CUTERA INC - Quarter Report: 2007 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2007

OR

For the transition period                      to                     .

Commission file number: 000-50644

Cutera, Inc.

(Exact name of registrant as specified in its charter)

3240 Bayshore Blvd., Brisbane, California 94005

(Address of principal executive offices)

(415) 657-5500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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 such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer  ¨                    Accelerated filer  x                    Non-accelerated filer  ¨

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

The number of shares of Registrant’s common stock issued and outstanding as of July 31, 2007 was 13,323,118.

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CUTERA, INC.

FORM 10-Q

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

CUTERA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

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

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CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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CUTERA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Summary of Significant Accounting Policies

Description of Operations

Cutera, Inc., or Cutera or the Company, is a Delaware corporation headquartered in Brisbane, California. The Company is a medical device company specializing in the design, development, manufacture, marketing and servicing of laser and other light-based aesthetic systems for practitioners worldwide. The Company offers easy-to-use products on three platforms - CoolGlide, Xeo and Solera - which enable dermatologists, plastic surgeons, gynecologists, primary care physicians, and other qualified practitioners to offer safe, effective and non- and minimally-invasive aesthetic treatments to their customers. The Company has wholly-owned subsidiaries in Australia, Canada, France, Germany, Japan, Spain, Switzerland and United Kingdom. The purpose of these subsidiaries is to market, sell and service the Company’s products outside of the United States.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Unaudited Interim Financial Information

The financial information furnished is unaudited. The Condensed Consolidated Financial Statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for the fair statement of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The December 31, 2006 Condensed Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. The results for interim periods are not necessarily indicative of the results for the entire year or any other interim period. The Condensed Consolidated Financial Statements should be read in conjunction with the Company’s financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2006 filed with the Securities and Exchange Commission, or SEC, on March 16, 2007.

Use of Estimates

The preparation of the interim Condensed Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States requires the Company’s management to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, the Company evaluates their estimates, including those related to the accounts receivable and sales allowances, fair values of marketable investments, fair values of acquired intangible assets, useful lives of intangible assets and property and equipment, fair values of options to purchase the Company’s common stock, recoverability of deferred tax assets, and effective income tax rates, among others. Management bases their estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

Significant Accounting Policies

The Company’s significant accounting policies are disclosed in the Company’s annual report on Form 10-K for the year ended December 31, 2006 and have not changed significantly as of June 30, 2007, except for the following:

Accounting for Income Taxes

In July 2006, the Financial Accounting Standards Board, or FASB, issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” or FIN 48. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards, or SFAS, No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company adopted the provisions of FIN 48 effective January 1, 2007. Refer to Note 7 for further details of the impact of adoption.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115.” This Statement permits an entity to choose to measure financial instruments and certain other items similar to financial instruments at fair value. All subsequent changes in fair value for the financial instrument would be reported in earnings. By electing the fair value option, an entity can also achieve consistent accounting for related assets and liabilities without having to apply complex hedge accounting. This Statement is effective January 1, 2008. The Company is currently evaluating the impact of adopting this standard on the consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” or SFAS No. 157. This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will be required to adopt SFAS 157 in the quarter ended March 31, 2008. The Company is currently assessing the impact that SFAS 157 may have on its consolidated financial position, results of operations and cash flows.

Note 2. Balance Sheet Details

Cash, Cash Equivalents and Marketable Investments:

The Company considers all highly liquid investments, with an original maturity of three months or less at the time of purchase, to be cash equivalents. Investments in debt securities are accounted for as “available-for-sale” securities, carried at fair value with unrealized gains and losses reported in other comprehensive income, held for use in current operations and classified in current assets as “Marketable Investments.”

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The following is a summary of cash, cash equivalents and marketable investments (in thousands):

Inventories:

Inventories consist of the following (in thousands):

Intangible Assets:

Intangible assets are principally comprised of a technology sublicense acquired in 2002; a patent sublicense acquired in 2006; and other intangibles. The components of intangible assets were as follows (in thousands):

For the six months ended June 30, 2007 and 2006, amortization expense for intangible assets was $138,000 and $103,000, respectively.

