Summary of OBAGI MEDICAL PRODUCTS, INC.

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and related notes appearing elsewhere in this Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business and related financing requirements, includes forward-looking statements that involve risks and uncertainties. You should review the "Risk Factors" section of this Report for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.

Overview

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 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 December 31, 2011, we sold our products to approximately 6,600 physician-dispensing accounts in the United States, with no single customer accounting for more than 10% of our net sales. Our current products are not eligible for reimbursement from third-party payors such as health insurance organizations. We

generated U.S. net sales of $94.8 million and $94.5 million during the years ended December 31, 2011 and 2010, respectively.

International distribution. We market our products internationally through 18 international distribution partners and beginning January 1, 2012, one licensing partner, all of which have sales and marketing activities in 43 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 net sales of $14.8 million and $13.9 million during the years ended December 31, 2011 and 2010, respectively.

Licensing. We market our products in the Japanese retail markets through license agreements with 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 sales of Obagi branded products in Japan by Rohto. Rohto's Obagi branded products are sold through approximately 6,300 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.

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 2 to our 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 10 to our Consolidated Financial Statements for 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. On May 17, 2011, the insurance carrier filed a complaint in federal court for Declaratory Relief requesting an interpretation of its coverage responsibilities. On or about July 6, 2011, we filed an answer and cross claim against the carrier and our previous primary general liability insurance carrier. Discovery continues and therefore, at present, we cannot estimate the amount of litigation costs and settlement fees, if any, we may recover from the insurance carrier. Effective October 1, 2011, we converted our payment arrangements with our legal counsel on this matter from an hourly rate to a contingency fee arrangement.

Texas regulatory matter. In November 2009, we received a letter from the Texas Department of State Health Services 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. We submitted our response to the Agency in January 2010 indicating why we believed we were in compliance with the Texas statutes. In May 2010, the Agency sent us a letter indicating that it did not agree with the arguments set forth in our January 2010 letter. In June 2010, we had an in-person meeting with officials from the Agency to further discuss its concerns. In August 2010, we submitted additional written information to the Agency in response to the topics discussed and additional information requested by the Agency at the June meeting. From that time until April 2011, the Agency did not have any further communication with us. In March 2011, the Agency, in response to what we then understood was a new complaint, detained our HQ Products from one of our customers as being unapproved new drugs and further cited this customer for dispensing prescription drugs without a pharmacy license in violation of various Texas statutes. Despite repeated requests, neither the Agency nor the AG has been able to identify or provide us with any additional complaints. In early April 2011, the Agency detained products from several more of our customers citing similar violations. Shortly thereafter, we attempted to contact the Agency to ascertain what the issues were that prompted the recent actions taken

by the Agency against these customers. In mid-April 2011, the Agency indicated to us that it had referred the matter to the AG for enforcement action. 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. In July 2011, the AG reiterated its position, as noted above, to us in a letter. In July 2011, our counsel met with the AG to continue discussions regarding an amicable settlement of this matter. In August 2011, the AG sent a letter following up on certain aspects of the July 2011 meeting.

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 FDA Q&A document issued 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 NTP; and (iii) its acknowledgment of the relevance of the FDA's CPG policy 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. 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. Now that the investigation has been completed and the complaint withdrawn, we will evaluate the appropriate time for re-introducing our HQ Products into Texas. Our delay in resuming shipment of our HQ Products into the state of Texas for an extended period of time could have a material adverse impact on our consolidated financial position, results of operations and cash flows. Texas net sales, including products containing hydroquinone, represented approximately 5% and 9% of our total net sales during the years ended December 31, 2011 and 2010, respectively.

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. Accordingly, we adjusted the sales returns and allowances provision estimated as of March 31, 2011 by $0.3 million, which was recorded as an increase to "Net sales" and as a reduction to "Accrued liabilities" during the three months ended June 30, 2011. As of December 31, 2011, we did not expect to receive any additional sales returns related to the matter.

Exit of Pharmacy Channel. In August 2008, we entered the pharmacy channel for the first time by launching SoluCLENZ Rx Gel, a solubilized BPO gel for the treatment of acne, which was available only by prescription. However, after closely monitoring the progress of the launch and weekly sales data, we determined that the distribution of a single prescription product through the pharmacy channel and the ongoing investment to support that channel had become cost-prohibitive. Accordingly, on April 13, 2009, we announced that we would no longer sell SoluCLENZ in the pharmacy channel.

In connection with the exit of the pharmacy channel, during the year ended December 31, 2009, we recorded charges approximating $0.8 million, related to contractual deposits, obsolete selling materials and other contract termination fees (included within "Selling, general and administrative expenses" in the Consolidated Statements of Income). In addition, during the year ended December 31, 2009, we reserved approximately $0.4 million in inventory (included within "Cost of sales" in the Consolidated Statements of Income). During the quarter ended December 31, 2009, revenue for the remaining units dispensed during the period was fully recognized as we informed our SoluCLENZ distributors that we were no longer going to issue credit for returned inventory.

