426,~~296~~439	$	411,~~074~~198,~~091~~665
Commercial paper				21,940,835
Agency bonds – short-term	$	47,986,775	$	35,000,000
Agency bonds – short term		50,000,000		66,000,000
Agency bonds – long-term	$	34,000,000	$	44,000,000
Agency bonds – long term		32,000,000
	$	89,720,296	$	92,014,926

At ~~September~~June 30, ~~2005~~ 2006, all of the Company’s investments are classified as held-to-maturity and are reported at amortized cost that approximates fair value as the Company has the positive intent and ability to hold these securities to maturity. As of ~~September~~ June 30, 2006 and December 31, 2005, the long term agency bonds had maturity dates within 24 months and all other investments had maturities within 12 months. ~~At December 31, 2004, all of the Company’s investments had maturities within 90 days.~~

4.	Revenues

Revenues from product sales are as follows:

	Three months endedSeptember 30,				Nine months endedSeptember 30,
	Three months endedJune 30,				Six months endedJune 30,
	2005		2004		2005		2004
	2006		2005		2006		2005
Laser revenues	$	1115,~~050~~263,~~416~~924	$	811,~~553~~045,~~121~~233	$	3229,~~537~~887,~~211~~502	$	21,~~696~~486,~~394~~795
Per procedure revenues (inclusive of a disposable patient interface)		914,~~736~~293,~~561~~752		510,~~729~~107,~~870~~097		2827,~~871~~665,~~608~~145		1619,~~063~~135,~~848~~047
Maintenance revenues		2,~~100~~613,~~817~~250		1,~~210~~850,~~338~~639		54,~~662~~681,~~917~~333		3,~~044~~562,~~781~~100
	$	2232,~~887~~170,~~794~~926	$	1523,~~493~~002,~~329~~969	$	6762,~~071~~233,~~736~~980	$	4044,~~805~~183,~~023~~942

5.	Inventories

Inventories are as follows:

	September 30,2005				December 31,2004
	June 30,2006			December 31,2005
Raw materials	$	53,~~551~~763,~~298~~139		$	$3,973,984	~~4,757,720~~
Work-in-process		67,~~199~~167,~~165~~726			6,275,690	~~3,303,745~~
Finished goods		43,~~105~~116,~~536~~855			3,222,287	~~1,620,043~~
		15,855,999				9,681,508
	$	14,047,720		$	13,471,961
Less reserve for obsolescence		(1,388,128	)			(779,824	)
	$	14,467,871			$	8,901,684

Amounts charged to expense for excess and obsolete inventories were $~~880~~502,~~000~~388 and $~~433~~454,000 for the six ~~nine~~ months ended ~~September~~June 30, ~~2005~~2006 and ~~2004~~2005, respectively.

6.	Commitment and Contingencies

Indemnities and Guarantees—During its normal course of business, the Company has made certain indemnities and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include (i) certain real estate leases, under which the Company may be required to indemnify property owners for general liabilities; and (ii) certain agreements with the Company’s officers; under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship; (iii) certain agreements with its customers in which the Company provides intellectual property indemnities; and (iv) certain agreements with licensors, under which the Company indemnifies the party granting the license against claims, losses and expenses arising out of the manufacture, use, sale or other disposition of the products the Company manufactures using the licensed technology or patents. The duration of these indemnities and guarantees varies and, in certain cases, is indefinite. The majority of these indemnities and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

for liabilities arising out of their employment relationship; (iii) certain agreements with its customers in which the Company provides intellectual property indemnities; and (iv) certain agreements with licensors, under which the Company indemnifies the party granting the license against claims, losses and expenses arising out of the manufacture, use, sale or other disposition of the products the Company manufactures using the licensed technology or patents. The duration of these indemnities and guarantees varies and, in certain cases, is indefinite. The majority of these indemnities and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. Historically, the Company has not been obligated to, nor does it expect to make significant payments for these obligations and no liabilities have been recorded for these indemnities and guarantees in the accompanying balance sheets.

Employment Agreement — In ~~April~~February ~~2003,~~of 2006 the Company entered into a annew three-year employment agreement with the Chief Executive Officer of the Company, ~~that~~which ~~calls~~took ~~for~~effect ~~minimum~~in ~~annual~~April ~~payments~~of at2006, aupon ~~rate~~expiration of ~~$450,000, effective~~his ~~with~~previous ~~the~~contract. ~~initial~~The ~~public~~new ~~offering,~~employment ~~plus~~agreement ~~reimbursement~~provides for ~~certain~~minimum ~~expenses.~~annual ~~The~~payments ~~employment~~of ~~agreement~~$472,500 ~~has~~plus reimbursement afor ~~three~~certain ~~year term~~expenses.

Litigation— On June 10, 2004, the Company received notice from Escalon Medical Corp. of its intent to terminate the Company’s license agreement unless the Company paid additional royalties and expenses which Escalon claimed were owed under its interpretation of the parties’ license agreement. Escalon sought payment of approximately $645,000 through March 31, 2004 and additional unspecified amounts for future periods. The Company disputed Escalon’s contract interpretation. On June 21, 2004, the Company filed a complaint against Escalon for declaratory and injunctive relief in the United States District Court for the Central District of California to clarify its obligations and prevent Escalon from terminating the license agreement (the “First California Action”).

On March 1, 2005, the court in the First California Action entered a summary judgment order, ruling on the majority of issues in the case. The court ruled in the Company’s favor on some issues and in Escalon’s favor on others. On April 1, 2005 Escalon again attempted to terminate the license agreement. On April 25, 2005 the court found the purported termination to be ineffective. On May 5, 2005, the court entered a final judgment in the First California Action, in effect adopting its prior summary judgment rulings. This ended the First California Action. Of the approximately $645,000 demanded by Escalon through March 31, 2004, approximately $229,000 was found to be due under the court’s rulings in the First California Action. The Company has timely paid this amount. The Company does not believe that the judgment in the First California Action will have a material adverse effect on its business, financial condition and results of operations~~, and the Company’s financial statements were not affected at December 31, 2004~~. The decision in the First California Action, if upheld, represents an increase in royalties payable to Escalon of approximately 0.2% of revenues, and a concomitant 0.2% reduction in gross margins and operating profits. These effects are reflected in the Company’s reported financial results for ~~the first three quarters of~~ 2005. The Company has appealed certain aspects of the court’s judgment in the First California Action to the United States Court of Appeals for the Ninth Circuit.

The First California Action did not resolve all of the parties’ disputes, and Escalon ~~continues~~continued to contend in written notices to the Company that the Company’s royalty payments ~~are~~were inadequate~~, although the notices do not specify the amount of the claimed underpayment~~. On May 9, 2005, the Company commenced a new lawsuit against Escalon in the United States District Court for the Central District of California to clarify the open issues (the “Second California Action”). One week later, Escalon commenced a new lawsuit against the Company in the Delaware Chancery Court, alleging, among other things, breach of the license agreement and breach of fiduciary duty (the “Delaware Action”). Escalon ~~has~~ moved to dismiss the Second California Action, and the Company ~~has~~ moved to dismiss or stay the later filed Delaware Action. ~~These motions are pending.~~

~~One~~On ofJanuary 11, ~~the~~2006, ~~issues now in dispute is valuation of~~ the ~~Company’s~~Second ~~accounts~~California ~~receivable~~action ~~for~~was ~~royalty~~dismissed ~~calculation~~without ~~purposes~~prejudice. ~~The~~In ~~court~~its indecision, the ~~First~~court ~~California~~explained ~~Action found~~ that ~~creation~~it ofwas anexercising ~~account receivable on the~~its ~~Company’s~~discretion ~~books~~to ~~constituted~~abstain ~~non-cash~~from ~~“other~~hearing ~~property”~~the ~~received,~~case ~~but~~because ~~expressly~~of ~~left open~~ the ~~value~~pending ofNinth ~~such~~Circuit ~~property for royalty calculation purposes. On April 22~~appeal, ~~2005,~~as ~~Escalon,~~well ~~purporting to act in its capacity~~ as ~~a Company shareholder, sent~~ the ~~Company~~similar anissues ~~inspection~~presented ~~demand~~in ~~under section 220 of~~ the Delaware ~~corporation~~Action. ~~law~~By ~~(the~~prior ~~“First~~agreement ~~220~~of ~~Demand”),~~the ~~seeking~~parties, ~~among~~this ~~other~~triggered ~~things,~~the ~~detailed~~briefing ~~records~~schedule ~~concerning~~on the Company’s ~~accounts receivable. The Company~~ ~~rejected~~motion ~~Escalon’s~~to ~~First~~dismiss ~~Section 220~~or ~~Demand~~stay asthe ~~having an improper purpose under~~ Delaware ~~law. On July 18~~Action, ~~2005,~~and ~~Escalon~~on ~~Holdings~~January 31, ~~Inc.,~~2006 ~~apparently~~the aCompany ~~wholly-owned~~filed ~~subsidiary~~its ofopening ~~Escalon,~~brief ~~also~~in ~~purporting~~support toof ~~act~~the asmotion. aOn ~~Company~~February 21, ~~shareholder~~2006, ~~sent~~ ~~the~~Escalon ~~Company~~filed aan ~~new~~amended ~~section~~complaint ~~220~~in ~~demand (~~the ~~“Second~~Delaware ~~220~~Action ~~Demand”)~~in ~~with~~lieu ~~language~~of ~~copied~~responding ~~verbatim from~~ to the ~~First~~Company’s ~~220~~opening ~~Demand~~brief. ~~The~~On ~~Company has rejected~~ the ~~Second 220 Demand on the~~ same ~~basis~~day, asit ~~the~~sent ~~first. Under Delaware law,~~ a ~~shareholder may~~new ~~bring~~default annotice ~~action~~ to ~~enforce~~the aCompany, ~~section~~alleging ~~220~~breach ~~demand~~of ~~if its statutory demand upon~~ the ~~corporation~~license ~~has~~agreement ~~been~~(see ~~rejected~~below).

10One of the issues now in dispute is valuation of the Company’s accounts receivable for royalty calculation purposes. The court in the First California Action found that creation of an account receivable on the Company’s books constituted non-cash “other property” received, but expressly left open the value of such property for royalty calculation purposes. On April 22, 2005, Escalon, purporting to act in its capacity as a Company shareholder, sent the Company an inspection demand under section 220 of the Delaware corporation law (the “First 220 Demand”), seeking, among other things, detailed records concerning the Company’s accounts receivable. The Company rejected Escalon’s First Section 220 Demand as having an improper purpose under Delaware law. On July 18, 2005, Escalon Holdings, Inc., apparently a wholly-owned subsidiary of Escalon, also purporting to act as a Company shareholder, sent the Company a new section 220 demand (the “Second 220 Demand”) with language copied verbatim from the First 220 Demand. The Company rejected the Second 220 Demand on the

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

~~On September 2, 2005, Escalon and Escalon Holdings, Inc. commenced an action against the Company~~ in the Delaware Chancery Court under section 220 of the Delaware Corporation Law (the “220 Action”). In the 220 Action, Escalon seeks to inspect the Company records described in the Section 220 Demands. The crux of Escalon’s position appears to be that the amount of royalties which Escalon receives under its contract with the Company is less than what it believes it would receive if receivables were valued under the contract the same ~~way~~basis ~~they~~as ~~are valued on~~ the ~~Company’s~~ ~~financial statements, and that therefore the Company is purportedly overstating the value of receivables on its financial statements to the detriment of shareholders~~first. ~~The~~Under ~~question~~Delaware ~~of the proper valuation of receivables under the contract is already the subject of pending litigation between the Company and Escalon~~law, ~~and both parties have requested~~ a ~~judicial~~shareholder ~~declaration~~may asbring to the meaning of the applicable contract language. The Company does not believe that a disruptive inspection of its proprietary business records would have a bearing on the resolution of this contract dispute. The Company contends that the 220 Action is an ~~Escalon~~action ~~litigation tactic intended~~ to ~~benefit~~enforce ~~Escalon in its capacity as~~ a ~~litigant~~section ~~by allowing~~220 itdemand toif ~~circumvent existing contractual limitations on~~ its ~~inspection~~statutory ~~rights. The Company believes this is an improper basis for a~~ demand ~~under~~upon ~~section 220 of~~ the ~~Delaware~~ corporation has ~~statute,~~been ~~and intends to defend against the 220 Action vigorously~~rejected.

On September 2, 2005, Escalon and Escalon Holdings, Inc. commenced an action against the Company in the Delaware Chancery Court under section 220 of the Delaware Corporation Law (the “220 Action”). In the 220 Action, Escalon seeks to inspect the Company records described in the Section 220 Demands. The crux of Escalon’s position appears to be that the amount of royalties which Escalon receives under its contract with the Company is less than what it believes it would receive if receivables were valued under the contract the same way they are valued on the Company’s financial statements, and that therefore the Company is purportedly overstating the value of receivables on its financial statements to the detriment of shareholders. The question of the proper valuation of receivables under the contract is already the subject of pending litigation between the Company and Escalon. The Company does not believe that a disruptive inspection of its proprietary business records would have a bearing on the resolution of this contract dispute. The Company contends that the 220 Action is an Escalon litigation tactic intended to benefit Escalon in its capacity as a litigant by allowing it to circumvent existing contractual limitations on its inspection rights. The Company believes this is an improper basis for a demand under section 220 of the Delaware corporation statute, and is defending the 220 Action vigorously.

On February 21, 2006, the Company received a written notice from Escalon asserting that the Company was in default under the license agreement by reason of alleged improper valuation of accounts receivable in the Company’s royalty payments as well as the Company’s alleged refusal to permit Escalon to audit the Company’s books and records (the “Default Notice”). The Default Notice appears to threaten termination of the license agreement if the accounts receivable deductions taken against royalty payments for each of the first three quarters of 2005 are not paid within fifteen days of the date of the letter. However, to date Escalon has refused to confirm this or provide the Company with the amount it believes is required to cure the alleged default, despite multiple requests from the Company. The Default Notice also threatened termination if Escalon was not satisfied with respect to the resolution of its audit rights within sixty days of the date of the letter.

On February 24, 2006, the parties agreed to submit their disputes to mediation, in Delaware, under Court of Chancery Rule 174, and to stay all litigation pending the outcome of the mediation. In addition, Escalon agreed that its Termination Notice would be suspended pending the outcome of the mediation and that, should the mediation be unsuccessful, the Company would be afforded the full fifteen and sixty day response periods set forth in the Notice, which periods would commence ten days after the Chancery Court issued an order lifting the stay. Escalon has also agreed that the time period for responding to Escalon’s amended complaint in the Delaware Action would be tolled on the same basis.

On June 28, 2006 Escalon notified the Chancery Court that the mediation was unsuccessful, resulting in a lifting of the stay effective July 19, 2006. Accordingly, the parties’ Delaware Chancery Court litigation will proceed, and the cure periods in Escalon’s February termination notice have begun to run. The Chancery Court has agreed to conduct an expedited trial of the parties’ audit dispute in late August, 2006.

The Company believes Escalon will persist in attempting to terminate the license agreement. Termination of the Escalon license agreement could have a material adverse effect on the Company’s business, financial condition and results of operations.

On May 24, 2005, Ari Weitzner M.D., P.C., a Brooklyn ophthalmologist, commenced a lawsuit against the Company in the United States District Court for the Eastern District of New York, purportedly as a class action, alleging that the Company violated the Telephone Consumer Protection Act (TCPA) by sending unsolicited fax advertisements in violation of the TCPA. The complaint seeks statutory damages, costs and attorneys fees. The TCPA provides for statutory damages of $500 per violation ($1,500 if knowing and willful). The Company intends to contest the Weitzner action vigorously.

On August 23, 2004, the United States Patent and Trademark Office (PTO) granted a request for ~~re-examination~~reexamination with respect to ~~U.S.~~US Patent RE 37,585, one of the four U.S. patents licensed to the Company by the University of Michigan, which means that the PTO found that the request raised a new issue of patentability with regard to some of the claims. ~~Re-examination~~On ~~may~~July ~~result~~25, in2006, the ~~scope~~USPTO ofterminated ~~protection and rights provided by~~ the ~~patent license being lost or narrowed. The irrevocable license the Company acquired and the payment the~~ ~~Company~~proceedings ~~made~~favorable ~~pursuant~~ to the ~~July 15~~Patent Owner, ~~2004 license agreement will not be affected by~~ the ~~granting~~University of ~~re-examination~~Michigan, ~~regardless~~by ofissuing ~~the~~a ~~outcome.~~document ~~Although~~entitled ~~the~~“Notice ~~Company~~of ~~believes~~Intent ~~that~~to ~~the~~Issue ~~intellectual~~Ex ~~property~~Parte ~~covered~~Reexamination byCertificate” ~~the~~(NIRC). ~~patent~~In ~~subject to~~ the ~~re-examination~~ ~~is important to its business~~NIRC, ifthe ~~this~~PTO ~~patent~~confirmed isthe ~~invalidated~~patentability ~~there will be no effect on its ability to sell its products. However, invalidation or narrowing~~ of ~~this~~the ~~patent~~RE ~~might allow others to market competitive products that would~~37,585 ~~otherwise~~claims ~~have~~as ~~infringed~~amended during the ~~patent~~reexamination.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

June 30, 2006

(unaudited)

The Company is also currently involved in other litigation incidental to its business. In the opinion of management, the ultimate resolution of such litigation will not likely have a significant effect on the Company’s financial statements.

