TABLE OF CONTENTS

 

				Page
PART I		FINANCIAL INFORMATION
Item 1.		Financial Statements (unaudited)		1
		Condensed Consolidated Balance Sheets		1
		Condensed Consolidated Statements of Operations		2
		Condensed Consolidated Statements of Cash Flows		3
		Notes to Condensed Consolidated Financial Statements		4
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		28
Item 4.		Controls and Procedures		29
PART II		OTHER INFORMATION
Item 1.		Legal Proceedings		30
Item 1A		Risk Factors		30
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		43
Item 3.		Defaults Upon Senior Securities		43
Item 4.		Submission of Matters to a Vote of Security Holders		44
Item 5.		Other Information		44
Item 6.		Exhibits		44
		Signature		45

 

 

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Note 9. Subsequent Events

Management evaluated all activity of the Company through November 2, 2009 (the issue date of these Condensed Consolidated Financial Statements) and concluded that no subsequent events have occurred that would require recognition in the Condensed Consolidated Financial Statements or disclosure in Notes to Condensed Consolidated Financial Statements.

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Caution Regarding Forward-Looking Statements

 

The following discussion should be read in conjunction with the attached financial statements and notes thereto, and with our audited financial statements and notes thereto for the fiscal year ended December 31, 2008 as contained in our annual report on Form 10-K filed with the SEC on March 16, 2009. This quarterly report, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Throughout this report, and particularly in this Item 2, the forward-looking statements are based upon our current expectations, estimates and projections and reflect our beliefs and assumptions based upon information available to us at the date of this report. In some cases, you can identify these statements by words such as “may,” “might,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue,” and other similar terms. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Our actual results, performance or achievements could differ materially from those expressed or implied by the forward-looking statements. These forward-looking statements include, but are not limited to, statements relating to our future financial performance, the ability to grow our business, increase our revenue, manage expenses, generate additional cash, achieve and maintain profitability, develop and commercialize existing and new products and applications, and improve the performance of our worldwide sales and distribution network, and the outlook regarding long term prospects. These forward-looking statements involve risks and uncertainties. The cautionary statements set forth below and those contained in Part II, Item 1A – “Risk Factors” commencing on page 30, identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution you to not place undue reliance on these forward-looking statements, which reflect management’s analysis and expectations only as of the date of this report. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.

 

Introduction

 

The Management’s Discussion and Analysis, or MD&A, is organized as follows:

 

·

Executive Summary. This section provides a general description and history of our business, a brief discussion of our product lines and the opportunities, trends, challenges and risks we focus on in the operation of our business.

·

Critical Accounting Policies and Estimates. This section describes the key accounting policies that are affected by critical accounting estimates.

·

Recent Accounting Guidance. This section describes the issuance and effect of new accounting pronouncements that are and may be applicable to us.

·

Results of Operations. This section provides our analysis and outlook for the significant line items on our Consolidated Statements of Operations.

·

Liquidity and Capital Resources. This section provides an analysis of our liquidity and cash flows, as well as a discussion of our commitments that existed as of September 30, 2009.

Executive Summary

 

Company Description. We are a global medical device company engaged in the design, development, manufacture, marketing and servicing of laser and other light-based aesthetics systems for practitioners worldwide. We offer products on three platforms—Xeo, CoolGlide, and Solera— for use by physicians and other qualified practitioners to allow our customers to offer safe and effective aesthetic treatments to their customers.

 

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Our corporate headquarters and U.S. operations are located in Brisbane, California, from where we conduct our manufacturing, warehousing, research and development, regulatory, sales and marketing, service, and administrative activities. In the United States, we market, sell and service our products primarily through direct sales and service employees and through a distribution relationship with PSS World Medical Shared Services, Inc., a wholly owned subsidiary of PSS World Medical, or PSS, which has over 700 sales representatives serving physician offices throughout the United States. In addition, we also sell certain items, like Titan hand piece refills and marketing brochures, through the internet.

 

International sales are generally made through direct sales employees and through a worldwide distributor network in over 30 countries. Outside the United States, we have a direct sales presence in Australia, Canada, France, Japan, Spain, Switzerland and the United Kingdom.

 

Products. Our revenue is derived from the sale of Products, Upgrades, Service and Titan hand piece refills. Product revenue represents the sale of a system, which consists of one or more hand pieces and a console that incorporates a universal graphic user interface, a laser and/or other light-based module, control system software and high voltage electronics. However, depending on the application, the laser or other light-based module is sometimes contained in the hand piece, such as with our Pearl and Pearl Fractional applications, instead of in the console. We offer our customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications to their system as their practice grows. This enables customers to upgrade their systems whenever they want and provides us with a source of recurring revenue, which we classify as Upgrade revenue. Service revenue relates to amortization of pre-paid service contract revenue and receipts for services on out-of-warranty products. Titan hand piece refill revenue is associated with our Titan hand piece which requires replacement of the optical source after a set number of pulses has been used.