Sales. Our total net sales have grown from $112.8 million for the year ended December 31, 2010 to $114.1 million for the year ended December 31, 2011. Factors contributing to our sales generation include:

· Our professional marketing efforts to physicians. Our professional sales force targets physicians who are focused on aesthetic and therapeutic skin care and educates them on how to best provide our products to their patients. Our professional sales force also provides education to physicians, aestheticians, other staff and patients about the benefits of promoting skin health. We have increased our sales force from 96 employees as of January 1, 2006 to 126 employees as of December 31, 2011. We will continue to invest in expanding our sales force as warranted by the success of new product offerings and continued core product growth. We currently do not have plans to hire a substantial number of employees in 2012.

· Strong growth in the aesthetic skin care market. We believe the market demand for cosmetic facial procedures reflects a growing desire and acceptance among the aging population to seek aesthetic facial products and procedures from their physicians. With our leading position in the physician-dispensed channel, the clinically proven aesthetic benefits of our products and the potential of our systems to enhance or complement many other facial procedures, we believe we are well positioned to meet this growing patient demand.

· Conducting clinical studies on our products. We have completed 105 clinical studies since 2003 to demonstrate the efficacy of our products. We believe that these clinical studies provide our products added scientific credibility in the physician-dispensed market. We currently plan to initiate approximately 29 additional clinical studies in 2012.

· International. We have formal distribution agreements with 18 distributors and one licensing partner and a trademark and product know-how license agreement in the OTC market in Japan. Currently, those distributors have sales activities in approximately 43 countries, with the most successful distributors in 2011 coming primarily from the Europe, Middle East and Southeast Asia.

Results of operations. We commenced operations in 1997, and as of December 31, 2011, we had accumulated earnings of $37.4 million. We reported net income of $10.0 million and $9.5 million for the years ended December 31, 2011 and December 31, 2010, 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 are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 returns and allowances, accounts receivable, inventory, goodwill and other intangible assets. We use authoritative pronouncements, 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, it is possible that our actual results will differ significantly from these estimates. Our significant accounting policies are further described in Note 2 of Notes to Consolidated Financial Statements included elsewhere in this Report.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue recognition. We recognize revenues for our physician-dispensed segment in accordance with ASC 605, Revenue Recognition ("ASC 605"), which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. ASC 605 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies. We recognize revenue when: (i) persuasive evidence of an arrangement exists; (ii) shipment of products has occurred or services have been rendered; (iii) the sales price charged is fixed or determinable; and
(iv) collection is reasonably assured. Our shipment terms are FOB shipping point as outlined in our sales agreements.

Our domestic sales agreements do not provide for rights of return or price protection. However, we may approve returns on a case-by-case basis at our discretion. Certain international distribution agreements do provide for rights of return and price protection. Generally, such return rights are for a period of not more than 90 days after the products have been shipped to the distributors. In accordance with ASC 605-15, Revenue Recognition - Products ("ASC 605-15"), we continuously monitor and track product returns and record a provision for the estimated amount of such returns, based on historical experience and any notification we receive of pending returns. We do not grant any warranty provisions on our products. We provide for discounts and allowances based on historical experience at the time revenue is recognized as a reduction to revenue. To date, such provisions have approximated management's estimates. Other than our allowance for sales returns, the only estimates that we have to make regarding revenue recognition pertain to the collectability of the resulting receivable, both of which are discussed below.

We grant price protection rights to certain international distributors. Such price protection rights require us to pay the distributor if there is a reduction in the list price of our products. Price protection payments would be required for the distributor's inventory on-hand or in-transit on the date of the price reduction, for a period not to exceed 90 days prior to the date of the price reduction. We have not recorded a liability in connection with such price protection rights as we have never reduced the list prices of our products.

In September 2002, we entered into a licensing agreement, as amended in December 2008, with Rohto (see Note 8 of Notes to Consolidated Financial Statements), a large Japan-based company that specializes in the distribution and marketing of OTC medical oriented products in the drug store and retail channels. In January 2006, we entered into a three-year licensing agreement, renewable by mutual agreement for additional one year periods, with Tokyo Beauty Center, a diversified Japanese consumer products and services company, which also owns and operates a large chain of aesthetic spas in Japan. In January 2012, we did not exercise the option to renew this licensing arrangement. Royalty revenue is recognized as earned and is based upon a predetermined rate within the respective licensing agreement.

As noted earlier, during the year ended December 31, 2008, we entered the pharmacy channel for the first time by launching SoluCLENZ Rx Gel, which was available only by prescription. We sold SoluCLENZ to pharmaceutical wholesalers, who had the right to return purchased product prior to the units being dispensed through patient prescriptions. On April 13, 2009, we announced that we would no longer sell SoluCLENZ in the pharmacy channel. Revenue for this product was . . .