7.	Stock-Based Compensation

Stock Option Plans—The Company has four stock option plans: (i) the 1997 Stock Option Plan under which nonstatutory or incentive stock options to acquire shares of the Company’s stock may be granted to employees and non-employees of the Company, (ii) the 2000 Stock Incentive Plan provides for granting of options which vest over time, (iii) the 2000 Executive Option Plan provides for the granting of options which vest after the earlier of seven years or upon the grantee’s achievement of present goals or milestones (performance-based stock awards) and (iv) the 2004 Stock Incentive Plan for granting nonstatutory or incentive stock options, restricted stock, stock appreciation rights, performance shares and performance units to employees, directors and consultants. The plans initially permitted the issuance of options for the purchase of up to 1,309,213 shares of common stock, 5,772,224 shares of common stock, 721,528 shares of common stock, and 5,607,640 shares of common stock, respectively.

The plans are administered by the Board of Directors (the “Administrator”) and permit the issuance for purchase of the Company’s common stock at exercise prices not less than fair market value of the underlying shares on the date of grant. Options granted under the plans are exercisable over a period of time (generally not to exceed 10 years), designated by the Administrator and are subject to other terms and conditions, as determined by the Administrator.

At June 30, 2006, there were 3,538,643 available for future grant under the 2004 Stock Incentive Plan. Future grants under the three other stock option plans described above are no longer authorized.

In December 2004, the FASB issued SFAS No. 123R, which requires that the compensation cost related to share-based payment transactions, measured based on the fair value of the equity or liability instruments issued, be recognized in the financial statements. The adoption of SFAS No. 123R is required in fiscal years beginning after June 15, 2005. Determining the fair value of options using the Black-Scholes model requires subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affects the calculated fair value on the grant date.

For the six months ended June 30, 2005, the Company accounted for its stock-based awards to employees using the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees and related Interpretations. Stock-based awards to non-employees were recorded using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based Compensation.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

~~September~~June 30, ~~2005~~2006

(unaudited)

7If the computed fair value of the awards had been amortized to expense over the vesting period of the awards under SFAS No. 123, ~~Stockholders’~~net ~~Equity~~income would have been as follows for the periods ended:

Stock Option Activity—A summary of the Company’s stock option activity for the nine months ended September 30, 2005 follows:


	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Net income as reported	$	1,309,777		$	3,305,993
Add: Stock-based employee compensation expense included in reported net income		724,237			1,064,582
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(995,172	)		(1,869,758	)

Pro forma net income	$	1,038,842		$	2,500,817

Net income per share—basic, as reported	$	0.05		$	0.12

Pro forma net income per share—basic	$	0.04		$	0.09

Net income per share—diluted, as reported	$	0.04		$	0.11

Pro forma net income per share—diluted	$	0.03		$	0.08

	SharesUnderOption		WeightedAverageExercisePrice		Exercisableat End ofPeriod	WeightedAverageExercisePrice
Outstanding—January 1, 2005	5,439,795		$	3.83	2,418,454	$	1.82
Granted	437,740		$	20.49
Forfeited	(105,683	)	$	8.05
Exercised	(42,313	)	$	1.51
Outstanding—March 31, 2005	5,729,539		$	5.04	2,604,355	$	1.86
Granted	644,822		$	15.41
Forfeited	(117,298	)	$	12.52
Exercised	(569,051	)	$	1.50
Outstanding—June 30, 2005	5,688,012		$	6.42	2,430,932	$	2.40
Granted	291,602		$	17.86
Forfeited	(22,014	)	$	10.53
Exercised	(264,012	)	$	1.76
Outstanding—September 30, 2005	5,693,588		$	7.20	2,590,697	$	3.16

SFAS No. 123 requires the disclosure of pro forma net income had the Company adopted the fair value method in accounting for employee stock-based awards. Under SFAS No. 123, the fair value of stock- based awards to employees is calculated through the use of option-pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock-option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company’s calculations were made using the Black-Scholes option-pricing model with the following weighted-average assumptions:

Deferred stock-based compensation is included as a component of stockholders’ equity and is being amortized to expense over the vesting period of the options in accordance with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. The Company recorded stock-based compensation expense of $1,205,470 and $2,402,818 during the nine months ended September 30, 2005 and September 30, 2004; respectively. This total stock-based compensation expense included an $89,290 credit and $1,304,097 of expense during the nine months ended September 30, 2005 and 2004, respectively, in connection with stock options granted to non-employees subject to remeasurement. Options granted to non-employees are accounted for under variable accounting in accordance with SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services. Under variable accounting, the market value of the underlying common stock is remeasured during each reporting period and the excess of the fair value over the option exercise price is charged to operations ratably over the remaining period in which the awards vest. The total stock-based compensation expense also included stock-based compensation expense of $1,294,760 and $1,098,721 for the nine months ended September 30, 2005 and September 30, 2004; respectively, associated with employee performance-based and employee time-based awards. As of September 30, 2005, $645,002 of the total remaining deferred compensation of $1,659,208 is subject to periodic remeasurement.


	Three Months Ended June 30,				Six Months Ended June 30,
	2006		2005		2006		2005
Expected life (1)	75 months		60 months		75 months		60 months
Risk-free rate of return	5.1	%	3.83	%	4.8	%	4.0	%
Stock volatility	49	%	55	%	50	%	61	%
Dividends	none		none		none		none

(1).	Expected life of six months for employee stock purchase plan in 2006 and 2005

As of June 30, 2006, there was $17,465,887 of total unrecognized compensation cost related to non-vested share-based compensation arrangements under the plans in addition to the deferred stock-based compensation for non-employees described below. That cost is expected to be recognized over a weighted average period of 3.2 years.

The weighted-average fair value of option awards granted during the three and six months ended June 30, 2006 were approximately $11.49 per share and $11.36 per share, respectively. The total intrinsic value of stock options exercised during the three and six months ended June 30, 2006 were $1,281,393 and $3,056,697, respectively.

Cash received from share option exercises under stock-based payment plans for the six months ended June 30, 2006 was $1,505,947. The Company did not realize any tax effect, which would be a reduction in its tax rate, on options due to the full valuation allowances established on its deferred tax assets.

IntraLase Corp.

Notes to Condensed Consolidated Financial Statements

June 30, 2006

(unaudited)

Stock Option Activity—A summary of the Company’s stock option activity for the six months ended June 30, 2006 follows:


	Shares Under Option		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (years)	Aggregate Intrinsic Value
Outstanding—January 1, 2006	5,504,615		$	7.73
Granted	111,199		$	18.25
Forfeited	(59,037	)	$	11.44
Exercised	(342,746	)	$	3.05

Outstanding—March 31, 2006	5,214,031		$	8.22	7.73	$	78,106,184

Granted	1,199,025		$	22.21
Forfeited	(57,461	)	$	13.98
Exercised	(88,262	)	$	5.22

Outstanding—June 30, 2006	6,267,333		$	10.69	7.93	$	45,769,997

Exercisable—June 30, 2006	3,307,795		$	7.03	7.15	$	34,372,995

Deferred stock-based compensation is included as a component of stockholders’ equity and includes options granted to non-employees that are accounted for under variable accounting in accordance with SFAS No. 123R and EITF No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services. Under variable accounting, the market value of the underlying common stock is remeasured during each reporting period and the excess of the fair value over the option exercise price is charged to operations ratably over the remaining period in which the awards vest. As of June 30, 2006 the total remaining deferred compensation of $927,933 is subject to periodic remeasurement.

Item 2

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements as defined within the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by the use of words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Those risks and uncertainties include, but are not limited to: the degree of continued acceptance of LASIK surgery; potential complications revealed by long term follow up; the extent of adoption of our product offering by LASIK surgeons; general economic conditions; changes in federal tax laws governing the ability of potential LASIK patients to use pre-tax dollars to pay for LASIK surgery; the scope of government regulation applicable to our products; patients’ willingness to pay for LASIK surgery; our ability to compete against our competitors; the effectiveness of our measures to ensure full payment of procedure fees; the occurrence and outcome of product liability suits against us; our ability to adequately protect our intellectual property; whether we become subject to claims of infringement or misappropriation of the intellectual property rights of others; the continued availability of supplies from single-source suppliers and manufacturers of our key laser components; the ability of our managers, operations and facilities to manage our growth; the success of our expansion into markets outside the United States; whether we lose any of our key executives or fail to attract qualified personnel; or if our new products or applications fail to become commercially viable.

Certain of these risks and uncertainties, in addition to other risks, are more fully described under “Factors that May Affect Results of Operations and Financial Condition” contained elsewhere herein and in our annual report on Form 10-K, as filed with the Securities and Exchange Commission on March 293, ~~2005~~2006.

Overview

Background

We are a medical device company focused on the design, development and marketing of an ultra-fast laser, related software and disposable devices for use in LASIK surgery. Our product offering is primarily used to create the corneal flap in the first step of LASIK surgery. IntraLase lasers are also used in surgical approaches to the treatment of diseased corneas, and we continue to explore other potential ophthalmic applications. From our incorporation in late 1997 through late 2001, we devoted substantially all of our resources to designing, developing, commercializing and marketing our IntraLase® FS laser, our IntraLASIK® software and our disposable patient interface. In late 2001, we introduced our product offering to the U.S. market, and we began expanding into key international markets in the second half of 2003. ~~In the three months ended September 30, 2005, we captured approximately 19 to 20% of the U.S. market for LASIK corneal flap creation.~~

Our quarterly laser sales or leases, cumulative lasers installed and approximate per-procedure patient interface units in ~~2005~~2006, ~~2004~~2005 and ~~2003~~2004 were as follows:

2005

2004

2003

2006

2005

2004

Laser Sales/Leases Per Quarter

3452

3949

3944

3734

2739

3039

1737

2627

1430

2217

Cumulative Lasers Installed (1)

~~327~~471

~~293~~419

~~254~~371

~~217~~327

~~180~~293

~~153~~254

~~123~~217

~~106~~180

80153

66123

Total Per-procedure Fees, Inclusive of Disposable Patient Interface, Sold

83119,000

85112,~~284~~000

7595,~~188~~000

5283,~~418~~000

4985,~~927~~284

4875,~~422~~188

4152,~~094~~418

2749,~~372~~927

2248,~~164~~422

1941,~~208~~094

~~15,486~~

(1) Installed base does not represent cumulative sales since an existing ~~customer~~customers bought ~~two new~~ lasers in the first ~~quarter~~quarters of 2006 and 2005 to retire original purchases.

We were profitable for the ~~nine~~six months ended ~~September~~ June 30, ~~2005~~2006 with net income of $58.78 million. We ~~incurred~~had net ~~losses~~income ~~applicable to common stockholders~~ of ~~approximately~~ $109.2 5 million in ~~2004~~2005 and we incurred net losses of $1210.02 million in ~~2003~~2004. As of ~~September~~June 30, ~~2005~~2006, we had an accumulated deficit of approximately $5745.71 million.

1314

Revenues

We generate revenues primarily from the sale or lease of our IntraLase^{^®} FS laser and the sale of our per procedure fees inclusive of a disposable patient interface. We derive a smaller portion of our revenues from product maintenance.

The following table sets forth the sources and amounts of our revenues for the periods indicated:

	Three months ended September 30,						Nine months ended September 30,
	Three months ended June 30,						Six months ended June 30,
	2005			2004			2005			2004
	2006			2005			2006			2005
	Units	Revenue		Units	Revenue		Units	Revenue		Units	Revenue
IntraLase® FS laser	3452	$	1115,~~050~~263,~~416~~924	2739	$	811,~~553~~045,~~121~~233	~~112~~101	$	3229,~~537~~887,~~211~~502	7478	$	21,~~696~~486,~~394~~795
Per procedure fees inclusive of a disposable patient interface	83119,000		914,~~736~~293,~~561~~752	4985,~~927~~284		510,~~729~~107,~~870~~097	~~243~~231,~~472~~000		2827,~~871~~665,~~608~~145	~~139~~160,~~443~~472		1619,~~063~~135,~~848~~047
Product maintenance	—		2,~~100~~613,~~817~~250	—		1,~~210~~850,~~338~~639	—		54,~~662~~681,~~917~~333	—		3,~~044~~562,~~781~~100
Total revenues		$	2232,~~887~~170,~~794~~926		$	1523,~~493~~002,~~329~~969		$	6762,~~071~~233,~~736~~980		$	4044,~~805~~183,~~023~~942

We target the most active LASIK surgery practices in the United States and in key international markets to adopt our product offering in order to generate recurring business from our per procedure fees inclusive of a disposable patient interface. We expect that, even with increased sales and leases of our IntraLase^{^®} FS laser, repeat revenues from the higher gross margin per procedure fees will continue to increase as a percentage of our total revenues, which will, in turn, drive higher overall gross margin.

Terms of Sale and Revenue Recognition Laser

Laser

• Terms of sale. In the United States, we primarily sell our lasers to LASIK surgery practices. We also selectively enter into operating leases, ~~either directly~~ or ~~through third~~sales-~~party~~type ~~financing companies~~leases. Leases typically have terms of 36up to 39four ~~months~~years, commencing on installation and acceptance. Our terms of sale are typically on the basis of cash in advance, paid directly by our customers or on terms, typically net 30 days from acceptance, to fiscally sound third party financing companies, institutions or well established corporate customers, or under sales-type leases over the term of the agreement. No customer accounted for more than 10% of revenue in the three or ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 or ~~2004~~2005.

In the ~~nine~~six months ended ~~September~~June 30, ~~2005~~ 2006, approximately 6574% of our new domestic laser unit sales or leases were sales, representing 9392% of our total domestic laser revenues, and approximately 3526% were operating leases, representing 78% of our total domestic laser revenues. In comparison, in the ~~nine~~six months ended ~~September~~June 30, ~~2004~~2005, 6971% of our new domestic laser unit sales or leases were sales, representing 93% of our total domestic laser revenues, and 3129% were operating leases, representing 7% of our total domestic laser revenues.

Outside the United States, we primarily sell to our international distributors and, in selected countries, directly to LASIK surgery practices. Historically, payment terms have been cash in advance or irrevocable letters of credit; however, in the second quarter of 2005 we began selling to selected and qualified distributors on credit terms, with the number of international distributors qualifying for credit expanding each quarter.

• Revenue recognition. For the lasers we sell directly, we recognize revenue when the equipment has been delivered, installed and accepted at the customer location. Revenues from our leased lasers are ~~recognized~~classified ~~ratably~~as ~~over~~either ~~the~~operating ~~term~~or ofsales-type leases as prescribed by SFAS No. 13, Accounting for Leases. Revenues from our lasers under operating leases are recognized as earned over the lease term, commencing immediately after the laser is installed and accepted by the customer. Under sales-type lease arrangements, laser revenues are recognized based on the net present value of the expected cash flow after installation. For laser sales to a distributor, revenues are recognized when the laser is shipped and title has transferred to the distributor. For laser sales in the ~~second~~first quarter of ~~2005~~2006 that were sold prior to the availability of our 3060 kilohertz (kHz) upgrade, the fair value of the upgrade was deferred and revenue ~~was~~will be subsequently recognized when the upgrade ~~had~~has been delivered, installed and accepted at the customer location. ~~The~~This 30is ~~kHz~~consistent ~~upgrade~~with isthe ~~not~~deferral ~~required~~of ~~for~~the ~~laser~~fair ~~functionality~~value ~~but~~of ~~does~~the ~~increase~~Company’s ~~the~~30 ~~speed~~kilohertz ofupgrade ~~the~~in ~~procedure.~~the

1415

second quarter of 2005, prior to availability. The upgrade is not required for laser functionality but does increase the speed of the procedure.

Per procedure fee inclusive of a disposable patient interface

• Terms of sale. Our customers order per procedure fees inclusive of a disposable patient interface directly from us as needed. In the United States, payment is typically due 30 days after shipment and the per procedure fee inclusive of a disposable patient interface is non-refundable. A small percentage of our U.S. customers have agreed to a minimum monthly purchase requirement for per procedure fees. International customers, primarily distributors, have typically paid for their per procedure fees inclusive of a disposable patient interface with cash in advance or by irrevocable letter of credit; however, in the second quarter of 2005, we began selling to selected and qualified distributors on credit terms, with the number of international distributors qualifying for credit expanding each quarter.

•

Revenue recognition. Revenue from the sale of our per procedure fees inclusive of a disposable patient interface is recognized upon shipment, and when title has passed in accordance with the sales terms. We do not allow customers to return product.

Product maintenance

• Terms of sale. Our product offering includes maintenance. We provide product maintenance when we sell directly or lease to customers and our international distributors provide maintenance for their territory sales outside the United States. Where we provide maintenance, maintenance agreements are renewable annually ~~and~~(as ~~are~~maintenance is required ~~at all times~~ for the ~~continued~~ use of our laser ~~and to receive on-going maintenance and support~~). When we receive prepaid maintenance funds we amortize the deferred maintenance amounts over the maintenance period.

•

Revenue recognition. Revenue from product maintenance is recognized on a straight-line basis over the term of the maintenance period.

International Revenue Expansion

We introduced our product offering in the United States in late 2001 and internationally in the second half of 2003. As of ~~September~~June 30, ~~2005~~2006, we had sold or leased ~~218~~292 lasers in the United States and we had sold ~~111~~182 internationally, primarily in the Asia-Pacific region and Europe. In international markets, we mainly sell our product offering through local country third-party distributors. These distributors are responsible for sales, customer support and product maintenance, and as a result generally pay a lower price for our product offering. As a result, the mix between direct sales in the United States and distributor sales internationally may create fluctuations in our revenues and gross margin.

