The Daily Magic Formula Stock for 12/28/2007 is Cutera Inc. According to the Magic Formula Investing Web Site, the ebit yield is 17% and the EBIT ROIC is >100%.
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We are a global medical device company specializing in the design, development, manufacture, marketing and servicing of laser and other light-based aesthetics systems for practitioners worldwide. We offer easy-to-use products based on three platformsâ€”CoolGlide Â® , Xeo Â® and Solera Â® â€”which enable dermatologists, plastic surgeons, gynecologists, primary care physicians and other qualified practitioners to perform safe, effective and non-invasive aesthetic procedures for their customers.
â€˘ CoolGlide - Our first product platform, CoolGlide, was launched in March 2000. This product offers hair removal, treatment of a range of vascular lesions, including leg and facial veins, and laser genesisâ€”a non-ablative procedure to promote healthy looking skin, reduce pore size and improve skin texture.
â€˘ Xeo- In 2003, we introduced the Xeo platform of products, which combine pulsed light and laser applications in a single platform. The Xeo is a fully upgradeable platform on which a customer can use every application that we offer, in order to perform such procedures as hair removal, skin rejuvenation, vascularâ€”and pigmented lesion therapies and wrinkle treatment.
â€˘ Solera- In 2004, we introduced our Solera platformâ€”a compact tabletop system designed to support a single technology platform.
Âˇ Solera Titan- The first technology available on the Solera platform was the Titan Â® , an infrared heat lamp used for deep dermal heating to treat wrinkles. In 2006, we introduced two new handpiecesâ€”Titan V and Titan XLâ€”that improve the efficiency of the Titan procedures. Titan V allows practitioners to effectively treat delicate areas such as the skin around the eyes and nose, and the Titan XL designed for treating large body areas, such as arms, abdomens and legs.
Âˇ Solera Opus - In 2005, we introduced a product called Solera Opus that offers applications for hair removal, skin rejuvenation and treatment of facial vascular conditions.
In addition, in 2006, we also introduced a product called LimeLight â„˘ â€”a three-in-one hand piece for skin rejuvenation, pigmented lesions and facial vascular lesions. LimeLight can be used with our Xeo or Solera platforms.
Each of our products consists of one or more handpieces and a console that incorporates a universal graphic user interface, a laser or other light-based module, control system software and high voltage electronics. We offer our customers the ability to select the system that best fits their practice. We design our products to allow our customers to cost-effectively upgrade to our multi-application products, which enables them to add applications to their aesthetic practice and provides us with a source of recurring revenue.
The Structure of Skin and Conditions that Affect Appearance
The skin is the bodyâ€™s largest organ and is comprised of layers called the epidermis and dermis. The epidermis is the outer layer, and serves as a protective barrier for the body. It contains cells that determine pigmentation, or skin color. The underlying layer of skin, the dermis, contains hair follicles and large and small blood vessels that are found at various depths below the epidermis. Collagen, also found within the dermis, provides strength and flexibility to the skin.
Many factors, such as age, sun damage and the human bodyâ€™s diminished ability to repair and renew itself over time, can result in aesthetically unpleasant changes in the appearance of the skin. These changes can include undesirable hair growth. Additionally, blood vessels can enlarge or swell due to circulatory changes and become visible at the skinâ€™s surface in the form of unsightly veins. Collagen can deteriorate, thereby weakening the skin, leading to wrinkles and looseness. Long-term sun exposure can result in uneven pigmentation, or sun spots. People with undesirable hair growth or the above mentioned skin conditions often seek aesthetic treatments to improve their appearance.
The Market for Non-Surgical Aesthetic Procedures
The market for non-surgical aesthetic procedures has grown significantly over the past several years. The American Society of Plastic Surgeons estimates that in 2005 there were 8.4 million minimally-invasive aesthetic procedures performed, a 13% increase over 2004 and a 53% increase over 2000. We believe there are several factors contributing to the growth of these aesthetic procedures, including:
â€˘ Aging of the U.S. Population. The â€śbaby boomerâ€ť demographic segment, ages 42 to 60 in calendar 2006, represented approximately 28% of the U.S. population in 2003. The size of this aging segment, and its desire to retain a youthful appearance, has driven the growth for aesthetic procedures.
â€˘ Broader Range of Safe and Effective Treatments. Technical developments have led to safe, effective, easy-to-use and low-cost treatments with fewer side effects, resulting in broader adoption of aesthetic procedures by practitioners. In addition, technical developments have enabled practitioners to offer a broader range of treatments. Finally, these technical developments have reduced the required treatment and recovery time, which in turn has led to greater patient demand.
â€˘ Changing Practitioner Economics. Managed care and government payer reimbursement restrictions in the United States, and similar payment related constraints outside the United States, are motivating practitioners to establish or expand their elective aesthetic practices with procedures that are paid for directly by patients. As a result, in addition to the traditional users such as dermatologists and plastic surgeons, other practitioners, such as gynecologists, primary care physicians and other practitioners, or non-core customers, are performing these procedures.
