CUTERA INC - Quarter Report: 2008 September (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 September 30, 2008

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, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer  ¨        Accelerated filer  x        Non-accelerated filer  ¨        Smaller reporting company  ¨

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 October 24, 2008 was 12,779,692.

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CUTERA, INC.

FORM 10-Q

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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 and Principles of Consolidation.

Cutera, Inc. (“Cutera” or the “Company”) is a global provider of laser and other light-based aesthetic systems for practitioners worldwide. The Company designs, develops, manufactures, and markets the CoolGlide, Xeo and Solera product platforms for use by physicians and other qualified practitioners to allow its customers to offer safe and effective aesthetic treatments to their customers.

Headquartered in Brisbane, California, the Company has wholly-owned subsidiaries in Australia, Canada, France, Japan, Spain, Switzerland and United Kingdom that market, sell and service its products outside of the United States. The Condensed Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All inter-company transactions and balances 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, 2007 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, or GAAP. 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, 2007 filed with the Securities and Exchange Commission, or SEC, on March 13, 2008.

Use of Estimates

The preparation of interim Condensed Consolidated Financial Statements in conformity with GAAP 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 and long term 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, 2007 and have not changed significantly as of September 30, 2008, except for the following:

Fair Value Measurements

On January 1, 2008, the Company adopted Statement of Financial Accounting Standards, or SFAS, No. 157, “Fair Value Measurements,” or SFAS 157, as it relates to financial assets and financial liabilities. In February 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) No. FAS 157-2, “Effective Date of FASB Statement No. 157,” which delayed the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on at least an annual basis, until January 1, 2009 for calendar year-end entities. SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This standard is now the single source in GAAP for the definition of fair value, except for the fair value of leased property as defined in SFAS No. 13, “Accounting for Leases.” SFAS 157 establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy under SFAS 157 are described below:

In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as considers counterparty credit risk in its assessment of fair value. The following section describes the valuation methodologies used by the Company to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified.

At September 30, 2008, the Company held $13.4 million (par value), with an estimated fair value of $11.0 million, of AAA to Aa3 rated municipal bonds with an auction interest rate reset feature, known as auction rate securities, or ARS. The ARS held by the Company are guaranteed either by the Federal Family Education Loan Program or the Maine Education Loan Authority, and were issued for the purpose of financing student loans. ARS have historically traded at par and are redeemable at

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par plus accrued interest at the option of the issuer. Interest is typically paid at the end of each auction period or semi-annually. Until February 2008, the market for the Company’s ARS was highly liquid. Since February 2008, a substantial number of auctions “failed,” meaning that there was not enough demand to sell all of the securities that holders desired to sell at auction. The immediate effect of a failed auction is that such holders cannot sell the securities at auction and the interest rate on the security generally resets to a maximum interest rate. In the case of funds invested by the Company in ARS which are the subject of a failed auction, the Company may not be able to access the funds without a loss of principal, unless a future auction of these investments is successful or the issuer redeems the security. As of September 30, 2008, the Company has classified its ARS investment balance as long term investments because of the Company’s belief that it could take more than one year before they are readily marketable. The Company has also modified its current investment strategy and increased its investments in more liquid money market funds.

At September 30, 2008, observable market information was not available to determine the fair value of the Company’s ARS investments. Therefore, the Company estimated their fair values using valuation models that relied on Level 3 inputs including those that are based on expected cash flow streams and collateral values, assessments of counterparty credit quality, default risk underlying the security, market discount rates and overall capital market liquidity. The valuation of the Company’s ARS investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact the Company’s valuation in the future include changes to credit ratings of the securities, as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, counterparty risk and ongoing strength and quality of market credit and liquidity. These financial instruments are classified within Level 3 of the fair value hierarchy.

