FORM 10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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

For the fiscal year ended SEPTEMBER 24, 2005

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

For the transition period from ______ to ______

Commission file No. 0-15338

PHOTOWORKS, INC.

(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes: [ ] No: [ X ]

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

As of September 24, 2005 the aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant was $12,272,774 based on the last sale price of the Registrant’s Common Stock as reported by the Over the Counter Bulletin Board Market.

As of September 24, 2005, there were issued and outstanding 19,794,672 shares of Common Stock, par value $.01 per share.

Documents incorporated by reference:

Portions of the registrant's definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders, to be held in 2006, are incorporated by reference into Part III.

Page 1 of 60

PART I

ITEM 1 - BUSINESS

Description of Business

PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is an internet based digital photo-publishing company. The company’s web based services allow PC and Mac users to create hard bound photo books, customized greeting cards, calendars, prints and other photography sourced products straight from their computers.

PhotoWorks was incorporated in Washington State in June 1976. The executive offices are located at 1260 Sixteenth Avenue West, Seattle, Washington 98119, and the telephone number is (206) 281-1390. References to PhotoWorks and the Company in this Report include PhotoWorks, Inc., and its wholly-owned subsidiaries.

Forward-Looking Information

This report contains forward-looking statements that relate to future events, product or service offerings or the future financial performance of the Company. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue" or the negative of such terms and other comparable terminology. These statements only reflect expectations and estimates of the Company's management. Actual events or results may differ materially from those expressed or implied by such forward-looking statements. Relevant risks and uncertainties include, among others, those discussed in Item 1 of Part 1 under the heading "Risk Factors" and elsewhere in this report and those described from time to time in the Company's other filings with the Securities and Exchange Commission, press releases and other communications. All forward-looking statements contained in this report reflect PhotoWorks' expectations at the time of this report only, and the Company disclaims any responsibility to revise or update any such forward-looking statement except as may be required by law.

Overview

Fiscal year 2005 completes the restructuring phase of the 30 year old company. We successfully repositioned the Company from a legacy mail order film processing business to an internet based digital photo-publishing company. Sales of our new photo book products and other digital-photo publishing sales during the holiday season were strong and we believe the Company is well positioned to deliver on our growth objectives for fiscal year 2006.

Total net revenues decreased 32% to $13,723,000 in fiscal 2005 compared to $20,160,000 in fiscal 2004. The decrease in total net revenues is due to the industry-wide decline in film-based processing volumes, a trend which will continue. However, and more importantly, net revenues from digital-based processing increased in fiscal 2005 by 24% to $3,785,000 compared to $3,054,000 in fiscal 2004. Gross margin as a percentage of net revenues for fiscal 2005 increased to 28.7% compared to 27.6% in fiscal 2004.

The Company reported a net loss of $7,370,000, or a loss of $0.96 per share, for the fiscal year 2005 compared to a net loss of $1,672,000, or a net loss of $0.50 per share for the fiscal year 2004. Net loss for fiscal 2005 is the result of the decrease in total net revenues, unabsorbed overhead costs, valuation adjustments related to our recapitalization during 2005 and accruals for restructuring expenses related to the outsourcing of the entire production capacity, the move to new offices and losses on impairment of assets.

PhotoWorks embarked on a comprehensive restructuring plan in late 2003 upon the appointment of new CEO Philippe Sanchez. Following a three-step plan (“Stop the bleeding”, “Rebuild” and “Grow”), the management team completed the re-organization from a mail-order film processing business to a leading internet based photo-publishing service focused on the higher margin – and rapidly growing – digital photography market.

During the fiscal year 2005, PhotoWorks achieved five critical accomplishments:

The Company eliminated all production overhead costs by outsourcing its film processing operations during the 2nd and 3rd quarter 2005 and by outsourcing its digital print operation during the 4th quarter 2005. As of September 24, 2005, the Company employed a staff of 55 consisting primarily of web engineers, marketing professionals, customer service and a small administration department. This is down from 248 employees in October 2003, most of them were in manufacturing capacity. Furthermore, PhotoWorks has successfully terminated its lease of substantial excess manufacturing space and is re-locating to better and more efficient headquarters at lower costs. Costs related to the layoffs, shut down and write off of redundant process equipments as well as costs related to the move are provided for in the 4th quarter of 2005.

In July 2005, PhotoWorks secured shareholders approval for a recapitalization plan negotiated with the holders of the subordinated debt and holders of the preferred shares. This plan resulted in:

As a result, the Company emerged with a strengthened balance sheet, free of long-term debt and a single class common stock capital structure.

During 2005, PhotoWorks focused its web development efforts on improving the customer experience online and, in October 2005, launched a new service that significantly improves the ease of creating hardbound photo books for both PC and Mac users. Through the course of 2005, the Company also completed the migration of more than 275 million customer images to a cost efficient and highly scalable storage platform.

In anticipation of the Holiday season, PhotoWorks unveiled a new line of unique books, industry defining signature cards and Photo Clutch™ - a small hardback photo book encased in a leather wallet. PhotoWorks’ products appeared in a variety of media including: The TODAY Show, the Washington Post, Real Simple Magazine, InStyle Magazine, PC Magazine and MacWorld.

PhotoWorks augmented its leadership team with the appointment of Werner Reisacher as Vice President, CFO and COO in June 2005. Reisacher joined Tom Kelley, VP and CMO and Jerry Barber, VP and CTO who joined the team in 2004. Sixteen key management positions were also filled in 2005 and two directors joined a newly restructured Board.

Business Outlook

Fiscal year 2005 marks the completion of the restructuring phase, where the Company’s focus was on disbanding the legacy film business, streamlining its operations and building its core competencies in the digital photo-publishing business. Looking ahead, management believes PhotoWorks is well positioned to gain share in the rapidly growing digital photography market and will focus its effort on accelerating growth in fiscal year 2006 while continuing to optimize operations for sustained performance.

Operating Strategy

The principal elements of our operating strategy are the introduction of innovative, convenient, easy-to-use digital services and products and a commitment to service and customer satisfaction. We will continue to emphasize excellent service, professional quality, and convenience rather than try to be a low-price provider.

