CUTERA INC - Quarter Report: 2019 September (Form 10-Q)

 

 

Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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FORM 10-Q

 

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(Mark One)

 

☒

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

 

For the quarterly period ended September 30, 2019

 

OR

 

☐

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

 

For the transition period _____ to_____.

 

Commission file number: 000-50644

 

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Cutera, Inc.

 

(Exact name of registrant as specified in its charter)

 

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Delaware	77-0492262
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

 

3240 Bayshore Blvd., Brisbane, California 94005

(Address of principal executive offices)

 

(415) 657-5500

(Registrant’s telephone number, including area code)

 

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock ($0.001 par value)	CUTR	The NASDAQ Stock Market, LLC

 

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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    ☒    No    ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒    No    ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer ☐     Accelerated filer ☒      Non-accelerated filer ☐      Smaller reporting company ☐     Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.☐

 

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

 

The number of shares of Registrant’s common stock issued and outstanding as of November 1, 2019 was 14,233,487.

 

 

 

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		September 30, 2019				December 31, 2018
Assets
Current assets:
Cash and cash equivalents		$	22,879			$	26,052
Marketable investments			6,448				9,523
Accounts receivable, net			23,222				19,637
Inventories			34,042				28,014
Other current assets and prepaid expenses			5,334				3,972
Total current assets			91,925				87,198
Property and equipment, net			2,771				2,672
Deferred tax asset			459				457
Operating lease right-of-use assets			8,332				—
Goodwill			1,339				1,339
Other long-term assets			6,410				5,971
Total assets		$	111,236			$	97,637
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable		$	14,140			$	11,279
Accrued liabilities			28,096				23,300
Operating lease liabilities			634				—
Extended warranty liability			2,232				3,159
Deferred revenue			10,164				9,882
Total current liabilities			55,266				47,620
Deferred revenue, net of current portion			3,309				2,684
Income tax liability			93				394
Operating lease liabilities, net of current portion			7,888				—
Other long-term liabilities			690				553
Total liabilities			67,246				51,251
Commitments and Contingencies (Notes 12 and 13)
Stockholders’ equity:
Common stock, $0.001 par value; authorized: 50,000,000 shares; issued and outstanding: 14,199,821 and 13,968,852 shares at September 30, 2019 and December 31, 2018, respectively			14				14
Additional paid-in capital			78,305				70,451
Accumulated deficit			(34,270)				(24,010)
Accumulated other comprehensive loss			(59)				(69)
Total stockholders’ equity			43,990				46,386
Total liabilities and stockholders’ equity		$	111,236			$	97,637

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		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2019				2018				2019				2018
Net revenue:
Products		$	40,315			$	35,675			$	113,045			$	102,589
Service			5,802				4,898				16,872				14,662
Total net revenue			46,117				40,573				129,917				117,251
Cost of revenue:
Products			16,343				15,909				50,278				46,876
Service			3,541				2,779				10,266				8,779
Total cost of revenue			19,884				18,688				60,544				55,655
Gross profit			26,233				21,885				69,373				61,596
Operating expenses:
Sales and marketing			17,691				14,479				50,786				43,102
Research and development			3,643				3,244				10,622				10,895
General and administrative			7,308				5,160				18,100				15,501
Total operating expenses			28,642				22,883				79,508				69,498
Loss from operations			(2,409)				(998)				(10,135)				(7,902)
Interest and other expense, net			(146)				(49)				(180)				(80)
Loss before income taxes			(2,555)				(1,047)				(10,315)				(7,982)
Income tax expense (benefit)			73				(174)				(55)				(3,505)
Net loss		$	(2,628)			$	(873)			$	(10,260)			$	(4,477)
Net loss per share:
Basic		$	(0.19)			$	(0.06)			$	(0.73)			$	(0.33)
Diluted		$	(0.19)			$	(0.06)			$	(0.73)			$	(0.33)
Weighted-average number of shares used in per share calculations:
Basic			14,182				13,851				14,095				13,717
Diluted			14,182				13,851				14,095				13,717

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		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2019				2018				2019				2018
Net loss		$	(2,628)			$	(873)			$	(10,260)			$	(4,477)
Other comprehensive loss:
Available-for-sale investments
Net change in unrealized gains on available-for-sale investments			1				13				10				9
Less: Reclassification adjustment for (gains) losses on investments recognized during the period			—				—				—				9
Net change in unrealized gains and losses on available-for-sale investments			1				13				10				18
Tax provision			—				—				—				—
Other comprehensive income, net of tax			1				13				10				18
Comprehensive loss		$	(2,627)			$	(860)			$	(10,250)			$	(4,459)

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		Common Stock								Additional Paid-in				Retained Earnings (Accumulated				Accumulated Other Comprehensive				Total Stockholders’
		Shares				Amount				Capital				Deficit)				Income (loss)				Equity
Balance at December 31, 2018			13,968,852			$	14			$	70,451			$	(24,010)			$	(69)			$	46,386
Issuance of common stock for employee purchase plan			53,803				—				833				—				—				833
Exercise of stock options			79,420				—				767				—				—				767
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes, and stock awards			97,746				—				(750)				—				—				(750)
Stock-based compensation expense			—				—				7,004				—				—				7,004
Net loss			—				—				—				(10,260)				—				(10,260)
Net change in unrealized loss on available-for-sale investments			—				—				—				—				10				10
Balance at September 30, 2019			14,199,821			$	14			$	78,305			$	(34,270)			$	(59)			$	43,990