Seasonality

Lasers. Sales and leases of our lasers are seasonal. The second and fourth calendar quarters are typically stronger than the first and third calendar quarters. Two of the largest ophthalmology shows for refractive surgeons, the American Society of Cataract and Refractive Surgery, or ASCRS, and the American Academy of Ophthalmology, or AAO, are typically held in the second and fourth quarters, leading prospective customers to delay purchases in the first and third quarters until they have an opportunity to attend the shows, visit with us and attend lectures and symposiums on our product offering. In 2006, the ASCRS show was held in late March of the first quarter. In addition, tax incentives typically help to drive U.S. capital equipment spending higher in the fourth quarter. Sales and leases of our lasers in the third quarter are generally slower as surgeons in the United States and internationally typically take increased vacation time during the summer.

Per procedure fees inclusive of a disposable patient interface. Sales of our per procedure fees inclusive of a disposable patient interface are also seasonal. The first quarter typically shows an increase in volume in the United States. We believe this is because many potential LASIK patients in the United States access annual funding accounts established under Internal Revenue Code Section 125 pre-tax medical savings plans, or cafeteria plans, to purchase LASIK surgery, as LASIK surgery is not generally paid for through insurance programs or government reimbursement. The second quarter typically is lower than the seasonally highest first quarter. Generally, procedure volume is slowest during the third quarter, as surgeons in the United States and internationally typically take increased vacation time during the summer.

1516

Results of Operations

The following table sets forth our results of operations expressed as a percentage of total revenues for the periods indicated.

	Three Months EndedSeptember 30,				Nine Months EndedSeptember 30,
	Three Months EndedJune 30,				Six Months EndedJune 30,
	2005		2004		2005		2004
	2006		2005		2006		2005
Total revenues	100.0	%	100.0	%	100.0	%	100.0	%
Costs of goods sold	4644.07		5447.96		4745.0		5847.05
Gross margin	5455.03		4552.14		5355.0		4252.05
Operating expenses:
Research and development	1211.25		2413.34		1211.57		2212.07
Selling, general and administrative	3429.42		4136.10		3431.9		3735.41
Total operating expenses	4640.67		6549.4		4743.46		5947.48
Income (loss) from operations	7.4		(20.3	)	5.6		(17.4	)
Income from operations	14.6		3.0		11.4		4.7
Interest and other income (expense), net	3.43		02.09		3.2		03.10
Income (loss) before provision for income taxes	10.8		(20.3	)	8.8		(17.3	)
Income before provision for income taxes	17.9		5.9		14.6		7.7
Provision for income taxes	0.46		—0.2		0.45		0.12
Net income (loss)	10.4		(20.3	)	8.4		(17.4	)
Net income	17.3	%	5.7	%	14.1	%	7.5	%
Accretion of preferred stock	—		(0.1	)	—		(0.1	)
Net income (loss) applicable to common stockholders	10.4	%	(20.4	)%	8.4	%	(17.5	)%

Comparison of Three Months Ended ~~September~~ June 30, ~~2005~~2006 and ~~2004~~2005

Revenues

Total revenues increased to $2232.92 million for the three months ended ~~September~~ June 30, ~~2005~~2006 from $1523.50 million for the three months ended ~~September~~June 30, ~~2004~~2005. The increase was attributable to continued market acceptance of our product offering and our accelerated expansion into international markets, primarily in the Asia-Pacific region and Europe. During the three months ended ~~September~~June 30, ~~2005~~2006, we sold or leased 3452 lasers and generated $1014.02 million in revenues. Additionally, our 60 and 30 kHz upgrades resulted in the sale of 45 88 upgrades and generated $ 1.1 0 million in revenues, for total laser revenues of $1115.13 million. In comparison, during the three months ended ~~September~~June 30, ~~2004~~2005, we sold or leased 2739 lasers and generated $811.60 million in revenues. The average selling price per laser sold or leased in the three months ended ~~September~~June 30, ~~2005~~2006 decreased 8by 3% as compared to the three months ended ~~September~~June 30, ~~2004~~2005 primarily because US operating leased ~~units~~lasers, which generate revenue typically over 39 months, increased to 5033% of all US placements in the three months ended ~~September~~June 30, ~~2005~~2006 as compared to 3525% of all US placements in the three months ended ~~September~~June 30, ~~2004~~2005. The average selling price per laser excludes laser upgrades and the deferral of the fair value of the maintenance services from US and international direct sale laser revenue, which is amortized over the twelve month warranty period as maintenance revenue. The average selling price sold or leased is also affected by the mix between international distributor sales and domestic sales and leases.

In the three months ended ~~September~~June 30, ~~2005~~2006, we sold approximately 83119,000 per procedure fees inclusive of a disposable patient interface and generated $914.73 million in revenues. In comparison, during the three months ended ~~September~~June 30, ~~2004~~2005, we sold approximately 5085,000 per procedure fees inclusive of a disposable patient interface and generated $510.71 million in revenues. We attribute the increase in sales of per procedure fees to an increased installed base of lasers, as we entered the ~~third~~second quarter ended ~~September~~June 30, ~~2005~~2006 with ~~almost twice the~~ an installed base of lasers that is 65% larger as compared to the same period in ~~2004~~2005. We expect sales of our per procedure fees inclusive of a disposable patient interface to continue to increase as the installed base of lasers increases.

The increase in our installed base of lasers in the US and direct international customers that we service also primarily led to an increase in our maintenance revenues to $2.16 million during the three months ended ~~September~~June 30, ~~2005~~2006, as compared to $1.29 million during the three months ended ~~September~~June 30, ~~2004~~2005. We expect our maintenance revenues to continue to increase as the installed base of lasers in the US and lasers directly serviced outside the US increases.

1617

Gross Margin

Gross margin, as a percentage of total revenues, increased to 5455% in the three months ended ~~September~~June 30, ~~2005~~2006 from 4552% in the three months ended ~~September~~ June 30, ~~2004~~2005. Costs of goods sold, as a percentage of total revenues, decreased ~~primarily~~ due to higher average selling prices for our per ~~procedure~~procedures fees inclusive of a patient interface, ~~which~~along ~~generate~~with ~~higher~~lower ~~margins, increasing to 43% of total revenues in the three months ended September 30, 2005 from 37% of total revenues in the three months ended September 30, 2004. In addition, larger~~ production ~~runs~~ and ~~engineering~~material ~~producibility~~costs ~~improvements have contributed to cost savings~~ for ~~our~~ laser and patient interface products.

We expect gross margins to continue to improve as the percentage of total revenues derived from per procedure fees inclusive of a disposable patient ~~interface continues to increase. We expect that in the fourth quarter of 2005, revenues derived from per procedure fees inclusive of a~~ ~~disposable patient~~ interface ~~are~~is expected to increase as a percentage of total revenues.

Research and Development

Research and development expenses consist of costs of product research, product development, engineering, regulatory compliance and clinical support studies. Research and development expenses ~~decreased~~increased by $~~979~~606,000 to $23.87 million in the three months ended ~~September~~June 30, ~~2005~~2006 from $3.81 million in the three months ended ~~September~~June 30, ~~2004~~2005. This ~~decrease~~increase resulted primarily from ~~$765,000~~higher inconsulting service ~~expenses~~and ~~related~~support tofees aassociated ~~technology~~with ~~license~~clinical ~~from~~studies ~~the~~and ~~University~~consulting of ~~Michigan in the three months ended September 30~~$366, ~~2004. In addition~~000, ~~decreased~~higher ~~stock~~salaries ~~based~~and compensation ~~expense~~ of $~~253~~208,000, ~~decreased clinical study~~ and ~~outside~~increased ~~service~~research ~~expense of $172,000~~ and ~~decreased~~development ~~legal~~equipment expense of $~~141~~120,000; offset ~~$306,000~~by ofa ~~higher personnel costs and $196,000 of increased facilities and depreciation expense. The~~ decrease in stock -based compensation ~~results primarily from lower stock based compensation associated with options granted to non-employees subject to remeasurement (variable~~ ~~plan~~of ~~accounting treatment)~~$52,000.

Although we expect research and development expenses to ~~continue~~remain toat ~~decline~~approximately asthe asame percentage of our revenues as incurred in the three months ended June 30, 2006, we expect that the dollar amount of our research and development expenses will continue to increase ~~by 10% or greater~~ in future years as we continue to develop, enhance and commercialize new and existing products, product enhancements and applications. However, the increased dollar amount of spending for the full year of 2005 as compared to 2004 is expected to be lower than 10% due to the second half of 2004 including a total of $1,065,000 for the aforementioned $765,000 in expenses related to the University of Michigan and expenses associated with their related sale of stock in our initial public offering of stock in the fourth quarter of 2004. We also expect to incur increased expenses relating to regulatory compliance associated with new and existing applications and products and for regulatory approval for expansion of our existing product offering into new markets outside of the United States. We also expect to incur increased expenses as we continue to support clinical studies.

Selling, General and Administrative

Selling, general and administrative expenses consist of expenses associated with sales, marketing, field service and clinical applications that are not otherwise direct costs of installing and supporting our product offering, finance, information technology , legal and human resources. Selling, general and administrative expenses increased by $1.51 million to $7.9.4 million in the three months ended ~~September~~June 30, ~~2005~~2006 from $68.43 million in the three months ended ~~September~~June 30, ~~2004~~2005. The increase resulted from higher personnel costs in sales, marketing and general and administrative departments of $~~708,000;~~1.5 ~~higher~~million ~~outside~~and ~~services,~~higher ~~which~~stock-based ~~primarily~~compensation ~~include~~expense ~~consulting and legal fees,~~ of $~~695~~38,000; anoffset ~~increase~~by inlower ~~facilities~~conference and ~~depreciation~~trade ~~expense~~shows of ~~$193,000;~~ ~~higher insurance expense of~~ $~~186~~356,000; and anlower ~~increase~~communications inand ~~commissions~~advertising ~~paid~~expenses ~~to sales representatives on higher sales totaling $144,000; offset by decreased stock based compensation~~ of $~~458~~160,000.

We expect selling, general and administrative expenses, which are primarily driven by sales and marketing expenses, to decline slightly as a percentage of revenues, although we expect the dollar amount to increase in the future as a result of continued growth in our sales and support infrastructure to support projected growth in revenues. ~~In addition, we expect general and administrative cost increases, due to the increased costs of being a public company, to continue in the future.~~

Interest and other income ~~(expense)~~, net

Interest and other income ~~(expense)~~, net consists primarily of interest earned on investments in cash, cash equivalents and marketable securities offset by interest expense. Interest and other income ~~(expense)~~, net increased by $~~773~~394,000 to $1.1 million of income in the three months ended June 30, 2006 from income of approximately $664,000 in the three months ended June 30, 2005 due to higher interest income earned from higher interest rates on our investments.

$771,000 of income in the three months ended September 30, 2005 from expense of approximately $2,000 in the three months ended September 30, 2004 due to the investment of the proceeds from our initial public offering in the fourth quarter of 2004.

Stock-Based Compensation

~~Over~~In ~~the~~December ~~next several years~~2004, weFASB ~~will~~issued ~~incur~~SFAS ~~non-cash~~No ~~expenses~~123 ~~for~~(revised ~~employee~~2004) ~~stock~~(“SFAS 123R”), Share-~~based~~Based ~~compensation,~~Payment. ~~decreasing~~SFAS ~~quarterly,~~No. 123R was effective for ~~stock-based~~us ~~compensation~~beginning ~~for~~in ~~stock~~the ~~options~~first ~~determined~~quarter toof ~~have~~fiscal ~~been~~2006 ~~issued~~and ~~with~~we ~~exercise~~used ~~prices~~the ~~less~~modified ~~than~~prospective ~~estimated fair~~application ~~value~~method. In addition, we expect to incur stock-based compensation expenses, primarily for options granted to non-employees, that may decrease or increase quarterly, depending upon future fluctuations in our stock price. InSimilar ~~December 2004, FASB issued SFAS No 123 (revised 2004) (“SFAS 123R”), Share-Based Payment .We are currently evaluating SFAS No. 123R~~ to determine which fair-value-based model and transitional provision we will follow upon adoption. SFAS No. 123R will be effective for us beginning in first quarter of fiscal 2006. Although we will continue to evaluate the ~~application~~historical ~~of SFAS No. 123R~~accounting, ~~management expects adoption to have a material impact on our results of operations in amounts not yet determinable. Additionally,~~ unearned deferred stock compensation for non-employees continues isto be periodically remeasured through the vesting date under ~~current~~SFAS ~~and future accounting rules~~123R. This periodic remeasurement could have a significant impact on our results of operations. See “—Critical ~~Accounting Policies—Stock-Based Compensation.”~~

~~Comparison~~18 ~~of Nine Months Ended September 30, 2005 and 2004~~

Accounting Policies—Stock-Based Compensation” and Note 2 and Note 7 to our financial statements contained elsewhere within this Form 10-Q for further discussion. Management estimates that stock-based compensation expense in 2006 will be $6.0 million, the majority of which will arise from the adoption of SFAS 123R, as compared to approximately $2.1 million of stock-based compensation expense recognized in 2005. However, actual results may vary depending upon 2006 stock option grants, stock compensation programs and the fluctuation in our stock price.

Comparison of Six Months Ended June 30, 2006 and 2005

Revenues

Total revenues increased to $6762.12 million for the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 from $4044.82 million for the ~~nine~~six months ended ~~September~~ June 30, ~~2004~~2005. The increase was attributable to continued market acceptance of our product offering and our accelerated expansion into international markets, primarily in the Asia-Pacific region and Europe. During the ~~nine~~six months ended ~~September~~ June 30, ~~2005~~2006, we sold or leased ~~112~~101 lasers and generated $3128.41 million in revenues. Additionally, our 60 and 30 kHz upgrades resulted in the sale of 45121 upgrades and generated $1.17 million in revenues, for total laser revenues of $3229.59 million. In comparison, during the ~~nine~~ six months ended ~~September~~June 30, ~~2004~~2005, we sold or leased 7478 lasers and generated $21.75 million in revenues. The average selling price per laser sold or leased in the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 ~~decreased 4~~increased 2% as compared to the ~~nine~~six months ended ~~September~~ June 30, ~~2004~~2005 primarily because US leased units, which generate revenue typically over 39 months, ~~increased~~decreased to 3526% of all US placements in the ~~three~~six months ended ~~September~~June 30, 2005 as compared to 3129% of all US placements in the ~~nine~~six months ended ~~September~~ June 30, ~~2004~~2005.

In the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006, we sold approximately ~~243~~231,000 per procedure fees inclusive of a disposable patient interface and generated $2827.97 million in revenues. In comparison, during the ~~nine~~ six months ended ~~September~~June 30, ~~2004~~2005, we sold approximately ~~139~~160,000 per procedure fees inclusive of a disposable patient interface and generated $1619.1 million in revenues. We attribute the increase in sales of per procedure fees to an increased installed base of lasers, as we entered ~~2005~~2006 with ~~approximately~~an ~~twice the~~ installed base of lasers seventy percent larger as compared to the same period in ~~2004~~2005. We expect sales of our per procedure fees inclusive of a disposable patient interface to continue to increase as the installed base of lasers increases.

The increase in our installed base of lasers in the US and direct international customers that we service also primarily led to an increase in our maintenance revenues to $54.7 million during the ~~nine~~six months ended ~~September~~ June 30, ~~2005~~2006, as compared to $3.06 million during the ~~nine~~six months ended ~~September~~June 30, ~~2004~~ 2005. We expect our maintenance revenues to continue to increase as the installed base of lasers in the US and lasers directly serviced outside the US increases.

Gross Margin

Gross margin, as a percentage of total revenues, increased to ~~53.0~~55% in the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 from ~~42.0~~53% in the ~~nine~~six months ended ~~September~~ June 30, ~~2004~~2005. Costs of goods sold, as a percentage of total revenues, decreased primarily due to our per procedure fees inclusive of a patient interface, which generate higher margins, increasing to 4344% of total revenues in the ~~nine~~ six months ended ~~September~~June 30, ~~2005~~2006 from 3943% of total revenues in the ~~nine~~six months ended ~~September~~June 30, ~~2004. In addition~~2005, ~~larger~~along ~~production~~with ~~runs~~lower production and ~~engineering~~material ~~producibility~~costs ~~improvements have contributed to cost savings~~ for ~~our~~ laser and patient interface products.

Research and Development

Research and development expenses ~~decreased~~increased by $~~613,000~~1.7 million to $87.43 million in the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 from $95.06 million in the ~~nine~~six months ended ~~September~~June 30, ~~2004~~2005. This ~~decrease~~increase resulted primarily from increased personnel costs of $~~765~~589,000, inhigher ~~expenses~~stock-based compensation expense of $544,000 and increased consulting service and support fees associated with clinical studies and consulting of $479,000.

related to a technology license from the University of Michigan in the nine months ended September 30, 2004. In addition, decreased stock based compensation expense of $708,000 offset $938,000 of higher personnel costs. The decrease in stock based compensation results primarily from lower stock based compensation associated with options granted to non-employees subject to remeasurement (variable plan accounting treatment).