 

Significant Business Trends. We believe that our ability to grow revenue has been, and will continue to be, primarily dependent on the following:

 

·

Investments made in our global sales and marketing infrastructure.

·

Use of clinical results to support new aesthetic products and applications.

·

Enhanced luminary development and reference selling efforts (to develop a location where our products can be displayed and used to assist in selling efforts).

·

Customer demand for our products and consumer demand for the applications they offer.

·

Marketing to physicians in the core dermatology and plastic surgeon specialties, as well as outside those specialties.

·

Generating Service, Upgrade and Titan hand piece refill revenue from our growing installed base of customers.

 

Our U.S. revenue decreased 49% for the three months and 54% for the nine months ended September 30, 2009, compared to the same periods in 2008, and our international revenue decreased 24% for the three months and 28% for the nine months ended September 30, 2009, compared to the same periods in 2008. International revenue as a percent of total revenue was 60% for the three months and 59% for the nine months ended September 30, 2009, compared with 50% for the three months and 48% for the nine months ended September 30, 2008. We believe that the decline in U.S. and international revenue was primarily attributable to the global recession that has caused our prospective customers to be reluctant to spend significant amounts of money on capital equipment during these unstable economic times. Historically a significant portion of our U.S. revenue was sourced from the non-core market of practitioners such as primary care physicians, gynecologists and physicians offering aesthetic treatments in spa environments. We believe our U.S. revenue declined greater than our international revenue, because the recession impacted the U.S. market ─ and particularly the non-core market ─ more severely than our international market. Further, we also believe that those prospective customers who do not have established medical offices, are finding it more difficult to obtain credit financing, which also contributed to the reduced U.S. revenue.

 

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Our service revenue increased 10% for the three months and 19% for the nine months ended September 30, 2009, compared to the same periods in 2008. Service contract amortization is the primary component of our total service revenue. Due to an increasing installed base of customers, our revenue from contract amortization has consistently increased. However, our deferred service revenue balance decreased by $3.0 million, or 26%, to $8.6 million as of September 30, 2009, compared to December 31, 2008. We believe, this decline was primarily attributable to: (i) fewer customers purchasing extended service contracts in response to improved product liability and the tougher economy, (ii) a decrease in unit sales volume in the U.S. that historically included an element of deferred revenue for service contracts beyond our standard warranty terms; (iii) a shift by customers towards purchasing more quarterly, rather than annual or multi-year, service contracts and (iv) a reduction of our service contract pricing, but including prorate charges for hand piece usage, which resulted in a reduction of our deferred service revenue balance as of September 30, 2009. With the reconfiguring of our service contracts to include prorate charges for hand piece usage during the service coverage period, we expect that in the long term, there will be an increase in revenue derived from hand piece sales which would offset the service contract amortization decline resulting from lower priced contracts being sold.

 

Our gross margin increased slightly to 60% for the three months ended September 30, 2009, compared to 59% for the same period in 2008, and decreased to 58% for the nine months ended September 30, 2009, compared to 61% for the same period in 2008. This decrease in gross margin for the nine months ended September 30, 2009, was due primarily to: (i) lower overall revenue, due to lower volume, which resulted in reduced leverage of our manufacturing and service department expenses; (ii) higher Service and Titan refill revenue as a percentage of our total revenue, which has a lower gross margin than our total revenue; and (iii) higher international distributor revenue as a percentage of total revenue, which has a lower gross margin than our direct business; partially offset by (iv) reduced manufacturing expenses resulting primarily from headcount reductions and improved product reliability.

 

Our sales and marketing expenses, as a percentage of net revenue, remained flat at 42% for the three months ended September 30, 2009, compared to the same period in 2008, and increased to 47% for the nine months ended September 30, 2009, compared to 44% for the same period of 2008. This increase in expenses as a percentage of net revenue for the nine months ended September 30, 2009, was due primarily to lower revenue in the nine months ended September 30, 2009, compared to the same period in 2008. In absolute dollars, sales and marketing expenses decreased by $3.0 million to $5.1 million for the three months and decreased by $10.6 million to $18.2 million for the nine months ended September 30, 2009, compared to same periods in 2008. These decreases in absolute dollars were due primarily to reduced personnel expenses in the United States, attributable to lower headcount, and reduced sales commission expenses resulting from lower revenue.