Non-Surgical Aesthetic Procedures for Improving the Skinâ€™s Appearance and Their Limitations
Many alternative therapies are available for improving a personâ€™s appearance by treating specific structures within the skin. These procedures utilize injections or abrasive agents to reach different depths of the dermis and the epidermis. In addition, non-invasive treatments have been developed that employ laser and other light-based technologies to achieve similar therapeutic results. Some of these more common therapies and their limitations are described below.
Hair Removal- Techniques for hair removal include waxing, depilatories, tweezing, shaving, electrolysis and laser and other light-based hair removal. The only techniques that provide a long-lasting solution are electrolysis and light-based hair removal. Electrolysis is usually painful, time-consuming and expensive for large areas, but is the most common method for removing light-colored hair. During electrolysis, an electrologist inserts a needle directly into a hair follicle and activates an electric current in the needle. Since electrolysis only treats one hair follicle at a time, the treatment of an area as small as an upper lip may require numerous visits and up to ten hours of treatment. In addition, electrolysis can cause blemishes and infection related to needle use.
Leg and Facial Veins- The current aesthetic treatment methods for leg and facial veins include sclerotherapy and light-based treatments. With these treatments, patients seek to eliminate visible veins and improve overall skin appearance. Sclerotherapy requires a skilled practitioner to inject a saline or detergent-based solution into the target vein, which breaks down the vessel causing it to collapse and be absorbed into the body. The need to correctly position the needle on the inside of the vein makes it difficult to treat smaller veins, which limits the treatment of facial vessels and small leg veins. The American Society of Plastic Surgeons estimates that its members performed over 590,000 sclerotherapy procedures in 2005.
Skin Rejuvenation- Non-light-based skin rejuvenation treatments include a broad range of popular alternatives, including Botox and collagen injections, chemical peels and microdermabrasions. With these treatments, patients hope to improve overall skin tone and texture, reduce pore size, and remove other signs of aging, including mottled pigmentation, diffuse redness and wrinkles. All of these procedures are temporary solutions and must be repeated within several weeks or months to sustain their effect, thereby increasing the cost and inconvenience to patients. For example, the body absorbs Botox and collagen and patients require supplemental injections every three to six months to maintain the benefits of these treatments.
Some skin rejuvenation treatments, such as chemical peels and microdermabrasions, can have undesirable side effects. Chemical peels use acidic or caustic solutions to peel away the epidermis, and microdermabrasion generally utilizes sand crystals to resurface the skin. These techniques can lead to post-procedure stinging, redness, irritation and scabbing. In addition, more serious complications, such as changes in skin color, can result from deeper chemical peels. Patients that undergo these deep chemical peels are also advised to avoid exposure to the sun for several months following the procedure. The American Society of Plastic Surgeons estimates that in 2005 its members administered 3.8 million injections of Botox and over 870,000 injections of collagen and other soft-tissue fillers, and performed 1.0 million chemical peels and over 800,000 microdermabrasion procedures.
Tissue Tightening and the Treatment of Wrinkles- Non-surgical techniques for treating wrinkles include radiofrequency and light-based technologies. In radio-frequency tissue tightening energy is applied to heat the dermis of the skin with the goal of shrinking and tightening the collagen fibers. This approach may result in a more subtle and incremental change to the skin than a surgical facelift. Drawbacks to this approach may include surface irregularities that can resolve over time, and the risk of burning the treatment area.
Laser and Other Light-Based Aesthetic Treatments
Laser and other light-based aesthetic treatments can achieve therapeutic results by non-invasively affecting structures within the skin. The development of safe and effective aesthetic treatments has created a well-established and growing market for these procedures.
Ablative skin resurfacing is a method of improving the appearance of the skin by removing the outer layers of the skin. Non-ablative skin resurfacing is a method of improving the appearance of the skin by treating the underlying structure of the skin without damaging the outer layers of the skin. Practitioners use laser and other light-based technologies to selectively target hair follicles, veins or collagen in the dermis, as well as cells responsible for pigmentation in the epidermis, without damaging surrounding tissue. Safe and effective laser and other light-based treatments require an appropriate combination of the following four parameters:
â€˘ Energy Level : the amount of light emitted to heat a target;
â€˘ Pulse Duration : the time interval over which the energy is delivered;
â€˘ Spot Size : the diameter of the energy beam, which affects treatment depth and area; and
â€˘ Wavelength : the color of light, which impacts the effective depth and absorption of the energy delivered.