Based on intangible assets recorded at June 30, 2007, and assuming no subsequent additions to, or impairment of the underlying assets, the remaining estimated annual amortization expense is expected to be as follows (in thousands):

Note 3. Service Contract Revenue

Service contract revenue is recognized on a straight-line basis over the period of the applicable service contract. The deferred service contract revenue balances as of June 30, 2007 and 2006, were as follows (in thousands):

Costs incurred under service contracts during the three months ended June 30, 2007 and 2006 amounted to $566,000 and $449,000, respectively. For the six months ended June 30, 2007 and 2006, costs incurred under service contracts amounted to $1,030,000 and $851,000, respectively. All service contract costs are recognized as incurred.

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Note 4. Stock Repurchase Program and Stock-based Compensation

Stock Repurchase Program

On May 15, 2007, the Company’s Board of Directors approved a stock repurchase program under which the Company is authorized to use up to $25 million to repurchase shares of its common stock. The Company entered into a pre-arranged Rule 10b5-1 trading plan with a broker to facilitate the repurchase of its shares. Acquisitions are made in accordance with the trading plan, at prevailing prices, subject to market conditions and other factors. Purchases under the trading plan may be modified at any time by giving the broker sixty days’ notice. This repurchase program shall terminate at the earliest of: (i) the Company acquiring $25 million worth of shares of its common stock, or (ii) May 15, 2008. The stock repurchased under the plan will be cancelled and returned to authorized share status.

During the quarter ended June 30, 2007, the Company used $3.0 million to purchase 123,800 shares of its common stock at an average price of $24.36. As of June 30, 2007, share repurchase transactions for $500,000 had not been paid for as the trades had not yet settled.

Stock-based Compensation Expenses

The pre-tax stock-based compensation expense recognized during the three and six months ended June 30, 2007 and 2006 was as follows (in thousands):

Note 5. Net Income (Loss) Per Share

Basic net income (loss) per share is calculated by dividing net income (loss) available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is calculated by using the weighted-average number of common shares outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options, Employee Stock Purchase Plan, or ESPP, shares and restricted stock units is reflected in diluted net income (loss) per share by application of the treasury stock method, which includes consideration of stock-based compensation required by Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment (revised 2004),” or SFAS 123(R), and SFAS No. 128, “Earnings Per Share.”

The following table sets forth the computation of basic and diluted net income and the weighted average number of shares used in computing basic and diluted net income per share (in thousands):

Anti-dilutive securities

The following number of outstanding options and restricted stock units, prior to the application of the treasury stock method, were excluded from the computation of diluted net income (loss) per common share for the periods presented because including them would have had an anti-dilutive effect (in thousands):

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Note 6. Comprehensive Income (Loss)

Comprehensive income (loss) generally represents all changes in stockholders’ equity except those resulting from investments or contributions by stockholders. The Company’s unrealized loss on marketable investments represents the only component of other comprehensive income (loss) that is excluded from net income (loss). The changes in components of other comprehensive income (loss) for the periods presented are as follows (in thousands):

Note 7. Income Taxes

The interim effective income tax rate is based on management’s best estimate of the annual effective income tax rate. The effective tax rates for the three and six months ended June 30, 2007 were 33% and 34%, respectively, and for the three and six months ended June 30, 2006 were 40% and 41%, respectively. These rates reflect applicable United States federal and state tax rates and the tax impact of foreign operations, offset primarily by research and development tax credits and tax exempt interest income. The higher effective tax rate for the three and six months ended June 30, 2006, compared with the same periods in 2007, was primarily attributable to the impact of the $18.4 million litigation settlement expense that was included at the marginal rate of 39.75%; to the expiration of federal research and development tax credits; and the reduction of the section 199 deduction and Extraterritorial Income exclusion as a result of the net loss before income taxes that resulted from the inclusion of the $18.4 million litigation settlement expense.

Undistributed earnings of the Company’s foreign subsidiaries of approximately $1,799,000 and $752,000 at June 30, 2007 and 2006, respectively, are considered to be indefinitely reinvested and, accordingly, no provision for federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various foreign countries.

Impact of Adoption of FIN 48

The Company implemented the provisions of FIN 48 as of January 1, 2007 and recorded the cumulative effect of applying the provisions of the Interpretation as an adjustment to the Company’s retained earnings balance as of January 1, 2007. The total amount of unrecognized tax benefits as of the date of adoption was approximately $943,000. The Company reduced its January 1, 2007 retained earnings by approximately $91,000.