 

Our research and development (R&D) expenses, as a percentage of net revenue, increased to 14% for the three months ended September 30, 2009, compared to 10% for the same period in 2008, and increased to 13% for the nine months ended September 30, 2009, compared to 9% for the same period in 2008. These increases in expenses as a percentage of net revenue were due primarily to lower revenue in the three and nine months ended September 30, 2009, compared to the same period in 2008. In absolute dollars, R&D expenses decreased by $144,000 to $1.7 million for the three months and decreased by $695,000 to $4.9 million for the nine months ended September 30, 2009, compared to the same periods in 2008. These decreases in absolute dollars were due primarily to lower material spending resulting from one of our products under development in our R&D pipeline nearing commercialization. During the initial phases of the development of a product, material expenditure is significantly higher due to the design and development of a prototype, however, in the later stages of the product development efforts are mostly labor intensive.

 

General and administrative (G&A) expenses, as a percentage of net revenue, increased to 17% for the three months ended September 30, 2009, compared to 13% for the same period in 2008, and increased to 22% for the nine months ended September 30, 2009, compared to 13% for the same period in 2008. These increases in expenses as a percentage of net revenue was due primarily to lower revenue in the three and nine months ended September 30, 2009, compared to the same period in 2008. In absolute dollars, G&A expenses decreased by $462,000 to $2.1 million for the three months and decreased by $290,000 to $8.3 million for the nine months ended September 30, 2009, compared to the same periods in 2008. The decrease in G&A expenses for the three months ended September 30, 2009, was due primarily to a decrease in personnel expenses and legal, audit, tax, and consulting fees. The decrease in G&A expenses for the nine months ended September 30, 2009, was due primarily to a decrease in legal, audit, tax, and consulting fees, and other legal expense.

We are a defendant in a Telephone Consumer Protection Act class action lawsuit. See Part II, Item 1 – Legal Proceedings below. We have included $850,000 in our Condensed Consolidated Statement of Operations for the nine months ended September 30, 2009 for the estimated cost of the tentative settlement, net of administrative expenses and amounts that may be recoverable from our insurance carrier.

 

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In response to the current economic environment, we reduced our company-wide workforce by approximately 12% in April 2009 and implemented other cost-reduction measures in the first half of 2009. The headcount reductions impacted all departments and functions and resulted in restructuring charges of approximately $646,000 in our second quarter ended June 30, 2009. As of June 30, 2009, there were no service requirements outstanding from the employees who were affected. As a result of these cost-reduction measures our third quarter 2009 quarterly operating expenses declined, compared to our first and second quarter 2009 operating expenses.

 

We recognized an income tax provision of $12.1 million and $9.2 million for the three months and nine months ended September 30, 2009, respectively, despite losses before taxes. The year-to-date provision is primarily due to the recording of a valuation allowance of $10.2 million on our U.S. deferred tax assets as of September 30, 2009. The valuation allowance was recorded at the end of the third quarter of 2009 to reduce certain U.S. federal and state net deferred tax assets to their anticipated realizable value. The valuation allowance was offset by $969,000 of certain tax benefits resulting from losses generated during fiscal 2009 that can be carried-back to prior periods. Also, included in the third quarter 2009 provision is the reversal of $3.1 million tax benefit primarily related to net operating losses previously recognized in the first and second quarters of 2009. See “Provision (Benefit) for Income Taxes” below for further discussion.

Factors that May Impact Future Performance.

Our industry is impacted by numerous competitive, regulatory and other significant factors. Our industry is highly competitive and our future performance depends on our ability to compete successfully. Additionally, our future performance is dependent upon our ability to continue to develop new products and innovative technologies, obtain regulatory clearances for our products, protect the proprietary technology of our products and our manufacturing processes, manufacture our products cost effectively, and successfully market and distribute our products in a profitable manner. If we fail to execute on the aforementioned initiatives, our business would be adversely affected. A detailed discussion of these and other factors that could impact our future performance are provided in Part II, Item 1A “Risk Factors” below.

 

Critical Accounting Policies and Estimates.

 

The preparation of our Condensed Consolidated Financial Statements and related disclosures in conformity with generally accepted accounting principles in the United States, or GAAP, requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. These estimates, judgments and assumptions are based on historical experience and on various other factors that we believe are reasonable under the circumstances. We periodically review our estimates and make adjustments when facts and circumstances dictate. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected.