For example, in the case of hair removal, by utilizing the correct combination of these parameters, a practitioner can use a laser or other light source to selectively target melanin within the hair follicle to absorb the laser energy and destroy the follicle, without damaging other delicate structures in the surrounding tissue. Wavelength and spot size permit the practitioner to target melanin in the base of the hair follicle, which is found in the dermis. The combination of pulse duration and energy level may vary, depending upon the thickness of the targeted hair follicle. A shorter pulse length with a high energy level is optimal to destroy fine hair, whereas coarse hair is best treated with a longer pulse length with lower energy levels. If treatment parameters are improperly set, non-targeted structures within the skin may absorb the energy thereby eliminating or reducing the therapeutic effect. In addition, improper setting of the treatment parameters or failure to protect the surface of the skin may cause burns, which can result in blistering, scabbing and skin discoloration.
Our unique CoolGlide, Xeo and Solera platforms provide the long-lasting benefits of laser and other light-based aesthetic treatments. Our technology allows for a combination of a wide variety of applications available in a single system. Key features of our solution include:
â€˘ Multiple Applications Available in a Single System. Our technology platforms enable practitioners to perform multiple aesthetic procedures using a single device. These procedures include hair removal,treatment of unsightly veins, skin rejuvenation, treatment of pigmented lesions and tissue tightening. Because practitioners can use our systems for multiple indications, the cost of a unit may be spread across a potentially greater number of patients and procedures, and therefore may be more rapidly recovered.
â€˘ Technology and Design Leadership. We offer innovative and advanced laser and other light-based solutions for the aesthetic market. Our laser technology combines long wavelength, adjustable energy levels, variable spot sizes and a wide range of pulse durations, allowing our users to customize treatments for each patient and condition. Our proprietary pulsed light handpieces for the treatment of pigmented lesions, hair removal and vascular treatments, optimize the wavelength used for treatments and incorporate a monitoring system to increase safety. Our Titan handpieces utilize a novel light source that had not been previously used for aesthetic treatments.
â€˘ Upgradeable Platform. We design our products to allow our customers to cost-effectively upgrade to our multi-application systems, which provides our customers the option to add additional applications to their existing systems and provides us with a source of recurring revenue. We believe that product upgradeability is a competitive advantage because it allows our users to take advantage of our latest product offerings and provide additional treatment options to their patients, thereby expanding the opportunities for their aesthetic practices.
â€˘ Treatments for Broad Range of Skin Types and Conditions. Our products remove hair safely and effectively on patients of all skin types, including harder-to-treat patients with dark or tanned skin. In addition, the wide parameter range of our systems allows practitioners to effectively treat patients with both fine and coarse hair. Practitioners may also use our products to treat spider and reticular veins, which are unsightly small veins in the leg, as well as small facial veins. The ability to customize treatment parameters enables our customers to offer safe and effective therapy to a broad base of their patients.
â€˘ Ease of Use. We design our products to be easy to use. Our proprietary handpieces are lightweight and ergonomic, minimizing user fatigue. Our control console contains a universal graphic user interface with three simple, independently adjustable controls from which to select a wide range of treatment parameters to suit each patientâ€™s profile. Our ClearView handpiece allows practitioners to view an area as it is being treated, reducing the possibility of unintended damage to the skin and increasing the speed of application. The Titan V handpiece has a treatment tip that extends beyond the handpiece housing to give an unobstructed view of the skinâ€™s surface, thus making it easier to treat delicate areas such as the skin surrounding the eye and nose areas. In addition to increased visibility, the Titan XL handpiece has a larger spot size than the original Titan, for treating large body areas, such as arms, abdomens and legs. The clinical navigation user interface on the Xeo platform provides recommended clinical treatment parameter ranges based on patient criteria entered.
Risks involved in the use of our products include risks common to laser and other light-based aesthetic procedures, including the risk of burns, blistering and skin discoloration.
Cuteraâ€™s mission is to maintain and expand its position as a leading, worldwide provider of light-based aesthetic devices by:
â€˘ Continuing to Develop New Products. We have introduced at least one new product every year since 2000. In 2006, we introduced two new Titan handpiecesâ€”Titan V and Titan XLâ€”added the LimeLight pulsed light handpiece for treating veins and pigmented lesions, and introduced the Navigation feature for the Xeo platform. We are continuing to develop our existing technology platforms and are developing other platforms with the intent of expanding applications for our customers.
â€˘ Increasing Sales of Existing Products in the United States. We believe that the U.S. market for aesthetic systems is growing rapidly. As a result, in 2006 we expanded our U.S. direct sales force,excluding management and customer relations, to 46 employees. We plan on continuing to hire additional sales representatives to take advantage of our growing U.S. market opportunity.
â€˘ Expanding our International Presence . We believe that the international market continues to be a significant growth opportunity for us. As such, we are focused on increasing our market penetration overseas and building global brand-recognition. In 2006, we increased our direct international sales force to 25 employees, from 18 employees as of December 31, 2005. In addition to direct sales employees, in 2006 we expanded our distributor territories to over 30 countries. We plan on continuing to hire additional international direct sales employees, distributors and support staff to increase sales and strengthen customer relationships in the international markets.