As of September 30, 2008, financial assets measured and recognized at fair value on a recurring basis and classified under the appropriate level of the fair value hierarchy as described above was as follows (in thousands):

The table presented below summarizes the change in carrying value associated with Level 3 financial assets, which represents our investment in ARS and classified as long term investments, for the three and nine months ended September 30, 2008 (in thousands):

In accordance with the guidance provided in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and SEC Staff Accounting Bulletin (SAB) Topic 5M, “Accounting for Noncurrent Marketable Equity Securities “ the Company determines when an investment is other-than-temporarily impaired by performing quarterly reviews of its investments. If the cost of an investment exceeds its fair value, in making the judgment of whether there has been an other-than-temporary impairment, the Company considers available quantitative and qualitative evidence, including, among other factors, the Company’s intent and ability to hold the investment to recovery, the duration and extent to which the fair value is less than cost, specific adverse conditions related to the financial health of and business outlook for the investee and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

Since February 2008, due to the lack of liquidity experienced in the global credit and capital markets, and specifically in the ARS market, the Company’s ARS have experienced failed auctions and the estimated market values continue to decline. As a result, as of September 30, 2008 the Company concluded that the previously unrealized loss on their 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 Loss,’ during the third quarter ended September 30, 2008.

Recent Accounting Pronouncements

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” or SFAS 162. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. This Statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” The Company does not expect SFAS 162 to have a material impact on its Consolidated Financial Statements.

In April 2008, the FASB issued FASB Staff Position, or FSP, FAS 142-3, “Determination of the Useful Life of Intangible Assets,” or FSP FAS 142-3. FSP FAS 142-3 removes the requirement of SFAS 142, “Goodwill and Other Intangible Assets” for an entity to consider, when determining the useful life of an acquired intangible asset, whether the intangible asset can be renewed without substantial cost or material modifications to the existing terms and conditions associated with the intangible asset. FSP FAS 142-3 replaces the previous useful-life assessment criteria with a requirement that an entity considers its own experience in renewing similar arrangements. If the entity has no relevant experience, it would consider market participant assumptions regarding renewal. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact of adopting FSP FAS 142-3.

In February 2008, the FASB issued FSP No. FAS 157-2, “Effective Date of FASB Statement No. 157,” or FSP 157-2, to partially defer SFAS 157. FSP 157-2 defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to fiscal years, and interim periods within those fiscal years, beginning after November 15, 2008. The Company is currently evaluating what impact the adoption of the provisions of FSP 157-2 will have on its Consolidated Financial Statements.

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In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” (“SFAS 141R”). This issuance retains the fundamental requirements in SFAS 141 that the acquisition method of accounting (which SFAS 141 called the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141R defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control. SFAS 141R is effective for the Company beginning January 1, 2009. Though this pronouncement is not expected to have an effect on the Company’s consolidated financial position, annual results of operations or cash flows, if it were to acquire another entity, it would be required to account for it in accordance with this pronouncement.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” (“SFAS 160”). This issuance amends Accounting Research Bulletin 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. SFAS 160 is effective for the Company beginning January 1, 2009. Though this pronouncement is not expected to have an effect on the Company’s consolidated financial position, annual results of operations or cash flows, if it were to acquire another entity, it would be required to account for it in accordance with this pronouncement.

Note 2. Balance Sheet Details

Cash and Cash Equivalents, Marketable Investments and Long Term 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 (loss), held for use in current operations and classified in current assets as “Marketable investments” and in long term assets as “Long term investments.”

The following is a summary of cash and cash equivalents, marketable investments and long term investments:

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):

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For the nine months ended September 30, 2008 and 2007, amortization expense for intangible assets was approximately $151,000 and $188,000, respectively.

Based on intangible assets recorded at September 30, 2008, 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. Stock-based Compensation and Stock Repurchase Program

Stock-based Compensation Expenses

The pre-tax stock-based compensation expense recognized during the three and nine months ended September 30, 2008 and 2007 was as follows (in thousands):

Stock Repurchase Program

During the nine months ended September 30, 2007, the Company repurchased 1,107,856 shares of its common stock at an average price of $22.57 for a total of $25.0 million. The stock repurchased under the plan was cancelled and returned to authorized share status.