Management believes that providing high-quality services to the digital market is the key driver to our success. We believe that consumers will continue to convert from traditional film-based cameras to digital cameras. We will seek opportunities to transition our operations to focus on digital services and products.

We have structured our operations so that all of our product processing and delivery has been outsourced to third party vendors. We believe this strategy will allow us to grow our business without significant additional capital investment for plant and equipment and to adjust our expense structure rapidly to match our revenues.

We believe that PhotoWorks can distinguish itself from its competitors through product differentiation. We believe that our complementary value-added services and products, including Custom Photo Books, Signature Photo Cards and keepsakes, promote customer loyalty and increase customer demand. Our commitment to ease of use and expanded service and product offerings is intended to support this strategy.

Risk Factors

In addition to the other information in this filing, the following risk factors should be carefully considered in evaluating us and our business. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be harmed.

We may be unsuccessful in increasing revenues from digital services, which would adversely affect our results of operations

Our business model emphasizes the sale and distribution of products and services for users of digital cameras. We have developed additional products and services designed to establish us as the choice for digital camera users for printing, archiving, sharing, viewing and managing personal digital images. However, a number of other companies are attempting to establish this position. Competitors in this area include Ofoto (a Kodak Company), Snapfish, Shutterfly and other traditional providers of photofinishing services. We may not be successful against this competition. The digital printing market has not been fully established. Even if we establish a strong position among consumers for digital products and services, we may not be able to generate significant revenues from this market.

If we do not obtain additional financing, our growth plans may be adversely affected

The Company has a shareholders' deficit at September 24, 2005 of ($189,000) and has incurred substantial operating losses in each of the last four years. The Company is in the process of raising additional capital to finance its growth plans and to provide working capital. No assurance can be given that such capital will be available, or if available, on terms that will not significantly dilute current shareholders.

We expect continued declines in film-based processing that will adversely affect our revenues

We have experienced significant declines in revenues from film-based processing in each of the last four fiscal years and we believe this trend will continue. We believe that this is primarily attributable to declines in the mail order photofinishing market and the photofinishing industry in general. In addition, we believe the market shift away from traditional 35mm film and towards digital cameras will continue due to the declining prices for printing and the rapid increase of the digital camera markets increased availability and consumer acceptance of digital cameras. As a result, our revenues from film-based processing are likely to continue to decline for the foreseeable future.

We may not be able to retain existing customers or acquire new customers at a reasonable cost

Future revenues and profitability depend in large part on our ability to retain our current customers and our ability to acquire new digital customers at a reasonable cost. Historically, we used direct-marketing programs offering low-priced or free introductory offers as our primary customer acquisition technique. Over the past years, the cost for these programs has increased and we have seen a decline in customer response rates. Our current marketing focuses on customer reactivation and retention and opportunities to acquire new customers through online channels at a reasonable cost. Our customer acquisition and retention efforts may not be effective. If we do not find a way to successfully acquire new digital customers, retain our current customers, or market successfully against competitors, our business, financial condition and operating results could be harmed.

We rely on key vendors, suppliers and foreign sourcing

During 2005, we have outsourced our mail order film processing and printing to District Photo. In first quarter in 2006, we have recently outsourced our digital printing to Qualex (a Kodak company) and have closed our production facilities. Our Custom Photo Books, Signature Photo Cards and keepsakes are produced by third-party vendors. The success of our business is dependent in part on the quality and service provided by our vendors. If we experience significant quality or service problems at one or more of our vendors, it could adversely affect our business.

We have no significant long-term purchase contracts or agreements to ensure continued supply, pricing or access to film, paper or chemicals. While we believe that alternate sources of third-party providers are available, it is possible that our vendors might not be able to continue to meet our requirements for services or supplies, or purchase services or supplies in sufficient quantities or on terms as favorable to us as those currently available. Also, changing to an alternate vendor or supplier may cause delays, reduced quality or other problems.

Sales of our services and products on a direct-to-consumer mail-order basis largely depend on the U.S. Postal Service and other common carriers for receipt of orders and delivery of our products. Any significant changes in the operations or prices charged by the U.S. Postal Service or other common carriers or extended interruptions in postal deliveries could harm our business, financial condition and operating results.

We may be adversely affected by actions of competitors

The market for consumer photofinishing and digital imaging services is highly competitive. Many of our competitors have substantially greater financial, technical and other resources than we have. We face competition in consumer photofinishing and digital imaging services from other direct marketers, online companies, and competitors in other distribution channels, including much larger companies. Many of these companies provide photofinishing services on a wholesale basis to independent retail outlets and, in some cases, through multiple retail outlets owned by the photofinisher or online service providers. Many of these competitors also provide photofinishing services within hours. There are no significant proprietary or other barriers to entry into the traditional photofinishing or digital imaging industry. Many of our competitors offer similar photofinishing and digital imaging services and products at lower prices and with a more rapid turnaround time than we offer. Our ability to compete effectively depends on our ability to differentiate our services by offering innovative services and products. Although we believe we are a leader in developing and marketing innovative photo-related services and products, competitors can and do provide similar services and products. There can be no assurance we will continue to compete effectively through development of innovative services and products or that we will respond appropriately to industry trends or to activities of competitors.

We may not be able to keep up with rapid technological changes in the photofinishing industry

The photography industry is currently characterized by rapidly evolving technology and consumer demand for services and products. The introduction of digital services and products that use new technologies could render existing services and products obsolete. Our future success will depend on our ability to adapt to new technologies and develop new or modify existing services, products and marketing techniques to satisfy changing consumer needs and attract new customers. The expanded use of digital cameras has had a negative impact on companies such as PhotoWorks that have primarily processed traditional film-based images and slides. The development of these or other new technologies, or failure by us to anticipate or successfully respond to such developments, could harm our business, financial condition and operating results.

Any acquisitions we make could disrupt our business and harm our financial condition

We may attempt to acquire other businesses that are compatible with our business, but we have no current understanding, agreement or arrangement to make any acquisitions. Acquisitions could result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Since we will not be able to accurately predict these difficulties and expenditures, it is possible that these costs may outweigh the value we realize from a future acquisition. Future acquisitions could result in issuances of equity securities that would reduce our shareholders' ownership interest, the incurrence of debt, contingent liabilities or amortization of expenses related to goodwill or other intangible assets and the incurrence of large, immediate write-offs.