		Common Stock								Additional Paid-in				Retained Earnings (Accumulated				Accumulated Other Comprehensive				Total Stockholders’
		Shares				Amount				Capital				Deficit)				Income (loss)				Equity
Balance at July 1, 2019			14,142,296			$	14			$	74,870			$	(31,642)			$	(60)			$	43,182
Exercise of stock options			38,966				—				437				—				—				437
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes, and stock awards			18,559				—				(180)				—				—				(180)
Stock-based compensation expense			—				—				3,178				—				—				3.178
Net loss			—				—				—				(2,628)				—				(2,628)
Net change in unrealized loss on available-for-sale investments			—				—				—				—				1				1
Balance at September 30, 2019			14,199,821			$	14			$	78,305			$	(34,270)			$	(59)			$	43,990

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		Common Stock								Additional Paid-in				Retained Earnings (Accumulated				Accumulated Other Comprehensive				Total Stockholders’
		Shares				Amount				Capital				Deficit)				Income (loss)				Equity
Balance at December 31, 2017			13,477,973			$	13			$	62,025			$	2,947			$	(92)			$	64,893
Adjustment to opening balance for ASC 606 adoption			—				—				—				3,813				—				3,813
Issuance of common stock for employee purchase plan			34,776				—				1,154				—				—				1,154
Exercise of stock options			241,021				1				2,448				—				—				2,449
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes, and stock awards			136,820				—				(2,971)				—				—				(2,971)
Stock-based compensation expense			—				—				5,524				—				—				5,524
Net loss			—				—				—				(4,477)				—				(4,477)
Net change in unrealized loss on available-for-sale investments			—				—				—				—				18				18
Balance at September 30, 2018			13,890,590			$	14			$	68,180			$	2,283			$	(74)			$	70,403

		Common Stock								Additional Paid-in				Retained Earnings (Accumulated				Accumulated Other Comprehensive				Total Stockholders’
		Shares				Amount				Capital				Deficit)				Income (loss)				Equity
Balance at July 1, 2018			13,824,252			$	14			$	66,291			$	3,156			$	(87)			$	69,374
Exercise of stock options			52,162				—				565				—				—				565
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes, and stock awards			14,176				—				(307)				—				—				(307)
Stock-based compensation expense			—				—				1,631				—				—				1,631
Net loss			—				—				—				(873)				—				(873)
Net change in unrealized loss on available-for-sale investments			—				—				—				—				13				13
Balance at September 30, 2018			13,890,590			$	14			$	68,180			$	2,283			$	(74)			$	70,403

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		Nine Months Ended September 30,
		2019				2018
Cash flows from operating activities:
Net loss		$	(10,260)			$	(4,477)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock-based compensation			7,004				5,524
Depreciation of tangible assets			1,184				849
Amortization of contract acquisition costs			2,169				1,304
Change in deferred tax asset			(2)				(3,507)
Provision for doubtful accounts receivable			647				877
Other			55				215
Changes in assets and liabilities:
Accounts receivable			(4,232)				(5,544)
Inventories			(6,028)				(2,540)
Other current assets and prepaid expenses			(1,423)				(797)
Other long-term assets			(2,608)				(2,301)
Accounts payable			2,861				6,319
Accrued liabilities			4,900				(4,177)
Extended warranty liabilities			(927)				—
Other long-term liabilities			(140)				105
Deferred revenue			907				58
Income tax liabilities			(301)				(27)
Net cash used in operating activities			(6,194)				(8,119)
Cash flows from investing activities:
Acquisition of property, equipment and software			(524)				(1,214)
Disposal of property and equipment			45				41
Proceeds from sales of marketable investments			—				13,044
Proceeds from maturities of marketable investments			11,450				8,050
Purchase of marketable investments			(8,304)				(4,390)
Net cash provided by investing activities			2,667				15,531
Cash flows from financing activities:
Proceeds from exercise of stock options and employee stock purchase plan			1,600				3,603
Taxes paid related to net share settlement of equity awards			(750)				(2,971)
Payments on finance lease obligations			(496)				(362)
Net cash provided by financing activities			354				270
Net increase (decrease) in cash and cash equivalents			(3,173)				7,682
Cash and cash equivalents at beginning of period			26,052				14,184
Cash and cash equivalents at end of period		$	22,879			$	21,866
Supplemental disclosure of non-cash items:
Assets acquired under finance lease		$	903			$	610

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Note 1. Summary of Significant Accounting Policies

 

Description of Operations and Principles of Consolidation

 

Cutera, Inc. (“Cutera” or the “Company”) provides energy-based aesthetic systems for practitioners worldwide. The Company designs, develops, manufactures, distributes and markets energy-based product platforms for use by physicians and other qualified practitioners, enabling them to offer safe and effective aesthetic treatments to their customers. The Company currently markets the following system platforms: excel, enlighten, Juliet, Secret RF, truSculpt and xeo. Several of the Company’s systems offer multiple hand pieces and applications, providing customers the flexibility to upgrade their systems. The sales of (i) systems, system upgrades, and hand pieces (collectively “Systems” revenue); (ii) replacement hand pieces, truSculpt iD and truSculpt flex cycle refills, as well as single use disposable tips applicable to Juliet and Secret RF (“Consumables” revenue); and (iii) the distribution of third party manufactured skincare products (“Skincare” revenue); are collectively classified as “Products” revenue. In addition to Products revenue, the Company generates revenue from the sale of post-warranty service contracts, parts, detachable hand piece replacements (except for Titan, truSculpt 3D, truSculpt iD and truSculpt flex) and service labor for the repair and maintenance of products that are out of warranty, all of which are collectively classified as “Service” revenue.

