Obagi Medical Products 10Q 2012 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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 30, 2012
OR
¨	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: 001-33204

OBAGI MEDICAL PRODUCTS, INC.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		22-3904668 (I.R.S. Employer Identification No.)
3760 Kilroy Airport Way, Suite 500, Long Beach, CA (Address of principal executive offices)		90806 (zip code)

(562) 628-1007

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 xNo ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes xNo ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨		Accelerated filer x
Non-accelerated filer ¨ (Do not check if a smaller reporting company)		Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No x

There were 17,413,304 shares of the registrant’s common stock issued and outstanding as of October 29, 2012.

OBAGI MEDICAL PRODUCTS, INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS


	PART I	PAGE
Item 1.	Financial Statements	1
	Unaudited Condensed Consolidated Balance Sheets – As of September 30, 2012 and December 31, 2011	1
	Unaudited Condensed Consolidated Statements of Income and Comprehensive Income – For the three and nine months ended September 30, 2012 and 2011	2
	Unaudited Condensed Consolidated Statement of Stockholders’ Equity – For the nine months ended September 30, 2012	3
	Unaudited Condensed Consolidated Statements of Cash Flows – For the nine months ended September 30, 2012 and 2011	4
	Notes to the Unaudited Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	28
Item 4.	Controls and Procedures	29

	PART II
Item 1.	Legal Proceedings	30
Item 1A.	Risk Factors	31
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	32
Item 3.	Defaults Upon Senior Securities	32
Item 4.	Mine Safety Disclosures	32
Item 5.	Other Information	32
Item 6.	Exhibits	33

Obagi®, Blue Peel®, Blue Peel RADIANCE® Condition & Enhance®, ELASTIderm®, ELASTILash® Nu-Derm®, Obagi-C®, Obagi CLENZIderm®, Rosaclear® and Penetrating Therapeutics™ are among the trademarks of Obagi Medical Products, Inc. and/or its affiliates in the United States and certain other countries. Refissa® is a trademark of Spear Pharmaceuticals Inc. Any other trademarks or trade names mentioned are the property of their respective owners.

PART I

ITEM 1: FINANCIAL STATEMENTS

Obagi Medical Products, Inc.

Unaudited Condensed Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)



	September 30,			December 31,
	2012			2011

Assets
Current assets
Cash and cash equivalents	$	21,491		$	35,049
Accounts receivable, net		21,379			20,985
Inventories, net		6,798			4,389
Prepaid expenses and other current assets		8,175			6,048
Total current assets		57,843			66,471
Property and equipment, net		5,017			2,841
Goodwill		4,629			4,629
Intangible assets, net		3,118			3,538
Other assets		364			172
Total assets	$	70,971		$	77,651

Liabilities and Stockholders' Equity
Current liabilities
Accounts payable	$	7,071		$	7,216
Current portion of long-term debt		11			9
Accrued liabilities		7,712			7,065
Total current liabilities		14,794			14,290
Long-term debt		11			13
Other long-term liabilities		2,382			2,476
Total liabilities		17,187			16,779
Commitments and contingencies (Note 7)
Stockholders' equity
Common stock, $.001 par value; 100,000,000 shares authorized, 23,297,165 and 23,066,707 shares issued and 17,413,304 and 18,682,721 shares outstanding at September 30, 2012 and December 31, 2011, respectively		23			23
Additional paid-in capital		67,111			63,796
Retained earnings		46,779			37,401
Treasury stock, at cost; 5,867,941 and 4,367,941 shares at September 30, 2012 and December 31, 2011, respectively		(60,129	)		(40,348	)
Total stockholders' equity		53,784			60,872
Total liabilities and stockholders' equity	$	70,971		$	77,651

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

Obagi Medical Products, Inc.

Unaudited Condensed Consolidated Statements of Income and Comprehensive Income

(Dollars in thousands, except per share amounts)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011

Net sales	$	29,148		$	28,112		$	90,407		$	83,501
Cost of sales		5,892			5,654			18,300			17,646
Gross profit		23,256			22,458			72,107			65,855
Selling, general and administrative expenses		17,752			15,091			55,003			56,709
Research and development expenses		493			518			1,570			1,337
Income from operations		5,011			6,849			15,534			7,809
Interest income		15			10			50			21
Interest expense		(19	)		(24	)		(59	)		(119	)
Income before provision for income taxes		5,007			6,835			15,525			7,711
Provision for income taxes		1,981			2,390			6,147			2,786
Net income and comprehensive income	$	3,026		$	4,445		$	9,378		$	4,925

Net income attributable to common shares
Basic	$	0.16		$	0.24		$	0.50		$	0.26
Diluted	$	0.16		$	0.24		$	0.50		$	0.26

Weighted average common shares outstanding
Basic		18,350,703			18,599,644			18,601,102			18,557,381
Diluted		18,500,923			18,678,787			18,730,565			18,648,367

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

Obagi Medical Products, Inc.

Unaudited Condensed Consolidated Statement of Stockholders’ Equity

(Dollars in thousands)



	Common Stock			Additional Paid-In		Retained		Treasury Stock
	Shares	Amount		Capital		Earnings		Shares	Amount		Total

Balances, as of December 31, 2011	23,050,662	$	23	$	63,796	$	37,401	(4,367,941)	$	(40,348)	$	60,872
Net income and comprehensive income for the nine months ended September 30, 2012	—		—		—		9,378	—		—		9,378
Issuance of vested restricted stock	16,045		—		—		—	—		—		—
Issuance of common stock upon exercise of stock options	214,538		—		1,825		—	—		—		1,825
Repurchase of common stock	—		—		—		—	(1,500,000)		(19,781)		(19,781)
Stock-based compensation expense	—		—		1,490		—	—		—		1,490
Balances, as of September 30, 2012	23,281,245	$	23	$	67,111	$	46,779	(5,867,941)	$	(60,129)	$	53,784

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

Obagi Medical Products, Inc.

Unaudited Condensed Consolidated Statements of Cash Flows

(Dollars in thousands)



	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities
Net income	$	9,378		$	4,925
Adjustments to reconcile net income to net cash provided by
operating activities
Depreciation and amortization		1,183			1,442
Gain on disposal of assets		—			(54	)
Impairment of intangible assets		70			504
Provision for doubtful accounts		24			60
Stock-based compensation expense		1,490			961
Changes in operating assets and liabilities
Accounts receivable		(418	)		3,095
Income taxes receivable		(1,432	)		908
Inventories		(2,409	)		1,583
Prepaid expenses and other current assets		(695	)		(16	)
Other assets		(178	)		28
Accounts payable		(145	)		(283	)
Accrued liabilities		1,740			(1,530	)
Income taxes payable		(1,725	)		—
Other long-term liabilities		(94	)		19
Net cash provided by operating activities		6,789			11,642
Cash flows from investing activities
Purchases of property and equipment		(2,222	)		(381	)
Disposal of property and equipment		—			54
Purchase of other intangible assets		(131	)		(239	)
Net cash used in investing activities		(2,353	)		(566	)
Cash flows from financing activities
Principal payments on capital lease obligations		(8	)		(4	)
Proceeds from the exercise of stock options		1,825			793
Debt issuance costs for line of credit		(30	)		—
Repurchase of common stock		(19,781	)		—
Net cash (used in) provided by financing activities		(17,994	)		789
Net (decrease) increase in cash and cash equivalents		(13,558	)		11,865
Cash and cash equivalents at beginning of period		35,049			15,139
Cash and cash equivalents at end of period	$	21,491		$	27,004

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

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

Note 1: Description of Business and Basis of Presentation

Obagi Medical Products, Inc. (the “Company”) is a specialty pharmaceutical company that develops, markets and sells proprietary topical aesthetic and therapeutic prescription-strength skin care systems in the physician-dispensed market. The Company is incorporated under the laws of the state of Delaware. The Company markets its products through its own sales force throughout the United States, and through 21 distribution and one licensing partner in 47 other countries in regions, including North America, Europe, Asia, the Middle East, Central America and South America. The Company also licenses certain non-prescription product concepts under the Obagi trademark to a large Japanese-based pharmaceutical company for sale through consumer distribution channels in Japan.

Principles of Consolidation and Basis of Presentation

The unaudited condensed consolidated financial statements include the accounts of Obagi Medical Products, Inc. and its wholly owned subsidiaries, OMP, Inc. and OPO, Inc. (“OPO”). OPO was established in January 2012 to conduct the Company’s e-Commerce and fulfillment business. All intercompany accounts and transactions have been eliminated in consolidation. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary (consisting only of normal recurring accruals) to fairly state the financial information contained therein. These statements do not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for annual periods and should be read in conjunction with the Company’s audited consolidated financial statements and related notes for the year ended December 31, 2011. The Company prepared the condensed consolidated financial statements following the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012 or any other period(s).

Note 2: Recent Accounting Pronouncements

In August 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2012-03, Technical Amendments and Corrections to SEC Sections: Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 114, Technical Amendments Pursuant to SEC Release No. 33-9250, and Corrections Related to FASB Accounting Standards Update 2010-22 (SEC Update) (“ASU 2012-03”). This update amends various SEC paragraphs pursuant to the issuance of Staff Accounting Bulletin No. 114. The adoption of ASU 2012-03 is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued authoritative guidance in Accounting Standards Codification (“ASC”) 220, Comprehensive Income, on the presentation of other comprehensive income. The new guidance eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity and requires an entity to present either one continuous statement of net income and other comprehensive income or two separate, but consecutive statements. Further, the guidance requires reclassification adjustments from other comprehensive income to net income to be presented on the face of the financial statements. However, in December 2011, the FASB issued follow-up guidance to defer the requirement to present reclassification adjustments from other comprehensive income on the face of the financial statements and allow entities to continue to report reclassifications out of accumulated other comprehensive income. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. The Company adopted this new guidance beginning January 1, 2012, and has applied it retrospectively. The adoption of this guidance did not have a significant impact on the Company’s consolidated financial statements.

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

Note 3: Composition of Certain Financial Statement Captions


	September 30,			December 31,
Inventories	2012			2011

Raw materials	$	1,000		$	1,020
Finished goods		6,092			3,834
		7,092			4,854
Less reserve for inventories		(294	)		(465	)
	$	6,798		$	4,389

Inventories consist of raw materials and finished goods that are manufactured through contracted third party manufacturers and that are purchased from third parties and are valued at the lower of cost or market. Cost is determined on a first-in, first-out basis with market being determined as the lower of replacement cost or net realizable value. Inventory reserves are established when conditions indicate that the selling price could be less than cost due to physical deterioration, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory reserves are measured as the difference between cost of inventory and the estimated market value. Inventory reserves are established charges to cost of sales and establish a lower cost basis for the inventory. The Company’s estimated inventory reserve is provided in the condensed consolidated financial statements and actual reserve requirements have approximated management’s estimates.


	September 30,			December 31,
Property and Equipment	2012			2011

Furniture and fixtures	$	745		$	740
Computer software and equipment		4,114			3,757
Laboratory and office equipment		464			464
Leasehold improvements		2,200			2,200
Capital lease (office equipment)		37			29
Construction in progress		2,529			62
		10,089			7,252
Less accumulated depreciation and amortization		(5,072	)		(4,411	)
	$	5,017		$	2,841

During the three and nine months ended September 30, 2012, the Company added $1,536 and $2,892 in fixed assets, respectively, of which $1,461 and $2,594 during the same periods, respectively, relate to the creation of the Company’s e-Commerce platform and fulfillment center.