Included in the balance of unrecognized tax benefits at January 1, 2007 were approximately $542,000 of tax benefits that, if recognized, would affect the effective tax rate; and approximately $401,000 of tax benefits that, if recognized, would result in an adjustment to deferred tax assets.

Accrued interest and penalties relating to the income tax on the unrecognized tax benefits as of June 30, 2007 and January 1, 2007 were approximately $110,000 and $93,000, respectively, with approximately $17,000 being included as a component of provision for income taxes in the six months ended June 30, 2007.

In general, the Company’s income tax returns are subject to examination by U.S. federal, state and foreign tax authorities for tax years 2002 forward. The Company does not expect that the amounts of unrecognized tax benefits will change significantly within the next 12 months.

Note 8. Commitments and Contingencies

Litigation

Two securities class action lawsuits were filed against the Company and two of its executive officers in April 2007 and May 2007, respectively, in the U.S. District Court for the Northern District of California following declines in the Company’s stock price. The plaintiffs claim to represent purchasers of the Company’s common stock from January 31, 2007 through May 7, 2007. The complaints generally allege that materially false statements and omissions were made regarding the Company’s financial prospects, and seek unspecified monetary damages. The Company intends to defend these cases vigorously. Since the outcome of the litigation is unpredictable, and since the Company believes that a significant adverse result is not probable, no expense has been recorded with respect to the contingent liability associated with these matters. The Company retains director and officer liability insurance but there is no assurance that such insurance will cover the claims that are made or will insure the Company fully for all losses on covered claims.

Other Legal Matters

In addition to the foregoing lawsuits, the Company is named from time to time as a party to product liability and contractual lawsuits in the normal course of its business. As of June 30, 2007, the Company is not a party to any material pending litigation.

Facility Leases

The Company leases its office and manufacturing facility in Brisbane, California, and also leases offices in Japan, Switzerland and France under operating leases. These leases qualify for operating lease accounting treatment under SFAS No. 13, “Accounting for Leases,” and, as such, these facilities are not included on its Condensed Consolidated Balance Sheets.

The following is a schedule of operating leases payments (in thousands):

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Warranty Obligations.

The Company provides standard one to two year warranty coverage on its systems. Warranty coverage is for labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost as a charge to cost of revenue, when revenue is recognized. The estimated warranty cost is based on historical product performance and expenses to repair systems. Utilizing actual service records, the Company calculates the average service labor, overhead and parts expense per system and applies those averages to the actual units exposed to future warranty claims. The Company updates these estimates on a quarterly basis.

The following table provides the changes in the product warranty accrual for the six months ended June 30, 2007 and 2006 (in thousands):

Purchase Commitments.

The Company maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. The Company’s liability in these purchase commitments is generally restricted to a forecasted time-horizon as agreed between the parties. These forecasted time-horizons can vary among different suppliers. The Company’s open inventory purchase commitments were not material at June 30, 2007.

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, 2006 as contained in our annual report on Form 10-K filed with the SEC on March 16, 2007. This quarterly report, including the following sections, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties. These statements include, but are not limited to, statements relating to future financial performance, the planned expansion of and improvements in our sales force, distribution networks and customer base, the success of new product launches, future capital expenditures and requirements and the impact of exchange rate volatility. 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 16, identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. The reader is cautioned not to 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

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 to the professional aesthetic market. Our easy-to-use platforms—CoolGlide, Xeo and Solera—enable dermatologists, plastic surgeons, gynecologists, primary care physicians and other qualified practitioners to perform safe, effective and non- or minimally-invasive aesthetic procedures for their customers.

Our corporate headquarters and U.S. operations are located in Brisbane, California, from where we conduct our manufacturing, warehousing, research, regulatory, sales, service, marketing 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 handpiece refills and marketing brochures, via the web.

International sales are generally made through a direct sales force and through independent sales representatives and distributors 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, product upgrades, service and Titan handpiece refills. Product revenue represents the sale of a system console that includes a universal graphic user interface, a laser and/or other light-based module, control system software, high voltage electronics and one or more handpieces. 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 product upgrade revenue. Service revenue relates to amortization of prepaid service contract revenue and receipts for services on out-of-warranty products. Titan handpiece refill revenue is associated with our Titan handpiece, which requires a periodic “refilling” process, which includes the replacement of the optical source after a set number of pulses has been performed.