 

Headquartered in Brisbane, California, the Company operates wholly-owned subsidiaries in Australia, Belgium, Canada, France, Germany, Hong Kong, Japan, Spain, Switzerland and the United Kingdom. The Company’s wholly owned subsidiary in Italy is currently dormant. These active subsidiaries market, sell and service the Company’s 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

 

In the opinion of the Company, the accompanying unaudited Condensed Consolidated Financial Statements included in this report reflect all adjustments (consisting of only normal recurring adjustments) necessary for a fair statement of its financial position as of September 30, 2019 and 2018, its results of operations, comprehensive income (loss), consolidated statements of changes in equity for the three and nine months ended September 30, 2019 and 2018, and cash flows for the nine months ended September 30, 2019 and 2018. The December 31, 2018 condensed consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles in the United States of America (“GAAP”). The results for interim periods are not necessarily indicative of results for the entire year or any other interim period. The accompanying Condensed Consolidated Financial Statements should be read in conjunction with the Company’s previously filed audited financial statements and the related notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2018 filed with the Securities and Exchange Commission (the “SEC”) on March 18, 2019.

 

Accounting Policies

 

These unaudited Condensed Consolidated Financial Statements are prepared in accordance with the rules and regulations of the SEC applicable to interim financial statements. While these statements reflect all normal recurring adjustments that are, in the opinion of management, necessary for fair presentation of the results of the interim period, they do not include all of the information and footnotes required by GAAP for complete financial statements. These Condensed Consolidated Financial Statements should be read in conjunction with the financial statement disclosures in our annual report on Form 10-K for the year ended December 31, 2018 filed with the SEC on March 18, 2019.

 

The Company uses the same accounting policies in preparing quarterly and annual financial statements. Unless otherwise noted, amounts presented within the Notes to Condensed Consolidated Financial Statements refer to the Company’s continuing operations. Notes 2 and 12 provide information about the Company’s adoption of new accounting standards for leases.

 

Use of Estimates

 

The preparation of Condensed Consolidated Financial Statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the amounts reported of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Condensed Consolidated Financial Statements and the accompanying notes, and the reported amounts of revenue and expenses during the reported periods. Actual results could differ materially from those estimates.

 

On an ongoing basis, management evaluates its estimates, including those related to warranty obligations, sales commission, accounts receivable and sales allowances, valuation of inventories, fair value of goodwill, useful lives of property and equipment, incremental borrowing rates related to the Company’s leases, assumptions regarding variables used in calculating the fair value of the Company's equity awards, expected achievement of performance based vesting criteria, management performance bonuses, fair value of investments, the standalone selling price of the Company's products and services, the period of benefit used to capitalize and amortize contracts acquisition costs, variable consideration, contingent liabilities, recoverability of deferred tax assets, and effective income tax rates. Management bases 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.

 

 

Risks and Uncertainties

 

The Company's future results of operations involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from expectations include, but are not limited to, rapid technological change, continued acceptance of the Company's products, stability of global financial markets, cybersecurity breaches and other disruptions that could compromise the Company’s information or results, management of international activities, competition from substitute products and larger companies, ability to obtain and maintain regulatory approvals, government regulations and oversight, patent and other types of litigation, ability to protect proprietary technology from counterfeit versions of the Company's products, strategic relationships and dependence on key individuals.

 

Recently Adopted Accounting Pronouncements Adopted

 

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, "Leases," (also known as ASC Topic 842) which requires, among other items, a lessee to recognize most leases as assets and liabilities on the balance sheet. Qualitative and quantitative disclosures were enhanced to better understand the amount, timing and uncertainty of cash flows arising from leases. In July 2018, the FASB issued ASU 2018-11, "Targeted Improvements," which gives the option to apply the transition provisions of ASU 2016-02 at its adoption date instead of at the earliest comparative period presented in its financial statements. In addition, ASU 2018-11 provides a practical expedient that permits lessors to not separate non-lease components from the associated lease component if certain conditions are met. Also in July 2018, the FASB issued ASU 2018-10, "Codification Improvements to ASC Topic 842, Leases," which clarifies certain aspects of ASU 2016-02.

 

The Company adopted ASU 2016-02, as of January 1, 2019, using the modified retrospective method, to all leases existing at the date of initial application. The comparative period information has not been restated and continues to be reported under the accounting standards in effect for the period presented. The new standard provides a number of optional practical expedients in transition. The Company elected the package of practical expedients permitted under the transition guidance within the new standard, which allowed the Company to carry forward the Company’s historical conclusions about lease identification, lease classification and initial direct costs. The Company also elected the practical expedient related to land easements, allowing the Company to carry forward the Company’s accounting treatment for land easements on existing agreements. The Company did not elect the practical expedient to use hindsight in determining the lease term.

 

The adoption of the new standard resulted in the recording of additional lease assets and lease liabilities of $10.3 million and $10.4 million, respectively, as of January 1, 2019, based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. The difference between the additional lease assets and lease liabilities results from rent-free periods which were previously recorded as deferred rent. The Company’s accounting for finance leases remained substantially unchanged. The standard had no material impact on the Company’s condensed consolidated net earnings, results of operations, comprehensive loss, statements of changes in equity, and cash flows.

 

See Notes 2 and 12 for additional accounting policy and transition disclosures regarding ASC Topic 842.