	September 30,		December 31,
Accrued Liabilities	2012		2011

Salaries and related benefits	$	5,394	$	3,406
Income taxes payable		—		1,725
Amounts due to related parties (Note 6)		57		84
Other		2,261		1,850
	$	7,712	$	7,065

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)


	September 30,		December 31,
Other Long-Term Liabilities	2012		2011

Lease liabilities	$	1,211	$	1,317
Other		1,171		1,159
	$	2,382	$	2,476

Note 4: Intangible Assets

Intangible assets consist of trademarks, distribution rights, covenants not-to-compete, patents, customer lists, and proprietary formulations. Intangible assets are amortized over the expected period of benefit using the straight-line method over the following lives: trademarks (twenty years); distribution rights (ten years); covenants not-to-compete (seven years); other intangible assets (three to seventeen years).

At September 30, 2012 and December 31, 2011, the carrying amounts and accumulated amortization of intangible assets were as follows:

	September 30, 2012							December 31, 2011
	Gross Amount		Accumulated Amortization			Net Book Value		Gross Amount		Accumulated Amortization			Net Book Value

Trademarks	$	7,666	$	(5,425	)	$	2,241	$	7,700	$	(5,140	)	$	2,560
Licenses		200		(133	)		67		100		(58	)		42
Other intangible assets		2,135		(1,325	)		810		2,189		(1,253	)		936
	$	10,001	$	(6,883	)	$	3,118	$	9,989	$	(6,451	)	$	3,538

Amortization expense related to all intangible assets, including certain amounts reflected in cost of sales, for the three months ended September 30, 2012 and 2011 was $149 and $153, respectively and for the nine months ended September 30, 2012 and 2011 was $447 and $487, respectively.

Impairment of License

In March 2004, as part of an agreement with a third-party international licensor, the Company received an ongoing, non-exclusive right to market and sell any and all products marketed under the “Obagi” brand containing a specific range of Kinetin concentration, limited to existing channels of trade in Japan. Under the terms of the agreement, the Company’s license rights are valid until the last of the related patents expire in December 2014. In exchange for this right, the Company agreed to pay a total of $2,000 over the life of the agreement. The Company subsequently entered into a sub-license agreement under which the sublicensee was to pay the Company a royalty on the sale of products containing the specified Kinetin concentration.

In April 2011, the sublicensee communicated to the Company that it had ceased the manufacture and distribution of products containing the Kinetin concentration in February 2011. In addition, neither the Company nor the sublicensee had plans to develop or distribute products containing the Kinetin concentration in the future. As a result, the Company recorded an impairment charge of $522, consisting of the unamortized net book value of the initial license fee and the obligation for additional payments for which there was no future benefit. The impairment charge was recorded as a component of “Selling, general and administrative expenses” during the three months ended March 31, 2011.

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

Note 5: Income Taxes

The Company had unrecognized tax benefits (exclusive of interest and penalties), all of which affect the effective tax rate if recognized, of $258 and $243 as of September 30, 2012 and December 31, 2011, respectively. Management does not anticipate that there will be a material change in the balance of unrecognized tax benefits within the next 12 months.

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of September 30, 2012 and December 31, 2011, accrued interest related to uncertain tax positions was $8 and $11, respectively.

The tax years 2007 - 2011 remain open to examination by the major taxing jurisdictions to which the Company is subject.

Income taxes are determined using an annual effective tax rate, which generally differs from the United States federal statutory rate, primarily because of state taxes, adjusted for discrete items as appropriate. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities, along with net operating losses and credit carryforwards.

The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Income tax benefits credited to stockholders’ equity relate to tax benefits associated with amounts that are deductible for income tax purposes but do not impact net income. These benefits are principally generated from employee exercises of non-qualified stock options.

Note 6: Related-Party Transactions

Cobrek Pharmaceuticals, Inc.

From November 2010 through March 2011, the Company entered into consulting arrangements with certain individuals affiliated with Cobrek Pharmaceuticals, Inc. (“Cobrek”) to provide consulting services to the Company. These individuals include: (i) the Vice President of Regulatory Affairs and Quality Assurance; (ii) the Chairman of the board of directors; (iii) a member of the board of directors; and (iv) a senior consultant. In addition to the four consultants mentioned above, Albert F. Hummel, the Company’s President and Chief Executive Officer and a member of the Company’s Board of Directors, is also the Chief Executive Officer, a member of the board of directors and a holder of more than 10% of the outstanding stock of Cobrek. For the nine months ended September 30, 2011, the Company recorded fees and related expenses for consulting services provided by Mr. Hummel prior to entering into an employment arrangement with him. Effective April 2011, the Company entered into an employment arrangement with Mr. Hummel. As of September 30, 2012 and December 31, 2011, amounts due to the consultants noted in (ii) and (iii) above, aggregated to $57 and $84, respectively, and were recorded as “Amounts due to related parties” in Note 3.

Total fees and related expenses recorded for the consultants and Mr. Hummel for the three and nine months ended September 30, 2012 and 2011 are included in the accompanying Unaudited Condensed Consolidated Statements of Income and Comprehensive Income and are as follows:

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Consultants
Selling, general and administrative	$	263	$	156	$	751	$	555
Research and development		—		—		—		81
Total	$	263		156		751		636

Albert F. Hummel
Selling, general and administrative	$	—	$	—	$	—	$	160

Note 7: Commitments and Contingencies

Comerica Amendment

On April 17, 2012, the Company entered into an amendment to its Amended and Restated Credit and Term Loan Agreement with Comerica Bank (the “Credit and Term Loan Agreement”), to: (i) extend the maturity date of the revolving credit facility from July 1, 2012 to July 1, 2014, unless otherwise terminated in accordance with the Credit and Term Loan Agreement; (ii) extend the draw period of the Term Loans (as defined below) from May 3, 2012 to earliest to occur of (a) the aggregate outstanding principal balance of the Term Loans equaling the term commitment, (b) July 1, 2013, and (c) the date the Company requests to close out the Term Loans; (iii) increase the maximum stock repurchases the Company may effect from $50,300 to $70,300; (iv) allow intercompany loans or intercompany investments in the Company’s subsidiary created for the e-Commerce initiative in an aggregate not to exceed $12,000; and (v) exempt the Company’s subsidiary related to the e-Commerce initiative from the subsidiary requirements of the Credit and Term Loan Agreement. The amendment is retroactively effective as of March 30, 2012.

Debt Compliance

On November 3, 2010, the Company entered into the Credit and Term Loan Agreement with Comerica Bank, which provides the Company access to a $20,000 revolving credit facility (the “Facility”) and $15,000 in term loans (the “Term Loans”). As of September 30, 2012 and December 31, 2011, the Company did not have an outstanding balance on its Facility or Term Loans. As of September 30, 2012 and December 31, 2011, the Company was in compliance with all financial and non-financial covenants under the Credit and Term Loan Agreement.

Software License, Development and Services Agreement

On March 6, 2012, OPO, entered into a Software License, Development and Services Agreement (the “Software Agreement”) with Koogly, LLC (“Koogly”). Under the Software Agreement, Koogly will develop, install, maintain and host software for OPO that will enable end users to acquire the Company’s products through OPO’s website, assist end users in obtaining prescriptions from their physicians for any of the Company’s prescription-based products, allow OPO to track and manage online orders and provide warehouse management functionality. OPO paid Koogly $675, half of the one-time license fee, upon execution of the Software Agreement and will pay the remaining half of such fee after it receives the software from Koogly and has had the opportunity to test and use it for a satisfactory period. In addition, OPO has agreed to pay Koogly a royalty in an amount less than one percent of net sales of the Company’s products that are sold through the OPO website during the term of the Software Agreement. The term of the Software Agreement is seven years. Thereafter, the software license may be renewed upon mutual agreement of Koogly and OPO. Either party has the right to terminate the Software Agreement upon prior written notice in the case of a breach of the agreement by the other party and failure to cure such breach within a specified period. In addition, OPO may terminate the Software Agreement if Koogly has not delivered the software within 12 months or, if once delivered and used in a commercial environment, the software is unavailable for five consecutive days. As of September 30, 2012,

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

the Company recorded the initial payment of $675 in construction in progress, a component of software costs recorded in “Property and equipment, net.”

Supply and Distribution Agreement

In conjunction with the execution of the Software Agreement, on March 6, 2012, OPO entered into a Supply and Distribution Agreement (the “Distribution Agreement”) with Bella Brands, LLC, an affiliate of Koogly (“Bella”). Under the Distribution Agreement, OPO has appointed Bella as an authorized distributor of the Company’s products solely through its www.bellarx.com website and solely to end users in the United States. Bella’s website will be dedicated only to the sale of the Company’s products and to assisting end users who do not yet have a prescription for the Company’s products in obtaining such a prescription. Bella and OPO have agreed to co-locate new warehousing and fulfillment operations to facilitate their obligations under the Distribution Agreement, but will maintain separate employees. OPO has agreed that it will not sell products going forward to any distributor who sells the Company’s products solely through the Internet at a lower price than it sells its products to Bella. In addition, OPO has provided Bella a minimum annual gross profit guaranty of $250 per year. The term of the Distribution Agreement is seven years. Thereafter, the Distribution Agreement may be renewed upon mutual agreement of Bella and OPO. Either party has the right to terminate the Distribution Agreement upon prior written notice in the case of a breach of the agreement by the other party and failure to cure such breach within a specified period. In addition, OPO may terminate the Distribution Agreement upon termination of the Software Agreement.

Both Koogly and Bella are affiliates of Phoenix Capital Management, LLC and PCM Venture I, LLC, which owns the website www.kwikmed.com.

Lease Agreement

On April 18, 2012, OPO, entered into a lease agreement with Pheasant Hollow Business Park, LLC, for the lease of office and warehouse space located in South Jordan, Utah. The facility’s primary function will be to fulfill online orders. The facility consists of 41,252 rentable square feet and the initial term of the lease is for 87 months beginning upon receipt of a Certificate of Occupancy from South Jordan City. The total lease payments over the initial term will approximate $1,593. As of September 30, 2012, the lease had not yet commenced.

Litigation

On January 7, 2010, ZO Skin Health, Inc., a California corporation, filed a complaint in the Superior Court of the State of California, County of Los Angeles: ZO Skin Health, Inc. vs. OMP, Inc. and Obagi Medical Products, Inc. and Does 1-25; Case No. BC429414. The complaint alleged claims against the Company and sought injunctive relief, compensatory damages and other damages in an unspecified amount, punitive damages and costs of suit, including attorneys’ fees. The Company answered the complaint and denied the allegations in that pleading. In addition, the Company asserted counterclaims against the plaintiff.

In addition, on or about January 7, 2010, Zein Obagi and his spouse, Samar Obagi, and the Zein and Samar Obagi Family Trust and certain other entities allegedly affiliated with Zein Obagi sent the Company an arbitration demand before JAMS (formerly Judicial Arbitration and Mediation Services) in Los Angeles, California in which the claimants claimed breaches of the 2006 Services Agreement and 2006 Separation and Release Agreement between the Company and the claimants and various breaches of common law, California law and federal law. The Company filed an answer to the Demand for Arbitration denying the allegations and asserting various counterclaims. In May 2010, the claimants in the arbitration proceeding filed an amended demand, again before JAMS in Los Angeles.

On May 2, 2011, the Company entered into a Settlement and Release Agreement with Zein E. Obagi, M.D., Zein E. Obagi, M.D., Inc., ZO Skin Health, Inc., Skin Health Properties, Inc., the Zein and Samar Obagi Trust, and Samar Obagi (collectively, the “ZO Parties”) (the “Settlement Agreement”) that resulted in the dismissal with prejudice of all claims and counterclaims in both the litigation and arbitration. Under the Settlement Agreement, the Company and

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

ZO Parties have agreed to mutual releases. The Settlement Agreement also provided for: (i) a one-time payment of $5,000 from the Company to the ZO Parties; and (ii) the grant of a limited, non-exclusive license by the Company to the ZO Parties to use certain trademarks of the Company in up to three locations. In addition to the one-time settlement payment, the Company incurred legal costs related to the matter. The other non-economic terms of the Settlement Agreement are confidential. The Company recorded $5,000 for the one-time payment and $2,882 in related litigation fees as components of “Selling, general and administrative expenses” during the nine months ended September 30, 2011.