â€˘ Broadening our Customer Base. We believe we have an opportunity for significant growth targeting non-traditional aesthetic practitioners. Dermatologists and plastic surgeons had generally been regarded as the traditional customers for laser and other light-based aesthetic equipment. However, in the United States, in 2006 and 2005, approximately 78% and 72%, respectively, of the number of our orders were received from non-traditional aesthetic practitioners, which include gynecologists, primary care physicians, physicians offering aesthetic treatments in a spa environment, and other qualified practitioners.
â€˘ Leveraging our Installed Base with Sales of Upgrades. Each time we have introduced a major new product, we have designed it to allow existing customers to upgrade their previously purchased systems to offer additional capabilities. We believe that providing upgrades to our existing installed base of customers continues to represent a significant opportunity for recurring revenue. We also believe that our upgrade program aligns our interest in generating revenue with our customersâ€™ interest in improving the return on their investment by expanding the range of applications they can perform.
â€˘ Generating Revenue from Services and Disposables. Our Titan product includes a disposable component, which provides us with a source of recurring revenue from our existing customers. Our extended service contracts are also a source of recurring revenue. We will continue to focus our research and development and our sales and marketing efforts on opportunities that can leverage our relationships with our existing customers for additional revenue opportunities.
Kevin P. Connors has served as our President and Chief Executive Officer and as a member of our board of directors since our inception in August 1998. Mr. Connors also currently serves as a member of the board of directors of the Exploratorium in San Francisco. From May 1996 to June 1998, Mr. Connors served as President and General Manager of Coherent Medical Group, a unit of Coherent Inc., which manufactures lasers, optics and related accessories.
David A. Gollnick has served as our Vice President of Research and Development and as a member of our Board since our inception in August 1998. From June 1996 to July 1998, Mr. Gollnick was Vice President of Research and Development at Coherent Medical Group, a unit of Coherent Inc. Mr. Gollnick holds a B.S. in Mechanical Engineering from Fresno State University.
David B. Apfelberg, MD has served as a member of our board of directors since November 1998. Dr. Apfelberg has been an Adjunct Associate Professor of Plastic Surgery at the Stanford University Medical Center since 1980. Since 1987, Dr. Apfelberg has also been a consultant for individual entrepreneurs, venture capital companies and attorneys, with special expertise in the area of lasers in medicine. From June 1991 to May 2001, Dr. Apfelberg was Director of the Plastic Surgery Center in Atherton, California. Dr. Apfelberg holds both a B.M.S., Bachelor of Medical Science, and an M.D. from Northwestern University Medical School.
Timothy J. Oâ€™Shea has served as a member of our board of directors since April 2004. Since joining Boston Scientific in 1981, he has served in a variety of management positions, including business development, corporate project management, international and domestic marketing and sales. Mr. O'Shea currently serves as a board observer on behalf of Boston Scientific for several private and public companies. Mr. O'Shea holds a B.A. in history from the University of Detroit.
Ronald J. Santilli has served as our Chief Financial Officer since September 2001. From April 2001 to August 2001, Mr. Santilli served as Senior Director of Financial Planning and Accounting at Lumenis, a manufacturer of medical lasers. From May 1993 to March 2001, Mr. Santilli held several positions at Coherent Inc., including Sales Operations Manager, Controller of the Medical Group and, most recently, Director of Finance and Administration. Mr. Santilli holds a B.S. in Business Administration from San Jose State University and an M.B.A. in Finance from Golden Gate University.
John J. Connors has served as our Vice President of North American Sales since April 2005. From February 2004 to April 2005, Mr. Connors served as our Director of North American Sales. From February 2001 to February 2004, Mr. Connors served as our Western Regional Sales Manager. From July 1999 to January 2001, Mr. Connors served as a Sales Manager for Coherent Medical Group, a unit of Coherent Inc. Mr. Connors holds a B.S. in Economics from Miami University.
Robert J . Shine, Jr., Ph.D . has served as our Vice President of International since September 2006. From December 2002 to September 2006, Dr. Shine served as our Director of Marketing. Prior to joining us, Dr. Shine held positions in marketing at WaveSplitter Technologies, Inc. and New Focus, Inc. Dr. Shine holds a B.A. and M.A. in Chemistry and Physics from Harvard University and a Ph.D. in Applied Physics from Stanford University .
Kevin P. Connors owns 151,607 shares outstanding and 597,916 Warrants and options Exercisable Within 60 Days, David A. Gollnick owns 173,696 shares outstanding and 147,462 Warrants and options Exercisable Within 60 Days, David B. Apfelberg owns 20,000 shares outstanding and 20,000 Warrants and options Exercisable Within 60 Days, Ronald J. Santilli owns 5,944 shares outstanding and 63,125 Warrants and options Exercisable Within 60 Days,
John J. Connors owns 5,511 shares outstanding and 90,029 Warrants and options Exercisable Within 60 Days,
Robert J. Shine, Jr. owns 4,512 shares outstanding and 39,125 Warrants and options Exercisable Within 60 Days,
MANAGEMENT DISCUSSION FROM LATEST 10K
We are a global medical device company engaged in the design, development, manufacture, marketing and servicing of laser and other light-based aesthetics systems to the professional aesthetic market. Our easy-to-use platformsâ€”CoolGlide, Xeo and Soleraâ€”enable dermatologists, plastic surgeons, gynecologists, primary care physicians and other qualified practitioners to perform safe, effective and non-invasive aesthetic procedures for their customers.