 

Critical accounting policy and estimates, as defined by the SEC, are those that are most important to the portrayal of our financial condition and results of operations and require our management’s most difficult and subjective judgments and estimates of matters that are inherently uncertain. The accounting policies that we consider to be critical, subjective, and requiring judgment in their application are summarized in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2008 filed with SEC on March 16, 2009. There have been no significant changes to those accounting policies and estimates disclosed in our Form 10-K, except for the following policies that were adopted in 2009 and discussed below.

Fair Value Measurement of our Long Term Auction Rate Securities Investments

We hold a variety of interest bearing auction rate securities (ARS) that represent investments in pools of student loan assets. At the time of acquisition, these ARS investments were intended to provide liquidity through an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. Since February 2008, uncertainties in the credit markets affected our ARS investments and auctions for some of ARS have continued to fail to settle on their respective settlement dates while some have been redeemed in full at their respective par values. The current portfolio of investments shown as “Long term investments” in our Condensed Consolidated Financial Statements represents those investments that are not currently liquid and we will not be able to access these funds until a future auction of these investments is successful, a buyer is found outside of the auction process or the issuer refinances their debt. Maturity dates for these ARS investments range from to 2028 to 2043.

 

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At September 30, 2009, total financial assets measured and recognized at fair value were $101.8 million and of these assets, $7.3 million, or 7%, were ARS that were measured and recognized using significant unobservable inputs (Level 3). During the nine months ended September 30, 2009, as a result of the redemption of $4.1 million at their full par value, we transferred $2.2 million of Level 3 assets into cash and cash equivalents (Level 1) and $155,000 of Level 3 assets into marketable investments (Level 2). This redemption resulted in a gain of $1.9 million being recorded to accumulated comprehensive income (loss) for the nine months ended September 30, 2009.

 

As of September 30, 2009, we had $8.9 million par value ($7.3 million fair value) of long-term ARS investments and $155,000 par value of ARS recorded in marketable investments. The aggregate loss in value is included as an unrealized loss in accumulated other comprehensive income (loss). Given observable market information was not available to determine the fair values of our ARS portfolio, we valued these investments based on a discounted cash flow model. While our ARS valuation model was based on both Level 2 (credit quality and interest rates) and Level 3 inputs, we determined that the Level 3 inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates. The expected future cash flows of the ARS were discounted using a risk adjusted discount rate that compensated for the illiquidity. Projected future cash flows over the economic life of the ARS were modeled based on the contractual penalty rates for the security added to a tax adjusted LIBOR interest rate curve. The discount rates that were applied to the cash flows were based on a premium over the projected yield curve and included an adjustment for credit, illiquidity, and other risk factors. See Note 2 “Balance Sheet Details- Fair Value of Financial Instruments” in Notes to Condensed Consolidated Financial Statement in Part I, Item 1 of this Form 10-Q for more information.

 

The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact the valuation include duration of time that the ARS remain illiquid, changes to credit ratings of the securities, rates of default of the underlying assets, changes in the underlying collateral value, market discount rates for similar illiquid investments, and ongoing strength and quality of credit markets. If the auctions for our ARS investments continue to fail, and there is a further decline in their valuation, then we would have to: (i) record additional reductions to the fair value of our ARS investments; (ii) record unrealized losses in our accumulated comprehensive income (loss) for the losses in value that are associated with market risk; and (iii) record an other-than-temporary-impairment charge in our Consolidated Statement of Operations for the loss in value associated with the worsening of the credit worthiness (credit losses) of the issuer, which would reduce future earnings and harm our business.

We had no non-financial assets or liabilities measured at fair value as of September 30, 2009.

Recognition and Presentation of Other-Than-Temporary-Impairments

We review our impairments on a quarterly basis in order to determine the classification of the impairment as “temporary” or “other-than-temporary.” Beginning April 1, 2009, impairment recognition applies only to fixed maturity investments that are subject to the other-than-temporary impairments. If an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is other-than-temporarily impaired and the full amount of the impairment is required to be recognized as a loss through earnings. Otherwise, losses on securities which are other-than-temporarily impaired are separated into: (i) the portion of loss which represents the credit loss; or (ii) the portion which is due to other factors.

 

The credit loss portion is recognized as a loss through earnings while the loss due to other factors is recognized in other comprehensive income (loss), net of taxes and related amortization.

 

With respect to the ARS that we held as of April 1, 2009, we determined that the cumulative effect adjustment required to reclassify the non-credit portion of previously recognized other-than-temporarily impaired adjustments was $3.5 million. Therefore, we increased our accumulated earnings and decreased our accumulated other comprehensive income (loss) by the $3.5 million cumulative effect adjustment. With respect to the $9.1 million of par value ARS investments held as of September 30, 2009, the unrealized losses included in accumulated comprehensive income (loss) was $1.6 million.