From time to time, the Company is involved in other litigation and legal matters or disputes in the normal course of business. Management does not believe that the outcome of any of these other matters at this time individually and in the aggregate will have a material adverse effect on the Company’s business, consolidated financial position, results of operations or cash flows.

Insurance Coverage

During the three months ended March 31, 2011, the Company received a coverage letter from its general liability insurance carrier, agreeing to defend the lawsuit described above, under a reservation of rights. In May 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities. In July 2011, the Company filed an answer and cross claim against the carrier and its previous general liability insurance carrier. During the three months ended March 31, 2012, the Company and the insurance carriers filed cross motions for summary judgment related to the insurers’ duty to defend. They did not address the indemnity issues or bad faith claims. The hearing on the cross motions was heard in May 2012. The Company’s motions on the duty to defend were granted and the insurance carriers made a partial payment of the defense costs subject to a reservation of rights. As a result, these funds were being held in an interest-bearing escrow account pending final disposition of the matter. As of September 30, 2012, the Company had not recorded a gain contingency related to the matter pending final disposition of the matter. At such time, discovery was still ongoing and therefore the Company could not determine the amount of litigation costs and settlement fees, if any, it would recover due to the preliminary nature of the proceedings. As a result, the Company had not recorded any insurance recovery from the carriers during the year ended December 31, 2011 or during the three- and nine-month periods ended September 30, 2012. Effective October 2011, the Company converted its payment arrangements with its legal counsel on this matter from an hourly rate to a contingency fee arrangement. On October 23, 2012, the Company and the insurance carriers entered into a Settlement Agreement and Release. See Note 12 “Subsequent Events” for further discussion.

Texas Regulatory Matter

In November 2009, the Company received a letter from the Texas Department of State Health Services (the “Agency”) regarding the Company’s shipping in Texas of products containing unapproved new drugs and, specifically, referencing certain retail businesses in Texas that were selling the Company’s products containing prescription drugs over the Internet. Prior to this time, the Agency had detained products from three of the Company’s customers that sold the Company’s products on the Internet as a result of a complaint received from a third party. In its letter, the Agency alleged that the Company was shipping unapproved new drug articles to these establishments in violation of certain Texas statutes. After a series of communications with the Agency, at the end of April 2011, the Company met with the Agency and the Texas Attorney General (the “AG”), at which time the AG stated that it viewed the Company to be in violation of the Texas Food, Drug and Cosmetic Act and the Texas Deceptive Trade Practices Act arising from the sale in Texas of the Company’s products containing 4% hydroquinone (“HQ Products”). Beginning April 2011, the Company voluntarily ceased shipping any HQ Products into the state of Texas. In addition, the Company developed a plan that enabled its customers in Texas to return any of these products (that had not otherwise been detained) in their possession in exchange for a credit or refund.

By letter dated February 29, 2012 the Agency notified the AG that it would be closing its pending investigation and enforcement action against the Company relating to the Company’s promotion, sales and distribution of HQ Products in Texas effective that date and withdrew its April 13, 2011 referral of the matter to the AG. The Agency

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

based its decision on: (i) a directive that the Agency set priorities for enforcement and allocate its resources and concentrate its efforts on cases that represent the greatest risk to public health and safety; (ii) a Q&A document issued by the U.S. Food and Drug Administration (“FDA”) in 2010 wherein the FDA acknowledged the potential medical benefits of hydroquinone-containing products for a certain medical condition, the uncertainty of the public health risks associated with the ingredient and its intent to conduct long-term studies through the National Toxicology Program; and (iii) its acknowledgment of the relevance of the FDA’s Compliance Policy Guide statement that the FDA has been using to guide its staff and industry concerning the FDA’s enforcement priorities for unapproved drug products. The Agency also noted that it did not have sufficient evidence to conclude that there is an immediate risk to public health and safety from the topical use of products containing hydroquinone. No monetary penalties or other administrative fees were levied against the Company as the result of the Agency’s investigation and no lawsuit was ever filed by the AG against the Company. As the investigation has been completed and the complaint withdrawn, in May 2012, the Company re-introduced its HQ Products into the Texas market.

Provision for Sales Returns and Allowances

During the three months ended March 31, 2011, the Company recorded a sales returns and allowances provision for product to be returned from its customers residing in Texas of $1,927, which was recorded as a component of “Accrued liabilities” and as an offset to “Net sales” during the three months ended March 31, 2011. In addition, the Company recorded $282 in estimated finished goods inventory to be returned and as an offset to “Cost of sales” during the three months ended March 31, 2011. The Company’s methodology for calculating the provision considered, by customer, the previous 12 months of sales history.

The Company engaged a third party to assist in the efforts to manage the return of product from its customers residing in Texas. As a result of the Company’s efforts, during the second and third quarters of 2011, the Company processed credits and refunds totaling $1,669 for returned or detained products. As of September 30, 2012, the Company did not anticipate further sales returns and allowances related to the matter.

California Inquiry

In February 2012 the Company received a Subpoena to Answer Interrogatories and Produce Documents from the California Attorney General (the “CAG”) in connection with an investigation of the Company’s business practices. The subpoena seeks information and documents relating to the Company’s belief that its HQ Products are not new drugs that require pre-market review and marketing approval by the FDA. The subpoena also requested information and documents concerning the methods by which the Company promotes, markets and sells its HQ Products, the identities of persons who dispense its HQ Products in California, the amount of HQ Products it sells in California, complaints it has received and adverse event reports concerning its HQ Products, communications to and from the FDA regarding the safety and effectiveness of its HQ Products, and certain other information regarding its HQ Products.

The Company has had discussions with the CAG’s office in an attempt to better understand the concerns raised by the CAG. In March and April 2012, the Company responded to the subpoena. The CAG is currently evaluating the Company’s response. The Company expects to continue to have discussions with the CAG’s office and to cooperate fully with its investigation.

Although the Company is in discussions with the CAG on this matter, no resolution has been reached and based upon the information and documents requested by the CAG it is possible that the CAG could seek to limit or prohibit sales of the Company’s HQ Products in or from California or force it to change the methods by which it promotes, markets, sells and distributes its HQ Products in or from California. In the event the CAG takes actions that cause the Company to limit or cease sales of its HQ Products in or from California or require it to materially change the methods by which it promotes, markets, sells and distributes its HQ Products in or from California, such actions would have a material adverse effect on the Company’s results of operations and financial condition.

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

Note 8: Earnings per Common Share

The Company computes earnings per share in accordance with ASC 260, Earnings per Share. Basic earnings per share are computed by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per common share are computed similar to basic earnings per share, except that the denominator is increased to include the number of additional potential common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Potential common shares are excluded from the computation for a period in which a net loss is reported or if their effect is anti-dilutive. The Company’s potential common shares consist of stock options and restricted stock awards issued under the Company’s stock incentive plans.

Under the treasury stock method, the assumed proceeds calculation includes: (i) the actual proceeds to be received from the employee upon exercise, (ii) the average unrecognized compensation cost during the period, and (iii) any tax benefits that will be credited upon exercise to additional paid-in capital. Basic and diluted earnings per common share were calculated using the following weighted average shares outstanding for the three and nine months ended September 30, 2012 and 2011:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Weighted average shares outstanding - basic		18,350,703		18,599,644		18,601,102		18,557,381
Effect of dilutive stock options		150,220		79,143		129,463		90,986
Weighted average shares outstanding - diluted		18,500,923		18,678,787		18,730,565		18,648,367

Diluted earnings per share for the three and nine months ended September 30, 2012 does not include the impact of common stock options, restricted stock units (“RSUs”) and unvested restricted stock totaling 768,738 and 799,920 shares, respectively, and the impact of common stock options, RSUs and unvested restricted stock totaling 876,059 shares for both of the three- and nine-month periods ended September 30, 2011, as the effect of their inclusion would be anti-dilutive.

Note 9: Stock Awards

During the three months ended September 30, 2012, the Company’s Board of Directors, through its Compensation Committee, granted 55,000 options under the 2005 Stock Incentive Plan, as amended, to employees of the Company, including one executive officer, with an exercise price of $13.33 to $15.40 per share, which was equal to the fair value of the underlying common stock on the date of grant. During the nine months ended September 30, 2012, the Company’s Board of Directors, through its Compensation Committee, granted 579,000 options to employees of the Company, including executive officers, with exercise prices ranging from $10.27 to $15.40 per share, which was equal to or greater than the fair value of the underlying common stock on the date of grant.

In connection with Al Hummel’s appointment as President and Chief Executive Officer on April 21, 2011, the Compensation Committee granted Mr. Hummel an option to purchase 100,000 shares of the Company’s common stock, with an exercise price of $12.55, the closing selling price of the Company’s common stock on the date of grant. In addition, on the same date, the Compensation Committee awarded Mr. Hummel 50,000 RSUs, which also have a fair market value of $12.55 per share.

In addition to the stock options granted to Mr. Hummel, during the nine months ended September 30, 2011, the Company’s Board of Directors, through its Compensation Committee, granted to other employees 18,000 and 46,000 options, respectively, with an exercise price of $10.48 and a range of exercise prices of $9.39 to $11.39, respectively, which were equal to the fair value of the underlying common stock on the date of grant.

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

On July 31, 2012, Kristina M. Leslie was appointed to the Board of Directors and was issued 4,890 shares of restricted stock with a fair market value of $15.34 per share.

During the nine months ended September 30, 2012, the Company issued 11,030 shares of restricted stock to the remaining members of its Board of Directors, with a fair market value of $13.60 per share. During the nine months ended September 30, 2011, the Company issued 16,045 shares of restricted stock to members of its Board of Directors, with a fair market value of $9.35 per share. The restricted stock awards granted during the nine-month period ended September 30, 2011, fully vested on June 7, 2012. The fair market value of the restricted stock granted during each of the three- and nine-month periods ended September 30, 2012 and 2011 was equal to the fair value of the underlying common stock on the date of grant.

As of September 30, 2012, total unrecognized stock-based compensation expense related to unvested stock options was approximately $3,602, which is expected to be recognized over a weighted average period of approximately 2.31 years.

Note 10: Common Stock

Increase in Stock Repurchase Program

On October 26, 2010, the Company announced that its Board of Directors authorized it to repurchase up to $45,000 of its common stock, depending on market conditions and other factors. During the fourth quarter ended December 31, 2010, the Company repurchased 3,556,910 shares of the Company’s outstanding common stock from certain selling stockholders for a cost of $35,000. No repurchases were effected during the year ended December 31, 2011, resulting in the availability of $10,000 for repurchases under the program. On March 6, 2012, the Company’s Board of Directors authorized a $20,000 increase to the Company’s stock repurchase program, resulting in the availability to repurchase up to $30,000 of the Company’s common stock as of such date. This authorization does not obligate the Company to acquire any particular amount of common stock nor does it ensure that any shares will be repurchased, and it may be suspended at any time at the Company’s discretion. During the three- and nine-month periods ended September 30, 2012, the Company repurchased 1,500,000 shares of its outstanding common stock for a cost of $19,781. As of September 30, 2012, there was $10,219 available for repurchases under the program.

Note 11: Segments

ASC 280, Segment Reporting, requires that the Company disclose certain information about its operating segments where operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Generally, financial information is required to be reported on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments.