Our corporate headquarters and U.S. operations are located in Brisbane, California, where we conduct our manufacturing, warehousing, research, regulatory, sales, marketing and administrative activities. In the United States, we market and sell our products primarily through a direct sales force of 46 employees as of December 31, 2006 and through a distribution relationship with PSS World Medical Shared Services, Inc., a wholly owned subsidiary of PSS World Medical, which has over 700 sales representatives serving physician offices throughout the United States. In addition, we also sell certain items like Titan handpiece refills and marketing brochures via the web.
International sales are generally made through a direct sales force, independent sales representatives and distributors in over 30 countries worldwide. Outside the United States, we have a direct sales presence in Australia, Canada, France, Germany, Japan, Spain, Switzerland and the United Kingdom.
Products. Our revenue is derived from the sale of products, product upgrades, service, and Titan handpiece refills. Product revenue represents the sale of a system console that incorporates a universal graphic user interface, a laser and/or other light-based module, control system software, high voltage electronics, and one or more handpieces. We offer our customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications as their practice grows. This enables customers to upgrade their systems whenever they want and provides us with a source of recurring revenue, which we classify as product upgrade revenue. Service revenue relates to amortization of pre-paid maintenance and support contract revenue and receipts for services on out-of-warranty products. Titan handpiece refill revenue is associated with our Titan handpiece, which requires a periodic â€śrefillingâ€ť process, which includes the replacement of the optical source, after a set number of pulses has been performed.
Significant Business Trends. We believe that revenue growth has been, and will continue to be, primarily attributable to the following:
â€˘ Investments made in our global sales and marketing infrastructure, including the expansion of our sales force to increase our market penetration in an expanding aesthetic laser market.
â€˘ Continuing introduction of new aesthetic products and applications.
â€˘ Marketing to physicians outside the core dermatologist and plastic surgeon specialties.
â€˘ Generating service and Titan handpiece refill revenue from our growing installed base of customers.
During 2006, our business continued to experience significant growth. In 2006, compared to 2005, our U.S. revenue grew 28% and our international revenue grew 46%. In contrast, in 2005, compared to 2004, our U.S. revenue grew by 57%, while our international revenue grew by 19%. The weaker U.S. revenue growth from 2005 to 2006, as compared to 2004 to 2005, was primarily attributable to the slow ramp-up of revenue from newly hired sales representatives. The stronger international revenue growth from 2005 to 2006, compared to 2004 to 2005, was primarily attributable to significant revenue growth coming from Canada, Japan, and Switzerland. The growth in revenue from Switzerland was attributable to the setting up of our European hub office in Zurich in July 2005, from where we coordinate our European marketing and service activities. We believe that, amongst other factors, if and when we obtain FDA marketing clearance for our YSGG-based laser technology, our revenue will be positively impacted.
For 2006, our gross margin declined to 70%, compared to 74% in 2005. This decrease was primarily attributable to the royalty expense recorded with effect from April 1, 2006 due to the settlement of our litigation with Palomar, which was 3% of net revenue in 2006, and to higher stock-based compensation expense due to the adoption of the fair value recognition provisions of SFAS 123(R) with effect from January 1, 2006. Given our royalty expense and stock-based compensation expense will continue in 2007, we expect our gross margin for 2007 to be similar to 2006.
General and administrative expenses for 2006, compared with 2005, increased by $6.4 million, or 73%, to $15.2 million and were 15% of net revenue. In 2007, we expect our G&A expenses to decrease and be in the range of approximately 10% â€“ 12% of revenue. This expected decrease is primarily attributable to the following expenses which were included in G&A in 2006 but not expected to be incurred in 2007: $3.3 million of legal expenses related to the patent litigation matter and an estimated charge of $505,000 relating to a liability for sales taxes in jurisdictions that we had believed we did not have a taxable presence.
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 I, Item 1Aâ€”â€śRisk Factorsâ€ť section.
Critical Accounting Policies and Estimates
The preparation of our financial statements and related disclosures in conformity with generally accepted accounting principles in the United States, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. These estimates and assumptions are based on historical experience and on various other factors that we believe are reasonable under the circumstances. We periodically review our accounting policies and estimates and make adjustments when facts and circumstances dictate. In addition to the accounting policies that are more fully described in the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K, we consider the critical accounting policies described below to be affected by critical accounting estimates. Our critical accounting policies that are affected by accounting estimates include, stock-based compensation expense, revenue recognition, valuation of allowance for doubtful accounts, valuation of inventories, valuation of warranty obligations and valuation of income taxes on earnings. Such accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from these estimates.