Note 4. 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 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, shares and restricted stock units is reflected in diluted net income per share by application of the treasury stock method, which includes consideration of stock-based compensation required by SFAS No. 123(R), “Share-Based Payment (revised 2004) ,” and SFAS No. 128, “Earnings Per Share.”

For periods presented with a net loss available to common stockholders, diluted net loss per common share is the same as basic net loss per common share, as the effect of the potential common stock equivalents is anti-dilutive and as such is excluded from the calculations of the diluted net loss per share.

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

Anti-dilutive securities

The following number of weighted shares outstanding, 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 5. 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 September 30, 2008 and September 30, 2007, were as follows (in thousands):

Costs incurred under service contracts during the nine months ended September 30, 2008 and 2007, amounted to $3.4 million and $1.6 million respectively. All service contract costs are recognized as incurred.

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 gain (loss) on marketable and long term 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 reflects applicable United States federal and state tax rates and the tax impact of foreign operations, reduced primarily by research and development tax credits (U.S. federal income tax credits in 2007 but not in the nine months ended September 30, 2008) and tax exempt interest income. The interim effective income tax rate is based on management’s best estimate of the annual effective income tax rate. The decrease in the effective tax rate for the three and nine months ended September 30, 2008, to 3% and 1%, compared to 26% and 31% for the same periods in 2007, respectively, was primarily attributable to tax exempt interest income being a larger percentage of the lower projected pre-tax income for fiscal year 2008, compared to fiscal year 2007.

With respect to the $2.4 million impairment charge for ARS investments recognized in the third quarter ended September 30, 2008, the Company treated this for income tax purposes as a discrete item in the quarter. Given this impairment charge is a capital loss, the Company recorded a deferred tax asset but because it did not believe it is more likely than not realizable, it recorded a valuation allowance against the deferred tax asset. As a result, there was no effect on the Company’s total tax provision for the quarter and nine months ended September 30, 2008 for this charge.

The “Emergency Economic Stabilization Act of 2008,” which contains the “Tax Extenders and Alternative Minimum Tax Relief Act of 2008”, was signed into law on October 3, 2008. Under the Act, the research credit was retroactively extended for amounts paid or incurred after December 31, 2007 and before January 1, 2010. The effects of the change in the tax law will be recognized in the Company’s fourth quarter 2008, which is the quarter in which the law was enacted. The Company is still assessing the impact of this new legislation but does not expect the effect to its fourth quarter provision for income taxes to be material.

Undistributed earnings of the Company’s foreign subsidiaries of approximately $2.0 million and $1.5 million at September 30, 2008 and 2007, 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.

As of September 30, 2008, the Company had included in its Condensed Consolidated Balance Sheet $1.4 million in long term income tax liability with respect to unrecognized tax benefits and accrued interest. In general, the Company’s income tax returns are subject to examination by U.S. federal tax authorities for tax years 2005 onward and by various U.S. state and foreign tax authorities for tax years 2002 onward. The Company is currently under audit by the Internal Revenue Service for federal income tax years ended December 31, 2005 and 2006. In addition, other state and international tax authorities audit the Company’s tax returns from time to time. The Company has reserved for potential adjustments to its provision for income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities, and it believes that the final outcome of these examinations or agreements will not have a material effect on its results of operations. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in the recognition of tax benefits in the period it determines the liabilities are no longer necessary. If the Company’s estimates of the federal, state, and foreign income tax liabilities are less than the ultimate assessment, a further charge to expense would result. As of September 30, 2008, the Company does not expect any unrecognized tax benefits to be paid within the next twelve months, nor can it make a reliable estimate when cash settlement with a taxing authority may occur.

