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 the Company's business strategy, timing of, and plans for, the introduction of new products and enhancements, future sales, market growth and direction, 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, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements, 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 the Company as of the date of this report. We undertake no on-going 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, levels of activity, performance or achievements. 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 2008 Annual Report on Form 10-K and Item IA of Part II of this report on Form 10-Q. 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 focused on the aesthetic and therapeutic skin health markets. We develop and commercialize prescription-based, topical skin health systems that enable physicians to treat a range of skin conditions, including pre-mature aging, photo-damage, hyperpigmentation, acne 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 only clinically proven, prescription-based, topical skin health system on the market that has been shown to enhance the skin's overall health by correcting photo-damage 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 over the counter, or 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 cosmetic procedures including Botox® injections. 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 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. We also market tretinoin, used for the topical treatment of acne in the U.S., and Obagi Blue Peel® products, used to aid the physician in the application of skin peeling actives. In August 2008, we entered the pharmacy Rx channel with our first product, SoluCLENZ™, a solubilized benzoyl peroxide gel for the treatment of acne. In April 2009, we announced our exit of the pharmacy Rx channel. In January 2009, we introduced the Obagi Rosaclear™ system, which is an all in one prescription based system that treats the signs and symptoms of rosacea.

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™. There can be no assurance 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 U.S. primarily to plastic surgeons, dermatologists and other physicians who are focused on aesthetic skin care.

Aesthetic skin care. As of March 31, 2009, we sold our products to approximately 5,800 physician-dispensing accounts in the U.S., with no single customer accounting for more than 5% of our net sales. We generated U.S. net sales of $19.2 million and $21.4 million during the three months ended March 31, 2009 and 2008, respectively.

Retail Pharmacy Rx Channel. As noted earlier, we launched SoluCLENZ into the pharmacy Rx channel during the year ended December 31, 2008. We marketed SoluCLENZ through our dermatology sales force and an outside third party contract sales organization in the U.S. primarily to dermatologists. We sold SoluCLENZ to pharmaceutical wholesalers who then distributed directly to the pharmacy to fill patient prescriptions. On April 13, 2009, we announced that we would no longer sell SoluCLENZ in the pharmacy Rx channel as the distribution of a single prescription product through the pharmacy channel and the ongoing investment to support that channel had become cost-prohibitive for us. We made this decision, after discussions with, and concurrence of, our Board of Directors. During the three months ended March 31, 2009, we generated $0.2 million in revenues related to SoluCLENZ and incurred approximately $1.6 million in expenses to support the product and the channel, which includes the write off of approximately $0.4 million in nonrefundable deposits and selling materials.

In connection with the exit of the pharmacy channel, as of March 31, 2009, we recorded charges of approximating $0.4 million in contractual deposits primarily relating to our contract sales force dedicated to selling SoluCLENZ and reserved approximately $0.5 million in inventory. We expect to incur additional costs related to the exit during the quarter ending June 30, 2009, as we finalize termination of various service provider contracts related to the pharmacy Rx channel. Total costs expected to exit the channel, including the charges and reserves recorded as of March 31, 2009, are expected to be in the amount of $1.3 to $1.8 million on a pre-tax basis. We anticipate that we will have fully exited the channel by the end of the quarter ended June 30, 2009 or shortly thereafter.

We continue to believe, based upon the compelling clinical data, that our patented solubilized BPO is a novel technology.

International distribution. We market our products internationally through 19 international distribution partners that have sales and marketing activities in 43 countries outside of the U.S. Much like our business model in the U.S., these distributors sell our products through direct sales representatives to physicians, or through alternative distribution channels depending on regulatory requirements and industry practices. We generated international net sales of $3.4 million and $3.9 million during the three months ended March 31, 2009 and 2008, respectively.

Licensing. We market our products in the Japanese retail markets through a Trademark and Know-how license agreement with Rohto Pharmaceutical Co., LTD ("Rohto"). Under our agreement, Rohto is licensed to manufacture and sell a series of OTC products under the Obagi brand name in the Japanese drug store channel, and we receive a royalty based upon sales of Obagi branded products in Japan by Rohto. Rohto's Obagi branded products are sold through approximately 6,300 high-end drug stores. We have other licensing arrangements in Japan to market and sell OTC product systems under the Obagi brand, both for in-office use in facial procedures, as well as for sale as a take-home product kit in the spa channel. We receive royalties based upon these arrangements. We generated licensing revenue of $0.8 million and $1.2 million during the three months ended March 31, 2009 and 2008, respectively.

Results of operations. As of March 31, 2009, we had accumulated earnings of $7.2 million. We reported net income of $0.6 million and $3.0 million for the three months ended March 31, 2009 and 2008, 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.