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Significant Business Trends. We believe that our revenue growth has been, and will continue to be, primarily attributable to the following:

During the six months ended June 30, 2007, compared to the same period in 2006, our total revenue increased by 4%, our U.S. revenue decreased by 1% and our international revenue increased by 17%. During the three months ended June 30, 2007, compared to the same period in 2006, our total revenue decreased by 2%, our U.S. revenue decreased by 8% and our international revenue increased by 10%. The decrease in U.S. revenue growth rates for the three and six months ended June 30, 2007, compared to the same periods in 2006, was primarily attributable to U.S. sales-productivity issues. The increase in the international revenue growth rate was primarily attributable to continuing investments we have been making toward building our international sales channels. These efforts have resulted in increased revenue from Australia, Canada, Japan and with our international-distributor network.

In the second quarter ended June 30, 2007, we started shipping a new product called Pearl. Pearl represents the first application of the 2790 nm wavelength for cosmetic dermatology, and is designed to provide a more-pronounced clinical outcome than non-invasive light-based treatments, with minimal patient downtime. Primarily due to upgrades to our multi-application Xeo systems and upgrades for out new Pearl product, our product upgrade revenue increased by 84% in the second quarter ended June 30, 2007, compared to the same period in 2006. We anticipate that, during the second half of 2007, many of our customers will upgrade their existing systems with Pearl, and many new customers will acquire Pearl as part of their purchase of multi-application Xeo systems. Partially due to this reason, and due to the continuing expansion of our sales force, we expect our upgrade and total revenue to increase during the second half of 2007.

For the six months ended June 30, 2007, our gross margin declined to 67%, compared to 70% in the same period of 2006. This percentage decrease was primarily attributable to $963,000, or 2% of revenue, of higher patent royalty expense in the six months ended June 30, 2007, compared to the same period in 2006. We settled our patent litigation in the second quarter of 2006, and as a result, the first quarter of 2006 did not include patent royalty expense. The reduction in margin was also partially attributable to $2.0 million of lower revenue in the six months ended June 30, 2007, compared to the same period in 2006, which resulted in reduced contributions to increased manufacturing and service costs. Given that our royalty expense will continue in the future, and that we expect our revenue to increase in the second half of 2007, we expect our gross margin to improve to approximately 68% to 70% of revenue in the second half of 2007.

General and administrative expenses for the six months ended June 30, 2007, compared to the same period in 2006, decreased by $2.7 million or 31%. This decrease was primarily attributable to $3.5 million of reduced legal expenses due to the patent litigation settlement in the second quarter of 2006. This reduction in expenses was partially offset by an increase in stock-based compensation expenses by $510,000. In April and May 2007, two securities class action lawsuits were filed against us, respectively- see Part II, Item 1 “Legal Proceedings.” However, given that we retain director and officer liability insurance with a deductible, we expect the impact from this litigation to not be material for the remainder of 2007. As a percentage of total revenue, general and administrative expenses for the six months ended June 30, 2007 were at 12%. In the second half of 2007, we expect our general and administrative expenses to remain in the range of $3.0 million to $3.5 million per quarter.

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 success depends on our ability to compete successfully. Additionally, the growth of our business relies on 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 compete effectively, fail to continue to develop new products and technologies, fail to obtain regulatory clearances, fail to protect our intellectual property, fail to produce our products cost effectively, or fail to market and distribute our products in a profitable manner, our business could suffer. A detailed discussion of these and other factors that could impact our future performance are provided in Part II, Item 1A — “Risk Factors” section.

Critical Accounting Policies and Estimates

The accounting policies that we consider to be critical, subjective, or requiring complex judgments 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, 2006 filed with the SEC on March 16, 2007. Other than the adoption of FIN 48, there have been no significant changes during the six months ended June 30, 2007 to the items that we disclosed as our critical accounting policies and estimates in our Annual Report on Form 10-K for the year ended December 31, 2006.