Selling, General and Administrative

Selling, general and administrative expenses increased by $84.23 million to $2319.49 million in the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 from $15.35 million in the ~~nine~~six months ended ~~September~~June 30, ~~2004~~2005. The increase resulted from higher personnel costs in sales, marketing and general and administrative departments of $32.78 million; ~~higher~~an ~~outside~~increase ~~services,~~in ~~which~~facilities ~~primarily include consulting~~ and ~~legal~~depreciation ~~fees,~~expense of $~~1.9 million; higher marketing~~439,000 ~~advertising,~~as ~~promotion~~well ~~and~~as ~~event~~increased ~~costs~~stock-based ofcompensation ~~$930,000;~~due ~~an increase in commissions paid~~ to ~~sales~~the ~~representatives on~~adoption ~~higher~~of ~~sales totaling $557,000;~~ and implementation ~~an increase in facilities and depreciation expense~~ of ~~$476~~SFAS No.123R,~~000;~~ ~~offset~~Share-Based byPayment ~~decreased stock based compensation~~ of $~~430~~993,000.

Interest and other income (expense), net

Interest and other income (expense), net increased by $2.1 million to $2.1 million of income in the nine months ended September 30, 2005 from $38,000 in the nine months ended September 30, 2004 due to the investment of the proceeds from our initial public offering in the fourth quarter of 2004.

Liquidity and Capital Resources

General

We require capital principally for operating our business, working capital and capital expenditures for both the fixed assets used in our business and the revenue-generating assets under our operating leases. Our capital expenditures for fixed assets consist primarily of capitalization of our lasers for use in manufacturing and developing our product offering, and information technology infrastructure and equipment used to support the growth of our business. Additionally, during the nine months ended September, 2005 we paid approximately $3.6 million, which is included in our purchases of property, plant and equipment for the nine months ended September 30, 2005, and $0.2 of related expenses for leasehold improvements and other expenditures related to our new rental facility in Irvine, California. Our capital expenditures for revenue-generating assets consist of the capitalization of lasers under operating leases. Working capital is required principally to finance accounts receivable and inventory.

Our initial public offering, which was effective under applicable securities laws on October 6, 2004 and closed on October 13, 2004, resulted in our receipt of net proceeds of $86.1 million from the sale of 7,295,447 shares of common stock, including the sale of 995,447 over-allotment shares. The proceeds were net of expenses of $2.2 million. The net proceeds of the offering were used for the repayment of our bank debt in the amount of $1.3 million and the payment to the University of Michigan of $765,000. In addition, 22,191,333 shares of redeemable convertible preferred stock converted to 16,797,103 shares of common stock.

We believe that our current cash and cash equivalents, together with our marketable securities and investments and cash expected to be generated from sales of our product offering, will be sufficient to meet our projected operating requirements for at least the next 12 months. Our uses of cash included purchases of investment-grade securities, for which $82.0 million were held at September 30, 2004 with diversification among issuers and maturities ranging from one to 24 months. We maintain our cash and cash equivalents, marketable securities and investments with two major financial institutions in the United States and intend to hold our marketable securities and investments to maturity.

Cash and cash equivalents decreased by $18.3 million to $7.7 million at September 30, 2005 from $26.0 million at December 31, 2004. This decrease was primarily due to the increase in purchases of marketable securities net of maturities of $19.0 million, increased purchases of property, plant and equipment of $8.9 million, offset by an increase in cash provided by operating activities of $7.6 million and an increase in the cash provided by investing activities of $3.5 million in the nine months ended September 30, 2005, as well as net changes in other cash flow activities. The increase in property, plant and equipment included a $3.2 million leasehold improvement cash allowance from the landlord of our new building, which has been recorded as a deferred lease incentive on our financial statements.

~~Net~~Interest ~~cash~~and ~~provided~~other by operating activities increased to $6.4 million in the nine months ended September 30, 2005 from a $1.2 million use of cash in the nine months ended September 30, 2004. The increase of $7.6 million was primarily due to a $12.8 million increase caused by the improvement to net income ~~in the nine months ended September 30~~, ~~2005 from a~~ net loss in the nine months ended September 30, 2004 and an increase in deferred rent and lease incentives of $4.0 million, partially offset by a decrease in accounts payable of $4.1 million, an increase in inventories of $3.5 million, and a decrease in stock-based compensation of $1.2 million, as well as changes in other assets and liabilities. The decrease in accounts payable was primarily due to initial public offering expenditures that were incurred but not yet paid in the nine months ended September 30, 2004. The increase in inventories was primarily due to the timing of inventory purchases and production in advance of the fourth quarter of 2005 as opposed to a larger portion of purchases and production for fourth quarter 2004 sales occurring during the fourth quarter of 2004. The increase in deferred rent and lease incentives was primarily due to a $3.2 million leasehold improvement allowance from the landlord of our new building.

~~Net~~Interest ~~cash~~and ~~used~~other byincome, ~~investing~~net ~~activities~~ increased by $658,000 to $272.50 million in the ~~nine~~six months ended ~~September~~June 30, ~~2005~~2006 asfrom ~~compared to~~ $~~89,000~~1.3 ~~provided~~million in the ~~nine~~six months ended ~~September~~June 30, ~~2004.~~2005 ~~This increase of $27.5 million was primarily~~ due to anhigher ~~increase~~interest inincome ~~the~~earned ~~purchase of marketable securities~~from ~~net~~higher ofinterest ~~proceeds~~rates ofon ~~$19.0 million, and an increase in the purchase of property, plant and equipment of $8.9 million that included approximately $3.6 million for leasehold improvements and other expenditures related to~~ our ~~new rental facility in Irvine, California paid by us and the $3~~investments.2 ~~million leasehold improvement allowance from the landlord of our new building.~~

~~Net~~Liquidity cash flows provided by financing activities were $2.7 million in the nine months ended September 30, 2005 as compared to a $727,000 use of cash in the nine months ended September 30, 2004. The $3.5 million increase was primarily due to a reduction from the $1.4 million of cash used in the nine months ended September 30, 2004 related to our 2004 initial public offering of common stock; increases in net proceeds from the issuance of stock options under employee stock plans and ~~the~~Capital ~~employee~~Resources stock purchase plan of $1.2 million and $672,000, respectively; and notes receivable payments of $700,000. These increases were partially offset by a decrease in the net proceeds from issuance and payments on long-term debt of $527,000.

General

We require capital principally for operating our business, working capital and capital expenditures for both the fixed assets used in our business and the revenue-generating assets under our operating leases. Our capital expenditures for fixed assets consist primarily of capitalization of our lasers for use in manufacturing and developing our product offering, and information technology infrastructure and equipment used to support the growth of our business. Our capital expenditures for revenue-generating assets consist of the capitalization of lasers under operating leases. Working capital is required principally to finance accounts receivable and inventory, as well to enable us to provide long-term financing for customer sales-type leases for laser sales.

We believe that our current cash and cash equivalents, together with our marketable securities and investments and cash expected to be generated from sales of our product offering, will be sufficient to meet our projected operating requirements for at least the next 12 months. Our uses of cash included purchases of investment-grade securities, for which $82 million were held at June 30, 2006 with diversification among issuers and maturities ranging from one to 24 months. We maintain our cash and cash equivalents, marketable securities and investments with two major financial institutions in the United States and intend to hold our marketable securities and investments to maturity.

Net cash provided by operating activities increased by $5.7 million to $8.5 million in the six months ended June 30, 2006 from $2.8 million of cash provided in the six months ended June 30, 2005. The increase was primarily due to a $5.5 million increase in net income in the six months ended June 30, 2006 over June 30, 2005. In addition, a decrease in cash used for inventory of $2.3 million, an increase in non-cash charges for stock-based compensation of $1.7 million, an increase in accounts payable of $1.4 million and an increase in depreciation and amortization contributed to the increase in net cash provided by operating activities, and were partially offset by a decrease in deferred rent and lease incentives of $3.7 million and an increase in other assets of 2.2 million.

Net cash used by investing activities decreased by $17.1 million to $6.6 million in the six months ended June 30, 2006 as compared to $23.7 million used in the six months ended June 30, 2005. The net decrease was primarily due to a decrease in the purchase of marketable securities net of proceeds of $13 million, a decrease in the purchase of property, plant and equipment of $4.5 million, partially offset by an increase in the purchase of assets placed in service of $504,000.

Net cash flows provided by financing activities were $2.3 million in the six months ended June 30, 2006 as compared to $2.1 million in the six months ended June 30, 2005. The $179,000 increase was primarily due to an increase in the net proceeds from the exercise of stock options under employee stock plans of $586,000, partially offset by a decrease in the net proceeds for issuance and payments on long-term debt owed to us of $463,000.

Accounts Receivable

Our accounts receivable days sales outstanding were 52 days at June 30, 2006; compared to 61 days at March 31, 2006; 52 days at December 31, 2005; 46 days at September 30, 2005; 50 days at June 30, 2005; and 3446 at March 31, 2005. While days sales outstanding at ~~December~~June 30, 2006 decreased sequentially from March 31, ~~2004~~2006; the increase in days sales outstanding as compared to June 30, 2005 was due to our introduction of credit terms for selected international distributors in 2005 and 2006, further described below, and the increase in per procedure fees inclusive of a disposable patient interface, which generally have longer credit terms than lasers. Our laser sales in the USU.S. are typically on the basis of cash in advance paid directly by our customers or on terms, which are typically net 30, to fiscally sound third party financing companies, institutions or well established corporate customers. Our per procedure fees inclusive of a disposable patient interface are typically sold for terms net 30 days from shipment. International customers, primarily distributors, have typically paid with cash in advance or by irrevocable letter of credit; however, in the second quarter of 2005, we began selling to selected and qualified distributors on credit terms, with the number of international distributors qualifying for credit expanding each quarter.

We review our accounts receivable balances and customers regularly to establish and maintain an appropriate allowance for doubtful accounts. We take into account the customer’s payment history, the number of days an account is overdue and any specific knowledge about an account’s financial status. The reserve requirements are based on our review of every account and we place particular emphasis on analyzing each account with an accounts receivable balance more than 90 days old and on that account’s specific payment history and financial risk. On that basis, the allowance for doubtful accounts as a percentage of gross accounts receivable was 2.0% and 2.1% at September 30, 2005 and December 31, 2004, respectively.

As we further extend terms to additional international distributors or increase their credit lines, we expect days sales outstanding to increase, although our expectation is that days sales outstanding will remain in the range of 50 to 60 days in the short term. Additionally, as revenues from our per procedure fee inclusive of a disposable patient interface increase as a percentage of total revenues, we expect days sales outstanding to increase as we grant payment terms of a longer duration on these revenues than we do on our laser sales. As extensions of international credit and per procedure fees inclusive of a disposable patient interface revenues increase, we will be exposed to an increased risk of not receiving payment on time for a portion of our sales. In addition, as the percentage of our revenues with longer credit terms increase, we will use more capital resources to fund the increase in accounts receivable outstanding.

We review our accounts receivable balances and customers regularly to establish and maintain an appropriate allowance for doubtful accounts. We take into account the customer’s payment history, the number of days an account is overdue and any specific knowledge about an account’s financial status. The reserve requirements are based on our review of every account and we place particular emphasis on analyzing each account with an accounts receivable balance more than 90 days old and on that account’s specific payment history and financial risk. On that basis, the allowance for doubtful accounts as a percentage of gross accounts receivable was 1.7% and 1.9% at June 30, 2006 and December 31, 2005 respectively.

As we further extend terms to additional international distributors or increase their credit lines, we expect day’s sales outstanding to increase, although our expectation is that days sales outstanding will remain in the range of 60 days in the short term. Additionally, as revenues from our per procedure fee inclusive of a disposable patient interface increase as a percentage of total revenues, we expect days sales outstanding to increase as we grant payment terms of a longer duration on these revenues than we do on our laser sales. As extensions of international credit and per procedure fees inclusive of a disposable patient interface revenues increase, we will be exposed to an increased risk of not receiving payment on time for a portion of our sales. In addition, as the percentage of our revenues with longer credit terms increase, we will use more capital resources to fund the increase in accounts receivable outstanding.

Debt

On August 4, 2005, we established a new revolving line of credit, which allows for maximum borrowing of $10.0 million, with a $1.5 million sub-limit to secure cash management services and a $1.0 million sub-limit to secure letters of credit. The line of credit has a variable rate of interest equal to the bank’s prime rate (8.25% at June 30, 2006) and matures August 3, 2006. The line of credit did not have an outstanding balance as of ~~September~~June 30, ~~2005~~2006 and contains covenants for minimum quick ratio and profitability with which we were in compliance on June 30, 2006.

Contractual Obligations

The following summarizes our long-term contractual obligations as of ~~September~~June 30, ~~2005~~2006:

	Payments due by period
Contractual Obligations	Total		Less than1 year		1 to 3 years		4 to 5 years		After 5 years
	Total		Less than1 year		1 to 3years		4 to 5years		After 5years
	(in thousands)
Operating leases (1)		17,449		1,811		3,509		3,507		8,622
Contractual Obligations
Royalty payments (2)		688		124		237		218		109
Operating leases	$	17,090	$	1,587	$	3,295	$	3,550	$	8,658
Letter of credit		50		50
Royalty payments (1)		677		124		226		218		109
Employment agreement with Robert Palmisano, CEO		~~275~~1,404		~~275~~535		—869		—		—
	$	1819,~~462~~171	$	2,~~260~~246	$	34,~~746~~390	$	3,~~725~~768	$	8,~~731~~767

(1) OnRepresents ~~January~~minimum ~~31,~~annual ~~2005~~royalties weunder ~~entered~~licensing ~~into~~agreements awhich ~~lease~~continue ~~agreement~~until ~~for a larger facility in Irvine, California with approximately 128,670 square feet and completed~~ the ~~move~~soonest ~~during~~of the ~~third~~following: ~~quarter~~expiration of ~~2005.~~the ~~The~~patents ~~lease~~or istermination ~~for a period~~ of ~~ten~~the ~~years~~agreement ~~and~~in ~~four~~accordance ~~months~~with ~~beginning~~its ~~May 1, 2005~~terms.

(2) Represents minimum annual royalties under licensing agreements which continue until the soonest of the following: expiration of the patents or termination of the agreement in accordance with its terms.

Off-Balance Sheet Arrangements

We have not engaged in any off-balance sheet arrangements within the meaning of Item 303(a)(4)(ii) of Regulation S-K under the Securities Act of 1933.

Income Taxes

Realization of our deferred tax assets is dependent upon the uncertainty of the timing and amount of our future earnings, if any. Accordingly, based upon available evidence and the criteria set forth in SFAS 109, Accounting for Income Taxes, we have established full deferred tax asset valuation allowances as of ~~September~~June 30, ~~2005~~2006 and December 31, ~~2004~~ 2005 to reflect these uncertainties. Management will continue to assess the available evidence related to the realization of deferred tax assets and at

As of December 31, 2004, we had federal and state net operating loss carryforwards of approximately $55.6 million and $38.8 million, respectively, and federal and state tax credit carryforwards of approximately $1.6 million and $1.7 million, respectively. Federal tax credit carryforwards begin to expire in 2005 unless previously utilized. The state credit carryforwards do not expire. Pursuant to Section 382 of the Internal Revenue Code, use of our net operating loss and credit carryforwards may be limited if we experience a cumulative change in ownership of greater than 50% in a moving three-year period. Ownership changes could impact our ability to utilize net operating losses and credit carryforwards remaining at the ownership change date. See “Risk Factors—Risks Related to our Business—Our ability to use net operating loss carryforwards may be limited.”

Inflation

We do not believe that inflation has had a material effect on our business, financial condition or results of operations during the periods presented, and we do not anticipate that it will have a material effect in the future.

such time we determine that it is more likely than not that deferred taxes will be realized, a tax benefit will be realized and the valuation allowance will be released.

As of December 31, 2005, we had federal and state net operating loss carryforwards of approximately $55.0 million and $39.7 million, respectively, and research and development credit carryforwards of $1.6 million and $2.2 million, respectively, which will expire on various dates beginning in 2007 through 2025.

Pursuant to Section 382 of the Internal Revenue Code, use of our net operating loss and credit carryforwards may be limited if in the future we experience cumulative change in ownership of greater than 50% in a moving three-year period. Ownership changes would impact the Company’s ability to utilize net operating losses and credit carryforwards remaining at the ownership change date.

Inflation

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates including those related to bad debts, inventories and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in Note 2 to our financial statements appearing elsewhere within this Form 10-Q, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenues in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition. SAB 104 requires that four basic criteria must be met before revenues can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgment regarding the fixed nature of the fee charged for products delivered and the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenues recognized for any reporting period could be adversely impacted.

For arrangements with multiple deliverables, we allocate the total revenues to each deliverable based on its relative fair value in accordance with the provisions of Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” and recognize revenues for each separate element as the above criteria are met.

Reserves for Doubtful Accounts, Billing Adjustments and Contractual Allowances

At the end of each fiscal quarter, we estimate the reserve necessary for doubtful accounts to ensure that we have established an appropriate allowance for accounts receivable that may not ultimately be collectible. To develop this estimate we review all accounts and identify those with overdue balances, particularly those with balances 90 days, or more, overdue. For these accounts we estimate individual specific reserves based on our analysis of the amount overdue, the customer’s payment history, operations and finances of each account. For all other accounts, we review historical bad debt trends, general and industry-specific economic trends, and current payments along with the reasonable probability that payment will occur in the future. On that basis, the allowance for doubtful accounts as a percentage of gross accounts receivable was 21.07% and 2.1.9% at ~~September~~ June 30, ~~2005~~2006 and December 31, ~~2004~~2005, respectively. To date, our estimates of our doubtful accounts have been materially ~~accurate. Subject to any major changes in our business model, our operating environment or the economy in general,~~ ~~and taking into consideration our typical customer, we do not expect either our methodology or the accuracy of our estimates to change significantly in the future.~~

Inventories

Adjustments to the carrying value of inventory for excess and obsolete items are based, in part, on our estimate of usage of component parts in the assembly of our lasers and the timing of design changes. This estimate, though based on our product design plans and other relevant factors, such as the current economic climate, is subject to some uncertainty. Amounts charged to income for excess and obsolete inventories and as a percentage of total revenues, were $880,000 or 1.3% of total revenues in the nine months ended September 30, 2005 as compared to $433,000 or 1.1% of total revenues in the nine months ended September 30, 2005. To date, our estimates of excess and obsolete inventory have been materially accurate. Subject to any major changes in our business model, our operating environment or the economy in general, and taking into consideration the ongoing development of our technology we do not expect either our methodology or the accuracy of our estimates to change significantly in the future.

accurate. Subject to any major changes in our business model, our operating environment or the economy in general, and taking into consideration our typical customer, we do not expect either our methodology or the accuracy of our estimates to change significantly in the future.