We experience fluctuations in quarterly results

Our quarterly operating results will fluctuate for many reasons, including:

Demand for our photo-related services and products is seasonal, with the highest volume of photofinishing activity generally occurring during the summer months and holiday season. As a result, our operating results for any period do not necessarily indicate the results that can be expected for any future period. Our operating results in a future period may be below the expectations of public market analysts and investors which may cause the price of our common stock to decline.

We may be adversely affected by the outcome of litigation

We were a defendant in a claim filed by Fuji Photo Film Co., Ltd., with the International Trade Commission. Fuji alleged that a number of companies, including the Company's OptiColor subsidiary, violated patents held by Fuji on single-use cameras by bringing recycled single-use cameras into the United States for resale. The ITC Commissioners issued a final order in June 1999 prohibiting PhotoWorks and our subsidiaries from importing and selling imported recycled single-use cameras.

In 2002, the ITC determined that we violated the ITC's previous order through the importation and sale of certain newly manufactured reloadable cameras. We were assessed a penalty of $1.6 million and in September 2003, we negotiated a settlement agreement with the ITC to reduce the penalty to a total of $1,000,000. The settlement included a payment schedule of $250,000 in each of the four years beginning in July 2004.

There is a risk that Fuji could bring a civil action against us for damages for patent infringement by reason of sales of cameras that have been found in the ITC proceedings to infringe Fuji patents. If such a suit was filed against us, it could have a significantly harmful impact on our financial condition, results of operations and liquidity. We are unable to determine the probability or likelihood of such an action.

We could be required to collect taxes on the products we sell

In accordance with current industry practice, we do not currently collect sales taxes or other taxes with respect to shipments of goods into states other than Washington. One or more states may seek to impose sales or tax collection or other obligations on out-of-jurisdiction companies which engage in electronic commerce as we do. In addition, states may aggressively attempt to establish that our Company has presence (nexus) in their state which could subject our mail order business to sales or other tax collection obligations. A successful assertion by one or more states that we should collect sales or other taxes on the sale of merchandise could result in substantial tax liabilities for past sales, decrease our ability to compete with traditional retailers and otherwise harm our business.

On December 3, 2004, the Internet Tax Non-Discrimination Act (Public Law 108-435) was signed into law, extending the Internet Tax Freedom Act that had expired in November 2003. The Internet Tax Non-Discrimination Act bans taxes that unfairly single out the Internet, including: taxes on high-speed and dial-up Internet access; double taxation on products purchased over the Internet; and discriminatory taxes that treat Internet purchases differently from other types of sales.

Our management information systems and technology may not be viable

We depend on our management information systems, website and technology systems to communicate with customers, process orders, provide rapid response to customer inquiries, manage inventory, and purchase, sell and ship products efficiently. We periodically replace and upgrade certain portions of our systems software and hardware. We take a number of precautions against certain events that could disrupt our systems, including events associated with continuing software and hardware upgrades. Any damages or failures to our computer equipment, technology systems and the information stored in our data center could harm our business, financial condition, and operating results.

Governmental regulation could harm our business

Our operations, including our transmission of digital images over the Internet, are subject to regulation by the U.S. Postal Service, the Federal Trade Commission and various state, local, and private consumer protection and other regulatory authorities. In general, these regulations govern privacy, the manner in which orders may be solicited, the form and content of advertisements, information which must be provided to prospective customers, the time within which orders must be filled, obligations to customers if orders are not shipped within a specified period of time, and the time within which refunds must be paid if the ordered merchandise is unavailable or returned. Congress has enacted legislation to specifically regulate online commerce and communications and has addressed such issues as the transmission of certain materials to children, intellectual property protection, taxation, and the transmission of sexually explicit material. In addition, some states have enacted legislation that makes the transmission of certain kinds of information, such as obscene content and information that facilitates the commission of criminal acts, a crime.

Other legislation could result in additional regulation or prohibition of the transmission of certain types of content over the Internet. This legislation could result in significant potential liability to us for content transmitted over our website, as well as additional costs and technological challenges in complying with mandatory requirements. We do not assume responsibility to edit

the content of our customers' photographs, slides, digital images or personal home pages unless responding to a specific complaint. Legislation which imposes potential liability for content made available over the Internet through our website could require us to implement additional measures to reduce our exposure to such liability. This may require us to incur significant costs or discontinue certain service or product offerings. Although we carry general liability insurance, such insurance may not cover potential claims of this type or may not be adequate to compensate us for the amount of these liabilities. Any costs not covered by insurance incurred as a result of such liability or asserted liability could harm our business, financial condition and operating results.

Sales of a substantial number of shares of our common stock into the public market by major stockholders may result in significant downward pressure on the price of our common stock and could affect the ability of our stockholders to realize the current trading price of our common stock.

Sales of a substantial number of shares of our common stock in the public market could cause a reduction in the market price of our common stock. We had 19,794,672 shares of common stock issued and outstanding as of September 24, 2005. At that date, 5 shareholders owned, directly or indirectly, 72% of the outstanding common stock. If one or more of those shareholders decided to sell a significant portion of their holdings, it could cause the price of our stock to decline substantially.

Trading on the OTC Bulletin Board may be sporadic because it is not a stock exchange, and stockholders may have difficulty reselling their shares.

Our common stock is quoted on the OTC Bulletin Board. Trading in stock quoted on the OTC Bulletin Board is often thin and characterized by wide fluctuations in trading prices, due to many factors that may have little to do with the company's operations or business prospects. Moreover, the OTC Bulletin Board is not a stock exchange, and trading of securities on the OTC Bulletin Board is often more sporadic than the trading of securities listed on a quotation system like Nasdaq or a stock exchange like Amex. Accordingly, you may have difficulty reselling any of the shares you purchase from the selling stockholders. Some of our existing shareholders can exert control over us and may not make decisions that are in the best interests of all shareholders.