Stock-based Compensation Expense
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards, or SFAS No. 123(R), â€śShare-Based Payment (revised 2004) ,â€ť using the modified prospective transition method, which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors, including stock options, employee stock purchases related to the Employee Stock Purchase Plan and restricted stock unit awards. Our consolidated financial statements as of and for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in our Consolidated Statements of Operations for the year ended December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of, December 31, 2005 based on the fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), we estimated the fair value of each stock option on the date of grant using the Black-Scholes option valuation model and elected to attribute the value of share-based compensation to expense using the straight-line method, which was previously used for our pro forma information required under SFAS No. 123 â€ś Accounting for Stock-Based Compensation ,â€ť or SFAS 123. The Block-Scholes option valuation model requires the input of subjective assumptions including expected stock price volatility, expected term of stock option and risk-free interest rate. Due in part to the limited amount of historical data available to us, particularly with respect to stock-price volatility, employee exercise patterns and forfeitures, actual results could differ from our assumptions.
Prior to the adoption of SFAS 123(R), we accounted for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board, or APB, Opinion No. 25, â€ś Accounting for Stock Issued to Employees ,â€ť and its interpretations and complied with the disclosure provisions of SFAS 123 as amended by SFAS No. 148, â€śAccounting for Stock-Based Compensationâ€”Transition and Disclosureâ€”an amendment of FASB Statement No. 123.â€ť Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant between the fair market value of our stock and the exercise price. Employee stock-based compensation is amortized on a straight-line basis over the vesting period of the underlying options.
We recognize distributor and non-distributor revenue in accordance with the SECâ€™s Staff Accounting Bulletin, or SAB, No. 104, â€ś Revenue Recognition .â€ť SAB No. 104 requires that four basic criteria must be met before revenue can be recognized:
â€˘ persuasive evidence of an arrangement exists;
â€˘ delivery has occurred or services have been rendered;
â€˘ the fee is fixed and determinable; and
â€˘ collectibility is reasonably assured.
Determination of whether persuasive evidence of an arrangement exists and whether delivery has occurred or services have been rendered, are based on managementâ€™s judgments regarding the fixed nature of the fee charged for services rendered and products delivered, and the collectibility of those fees. In instances where final acceptance of the product is specified by the customer or collectibility has not been reasonably assured, revenue is deferred until all acceptance criteria have been met. Revenue under service contracts is recognized on a straight-line basis over the period of the applicable service contract. Service revenue, not under a service contract, is recognized as the services are provided. Total deferred revenue for service contracts was $6.7 million and $3.1 million as of December 31, 2006 and December 31, 2005, respectively. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.
Allowance for Doubtful Accounts
Our accounts receivable balance, net of allowance for doubtful accounts, was $9.6 million as of December 31, 2006, compared with $6.5 million as of December 31, 2005. The allowance for doubtful accounts as of December 31, 2006, was $34,000, compared with $177,000 as of December 31, 2005. We perform periodic credit evaluations of our customers and adjust credit limits based upon payment history and the customerâ€™s current creditworthiness, as determined by our review of current credit information. We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that have been identified. While our credit losses have historically been within our expectations and the allowance established, we may not continue to experience the same credit loss rates that we have in the past.
We state our inventories at the lower of cost or market, computed on a standard cost basis, which approximates actual cost on a first-in, first-out basis and market being determined as the lower of replacement cost or net realizable value. Standard costs are monitored and updated quarterly or as necessary, to reflect changes in raw material costs, labor to manufacture the product and overhead rates. Our inventories balance was $5.2 million as of December 31, 2006 and 2005. Our inventories allowances as of December 31, 2006 were $851,000, compared with $992,000 as of December 31, 2005. We provide inventory allowances when conditions indicate that the selling price could be less than cost due to physical deterioration, usage, obsolescence, reductions in estimated future demand and reductions in selling prices. Inventory allowances are measured as the difference between the cost of inventory and estimated market value. Inventory reserves are charged to cost of revenue and establish a lower cost basis for the inventories. We balance the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact our gross margins. Conversely, favorable changes in demand could result in higher gross margins when product is sold.
We provide a standard one-year warranty coverage on our systems and from time to time have promotional offers when we offer a twenty-four month warranty. Warranty coverage provided is for labor and parts necessary to repair the systems during the warranty period. We provide for the estimated future costs of warranty obligations in cost of revenue when the related revenue is recognized. The accrued warranty costs represent our best estimate at the time of sale, and as reviewed and updated quarterly, of the total costs that we expect to incur in repairing or replacing product parts that fail while still under warranty. Accrued warranty costs include costs of material, technical support labor and associated overhead. The amount of accrued estimated warranty costs obligation for established products is primarily based on historical experience as to product failures adjusted for current information on repair costs. For new products, estimates will include historical experience of similar products, as well as reasonable allowance for start-up expenses. Actual warranty costs could differ from the estimated amounts. On a quarterly basis, we review the accrued balances of our warranty obligations and update the historical warranty cost trends. The accrued balance for product warranties was $3.1 million and $2.0 million as of December 31, 2006 and 2005, respectively. For more information on warranty reserves, see Note 3 to the Notes to Consolidated Financial Statements. If we were required to accrue additional warranty cost in the future due to actual product failure rates, material usage, service delivery costs or overhead costs differing from our estimates, revisions to the estimated warranty liability would be required, which would negatively impact our operating results.