Inventories

Adjustments to the carrying value of inventory for excess and obsolete items are based, in part, on our estimate of usage of component parts in the assembly of our lasers and the timing of design changes. This estimate, though based on our product design plans and other relevant factors, such as the current economic climate, is subject to some uncertainty. Amounts charged to income for excess and obsolete inventories and as a percentage of total revenues, were $502,000 or 0.8% of total revenues in the six months ended June 30, 2006 as compared to $454,000 or 1.0% of total revenues in the six months ended June 30, 2005. To date, our estimates of excess and obsolete inventory have been materially accurate. Subject to any major changes in our business model, our operating environment or the economy in general, and taking into consideration the ongoing development of our technology we do not expect either our methodology or the accuracy of our estimates to change significantly in the future.

Stock-Based Compensation

WeIn ~~account~~December ~~for~~2004, ~~employee~~the ~~and~~FASB ~~director~~issued ~~stock~~SFAS ~~options~~No. 123R, ~~and~~which ~~restricted~~requires ~~stock~~that ~~using~~ the ~~intrinsic-value~~compensation ~~method~~cost inrelated ~~accordance~~to ~~with~~share-based ~~Accounting~~payment transactions, ~~Principles~~measured ~~Board (APB)~~based ~~Opinion~~on ~~No. 25,~~the ~~Accounting~~fair ~~for~~value ~~Stock~~of ~~Issued~~the toequity ~~Employees,~~or ~~and~~liability ~~related~~instruments ~~interpretations~~issued, ~~and~~be ~~have~~recognized ~~adopted~~in the ~~disclosure-only~~financial ~~provisions~~statements. ofThe ~~Statement~~adoption of ~~Financial Accounting Standards (~~SFAS) No. ~~123~~123R, ~~Accounting~~which ~~for~~we ~~Stock-Based Compensation.~~adopted ~~Stock~~effective ~~options~~January 1, ~~issued to non-employees~~2006, ~~who~~is ~~are~~required ~~principally~~in ~~surgeons~~fiscal onyears beginning ~~our~~after ~~medical advisory board~~June 15, ~~are~~2005. ~~recorded~~Determining atthe ~~their~~ fair value asof ~~determined~~options inusing ~~accordance~~the ~~with~~Black-Scholes ~~SFAS~~model ~~No. 123~~requires ~~and~~subjective ~~Emerging Issues Task Force (EITF) No. 96-18~~assumptions, ~~Accounting~~including ~~for~~future ~~Equity~~stock ~~Instruments~~price ~~That~~volatility ~~are~~and ~~Issued~~expected totime ~~Other~~until ~~Than Employees for Acquiring~~exercise, orwhich ingreatly ~~Conjunction~~affects ~~with~~the ~~Selling,~~calculated fair ~~Goods~~value ~~or Services, and amortized~~ on ~~a declining basis over~~ the ~~service~~grant ~~period~~date.

~~Stock~~Prior ~~compensation expense, which is a noncash charge, results from stock option grants made~~ to ~~employees at exercise prices below~~ the ~~deemed~~adoption ~~fair value~~ of ~~the~~SFAS ~~underlying common stock~~No. 123R, ~~and~~we ~~from~~accounted for stock-based ~~option~~awards ~~grants made~~ to ~~non-~~employees atusing the intrinsic ~~fair~~ value ofmethod ~~the~~under ~~option~~Accounting ~~granted~~Principles asBoard ~~determined~~(“APB”) ~~using~~Opinion ~~the Black-Scholes valuation model~~No. 25, ~~Stock~~Accounting ~~compensation expense~~ for ~~grants~~Stock ~~made~~Issued to ~~employees~~Employees ~~below~~and ~~the~~related ~~fair~~Interpretations. ~~value~~Stock-based ofawards ~~the~~to ~~underlying~~non-employees ~~common~~were ~~stock~~recorded isusing ~~amortized on a declining basis over~~ the ~~vesting~~fair ~~period~~value method ofin ~~the~~accordance ~~underlying~~with ~~option,~~FSAS ~~generally four years~~No. 123, ~~Unearned~~Accounting ~~deferred compensation~~ for ~~non~~Stock-~~employees~~Based ~~is periodically remeasured through the vesting date~~Compensation. WeIn ~~have~~addition, ~~recorded~~prior ~~deferred~~to ~~stock-based~~the ~~compensation~~adoption ~~representing~~of ~~the~~SFAS ~~difference~~No. 123R, ~~between~~we ~~the~~accounted ~~option~~for ~~exercise~~employee ~~price~~ and ~~the~~director ~~fair~~stock ~~value~~options ofand ~~our~~restricted ~~common~~ stock onusing the ~~grant~~ ~~date~~intrinsic-value ~~for~~method ~~financial~~in ~~reporting~~accordance ~~purposes.~~with ~~Prior~~Accounting toPrinciples ~~issuing~~Board ~~our~~(APB) ~~stock~~Opinion ~~publicly~~No. 25, weAccounting ~~determined~~for ~~the~~Stock ~~deemed~~Issued ~~fair~~to ~~value~~Employees, ofand ~~our~~related ~~common~~interpretations. ~~stock~~Stock ~~based~~options ~~upon~~issued ~~several~~to ~~factors~~non-employees, ~~including~~who ~~operating~~are ~~performance,~~principally ~~liquidation~~surgeons ~~preferences~~on ofour medical ~~the~~advisory ~~preferred stock~~board, ~~an independent~~were ~~valuation~~recorded ~~analysis,~~at ~~the~~their ~~market~~fair ~~capitalization~~value ofas ~~peer~~determined ~~companies~~in ~~and~~accordance ~~the~~with ~~expected~~SFAS ~~valuation~~No. 123 weand ~~would~~Emerging ~~obtain~~Issues inTask anForce ~~initial~~(EITF) ~~public~~Issue ~~offering~~No. 96-18, ~~Had~~Accounting ~~different~~for ~~assumptions~~Equity orInstruments ~~criteria~~That ~~been~~are ~~used~~Issued to ~~determine~~Other ~~the~~Than ~~deemed~~Employees ~~fair~~for Acquiring, ~~value~~or ofin ~~our~~Conjunction ~~common stock~~with Selling, ~~different~~Goods ~~amounts~~or ofServices, ~~stock-based~~and ~~compensation~~amortized ~~could~~on ~~have~~a ~~been~~declining ~~reported~~basis over the service period.

WeStock compensation ~~recorded~~expense ~~stock-based~~prior ~~compensation~~to ~~expense~~the adoption of ~~$1,205,470~~SFAS inNo. 123R ~~the~~resulted ~~nine~~from ~~months~~stock ~~ended~~option ~~September 30,~~grants ~~2005.~~made ~~From~~to ~~inception~~employees ~~through~~at ~~September 30,~~exercise ~~2005,~~prices webelow ~~recorded~~the ~~amortization~~deemed fair value of ~~deferred~~the underlying common stock, ~~compensation~~and ~~of $6.4~~from ~~million.~~stock Atoption ~~September 30,~~grants ~~2005,~~made weto ~~had~~non-employees aat the ~~total~~fair value of $1the option granted as determined using the Black-Scholes valuation model.7 ~~million~~Unearned ~~remaining~~deferred tocompensation befor ~~amortized~~non-employees ~~over~~is periodically remeasured through the vesting ~~period~~date ofunder ~~the~~current ~~stock~~and ~~options,~~historical ofaccounting ~~which~~rules. ~~$645,000~~See isNote 2 ~~subject~~and Note 7 to ~~periodic~~our ~~remeasurement~~financial statements contained elsewhere within this Form 10-Q for further discussion.

The amount of stock-based compensation expense to be recorded in future periods may decrease if unvested options for which we have recorded deferred compensation are subsequently cancelled or expire or if the fair value of our stock decreases; or may increase if the fair market value of our stock increases or we make additional grants of non-qualified stock options to members of our medical advisory board or other non-employee consultants.

Pro forma information regarding net loss applicable to common stockholders and net loss per share applicable to common stockholders is required in order to show our net loss as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148. This information is contained in Note 2 to our financial statements contained elsewhere within this Form 10-Q. The fair values of options and shares issued pursuant to our option plan at each grant date were estimated using the Black-Scholes option-pricing model.

We currently are not required to record stock-based compensation charges if the employee stock option exercise price or restricted stock purchase price equals or exceeds the deemed fair value of our common stock at the date of grant. In December 2004, the FASB issued SFAS No. 123 (Revised 2004) Share Based Payment, which is a revision to SFAS 123 and supersedes APB 25 and SFAS 148. This statement requires that the estimated fair value resulting from all share-based payment transactions be recognized in the financial statements. If we had estimated the fair value of the options or restricted stock on the date of grant in our financial statements, and then amortized this estimated fair value over the vesting period of the options or restricted stock, our net loss would have been adversely affected. See Note 2 to our financial statements contained elsewhere within this Form 10-Q for a discussion of how our net income (loss) would have been adversely affected.

Accounting for Income Taxes

We account for income taxes under the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of assets and income. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a full valuation allowance on our net deferred tax assets as of ~~September~~June 30, ~~2005~~2006 and December 31, 2005, due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of net operating loss carryforwards and research and development tax credits.

31, 2004, due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of net operating loss carryforwards and research and development tax credits.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment. This statement replaces SFAS No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method under APB 25, Accounting for Stock Issued to Employees, and requires instead that such transactions be accounted for using a fair-value-based method. ~~We are currently evaluating~~ SFAS No. 123R towas ~~determine~~effective for ~~which~~us ~~fair-value-based model~~beginning ~~and~~in ~~transitional~~our ~~provision~~first quarter of fiscal 2006 and we ~~will~~use ~~follow~~the ~~upon~~modified ~~adoption~~prospective application method. Under SFAS ~~No.~~ 123R, unearned deferred stock compensation for non-employees will continue to be ~~effective~~periodically ~~for~~remeasured usthrough ~~beginning~~the investing date. This periodic remeasurement could have a significant impact on our ~~first~~results ~~quarter~~of operations. We believe that the adoption of ~~fiscal~~SFAS 123R will result in stock-based compensation in 2006 of approximately $6.0 ~~Although~~million, wethe ~~will~~majority ~~continue~~of towhich ~~evaluate~~will arise from the ~~application~~adoption of SFAS ~~No.~~ 123R, ~~management~~as ~~expects adoption~~compared to ~~have~~approximately a$2.1 ~~material~~million ~~impact~~of onstock-based ~~our~~compensation recognized in 2005. However, actual results ofmay ~~operations~~vary independing ~~amounts~~upon ~~not~~2006 ~~yet~~stock ~~determinable~~option grants and stock compensation programs.

In ~~December~~November 2004, the FASB issued SFAS No. ~~153~~151, ~~Exchanges~~Inventory ofCosts. ~~Nonmonetary~~SFAS ~~Assets~~No. 151 –clarifies Anthe ~~amendment~~accounting for abnormal amounts of ~~APB~~idle facility 29expense, ~~Accounting~~freight, ~~for~~handling ~~Nonmonetary Transactions.~~costs ~~This~~and ~~statement~~wasted ~~amends~~material ~~APB~~(spoilage) ~~Opinion~~to ~~No. 29~~be toexpensed ~~eliminate~~as ~~the~~incurred ~~exception~~and ~~for~~not ~~nonmonetary~~included ~~exchanges~~in ofoverhead. ~~similar~~Further, ~~productive~~SFAS ~~assets~~No. 151 ~~and~~requires ~~replaces~~that itallocation ~~with~~of afixed ~~general~~production ~~exception~~overheads ~~for~~to ~~exchanges~~conversion ofcosts ~~nonmonetary~~should ~~assets~~be ~~that~~based on donormal ~~not~~capacity ~~have commercial~~of ~~substance~~the production facilities. AThe ~~nonmonetary~~provisions ~~exchange~~of ~~has~~SFAS ~~commercial~~No. 151 ~~substance~~are ifeffective ~~the~~for ~~future~~inventory ~~cash~~costs ~~flows~~incurred ofduring ~~the~~fiscal ~~entity~~years ~~are~~beginning ~~expected~~after toJune 15, ~~change~~2005. ~~significantly~~Our ascurrent aaccounting ~~result~~policies ofare ~~the~~consistent ~~exchange.~~with Wethe accounting ~~will~~required ~~evaluate~~by ~~the~~SFAS ~~effect~~No. 151 and, ifas ~~any~~such, the adoption of ~~adopting~~this ~~SFAS~~statement Nohad no effect on our financial statements. ~~153.~~

In ~~November 2004~~May 2005, the FASB issued SFAS No. ~~151~~154, ~~Inventory Costs~~Accounting Changes and Error Corrections, which replaces APB Opinion No. 120, Accounting Changes and SFAS No. ~~151~~3, ~~clarifies~~Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 changes the ~~accounting~~requirements for ~~abnormal~~accounting ~~amounts~~and ofreporting ~~idle~~a ~~facility~~change ~~expense,~~in ~~freight~~accounting principle, ~~handling~~and ~~costs~~applies ~~and~~to ~~wasted~~all ~~material~~voluntary ~~(spoilage)~~changes toin beaccounting ~~expensed~~principles, as ~~incurred~~well ~~and~~as ~~not~~changes ~~included~~required by an accounting pronouncement in ~~overhead~~the unusual instance it does not include specific transition provisions. ~~Further~~Specifically, SFAS No. ~~151~~154 requires ~~that~~retrospective application to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects or the ~~allocation~~cumulative effect of ~~fixed~~the ~~production~~change. ~~overheads~~When it is impracticable to ~~conversion~~determine ~~costs~~the ~~should~~effects of the change, the new accounting principle must be ~~based~~applied onto ~~normal~~the ~~capacity~~balances of assets and liabilities as of the ~~production~~beginning ~~facilities~~of the earliest period for which retrospective application is practicable and a corresponding adjustment must be made to the opening balance of retained earnings for that period rather than being reported in an income statement. ~~The~~When ~~provisions~~it is impracticable to determine the cumulative effect of the change the new principle must be applied as if it were adopted prospectively from the earliest date practicable. SFAS No. ~~151~~154 ~~are~~is effective for ~~inventory~~accounting ~~costs~~changes ~~incurred~~and ~~during~~corrections of errors made in fiscal years beginning after ~~June~~December 15, 2005. ~~Our~~SFAS ~~current~~No. 154 ~~accounting~~does ~~policies~~not ~~are~~change ~~consistent~~the ~~with~~transition ~~the~~provisions ~~accounting~~of ~~required~~any byexisting pronouncements. We have evaluated the impact of SFAS No. ~~151~~154 and, asdo ~~such,~~not expect the adoption of this ~~statement~~Statement ~~will~~to have noa ~~effect~~significant onimpact on our financial statements. We will apply SFAS No. 154 in future periods, when applicable.

In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 are effective for reporting periods beginning after December 15, 2006. We are currently assessing the impact of the adoption of FIN 48 and its impact on our condensed consolidated financial statements.

Factors that May Affect Results of Operations and Financial Condition

Risks Related to our Industry

Our success depends upon the continued acceptance of LASIK surgery.

Our business depends upon continued market acceptance of LASIK surgery by both surgeons and patients in the United States and international markets. LASIK surgery has only been approved since 1995 and commercially available since 1996 and, to date, has penetrated approximately 78% of the eligible U.S. population. We believe that if market acceptance of LASIK ~~surgery declines, demand for our product offering by LASIK surgery practices and potential patients will decline, resulting in a decrease in our revenues.~~

Some consumers may choose not to undergo LASIK surgery due to concerns with the safety and efficacy of an elective surgery in general or the LASIK procedure in particular, due to concerns about price or due to their belief that improved technology or alternative methods of treatment will be available in the near future. LASIK surgery itself can result in potential complications and side effects, such as post-operative discomfort, unintended over- or under- corrections, disorders in corneal healing, undesirable visual sensations caused by bright lights such as glare or halos and dry eye.

Should either the ophthalmic community or the general population turn away from LASIK surgery as an alternative to existing methods of treating refractive vision disorders, or if future technologies replace LASIK surgery, these developments would have a material adverse effect on our business, financial condition and results of operations.

surgery declines, demand for our product offering by LASIK surgery practices and potential patients will decline, resulting in a decrease in our revenues.

Some consumers may choose not to undergo LASIK surgery due to concerns with the safety and efficacy of an elective surgery in general or the LASIK procedure in particular, due to concerns about price or due to their belief that improved technology or alternative methods of treatment will be available in the near future. LASIK surgery itself can result in potential complications and side effects, such as post-operative discomfort, unintended over- or under-corrections, disorders in corneal healing, undesirable visual sensations caused by bright lights, glare or halos and dry eye.

Weak or uncertain economic conditions could adversely affect demand for our product offering.