The Company operates its business on the basis of two reportable segments: (i) physician-dispensed and (ii) licensing. The physician-dispensed segment produces a broad range of topical skin health systems and products that enable physicians to sell products to their patients to treat a range of skin conditions, including premature aging, photodamage, hyperpigmentation, acne, sun damage, facial redness and soft tissue deficits, such as fine lines and wrinkles. The licensing segment includes revenues generated from licensing arrangements with international distributors that specialize in the distribution and marketing of over-the-counter (“OTC”) medical-oriented products in the drug store, retail and aesthetic spa channels.

Management evaluates its segments on a revenue and gross profit basis, which is presented below. The United States information is presented separately as the Company’s headquarters reside in the United States. United States sales

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

represented 81% and 85% of total consolidated net sales for the three months ended September 30, 2012 and 2011, respectively, and 82% and 84% of total consolidated net sales for the nine months ended September 30, 2012 and 2011, respectively. No other country accounted for over 10% of total Company consolidated net sales. No customer accounted for over 10% of total Company consolidated net sales during the three months ended September 30, 2012 and the three- and nine-month periods ended September 30, 2011. Revenues from one customer of the Company’s physician-dispensed segment represented approximately $10,027 of consolidated net sales for the nine months ended September 30, 2012. Except as mentioned, no other customer accounted for over 10% of total Company consolidated net sales during the nine months ended September 30, 2012.

All of the Company’s long-lived assets are located in the United States. The Company does not disaggregate assets on a segment basis for internal management reporting and, therefore, such information is not presented.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
Net sales by segment
Physician-dispensed	$	27,586	$	27,245	$	86,776	$	80,422
Licensing		1,562		867		3,631		3,079
Net sales	$	29,148	$	28,112	$	90,407	$	83,501

Gross profit by segment
Physician-dispensed	$	21,693	$	21,593	$	68,480	$	62,786
Licensing		1,563		865		3,627		3,069
Gross profit	$	23,256	$	22,458	$	72,107	$	65,855

Geographic information
United States	$	23,693	$	23,771	$	74,141	$	69,938
International		5,455		4,341		16,266		13,563
Net sales	$	29,148	$	28,112	$	90,407	$	83,501


	Three Months Ended September 30,				Nine Months Ended September 30,
		2012		2011		2012		2011
Net sales by product line
Physician-dispensed
Nu-Derm	$	14,679	$	14,917	$	45,990	$	44,071
Vitamin C		4,260		4,016		13,745		11,870
Elasticity		3,371		3,147		10,674		8,735
Therapeutic		1,803		1,546		5,317		4,374
Other		3,473		3,619		11,050		11,372
Total		27,586		27,245		86,776		80,422
Licensing		1,562		867		3,631		3,079
Total net sales	$	29,148	$	28,112	$	90,407	$	83,501

Obagi Medical Products, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

(Dollars in thousands, except per share amounts)

Note 12: Subsequent Events

Insurance Settlement

On October 23, 2012, the Company and its previous general liability insurance carriers entered into a Settlement Agreement and Release (the “Insurance Settlement”). Pursuant to the Insurance Settlement, the Company released the insurance carriers of all claims that the Company did assert and could have asserted in the motions filed by the Company against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties. See Note 7 “Commitments and Contingencies” for additional details. In consideration for the final disposition of the matter, the insurance carriers paid the Company $14,000 in October 2012, at which time, the Company recorded net proceeds of approximately $8,400 after legal expense as a gain on legal settlement related to the matter.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking statements

In addition to historical information, this report on Form 10-Q contains certain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These statements relate to future events or future financial performance, and include statements regarding our business strategy, timing of, and plans for, the introduction of new products and enhancements, our e-Commerce and fulfillment initiative, future sales, market growth and direction, the effects of future regulations, litigation, competition, market share, revenue growth, operating margins and profitability. All forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from any future results, expressed or implied, by these forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology. These statements are only predictions and are based upon information available to us as of the date of this report. We undertake no ongoing obligation to update these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in the “Risk Factors” section of our 2011 Annual Report on Form 10-K. You are urged to carefully consider these factors. All forward-looking statements attributable to us are expressly qualified in their entirety by the foregoing cautionary statements.

Overview and Recent Developments

The following discussion is intended to help the reader understand the results of operations and financial condition of Obagi Medical Products, Inc. This discussion is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes to the consolidated financial statements.

We are a specialty pharmaceutical company that develops, markets and sells, and are a leading provider of, proprietary topical aesthetic and therapeutic prescription-strength skin care systems in the physician-dispensed market. Our products are designed to prevent and improve some of the most common and visible skin disorders in adult skin, including premature aging, photodamage, skin laxity, hyperpigmentation, acne, sun damage, facial redness and soft tissue deficits, such as fine lines and wrinkles.

Current products. Our primary product line is the Obagi Nu-Derm System, which we believe is the leading clinically proven, prescription-based, topical skin health system on the market that has been shown to enhance the skin’s overall health by correcting photodamage at the cellular level, resulting in a reduction of the visible signs of aging. The primary active ingredients in this system are 4% hydroquinone and OTC skin care agents. In April 2004, we introduced the Obagi-C Rx System consisting of a combination of prescription and OTC drugs and adjunctive cosmetic skin care products to treat skin conditions resulting from sun damage and the oxidative damage of free radicals. The central ingredients in this system are 4% hydroquinone and Vitamin C. In October 2005, we launched the Obagi Professional-C products, a complete line of proprietary, non-prescription products, which consists of Vitamin C serums used to reduce the appearance of damage to the skin caused by ultraviolet radiation and other environmental influences. In July 2006, we launched our Obagi Condition & Enhance System, for use in conjunction with commonly performed surgical and non-surgical cosmetic procedures. In October 2006, we launched our first product in the ELASTIderm product line, an eye cream for improving the elasticity and skin tone around the eyes. We introduced the Obagi CLENZIderm M.D. System and a second product in the ELASTIderm product line to address acne and skin elasticity around the eye, respectively, based on positive interim clinical results, in February 2007. In July 2007, we launched our second system in the CLENZIderm M.D. line, CLENZIderm M.D. System II, which is specifically formulated for normal to dry skin. In August 2007, we launched two new Nu-Derm Condition & Enhance Systems. One is designed specifically for use with non-surgical procedures while the other has been developed for use with surgical procedures. In February 2008, we launched ELASTIderm Décolletage, a system to treat skin conditions resulting from sun damage and improve the elasticity and skin tone for the neck and chest area. In January 2009, we launched Obagi Rosaclear, a system to treat the

symptoms of rosacea. In September 2009, we also began offering Refissa by Spear, a FDA-approved 0.05% strength tretinoin with an emollient base that has a broad indication for treatment of fine facial lines, hyperpigmentation and tactile roughness. In October 2010, we launched ELASTILash Eyelash Solution, a peptide-based eyelash solution that can help achieve the appearance of thicker, fuller-looking eyelashes. In January 2011, we launched Blue Peel RADIANCE, a gentle salicylic acid-based peel that utilizes a unique blend of acids and other soothing ingredients to exfoliate, even out skin tone and improve overall complexion, with little-to-no downtime. In January 2012, we launched ELASTIderm Complete Complex Eye Serum that utilizes an innovative roller ball technology for application. We also market tretinoin, used for the topical treatment of acne in the U.S., metronidazole, used for the treatment of facial rosacea in the U.S., and the Obagi Blue Peel Essential Kit, used to aid the physician in the application of skin peeling actives.

Future products. We focus our research and new product development activities on improving the efficacy of established prescription and OTC therapeutic agents by enhancing the penetration of these agents across the skin barrier using our proprietary technologies collectively known as Penetrating Therapeutics. However, we cannot assure you that we will be able to introduce any additional systems using these technologies.

U.S. distribution. We market all of our products through our direct sales force in the United States primarily to plastic surgeons, dermatologists and other physicians who are focused on aesthetic skin care.

Aesthetic skin care. As of September 30, 2012, we sold our products to over 6,600 physician-dispensing accounts in the United States. During the nine-month period ended September 30, 2012, we had one customer within our physician-dispensed segment that accounted for $10.0 million of our consolidated net sales. Aside from this customer, there was no other customer accounting for more than 10% of our net sales during the nine months ended September 30, 2012. No customer accounted for over 10% of our total consolidated net sales during the three months ended September 30, 2012 and the three- and nine-month periods ended September 30, 2011. Our current products are not eligible for reimbursement from third-party payors such as health insurance organizations. We generated U.S. physician-dispensed sales of $23.7 million and $23.8 million during the three months ended September 30, 2012 and 2011, respectively, and $74.1 million and $69.9 million during the nine months ended September 30, 2012 and 2011, respectively.

International distribution. We market our products internationally through 21 international distribution partners and, beginning January 1, 2012, one licensing partner, which collectively have sales and marketing activities in 47 countries outside of the United States. Our distributors use a model similar to our business model in the United States, selling our products through direct sales representatives to physicians, or through alternative distribution channels depending on regulatory requirements and industry practices. We generated international physician-dispensed sales of $3.9 million and $3.5 million during the three months ended September 30, 2012 and 2011, respectively, and $12.6 million and $10.5 million during the nine months ended September 30, 2012 and 2011, respectively.

Licensing. We market our products in the Japanese retail markets through license agreements with Rohto Pharmaceutical Co, Ltd (“Rohto”). Under our agreements, Rohto is licensed to manufacture and sell a series of OTC products developed by it under the Obagi brand name, as well as Obagi-C products, in the Japanese drug store channel, and we receive a royalty based upon Rohto’s sales of Obagi branded products in Japan. Rohto sells and markets Obagi branded products through high-end drug stores. Through December 2011, we had other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel. We receive royalties based upon these arrangements. We generated licensing revenue of $4.4 million during each of the years ended December 31, 2011 and 2010. We generated licensing revenue of $1.6 million and $0.9 million during the three months ended September 30, 2012 and 2011, respectively, and $3.6 million and $3.1 million during the nine months ended September 30, 2012 and 2011, respectively.

E-Commerce and fulfillment platform. We are in the process of writing the code necessary to establish a web-based marketing and fulfillment operation. We believe a robust e-Commerce platform will help build and strengthen the relationship between our physician customers and their patients. Once fully developed and deployed our new national distribution system will allow us to deploy additional channel expansion strategies and will protect our brand from internet discounters by implementing a track and trace mechanism to follow products’ pedigrees through the sales channel. Having an e-Commerce platform, we believe, will enable us to capitalize on the interest in our products by directing consumers to one place to learn about and purchase our products, capture a portion of this new business for our

physician customers and serve a larger population of potential patients. However, we cannot assure you that our e-Commerce platform will actually expand our base of end-users or result in the growth of our business. Moreover, the creation and maintenance of an e-Commerce platform will require a significant investment in capital and other resources and may divert the attention of our management and other key employees from the operation of our core business, which could materially and adversely impact our business and results of operations beginning in 2012. During the three- and nine-month periods ended September 30, 2012, we incurred $1.2 million and $2.9 million in expenses, respectively, and $2.6 million capital expenditures as of September 30, 2012, related to our e-Commerce fulfillment initiative.

Impairment of license. In 2004, we entered into a license agreement with a third-party licensor to market and sell products containing a specific range of Kinetin concentration in Japan (see Note 4 to our Unaudited Condensed Consolidated Financial Statements). We subsequently sublicensed these rights to an international distributer in Japan. During the three months ended March 31, 2011, our sublicensee discontinued the manufacture and sale of products containing the Kinetin concentration. In addition, neither we nor the sublicensee has current plans to develop or distribute products containing the Kinetin concentration in the future. As a result, we recorded an impairment charge of $0.5 million consisting of the unamortized net book value of the initial license fee and the obligation for additional payments for which there is no future benefit. These charges were recorded as a component of “Selling, general and administrative expense.”