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 will, to some extent, be

influenced by the economic conditions within the geographic markets in which we sell our products. During the three months ended March 31, 2009, we saw the unprecedented economic conditions within the U.S. have a negative impact on our revenue performance. We believe that the economic downturn has reduced disposable income, which we believe has led to reduced patient visits to physician offices for aesthetic procedures and patients using less product per application to extend the time needed for obtaining refills of product from their physicians. The U.S. economic slow down effect was seen in all of our product categories, as growth was slower than expected, but was more pronounced within the Nu-Derm product line. At this time, it is extremely difficult to measure the severity, length, geographic and financial impact of the economic downturn and its longer term impact on our product sales, but we will continue to monitor it closely. We believe that some of the negative impact may be partially offset due to the following: (i) the continued growth in our market share; (ii) the aesthetic nature of our products; (iii) the lower price point of our products compared to other aesthetic products and procedures 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. We plan to continue to invest resources on 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. However, due to the uncertainties in the economic markets, our current business plan does not anticipate that we will invest significant resources in these strategic initiatives over the near term. As a result, we believe that our near-term on-going profitability is primarily dependent upon the continued success of our current product offerings.

Critical accounting policies and use of estimates

Our discussion and analysis of our financial condition and results of operations is based upon our 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, leases, stock-based compensation and accounting for income taxes have the greatest potential impact on our 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. The critical accounting estimates associated with these policies are described in Part II, Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operation" of our 2008 Annual Report on Form 10-K filed with the Securities Exchange Commission on March 11, 2009.

Results of operations

The three months ended March 31, 2009 compared to the three months ended March 31, 2008

Net sales. The following table compares net sales by product line and certain selected products for the three months ended March 31, 2009 and 2008:

               Physician dispensed
               Nu-Derm                $   11,907     $ 12,716           -6 %
               Vitamin C                   2,642        2,855           -7 %
               Elasticity                  2,097        4,570          -54 %
               Therapeutic                 2,466        1,442           71 %
               Other                       2,511        2,602           -3 %
               Total                      21,623       24,185          -11 %
               Pharmacy Rx                   238            -            -
               Licensing                     759        1,189          -36 %
               Total net sales        $   22,620     $ 25,374          -11 %

               United States                  85 %         84 %
               International                  15 %         16 %

Net sales decreased by $2.8 million to $22.6 million during the three months ended March 31, 2009, as compared to $25.4 million during the three months ended March 31, 2008. Overall, we believe the economic conditions within the U.S. had a negative impact on our revenue performance during the three months ended March 31, 2009. We believe that the economic downturn has reduced disposable income, which we believe has led to reduced patient visits to physician offices for aesthetic products and procedures, and fewer such procedures being performed and products being purchased. The U.S. economic slow down effect was seen in all product categories, as growth was lower than expected, but was more pronounced within the Elasticity and Nu-Derm product lines.

Physician dispensed sales decreased $2.6 million, to $21.6 million during the three months ended March 31, 2009, as compared to $24.2 million during the three months ended March 31, 2008. The decline was due to the following: (i) a $2.5 million decline in Elasticity sales primarily due to the increased promotional activity surrounding the launch of our ELASTIderm™ Décolletage product in February 2008 compared to the first quarter ended March 31, 2009;
(ii) a decline in Nu-Derm sales of $0.8 million; and (iii) a combined sales decline of $0.3 million in the Vitamin C and Other product categories. These declines were offset by an increase in the Therapeutic category of $1.0 million. This growth was primarily attributable to the launch of our Rosaclear™ system, which contributed $1.3 million in sales during the three months ended March 31, 2009, and was offset by a decline of approximately $0.3 million in our CLENZIderm system sales.

Pharmacy Rx sales, which solely includes sales of our SoluCLENZ product, generated $0.2 million during the three months ended March 31, 2009. Licensing fees decreased by $0.4 million.

Our aggregate sales decline was comprised of a $2.2 million decrease in the U.S. and a $0.6 million decrease from our international markets. International sales decline was primarily in the Elasticity and Nu-Derm categories and primarily came from three regions: (i) $0.3 million from the Middle East; (ii) $0.2 million from the America's Region; (iii) $0.1 million from Europe and Other; offset by (iv) an increase of $0.4 million from the Far East Region. Our licensing fees decreased $0.4 million primarily due to new product launch delays and the economic downturn. We believe, depending upon its duration and severity, that a continued global economic slow down may negatively impact our future net sales.

Gross margin percentage. Overall, our gross margin percentage decreased to 77.6% for the three months ended March 31, 2009 compared to 81.4% for the three months ended March 31, 2008. The overall decline is primarily attributable to a decline in gross margin for our physician dispensed segment, which decreased to 78.9% compared to 80.6% for the same period last year. The decline is primarily a result of an increase in discounting promotional activities. Gross margin for our licensing segment decreased to 96.0% compared to 97.2% for the same period last year. The decline is primarily due to a $0.4 million decline in our licensing fees during the three months ended March 31, 2009. During the three months ended March 31, 2009, pharmacy Rx gross margin was negative due to a $0.4 million reserve on SoluCLENZ inventory in connection with our exit of the pharmacy Rx channel. Cost of sales also consists of outbound shipping and handling, work order scrap, licensing and royalty fees related to licensed intellectual property, depreciation and amortization attributable to products sold, and an inventory reserve for shrinkage and write-downs.