Provision for Income Taxes
We are subject to taxes on earnings in both the United States and numerous foreign jurisdictions. As a global taxpayer, significant judgments and estimates are required in evaluating our tax positions and determining our provision for taxes on earnings. The calculation of our tax liabilities involves addressing uncertainties in the application of complex tax regulations. We maintain reserves for potential tax contingencies arising in the jurisdictions in which we do business. Such reserves are based on our assessment of the likelihood of an unfavorable outcome and the potential loss from such contingencies, and may be adjusted from time to time in light of changing facts and circumstances. These reserves are maintained until such time as the matter is settled or the statutory period for adjustment has passed. Adjustments could be required in the future if we determine that our reserves for tax contingencies are inadequate. The provision for taxes on earnings includes the effect of changes to these reserves that are considered appropriate. In addition, the carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable earnings in certain tax jurisdictions to utilize these deferred tax assets.
Earnings derived from our international regions are generally taxed at different rates than in the United States. Our effective rate is impacted by existing tax laws in both the United States and in the respective countries in which our international subsidiaries are located. A change in the mix of total earnings from our United States operations and the respective international regions among particular tax jurisdictions could change our effective income tax rate. Also, our current effective tax rate does not assume U.S. taxes on undistributed profits of foreign subsidiaries. These earnings could become subject to incremental foreign withholding or U.S. federal and state taxes, should they either be deemed or actually remitted to the United States.
Recent Accounting Pronouncements
In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159, â€śThe Fair Value Option for Financial Assets and Financial Liabilitiesâ€ť (â€śSFAS 159â€ť). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of implementing SFAS 159 on our consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, â€śFair Value Measurements.â€ť This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will be required to adopt SFAS No. 157 in the first quarter of fiscal year 2008. We are currently assessing the impact that SFAS 157 may have on our consolidated financial position, results of operations or cash flows.
In September 2006, the SEC issued SAB No. 108, â€ś Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements ,â€ť or SAB 108, to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires the quantification of misstatements based on their impact on both the balance sheet and the income statement to determine materiality. The guidance provides for a one-time cumulative effect adjustment to correct for misstatements that were not deemed material under a companyâ€™s prior approach but are material under the SAB 108 approach. SAB No. 108 has not had any impact on our annual financial statements for the year ended December 31, 2006.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxesâ€”an interpretation of FASB Statement No. 109 , or SFAS 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterpriseâ€™s financial statements in accordance with SFAS 109 . The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure, and transition. This interpretation is effective for us in the first quarter ending on March 31, 2007. Based on a preliminary evaluation of the impact of adopting this Interpretation, we believe that it will not have a material effect on our financial position or results of operations in 2007.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Company Description. We are a global medical device company engaged in the design, development, manufacture, marketing and servicing of laser and other light-based aesthetics systems to the professional aesthetic market. Our easy-to-use platformsâ€”CoolGlide, Xeo and Soleraâ€”enable dermatologists, plastic surgeons, gynecologists, primary care physicians and other qualified practitioners to perform safe, effective and non-invasive aesthetic procedures for their customers.
Our corporate headquarters and U.S. operations are located in Brisbane, California, from where we conduct our manufacturing, warehousing, research, regulatory, sales, service, marketing and administrative activities. In the United States, we market, sell and service our products primarily through direct sales and service employees and through a distribution relationship with PSS World Medical Shared Services, Inc., a wholly owned subsidiary of PSS World Medical, or PSS, which has over 700 sales representatives serving physician offices throughout the United States. In addition, we also sell certain items, like Titan handpiece refills and marketing brochures, via the web.
International sales are generally made through a direct sales force and through independent sales representatives and distributors in over 30 countries worldwide. Outside the United States, we have a direct sales presence in Australia, Canada, France, Japan, Spain, Switzerland and the United Kingdom.
Products. Our revenue is derived from the sale of products, product upgrades, service and Titan handpiece refills. Product revenue represents the sale of a system console that incorporates a universal graphic user interface, a laser and/or other light-based module, control system software, high voltage electronics and one or more handpieces. We offer our customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications as their practice grows. This enables customers to upgrade their systems whenever they want and provides us with a source of recurring revenue, which we classify as product upgrade revenue. Service revenue relates to amortization of pre-paid service contract revenue and receipts for services on out-of-warranty products. Titan handpiece refill revenue is associated with our Titan handpiece, which requires a periodic â€śrefillingâ€ť process, which includes the replacement of the optical source after a set number of pulses have been performed.