Litigation settlement and insurance coverage. In January 2010, Dr. Zein Obagi, ZO Skin Health, Inc., and related parties filed a complaint and an arbitration demand against us. We later filed counterclaims in both proceedings. On May 2, 2011, the parties to those proceedings entered into a Settlement Agreement that required dismissal of all claims and counterclaims in both proceedings. Pursuant to the Settlement Agreement, we made a one-time settlement payment of $5.0 million. The Settlement Agreement also contains a number of non-economic terms. See Note 7 to our Unaudited Condensed Consolidated Financial Statements for a further discussion on the litigation and the Settlement Agreement. Since January 2010 through December 31, 2011, we incurred significant litigation and related fees, including the $5.0 million settlement, of $13.5 million. During the three months ended March 31, 2011, we received a coverage letter from our primary general liability insurance carrier, agreeing to defend the lawsuit, under a reservation of rights. In May 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities. In July 2011, we filed an answer and cross claim against the carrier and our previous primary general liability insurance carrier. During the three months ended March 31, 2012, both we and the carriers filed cross motions for summary judgment related to the insurers’ duty to defend. They did not address the indemnity issues or bad faith claims. The hearing on the cross motions was heard in May 2012. Our motions on the duty to defend were granted and the insurance carriers made a partial payment of the defense costs subject to a reservation of rights. As a result, these funds were being held in an interest bearing escrow account pending final disposition of the matter. As of September 30, 2012, we had not recorded a gain contingency related to the matter pending final disposition of the matter. At such time, discovery was still ongoing and therefore we could not estimate the amount of litigation costs and settlement fees, if any, we would recover from the insurance carriers. Effective October 2011, we converted our payment arrangements with our legal counsel on this matter from an hourly rate to a contingency fee arrangement.

On October 23, 2012, we entered into the Insurance Settlement with our insurance carriers. Pursuant to the Insurance Settlement, we released the insurance carriers of all claims we did assert and could have asserted in the motions filed by us against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties. In consideration for the final disposition of the matter, the insurance carriers paid us $14.0 million in October 2012, at which time we recorded net proceeds of approximately $8.4 million after legal expense as a gain on legal settlement related to the matter.

Texas regulatory matter. In November 2009, we received a letter from the Agency regarding our shipping in Texas of products containing unapproved new drugs and, specifically, referencing certain retail businesses in Texas that were selling our products containing prescription drugs over the Internet. Prior to this time, the Agency had detained products from three of our customers that sold products on the Internet as a result of a complaint received from a third party. In its letter, the Agency alleged that we were shipping unapproved new drug articles to these establishments in violation of certain Texas statutes. After a series of communications with the Agency, at the end of April 2011, we met with the Agency and the AG, at which time the AG stated that it viewed us to be in violation of the Texas Food, Drug and Cosmetic Act and the Texas Deceptive Trade Practices Act arising from the sale in Texas of our HQ Products, which the state believes to be an unapproved new drug. Beginning April 2011, we voluntarily ceased shipping any HQ

Products into the state of Texas. In addition, we developed a plan that enabled our customers in Texas to return any of these products (that had not otherwise been detained) in their possession in exchange for a credit or refund.

By letter dated February 29, 2012 the Agency notified the AG that it would be closing its pending investigation and enforcement action against us relating to our promotion, sales and distribution of HQ Products in Texas effective that date and withdrew its April 13, 2011 referral of the matter to the AG. The Agency based its decision on: (i) a directive that the Agency set priorities for enforcement and allocate its resources and concentrate its efforts on cases that represent the greatest risk to public health and safety; (ii) a Q&A document issued by the FDA in 2010 wherein the FDA acknowledged the potential medical benefits of hydroquinone-containing products for a certain medical condition, the uncertainty of the public health risks associated with the ingredient and its intent to conduct long term studies through the National Toxicology Program; and (iii) its acknowledgment of the relevance of the FDA’s Compliance Policy Guide statement that the FDA has been using to guide its staff and industry concerning the FDA’s enforcement priorities for unapproved drug products. The Agency also noted that it did not have sufficient evidence to conclude that there is an immediate risk to public health and safety from the topical use of products containing hydroquinone. No monetary penalties or other administrative fees were levied against us as the result of the Agency’s investigation and no lawsuit was ever filed by the AG against us. Now that the investigation has been completed and the complaint withdrawn, we re-introduced our HQ Products into Texas in May 2012.

In light of the aforementioned events, we recorded a sales returns and allowances provision for product to be returned from our customers residing in Texas of $1.9 million, which was recorded as a component of “Accrued liabilities” as of March 31, 2011 and as an offset to “Net sales” during the three months ended March 31, 2011. In addition, we recorded $0.3 million in estimated finished goods inventory to be returned as of March 31, 2011 and as an offset to “Cost of sales” during the three months ended March 31, 2011. Our methodology for calculating the provision considered, by customer, the previous 12 months of sales history.

We engaged a third party to assist in the efforts to manage the return of product from our customers residing in Texas. As a result of our efforts, during the second and third quarters of 2011, we processed credits and refunds of $1.7 million in returned or detained products. As of September 30, 2012, we did not expect to receive any additional sales returns related to the matter.

Results of operations. We commenced operations in 1997, and as of September 30, 2012, we had retained earnings of $46.8 million. We reported net income of $3.0 million and $4.4 million for the three months ended September 30, 2012 and 2011, respectively, and $9.4 million and $4.9 million for the nine months ended September 30, 2012 and 2011, respectively.

Seasonality. Sales of our products have historically been higher between September and March. We believe this is due to increased product use and patient compliance during these months. We believe this increased usage and compliance relates to several factors such as higher patient tendencies toward daily compliance inversely proportionate to their tendency to travel and/or engage in other disruptive activities during summer months. Patient travel and other disruptive activities that affect compliance are at their peak during July and August. The effects of seasonality in the past have been offset by the launch of new products. This trend was very pronounced during 2007 when we launched four new product offerings and rebranded two systems. However, we cannot assure you that we will continue to be able to offset such seasonality in the future.

Economy. Many treatments in which our products are used are considered cosmetic in nature, are typically paid for by the patient out of disposable income and are generally not subject to reimbursement by third-party payors such as health insurance organizations. As a result, we believe that our current and future sales growth may be influenced by the economic conditions within the geographic markets in which we sell our products. Although there are modest signs of economic recovery, it is unclear whether the economy will show sustained growth and/or stability. Even with continued growth in many of our markets, the recent recession could adversely impact our business in the future causing a decline in demand for our products, particularly if uncertain economic conditions are prolonged or worsen. We do believe that some of the negative impact experienced during the majority of 2009 was partially offset due to the following: (i) we are the leader in the physician-dispensed market; (ii) the aesthetic nature of our products; (iii) the lower price point of our products compared to other aesthetic products in our market; (iv) the desire to maintain a healthy and youthful appearance; and (v) the demographics of the patients who use our products.

Future growth. We believe that our future growth will be driven by increased direct sales coverage, penetration into non-core markets such as other medical specialties, ongoing marketing efforts to create increased awareness of the Obagi brand and the benefits of skin health and new product offerings. Although we have in recent history moderated our investments in our strategic initiatives as a result of the recent recession and uncertain economic conditions, we plan to increase our investment in initiatives that we believe will facilitate growth in the business. Beginning in 2012, we plan to invest significant capital and other resources into the creation and maintenance of an e-Commerce platform that we currently believe will expand our base of end-users. However, we cannot assure you that the e-Commerce platform will result in the expected growth of our business. In addition, as opportunities present themselves, we plan to look towards the commercialization of new applications of our current products, the continuing development of our pipeline of products and the in-licensing or acquisition of new product opportunities. Such future investments could involve significant resources to facilitate more rapid growth. At present, we believe that our ongoing profitability is primarily dependent upon the continued success of our current product offerings and certain other strategic marketing initiatives.

Critical accounting policies and use of estimates

Our discussion and analysis of our financial condition and results of operations is based upon our Unaudited Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, sales and expenses, and disclosures of contingent assets and liabilities at the date of the financial statements. On a periodic basis, we evaluate our estimates, including those related to revenue recognition, sales return reserve, accounts receivable, inventory, goodwill and other intangible assets. We use historical experience and other assumptions as the basis for making estimates. By their nature, these estimates are subject to an inherent degree of uncertainty. As a result, we cannot assure you that future actual results will not differ significantly from estimated results.

We believe that the estimates, assumptions and judgments involved in revenue recognition, sales returns and allowances, accounts receivable, inventory, goodwill and intangible assets, stock-based compensation and accounting for income taxes have the greatest potential impact on our Unaudited Condensed Consolidated Financial Statements, so we consider these to be our critical accounting policies. Historically, our estimates, assumptions and judgments relative to our critical accounting policies have not differed materially from actual results. However, it is possible that the actual results we experience may differ materially and adversely from our estimates in the future. There have been no material changes to the critical accounting estimates associated with these policies as described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our 2011 Annual Report on Form 10-K filed with the SEC on March 8, 2012.

Results of operations

The three months ended September 30, 2012 compared to the three months ended September 30, 2011

Net sales. The following table compares net sales by product line and certain selected products for the three months ended September 30, 2012 and 2011:


	Three Months Ended September 30,
	2012			2011			Change
Net sales by product line
Physician-dispensed
Nu-Derm	$	14,679		$	14,917			-2	%
Vitamin C		4,260			4,016			6	%
Elasticity		3,371			3,147			7	%
Therapeutic		1,803			1,546			17	%
Other		3,473			3,619			-4	%
Total		27,586			27,245			1	%
Licensing		1,562			867			80	%
Total net sales	$	29,148		$	28,112			4	%

United States		81	%		85	%
International		19	%		15	%

Net sales increased by $1.0 million to $29.1 million during the three months ended September 30, 2012, as compared to $28.1 million during the three months ended September 30, 2011. Overall, our growth during the three months ended September 30, 2012 was primarily due to growth in the international physician-dispensed market and our re-introduction of prescription products into Texas in May 2012. Net sales attributed to Texas increased as a percentage of our total net sales from 4% for the three months ended September 30, 2011 to 7% for the three months ended September 30, 2012.

Physician-dispensed sales increased $0.4 million, to $27.6 million during the three months ended September 30, 2012, as compared to $27.2 million during the three months ended September 30, 2011. We experienced net increases in the majority of our product categories as follows: (i) an increase in Therapeutic sales of $0.3 million; (ii) a $0.2 million increase in Elasticity sales, which is primarily attributable to the launch of ELASTIderm Complete Complex Eye Serum during the three months ended March 31, 2012 and an increase in units sold related to our fall 2012 purchase-with purchase-promotion; and (iii) an increase in the Vitamin C category of $0.2 million. These increases were offset in part by: (i) a decrease in Nu-Derm of $0.2 million; and (ii) a decrease in the Other category of $0.2 million. Licensing fees increased by $0.7 million due to the launch of three new products by our Japanese partner, Rohto, during the three months ended September 30, 2012.

Our aggregate sales growth was composed of: (i) $0.4 million from our International physician-dispensed markets; and (ii) a $0.7 million increase in licensing fees; offset in part by a $0.1 million decrease in the U.S. physician-dispensed market. The increase in International sales was experienced across the majority of our product lines and was principally a result of: (i) a $0.4 million increase in the Europe and Other region; and (ii) a $0.1 million increase from the Americas; offset in part by a $0.1 million decrease from the Middle East.

Despite the growth we have experienced during 2011 and the first three quarters of 2012, we believe that until we see continued stabilization in the global economy, our future net sales could be negatively impacted.