Because LASIK surgery is not generally paid for through insurance programs or government reimbursement, patients typically pay for LASIK surgery directly with their own discretionary funds. Accordingly, weak or uncertain economic conditions may cause individuals to be less willing to pay for LASIK surgery, as was evidenced by the 14% decline in LASIK procedures in the United States in 2002 as compared to 2001. A decline in economic conditions in the United States or in international markets could result in a decline in demand for LASIK surgery and could have a material adverse effect on our business, financial condition and results of operations.

Changes in U.S. federal tax laws governing the ability of potential LASIK patients to use pre-tax dollars to pay for LASIK surgery could adversely affect demand for our product offering.

We believe a significant number of U.S. patients pay for LASIK surgery with pre-tax dollars pursuant to plans sponsored under Section 125 of the Internal Revenue Code. These plans are commonly referred to as cafeteria plans. Changes in the U.S. tax laws or regulations governing cafeteria plans could reduce or eliminate the ability of patients to use pre-tax dollars to pay for LASIK surgery, resulting in an increase in the total cost borne by patients, which would likely reduce the volume of LASIK surgeries, and thus demand for our per procedure fee inclusive of a disposable patient interface, which would have a material adverse effect on our business, financial condition and results of operations.

Risks Related to our Business

We are subject to extensive government regulation, and a failure to comply may increase our costs and prevent us from selling our product offering.

We are subject to extensive government regulation, including inspections and controls over research and development, testing, manufacturing, safety and environmental controls, efficacy, labeling, advertising, promotion, pricing, record keeping and the sale and distribution of our product offering. Although we have obtained all necessary clearances from the Food and Drug Administration, or FDA, as well as all necessary foreign governmental approvals to market and sell our product offering, we must continue to comply with such regulations to continue to manufacture, market and sell our product offering. Noncompliance with FDA requirements can result in fines, injunctions, penalties, mandatory recalls or seizures, manufacturing suspensions, recommendations by the FDA against governmental contracts, suspension in the issuance of export certificates and criminal prosecution. The FDA also has authority to request repair, replacement or the refund of the cost of any product we manufacture or distribute. Regulatory authorities outside of the United States may impose similar sanctions for noncompliance with applicable regulatory requirements. If we are subject to any sanctions by the FDA or a foreign regulatory agency, our costs may increase and we may be prevented from manufacturing or selling our product offering, which would have a material adverse effect on our business, financial condition and results of operations.

LASIK surgeons must continue to adopt our product offering as an attractive alternative to the microkeratome for creating the corneal flap.

~~In the three months ended September 30, 2005, we believe we captured approximately 19 to 20% of the U.S. market for creating the corneal flap.~~ We believe that LASIK surgeons may not continue to adopt our product offering unless they determine, based on experience, clinical data and studies and published journal articles, including peer review articles, that our product offering provides significant benefits or an attractive alternative over the traditional method of creating the corneal flap using the ~~microkeratome. A small number of surgeons have informed~~ ~~us, based on their experiences, of the following issues with our product offering when compared to the traditional microkeratome approach:~~

• surgeons may need to perform multiple procedures with our product offering to become skilled with our laser and related techniques; and

• the overall procedure to prepare the patient and create the corneal flap with our laser may take slightly longer per patient.

~~surgery being performed~~microkeratome. InA ~~comparison,~~small ~~our~~number ~~laser~~of ~~costs~~surgeons ~~approximately~~have ~~$375,000.~~informed ~~Additionally~~us, ~~using~~based ~~the~~on ~~microkeratome~~their ~~results in a cost between $25 and $50 per procedure to purchase the disposable blades~~experiences, ~~while our per procedure fee inclusive~~ of athe ~~disposable~~following ~~patient~~issues ~~interface costs new LASIK surgeons approximately $160 per procedure. The additional costs associated~~ with our product offering ~~could hinder~~when ~~continued~~compared ~~adoption~~to the oftraditional ~~our~~microkeratome ~~technology~~approach: ~~by LASIK surgeons, which would have a material adverse effect on our business, financial condition and results of operations.~~

•

surgeons may need to perform multiple procedures with our product offering to become skilled with our laser and related techniques; and

•

the overall procedure to prepare the patient and create the corneal flap with our laser may take slightly longer per patient.

LASIK surgeons also must determine that the advantages and benefits of our product offering outweigh the increased costs associated with switching to our technology from the microkeratome. The microkeratome device costs between $40,000 and $60,000 per device, and, because the devices must be cleaned after each patient use and must be returned to the manufacturer for any service, LASIK surgeons typically purchase multiple devices to ensure a device is available for each surgery being performed. In comparison, the list price of our laser is approximately $425,000. Additionally, using the microkeratome results in a cost between $25 and $50 per procedure to purchase the disposable blades, while our per procedure fee inclusive of a disposable patient interface costs new LASIK surgeons approximately $160 per procedure. The additional costs associated with our product offering could hinder continued adoption of our technology by LASIK surgeons, which would have a material adverse effect on our business, financial condition and results of operations.

In addition, we believe that recommendations and support of our laser by influential LASIK surgeons are essential for its market acceptance and adoption. If we do not receive support from such surgeons or from the data and experience of users, it may become difficult to have additional LASIK surgeons adopt our product offering. In such circumstances, we may not achieve expected revenues or profits.

Presently unknown side effects related to the use of our laser could emerge in the future.

Use of the IntraLase^® FS laser to create the LASIK flap is a relatively new technique. Consequently there is no long term follow up data beyond five years that might reveal unknown side effects or complications associated specifically with this technique. The possibility of unfavorable side effects, and any concomitant adverse publicity, could seriously harm our business. In addition to the potential side effects and complications associated with LASIK generally, some LASIK surgeons have observed incidents of transient light sensitivity in patients treated with our system, although this has affected only a small percentage of patients and appears to resolve quickly with treatment. Any future reported adverse outcomes or pattern of side effects involving the use of our laser specifically, or with respect to LASIK procedures generally, could have a material adverse effect on our business, financial condition and results of operations.

Patients must continue to be willing to pay for LASIK surgery using our product offering despite it being more expensive than LASIK surgery with the microkeratome.

LASIK surgeons typically receive an average of $394 more per eye when using our product offering instead of the traditional microkeratome. To date, LASIK surgeons have been able to improve the rate at which laser vision correction consultations translate into actual surgery from approximately 65% to 78% when using our product offering instead of the traditional microkeratome, according to aan independent survey of our customers conducted byin ~~SM2~~early ~~Consulting, an independent consultant~~2005. This indicates that patients have been willing to pay for LASIK surgery using our product offering despite its higher cost. There can be no assurance that this trend will continue.

We may not be able to compete successfully against our current and future competitors.

To date, we have competed primarily with manufacturers of the microkeratome, the traditional method used to create the corneal flap as the first step in LASIK surgery. Principal manufacturers of the microkeratome include Bausch & Lomb, with approximately ~~half~~40 percent of the U.S. microkeratome and blade market, Moria/Microtech, the second largest supplier of microkeratomes and blades in the U.S. market, Advanced Medical Optics and Nidek. Microkeratomes are less expensive to manufacture than our laser and our competitors may offer microkeratome systems at a lower price as part of a bundle of products or services, including the excimer laser used in the second step of LASIK surgery. Further, we expect that our competitors will continue to release new or enhanced microkeratome models which may offer improved performance over earlier generation products. Any of these actions could decrease demand for our product offering, which would have a material adverse effect on our business, financial condition and results of operations. Some of these competitors, particularly Bausch & ~~Lomb, have substantially greater resources, larger customer bases, longer operating histories and greater name recognition than we have.~~

We may also in the future compete with manufacturers of alternative technologies to create the corneal flap. In addition, several manufacturers have announced their intention to launch new femtosecond lasers that would compete directly with our products. These include Wavelight Technologies, Zeimer Ophthalmic Systems and 20/10 Perfect Vision. The latter two companies have displayed their systems. Successful introduction of competing products by these or other manufacturers could reduce demand for our products, particularly if the competing products were perceived to offer superior capabilities or were marketed at a lower price. If alternative technologies gain market acceptance, this may also reduce demand for our product offering.

~~techniques include intra-ocular lenses~~Lomb, ~~corneal~~have ~~inlays~~substantially ~~and~~greater ~~epithelial flaps~~resources, ~~also~~larger ~~known~~customer ~~as Epi-LASIK. If any of these alternative treatments result in decreased demand for LASIK surgery~~bases, ~~this~~longer ~~would~~operating ~~decrease~~histories ~~demand for our product offering. In addition, medical companies, academic~~ and ~~research~~greater ~~institutions~~name ~~and~~recognition ~~others~~than ~~could~~we ~~develop new therapies, medical devices or surgical procedures that could potentially render LASIK surgery obsolete. Any such developments would~~ have ~~a material adverse effect on our business, financial condition and results of operations~~.

We may also in the future compete with manufacturers of alternative technologies to create the corneal flap. In addition, several manufacturers have announced their intention to launch new femtosecond lasers that would compete directly with our products. These include Wavelight Technologies, Carl Zeiss Meditech and Zeimer Ophthalmic Systems, which has displayed its system, and 20/10 Perfect Vision, which we believe has commercially sold at least one system internationally. Successful introduction of competing products by these or other manufacturers could reduce demand for our products, particularly if the competing products were perceived to offer superior capabilities or were marketed at a lower price. If alternative technologies gain market acceptance, this may also reduce demand for our product offering.

Since our product offering is used in the first step of LASIK surgery, we also compete with other vision disorder treatments that compete with LASIK, such as eyeglasses, contact lenses and other surgical products and techniques. Such techniques include intra-ocular lenses, corneal inlays and epithelial flaps, also known as Epi-LASIK. If any of these alternative treatments result in decreased demand for LASIK surgery, this would decrease demand for our product offering. In addition, medical companies, academic and research institutions and others could develop new therapies, medical devices or surgical procedures that could potentially render LASIK surgery obsolete. Any such developments would have a material adverse effect on our business, financial condition and results of operations.

The medical device and ophthalmic laser industries are subject to rapid and significant technological change, frequent new device introductions and evolving surgical techniques. Demand for our product offering may decline if a new or alternative product or technology is introduced by one of our competitors that represents a substantial improvement over our existing product offering, which would have a material adverse effect on our business, financial condition and results of operations.

Measures we take to ensure collection of per procedure charges may be inadequate.

Generating per procedure revenues from our installed base of lasers is a key aspect of our business. We charge our customers a per procedure fee for each eye treated. This fee is inclusive of a disposable patient interface, which is intended to be used on a single eye and discarded. We typically charge our customers procedure fees based on our shipments to them of per procedure disposable interfaces.

We believe that a small percentage of our customers, in an effort to avoid procedure fees, ~~are~~have ~~using~~in the past used a single patient interface to treat multiple eyes. If this practice (or other fee avoidance practices) were to continue or to proliferate, it could have a material adverse effect on our business.

Our proprietary IntraLASIK® software contains a feature which requires the laser to periodically be reprogrammed in order to perform additional procedures. We have introduced technology which allows us to do this remotely using secure activation techniques. ~~Our~~Over ~~domestic~~90 ~~installed~~percent ~~base~~of ~~has~~IntraLase lasers have been ~~completely~~upgraded ~~enhanced~~to ~~with~~new ~~this~~software ~~secure activation~~versions ~~technology~~that ~~and~~require weeither ~~are~~remote ~~well~~electronic ~~into~~activation when the ~~process~~customers oforder ~~rolling~~procedures or ~~out~~an ~~this~~IntraLase-generated ~~technology~~activation ~~internationally~~code used by the customers at their sites. Secure activation capabilities allow us to align the number of procedures available on the laser with the number of patient interfaces purchased to prevent reuse. However, if these capabilities prove inadequate, or if other fee avoidance methods are devised which we are unable to detect or counter, or if we are unable to enhance ~~the~~all ~~majority~~ of the lasers in our worldwide installed base, this could have a material adverse effect on our business. By way of example, circumstances that could potentially hamper our enforcement efforts include: theft or disclosure of confidential passwords, improper or unauthorized tampering with laser hardware or software, lack of cooperation from international distributors, inability to obtain access to lasers in the field, legal impediments imposed by foreign jurisdictions and/or counterfeit patient interfaces.

Product liability suits brought against us could result in expensive and time-consuming litigation, payment of substantial damages and an increase in our insurance rates.

If our IntraLase® FS laser or our per procedure disposable patient interface is defectively designed or manufactured or contains defective components, our IntraLASIK® software is defective, any component of our product offering is misused or if a customer fails to adhere to operating guidelines, or if someone claims any of the foregoing, whether or not such claims are meritorious, we may become subject to substantial and costly litigation. Any product liability claims brought against us, with or without merit, could divert management’s attention from our business, be expensive to defend, result in sizable damage awards against us, damage our reputation, increase our product liability insurance rates, prevent us from securing continuing coverage, ~~or prevent or interfere with commercialization efforts~~ for our product offering, any of which occurrences would have a material adverse effect on us. In addition, we may not have sufficient insurance coverage for all future claims. Product liability claims brought against us in excess of our insurance coverage would likely be paid out of cash reserves, harming our financial condition and results of operations.

From time to time, we make field corrections to our laser, which are typically made by our field service representatives during scheduled service calls but which may sometimes be made using remote diagnostics. Although these field corrections have not had a financial impact on us to date, any future corrections or recalls, especially any that result in preventing use of our laser or customers returning the laser to us for repair, would have a material adverse effect on us.

or prevent or interfere with commercialization efforts for our product offering, any of which occurrences would have a material adverse effect on us. In addition, we may not have sufficient insurance coverage for all future claims. Product liability claims brought against us in excess of our insurance coverage would likely be paid out of cash reserves, harming our financial condition and results of operations.

From time to time, we make field corrections to our laser that are typically made by our field service representatives during scheduled service calls but which may sometimes be made using remote diagnostics. Although these field corrections have not had a financial impact on us to date, any future corrections or recalls, especially any that result in preventing use of our laser or customers returning the laser to us for repair, would have a material adverse effect on us.

Our inability to adequately protect our intellectual property could allow our competitors and others to produce products based on our intellectual property rights, which could substantially impair our ability to compete.

Our success and ability to compete depends in part upon our ability to maintain the proprietary nature of our technologies. We rely on a combination of patent, trade secret, copyright and trademark law and license agreements, as well as nondisclosure agreements, to protect our intellectual property. These legal means, however, afford only limited protection and may not be adequate to protect our rights. In addition, we cannot assure you that any of our pending patent applications will issue. The U.S. Patent and Trademark Office, or PTO, may deny or significantly narrow claims made under our patent applications and, even if issued, these patents may be challenged or may otherwise not provide us with commercial protection. On August 23, 2004, the PTO granted a request for re-examination with respect to U.S. Patent RE 37,585, one of the patents licensed to us by the University of Michigan, which means that the PTO found that the request raised a new issue of patentability with regard to a number of claims. Re-examination may result in the scope of protection and rights provided by the patent license being lost or narrowed.

We may in the future need to assert claims of infringement against third parties to protect our intellectual property. Regardless of the final outcome, any litigation to enforce our intellectual property rights in patents, copyrights, or trademarks could be highly unpredictable and result in substantial costs and diversion of resources, which could have a material adverse effect on our business, financial condition and results of operations. In the event of an adverse judgment, a court could hold that some or all of our asserted intellectual property rights are not infringed, or are invalid or unenforceable, and could award attorneys’ fees to the other party. In addition, the laws of other countries in which our product offering is or may be sold may not protect our product offering and intellectual property to the same extent as U.S. laws, if at all. We also may be unable to protect our rights in trade secrets and unpatented proprietary technology in these countries. Despite our efforts to safeguard our unpatented and unregistered intellectual property rights, we may not be successful in doing so, or the steps taken by us in this regard may not be adequate to detect or deter misappropriation of our technology or to prevent an unauthorized third party from copying or otherwise obtaining and using our products, technology or other information that we regard as proprietary. Our inability to adequately protect our intellectual property could allow our competitors and others to produce products based on our patented or proprietary technology and other intellectual property rights, which could substantially impair our ability to compete.

We may become subject to claims of infringement or misappropriation of the intellectual property rights of others, which could prohibit us from selling our product offering, require us to obtain licenses from third parties, require us to develop non-infringing alternatives and/or subject us to substantial monetary damages and injunctive relief.

Third parties could assert infringement or misappropriation claims against us with respect to our current or future product offerings, whether or not such claims are valid. We cannot be certain that we have not infringed the intellectual property rights of such third parties or others. Any infringement or misappropriation claim could result in significant costs, substantial damages and our inability to manufacture, market or sell our existing or future product offerings that are found to infringe. If a court determined, or if we independently discovered, that our product offering violated third-party proprietary rights, there can be no assurance that we would be able to re-engineer our product offering to avoid those rights or obtain a license under those rights on commercially reasonable terms, if at all. As a result, we could be prohibited from selling products that are found to infringe. Even if obtaining a license were feasible, it may be costly and time-consuming. A court also could enter orders that temporarily, preliminarily or permanently enjoin us and/or our customers from making, using, selling, offering to sell or importing our product offering, or could enter orders mandating that we undertake certain remedial activities. A court also could order us to pay compensatory damages for such infringement, plus prejudgment interest, and could in addition treble the compensatory damages and award attorneys’ fees. These damages could be substantial and could harm our reputation, business, financial condition and results of operations. We have been involved in litigation with Escalon Medical Corp. concerning a license ~~agreement with Escalon under which we license certain intellectual property. The litigation arose as a result of Escalon’s attempt to terminate the license agreement based~~ on alleged underpayment of royalties (see Part II, Item 1, Legal Proceedings). We believe that Escalon will persist in its attempts to terminate the license agreement, and intend to defend against such efforts vigorously. Termination of the Escalon license agreement could have a material adverse effect on our business, financial condition and results of operations.

agreement with Escalon under which we license certain intellectual property. The litigation arose as a result of Escalon’s attempt to terminate the license agreement based on alleged underpayment of royalties (see Part II, Item 1, Legal Proceedings). We believe that Escalon will persist in its attempts to terminate the license agreement, and intend to defend against such efforts vigorously. Termination of the Escalon license agreement could have a material adverse effect on our business, financial condition and results of operations.