As of September 24, 2005, officers, directors, and shareholders holding more than 5% of our outstanding shares collectively controlled approximately 81% of our outstanding common stock. As a result, these shareholders, if they act together, would be able to exert a significant degree of influence over our management and affairs and over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. Accordingly, this concentration of ownership may harm the market price of our ordinary shares by delaying or preventing a change in control of us, even if a change is in the best interests of our other shareholders. In addition, the interests of this concentration of ownership may not always coincide with the interests of other shareholders, and accordingly, they could cause us to enter into transactions or agreements that we would not otherwise consider.

Products and Services

PhotoWorks offers a variety of unique high-quality products and services through which it seeks to differentiate itself from its competitors. Our online services offer immediate viewing and sharing of images online and quick turnaround for products and we believe we are highly competitive in this market. Mail-order photofinishing is generally longer than many alternative sources for photofinishing services and turnaround time for traditional mail-in processing services remains a competitive disadvantage for us.

PhotoWorks has an established tradition of service and product innovation for both traditional and digital camera users. Our Signature Photo Cards are differentiated from other online offerings by their high-end design and professional quality and our Custom Photo Books allow consumers to easily custom design online a personal memento of photographic memories into a professionally printed and bound book.

Customer Service and Support

The direct-to-consumer photofinishing business involves contacts with a large number of customers. We believe that customer satisfaction is critical to our ongoing success. PhotoWorks has a 100% satisfaction-guarantee policy under which we will provide a full refund if a customer's complaint cannot otherwise be resolved. As of September 24, 2005, we had a customer service staff of 15. These personnel have direct access to our database and are trained to promote certain of our services and products, as well as to answer questions regarding order status and use of PhotoWorks' digital and online services.

PhotoWorks maintains a website on the Internet (www.photoworks.com). Our current website incorporates state of the art technology with an easy to use and intuitive user experience. While online, customers may use the PhotoWorks(TM) service to privately upload, view, store, share, manage or email their photos to friends and family, and order PhotoWorks' Custom Photo Books and Signature Photo Cards, as well as keepsakes, prints and reprints. Customers may also obtain the status of their orders, access answers to frequently asked questions, and send email messages to customer service.

Technology Systems

We have implemented technology to support customer order processing, image archiving, and Internet accessibility. These services and systems use a combination of proprietary technologies and commercially available, licensed technologies. Internal development is focused on creating and enhancing the specialized, proprietary software that is unique to the business. We use a set of applications for:

Systems are designed based on industry standard architectures and have been designed to reduce downtime in the event of outages or catastrophic occurrences. The systems provide a 24-hour-a-day, seven-day-a-week availability. We use load balancing systems and redundant servers to

provide for fault tolerance.

The market in which PhotoWorks competes is characterized by rapidly changing technology, evolving industry standards, frequent new service and product announcements and enhancements, and changing customer demands. Accordingly, future success will depend on our ability to:

Failure to adapt to such changes would have a material adverse effect on our business, results of operations, and financial condition.

Historically, PhotoWorks’ software architecture was based on IBM proprietary software modules. During the fiscal year 2004, the Company started to develop an integrated front end web application and a back end data processing system. The application is JAVA based and includes an image file storage application, an e-commerce front end and fulfillment module and an integrated SQL based database application. The migration to this new software platform was completed during the fourth quarter of 2005.

Competition

PhotoWorks faces competition in the consumer digital and photofinishing market from other online and direct marketers. We also face competition in other distribution channels from companies that provide digital and photo finishing services on a wholesale basis to independent retail outlets, and from mass merchant retail outlets (such as Wal-Mart and Costco), many of which provide photofinishing services within hours. The largest of the wholesale Photofinishers are Qualex Inc. and Fuji TruColor, Inc. Management believes that the largest mail order photofinisher is District Photo Inc. (dba York, Clark Labs, Mystic Color Lab and Snapfish). We also face competition in the online digital market with competitors such as Ofoto (a Kodak Company) and Shutterfly. Many of our competitors have substantially greater financial, technical, and other resources than PhotoWorks.

We believe that our success in the digital and photography industry will be based on our ability to generate brand awareness through the introduction of innovative and differentiated products and services such as our Signature Photo Cards and Custom Photo Books. We offer premium quality and competitive prices for our digital and film-based print services. Other competitors can and do provide similar services and products. There are no significant proprietary or other barriers to entry into the digital or consumer photofinishing industry.

The digital photography industry is characterized by rapidly evolving technology and consumer demand for services and products. The introduction of photographic services and products involving new technologies could render existing services and products obsolete. Our future success will depend on our ability to adapt to new technologies and develop new or modify existing services and products to satisfy evolving consumer needs. For example, the

commercialization of digital imaging technologies is having an adverse impact on the photofinishing industry and has among other factors, accounted for our declines in revenues. The development of new technologies or any failure by us to anticipate or successfully respond to such developments could have a material adverse effect on our business, financial condition and operating results. See "Risk Factors."

Proprietary Technology

We currently market our services and products under registered and common-law trademarks and service marks, including PhotoWorks®, Seattle FilmWorks®, PhotoMail®, PhotoStreamer®, Photo Clutch ™, Pictures On Disk™, and Pictures On Disk on CD™. See "Risk Factors."

We consider a large portion of our website and infrastructure processes to be proprietary. We make limited patent filings, in part to avoid disclosure of our competitive strengths. However, we do attempt to protect our proprietary rights through a combination of copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements, restricting access to certain portions of our premises, and contractual restrictions on use and disclosure in our end-user licenses. The legal and practical enforceability and extent of liability for violations of license agreements are unclear.

This Report contains trademarks other than those of PhotoWorks.

Governmental Regulation

PhotoWorks' operations, including transmission of digital images over the Internet, are subject to regulation by the U.S. Postal Service, the Federal Trade Commission, and various state, local, and private consumer protection and other regulatory authorities. In general, these regulations govern the manner in which orders may be solicited, the form and content of advertisements, privacy issues, information which must be provided to prospective customers, the time within which orders must be filled, obligations to customers if orders are not shipped within a specified period of time and the time within which refunds must be paid if the ordered merchandise is unavailable or returned. Congress has enacted legislation to specifically regulate online commerce and communications and has addressed such issues as the transmission of certain materials to children, intellectual property protection, taxation, and the transmission of sexually explicit material. In addition, some states have enacted legislation that makes the transmission of certain kinds of information, such as obscene content and information that facilitates the commission of criminal acts, a crime.