Gross margin percentage. Overall, our gross margin percentage slightly decreased to 79.8% for the three months ended September 30, 2012, as compared to 79.9% for the three months ended September 30, 2011. Gross margin for our physician-dispensed segment decreased to 78.6% as compared to 79.3% for the same period last year. The decline in our physician-dispensed gross margin is primarily due to a change in sales mix favoring our lower margin products and an increase in units sold of our fall 2012 purchase-with-purchase promotion, which typically has a lower margin than the majority of our products. The gross margin for our licensing segment increased to 100.1% compared to 99.8% for the same period last year. The increase in margin is due to an immaterial chargeback of royalty cost related to a discontinued product by our licensing partner during the quarter ended September 30, 2012. We anticipate further reduction in these royalty costs during the remainder of 2012, however, we do not believe such reduction will have a material impact on our consolidated financial statements.

Selling, general and administrative. Selling, general and administrative expenses consist primarily of salaries and other personnel-related costs, professional fees, insurance costs, stock-based compensation, depreciation and amortization not attributable to products sold, warehousing costs, advertising, travel expense and other selling expenses. Selling, general and administrative expenses increased $2.7 million to $17.8 million during the three months ended September 30, 2012, as compared to $15.1 million for the three months ended September 30, 2011. The increase was primarily due to the following: (i) $1.2 million in expenses directly related to the development and set-up of our e-Commerce platform; (ii) a $0.4 million increase in professional fees; (iii) $0.2 million in expenses associated with the regulatory matters in California; (iv) $0.2 million in research concerning the Japanese market; (v) a $0.2 million increase in promotions and training expenses; (vi) a $0.2 million increase in other marketing expenses; (vii) a $0.2 million increase in advertising primarily due to increased advertising support for our international distributors; (viii) a $0.2 million increase in non-cash compensation; (ix) $0.1 million in expenses related to the establishment of a second source for certain of our products; (x) $0.1 million in expenses related to researching physician opportunities; and (xi) a $0.1 million increase in other expenses. These increases were partially offset by: (i) a decrease of $0.1 million in expenses associated with regulatory matters in Texas; (ii) a decrease of $0.1 million in costs associated with the litigation and settlement of matters related to Dr. Obagi (see Note 7 to Unaudited Condensed Consolidated Financial Statements); (iii) a $0.1 million decrease in product development expenses; and (vi) a $0.1 million decline in volume-driven expenses. As a percentage of net sales, selling, general and administrative expenses in the three months ended September 30, 2012 were 61% as compared to 54% for the three months ended September 30, 2011. We expect selling, general and administrative expenses to increase as a percentage of net sales for the remainder of 2012 as we plan to invest significant resources in the development and launch of our e-Commerce platform. See discussion “Liquidity and capital resources,” for further information.

Research and development. Research and development expenses remained fairly flat at $0.5 million for both of the three-month periods ended September 30, 2012 and 2011. As a percentage of net sales, research and development costs were 2% for both of the three-month periods ended September 30, 2012 and 2011.

Interest income and Interest expense. Interest income increased to $15,000 for the three months ended September 30, 2012 from $10,000 for the three months ended September 30, 2011. We earn interest income from the investment of our cash balance into a money market account. Our average cash and cash equivalents increased from $24.4 million for the three months ended September 30, 2011 to $31.2 million for the three months ended September 30, 2012, and our weighted average annual interest rate increased from 0.23% during the three months ended September 30, 2011 to 0.27% during the three months ended September 30, 2012. Interest expense was $19,000 during the three months ended September 30, 2012, as compared to $24,000 for the three months ended September 30, 2011. The decrease is due to a decrease in the amortization of debt issuance costs related to our Credit and Term Loan Agreement, which we amended effective as of March 30, 2012.

Income taxes. Income tax expense was $2.0 million for the three months ended September 30, 2012, as compared to $2.4 million for the three months ended September 30, 2011. Our effective tax rate was 39.6% for the three months ended September 30, 2012 and 35.0% for the three months ended September 30, 2011. The increase in the effective rate is primarily due to the impact of the 2011 research and development credit accounted for during the three months ended September 30, 2011. As of September 30, 2012, the 2012 research and development tax credit had not yet been extended by Congress.

The nine months ended September 30, 2012 compared to the nine months ended September 30, 2011

Net sales. The following table compares net sales by product line and certain selected products for the nine months ended September 30, 2012 and 2011:


	Nine Months Ended September 30,
	2012			2011			Change
Net sales by product line
Physician-dispensed
Nu-Derm	$	45,990		$	44,071			4	%
Vitamin C		13,745			11,870			16	%
Elasticity		10,674			8,735			22	%
Therapeutic		5,317			4,374			22	%
Other		11,050			11,372			-3	%
Total		86,776			80,422			8	%
Licensing		3,631			3,079			18	%
Total net sales	$	90,407		$	83,501			8	%

United States		82	%		84	%
International		18	%		16	%

Net sales increased by $6.9 million to $90.4 million during the nine months ended September 30, 2012, as compared to $83.5 million during the nine months ended September 30, 2011. Overall, our growth during the nine months ended September 30, 2012 was primarily due to: (i) growth in the international physician-dispensed market; (ii) a decline of $1.7 million in the sales returns and allowances provision originally recorded during the nine months ended September 30, 2011, related to the actions brought by the Texas state regulatory bodies (see “Overview and Recent Developments” above for further discussion) in April 2011; and (iii) our re-introduction of prescription products into Texas in May 2012. Net sales attributed to Texas increased as a percentage of our total net sales from 4% for the nine months ended September 30, 2011 to 6% for the nine months ended September 30, 2012.

Physician-dispensed sales increased $6.4 million, to $86.8 million during the nine months ended September 30, 2012, as compared to $80.4 million during the nine months ended September 30, 2011. We experienced net increases in the majority of our product categories as follows: (i) an increase in Nu-Derm sales of $1.9 million, of which $1.1 million is attributable to the sales returns provision related to Texas recorded during the nine months ended September 30, 2011; (ii) a $1.9 million increase in Elasticity sales, of which the majority is attributable to the launch of ELASTIderm Complete Complex Eye Serum during the nine months ended September 30, 2012; (iii) an increase in Vitamin C sales of $1.9 million; and (iv) an increase in the Therapeutic category of $0.9 million, the majority of which is attributable to the re-launch of our Normal to Oily CLENZIderm kit during the nine months ended September 30, 2012. These increases were partially offset by a decrease in the Other category of $0.3 million. Licensing fees increased by $0.6 million, which is primarily attributable to the launch of new products by our licensing partner Rohto, during the third quarter ended September 30, 2012.

Our aggregate sales growth was composed of $4.2 million and $2.2 million from our U.S. and International physician-dispensed markets, respectively, and an increase of $0.6 million in licensing fees. The increase in International sales was experienced across the majority of our product lines and was principally a result of: (i) a $1.2 million increase in the Europe and Other region; (ii) a $0.7 million increase from the Far East; (iii) a $0.2 million increase from the Americas; and (iv) a $0.1 million increase in the Middle East. The net increase in the U.S. was due to $2.5 million in sales growth, along with a decrease of $1.7 million in sales returns and allowances associated with the Texas regulatory matter during the nine months ended September 30, 2011.

Gross margin percentage. Overall, our gross margin percentage increased to 79.8% for the nine months ended September 30, 2012, as compared to 78.9% for the nine months ended September 30, 2011. Gross margin for our physician-dispensed segment increased to 78.9% as compared to 78.1% for the same period last year. The improvement in our physician-dispensed gross margin is primarily due to an improvement in product costs related to our Therapeutic products during the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, and a change in sales mix favoring our higher-margin products. In addition we experienced a reduction in inventory reserves during the first quarter of 2012, as $0.3 million in inventory was reserved during the first quarter of 2011 related

to the Texas matter. The gross margin for our licensing segment increased slightly to 99.9% compared to 99.7% for the same period last year.

Selling, general and administrative. Selling, general and administrative expenses decreased $1.7 million to $55.0 million during the nine months ended September 30, 2012, as compared to $56.7 million for the nine months ended September 30, 2011. This decline was primarily due to the following: (i) a decrease of $7.9 million in costs associated with the litigation and settlement of matters related to Dr. Obagi (see Note 7 to Unaudited Condensed Consolidated Financial Statements); (ii) a decrease of $0.9 million in expenses associated with regulatory matters in Texas; (iii) a $0.9 million decrease in other marketing expenses as during the nine months ended September 30, 2011, we invested in extensive market research and consumer engagement initiatives to update and enhance our Internet presence; (iv) a $0.5 million decrease in impairment charges (see “Impairment of License” discussion under “Overview and Recent Developments”); (v) a $0.2 million decrease in depreciation and amortization; and (vi) a $0.1 million decrease in product development expenses. These decreases were partially offset by: (i) $2.9 million in expenses directly related to the development and set-up of our e-Commerce platform; (ii) a $1.6 million increase in headcount-related expenses, primarily due to an increase accrued bonus during the nine months ended September 30, 2012 and an increase in operational and general and administrative headcount; (iii) $1.0 million in expenses associated with the regulatory matters in California; (iv) a $0.7 million increase in professional fees; (v) $0.6 million in research concerning the Japanese market; (vi) a $0.5 million increase in advertising primarily due to increased advertising support for our international distributors; (vii) a $0.5 million increase in non-cash compensation; (viii) $0.4 million in expenses related to the establishment of a second source for certain of our products; (ix) a $0.3 million increase in promotions and training expenses; (x) $0.2 million in expenses related to researching physician opportunities; and (xi) a $0.1 million increase in other expenses. As a percentage of net sales, selling, general and administrative expenses in the nine months ended September 30, 2012 were 61% as compared to 68% for the nine months ended September 30, 2011.

Research and development. Research and development expenses increased $0.2 million to $1.6 million for the nine months ended September 30, 2012, as compared to $1.3 million for the nine months ended September 30, 2011. This was due to a $0.1 million increase in expenses related to the development of new products and a $0.1 million increase in expenses related to the development of line extensions and reformulations of existing products. As a percentage of net sales, research and development costs were 2% in each of the nine-month periods ended September 30, 2012 and 2011.

Interest income and Interest expense. Interest income increased to $50,000 for the nine months ended September 30, 2012 from $21,000 for the nine months ended September 30, 2011. We earn interest income from the investment of our cash balance into a money market account. Our average cash and cash equivalents increased from $21.1 million for the nine months ended September 30, 2011 to $35.9 million for the nine months ended September 30, 2012, and our weighted average annual interest rate slightly increased from 0.24% during the nine months ended September 30, 2011 to 0.26% during the nine months ended September 30, 2012. Interest expense was $59,000 during the nine months ended September 30, 2012, as compared to $119,000 for the nine months ended September 30, 2011. The decrease is due to a decrease in the amortization of debt issuance costs related to our Credit and Term Loan Agreement, which we amended effective as of March 30, 2012.

Income taxes. Income tax expense was $6.1 million for the nine months ended September 30, 2012, as compared to $2.8 million for the nine months ended September 30, 2011. Our effective tax rate was 39.6% for the nine months ended September 30, 2012 and 36.1% for the nine months ended September 30, 2011. The increase in the effective rate is primarily due to the impact of the 2011 research and development credit accounted for during the nine months ended September 30, 2011. As of September 30, 2012, the 2012 research and development tax credit had not yet been extended by Congress.