 

In August 2018, the FASB issued ASU No. 2018-15, "Intangibles (Topic 350): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract", which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. This standard also requires customers to amortize the capitalized implementation costs of a hosting arrangement that is a service contract over the term of the hosting arrangement inclusive of expected contract renewals. The Company adopted this standard effective April 1, 2019, on a prospective basis for applicable implementation costs. The adoption of this guidance prospectively resulted in the capitalization of software development costs of $0.4 and $0.9 million during the three and six months ending September 30, 2019. These costs relate to implementation of a new Enterprise Resource Planning and Customer Relationship Management systems and are included in “other current assets and prepaid expenses” on the balance sheet.

 

 

 

Note 2. Effect of Adoption of the New Lease Standard (ASC Topic 842) on Condensed Consolidated Financial Statements

 

The Company adopted ASC Topic 842 on January 1, 2019, applying the modified retrospective method to all leases existing at the date of initial application. The comparative information has not been adjusted and continues to be reported under the accounting standards in effect for the prior period.

 

The following table summarizes the effects of adopting Topic 842 on the Company’s consolidated balance sheet as of January 1, 2019 (in thousands):

 

 

*Deferred rent included in other long-term liabilities

 

Note 3. Cash, Cash Equivalents and Marketable Investments

 

The Company invests its cash primarily in money market funds, U.S. Treasury bills and in highly liquid debt instruments of U.S. federal and municipal governments and their agencies, commercial paper and corporate debt securities. All highly liquid investments with stated maturities of three months or less from date of purchase are classified as cash equivalents; all highly liquid investments with stated maturities of greater than three months are classified as marketable investments. The majority of the Company’s cash and investments are held in U.S. banks and the Company's foreign subsidiaries maintain a limited amount of cash in their local banks to cover short term operating expenses.

 

The Company determines the appropriate classification of its investments in marketable securities at the time of purchase and re-evaluates such designation at each balance sheet date. The Company’s marketable securities are classified and accounted for as available-for-sale securities. Investments with remaining maturities of more than one year are viewed by the Company as available to support current operations and are classified as current assets under the caption marketable investments in the accompanying condensed consolidated balance sheets. Investments in marketable securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity. Any realized gains or losses on the sale of marketable securities are determined on a specific identification method, and such gains and losses are reflected as a component of interest and other income, net.

 

The following tables summarize the components, and the unrealized gains and losses position, related to the Company’s cash, cash equivalents and marketable investments (in thousands) as of September 30, 2019 and December 31, 2018:

 

 

 

 

As of September 30, 2019 and December 31, 2018, the gross unrealized gains and losses were $1,000 and $(9,000), respectively, and were related to interest rate changes on available-for-sale marketable investments. The Company has concluded that it is more-likely-than-not that the securities will be held until maturity or the recovery of their cost basis. No securities were in an unrealized loss position for more than 12 months.

 

The following table summarizes the contractual maturities of the Company’s available-for-sale securities, classified as marketable investments as of September 30, 2019 (in thousands):

 

 

Note 4. Fair Value of Financial Instruments

 

Fair value is an exit price representing the amount that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy contains three levels of inputs that may be used to measure fair value, in accordance with ASC 820, as follows:

 

●	Level 1: inputs, which include quoted prices in active markets for identical assets or liabilities;

●

Level 2: inputs, which include observable inputs other than Level 1 inputs, such as quoted prices for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability. For available-for-sale securities, the Company reviews trading activity and pricing as of the measurement date. When sufficient quoted pricing for identical securities is not available, the Company uses market pricing and other observable market inputs for similar securities obtained from various third-party data providers. These inputs either represent quoted prices for similar assets in active markets or have been derived from observable market data; and

●

Level 3: inputs, which include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the underlying asset or liability. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies, or similar valuation techniques, as well as significant management judgment or estimation.

 

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.

 

As of September 30, 2019, 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 were as follows (in thousands):

 

 

 

As of December 31, 2018, 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):

 

 

Money market funds and U.S. Treasury bills are highly liquid investments and are actively traded. The pricing information on these investment instruments are readily available and can be independently validated as of the measurement date. This approach results in the classification of these securities as Level 1 of the fair value hierarchy.

 

Corporate debt, U.S. government-backed securities, and commercial paper are measured at fair value using Level 2 inputs. The Company reviews trading activity and pricing for these investments as of each measurement date. When sufficient quoted pricing for identical securities is not available, the Company uses market pricing and other observable market inputs for similar securities obtained from various third party data providers. These inputs represent quoted prices for similar assets in active markets or these inputs have been derived from observable market data. This approach results in the classification of these securities as Level 2 of the fair value hierarchy. The average remaining maturity of the Company’s Level 2 investments as of September 30, 2019 is less than nine months and all of these investments are rated by S&P and Moody’s at A or better. The Company recognizes transfers between levels of the fair value hierarchy as of the end of the reporting period. There were no transfers within the hierarchy during the quarter and year ended September 30, 2019 and December 31, 2018, respectively.

 

Note 5. Balance Sheet Details

 

Inventories

 

As of September 30, 2019 and December 31, 2018, inventories consist of the following (in thousands):

 

 

 

Accrued Liabilities

 

As of September 30, 2019 and December 31, 2018, accrued liabilities consist of the following (in thousands):

 

 

 

Product Remediation Liability

 

During the fourth quarter of 2018, the Company recognized a liability for a product remediation plan related to one of its legacy systems. This product remediation plan, a voluntary action initiated by the Company, includes the replacement of a component in one of our legacy products. The accrued liability consists of the cost of materials and labor to replace the component in all units under the Company's standard warranty or covered under an existing Extended Warranty contract as of the fourth quarter of 2018. The Company recorded approximately $5.0 million related to this product remediation plan, of which $1.1 million was utilized in the fourth quarter of 2018. As of December 31, 2018, approximately $0.7 million of the balance was related to product warranty and included in accrued liabilities, and $3.2 million was separately recorded as Extended Warranty Liability.