Legislation enacted by Congress and the state legislatures could result in additional regulation or prohibition of the transmission of certain types of content over the Internet or in the imposition of taxes or fees on transactions conducted over the Internet. This could result in significant potential liability to PhotoWorks, as well as additional costs and technological challenges in complying with mandatory requirements. See "Risk Factors."

Environmental Compliance

As of November 7, 2005, all of our photofinishing is provided by third party vendors. Prior to that date, our photofinishing operations involved the use of several chemicals which are subject

to federal, state and local governmental regulations relating to the storage, use, handling and disposal of such chemicals. We actively monitored our compliance with applicable regulations and work with regulatory authorities to ensure compliance. To the best of our knowledge, we have never received a significant citation or fine for failure to comply with applicable environmental requirements. We decommissioned and outsourced our film processing facility during fourth quarter 2005 and are in the process of getting the remaining production facility decommissioned.

Employees

As of September 24, 2005, PhotoWorks had 55 employees, of whom approximately 13 were in administration, 8 in marketing and business development, 19 in technology and development and 15 in customer service. None of our employees are covered by a collective bargaining agreement, and we believe relations with our employees are good.

Executive Officers of the Registrant

The executive officers of PhotoWorks as of December 15, 2005 were:

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Philippe Sanchez has been the President and Chief Operating Officer since October 2003 and was elected Chairman of the Board on 9/20/05. From 2001 to 2003, Mr. Sanchez was senior Vice President of Marketing at Getty Images, a leading imagery company, where he managed worldwide strategic brand initiatives. From 1995 to 2001, Mr. Sanchez worked for Nike, Inc. serving in various general management, product marketing and merchandising roles in Europe, Asia and the Americas. From 1993 to 1995, Mr. Sanchez served as a licensing manager for Disney's Consumer Products Europe and Middle East out of the company's European headquarters in Paris.

Werner Reisacher was named Vice President and Chief Financial Officer in June 2005. Werner brings more than 30 years of executive-level international experience in both the private and public sectors. Prior to joining PhotoWorks, Reisacher held the senior financial positions of CFO, Corporate Controller and Treasurer for such major U.S. and European corporations as: DHL-Danzas, SwissAir, Raytheon and GTE. Reisacher has extensive experience in re-engineering of systems and procedures, value based management solutions, Sarbanes Oxley, and Merger and Acquisition projects. A native of Switzerland, he is fluent in English, German, and French, and is passionate about photography

Thomas J. Kelley was appointed PhotoWorks' Chief Marketing Officer in June 2004. Before joining PhotoWorks, Mr. Kelley was General Manager of Consumer Marketing for RealNetworks where he was responsible for creating marketing strategies and customer acquisition programs for RealNetworks' industry-leading subscription services including RealRhapsody, SuperPass, and RealPlayer. Mr. Kelley's credentials also include more than 10

years of advertising agency experience at two of the industry's premier creative agencies. Mr. Kelley led business development and account management for OWNP Advertising in San Francisco. Prior to that, he spent 7 years at Wieden + Kennedy managing the Nike account.

Gerald R. Barber joined PhotoWorks in May 2004 after PhotoWorks acquired assets of PhotoAccess Technologies. Mr. Barber, who served as President and CEO of PhotoAccess, has more than 25 years of experience in digital imaging and Internet development in the software industry. Before co-founding PhotoAccess, Mr. Barber was Senior Director of Core Technology at Adobe, where he was responsible for delivering key technology components for all of Adobe's products. He also served as Adobe's Director of Technology Integration, and was a founding member of several key industry consortiums including the Digital Imaging Group and Object Management Group. He holds a PhD in Electrical Engineering and Computer Science from the Massachusetts Institute of Technology.

Michael F. Lass has been a Vice President since September 1988 and is currently serving as Vice President of Operations. Mr. Lass joined PhotoWorks in 1984 as Manager of Operations. From 1982 to 1984, Mr. Lass was Vice President and General Manager of Breezin' Sportswear, a manufacturer and marketer of sportswear, and, from 1980 to 1982, General Manager and a director of Mountain Safety Research, Inc., a manufacturer of outdoor recreational products.

ITEM 2 - PROPERTIES

The Company's headquarters are located in Seattle, Washington. This 45,000 square foot building which houses our digital and mail order operations is occupied under a lease which expires in September 2010. Following the completion of the outsourcing project of our entire production capacity, we were successful in negotiating a termination of this lease during the first quarter of 2006. The Company plans to move to smaller office facility in downtown Seattle in January 2006 and reduce its occupancy cost, maintenance, property tax, and utility costs.

ITEM 3 - LEGAL PROCEEDINGS

We were a defendant in a claim filed by Fuji Photo Film Co., Ltd., with the International Trade Commission. Fuji alleged that a number of companies, including the Company’s OptiColor subsidiary, violated patents held by Fuji on single-use cameras by bringing recycled single-use cameras into the United States for resale. The ITC Commissioners issued a final order in June 1999 prohibiting PhotoWorks and our subsidiaries from importing and selling imported recycled single-use cameras.

In 2002, the ITC determined that we violated the ITC’s previous order through the importation and sale of certain newly manufactured reloadable cameras. We were assessed a penalty of $1.6 million and in September 2003, we negotiated a settlement agreement with the ITC to reduce the penalty to a total of $1,000,000. The settlement included a payment schedule of $250,000 in each of the four years beginning in July 2004.

We are also involved in various routine legal proceedings in the ordinary course of our business.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

PhotoWorks held its annual meeting of shareholders on June 28, 2005. A brief description of each matter voted on and the results of the shareholder voting are set forth below:

PART II

ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK

Our common stock is traded on the Over the Counter Bulletin Board (OTCBB) under the symbol "PHTW.OB." The following table sets forth, for the periods indicated, the high and low sale prices of our Common Stock as reported on the OTCBB. All prices are adjusted for the one for five reverse stock split effective August 8, 2005.