  

Recently Adopted and Recently Issued Accounting Guidance

For a full description of recent accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition see Note 1 “Summary of Significant Accounting Policies – Recent Accounting Guidance” in Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q”.

 

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Results of Operations

 

The following table sets forth selected consolidated financial data for the periods indicated, expressed as a percentage of net total revenue.

 

		Three Months Ended  September 30,								Nine Months Ended  September 30,
		2009				2008				2009				2008
Operating Ratio:
Net revenue			100%				100%				100%				100%
Cost of revenue			40%				41%				42%				39%
Gross profit			60%				59%				58%				61%
Operating expenses:
Sales and marketing			42%				42%				47%				44%
Research and development			14%				10%				13%				9%
General and administrative			17%				13%				22%				13%
Litigation settlement			—%			—%					2%				—%
Total operating expenses			73%				65%				84%				66%
Loss from operations			(13%	)			(6%	)			(26%	)			(5%	)
Interest and other income, net			2%				3%				4%				4%
Other-than-temporary impairment on long term investments			—%				(12%	)			—%				(3%	)
Loss before income taxes			(11%	)			(15%	)			(22%	)			(4%	)
Provision (benefit) for income taxes			100%				(1%	)			24%				0%
Net loss			(111%	)			(14%	)			(46%	)			(4%	)

Net Revenue

 

		Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)		2009			% Change			2008				2009			% Change			2008
Revenue mix by geography:
United States		$	4,825		(49%	)		$	9,498			$	15,721		(54%	)		$	34,266
International			7,346		(24%	)			9,612				22,545		(28%	)			31,216
Consolidated total revenue		$	12,171		(36%	)		$	19,110			$	38,266		(42%	)		$	65,482
United States as a percentage of total revenue			40%						50%				41%						52%
International as a percentage of total revenue			60%						50%				59%						48%
Revenue mix by product category:
Products		$	6,322		(51%	)		$	12,920			$	20,024		(57%	)		$	46,610
Upgrades			1,352		(31%	)			1,948				4,307		(32%	)			6,333
Service			3,210		10%				2,920				9,860		19%				8,311
Titan hand piece refills			1,287		(3%	)			1,322				4,075		(4%	)			4,228
Consolidated total revenue		$	12,171		(36%	)		$	19,110			$	38,266		(42%	)		$	65,482

 

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Our U.S. revenue decreased 49% for the three months and 54% for the nine months ended September 30, 2009, compared to the same periods in 2008, and our international revenue decreased 24% for the three months and 28% for the nine months ended September 30, 2009, compared to the same periods in 2008. International revenue as a percent of total revenue was 60% for the three months and 59% for the nine months ended September 30, 2009, compared with 50% for the three months and 48% for the nine months ended September 30, 2008. We believe that the decline in U.S. and international revenue was primarily attributable to the global recession that has caused our prospective customers to be reluctant to spend significant amounts of money on capital equipment during these unstable economic times. Historically a significant portion of our U.S. revenue was sourced from the non-core market of practitioners such as primary care physicians, gynecologists and physicians offering aesthetic treatments in spa environments. We believe our U.S. revenue declined greater than our international revenue, because the recession impacted the U.S. market ─ and particularly the non-core market ─ more severely than our international market. Further, we also believe that those prospective customers who do not have established medical offices, are finding it more difficult to obtain credit financing, which also contributed to the reduced U.S. revenue.

 

Our product revenue decreased 51% for the three months and 57% for the nine months ended September 30, 2009, compared to the same periods in 2008. We believe the decrease in Product and Upgrade revenue in 2009 was primarily driven by the global recession that has caused our prospective customers to be reluctant on spending significant amounts of money on capital equipment during these unstable economic times. We also believe that those prospects who do not have established medical offices are finding it more difficult to obtain credit financing.

 

Our service revenue increased 10% for the three months and 19% for the nine months ended September 30, 2009, compared to the same periods in 2008. Service contract amortization is the primary component of our total service revenue. Due to an increasing installed base of customers, our revenue from contract amortization has consistently increased. However, our deferred service revenue balance decreased by $3.0 million, or 26%, to $8.6 million as of September 30, 2009, compared to December 31, 2008. We believe, this decline was primarily attributable to: (i) fewer customers purchasing extended service contracts in response to improved product liability and the tougher economy, (ii) a decrease in unit sales volume in the U.S. that historically included an element of deferred revenue for service contracts beyond our standard warranty terms; (iii) a shift by customers towards purchasing more quarterly, rather than annual or multi-year, service contracts and (iv) a reduction of our service contract pricing, but including prorate charges for hand piece usage, which resulted in a reduction of our deferred service revenue balance as of September 30, 2009. With the reconfiguring of our service contracts to include prorate charges for hand piece usage during the service coverage period, we expect that in the long term, there will be an increase in revenue derived from hand piece sales which would offset the service contract amortization decline resulting from lower priced contracts being sold.