 

 

In the nine months ended September 30, 2019, the Company utilized $0.2 million related to product warranty and $0.9 million related to extended warranty liability. As of September 30, 2019, the product remediation warranty and extended warranty liability were $0.5 million and $2.2 million, respectively.

 

Note 6. Warranty and Extended Service Contract

 

The Company has a direct field service organization in North America (including Canada). Internationally, the Company provides direct service support in Australia, Belgium, France, Germany, Hong Kong, Japan, Spain and Switzerland, as well as through third-party service providers in the United Kingdom. In other countries, where the Company does not have a direct presence, the Company provides service through a network of distributors and third-party service providers.

 

After the original warranty period, maintenance and support are offered on an extended service contract basis or on a time and materials basis. The Company provides for the estimated cost to repair or replace products under standard warranty at the time of sale. Costs incurred in connection with extended service contracts are recognized at the time when costs are incurred, except the one-time extended service contracts charge of $3.2 million in December 31, 2018, related to the cost to replace a component in one of the Company's legacy products.

 

The following table provides the changes in the product standard warranty accrual for the three and nine months ended September 30, 2019 and 2018 (in thousands):

 

 

Note 7. Deferred Revenue

 

The Company records deferred revenue when revenue is to be recognized subsequent to invoicing. For extended service contracts, the Company generally invoices customers at the beginning of the extended service contract term. The Company’s extended service contracts typically have one, two or three year terms. Deferred revenue also includes payments for installation, training and extended marketing support service. As of September 30, 2019, approximately 75% of the deferred revenue balance of $13.5 million will be recognized over the next 12 months.

 

The following table provides changes in the deferred service contract revenue balance for the three and nine months ended September 30, 2019 and 2018 (in thousands):

 

 

Costs for extended service contracts were $2.3 million and $6.5 million, respectively, for the three and nine months ended September 30, 2019, and $1.7 million and $5.7 million, respectively, for the three and nine months ended September 30, 2018.

 

Note 8. Revenue

 

Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for promised goods or services. The Company’s performance obligations are satisfied either over time or at a point in time. Revenue from performance obligations that are transferred to customers over time accounted for approximately 13% and 9% respectively, of the Company’s total revenue for the nine months ended September 30, 2019 and 2018.

 

 

The Company has certain system sale arrangements that contain multiple products and services. For these bundled sale arrangements, the Company accounts for individual products and services as separate performance obligations if they are distinct. The Company’s products and services are distinct if a customer can benefit from the product or service on its own or with other resources that are readily available to the customer, and if the Company’s promise to transfer the products or service to the customer is separately identifiable from other promises in the sale arrangements. The Company’s system sale arrangements can include all or a combination of the following performance obligations: the system and software license (considered as one performance obligation), system accessories (hand pieces), training, other accessories, extended service contracts and marketing services.

 

For the Company’s system sale arrangements that include an extended service contract, the period of service commences at the expiration of the Company’s standard warranty offered at the time of the system sale. The Company considers the extended service contracts terms in the arrangements that are legally enforceable to be performance obligations. Other than extended service contracts and marketing services, which are satisfied over time, the Company generally satisfies all performance obligations at a point in time. Systems, system accessories (hand pieces), training, and time and materials services are also sold on a stand-alone basis, and these performance obligations are satisfied at a point in time. For contracts with multiple performance obligations, the Company allocates the transaction price of the contract to each performance obligation on a relative standalone selling price basis.

 

Nature of Products and Services

 

Systems

 

Systems revenue is generated from the sale of systems and from the sale of upgrades to existing systems. A system consists of a console that incorporates a universal graphic user interface, a laser or other energy based module, control system software and high voltage electronics, as well as one or more hand pieces. In certain applications, the laser or other energy-based module is contained in the hand piece, such as with the Company’s Pearl and Pearl Fractional applications, rather than within the console.

 

The Company offers 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 provides customers the flexibility to upgrade their systems whenever they choose and provides the Company with a source of additional Systems revenue.

 

The system or upgrade and the right to use the embedded software represent a single performance obligation as the software license is integral to the functionality of the system or upgrade.

 

The Company does not identify calibration and installation services for systems other than enlighten as performance obligations because such services are immaterial in the context of the sale arrangement. The related costs to complete calibration and installation for systems other than enlighten are immaterial. Calibration and installation services for enlighten systems are identified as separate performance obligations.

 

For systems sold directly to end-customers that are credit approved, revenue is recognized when the Company transfers control to the end-customer, which occurs when the product is shipped to the customer or when the customer receives the product, depending on the nature of the arrangement. When collectability is not established in advance of receipt of payment from the customer, revenue is recognized upon the later of the receipt of payment or the satisfaction of the performance obligation. For systems sold through credit approved distributors, revenue is recognized at the time of shipment to the distributor.

 

The Company typically receives payment for its system consoles and other accessories within 30 days of shipment. Certain international distributor arrangements allow for longer payment terms.

 

Skincare products

 

The Company sells third-party manufactured skincare products in Japan. The third-party skincare products are purchased from the third-party manufacturer and sold to licensed physicians. The Company acts as the principal in this arrangement, as it determines the price to charge customers for the skincare products, and controls the products before they are transferred to the customer. Sales of skincare products are typically the subject of contracts in which the skincare products represent the sole performance obligations. The Company recognizes revenue for skincare products at a point in time, at time of shipment.