Income Taxes — We operate in multiple taxing jurisdictions, both within the United States and outside the United States. We have filed tax returns with positions that may be challenged by the tax authorities. These positions relate to, among others, deductibility of certain expenses, transfer pricing, expenses included in our research and development tax credit computations, as well as other matters. Although the outcome of tax audits is uncertain, in management’s opinion, adequate provisions for income taxes have been made for potential liabilities resulting from such matters. We regularly assess the tax positions for such matters and include reserves for those differences in position. The reserves are utilized or reversed once the statute of limitations has expired and/or at the conclusion of the tax examination. We believe that the ultimate outcome of these matters will not have a material impact on our financial position, financial operations or liquidity. Effective January 1, 2007, we adopted FIN 48 (refer to Note 7).

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115.” This Statement permits an entity to choose to measure financial instruments and certain other items similar to financial instruments at fair value. All subsequent changes in fair value for the financial instrument would be reported in earnings. By electing the fair value option, an entity can also achieve consistent accounting for related assets and liabilities without having to apply complex hedge accounting. This Statement is effective January 1, 2008. We are currently evaluating the impact of adopting this standard on the consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” or SFAS No. 157. This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will be required to adopt SFAS No. 157 in the quarter ended March 31, 2008 and are currently assessing the impact that this may have on our consolidated financial position, results of operations and cash flows.

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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 revenue:

Total Revenue

During the three and six months ended June 30, 2007, compared to the same period in 2006, our U.S. revenue decreased by 8% and 1%, respectively, and our international revenue increased by 10% and 17%, respectively. The increase in international revenue growth was primarily attributable to continuing investments we have been making toward building our international sales channel. These efforts have resulted in increased revenue from Canada, Japan, Australia and with our international-distributor network. The decrease in U.S. revenue growth in the second quarter and six months ended June 30, 2007, when compared to the same period in 2006, was primarily attributable to U.S. sales productivity issues identified at the start of the second quarter of 2007, and for which strategic initiatives have been implemented.

From a product category perspective, during the three and six months ended June 30, 2007, compared to the same period in 2006, our product revenue decreased by 13% and 5%, respectively. This was primarily attributable to U.S. sales productivity issues. Our upgrade revenue in the second quarter and six months ended June 30, 2007, compared to the same period in 2006, increased by 84% and 78%, respectively. This was primarily attributable to upgrades to our multi-application Xeo systems, and upgrades for our new product, Pearl. Our Service revenue also continued to grow due to the increasing installed base of customers purchasing extended service contracts. Growth in Titan handpiece refills reflected the continuing sales of the Titan product as well as an increased consumer demand for Titan procedures.

We anticipate that, during the second half of 2007, many of our customers will upgrade their existing systems with Pearl, and many new customers will acquire Pearl as part of their purchase of multi-application Xeo systems. Partially due to this reason, and also due to the continuing expansion of our sales force, we expect our upgrade and total revenue to increase during the second half of 2007.

Gross Margin

Our cost of revenue consists primarily of material, labor, stock-based compensation, royalty expense, warranty and manufacturing overhead expenses. The decrease in gross margin in the second quarter of 2007 to 67%, compared to 68% in the same period in 2006, was primarily attributable to $522,000 of lower revenue, which resulted in reduced contributions to increased manufacturing and service costs. For the six months ended June 30, 2007, our gross margin declined to 67%, compared to 70% in the same period in 2006. This decrease in margin rates was primarily attributable to $963,000, or 2% of revenue, of higher patent royalty expenses in the six months ended June 30, 2007, compared to the same period in 2006. We settled our patent litigation in the second quarter of 2006, and as a result, the first quarter of 2006 did not include patent royalty expenses. In addition, the reduction in margin was partially attributable to $2.0 million of lower revenue in the six months ended June 30, 2007, compared to the same period in 2006, which resulted in reduced contributions to increased manufacturing and service costs. Given that our royalty expense will continue in the future, and that we expect our revenue to increase in the second half of 2007, we expect our gross margin to improve to approximately 68% to 70% of revenue in the second half of 2007.

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Sales and Marketing

Sales and marketing expenses consist primarily of labor, stock-based compensation, expenses associated with customer-attended workshops and trade shows, and advertising. The increase in sales and marketing expenses in the three months ended June 30, 2007, compared to the same period in 2006, was primarily attributable to the continued investments made in expanding our international distribution network and in expanding our U.S. sales force. The primary contributors to the $885,000 increase in sales and marketing expenses were higher employee-related expenses of $534,000, due partially to increased headcount, and increased advertising and promotional expenses of $354,000.