Significant Business Trends. We believe that our revenue growth has been, and will continue to be, primarily attributable to the following:
â€˘ Investments made in our global sales and marketing infrastructure, including the expansion of our sales force to increase our market penetration in an expanding aesthetic laser market.
â€˘ Continuing introduction of new aesthetic products and applications.
â€˘ Marketing to physicians outside the core dermatologist and plastic surgeon specialties.
â€˘ Generating service and Titan handpiece refill revenue from our growing installed base of customers.
During the three months ended March 31, 2007, compared to the same period in 2006, our U.S. revenue increased by 6% and our international revenue increased by 27%. During the three months ended March 31, 2006, compared to the same period in 2005, our U.S. revenue increased by 44% and our international revenue increased by 23%. The significant decrease in the U.S. revenue growth rate was primarily attributable to lower sales productivity of our junior sales representatives, reduced revenue from our PSS and other national accounts, which contributed to lower productivity for many of our U.S. sales people, and higher than expected turnover of sales representatives that absorbed significant amounts of sales-management time. In an effort to improve our revenue, we have implemented several strategic initiatives, including discontinuing the junior-sales program, planned expansion of our North American direct sales force with more experienced and senior representatives and dedicating additional senior sales representatives to work closely with, and increase the focus and attention on, our PSS relationship.
For the three months ended March 31, 2007, our gross margin declined to 67%, compared to 72% in the same period of 2006. This decrease was primarily attributable to patent royalty expense of $944,000, or 4% of revenue, that was included in our cost of goods sold for the three months ended March 31, 2007 but was not there in the same period in 2006. We resolved our patent litigation settlement in the second quarter of 2006. Given our royalty expense will now continue in the future and we expect our revenue growth rate compared to the prior year to improve in the second half of 2007, we expect our quarterly gross margin to be approximately 66% to 70% for the remainder of the year.
General and administrative expenses for the three months ended March 31, 2007, compared to the same period in 2006, decreased by $1.4 million, or 31%, to $3.0 million and were 13% of net revenue. This decrease was primarily attributable to decreased legal expenses of approximately $1.5 million primarily relating to the patent litigation, which was settled in the second quarter of 2006. In April 2007, there was a securities class action lawsuit filed against us- see Part II, Item 1 â€śLegal Proceedings.â€ť However, given we retain director and officer liability insurance, we expect the impact from this litigation to be not material for the remainder of 2007 and therefore expect our G&A expenses to remain in the range of $3.0 million to $3.5 million per quarter for the remainder of 2007.
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 â€” â€śRisk Factorsâ€ť section.
Critical Accounting Policies and Estimates.
The accounting policies that we consider to be critical, subjective, or requiring complex judgments in their application are summarized in â€śItem 7â€”Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operationsâ€ť in our Annual Report on Form 10-K for the year ended December 31, 2006 filed with SEC on March 16, 2007. Other than the adoption of FIN 48, there have been no significant changes during the three months ended March 31, 2007 to the items that we disclosed as our critical accounting policies and estimates in our Annual Report on Form 10-K for the year ended December 31, 2006.
Income Taxes â€” We operate in multiple taxing jurisdictions, both within the United States and outside the United States. We have filed tax returns with positions that may be challenged by the tax authorities. These positions relate to, among others, deductibility of certain expenses, transfer pricing, expenses included in our research and development tax credit computations, as well as other matters. Although the outcome of tax audits is uncertain, in managementâ€™s opinion, adequate provisions for income taxes have been made for potential liabilities resulting from such matters. We regularly assess the tax positions for such matters and include reserves for those differences in position. The reserves are utilized or reversed once the statute of limitations has expired and/or at the conclusion of the tax examination. We believe that the ultimate outcome of these matters will not have a material impact on our financial position, financial operations or liquidity. Effective January 1, 2007, we adopted FIN 48 (refer to Note 7)
Recent Accounting Pronouncements
In February 2007, the FASB issued SFAS No. 159, â€śThe Fair Value Option for Financial Assets and Financial Liabilitiesâ€ť or SFAS No. 159, which permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 also includes an amendment to SFAS No. 115, â€śAccounting for Certain Investments in Debt and Equity Securities,â€ť which applies to all entities with available-for-sale and trading securities. This statement is required to be adopted in our fiscal year ended December 31, 2008. We are currently assessing the potential impact of implementing this standard on our consolidated financial position, results of operations and cash flows.
In September 2006, the FASB issued SFAS No. 157, â€śFair Value Measurements,â€ť or SFAS No. 157. This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies under other accounting standards that require or permit fair value measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We will be required to adopt SFAS No. 157 in the quarter ended March 31, 2008 and are currently assessing the impact that this may have on our consolidated financial position, results of operations and cash flows.