 

Our Titan hand piece refill revenue decreased 3% for the three months and 4% for the nine months ended September 30, 2009, compared to the same periods in 2008. We believe that these slight decreases were due primarily to a decline in consumer spending on Titan procedures in response to the global recession.

 

Gross Profit

		Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)		2009			% Change			2008				2009			% Change			2008
Gross profit		$	7,261		(36%	)		$	11,287			$	22,290		(45%	)		$	40,169
As a percentage of total revenue			60%						59%				58%						61%

 

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Our cost of revenue consists primarily of material, labor, stock-based compensation, royalty expense, warranty and manufacturing overhead expenses. Gross margin as a percentage of net revenue was 60% for the three months ended September 30, 2009 compared to 59% for the same period in 2008, and 58% for the nine months ended September 30, 2009, compared to 61% for the same period in 2008. We believe this decrease in gross margin in 2009, was primarily attributable to:

      

(i)	Lower overall revenue, due to lower volume, which resulted in reduced leverage of our manufacturing and service department expenses;

 

(ii)	Higher Service and Titan refill revenue, as a percentage of our total revenue, which has a lower gross margin than our total revenue; and

 

(iii)

Higher international distributor revenue, as a percentage of total revenue, which has a lower gross margin than our direct business; partially offset by

 

(iv)	Reduced manufacturing expenses resulting primarily from headcount reductions and improved product reliability.

 

 Sales and Marketing

		Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)		2009			% Change			2008				2009			% Change			2008
Sales and marketing		$	5,112		(37%	)		$	8,076			$	18,186		(37%	)		$	28,786
As a percentage of total revenue			42%						42%				47%						44%

 

Sales and marketing expenses consist primarily of labor, stock-based compensation, expenses associated with customer-attended workshops and trade shows, and advertising. Sales and marketing expenses decreased by $3.0 million in the three months and $10.6 million for the nine months ended September 30, 2009, compared to the same periods in 2008. This decrease was mainly attributable to the following:

 

(i)	A decrease in personnel expenses of $1.5 million for the three months and $5.7 million for the nine months ended September 30, 2009, compared to the same periods in 2008, due primarily to lower headcount and reduced sales commission expenses resulting from lower revenue;

 

(ii)	A decrease in marketing expenses associated with workshop, advertising and other promotional activities of $258,000 for the three months and $1.9 million for the nine months ended September 30, 2009, compared to the same periods in 2008; and

 

(iii)

A decrease in travel and related expense of $449,000 for the three months and $1.6 million for the nine months ended September 30, 2009, compared to the same periods in 2008, due primarily to lower headcount.

 

Sales and marketing expenses, as a percentage of net revenue, remained flat at 42% for the three months ended September 30, 2009, compared to the same period in 2008, and increased to 47% for the nine months ended September 30, 2009, compared to 44% for the same period of 2008. This increase in expenses as a percentage of net revenue for the nine months ended September 30, 2009, was due primarily to lower revenue in the nine months ended September 30, 2009, compared to the same period in 2008.

Research and Development

		Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)		2009			% Change			2008				2009			% Change			2008
Research and development		$	1,684		(8%	)		$	1,828			$	4,922		(12%	)		$	5,617
As a percentage of total revenue			14%						10%				13%						9%

 

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R&D expenses consist primarily of labor, stock-based compensation, clinical, regulatory and material costs. R&D expenses decreased by $144,000 in the three months and $695,000 for the nine months ended September 30, 2009, compared to the same periods in 2008. These decreases were due primarily to lower material spending resulting from one of our products under development in our R&D pipeline nearing commercialization. During the initial phases of the development of a product, material expenditure is significantly higher due to the design and development of a prototype, however, in the later stages of the product development efforts are mostly labor intensive.

R&D expenses, as a percentage of net revenue, increased to 14% for the three months ended September 30, 2009, compared to 10% for the same period in 2008, and increased to 13% for the nine months ended September 30, 2009, compared to 9% for the same period in 2008. These increases in expenses as a percentage of net revenue was due primarily to lower revenue in the three and nine months ended September 30, 2009, compared to the same period in 2008.