We depend on certain single-source suppliers and manufacturers for key components of our laser, and the loss of any of these suppliers or manufacturers, or their inability to supply us with an adequate supply of materials, could harm our business.

We rely upon certain suppliers and contract manufacturers to supply key parts for our laser on a sole or limited source basis. Our arrangements with these key suppliers and manufacturers are not on a contractual basis and can be terminated by either party without advance notice. If any of these suppliers and manufacturers were to fail to supply our needs on a timely basis or cease providing us these key components, we would be required to locate and contract with substitute suppliers. We could have difficulty identifying a substitute supplier in a timely manner or on commercially reasonable terms. If this were to occur, we may not be able to meet our sales goals or continue manufacturing lasers, either of which would have a material adverse effect on our business, financial condition and results of operations.

Our failure to manage our rapid growth may strain the capabilities of our managers, operations and facilities.

We are growing rapidly. In the three months ended ~~September~~June 30, ~~2005~~2006 we sold or leased 3452 lasers and sold approximately 83119,000 per procedures fees inclusive of a disposable patient interface. In ~~2004~~2005 we sold or leased ~~111~~156 lasers and sold approximately ~~192~~338,000 per procedure fees inclusive of a disposable patient interface; and in ~~2003~~2004, we sold or leased 67111 lasers and sold approximately 84 192,000 per procedure fees inclusive of a disposable patient interface. This growth has resulted in, and continued growth will create in the future, additional capacity requirements, new and increased responsibilities for our management team and may create pressures on our operating and financial systems.

AsOur we continued to grow, we determined that our current facilities were unlikely to be adequate for our needs. As a result, on January 31, 2005 we entered into a lease agreement for a larger facility in Irvine, California with approximately 128,670 square feet. The lease is for a period of ten years and four months beginning May 1, 2005. The move was completed during our third quarter of 2005. In addition, our expected growth will require us to hire, train and manage additional qualified personnel sufficiently in advance to be in a position to meet the requirements of such growth. Continued growth ~~also~~ will also require us to improve existing, and implement new operating, financial and management information controls, reporting systems and procedures, and effectively manage multiple relationships with our customers, suppliers and other third parties. In addition, our anticipated growth may strain the ability of our suppliers to deliver an increasingly large supply of components in accordance with agreed-upon specifications on a timely basis. Additional growth may also prevent us from being able to respond to new opportunities and challenges quickly.

If we are unable to effectively manage our expected growth, this could have a material adverse effect on our business, financial condition and results of operations.

We plan to expand further into markets outside the United States, which subjects us to additional business and regulatory risks.

Our international sales commenced in 2003 and represented 4344% ~~of our total revenues in the nine months ended September 30, 2005~~ and 2740% of our total revenues in the ~~nine~~six months ended ~~September~~June 30, ~~2004~~2006 and 2005, respectively. We intend to derive an increasing portion of our total revenues from sales of our product offering in foreign countries. We plan to focus most of our efforts on the Asia-Pacific region, Europe, South America and the Middle East.

Conducting business internationally subjects us to a number of risks and uncertainties. In addition to being subject to political and economic instability in foreign markets, we require export licenses and are subject to tariffs and other trade barriers and overlapping tax structures. In addition, we must comply with foreign regulatory requirements. In creating and building our infrastructure internationally, we must also educate LASIK surgeons and optometrists about our product offering and attract and maintain relationships with third-party distributors. If we are unable to do any of this successfully, we may not be able to grow our international presence, and this could have an adverse effect on our business, financial condition and results of operations.

Our success is tied to a single product offering.

We have a single product offering used in LASIK surgery. As a result, our success is tied to the success of this product offering since we are not currently able to derive revenues from alternate product offerings. If for any reason we are unable to continue to manufacture or sell our product offering or if production of our product offering were interrupted or could not

~~continue~~Our insuccess ais ~~cost-effective~~tied ~~or timely manner, whether due~~ to ~~regulatory~~a ~~sanctions,~~single ~~manufacturing constraints,~~ product ~~defects or recalls, obsolescence of our technology, increased competition, intellectual property concerns or otherwise, our business would be materially harmed~~offering.

We have a single product offering used primarily in LASIK surgery. As a result, our success is tied to the success of this product offering since we are not currently able to derive revenues from alternate product offerings. If for any reason we are unable to continue to manufacture or sell our product offering or if production of our product offering were interrupted or could not continue in a cost-effective or timely manner, whether due to regulatory sanctions, manufacturing constraints, product defects or recalls, obsolescence of our technology, increased competition, intellectual property concerns or otherwise, our business would be materially harmed.

All of our operations are conducted at a single location. Any disruption at our existing or at a new facility could increase our expenses.

All of our operations are currently and will continue to be conducted at a single location. We take precautions to safeguard our existing facility, including insurance, health and safety protocols and off-site storage of computer data. However, a natural disaster, such as an earthquake or fire could cause substantial delays in our operations, damage or destroy our manufacturing equipment or inventory, and cause us to incur additional expenses. The insurance we maintain against fires and other natural disasters and the property and business interruption insurance we maintain may not be adequate to cover our losses in any particular case.

A loss of key executives or failure to attract qualified personnel could limit our growth and adversely affect our business.

Our future success depends in part on the continued service of key personnel. We do not have employment agreements with any of our employees other than with our Chief Executive Officer; our Executive Vice President, Chief Operating Officer; our Senior Vice President and General Counsel; and our Vice President, Human Resources; and we do not have key person insurance on any of our executives. The loss of any one or more key managers could place a significant strain on our remaining management team and we may have difficulty replacing any of these individuals. Furthermore, our future growth will depend in part upon our ability to identify, hire and retain additional key personnel, including qualified management, research and other highly skilled technical personnel.

Our new products or applications may not be commercially viable.

While we devote significant resources to research and development, our research and development may not lead to improved or new products or applications that are commercially successful. The research and development process is expensive, prolonged and entails considerable uncertainty. Development of medical devices, from discovery through testing and registration to initial product launch, typically takes between three and seven years. Each of these periods varies considerably from product to product and country to country. Because of the complexities and uncertainties associated with ophthalmic research and development, products and applications we are currently developing may not complete the development process or obtain the regulatory approvals required to market such products or applications successfully. The products and applications currently in our development pipeline may not be approved by regulatory entities and may not be commercially successful, and our current and planned products and applications could be surpassed by more effective or advanced products and applications developed and marketed by others.

If we choose to acquire new or complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete those acquisitions or to successfully integrate them in a cost-effective and non-disruptive manner.

While we have not made any acquisitions in the past and do not have current commitments to do so, we may in the future choose to acquire businesses, products or technologies to retain our competitive position within the marketplace or to expand into new markets. We cannot assure you, however, that we would be able to successfully complete any acquisition we choose to pursue, or that we would be able to successfully integrate any acquired business, product or technology in a cost-effective and non-disruptive manner. If we were unable to integrate any acquired businesses, products or technologies effectively, our business would likely suffer.

We have a history of net losses and may not maintain profitability.

Although we were profitable for the three and nine months ended September 30, 2005, we have incurred significant operating losses in each previous full year since our inception in 1997. We incurred net losses applicable to common stockholders of $10.2 million in 2004 and $12.0 million in 2003. As of September 30, 2005, we had an accumulated deficit of approximately $57.7 million. In order to maintain profitability, we will need to significantly increase our revenues from sales of our product offering, and we will also need to continue to derive an increasing percentage of our total revenues from sales of

~~our~~We ~~per~~have ~~procedure~~a ~~fee~~history ~~inclusive~~ of anet ~~disposable~~losses ~~patient interface, which generate a higher gross margin than sales~~ and ~~leases of our IntraLase® FS laser. Even if we do maintain profitability, we~~ may not bemaintain ~~able to sustain or increase~~ profitability ~~on a quarterly or annual basis due to, among other things, competitive pressures and regulatory compliance, in which case the price of our common stock may decline~~.

~~Our~~Although ~~ability~~we were profitable in the six months ended June 30, 2006 and in 2005, we have incurred significant operating losses in each previous full year, prior to ~~use~~2005, since our inception in 1997. We incurred net ~~operating~~losses ~~loss~~applicable ~~carryforwards~~to common stockholders of $10.2 million in 2004 and $12.0 million in 2003. As of June 30, 2006, we had an accumulated deficit of approximately $45.1 million. In order to maintain profitability, we will need to continue to increase our revenues from sales of our product offering, and we will also need to continue to derive an increasing percentage of our total revenues from sales of our per procedure fee inclusive of a disposable patient interface, which generate a higher gross margin than sales and leases of our IntraLase® FS laser. Even if we do maintain profitability, we may not be ~~limited~~able to sustain or increase profitability on a quarterly or annual basis due to, among other things, competitive pressures and regulatory compliance, in which case the price of our common stock may decline.

Section 382 of the Internal Revenue Code generally imposes an annual limitation on the amount of net operating loss carryforwards that may be used to offset taxable income when a corporation has undergone significant changes in its stock ownership. We have internally reviewed the applicability of the annual limitations imposed by Section 382 caused by previous changes in our stock ownership and believe such limitations should not be significant. Based on our review, we believe that as of December 31, 2004 approximately $55.6 million of net operating loss carryforwards were available to us for federal income tax purposes. Based on the size and price of our initial public offering, which was effective October 6, 2004 and closed October 13, 2004, we may trigger the annual limitations imposed by Section 382 and may limit our ability to use our remaining net operating loss carryforwards to approximately $15.3 million annually. In addition, any future ownership changes may affect our ability to use our remaining net operating loss carryforwards. If we lose our ability to use net operating loss carryforwards, our income will be subject to tax earlier, resulting in lower net income.

Changes to our accounting for stock options will adversely affect our earnings and may adversely affect stock price.

We ~~currently~~adopted ~~are~~SFAS ~~not~~No. 123R, ~~required~~Share toBased Payment, ~~record~~using ~~stock-based~~the ~~compensation~~modified ~~charges~~prospective ~~if an~~transition ~~employee’s~~method, ~~stock~~which ~~option~~required ~~exercise~~the ~~price~~application ~~equals~~of orthe ~~exceeds~~accounting standard in the ~~fair~~first ~~value~~quarter of ~~our~~fiscal ~~common~~year ~~stock~~2006. atOur ~~the~~Financial ~~date~~Statements as of ~~grant.~~and ~~However,~~for inthe ~~December~~three ~~2004~~and ~~the~~six ~~Financial~~months ~~Accounting~~ended ~~Standards~~June 30, 2006 ~~Board~~reflect ~~issued~~the ~~Statement~~impact of ~~Financial~~adopting ~~Accounting Standards, or~~ SFAS, No. ~~123~~123R ~~(Revised~~and ~~2004)~~in ~~that~~accordance ~~will~~with ~~require~~the usmodified toprospective ~~expense~~transition method, the ~~fair~~Financial ~~value~~Statements ofpresented ~~stock~~in ~~options~~prior ~~granted.~~periods Ifhave wenot ~~were~~been restated to ~~change~~reflect, ~~our~~and ~~accounting~~they ~~policy~~do innot ~~accordance~~include, ~~with~~ the ~~existing~~impact of SFAS No. ~~123,~~123R. ~~Accounting for~~ Stock-~~Based~~based ~~Compensation~~compensation ~~and~~expense recognized under SFAS No. ~~148,~~123R ~~Accounting~~ for ~~Stock-Based~~the ~~Compensation-Transition~~six ~~and~~months ~~Disclosure~~ended ~~and~~June 30, ~~retroactively~~2006 ~~restate~~was ~~all~~$2,835,244 ~~prior periods~~ as ifcompared weto ~~had~~stock-based ~~adopted~~compensation ~~SFAS~~of ~~123 for all periods presented~~$1,085,506 ~~our income from operations would have decreased by approximately $2.8 million~~ in the ~~nine~~six months ended ~~September~~June 30, 2005. ~~and~~We believe ~~our~~the ~~loss~~adoption ~~from~~of ~~operations~~SFAS ~~would~~No. 123R ~~have~~will ~~increased~~result byin total stock-based compensation of approximately $~~476,000~~6.0 million in ~~the~~2006 ~~nine~~as ~~months~~compared ~~ended~~to ~~September 30,~~stock-based ~~2004.~~compensation Weof ~~believe~~$2.1 ~~the~~million ~~adoption~~in of2005 ~~SFAS~~and ~~No. 123~~therefore ~~(Revised 2004)~~ will have a material impact on our results of operations.

We may incur increased costs as a result of recently enacted and proposed changes in laws and regulations.

Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules proposed by the Securities and Exchange Commission and by the Nasdaq Stock Market, have resulted in and are expected to continue to result in increased costs to us as a public company. The new rules could make it more difficult or more costly for us to obtain certain types of insurance, including directors’ and officers’ liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We are presently evaluating and monitoring developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs. Additionally, unearned deferred stock compensation for non-employees is periodically remeasured through the vesting date under current and future accounting rules. This periodic remeasurement could have a significant impact on our results of operations.

~~Item~~Our 3business ~~Quantitative~~depends upon continued market acceptance of LASIK surgery by both surgeons and ~~Qualitative~~patients ~~Disclosures~~in ~~about~~the ~~Market~~United ~~Risk~~States and international markets. LASIK surgery has only been approved since 1995 and commercially available since 1996 and, to date, has penetrated approximately 8% of the eligible U.S. population. We believe that if market acceptance of LASIK surgery declines, demand for our product offering by LASIK surgery practices and potential patients will decline, resulting in a decrease in our revenues.

~~The~~Some ~~primary~~consumers ~~objective~~may ofchoose ~~our~~not ~~investment activities is~~ to ~~preserve~~undergo ~~principal~~LASIK ~~while~~surgery ~~maximizing~~due ~~the~~to ~~income~~concerns wewith ~~receive from our investments without~~the ~~significantly~~safety ~~increasing~~and ~~the~~efficacy ~~risk~~ of ~~loss.~~an ~~Some~~elective ofsurgery ~~the securities~~ in ~~which~~general weor ~~may invest in~~ the ~~future~~LASIK ~~may~~procedure bein ~~subject~~particular, due to ~~market~~concerns ~~risk~~about ~~for~~price ~~changes~~or indue ~~interest~~to ~~rates.~~their Tobelief ~~mitigate~~that ~~this~~improved ~~risk,~~technology weor ~~plan~~alternative tomethods ~~maintain a portfolio~~ of ~~cash~~treatment ~~equivalents~~will ~~and investments~~be available in athe ~~variety~~near offuture. ~~marketable~~LASIK surgery ~~securities,~~itself ~~which~~can ~~may~~result ~~include~~in ~~commercial~~potential ~~paper,~~complications ~~money~~and ~~market~~side ~~funds~~effects, ~~government~~such ~~and~~as ~~non~~post-~~government~~operative ~~debt securities. Currently~~discomfort, weunintended ~~are~~over- ~~exposed~~or tounder- ~~minimal~~corrections, ~~market~~disorders ~~risks.~~in Wecorneal ~~manage~~healing, ~~the~~undesirable ~~sensitivity~~visual ofsensations ~~our~~caused ~~results of operations to these risks~~ by ~~maintaining~~bright alights ~~conservative~~such ~~portfolio,~~as ~~which~~glare ~~is comprised solely of highly rated investments. We do not hold~~ or halos ~~issue~~and ~~derivatives,~~dry ~~derivative commodity instruments or other financial instruments for trading purposes~~eye.

Weak or uncertain economic conditions could adversely affect demand for our product offering.

Changes in U.S. federal tax laws governing the ability of potential LASIK patients to use pre-tax dollars to pay for LASIK surgery could adversely affect demand for our product offering.

Item 3

Quantitative and Qualitative Disclosures about Market Risk

The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing the risk of loss. Some of the securities in which we may invest in the future may be subject to market risk for changes in interest rates. To mitigate this risk, we plan to maintain a portfolio of cash equivalents and investments in a variety of marketable securities, which may include commercial paper, money market funds, government and non-government debt securities. Currently, we are exposed to minimal market risks. We manage the sensitivity of our results of operations to these risks by maintaining a conservative portfolio, which is comprised solely of highly rated investments. We do not hold or issue derivatives, derivative commodity instruments or other financial instruments for trading purposes.

The risk associated with fluctuating interest rates is limited to our investment portfolio and our borrowings. We do not believe that a 10% change in interest rates would have a significant effect on our results of operations or cash flows.

All of our sales since inception have been made in U.S. dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations. We expect to continue to realize our sales in U.S. dollars, regardless of our intended expansion into international markets, although no assurances can be given. As we increase our international sales and support organization, we anticipate some level of exposure to foreign currency risk as a result of compensating these employees in local currencies.

Item 4

Controls and Procedures

(a)

Evaluation of disclosure controls and procedures

As of ~~September~~June 30, ~~2005~~2006, we have carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 of the Securities and Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information related to us that is required to be included in our periodic SEC filings. A controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls are met, and no evaluation of controls can provide absolute assurance that all controls and instances of fraud, if any, within a Company have been detected.