 

Consumables (Other accessories)

 

The Company treats its customers' purchases of replacement cycles for truSculpt iD and truSculpt flex, as well as replacement Titan and truSculpt 3D hand pieces, as Consumable revenue, which provides the Company with a source of recurring revenue from existing customers. The Juliet and Secret RF products have single use disposable tips which must be replaced after every treatment. Sales of these consumable tips further enhance the Company’s recurring revenue. Hand piece refills of the Company’s legacy truSculpt product are accounted for in accordance with the Company’s standard warranty and service contract policies.

 

 

Extended contract services

 

The Company offers post-warranty services to its customers through extended service contracts that cover parts and labor for a term of one, two, or three years. Service contract revenue is recognized over time, using a time based measure of progress, as the customers benefit from the service throughout the service period. The Company also offers services on a time-and-materials basis for systems and detachable hand piece replacements. Revenue related to services performed on a time-and-materials basis is recognized when performed. These post-warranty services serve as additional sources of recurring revenue from the Company’s installed product base.

 

Training

 

Sales of systems to customers include training on the use of the system to be provided within 180 days of purchase. The Company considers training a separate performance obligation as customers can immediately benefit from the training together with the customer’s system. Training is also sold separately from systems. The Company recognizes revenue for training when the training is provided. Training is not required for customers to use the systems.

 

Customer Marketing Support

 

In North America, the Company offers marketing and consulting phone support to its customers across all system platforms. These customer marketing support services include a practice development model and marketing training, performed remotely with ongoing phone consultations for six months from date of purchase. The Company considers customer marketing support a separate performance obligation, and recognizes revenue over the six-month term of the contracts.

 

Significant Judgments

 

The determination of whether two or more contracts entered into at or near the same time with the same customer should be combined and accounted for as one contract may require the use of significant judgment. In making this determination, the Company considers whether the contracts are negotiated as a package with a single commercial objective, have price interdependencies, or promise goods or services that represent a single performance objective

 

While the Company’s purchase agreements do not provide customers with a contractual right of return, the Company maintains a sales allowance to account for potential returns or refunds as a reduction in transaction price at the time of sale. The Company estimates sales returns and other variable consideration based on historical experience.

 

The Company determines standalone selling price ("SSP") for each performance obligation as follows:

 

●	Systems: The SSPs for systems are based on directly observable sales in similar circumstances to similar customers. When SSP is not directly observable, the Company estimates SSP using the expected cost plus margin approach.
●	Training: SSP is based on observable price when sold on a standalone basis.

●	Extended warranty/Service contracts: SSP is based on observable price when sold on a standalone basis (by customer type).

●	Customer Marketing Support: SSP is estimated based on cost plus a margin.

●	Set-up /Installation: SSP is based on observable price when sold on a standalone basis. Set-up or installation for all systems, excluding the enlighten system, is immaterial in the context of the contract. The related costs to complete set-up or installation are immaterial.

 

The calibration and installation service of the enlighten system are treated as separate performance obligations because the Company regularly sells enlighten systems without the calibration and installation service.

 

Loyalty Program

 

The Company launched a customer loyalty program during the third quarter of 2018 for qualified customers located in the U.S. and Canada. Under the loyalty program, customers accumulate points based on their purchasing levels. Once a loyalty program member achieves a certain tier level, the member earns a reward. A customer’s account must be in good standing to receive the benefits of the rewards program. Rewards are earned on a quarterly basis and must be used in the following quarter. Customers receive a notification regarding their rewards tier by the fifth day of the following quarter. All unused rewards are forfeited. The fair value of the reward earned by loyalty program members is included in accrued liabilities and recorded as a reduction of net revenue at the time the reward is earned.  As of September 30, 2019, the accrual for the loyalty program included in accrued liabilities was $0.2 million.

 

Deferred Sales Commissions

 

Incremental costs of obtaining a contract, which consist primarily of commissions and related payroll taxes, are capitalized and amortized on a straight-line basis over the expected period of benefit. The Company uses the portfolio method to recognize the amortization expense related to these capitalized costs related to initial contracts and such expense is recognized over a period associated with the revenue of the related portfolio, which is generally two to three years.

 

 

Total capitalized costs as of September 30, 2019 were $4.7 million and are included in other assets in the Company’s condensed consolidated balance sheet. Amortization expense for these assets was $0.8 million and $2.2 million respectively, during the three and nine months ended September 30, 2019 and is included in sales and marketing expense in the Company’s condensed consolidated statement of operations. Amortization expense was $0.5 million and $1.3 million, respectively, during the three and nine months ended September 30, 2018.

 

Note 9. Stockholders’ Equity and Stock-based Compensation Expense

 

The Company’s equity incentive plans are broad-based, long-term programs intended to attract and retain talented employees and align stockholder and employee interests. In June 2019, stockholders approved an amendment and restatement of the Amended and Restated 2004 Equity Incentive Plan (the “Prior Plan”) as the 2019 Equity Incentive Plan (the “2019 Plan”) and approved an additional 700,000 shares, available for future grants (in addition to the 9,701,192 shares provided under the Prior Plan). The 2019 Plan provides for the grant of incentive stock options, non-statutory stock options, RSAs, restricted stock units (“RSUs”), stock appreciation rights, performance stock units, performance shares, and other stock or cash awards.