 

General and Administrative (G&A)

		Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)		2009			% Change			2008				2009			% Change			2008
General and Administrative		$	2,121		(18%	)		$	2,583			$	8,257		(3%	)		$	8,547
As a percentage of total revenue			17%						13%				22%						13%

 

General and administrative expenses consist primarily of labor, stock-based compensation, legal fees, accounting, audit and tax consulting fees, and other general and administrative expenses.

G&A expenses decreased by $462,000 in the three months ended September 30, 2009, compared to the same period in 2008, due primarily to:

 

(i)	A decrease in personnel expenses of $174,000, primarily attributable to lower headcount in the United States;

 

(ii)	A decrease in legal, audit and tax consulting fees of $121,000, due to reduced fees from the consulting firms, partially offset by higher consulting fees related to our 2009 Option Exchange Program;

 

(iii)

A decrease in bad debt expense by $91,000, a decrease in travel and related expenses of $38,000, and a decrease in facility and equipment expenses of $38,000.

 

G&A expenses decreased by $290,000 for the nine months ended September 30, 2009, compared to the same periods in 2008, due primarily to:

 

(i)	A decrease in legal, audit and tax consulting fees of $354,000, due to reduced fees from the consulting firms, partially offset by higher consulting fees related to our 2009 Option Exchange Program; and

 

(ii)	A decrease in product litigation settlement expense of $78,000, a decrease in facility and equipment expenses of $73,000, and a decrease in travel and related expenses of $66,000, partly offset by;

 

(iii)

An increase in bad debt expense of $363,000, resulting primarily from one leasing company that defaulted on its payment in the second quarter of 2009 due to it having significant financial problems.

 

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G&A expenses, as a percentage of net revenue, increased to 17% for the three months ended September 30, 2009, compared to 13% for the same period in 2008, and increased to 22% for the nine months ended September 30, 2009, compared to 13% for the same period in 2008. These increases in expenses as a percentage of net revenue was due primarily to lower revenue in the three and nine months ended September 30, 2009, compared to the same period in 2008.

 

Litigation Settlement

We are a defendant in a Telephone Consumer Protection Act class action lawsuit. See “Litigation” in Note 8 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this quarterly report of Form 10-Q. We have included $850,000 in our Condensed Consolidated Statement of Operations for the nine months ended September 30, 2009 for the estimated cost of the tentative settlement, net of administrative expenses and amounts that may be recoverable from our insurance carrier.

 

Interest and Other Income, Net

Interest and other income, net consist of the following:

 

		Three Months Ended September 30,												Nine Months Ended September 30,
(Dollars in thousands)		2009				% Change				2008				2009				% Change				2008
Interest income		$	288				(61%	)		$	741			$	1,148				(54%	)		$	2,485
Other income (expense), net			—				N/A				(8	)			250				N/A				6
Total Interest and other income, net		$	288				(61%	)		$	733			$	1,398				(44%	)		$	2,491

 

Interest and other income, net decreased by $445,000 for the three months and $1.1 million for the nine months ended September 30, 2009, compared to the same period in 2008. These decreases were the result of:

 

(i)

A decrease in interest income of $453,000 for the three months and $1.3 million for the nine months ended September 30, 2009, compared to the same periods in 2008, due primarily to reduced tax-exempt interest yields as a result of the Federal Reserve cutting interest rates; which was partially offset by

 

(ii)	An increase in net foreign exchange gains of $223,000 for the nine months ended September 30, 2009, compared to the same period in 2008, due primarily to translation gains resulting form the devaluation of the US dollar relative to the currencies of our foreign subsidiaries.

Other-Than-Temporary Impairment of Long Term Investments

As of September 30, 2008, due to the lack of liquidity experienced in the global credit and capital markets, and specifically in the ARS market, our ARS portfolio experienced failed auctions since February 2008 and continued declines in their fair market values. As a result, we concluded that the previously unrealized loss on our ARS investments was other-than-temporary and therefore recognized approximately $2.4 million as an impairment of long term investments, with a corresponding decrease in ‘Accumulated Other Comprehensive Income (Loss),’ during the third quarter ended September 30, 2008.