On September 24, 2005, the last sale price reported for the Company’s common stock was $.62 per share and as of that date, the common stock was held by an estimated 4,550 shareholders with approximately 445 holders of record.

The Company has never declared or paid cash dividends on its common stock and does not anticipate paying any dividends in the foreseeable future. The Company is restricted under the covenants of a bank agreement that supports its corporate credit cards from declaring any dividends on shares of its capital stock without the bank’s prior consent.

ITEM 6 - SELECTED FINANCIAL DATA

The selected financial data set forth below with respect to the Company's consolidated statements of operations for the years ended September 24, 2005, September 25, 2004 and September 27, 2003 and the Company's consolidated balance sheets at September 24, 2005 and September 25, 2004 are derived from the audited consolidated financial statements included elsewhere in this report and should be read in conjunction with those consolidated financial statements and their related footnotes.

(in thousands, except per share and share data)

                                             Fiscal Years                                          

Consolidated Statements of Operations Data:

Net income (loss) attributable to

Weighted average shares and

Consolidated Balance Sheet Data:

See notes to consolidated financial statements.

(*) During fiscal 2002; the Company recognized $5,673,000 of income tax benefits.

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

Forward-Looking Information

This report contains forward-looking statements relate to future events, product or service offerings or the future financial performance of PhotoWorks. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of such terms and other comparable terminology. These statements only reflect expectations and estimates of PhotoWorks’ management. Actual events or results may differ materially from those expressed or implied by such forward-looking statements. Relevant risks and uncertainties include, among others, those discussed in Item 1 of Part 1 under the heading “Risk Factors” and elsewhere in this report and those described from time to time in PhotoWorks’ other filings with the Securities and Exchange Commission, press releases and other communications. All forward-looking statements contained in this report reflect expectations at the time of this report only, and PhotoWorks disclaims any responsibility to revise or update any such forward-looking statement except as may be required by law.

Controls and Procedures

As of September 24, 2005, as part of our annual internal audit, we carried out an evaluation, under the supervision of the Internal Audit Committee members, including two of our board members, the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 and 15d-14. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures are effective to timely alert them to any material information relating to the Company (including its consolidated subsidiaries) that must be included in our periodic SEC filings. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation.

We will continue to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.

Overview

PhotoWorks, Inc. (“PhotoWorks” or the “Company”) is an online photography services company. PhotoWorks offers processing and printing services to both digital and traditional camera users, primarily in the United States. PhotoWorks provides customers with the ability to store and organize photos online, share them with friends and family, and order prints, reprints, photo albums, and photo related products. In addition, customers can create unique and innovative Custom Photo Books and Signature Photo Cards offered by PhotoWorks using PhotoWorks’ state of the art website.

To promote our services and products, we rely primarily on online marketing channels and direct marketing. We believe our innovative products and commitment to customer service promote customer loyalty and increase customer demand. We strive to increase both average order size and order frequency by informing our existing customer base of our integrated array of services and products. We also believe that our online archive of customer images is a viable and economic opportunity to monetize a customer’s “personal equity” by providing image storage and management services for digital and film-based camera users and through photo output, in the form of Custom Photo Books, Signature Photo Cards, keepsakes, and digital prints and reprints. Our commitment to expanding our digital service and product offerings is intended to support this strategy. We use online channels and other direct-marketing media to communicate with prospective customers and our existing and inactive customers. We also utilize a customer relationship management system (CRM) which we installed in December 2004 to enhance our communication with new and existing customers.

Our net loss for fiscal 2005 was $7,370,000, compared to a net loss of $1,672,000 in fiscal 2004 and net loss of $4,075,000 for fiscal 2003. Our net loss for fiscal 2005 was due to a decrease in net revenues, unabsorbed overhead costs, valuation expenses related to the recapitalization in fiscal year 2005 and accruals related to the outsourcing of entire production capacity, the closure of our production facility, the move to new offices, and the revaluation of assets that out-lived their usefulness.

Cost of goods and services consist of labor, postage, supplies, and fixed costs of production related to our services, products, and third party billings for production services rendered. Marketing expenses include costs associated with customer acquisition and retention, building brand awareness, and testing of new marketing programs. Research and development expenses consist primarily of costs incurred in ongoing development of our online image management, developing online photo archiving and photo sharing services, other digital related services, and creating infrastructure necessary to support systems for customer interaction. General and administrative expenses consist of costs related to management information systems, computer operations, human resource functions, finance, legal, accounting, investor relations, and general corporate activities.

Critical Accounting Policies

Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of the financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net revenues, and expenses. Our estimates and judgments are based upon our historical experience, knowledge of economic and market factors and various other factors that we believe to be

relevant given the circumstances and our best estimates for identified one time costs relevant to the discontinuation of the in-house production capacity, the outsourcing of all production, the writing off of redundant assets and the clean up of the production facility and the move to the new office building.. Significant policies, methodologies, estimates, and the factors used therein, are reviewed on at least a quarterly basis with PhotoWorks’ Audit Committee. Actual results may differ from these estimates.

The following is a discussion of the estimates included in our financial statements that encompass matters of uncertainty, whereby different estimates could have reasonably been made or changes in such estimates could have a material impact on the financial statements of PhotoWorks.

We regularly assess the valuation of our inventory and write down those inventories that are obsolete, or in excess of forecasted usage, to their estimated realizable value. A reserve for obsolescence is also recorded against any film or paper inventories that are nearing their expiration dates. Additional reserves are recorded for slow-moving or discounted stock to the extent it is estimated the materials may go unused based on historical inventory turnover, planned changes in marketing promotions or other anticipated changes in product mix over the next year, seasonality, or other factors. Estimates of future usage are based on estimates of future sales and product mix. If actual sales or product mix differs from our estimates, we may need to record additional reserves for obsolete inventory.

Long-Lived Assets

As a result of the outsourcing of our entire production capacity, inventory items will be limited to advertising material and packaging/shipping items. The majority of these products will be stored at the vendor’s warehouse. The present inventory control system that is in place to watch off site inventory items will be used to keep track of these offsite items. Upon, the outsourcing of our entire production capacity, all production and warehousing equipment became redundant and the necessary depreciation provision was set up during the fourth quarter of 2005. In addition, management decided to include the depreciation of the capitalized assets that have outlived their usefulness. The remaining property, plant, and equipment are depreciated using the straight-line method based on the estimated useful asset lives, ranging from two to five years.