 

The Company awarded zero and 42,236 RSUs to its non-employee directors during the three and nine months ended September 30, 2019, respectively. Executive officers, senior management and certain employees were awarded 10,185 and 375,252 performance stock units (“PSUs”) by the Board of Directors (“Board”) during the three and nine months ended September 30, 2019, respectively. The PSUs granted in the nine months ended September 30, 2019 vest subject to the recipients’ continued service and the achievement of certain performance goals for the Company’s 2019 fiscal year established by the Board and relating to the achievement of revenue targets for consumable products, revenue targets for international revenue, and specific operational milestones related to product performance and IT systems implementation projects. On September 5, 2019, the Board made a modification to all the PSU grants outstanding as of September 4, 2019, such that 15% of the PSUs will now vest upon the achievement of revenue targets for consumable products or revenue targets for international revenue rather than upon the achievement of targets related to IT systems implementation projects.  The modified PSUs were valued at the Company’s share price on the date of the modification. The impact due to the PSU modification was $0.2 million.

 

The 10,185 PSUs awards during the three months ended September 30, 2019, relate to 15% of 67,897 shares the Company's Board awarded its new CEO, David H. Mowry, scheduled to vest over 4 years from 2019 through 2022.  These PSUs are subject to certain performance-based criteria related to achieving financial metrics in the Board approved annual budgets for the years 2019 through 2022. As of September 30, 2019, the Company concluded that only the 2019 tranche meets the criteria for measurement and recognition. However the 2020-2022 tranches (2020 tranche = 25% of the target number of the PSUs; 2021 tranche = 30% of the target number of the PSUs; and 2022 tranche = 30% of the target number of the PSUs) do not meet the criteria for measurement and recognition as of September 30, 2019, and will meet the criteria for measurement and commencement of recognition when the Company’s Board of Directors establishes the financial metrics for each fiscal year.

 

The Board also awarded executive officers, senior management and certain employees 147,317 and 414,423 RSUs during the three and nine months ended September 30, 2019, respectively. 25% of the RSUs granted vest on each of the first four anniversaries of the vest date subject to the recipients’ continued service.

 

As of September 30, 2019, there was approximately $15.8 million of unrecognized compensation expense, net of projected forfeitures, for stock options and stock awards. The expense is expected to be recognized over the remaining weighted-average period of 1.65 years. The actual expense recorded in the future may be higher or lower based on a number of factors, including, actual forfeitures experienced and the degree of achievement of the performance goals related to the PSUs granted.

 

Activities under the 2004 and 2019 Equity Incentive Plans are summarized as follows:

 

 

*The Company had a “fungible share” provision in the Prior Plan whereby for each full-value award (RSU/PSU) issued or canceled under the Prior Plan required the subtraction or add back of 2.12 shares from or to the Shares Available for Grant, respectively. The Company’s stockholders approved the removal of the “fungible share” provision for awards granted on or after June 14, 2019 upon adoption of the Amended and Restated Plan at the Company’s 2019 Annual Meeting of Stockholders held on June 14, 2019.

 

 

Non-Employee Stock-Based Compensation

 

The Company granted 9,303 RSUs and 11,920 PSUs to non-employees during the nine months ended September 30, 2019. The RSUs granted vest over four years at 25% on each anniversary of the grant date. The PSUs vest over a year subject to the same performance criteria as the PSUs granted to employees. The PSUs granted in the three and nine months ended September 30, 2019 vest subject to the recipients continued service.

 

Stock-based Compensation Expense

 

Stock-based compensation expense by department recognized during the three and nine months ended September 30, 2019 and 2018 were as follows (in thousands):

 

 

*Included in the nine-month ended September 30, 2019 stock-based compensation expense is the charge in connection with the accelerated vesting of 4,667 shares of the Company’s former CEO, in accordance with his separation agreement dated January 4, 2019.

 

Note 10. Net Loss Per Share

 

Basic net loss per share is computed using the weighted-average number of shares outstanding during the period. In periods of net income, diluted shares outstanding include the dilutive effect of in-the-money equity awards (stock options, RSUs, PSUs and employee stock purchase plan contributions), which is calculated based on the average share price for each fiscal period using the treasury stock method.

 

Diluted earnings per share is the same as basic earnings per share for the periods in which the Company had a net loss because the inclusion of outstanding common stock equivalents would be anti-dilutive.

 

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, except per share data):

 

 

 

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

 

 

Note 11. Income Taxes

 

For the three and nine months ended September 30, 2019, the Company's income tax expense and benefit were $73,000 and $55,000, respectively, compared to tax benefits of $174,000 and $3,505,000, respectively, for the same periods in 2018.

 

The Company's income tax benefit for the nine month ended September 30, 2019 is due primarily to the release of reserve for uncertain tax position in Germany of $0.3 million, partially offset by income taxes in foreign jurisdictions. Based on all available objectively verifiable evidence during the three and nine months ended September 30, 2019, the Company believes it is more likely than not that the tax benefits of the U.S. losses incurred will not be realized. Accordingly, the Company will continue to maintain a full valuation allowance on the U.S. deferred tax assets. There was no valuation allowance during the three months ended September 30, 2018 other than the California jurisdiction.

 

 

 

Note 12. Leases

 

The Company is a party to certain operating and finance leases for vehicles, office space and storages. The Company’s material operating leases consist of office space, as well as storage facilities. The Company’s leases generally have remaining terms of 1 to 10 years, some of which include options to renew the leases for up to 5 years. The Company leases space for operations in the United States, Japan, Belgium, France and Spain. In addition to the above facility leases, the Company also routinely leases automobiles for certain sales and field service employees under operating leases.