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

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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. On November 1, 2007, the Court ordered the two cases consolidated. On December 17, 2007, the plaintiffs filed a consolidated, amended complaint, and on January 31, 2008, the Company filed a motion to dismiss that complaint. On September 30, 2008, in response to the Company’s motion, the Court issued an order dismissing the plaintiffs’ amended complaint without prejudice, and allowed the plaintiffs thirty days to file a second amended complaint. On October 28, 2008, the plaintiffs filed a Notice Of Intention Not to File A Second Amended Consolidated Complaint. No final judgment has yet been entered in this case, and, upon entry of such a judgment, plaintiffs may choose to appeal the Court’s prior order dismissing their first amended complaint. The Company intends to continue to defend this case vigorously, regardless of the stage of litigation. The Company retains director and officer liability insurance, though 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. Since the outcome of this litigation is unpredictable and not reasonably estimable, and since the Company does not believe that a significant adverse result is probable, no expense has been recorded with respect to the contingent liability associated with this matter

A Telephone Consumer Protection Act, or TCPA, class action lawsuit was filed against the Company in January 2008 in the Illinois Circuit Court, Cook County, by Bridgeport Pain Control Center, Ltd., seeking monetary damages, injunctive relief, costs and other relief. The complaint alleges that the Company violated the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and other recipients nationwide during the four-year period preceding the lawsuit without the prior express invitation or permission of the recipients. Two state law claims, limited to Illinois recipients, allege a class period of three and five years, respectively. Under the TCPA, recipients of unsolicited facsimile advertisements may be entitled to damages of $500 per violation for inadvertent violations and $1,500 per violation for knowing or willful violations. On February 22, 2008, the Company removed the case to federal court in the Northern District of Illinois, and filed its response to the complaint on February 29, 2008. Although the Company is continuing to investigate the number of facsimiles transmitted during the period for which the plaintiff seeks class certification and the number of these facsimiles that were “unsolicited” within the meaning of the TCPA, the Company expects that the number of unsolicited facsimiles could be large and potential liability may be substantial as a result. The Company retains general liability insurance, with one insurer covering the first two years of the four-year period preceding the lawsuit, and a second insurer covering the latter two years of that four-year period. The first carrier has agreed to defend the Company subject to a reservation of rights. The second carrier has declined coverage. The Company intends to defend this case vigorously, including the plaintiff’s allegations seeking class certification, and regardless of the stage of litigation. Since the outcome of this litigation is unpredictable and not reasonably estimable, and since the Company does not believe that a significant adverse result is probable, no expense has been recorded with respect to the contingent liability associated with this matter.

Other Legal Matters

In addition to the foregoing lawsuits, the Company is named from time to time as a party to product liability and other lawsuits in the normal course of its business. As of September 30, 2008, the Company is not a party to any other 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. The following is a schedule of non-cancellable operating lease payments (in thousands):

Warranty Obligations.

The Company provides standard one-year or two-year warranty coverage on its systems. Warranty coverage provided is for labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost of the standard warranty coverage as a charge to costs of revenue when revenue is recognized. The estimated warranty cost is based on historical product performance. Utilizing actual service records, the Company calculates the average service hours and parts expense per system, and applies the actual labor and overhead rates to determine the estimated warranty charge. The Company updates these estimated charges every quarter.

The following table provides the changes in the product warranty accrual for the nine months ended September 30, 2008 and 2007 (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 mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. The Company’s open inventory purchase commitments were not material at September 30, 2008.

Income Taxes

The Company is currently under audit for the years ended December 31, 2005 and 2006 by the Internal Revenue Service. In addition, other state and international tax authorities audit the Company’s tax returns from time to time. The Company has reserved for potential adjustments to its provision for income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities, and it believes that the final outcome of these examinations or agreements will not have a material effect on its results of operations. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in the recognition of tax benefits in the period the Company determines the liabilities are no longer necessary. If the Company’s estimates of the federal and state income tax liabilities are less than the ultimate assessment, a further charge to expense would result. As of September 30, 2008, the Company does not expect any unrecognized tax benefits to be paid within the next twelve months, nor can it make a reliable estimate when cash settlement with a taxing authority may occur.