The increase in sales and marketing expenses in the six months ended June 30, 2007, compared to the same period in 2006, was primarily attributable to the continued investments made in expanding our international distribution network and in expanding of our U.S. sales force. The primary contributors to the $1.4 million, or 8%, increase in sales and marketing expenses was higher employee-related expenses of $1.1 million, due partially to increased headcount, and increased advertising and promotional expenses of $329,000.

In the second half of 2007, primarily due to an increase in our personnel expenses that would result from the planned sales force expansion, we expect our sales and marketing expenses to increase in absolute dollar terms but decrease as a percentage of revenue, as revenue is expected to grow at a rate faster than the growth rate of expenses.

Research and Development (R&D)

R&D expenses consist primarily of labor, stock-based compensation, clinical, regulatory and material costs. In the three months ended June 30, 2007, R&D expenses increased by $371,000 to 8% of total revenue. This increase was partially related to the research and development efforts associated with our new Pearl product released in the second quarter of 2007. The $371,000 increase was primarily attributable to $255,000 of higher material costs and $126,000 of higher outside services related to clinical studies and product development activities.

During the six months ended June 30, 2007, compared to the same period in 2006, R&D expenses increased by $812,000, or 28%, which was primarily attributable to higher employee-related expenses of $191,000, $379,000 of higher material costs and $180,000 of higher outside services related to clinical studies and product development activities, including the development of our new Pearl product.

For the remainder of 2007, we will continue to invest our R&D efforts and perform clinical studies to gather additional data relating to our Pearl application, as well as continue developing other products, and we expect our R&D expenses to increase in the second half of 2007, compared with the first half of 2007. However, with the expected increase in revenue in the second half of 2007, we expect our R&D expenses to decrease as a percentage of revenue.

General and Administrative (G&A)

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 for the three months ended June 30, 2007, compared to the same period in 2006, decreased by $1.3 million, or 32%, and were 12% of net revenue. This decrease was primarily attributable to decreased legal expenses of approximately $2.0 million, primarily relating to the patent litigation, which was settled in the second quarter of 2006. This was partially offset by an increase in stock compensation charges of $409,000. In April and May 2007, two securities class action lawsuits were filed against us- see Part II, Item 1 “Legal Proceedings.” However, given that we retain director and officer liability insurance with a deductible, we expect the impact from this litigation to be not material for the remainder of 2007.

General and administrative expenses for the six months ended June 30, 2007, compared to the same period in 2006, decreased by $2.7 million or 31%. This decrease was primarily attributable to $3.5 million of reduced legal expenses due to the patent litigation settlement in the second quarter of 2006. This reduction in expenses was partially offset by an increase in stock-based compensation expenses by $510,000.

In the second half of 2007, we expect our G&A expenses to remain in the range of $3.0 million to $3.5 million per quarter.

Interest and Other Income, Net

The increase in interest and other income, net, in the three and six months ended June 30, 2007, compared to the same period in 2006, was primarily attributable to improved tax-exempt interest yields on investments and an increased amount invested. Our cash, cash equivalents and marketable investment balances was at $115.4 million as of June 30, 2007 compared with $82.0 million as of June 30, 2006.

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Provision (benefit) for Income Taxes

Our effective tax rate reflects applicable United States federal and state tax rates and the tax impact of foreign operations, offset primarily by research and development tax credits and tax exempt interest income.

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, marketable investments, stock option exercises and employee stock purchases. We actively manage our cash usage and investment of liquid cash to ensure the maintenance of sufficient funds to meet our daily needs.

Cash, Cash Equivalents and Marketable Investments

The following table summarizes our cash, cash equivalents and marketable securities (in thousands):

The net increase in cash, cash equivalents and marketable investments of $7.3 million in the six months ended June 30, 2007 was primarily a result of $6.8 million of cash generated by operations, $3.1 million of cash generated from the exercise of common stock option exercises and employee stock purchases and $833,000 for excess tax benefits on employee stock option exercises, which were partially offset by $2.5 million used to repurchase our common stock and $758,000 used to purchase property and equipment. As of June 30, 2007, we believe we have sufficient cash resources for at least the next twelve months to meet our anticipated needs for working capital, capital expenditures and the $22.0 million of shares of our common stock that may be repurchased pursuant to our stock repurchase program.

Cash Flows