Deferred Revenues

Our deferred revenues relate to Prepaid Print Credits and the Pick Your Prints product. With prepaid print credits, customers essentially receive discounted prices on digital products by purchasing bulk quantities of print credits. No revenue is recognized at the time the print credits are purchased. The revenue is deferred until the credits are used to purchase actual products and the products have been shipped to the customer. The Pick Your Prints product, launched in late fiscal 2003, offers film developing with high-resolution scanning. For one price, the customer receives their developed negatives and subsequently orders, online, only the prints they want. The Company defers revenue from the initial film processing and scanning based on the relative fair value of the digital prints to all of the product components. This deferred revenue is recognized when customers order and are shipped their digital prints. In October 2004, this product was enhanced so that the print credits were extendable to all digital products. Given this

enhancement and the relative newness of this product offering, management does not believe it can currently estimate, with reasonable accuracy, any breakage on the above products. As more information becomes available over the life cycle of these products, management may be able to reasonably estimate a breakage factor, which may have a material impact on revenues and gross margins.

Deferred Tax Assets

We have net deferred tax assets totaling $14,220,000, comprised primarily of net operating loss carryforwards. Due to our operating losses, the uncertainty of future profits, and limitations on the utilization of net operating loss carryforwards under IRC Section 382, we have recorded a valuation allowance of $14,120,000 against our net deferred tax assets.

Contingencies

We are subject to various legal proceedings and claims (see Part I, Item 3 - Legal Proceedings and Note 12 of Notes to Consolidated Financial Statements), the outcomes of which are subject to significant uncertainty. Statement of Financial Accounting Standard (SFAS) No. 5, Accounting for Contingencies, requires that estimated amounts relating to a contingency should be recorded if it is probable that a liability or gain has been incurred and the amount can be reasonably estimated. Disclosure of a loss contingency is required if there is at least a reasonable possibility that a loss may have been incurred. We evaluate, among other factors, the degree of probability of the outcome and the ability to make a reasonable estimate of the amounts. In the third quarter of fiscal 2003, the Company was assessed a $1.6 million penalty by the International Trade Commission (“ITC”). This action and potential penalty was previously noted in the Company’s filings, but until that time, management had no basis on which to accrue a loss. In the fourth quarter of fiscal 2003, management negotiated a settlement with the ITC, lowering the penalty to approximately $875,000 and therefore, a gain was recorded in that quarter. During the second quarter of fiscal 2004, management successfully negotiated a settlement with one of its vendors for services rendered in prior periods, which resulted in a gain of approximately $738,000 in that quarter.

Results of Operations

The following table presents information from our consolidated statements of operations, expressed as a percentage of net revenues for the periods indicated.

                  Fiscal Years Ended                    

Operating expenses:

Net revenues decreased 32% to $13,723,000 in fiscal 2005 compared to $20,160,000 in fiscal 2004. Net revenues decreased 32% to $20,160,000 in fiscal 2004 from $29,416,000 in fiscal 2003. The decreases in net revenues for fiscal years 2005, 2004 and 2003 were exclusively due to declines in film-based processing volumes and this will be the overall trend for this declining line of business. Net revenues from digital-based processing increased in fiscal 2005 by 24% to $3,785,000 compared to $3,054,000 in fiscal 2004 and $2,631,000 in fiscal year 2003.

We have developed a new customer acquisition strategy and our business strategy focuses on the development of products and services in the digital market. We implemented a customer acquisition program designed to drive customers to the website, retain signed up customers and reactivate previous customers. The success of this approach is reflected in a 50% increase of the digital product line from 16% for 2003 to 2004 and 24% for 2004 to 2005.

Gross profit as a percentage of net revenues for fiscal 2005 increased to 28.7% compared to 27.6% in fiscal 2004 and 24.8% in fiscal 2003. The increase in the gross profit percentage in fiscal 2005 compared to the prior periods was primarily due to outsourcing of the film production resulting in reduced unabsorbed overhead cash. Gross profit fluctuates due to the seasonal nature of revenues and revenue per order, combined with fixed operating costs associated with equipment, facilities and fixed overhead costs related to our products and services.

Total operating expenses for fiscal 2005 were $9,901,000 compared to $7,213,000 for fiscal 2004 and $11,334,000 for fiscal 2003. The increase in operating costs in fiscal 2005 is the result of increased research and development costs to complete the transition to a new Java based software platform and a reduction in general and administrative costs as a result of the successful implementation of cost cutting projects. Fiscal 2004 operating costs also included a vendor settlement of approximately $738,000 that was recorded as a reduction in operating costs. In fiscal 2003, operating expenses included $875,000 for costs related to the settlement of a penalty assessment with the International Trade Commission (see Part I, Item 3 - Legal Proceedings). Future periods may reflect increased or decreased operating expenses due to the timing and magnitude of marketing activities as well as expenditures related to development of our digital services and products.

Marketing expenses in fiscal 2005 increased to $2,487,000 compared to $2,421,000 in fiscal 2004 and $2,662,000 in fiscal 2003. The increase in marketing expenses in fiscal 2004 were primarily due to a shift in our marketing strategy to target our customer base through retention and reactivation marketing programs compared to expenditures focused on customer acquisition. Our marketing expenses increased slightly in fiscal 2005 as we continued to test and evaluate marketing programs focused on effective customer acquisition and also improving productivity throughout the organization.

Research and development expenses in fiscal 2005 were $3,413,000 compared to $1,509,000 in fiscal 2004. Research and development expenses in fiscal 2004 were $1,509,000 compared to $2,442,000 in fiscal 2003. The increase in research and development expenditures in fiscal 2005 was primarily due to the continued upgrading of our infrastructure, launching the new website, and the completion of the migration to a Java based software platform.