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Indemnifications

In the normal course of business, the Company enters into agreements that contain a variety of representations, warranties, and indemnification obligations. For example, the Company has entered into indemnification agreements with each of its directors and executive officers. In 2007, two of the Company’s executive officers were named as defendants in securities class action litigation—see Litigation section above. The Company’s exposure under its various indemnification obligations, including those under the indemnification agreements with its directors and executive officers, is unknown since the outcome of that securities litigation is unpredictable and the amount that could be payable thereunder is not reasonably estimable, and since other indemnification obligations involve future claims that may be made against the Company. The Company has not accrued or paid any amounts for any such indemnification obligations. However, the Company may record charges in the future as a result of these potential indemnification obligations, including those related to the securities class action litigation.

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, 2007 as contained in our annual report on Form 10-K filed with the SEC on March 13, 2008. This quarterly report, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, but are not limited to, statements relating to the ability to grow our business, increase our revenue, manage expenses, generate additional cash, return to profitability, develop and commercialize existing and new products and applications, and improve the performance of our worldwide sales and distribution network, and to 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 19, 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 for practitioners worldwide. We offer products on three platforms—CoolGlide, Xeo and Solera— for use by physicians and other qualified practitioners to allow our customers to offer safe and effective aesthetic treatments to their customers.

Our corporate headquarters and U.S. operations are located in Brisbane, California. We conduct our manufacturing, warehousing, research, regulatory, sales, service, marketing and administrative activities from this facility. 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 products, 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 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 have 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:

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For the three and nine months ended September 30, 2008, compared to the same periods in 2007, our U.S. revenue decreased by 46% and 30%, respectively. We believe that the current market conditions may be causing our non-core physician prospects to defer a purchasing decision at this time, even though most of these physicians may not be limited by credit barriers. Further, we believe that a segment of our business – those aesthetic practices that operate in settings that are not medical offices – are being particularly affected by the economic environment and may be finding it more difficult to obtain credit financing. This may be resulting in them delaying their purchase decisions. Also, FDA clearance for our Pearl product was received in early 2007, which allowed us to begin shipping our Pearl product in June 2007 and provided significant Upgrade revenue for the third quarter of 2007. In contrast, our Pearl Fractional product started shipping at the end of the third quarter of 2008, which resulted in lower Upgrade revenue in that period.

For the three and nine months ended September 30, 2008, compared to the same period in 2007, our international revenue decreased by 8% and increased by 18%, respectively. The decrease in international revenue for the three months ended September 30, 2008, compared to the same period in 2007, was primarily due to difficult economic conditions. The increase in the first nine months of international revenue, compared to the same period in 2007, was primarily attributable to the continuing investments in developing our global infrastructure. These efforts resulted in increased revenue from several of our geographic locations, including Europe and emerging global markets.

For the three and nine months ended September 30, 2008, our gross margin declined to 59% and 61%, respectively, compared to 66% in the same periods of 2007. This decrease in gross margin was primarily attributable to:

Sales and marketing expenses for the three months ended September 30, 2008, compared to the same period in 2007, decreased by $2.5 million, primarily due to reduced marketing and sales costs in North America, resulting from a reduction in head count and lower sales commission expenses. Sales and marketing expense for the nine months ended September 30, 2008, compared to the same period in 2007, remained flat. As a percentage of revenue, sales and marketing expenses for the three and nine months ended September 30, 2008, increased to 42% and 44%, respectively, compared to 38% in the same periods in 2007. This increase in sales and marketing expenses as a percentage of revenue was primarily attributable to lower than-expected U.S. revenue.