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 $1.2 million to $15.5 million during the three months ended March 31, 2009, as compared to $14.3 million for the three months ended March 31, 2008. This increase is primarily due to the following: (i) a $1.6 million increase in expenses related to the distribution and support of our SoluCLENZ product in the pharmacy Rx channel, which includes a $0.4 million charge related to the write off of nonrefundable deposits; (ii) a $0.4 million increase in promotional expenses; (iii) a $0.2 million increase in our bad debt expense as our DSO has increased from 74 as of December 31, 2008 to 84 as of March 31, 2009; (iv) a $0.2 million increase in other expenses; (v) a $0.1 million increase in severance costs; and (vi) a $0.1 million increase in rent and related expenses due to the relocation of our corporate headquarters during the quarter ended September 30, 2008; offset by (i) a $0.8 million decrease in professional fees, consisting primarily of a reduction in legal expenses; and
(ii) a $0.6 million decrease in salaries and related expenses, largely due to the reduction of headcount in operations and support personnel during the fourth quarter of 2008. As a percentage of net sales, selling, general and administrative expenses in the three months ended March 31, 2009 were 68% as compared to 56% for the three months ended March 31, 2008.

Research and development. Research and development expenses decreased $0.3 million to $1.1 million for the three months ended March 31, 2009 as compared to $1.4 million for the three months ended March 31, 2008. The decrease is primarily due to the following: (i) a $0.2 million decrease in development costs related to new indications of our existing products; and (ii) a $0.1 million decrease in royalties paid to Dr. Obagi pursuant to the June 29, 2006 Services Agreement. As a percentage of net sales, research and development costs in the three months ended March 31, 2009 were 5% as compared to 6% in the three months ended March 31, 2008.

Interest income and Interest expense. Interest income declined to $60,000 for the three months ended March 31, 2009 from $103,000 for the three months ended March 31, 2008. We earn interest income from the investment of our cash balance into a higher interest rate yielding money market account. Although our average cash and cash equivalents, including short term investments, increased from $18.1 million for the three months ended March 31, 2008 to $19.4 million for the three months ended March 31, 2009, our weighted average interest rate decreased from 2.68% during the three months ended March 31, 2008 to 1.54% during the three months ended March 31, 2009. Interest expense was $18,000 during the three months ended March 31, 2009, as compared to $37,000 for the three months ended March 31, 2008. The decline is attributable to amortization of debt issuance costs related to our line of credit entered into in November 2008 being lower for the three months ended March 31, 2009, than compared to our previous line of credit in place during the three months ended March 31, 2008.

Income taxes. Income tax expense decreased $1.6 million to $0.4 million for three months ended March 31, 2009, as compared to $2.0 million for the three months ended March 31, 2008. Our effective tax rate was 38.2% for the three months ended March 31, 2009 and 40.0% for the three months ended March 31, 2008. The decrease is primarily due to a decrease in state taxes and the utilization of the Federal research and development credit, extended on October 3, 2008, for the year ending December 31, 2009.

Liquidity and capital resources

Trends and uncertainties affecting liquidity

Our primary sources of liquidity are our cash generated by operations and availability under our Revolving Credit Agreement (the "Facility") entered into in November 2008. As of March 31, 2009, we had approximately $23.2 million in cash and cash equivalents and short-term investments and $20.0 million available under the Facility. 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 within the next twelve months. The following has or is expected to impact liquidity:

††† We expect to continue to invest in our Enterprise Resource Planning ("ERP") system;

§ On August 5, 2008, the Board of Directors gave us the authority to repurchase up to $10 million of our outstanding common shares in the open market over the next two years. During the year ended December 31, 2008, we purchased $4.0 million of our outstanding stock. We did not purchase outstanding stock during the three months ended March 31, 2009; and

††† Our days sales outstanding ("DSO") has increased from 74 days at December 31, 2008 to 84 at March 31, 2009. In response, we have increased our allowance for doubtful accounts and sales returns to $1.4 million as of March 31, 2009, compared to $1.2 million as of December 31, 2008.

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 credit and housing markets leading to the current financial and credit crisis, 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.

We expect the weak economic environment to continue and do not expect macroeconomic conditions to be conducive to growth in 2009. Achieving financial results that compare favorably with year-ago results will be challenging in the first half of 2009. We intend to moderate our growth plans and avoid credit and market risk. We expect to continue to generate positive working capital through our operations and, at this time, we do not anticipate drawing on our Facility.

As of November 30 and December 31, 2008 and January 31, 2009, we were not in technical compliance with our non-financial covenant requiring us to submit a listing of intellectual property to the lender each month. On February 18, 2009, we obtained a waiver for November 30 and December 31, 2008 and January 31, 2009. We were in compliance with all other financial and non-financial covenants and we had no outstanding balance on the Facility as of December 31, 2008.

As of March 31, 2009, we had no outstanding balance on the Facility and we were in compliance with both our non-financial and financial covenants. We expect to remain in compliance during the remainder of 2009; however, economic conditions or the occurrence of events discussed under "Risk Factors" in our 2008 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 March 31, 2009 and December 31, 2008, we had approximately $45.4 million and $44.1 million, respectively, in working capital. During the three months ended . . .