(b)

Changes in internal controls

There have been no significant changes in our internal control over financial reporting during the most recent fiscal quarter ended ~~September~~June 30, ~~2005~~2006 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 1

Legal Proceedings

On June 10, 2004, we received notice from Escalon Medical Corp. of its intent to terminate our license agreement unless we paid additional royalties and expenses which Escalon claimed were owed under its interpretation of the parties’ license agreement. Escalon sought payment of approximately $645,000 through March 31, 2004 and additional unspecified amounts for future periods. We disputed Escalon’s contract interpretation. On June 21, 2004, we filed a complaint against Escalon for declaratory and injunctive relief in the United States District Court for the Central District of California to clarify our obligations and prevent Escalon from terminating the license agreement (the “First California Action”).

On March 1, 2005, the court in the First California Action entered a summary judgment order, ruling on the majority of issues in the case. The ~~court~~ court ruled in our favor on some issues and in Escalon’s favor on others. On April 1, 2005 Escalon again attempted to terminate the license agreement. On April 25, 2005 the court found the purported termination to be ineffective. On May 5, 2005, the court entered a final judgment in the First California Action, in effect adopting its prior summary judgment rulings. This ended the First California Action. Of the approximately $645,000 demanded by Escalon through March 31, 2004, approximately $229,000 was found to be due under the court’s rulings in the First California Action. We have timely paid this amount. We do not believe that the judgment in the First California Action will have a material adverse effect on our business, financial condition and results of operations~~, and our financial statements were not affected at December 31, 2004~~. The decision in the First California Action, if upheld, represents an increase in royalties payable to Escalon of approximately 0.2% of revenues, and a concomitant 0.2% reduction in gross margins and operating profits. These effects are reflected in our reported financial results for ~~the first three quarters of~~ 2005. We have appealed certain aspects of the court’s judgment in the First California Action to the United States Court of Appeals for the Ninth Circuit.

The First California Action did not resolve all of the parties’ disputes, and Escalon ~~continues~~continued to contend in written notices to us that our royalty payments ~~are~~were inadequate. On May 9, ~~although~~2005, we commenced a new lawsuit against Escalon in the ~~notices~~United doStates ~~not~~District ~~specify~~Court for the ~~amount~~Central District of California to clarify the ~~claimed~~open ~~underpayment~~issues (the “Second California Action”). OnOne ~~May 9,~~week ~~2005~~later, weEscalon commenced a new lawsuit against ~~Escalon~~us in the ~~United~~Delaware ~~States~~Chancery ~~District~~ Court, ~~for~~alleging, among other things, breach of the license agreement and breach of fiduciary duty (the “Delaware Action”). Escalon moved to dismiss the Second California Action, and we moved to dismiss or stay the later filed Delaware Action.

32On January 11, 2006, the Second California action was dismissed without prejudice. In its decision, the court explained that it was exercising its discretion to abstain from hearing the case because of the pending Ninth Circuit appeal, as well as the similar issues presented in the Delaware Action. By prior agreement of the parties, this triggered the briefing schedule on our motion to dismiss or stay the Delaware Action, and on January 31, 2006 we filed our opening brief in support of the motion. On February 21, 2006, Escalon filed an amended complaint in the Delaware Action in lieu of responding to our opening brief. On the same day, it sent a new default notice to us, alleging breach of the license agreement (see below).

One of the issues now in dispute is valuation of our accounts receivable for royalty calculation purposes. The court in the First California Action found that creation of an account receivable on our books constituted non-cash “other property” received, but expressly left open the value of such property for royalty calculation purposes. On April 22, 2005, Escalon, purporting to act in its capacity as a Company shareholder, sent us an inspection demand under section 220 of the Delaware corporation law (the “First 220 Demand”), seeking, among other things, detailed records concerning our accounts receivable. We rejected Escalon’s First Section 220 Demand as having an improper purpose under Delaware law. On July 18, 2005, Escalon Holdings, Inc., apparently a wholly-owned subsidiary of Escalon, also purporting to act as a Company shareholder, sent us a new section 220 demand (the “Second 220 Demand”) with language copied verbatim from the First 220 Demand. We rejected the Second 220 Demand on the same basis as the first. Under Delaware law, a shareholder may bring an action to enforce a section 220 demand if its statutory demand upon the corporation has been rejected.

On September 2, 2005, Escalon and Escalon Holdings, Inc. commenced an action against us in the Delaware Chancery Court under section 220 of the Delaware Corporation Law (the “220 Action”). In the 220 Action, Escalon seeks to inspect our

~~Central~~records ~~District~~described in the Section 220 Demands. The crux of ~~California~~Escalon’s position appears to ~~clarify~~be that the ~~open~~amount ~~issues~~of (royalties which Escalon receives under its contract with us is less than what it believes it would receive if receivables were valued under the ~~“Second~~contract ~~California~~the ~~Action”).~~same ~~One~~way ~~week~~they ~~later~~are valued on our financial statements, ~~Escalon~~and ~~commenced~~that atherefore ~~new~~we ~~lawsuit~~are ~~against~~purportedly overstating the value of usreceivables inon our financial statements to the ~~Delaware~~detriment ~~Chancery~~of ~~Court,~~shareholders. ~~alleging,~~The ~~among~~question ~~other~~of ~~things,~~the ~~breach~~proper valuation of receivables under the ~~license~~contract ~~agreement~~is already the subject of pending litigation between us and ~~breach~~Escalon. We do not believe that a disruptive inspection of ~~fiduciary~~our ~~duty~~proprietary (business records would have a bearing on the ~~“Delaware~~resolution ~~Action”)~~of this contract dispute. We contend that the 220 Action is an Escalon ~~has~~litigation ~~moved~~tactic intended to ~~dismiss~~benefit ~~the~~Escalon ~~Second~~in ~~California~~its ~~Action,~~capacity ~~and~~as wea ~~have~~litigant ~~moved~~by toallowing ~~dismiss~~it ~~the~~to ~~later~~circumvent ~~filed~~existing ~~Delaware~~contractual ~~Action~~limitations on its inspection rights. ~~These~~We ~~motions~~believe this is an improper basis for a demand under section 220 of the Delaware corporation statute, and are ~~pending~~defending against the 220 Action vigorously.

~~One~~On ofFebruary 21, ~~the~~2006, ~~issues~~we ~~now~~received ina ~~dispute~~written isnotice ~~valuation~~from ofEscalon ~~our~~asserting ~~accounts~~that ~~receivable~~we ~~for~~were ~~royalty~~in ~~calculation~~default ~~purposes.~~under ~~The court in~~ the ~~First~~license ~~California~~agreement ~~Action~~by ~~found~~reason ~~that~~of ~~creation~~alleged improper valuation of anaccounts ~~account~~ receivable onin our ~~books~~royalty ~~constituted~~payments ~~non-cash~~as ~~“other property”~~well ~~received,~~as ~~but~~our ~~expressly~~alleged ~~left~~refusal ~~open~~to ~~the~~permit ~~value of such property for royalty calculation purposes. On April 22, 2005,~~ Escalon, ~~purporting~~ to ~~act~~audit inour ~~its~~books ~~capacity~~and asrecords a(the ~~Company~~“Default ~~shareholder,~~Notice”). ~~sent~~The usDefault anNotice ~~inspection~~appears ~~demand~~to ~~under~~threaten ~~section~~termination ~~220~~ of the ~~Delaware~~license agreement ~~corporation~~if ~~law (~~the ~~“First 220 Demand”), seeking, among other things, detailed records concerning our~~ accounts receivable. Wedeductions ~~rejected~~taken ~~Escalon’s~~against ~~First~~royalty ~~Section 220~~payments ~~Demand~~for aseach ~~having~~of anthe ~~improper~~first ~~purpose~~three ~~under Delaware~~quarters ~~law.~~of ~~On July 18,~~ 2005, ~~Escalon~~are ~~Holdings,~~not ~~Inc.,~~paid ~~apparently~~within afifteen ~~wholly-owned~~days ~~subsidiary~~ of ~~Escalon,~~the ~~also~~date ~~purporting~~of tothe ~~act~~letter. ~~as a Company shareholder~~However, ~~sent~~to usdate aEscalon ~~new~~has ~~section~~refused ~~220~~to ~~demand~~confirm ~~(the~~this ~~“Second~~or ~~220~~provide us ~~Demand”)~~ with ~~language copied verbatim from~~ the ~~First~~amount ~~220~~it ~~Demand.~~believes Weis ~~have~~required ~~rejected~~to cure the ~~Second~~alleged ~~220~~default, ~~Demand~~despite onmultiple ~~the~~requests ~~same~~from ~~basis~~us. asThe ~~the~~Default ~~first.~~Notice ~~Under~~also ~~Delaware~~threatened ~~law,~~termination aif ~~shareholder~~Escalon ~~may~~was ~~bring~~not ansatisfied ~~action~~with respect to ~~enforce~~the aresolution ~~section~~of ~~220~~its ~~demand~~audit ifrights ~~its~~within ~~statutory~~sixty days ~~demand~~of ~~upon~~ the ~~corporation~~date ~~has~~of ~~been rejected~~the letter.

On ~~September~~February 224, ~~2005~~2006, ~~Escalon~~the ~~and~~parties ~~Escalon Holdings,~~agreed ~~Inc.~~to ~~commenced~~submit antheir ~~action~~disputes ~~against~~to usmediation, in ~~the~~ Delaware, ~~Chancery~~ under Court ~~under section 220~~ of ~~the~~Chancery ~~Delaware~~Rule ~~Corporation Law (the “220 Action”). In the 220 Action~~174, ~~Escalon~~and ~~seeks~~ to ~~inspect~~stay ~~our~~all ~~records~~litigation ~~described~~pending in the ~~Section 220 Demands.~~outcome ~~The crux~~ of ~~Escalon’s position appears to be that~~ the ~~amount~~mediation. ofIn ~~royalties~~addition, ~~which~~ Escalon ~~receives~~agreed ~~under~~that its ~~contract~~Termination ~~with~~Notice ~~us is less than what it believes it~~ would ~~receive~~be ifsuspended ~~receivables~~pending ~~were~~the ~~valued~~outcome ~~under~~of the ~~contract~~mediation ~~the same way they are valued on our financial statements,~~ and that, ~~therefore~~should ~~we are purportedly overstating~~ the ~~value~~mediation ofbe unsuccessful, ~~receivables~~we onwould ~~our~~be ~~financial~~afforded ~~statements to~~ the ~~detriment~~full offifteen ~~shareholders.~~and ~~The~~sixty ~~question~~day ofresponse ~~the~~periods ~~proper~~set ~~valuation~~forth ofin ~~receivables under~~ the ~~contract is already the subject of pending litigation between us and Escalon~~Notice, ~~and~~which ~~both~~periods ~~parties~~would ~~have~~commence ~~requested~~ten adays ~~judicial~~after ~~declaration as to~~ the ~~meaning~~Chancery ofCourt ~~the~~issued ~~applicable~~an ~~contract~~order ~~language.~~lifting ~~We do not believe that a disruptive inspection of our proprietary business records would have a bearing on~~ the ~~resolution~~stay. ofEscalon ~~this~~has ~~contract~~also ~~dispute.~~agreed ~~We contend~~ that the ~~220~~time ~~Action~~period for isresponding anto Escalon’s ~~litigation~~amended ~~tactic~~complaint ~~intended to benefit Escalon~~ in ~~its capacity as a litigant by allowing it to circumvent existing contractual limitations on its inspection rights. We believe this is an improper basis for a demand under section 220 of~~ the Delaware ~~corporation~~Action ~~statute,~~would ~~and~~be ~~intend~~tolled toon ~~defend against~~ the ~~220~~same ~~Action vigorously~~basis.

We believe Escalon will persist in attempting to terminate the license agreement. Termination of the Escalon license agreement could have a material adverse effect on our business, financial condition and results of operations.

On May 24, 2005, Ari Weitzner M.D., P.C., a Brooklyn ophthalmologist, commenced a lawsuit against us in the United States District Court for the Eastern District of New York, purportedly as a class action, alleging that we violated the Telephone Consumer Protection Act (TCPA) by sending unsolicited fax advertisements in violation of the TCPA. The complaint seeks statutory damages, costs and attorneys fees. The TCPA provides for statutory damages of $500 per violation ($1,500 if knowing and willful). We intend to contest the Weitzner action vigorously.

On August 23, 2004, the United States Patent and Trademark Office (PTO) granted a request for ~~re-examination~~reexamination with respect to ~~U.S.~~US Patent RE 37,585, one of the four U.S. patents licensed to us by the University of Michigan, which means that the PTO found that the request raised a new issue of patentability with regard to some of the claims. ~~Re-examination~~On ~~may result~~July in25, 2006, the ~~scope~~USPTO ofterminated ~~protection~~the ~~and~~proceedings favorable ~~rights~~to ~~provided by~~ the ~~patent~~Patent ~~license~~Owner, ~~being~~the ~~lost~~University orof ~~narrowed.~~Michigan, ~~The~~by ~~irrevocable~~issuing ~~license~~a wedocument ~~acquired~~entitled ~~and~~“Notice ~~the~~of ~~payment~~Intent ~~we made pursuant~~ to ~~the~~Issue ~~July 15,~~Ex ~~2004~~Parte ~~license~~Reexamination ~~agreement~~Certificate” ~~will~~(NIRC). ~~not~~In ~~be affected by~~ the ~~granting of re-examination~~NIRC, ~~regardless of~~ the ~~outcome.~~PTO ~~Although~~confirmed ~~we believe that~~ the ~~intellectual~~patentability ~~property~~of ~~covered by~~ the ~~patent~~RE ~~subject to the re-examination is important to our business~~37,585 ifclaims ~~this patent is invalidated there will be no effect on our ability~~as toamended ~~sell~~during ~~our products. However, invalidation or narrowing of this patent might allow others to market competitive products that would otherwise have infringed~~ the ~~patent~~reexamination.

We are also currently involved in other litigation incidental to our business. In the opinion of management, the ultimate resolution of such litigation will not likely have a significant effect on our financial statements.

3334

Item 1A

Risk Factors

There are no material changes from risk factors previously disclosed in our Annual Report on Form 10-K for the period ending December 31, 2005, although some risk factors (see “Factors that May Affect Results of Operations and Financial Condition” in Part I, Item 2 of this quarterly report) have been updated to reflect current information.

Item 2

Unregistered Sales of Equity Securities and Use of Proceeds

(b)

Use of Proceeds

The initial public offering of our common stock was effected through a Registration Statement on Form S-1 (File No. 333-116016) that was declared effective by the Securities and Exchange Commission on October 6, 2004. There has been no change in the other information set forth in Part II, Item 2(b) of our Quarterly Report on Form 10-Q for the Quarterly Period ended September 30, 2004 and summarized in Part II, Item 5(b) of our 2004 Annual Report on Form 10-K.

Item 4

Submission of Matters to a Vote of Security Holders

Our 2005 Annual Meeting of Stockholders (“Annual Meeting”) was held on ~~July~~May 2123, ~~2005~~2006. At the Annual Meeting, our stockholders: (a) elected two Class III Directors with terms expiring at the ~~2008~~2009 Annual Meeting of Stockholders; (b) approved amendments to our 2004 Stock Incentive Plan; (c) approved an additional two million shares of common stock for issuance under our 2004 Stock Incentive Plan and (bd) ratified the appointment of Deloitte & Touche LLP as our independent registered public accountants for the year ending December 31, 2005.

Following the Annual Meeting, two Class III Directors, having terms expiring in ~~2006~~2008, and three Class III Directors, having terms expiring in 2007, continued in office.

The following tables set forth the results of voting at the Annual Meeting:

(1) The election of the two nominated directors to hold office until the annual meeting in ~~2008~~2009.

Board Member	For	Withheld
Thomas S. Porter	21,972,204	1,663,587
William J. Link	24,749,353	1,917,042
Jay T. Holmes	23,020,943	614,848
Gilbert H. Kliman	24,745,507	1,920,888

(2) The ~~ratification~~approval of ~~the~~amendments ~~appointment~~to ~~of Deloitte & Touche LLP as~~ our ~~independent~~2004 ~~auditors~~Stock ~~for~~Incentive ~~the 2005 fiscal year~~Plan.

For	Against	Abstained	Non-Votes
23,001,184	634,384	223
15,352,644	8,189,919	20,176	3,103,656

34(3) The approval of an additional two million shares of common stock for issuance under our 2004 Stock Incentive Plan.


For	Against	Abstained	Non-Votes
12,687,194	10,850,236	25,309	3,103,656

(4)

The ratification of the appointment of Deloitte & Touche, LLP as our independent public accountants for 2006.


For	Against	Abstained	Non-Votes
26,569,633	90,212	6,550	—

Item 6

Exhibits

ExhibitNo.		Description
10.1		Amended and Restated 2004 Stock Incentive Plan.
31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes Oxley Act of 2002
31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes Oxley Act of 2002
32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002***
32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002***

***

In accordance with Item 601(b)(32)(ii) of Regulation S-K, this exhibit shall not be deemed “filed” for the purposes of Section 18 of the Securities and Exchange Act of 1934 or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.

3536

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

~~November~~July 931, ~~2005~~ 2006

INTRALASE CORP.

(Registrant)

/s/ Robert J. Palmisano

Robert J. Palmisano

President and Chief Executive Officer

/s/ Shelley B. Thunen

Shelley B. Thunen

Executive Vice President and Chief Financial Officer

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