General and administrative expenses decreased to $3,015,000 in fiscal 2005 compared to $3,283,000 in fiscal 2004. General and administrative expenses in fiscal 2004 decreased to $3,283,000 compared to $5,355,000 in fiscal 2003. During the second quarter of fiscal 2004, PhotoWorks, Inc. and one of its service providers reached a settlement agreement regarding disputed fees for services provided to PhotoWorks, resulting in a reduction of administrative expenses of $738,000. The decrease in general and administrative expenses in fiscal year 2005 reflects layoffs as a result of the outsourcing of the film business, the integration of the human resources department into the administration and the various costs cutting projects implemented in 2005.

Loss on impairment of tangible and intangible assets in the amount of $986,000 were incurred as a result of the necessary write-off of assets that become redundant during fiscal 2005.

Other operating expenses for fiscal 2003 included costs related to the settlement of a penalty assessment with the ITC of $875,000 (see Note 3 of Notes to Consolidated Financial Statements).

Total other expense in fiscal 2005 was $1,414,000, compared to $147,000 in fiscal 2004. This increase is mainly due to non-cash interest charges of $1,561,000 incurred by the recapitalization during fiscal 2005.

In fiscal 2004, we recorded a tax benefit of $115,000 related to refundable tax credit carrybacks for fiscal years 2001 and 2002. In fiscal 2003, we recorded net tax benefits of $92,000 related to

an AMT adjustment.

Liquidity and Capital Resources

As of September 24, 2005, our principal source of liquidity was approximately $1,872,000 of cash and cash equivalents.

The Company has experienced significant revenue declines and has incurred operating losses in the past several years. For fiscal 2005, cash flow used in operations was $4,139,000, primarily attributable to a net loss of $7,370,000. As compared to prior periods the net loss is primarily due to lower revenues, and increase in research and development expenses. In addition, the Company recognized non-operating expenses of $1,414,000. Cash and cash equivalents declined from $2,481,000 at the beginning of the fiscal year to $1,872,000 as of September 24, 2005 and the Company's current ratio declined from 1.10 to .81. The Company expects a further decline in cash and cash equivalents in fiscal 2006 primarily due to continued operating losses resulting from declines in film revenues.

Management has taken various actions to reduce operating expenses drastically and to eliminate all fixed product overhead expenses. Implementation of various cost reduction projects combined with the outsourcing of its entire production capacity resulted in the shut down of the 45,000 square foot production facility and the move to a 15,000 square foot office. The impact of the project on our general and administrative costs will be realized after the move to the new facility in the second quarter of 2006.

On July 27, 2005, PhotoWorks, Inc. consummated the sale of 3,710,575 shares of common stock and warrants to purchase 361,905 shares of common stock for an aggregate purchase price of $2,000,000. The purchase price of the common stock was $.539 per share. The exercise price of the warrants is $1.05 per share. The warrants expire in 5 years if not previously exercised.

On July 27, 2005, PhotoWorks consummated the conversion of two series of its outstanding debentures into common stock and warrants to acquire common stock. The aggregate amount of principal and accrued interest converted of $4,492,000, was converted into 8,244,478 shares of common stock and warrants to purchase 442,636 shares of common stock at an exercise price of $1.10 per share. The warrants have a term of five years.

On July 27, 2005, PhotoWorks exchanged 4,149,373 shares of common stock for all of the outstanding shares of its Series A Preferred Stock. The exchange ratio was based on a price for the common stock of approximately $3.615 per share.

Net cash used in investing activities was $511,000 in fiscal 2005 compared to $688,000 in fiscal 2004 and $256,000 in fiscal 2003. In fiscal 2005, 2004 and 2003, we purchased additional equipment to support our digital strategy.

Net cash from financing activities was $4,041,000 for fiscal 2005 compared to net cash provided of $13,000 in fiscal 2004 and net cash used of $93,000 in fiscal 2003. Net cash from financing activities in fiscal 2005 was primarily due to the $4,000,000 in cash investments into equity during fiscal 2005.

The ratio of current assets to current liabilities was 0.79 at the end of fiscal 2005 compared to 1.1

at the end of fiscal 2004. The decrease in fiscal 2005 is primarily due to the use of cash to fund operations for fiscal 2005.

As of September 24, 2005, our principal commitments consisted of obligations outstanding under non-cancelable leases and our settlement with the ITC.

Inflation

The results of our operations have not been significantly affected by inflation during the last three fiscal years.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET                            RISK

Not material.

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See pages 28 through 48.

Board of Directors

PhotoWorks, Inc.

Seattle, Washington

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We have audited the accompanying consolidated balance sheet of PhotoWorks, Inc. as of September 24, 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for the year then ended. Our audit also included the consolidated financial statement schedule listed in the index at item 15(a) for the year ended September 24, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PhotoWorks, Inc. as of September 24, 2005 and the results of its operations, stockholders equity and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the relates consolidated financial statement schedule for the year ended September 24, 2005, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects set forth therein.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company has generated recurring net losses and cash flow shortages. This condition raises substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding this issue are also discussed in Note 3. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Williams & Webster, P.S.

Certified Public Accountants

Spokane, Washington

January 9, 2005

Report of Ernst & Young LLP, Independent Registered Public Accounting Firm

Shareholders and Board of Directors

PhotoWorks, Inc.

We have audited the accompanying consolidated balance sheet of PhotoWorks, Inc. and subsidiaries (the Company) as of September 25, 2004, and the related consolidated statements of operations, shareholders' equity (deficit), and cash flows for each of the two years in the period ended September 25, 2004. Our audits also included the consolidated financial statement schedule listed in the Index at Item 15(a) for the years ended September 27, 2003 and September 25, 2004. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of PhotoWorks, Inc. and subsidiaries at September 25, 2004, and the results of their operations and their cash flows for each of the two years in the period ended September 25, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related consolidated financial statement schedule for the years ended September 27, 2003 and September 25, 2004, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Note 3, the Company has incurred recurring operating losses and has a shareholder deficit. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans as to these matters are also described in Note 3. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

Seattle, Washington

October 29, 2004

PHOTOWORKS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

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

PHOTOWORKS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)

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

PHOTOWORKS, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)

(in thousands)

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

PHOTOWORKS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(in thousands)