Our general and administrative expenses for the three and nine months ended September 30, 2008, compared to the same periods in 2007, decreased 16% and 5%, respectively, but increased slightly as a percentage of revenue due to lower levels of revenue.

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 in this Form 10-Q.

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, 2007 filed with SEC on March 13, 2008. There have been no significant changes during the nine months ended September 30, 2008 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, 2007, except for the items discussed below.

Fair Value Measurements

With effect from January 1, 2008, we adopted the fair value measurement provisions of Statement of Financial Accounting Standards, or SFAS, No. 157 “Fair Value Measurements”. This statement does not require any new fair value measurements. More specifically, SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy, which ranks the quality and reliability of the information used to determine fair value. SFAS No. 157 was effective January 1, 2008 for financial assets and liabilities and will be effective January 1, 2009 for non-financial assets and liabilities. For details on the adoption of SFAS No. 157 for financial assets and liabilities, see Note 1 “Summary of Significant Accounting Policies” to our Condensed Consolidated Financial Statements. We are currently evaluating the effect, if any, of the adoption of this statement for non-financial assets and liabilities on our financial condition and results of operations.

At September 30, 2008, total financial assets measured and recognized at fair value were $109.4 million and of these assets, $11.0 million, or 10%, were financial assets that were measured and recognized using significant unobservable inputs (Level 3). These assets were AAA to Aa3 rated municipal bonds, with an auction interest rate reset feature, known as auction rate securities (ARS). There were no non-financial assets or liabilities measured at fair value as of September 30, 2008.

The ARS held in our investment portfolio, were guaranteed either by the Federal Family Education Loan Program (FFELP) or the Maine Education Loan Authority (MELA), and were issued for the purpose of financing student loans. ARS have historically traded at par and are redeemable at par plus accrued interest at the option of the issuer. Interest is typically paid at the end of each auction period. Until February 2008, the market for our ARS portfolio was highly liquid. Starting in February 2008, a substantial number of auctions “failed,” meaning that there was not enough demand to sell all of the securities that holders desired to sell at auction. The immediate effect of a failed auction is that such holders cannot sell the securities at auction and the interest rate on the security generally resets to a maximum interest rate. In the case of funds invested by us in ARS which are the subject of a failed auction, we may not be able to access the funds without a loss of principal, unless a future auction of these investments are successful or the issuers redeem the securities. As of September 30, 2008, all of our ARS investment balance is classified as long term investments because of our belief that it could take more than one year before they are readily marketable. In addition, we also modified our current investment strategy and increased our investments in more liquid money market funds.

Given observable ARS market information was not available to determine the fair value of our ARS portfolio, we compared the fair value of our securities to a model using the discount rate adjustment technique as well as transaction data and bid-ask spread data for other similar illiquid securities from a secondary market. In determining the fair value using the discount rate adjustment technique, there were several significant assumptions, including:

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While our 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. For definitions of Level 2 and Level 3 inputs see ‘Note 1 Summary of Significant Accounting Policies’ of the Condensed Consolidated Financial Statements in Part I, Item I of this Form 10-Q. Based on the results of our fair value measurement, the net carrying value of our ARS as of September 30, 2008 was $11.0 million, which was classified as “Long term investments” on our Condensed Consolidated Balance Sheet.

The valuation of the ARS investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact the valuation of our ARS portfolio in the future include: changes to credit ratings of the securities, as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, counterparty risk and ongoing strength and quality of market credit and liquidity.

We determine if an investment is other-than-temporarily impaired by performing quarterly reviews of our portfolio of investments. If the cost of an investment exceeds its fair value, in making the judgment of whether there has been an other-than-temporary impairment, we consider available quantitative and qualitative evidence, including, among other factors, our intent and ability to hold the investment to maturity, the duration and extent to which the fair value is less than cost, specific adverse conditions related to the financial health of and business outlook for the investee and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, we record an impairment charge to our statement of operations and a new cost basis in the investment is established.