Liquidity and capital resources

Trends and uncertainties affecting liquidity

Our primary sources of liquidity are our cash generated by operations and availability under our Credit and Term Loan Agreement with Comerica Bank. As of September 30, 2012 we had approximately $21.5 million in cash and cash equivalents and $35.0 million available for borrowing under the Credit and Term Loan Agreement. We currently

believe that our existing cash balances and cash generated by operations, together with our available credit capacity, will enable us to meet foreseeable liquidity requirements. The following has impacted or is expected to impact liquidity:

On March 6, 2012, our Board authorized a $20.0 million increase to our stock repurchase program, resulting in the availability to repurchase up to $30.0 million of our common stock as of such date. During the three months ended September 30, 2012, we purchased 1,500,000 shares of our outstanding stock for a cost of $19.8 million. As of September 30, 2012, we have $10.2 million remaining available to repurchase our outstanding stock under the program;

The legal costs and settlement expense related to the litigation and arbitration involving us and Dr. Obagi were material. On October 23, 2012, we entered into an Insurance Settlement with our insurance carriers. Pursuant to the Insurance Settlement, we released the insurance carriers of all claims we did assert and could have asserted in the motions filed by us against the insurance carriers and in the underlying claims with Dr. Zein Obagi and related parties. In consideration for the final disposition of the matter, the insurance carriers paid us $14.0 million in October 2012, at which time we recorded net proceeds of approximately $8.4 million after legal expense as a gain on legal settlement related to the matter;

During the three months ended March 31, 2011, we recorded $1.9 million in sales returns for products returned from customers residing in the state of Texas, which was subsequently adjusted to $1.7 million during the second and third quarters of 2011. We voluntarily ceased shipment of certain of our products containing 4% hydroquinone into the state of Texas from April 2011 to May 2012. Although we resumed shipping HQ products in Texas in May 2012, we cannot assure you that our sales of such products in that state will return to historical levels. Texas net sales, including products containing hydroquinone, represented approximately 6% of our total net sales during the nine months ended September 30, 2012 and 5% and 9% for the years ended December 31, 2011 and 2010, respectively;

Although no enforcement action has been instituted against us for the California regulatory matter to date, it is possible that we will incur significant legal costs and potential penalties may be assessed. If the ultimate expenses, penalties and/or restrictions are material, this matter could have a material adverse effect on our consolidated financial position, results of operations and cash flows; and

We plan to invest significant capital and other resources in 2012 of between $9.0 million and $12.0 million into the creation and maintenance of an e-Commerce platform and fulfillment center. We cannot assure you that the e-Commerce platform will result in the growth of our business. Investment into this initiative could have a material adverse effect on our consolidated financial position, results of operations and cash flows. During the three- and nine-month periods ended September 30, 2012, we recorded $1.2 million and $2.9 million in expenses, respectively, and as of September 30, 2012, we recorded $2.6 million in capital expenditures, related to this strategic initiative.

We are operating in an uncertain and volatile economic environment, which could have unanticipated adverse effects on our business. The pharmaceutical industry has been impacted by recent volatility in the financial markets, including declines in stock prices, and by uncertain economic conditions. Changes in food and fuel prices, changes in the availability of consumer credit and housing markets, actual and potential job losses among many sectors of the economy, significant declines in the stock market resulting in large losses to consumer retirement and investment accounts, and uncertainty regarding future federal tax and economic policies have all added to declines in consumer confidence and curtailed consumer spending.

In order to remain competitive in the marketplace, for certain selected customers who we deemed to be creditworthy based upon their prior payment history, we extended our standard payment terms from net 30 days to net 60 days for selected product purchases made in connection with certain sales promotion programs. Such extension does not represent a permanent change to the payment terms for such customers but, rather, is applicable only to specified purchases made by such customers in connection with the applicable sales promotion program. Sales of products having net 60-day payment terms represented 48% and 49% of our net sales for the three- and nine-month periods ended September 30, 2012. Our days’ sales outstanding (“DSO”) increased from 60 days as of December 31, 2011 to 65 days as of September 30, 2012. The increase is primarily due to the timing of payments received from one of our international distributors. It is unclear how long the current economic environment will continue, whether there will be new events that could contribute to additional deterioration, and if so, what effect such events could have on our business

in 2012. As noted above, to facilitate more rapid growth, we plan to invest in a new e-Commerce platform and fulfillment center and, as the opportunities arise, the commercialization of new applications of our current products, the continuing development of our pipeline of products and the in licensing or acquisition of new product opportunities. While we plan to increase our investments in these initiatives, we expect to continue to generate positive cash flow through our operations.

As of September 30, 2012, we had no outstanding balance on the Facility or the Term Loans available under the Credit and Term Loan Agreement. We were in compliance with all financial and non-financial covenants under the Credit and Term Loan Agreement as of September 30, 2012 and December 31, 2011. In April 2012, we entered into an amendment to the Credit and Term Loan Agreement with Comerica Bank, to: (i) extend the Facility maturity date from July 1, 2012 to July 1, 2014, unless otherwise terminated in accordance with the Credit and Term Loan Agreement; (ii) extend the draw period of our Term Loans from May 3, 2012 to earliest to occur of (a) the aggregate outstanding principal balance of the Term Loans equaling the term commitment, (b) July 1, 2013, and (c) the date of our request to close out the Term Loans; (iii) increase the maximum stock repurchases we may effect from $50.3 million to $70.3 million; (iv) allow intercompany loans or intercompany investments in our subsidiary created for the e-Commerce initiative in an aggregate not to exceed $12.0 million; and (v) exempt our subsidiary related to the e-Commerce initiative from the subsidiary requirements of the Credit and Term Loan Agreement. The amendment is retroactively effective as of March 30, 2012. We expect to be in compliance with both our non-financial and financial covenants during 2012; however, economic conditions or the occurrence of any of the events discussed under Part I, Item IA, “Risk Factors” in our 2011 Annual Report on Form 10-K could cause noncompliance within our financial covenants.

We expect to be able to manage our working capital levels and capital expenditure amounts to maintain sufficient levels of liquidity. As of September 30, 2012 and December 31, 2011, we had approximately $43.0 million and $52.2 million, respectively, in working capital. During the nine months ended September 30, 2012, we invested approximately $2.9 million in capital expenditures, which largely related to our e-Commerce platform. For the remainder of 2012, we expect to spend approximately $1.0 million in capital expenditures, primarily related to the e-Commerce platform and fulfillment center, and software and IT upgrades.

Cash requirements for our business

Historically, we have generated cash from operations in excess of working capital requirements and through private and public sales of common stock. We currently invest our cash and cash equivalents in a money market account. As of September 30, 2012 and December 31, 2011, we had approximately $21.5 million and $35.0 million, respectively, of cash and cash equivalents.

On October 26, 2010, we announced that our Board of Directors authorized us to repurchase up to $45.0 million of our common stock, depending on market conditions and other factors. Share repurchases could include the repurchase of shares from the selling stockholders in connection with the secondary offering of our common stock completed in November 2010, as well as repurchases made through open market or privately negotiated transactions in compliance with SEC Rule 10b-18, subject to market conditions, applicable legal requirements and other factors. During the fourth quarter ended December 31, 2010, we repurchased 3,556,910 shares of our outstanding common stock for a cost of $35.0 million. No repurchases were effected during the year ended December 31, 2011, leaving us with $10.0 million available for repurchases under the program. On March 6, 2012, our Board authorized a $20.0 million increase to our stock repurchase program, resulting in the availability to repurchase up to $30.0 million of our common stock as of such date. This authorization does not obligate us to acquire any particular amount of common stock nor does it ensure that any shares will be repurchased, and it may be suspended at any time at our discretion. During the three months ended September 30, 2012, we purchased 1,500,000 shares of our outstanding stock for a cost of $19.8 million. As of September 30, 2012, we had $10.2 million available for repurchases under the program.

We continually evaluate new opportunities for products or therapeutic systems and, if and when appropriate, intend to pursue such opportunities through the acquisitions of companies, products or technologies and our own development activities. Our ability to execute on such opportunities in some circumstances may be dependent, in part, upon our ability to raise additional capital on commercially reasonable terms. There can be no assurance that funds from these sources will be available when needed or on terms favorable to us or our stockholders. If additional funds are raised by issuing equity securities, the percentage ownership of our stockholders will be reduced, stockholders may

experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock.

Cash flow

Nine months ended September 30, 2012. For the nine months ended September 30, 2012, net cash provided by operating activities was $6.8 million. The primary sources of cash were $9.4 million in net income, adjusted for: (i) non-cash items; partially offset by: (ii) a net increase in accounts payable and accrued liabilities through timing of purchasing and payments; (ii) an increase in inventory due to a buildup of safety stock at a new second source supplier of some of our products resulting in a decrease in our annual inventory turns from 5.2 as of December 31, 2011 to 4.3 as of September 30, 2012; (iii) an increase in income taxes receivable; (iv) an increase in prepaids and other current assets; and (v) an increase in accounts receivable due in part to an increase in our DSO from 60 days at December 31, 2011 to 65 days at September 30, 2012.

Net cash used in investing activities was $2.4 million for the nine months ended September 30, 2012, primarily attributable to the costs associated with our e-Commerce platform and investments in licenses and patent-related intellectual property during the nine months ended September 30, 2012. We anticipate spending approximately $1.0 million for the remainder of the year ending December 31, 2012 for capital expenditures primarily associated with IT upgrades and disaster recovery infrastructure.

Net cash used in financing activities was $18.0 million for the nine months ended September 30, 2012, which was primarily attributable to the repurchase of 1,500,000 shares of our outstanding stock for a cost of $19.8 million and payments made on capital lease obligations and debt issuance costs, partially offset by $1.8 million in proceeds received from the exercise of stock options.

Nine months ended September 30, 2011. For the nine months ended September 30, 2011, net cash provided by operating activities was $11.6 million. The primary sources of cash were $4.9 million in net income, adjusted for: (i) non-cash items; (ii) a decrease in accounts receivable due to lower sales during the three months ended September 30, 2011 as compared to the three months ended December 31, 2010 and an improvement in DSO from 66 days as of December 31, 2010 to 62 days as of September 30, 2011; (iii) a decrease in inventory due to an improvement in our annual inventory turns from 4.2 as of December 31, 2010 to 6.1 as of September 30, 2011; and (iv) a net decrease in our income tax receivable balance; partially offset by a net decrease in accounts payable and accrued liabilities through timing of purchasing payments.

Net cash used in investing activities was $0.6 million for the nine months ended September 30, 2011, primarily attributable to the costs associated with software and IT upgrades and investments in licenses and patent-related intellectual property during the nine months ended September 30, 2011.

Net cash provided by financing activities was $0.8 million for the nine months ended September 30, 2011, which was primarily attributable to proceeds received from the exercise of stock options.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We generally invest our excess cash primarily in money market funds or short-term certificates of deposit. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments.

Although substantially all of our sales and purchases are denominated in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the price competitiveness of our products outside the U.S. We do not believe, however, that we currently have significant direct foreign currency exchange rate risk and have not hedged exposures denominated in foreign currencies.

Interest rate risk

Our interest income and expense is more sensitive to fluctuations in the general level of the U.S. prime rate and LIBOR interest rates than to changes in rates in other markets. Changes in U.S. LIBOR interest rates affect the interest earned on our cash and cash equivalents. At September 30, 2012, we had approximately $21.5 million of cash and cash equivalents. If the interest rates on our cash and cash equivalents and short-term investments were to increase or decrease by 1% for the year, annual interest income would increase or decrease by approximately $0.2 million.

Other risks

Generally we have been able to collect our accounts receivable in the ordinary course of business. We continuously monitor collections and payments from customers and maintain a provision for estimated credit losses as deemed appropriate based upon historical experience and any specific customer collection issues that have been identified. Our DSO increased to 65 days as of September 30, 2012 from 60 days at December 31, 2011. We do not believe that our accounts receivable balance presents a significant credit risk based upon our past collection experience.

The recent recession has had an adverse impact on the financial services industry, including insurance companies, some of which currently provide coverage to us. To the extent we have any claims in the future and such insurance providers are unable, due to their financial condition, to pay covered claims, we could experience adverse impacts on our cash flow and cash balances. We have no way of knowing whether or not any insurance providers that are financially stable at this time will experience financial difficulties in the future that could impact their ability to pay covered claims.