Provision (Benefit) for Income Taxes

		Three Months Ended September 30,												Nine Months Ended September 30,
(Dollars in thousands)		2009				Change				2008				2009				Change				2008
Loss before income taxes		$	(1,368	)		$	1,471			$	(2,839	)		$	(8,527	)		$	(5,865	)		$	(2,662	)
Provision (benefit) for income taxes			12,126				12,212				(86	)			9,159				9,187				(28	)
Effective tax rate			N/A								3%				N/A								1%

 

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We recognized an income tax provision of $12.1 million and $9.2 million for the three months and nine months ended September 30, 2009, respectively, despite losses before taxes. The year-to-date provision is primarily due to the recording of a valuation allowance of $10.2 million on our U.S. deferred tax assets as of September 30, 2009. The valuation allowance was recorded at the end of the third quarter of 2009 to reduce certain U.S. federal and state net deferred tax assets to their anticipated realizable value. The valuation allowance was offset by $969,000 of certain tax benefits resulting from losses generated during fiscal 2009 that can be carried-back to prior periods. Also, included in the third quarter 2009 provision is the reversal of $3.1 million tax benefit primarily related to net operating losses previously recognized in the first and second quarters of 2009.

ASC 740 requires the consideration of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferrfsed tax assets, we considered available positive and negative evidence, giving greater weight to our recent cumulative losses and our ability to carry-back losses against prior taxable income and lesser weight to its projected financial results due to the challenges of forecasting future periods. We also considered, commensurate with its objective verifiability, the forecast of future taxable income including the reversal of temporary differences. We performed this evaluation as of the year ended December 31, 2008 and the quarters ended March 31, 2009 and June 30, 2009. At that time we continued to have sufficient positive evidence, including recent cumulative profits, a reduction in operating expenses, the ability to carry-back losses against prior taxable income and an expectation of improving operating results, showing a valuation allowance was not required. At the end of the quarter ended September 30, 2009, changes in previously anticipated expectations and continued operating losses necessitated a valuation allowance against the tax benefits recognized in this quarter and prior quarters since they are no longer “more-likely-than-not” realizable. Under current tax laws, this valuation allowance will not limit our ability to utilize federal and state deferred tax assets provided we can generate sufficient future taxable income in the U.S.

We anticipate we will continue to record a valuation allowance against the losses of certain jurisdictions, primarily federal and state, until such time as we are able to determine it is “more-likely-than-not” the deferred tax asset will be realized. Such position is dependent on whether there will be sufficient future taxable income to realize such deferred tax assets.  We expect our future tax provisions (benefits), during the time such valuation allowances are recorded, will consist primarily of the tax expense of our non-US jurisdictions that are profitable. Our effective tax rate may vary from period to period based on changes in estimated taxable income or loss by jurisdiction, changes to the valuation allowance, changes to federal, state or foreign tax laws, future expansion into areas with varying country, state, and local income tax rates, deductibility of certain costs and expenses by jurisdiction.

Liquidity and Capital Resources

 

Liquidity is the measurement of our ability to meet potential cash requirements, fund the planned expansion of our operations and acquire businesses. Our sources of cash include operations and stock option exercises. We actively manage our cash usage and investment of liquid cash to ensure the maintenance of sufficient funds to meet our daily needs. The majority of our cash and investments are held in U.S. banks and our foreign subsidiaries maintain a limited amount of cash in their local banks to cover their short-term operating expenses.

 

Cash, Cash Equivalents and Marketable Investments Summary

The following table summarizes our cash and cash equivalents, marketable investments and long-term investments (in thousands):

		September 30, 2009				December 31, 2008				Change
Cash and cash equivalents		$	34,302			$	36,540			$	(2,238	)
Marketable investments			62,572				60,653				1,919
Long-term investments			7,339				9,627				(2,288	)
Total		$	104,213			$	106,820			$	(2,607	)

 

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 Cash Flows

 

		Nine Months Ended September 30,
(Dollars in thousands)		2009				2008
Net cash flow provided by (used in):
Operating activities		$	(3,135	)		$	5,870
Investing activities			461				9,496
Financing activities			436				263
Net increase (decrease) in cash and cash equivalents		$	(2,238	)		$	15,629

 

Cash Flows from Operating Activities

Net cash used in operating activities was $3.1 million in the nine months ended September 30, 2009, which was due primarily to:

 

·

$2.3 million used by the net loss of $17.7 million after adjusting for non-cash related items of $15.4 million- consisting primarily of valuation allowance on our deferred tax asset of $12.3 million as of December 31, 2008, stock-based compensation expense of $3.4 million, net increase in the allowance for doubtful accounts of $550,000 due primarily to one leasing company that has defaulted on its payment and an increase in the provision for excess and obsolete inventories of $247,000 resulting from the reduced future demand for our products;

·

$3.0 million used as a result of a decrease in deferred revenue due primarily to a decrease in unit sales volume of Products and Upgrades that included purchases of extended service contracts, a reduction in our service contract pricing beginning in 2009, a shift by customers towards purchasing shorter term contracts, and fewer customers purchasing extended service contracts in response to improved product reliability and to a tougher economy; and

·