Since February 2008, due to the lack of liquidity experienced in the global credit and capital markets, and specifically in the ARS market, our ARS have experienced failed auctions and the estimated market values continue to decline. As a result, as of September 30, 2008 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 Loss,’ during the third quarter ended September 30, 2008.

The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, liquidity and ongoing strength and quality of credit markets. If the current market conditions deteriorate further, or the anticipated recovery in market values does not occur, we may be required to record additional impairment charges in future quarters.

We continue to monitor the market for ARS and consider its impact, if any, on the fair value of our ARS investments.

Recent Accounting Pronouncements

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 2 Summary of Significant Accounting Policies – Recent Accounting Pronouncement’ of the Condensed Consolidated Financial Statements in Part I, Item 1 of this Form 10-Q.

Results of Operations

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

Net Revenue

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For the three and nine months ended September 30, 2008, compared to the same periods in 2007, our U.S. revenue decreased by 46% and 30%, respectively. We believe that the current market conditions may be causing our non-core physician prospects to defer a purchasing decision at this time, even though most of these physicians may not be limited by credit barriers. Further, we believe that a segment of our business – those aesthetic practices that operate in settings that are not medical offices – are being particularly affected by the economic environment and may be finding it more difficult to obtain credit financing. This may be resulting in them delaying their purchase decisions. Also, FDA clearance for our Pearl product was received in early 2007, which allowed us to begin shipping our Pearl product in July 2007 and provided significant Upgrade revenue for the third quarter of 2007. In contrast, our Pearl Fractional product started shipping at the end of the third quarter of 2008, which resulted in lower Upgrade revenue in that period.

For the three and nine months ended September 30, 2008, compared to the same period in 2007, our international revenue decreased by 8% and increased by 18%, respectively. The decrease in international revenue for the three months ended September 30, 2008, compared to the same period last year, was primarily due to difficult economic conditions in some of our overseas markets. The increase in international revenue for the nine months ended September 30, 2008, compared to the same period in 2007, was primarily attributable to the continuing investments in developing our global infrastructure. These efforts have resulted in increased revenue from several of our geographic locations, including Europe and emerging global markets.

For the three and nine months ended September 30, 2008, compared to the same periods in 2007, our Product revenue decreased by 34% and 16%, respectively. This reflects slower revenue growth in the U.S. due to an uncertain worldwide economy, partially offset by higher international sales of our multi-application Xeo and CoolGlide products. Our Upgrade revenue in the third quarter and nine months ended September 30, 2008, compared to the same periods in 2007, decreased by 61% and 36%, respectively. This decrease was primarily attributable to reduced Upgrade revenue from our Pearl product, which accounted for significant Upgrade revenue in the third quarter of 2007. In contrast, our Pearl Fractional product started shipping at the end of the third quarter of 2008, which resulted in lower Upgrade revenue in that period.

Our service revenue increased by 25% and 32% in the three and nine months ended September 30, 2008, compared to the same periods in 2007, due primarily to a larger installed base of customers who are eligible to purchase extended service contracts. However, our sequential service revenue growth rates are declining as a result of fewer customers electing to purchase service contracts. We believe this reduced customer demand for service contracts is due to the challenging economic environment. Our Titan hand piece refills revenue increased 14% and 21% in the three and nine months ended September 30, 2008, compared to the same periods in 2007, due primarily to an increase in the installed base and grater utilization. Although we experienced modest growth when compared to year-ago periods, we have experienced flat sequential revenue in this category during the past four quarters. This revenue trend indicates a declining utilization level which we believe is caused by a softening economy.

Gross Profit

Our cost of revenue consists primarily of material, labor, stock-based compensation, royalty expense, warranty and manufacturing overhead expenses. For the three and nine months ended September 30, 2008, our gross margin declined to 59% and 61%, respectively, compared to 66% in the same periods of 2007. This decrease in gross margin was primarily attributable to:

Sales and Marketing