ITEM 4: CONTROLS AND PROCEDURES

Disclosure controls and procedures

As of the end of the period covered by this Report, we 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 (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in providing reasonable assurance that information is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules, regulations and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and the Chief Financial Officer as appropriate, to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting

There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1: LEGAL PROCEEDINGS

On January 7, 2010, ZO Skin Health, Inc., a California corporation, filed a complaint in the Superior Court of the State of California, County of Los Angeles: ZO Skin Health, Inc. vs. OMP, Inc. and Obagi Medical Products, Inc. and Does 1-25; Case No. BC429414. The complaint alleged claims against us and sought injunctive relief, compensatory damages and other damages in an unspecified amount, punitive damages and costs of suit including attorneys’ fees. We answered the complaint and denied the allegations in that pleading. In addition, we asserted counterclaims against the plaintiff.

In addition, on or about January 7, 2010, Zein Obagi and his spouse, Samar Obagi, and the Zein and Samar Obagi Family Trust and certain other entities allegedly affiliated with Zein Obagi sent us an arbitration demand before JAMS in Los Angeles, California in which the claimants claimed breaches of the 2006 Services Agreement and 2006 Separation and Release Agreement (see Note 7 in our Notes to Unaudited Condensed Consolidated Financial Statements) between us and the claimants and various breaches of common law, California law and federal law. We filed an answer to the Demand for Arbitration denying the allegations and asserting various counterclaims. In May 2010, the claimants in the arbitration proceeding filed an amended demand, again before JAMS in Los Angeles.

On May 2, 2011, we entered into the Settlement Agreement with the ZO Parties, including Zein E. Obagi, M.D., Zein E. Obagi, M.D., Inc., ZO Skin Health, Inc., Skin Health Properties, Inc., the Zein and Samar Obagi Trust, and Samar Obagi that resulted in the dismissal with prejudice of all claims and counterclaims in both the litigation and arbitration. Under the Settlement Agreement, we and ZO Parties have agreed to mutual releases. The Settlement Agreement also provided for: (i) a one-time payment of $5.0 million from us to the ZO Parties; and (ii) the grant of a limited, non-exclusive license by us to the ZO Parties to use certain of our trademarks in up to three locations. The other non-economic terms of the Settlement Agreement are confidential. We recorded $5.0 million for the one-time payment and $2.9 million in related litigation fees during the nine months ended September 30, 2011.

During the three months ended March 31, 2011, we received a coverage letter from our primary general liability insurance carrier, agreeing to defend the lawsuit and arbitration described above, under a reservation of rights. In May 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities. In July 2011, we filed an answer and cross claim against the carrier and our previous primary general liability insurance carrier. During the three months ended March 31, 2012, both we and the carriers filed cross motions for summary judgment related to the insurers’ duty to defend. They did not address the indemnity issues or bad faith claims. The hearing on the cross motions was heard in May 2012. Our motions on the duty to defend were granted and the insurance carriers made a partial payment of the defense costs subject to a reservation of rights. As a result, these funds were being held in an interest bearing escrow account pending final disposition of the matter. As of September 30, 2012, we had not recorded a gain contingency related to the matter pending final disposition of the matter. At such time, discovery was still ongoing and therefore we could not estimate the amount of litigation costs and settlement fees, if any, we would recover from the insurance carriers. Effective October 2011, we converted our payment arrangements with our legal counsel on this matter from an hourly rate to a contingency fee arrangement.

From time to time, we are involved in other litigation and legal matters or disputes in the normal course of business. Management does not believe that the outcome of any of these other matters at this time will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

ITEM 1A: RISK FACTORS

Our new online fulfillment strategy will require a significant investment in capital and other resources and we cannot assure you that it will be successfully implemented

We have identified the elements necessary to establish a web-based fulfillment operation and are currently in the process of completing the development of this platform. We believe that having an e-Commerce platform will enable us to capitalize on the current interest in our products on the Internet by directing consumers to one place to learn about and purchase our products, capture a portion of this new business for our physician customers and serve a larger population of potential patients. However, we cannot assure you that our e-Commerce platform will actually expand our base of end-users or result in the growth of our business. There are also a number of legal and regulatory considerations that may affect the timing and scope of the rollout of our e-Commerce platform. Moreover, the creation and maintenance of an e-Commerce platform will require a significant investment in capital and other resources of between $9.0 million and $12.0 million in 2012, and may divert the attention of our management and other key employees from the operation of our core business, which could materially and adversely impact our business and results of operations.

To be successful, we will have to convince a substantial number of both physician customers and their patients to adopt this new distribution channel, and we cannot assure you that we will be able to achieve this. If we are unable to do so, we may not realize the return on our investment in this strategy that we currently anticipate. For instance, in the past we have invested significant capital and resources to enter into a new distribution channel that did not perform as expected. In August 2008, we entered into the pharmacy channel for the first time with our SoluCLENZ Rx Gel, which was available by prescription only. However, after closely monitoring the progress of the launch and weekly sales data, we determined that distribution of a single prescription product through the pharmacy channel and the ongoing investment required to support that channel was cost prohibitive. Accordingly, in April 2009 we exited the pharmacy channel. In connection with such exit, we recorded charges approximating $0.8 million and reserved approximately $0.4 in inventory during the year ended December 31, 2009. If we are unable to successfully implement our online pharmacy fulfillment strategy, we may incur significant expenses without realizing a near-term or any financial return.

Provisions in our charter documents and Delaware law could discourage a takeover you may consider favorable or could cause current management to become entrenched and difficult to replace.

Provisions in our amended and restated certificate of incorporation and our bylaws, as well as Delaware law, could make it more difficult for other companies to acquire us, even if doing so would benefit our stockholders. Our certificate of incorporation and bylaws contain the following provisions, among others, which may inhibit an acquisition of our company by a third party:

·	advance notification procedures for matters to be brought before stockholder meetings;

·	a limitation on who may call stockholder meetings;

·	a prohibition on stockholder action by written consent; and

·	the ability of our Board of Directors to issue up to 10 million shares of preferred stock without a stockholder vote.

We are also subject to provisions of Delaware law that prohibit us from engaging in any business combination with any “interested stockholder,” meaning generally that a stockholder who beneficially owns more than 15% of our stock cannot acquire us for a period of three years from the date this person became an interested stockholder unless various conditions are met, such as approval of the transaction by our Board of Directors. Any of these restrictions could have the effect of delaying or preventing a change in control.

ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

On October 26, 2010, we announced that our Board of Directors authorized us to repurchase up to $45.0 million of our common stock, depending on market conditions and other factors. Share repurchases have included the repurchase of $35.0 million of shares from certain selling stockholders following completion of the registered public offering of shares of our common stock by such stockholders in November 2010, and may include future repurchases made through open market or privately negotiated transactions in compliance with SEC Rule 10b-18, subject to market conditions, applicable legal requirements and other factors. No repurchases were made during year ended December 31, 2011. Accordingly, as of December 31, 2011, $10.0 million was still authorized for the repurchase of shares.

As no repurchases were made subsequent to December 31, 2011 through March 6, 2012, the date on which our Board authorized a $20.0 million increase to our stock repurchase program, our availability to repurchase our common stock increased to $30.0 million of our common stock as of such date. This authorization does not obligate us to acquire any particular amount of common stock nor does it ensure that any shares will be repurchased, and it may be suspended at any time at our discretion.

The following table provides information regarding repurchases of our common stock made by or on behalf of us, or any “affiliated purchasers” as defined in SEC rules, of our equity securities registered pursuant to Section 12 of the Exchange Act, for each month during the three months ended September 30, 2012, in the format required by SEC rules:

	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Dollar Amount of Shares (in thousands) That May Yet Be Purchased Under the Plans or Programs
July 1, 2012 - July 31, 2012		—	$	—		—	$	30,000
August 1, 2012 - August 31, 2012		748,330		13.11		748,330		20,189
September 1, 2012 - September 30, 2012		751,670		13.26		751,670		10,219
		1,500,000		13.19		1,500,000		10,219

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4: MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5: OTHER INFORMATION

On October 30, 2012, our Board of Directors (the “Board”) approved an amendment to Article II, Section 2.6(c) of our Second Amended and Restated Bylaws to change the voting standard for the election of directors from a plurality to a majority of votes cast in uncontested elections. A majority of the votes cast means that the number of votes cast “for” a director must exceed the number of votes cast “against” that director. In contested elections the voting standard will continue to be a plurality of votes cast. A contested election is defined as an election in which our Secretary receives a notice that a stockholder has nominated a person for election to the Board in compliance with the advance

notice requirements for stockholder nominees for director set forth in Article II, Section 2.1 of the Bylaws and such nomination has not been withdrawn by that stockholder on or before the tenth business day before we first mail notice of the meeting to our stockholders. In addition, the Board adopted a new policy under which, in uncontested elections, each incumbent director nominee must submit a resignation to our Board prior to the election that will become effective if and only if such director nominee does not receive the required votes for reelection. The Nominating and Corporate Governance Committee of the Board will recommend whether it should accept or reject any tendered resignation from a director nominee who fails to receive the required votes, and the Board will act upon the committee’s recommendation within 90 days after certification of the election results. Any director whose resignation becomes effective pursuant to this policy shall not participate in the Nominating and Corporate Governance Committee recommendation or Board action regarding whether to accept the resignation. We will publicly disclose the Board’s decision regarding the resignation and the rationale behind the decision in a Current Report on Form 8-K filed with the SEC. The foregoing description of the Amendment to our Second Amended and Restated Bylaws is qualified in its entirety by reference to the full text of the Amendment, which is attached as Exhibit 3.3 to this Report and incorporated by reference herein.

ITEM 6: EXHIBITS


Exhibit	Exhibit title
3.1	Amended and Restated Certificate of Incorporation of the Company (1)
3.2	Amended and Restated Bylaws of the Company (1)
3.3	Amendment to Amended and Restated Bylaws of the Company*
3.4	Certificate of Designations of Series A Junior Participating Preferred Stock of the Company (2)
3.5	Certificate of Elimination of Series A Junior Participating Preferred Stock of the Company (3)
4.1	Specimen Stock Certificate (1)
4.2	Rights Agreement dated as of December 23, 2011 between the Company and American Stock Transfer & Trust Company, LLC, as rights agent (the “Rights Agreement”) (2)
4.3	Amendment No. 1 to Rights Agreement (4)
4.4	Amendment No. 2 to Rights Agreement (5)
31.1	Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
31.2	Certification of Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*
32.1	Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
32.2	Certification of Principal Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

* Filed herewith


(1)	Incorporated herein by reference to the Company’s Registration Statement on Form S-1/A (Registration No. 333-137272), previously filed with the SEC.
(2)	Incorporated herein by reference to the Company’s Registration Statement on Form 8-A, previously filed with the SEC on December 23, 2011.
(3)	Incorporated herein by reference to the Company’s Current Report on Form 8-K, previously filed with the SEC on July 10, 2012.
(4)	Incorporated herein by reference to the Company’s Registration Statement on Form 8-A/A, previously filed with the SEC on May 25, 2012.
(5)	Incorporated herein by reference to the Company’s Registration Statement on Form 8-A/A, previously filed with the SEC on July 10, 2012.

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.


	OBAGI MEDICAL PRODUCTS, INC.

Date: November 1, 2012	By:	/s/Albert F. Hummel
		Albert F. Hummel
		Chief Executive Officer
		(Principal Executive Officer)

Date: November 1, 2012	By:	/s/Preston S. Romm
		Preston S. Romm
		Chief Financial Officer
		(Principal Financial Officer)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Good

Obagi Medical Products (OMPI) Inactive 10-Q2012 Q3 Quarterly report

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