 

The Company determines if a contract contains a lease at inception. Operating lease assets and liabilities are recognized at the lease commencement date. Operating lease liabilities represent the present value of lease payments not yet paid. Operating lease assets represent the right to use an underlying asset and are based upon the operating lease liabilities adjusted for prepayments or accrued lease payments, initial direct costs, lease incentives, and impairment of operating lease assets. To determine the present value of lease payments not yet paid, the Company estimates the incremental secured borrowing rates corresponding to the maturities of the leases. The Company based the rate estimates on prevailing financial market conditions, credit analysis, and management judgment.

 

The Company recognizes expense for these leases on a straight-line basis over the lease term. Additionally, tenant incentives used to fund leasehold improvements are recognized when earned and reduce our right-of-use asset related to the lease. These are amortized through the right-of-use asset as reductions of expense over the lease term.

 

Below is supplemental balance sheet information related to leases (in thousands):

 

 

*Finance lease assets included in Property and equipment, net.

 

 

 

 

 

Lease costs during the three months ended September 30, 2019: 

 

Lease costs during the nine months ended September 30, 2019:

 

Cash paid for amounts included in the measurement of lease liabilities during the three months ended September 30, 2019 were as follows:

 

Cash paid for amounts included in the measurement of lease liabilities during the nine months ended September 30, 2019 were as follows:

 

 

Maturities of lease liabilities

 

Maturities of lease liabilities were as follows as of September 30, 2019 (in thousands):

 

 

Vehicle Leases

 

As of September 30, 2019, the Company was committed to minimum lease payments for vehicles leased under long-term non-cancelable finance leases as follows (in thousands):

 

 

As previously disclosed in our 2018 Annual Report on Form 10-K and under the previous lease accounting, maturities of lease liabilities were as follows as of December 31, 2018:

 

Facility Leases

 

As of December 31, 2018, the Company was committed to minimum lease payments for facilities and other leased assets under long-term non-cancelable operating leases as follows (in thousands):

 

Vehicle Leases – U.S.

 

As of December 31, 2018, the Company was committed to minimum lease payments for vehicles leased under long-term non-cancelable capital leases as follows (in thousands):

 

 

Weighted-average remaining lease term and discount rate, as of September 30, 2019, were as follows:

 

 

Note 13. Contingencies

 

The Company is named from time to time as a party to other legal proceedings, product liability, commercial disputes, employee disputes, and contractual lawsuits in the ordinary course of business. A liability and related charge are recorded to earnings in the Company’s consolidated financial statements for legal contingencies when the loss is considered probable and the amount can be reasonably estimated. The assessment is re-evaluated each accounting period and is based on all available information, including discussion with outside legal counsel. If a reasonable estimate of a known or probable loss cannot be made, but a range of probable losses can be estimated, the low-end of the range of losses is recognized if no amount within the range is a better estimate than any other. If a material loss is reasonably possible, but not probable and can be reasonably estimated, the estimated loss or range of loss is disclosed in the notes to the consolidated financial statements. The Company expenses legal fees as incurred.

 

As of September 30, 2019 and December 31, 2018, the Company had zero and $171,000 accrued, respectively, related to various pending contractual and product liability lawsuits. The Company does not believe that a material loss in excess of accrued amounts is reasonably likely.

 

Note 14. Debt

 

On May 30, 2018, the Company and Wells Fargo Bank, N.A. (“Wells Fargo”) entered into a Loan and Security Agreement (the “Original Revolving Line of Credit”) in the original principal amount of $25 million. The Original Revolving Line of Credit terminates on May 30, 2021.

 

On or about November 2, 2018, the Company entered into a First Amendment and Waiver to the Loan and Security Agreement with Wells Fargo (the “First Amended Revolving Line of Credit”). The First Amended Revolving Line of Credit provided for an original principal amount of $15 million, with the ability to request an additional $10 million, and a waiver of any existing defaults under the Original Revolving Line of Credit as long as the Company is in compliance with the terms of the First Amended Revolving Line of Credit.

 

On or about, March 11, 2019, the Company entered into a Second Amendment and Waiver to the Loan and Security Agreement with Wells Fargo (the “Second Amended Revolving Line of Credit”). The Second Amended Revolving Line of Credit requires the Company to maintain a minimum cash balance of $15 million at Wells Fargo, but removes all other covenants so long as no money is drawn on the line of credit. The Company may draw down on the line of credit at the time it reaches and maintains trailing twelve months adjusted EBITDA of not less than $10 million, and a leverage ratio not to exceed 2.5 to 1.0.

 

As of September 30, 2019, the Company had not drawn on the Original Revolving Line of Credit and the Company is in compliance with all financial covenants of the Original Revolving Line of Credit, as amended by the First and Second Amendment to the Revolving Line of Credit.

 

Note 15. Segment Reporting

 

Segment reporting is based on the “management approach,” following the method that management organizes the company’s reportable segments for which separate financial information is made available to, and evaluated regularly by, the chief operating decision maker in allocating resources and in assessing performance. The Company’s chief operating decision maker ("CODM") is its Chief Executive Officer ("CEO"), who makes decisions on allocating resources and in assessing performance. The CEO reviews the Company's consolidated results as one operating segment. In making operating decisions, the CEO primarily considers consolidated financial information, accompanied by disaggregated information about revenues by geography and product. All of the Company’s principal operations and decision-making functions are located in the U.S. The Company’s CEO views its operations, manages its business, and uses one measurement of profitability for the one operating segment - which sells aesthetic medical equipment and services, and distributes skincare products, to qualified medical practitioners. Substantially all of the Company’s long-lived assets are located in the U.S.

 

 

The following table presents a summary of revenue by geography for the three months ended September 30, 2019 and 2018:

 

 

The following table presents a summary of revenue by geography for the nine months ended September 30, 2019 and 2018: