form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q 

(Mark One)

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

For the quarterly period ended September 30, 2011

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
 

Cutera, Inc.
(Exact name of registrant as specified in its charter)

 
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)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes    x    No    ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    Yes x     No    ¨

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

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

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

The number of shares of Registrant’s common stock issued and outstanding as of October 31, 2011 was 13,908,207
 


 
 

 
 
CUTERA, INC.

FORM 10-Q

TABLE OF CONTENTS

       
Page
PART I
 
FINANCIAL INFORMATION
   
         
Item 1
   
1
     
1
     
2
     
3
     
4
Item 2
   
12
Item 3
   
22
Item 4
   
23
         
PART II
 
OTHER INFORMATION
   
         
Item 1
   
24
Item 1A
   
24
Item 2
   
35
Item 3
   
35
Item 4
   
35
Item 5
   
35
Item 6
   
36
     
37
 
 
i

 
PART I. FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS
 
CUTERA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)
 
   
September 30, 2011
   
December 31, 2010
 
Assets
           
Current assets:
           
Cash and cash equivalents
 
$
13,874
   
$
12,519
 
Marketable investments
   
74,502
     
77,484
 
Accounts receivable, net
   
4,085
     
4,208
 
Inventories
   
9,659
     
6,448
 
Deferred tax asset
   
17
     
63
 
Other current assets and prepaid expenses
   
1,841
     
2,740
 
Total current assets
   
103,978
     
103,462
 
                 
Property and equipment, net
   
643
     
597
 
Long-term investments
   
3,014
     
6,784
 
Intangibles, net
   
493
     
637
 
Deferred tax asset, net of current portion
   
345
     
325
 
Other long-term assets
   
493
     
 
Total assets
 
$
108,966
   
$
111,805
 
                 
Liabilities and Stockholders' Equity
               
Current liabilities:
               
Accounts payable
 
$
2,151
   
$
1,296
 
Accrued liabilities
   
7,339
     
6,194
 
Deferred revenue
   
5,447
     
5,633
 
Total current liabilities
   
14,937
     
13,123
 
                 
Deferred rent
   
1,432
     
1,501
 
Deferred revenue, net of current portion
   
775
     
1,287
 
Income tax liability
   
489
     
477
 
Total liabilities
   
17,633
     
16,388
 
                 
Commitments and Contingencies (Note 8)
               
                 
Stockholders’ equity:
               
Convertible preferred stock, $0.001 par value; authorized: 5,000,000 shares; none issued and outstanding
   
     
 
Common stock, $0.001 par value; authorized: 50,000,000 shares; issued and outstanding: 13,888,554 and 13,629,713 shares at September 30, 2011 and December 31, 2010, respectively
   
14
     
14
 
Additional paid-in capital
   
94,594
     
90,423
 
Retained earnings (accumulated deficit)
   
(2,438
)
   
6,736
 
Accumulated other comprehensive loss
   
(837
)
   
(1,756
)
Total stockholders’ equity
   
91,333
     
95,417
 
Total liabilities and stockholders’ equity
 
$
108,966
   
$
111,805
 
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Net revenue
 
$
15,232
   
$
12,092
   
$
41,748
     
38,058
 
Cost of revenue
   
6,772
     
5,661
     
18,472
     
16,825
 
Gross profit
   
8,460
     
6,431
     
23,276
     
21,233
 
                                 
Operating expenses:
                               
Sales and marketing
   
6,426
     
5,799
     
18,720
     
18,612
 
Research and development
   
2,352
     
1,871
     
6,828
     
4,831
 
General and administrative
   
2,310
     
2,352
     
7,226
     
7,338
 
Total operating expenses
   
11,088
     
10,022
     
32,774
     
30,781
 
Loss from operations
   
(2,628
)
   
(3,591
)
   
(9,498
)
   
(9,548
)
Interest and other income, net
   
91
     
132
     
474
     
439
 
Loss before income taxes
   
(2,537
)
   
(3,459
)
   
(9,024
)
   
(9,109
)
Provision for income taxes
   
326
     
     
150
     
129
 
Net loss
 
$
(2,863
)
 
$
(3,459
)
 
$
(9,174
)
 
$
(9,238
)
                                 
Net loss per share:
                               
Basic and Diluted
 
$
(0.21
)
 
$
(0.25
)
 
$
(0.67
)
 
$
(0.68
)
                                 
Weighted-average number of shares used in per share calculations:
                               
Basic and Diluted
   
13,862
     
13,589
     
13,765
     
13,512
 
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
 
(unaudited)
 
   
Nine Months Ended
 
   
September 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
 
$
(9,174
)
 
$
(9,238
)
Adjustments to reconcile net loss to net cash used in operating activities:
               
Stock-based compensation
   
3,105
     
3,670
 
Tax benefit from stock-based compensation
   
21
     
 
Excess tax benefit related to stock-based compensation
   
(21
)
   
 
Depreciation and amortization
   
483
     
560
 
Provision for excess and obsolete inventories
   
(174
)
   
217
 
Provision for doubtful accounts receivable
   
17
     
(91
)
Change in deferred tax asset net of valuation allowance
   
26
     
(29
)
Gain on sale of marketable investments, net
   
(2
   
(74
)
Tax on unrealized gains on marketable and long term investments
   
194
     
 
Changes in assets and liabilities:
               
Accounts receivable
   
106
     
394
 
Inventories
   
(3,037
)
   
(953
)
Other current assets and prepaid expenses
   
1,951
     
1,761
 
Other long-term assets
   
(493
)
   
 
Accounts payable
   
855
     
620
 
Accrued liabilities
   
1,086
     
(3,058
)
Deferred rent
   
(10
)
   
(158
)
Deferred revenue
   
(698
)
   
(1,069
)
Income tax liability
   
12
     
(183
)
Net cash used in operating activities
   
(5,753
)
   
(7,631
)
                 
Cash flows from investing activities:
               
Acquisition of property and equipment
   
(421
)
   
(193
)
Disposal of property and equipment
   
36
     
 
Proceeds from sales of marketable and long-term investments
   
17,597
     
38,800
 
Proceeds from maturities of marketable investments
   
35,085
     
34,135
 
Purchase of marketable investments
   
(46,255
)
   
(66,617
)
Net cash provided by investing activities
   
6,042
     
6,125
 
                 
Cash flows from financing activities:
               
Proceeds from exercise of stock options and employee stock purchase plan
   
1,045
     
380
 
Excess tax benefit related to stock-based compensation
   
21
     
 
Net cash provided by financing activities
   
1,066
     
380
 
                 
Net increase (decrease) in cash and cash equivalents
   
1,355
     
(1,126
 )
Cash and cash equivalents at beginning of period
   
12,519
     
22,829
 
Cash and cash equivalents at end of period
 
$
13,874
   
$
21,703
 
 
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 
CUTERA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Summary of Significant Accounting Policies

Description of Operations and Principles of Consolidation.
Cutera, Inc. (Cutera or the Company) is a global provider of laser and light-based aesthetic systems for practitioners worldwide. The Company designs, develops, manufactures, and markets the CoolGlide, Xeo, Solera, GenesisPlus and Excel V product platforms for use by physicians and other qualified practitioners to allow its customers to offer safe and effective aesthetic treatments to their customers. The Xeo and Solera platforms offer multiple hand pieces and applications, which allow customers to upgrade their systems (Upgrade revenue). In addition to systems and upgrade revenue, the Company generates revenue from the sale of post warranty service contracts, providing services for products that are out of warranty, Titan hand piece refills, and dermal fillers and cosmeceuticals.

Headquartered in Brisbane, California, the Company has wholly-owned subsidiaries in Australia, Canada, France, Japan, Spain, Switzerland (however, beginning October 1, 2011 the Company engaged a distributor in Switzerland instead of selling directly) and United Kingdom that market, sell and service its products outside of the United States. The Condensed Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All inter-company transactions and balances have been eliminated.

Business Segment
In accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 280 guidance on disclosures about segments of an enterprise and related information, operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions how to allocate resources and assess performance. Our chief decision maker, as defined under the FASB’s ASC 280 guidance, is a combination of the Chief Executive Officer; and the Executive Vice President and Chief Financial Officer. To date, the Company has viewed its operations, managed its business, and used one measurement of profitability for the one operating segment – the sale of aesthetic medical equipment and services, and distribution of cosmeceuticals and dermal filler products, to qualified medical practitioners. In addition, substantially all of the Company’s long-lived assets are located in one facility in the United States. As a result, the financial information disclosed in the Company’s Condensed Consolidated Financial Statements represents all of the material financial information related to the Company’s operating segment.

Unaudited Interim Financial Information
The financial information filed is unaudited. The Condensed Consolidated Financial Statements included in this report reflect all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for the fair statement of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The December 31, 2010 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 the results for the entire year or any other interim period. The Condensed Consolidated Financial Statements should be read in conjunction with the Company’s financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission, or SEC, on March 15, 2011.

Use of Estimates
The preparation of interim Condensed Consolidated Financial Statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the amounts reported and disclosed in the Condensed Consolidated Financial Statements and the accompanying notes. Actual results could differ materially from those estimates. On an ongoing basis, the Company evaluates these estimates, including those related to warranty obligation, sales commission, accounts receivable and sales allowances, provision for excess and obsolete inventories, fair values of marketable and long-term investments, fair values of acquired intangible assets, useful lives of intangible assets and property and equipment, recoverability of deferred tax assets, and effective income tax rates, among others. Management bases these estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

Significant Accounting Policies
The Company’s significant accounting policies are disclosed in the Company’s annual report on Form 10-K for the year ended December 31, 2010 filed with the SEC on March 15, 2011, and have not changed significantly as of September 30, 2011, except for the accounting standard on revenue recognition explained below.
 

Revenue Recognition

The FASB amended the accounting standards for multiple deliverable revenue arrangements to:

 
·
provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be allocated;
 
·
require an entity to allocate revenue in an arrangement using estimated selling price (ESP) of deliverables if a vendor does not first have vendor-specific objective evidence (VSOE) of selling price or secondly does not have third-party evidence (TPE) of selling price; and
 
·
eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.

Multiple-element arrangements - A multiple-element arrangement includes the sale of one or more tangible product offerings with one or more associated services offerings, each of which are individually considered separate units of accounting. The determination of the Company’s units of accounting did not change with the adoption of the new revenue recognition guidance and as such the Company allocates revenue to each element in a multiple-element arrangement based upon the relative selling price of each deliverable. When applying the relative selling price method, the Company determines the selling price for each deliverable using VSOE of selling price, if it exists, or TPE of selling price. If neither VSOE nor TPE of selling price exist for a deliverable, the Company uses its best estimate of selling price for that deliverable. Revenue allocated to each element is then recognized when the other revenue recognition criteria are met for each element.

The above mentioned update was effective for the Company from January 1, 2011 and the Company elected to apply it prospectively to new or materially modified revenue arrangements after its effective date. This did not have a material impact on the Company’s financial position or results of operations for the three and nine-month periods ended September 30, 2011 and does not change the units of accounting for its revenue transactions.

The new accounting standard, if applied to the year ended December 31, 2010, would not have had a material impact on our revenue for that year.

Recent Accounting Pronouncements

On January 1, 2011, the Company adopted changes issued by the FASB to the classification of certain employee share-based payment awards. These changes clarify that there is not an indication of a condition that other than market, performance or service if an employee share-based payment award’s exercise price is denominated in the currency of a market in which a substantial portion of the entity’s equity securities trade and differs from the functional currency of the employer entity or payroll currency of the employee. An employee share-based payment award is required to be classified as a liability if the award does not contain a market, performance or service condition. Prior to this guidance, the Company did not consider the difference between the currency denomination of an employee share-based payment award’s exercise price and the functional currency of the employer entity or payroll currency of the employee in determining the proper classification of the share-based payment award. The adoption of these changes had no impact on the Company's financial statements.

On January 1, 2011, the Company adopted changes issued by the FASB to disclosure requirements for fair value measurements. Specifically, the changes require a reporting entity to disclose, in the reconciliation of fair value measurements using significant unobservable inputs (Level 3), separate information about purchases, sales, issuances and settlements, i.e., on a gross basis rather than as one net number. These changes were applied to the disclosure in the Fair Value of Financial Instruments section of Note 2 to the Condensed Consolidated Financial Statements. The adoption of these changes had no impact on our financial statements.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement:  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards”. Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2011. The Company is still evaluating the potential future effects of this guidance.

In June 2011, the FASB amended its authoritative guidance on the presentation of comprehensive income. Under the amendment, an entity will have the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This amendment, therefore, eliminates the currently available option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendment does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The Company will adopt this amended guidance for the fiscal year beginning January 1, 2012. As this guidance relates to presentation only, the adoption of this guidance will not have any other effect on the Company's financial statements.
 
 
As discussed in detail in the Revenue Recognition section above, the Company adopted prospectively from January 1, 2011 the FASB amended standards for multiple deliverable revenue arrangements.

Note 2. Balance Sheet Details

Cash and Cash Equivalents, Marketable Investments and Long-Term Investments:
The Company considers all highly liquid investments, with an original maturity of three months or less at the time of purchase, to be cash equivalents. Investments in debt securities are accounted for as “available-for-sale” securities, carried at fair value with unrealized gains and losses reported in other comprehensive loss, held for use in current operations and classified in current assets as “Marketable investments” and in long term assets as “Long-term investments.”
 
The following tables summarize cash, cash equivalents, marketable investments and long-term investments (in thousands):

   
September 30, 2011
   
December 31, 2010
 
Cash and cash equivalents:
           
Cash
 
$
1,424
   
$
1,989
 
Cash equivalents:
               
Money market funds
   
10,700
     
8,330
 
Commercial paper
   
1,750
     
2,200
 
Total cash and cash equivalents
   
13,874
     
12,519
 
                 
Marketable investments:
               
U.S. government notes
   
3,672
     
2,070
 
U.S. government agencies
   
28,930
     
24,087
 
Municipal securities
   
6,811
     
15,011
 
Commercial paper
   
10,693
     
11,465
 
Corporate debt securities
   
24,396
     
24,851
 
Total marketable investments
   
74,502
     
77,484
 
                 
Long-term investments in Auction Rate Securities (ARS)
   
3,014
     
6,784
 
Total cash, cash equivalents, marketable investments and long-term investments
 
$
91,390
   
$
96,787
 

The following table summarizes unrealized gains and losses related to our marketable investments and long-term investments, both designated as available-for-sale (in thousands):

September 30, 2011
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Market Value
 
Cash and cash equivalents
 
$
13,874
   
$
   
$
   
$
13,874
 
                                 
Marketable investments
                               
U.S. government notes
   
3,660
     
12
     
     
3,672
 
U.S. government agencies
   
28,894
     
41
     
(5
   
28,930
 
Municipal securities
   
6,759
     
53
     
(1
   
6,811
 
Commercial paper
   
10,690
     
3
     
     
10,693
 
Corporate debt securities
   
24,415
     
19
     
(38
)
   
24,396
 
Total marketable investments
   
74,418
     
128
     
(44
)
   
74,502
 
                                 
Long-term investment in ARS
   
3,900
     
     
(886
)
   
3,014
 
Total cash, cash equivalents, marketable investments and long-term investments
 
$
92,192
   
$
128
   
$
(930
)
 
$
91,390
 
 
 
December 31, 2010
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Market
Value
 
Cash and cash equivalents
 
$
12,519
   
$
   
$
   
$
12,519
 
                                 
Marketable investments
                               
U.S. government notes
   
2,069
     
1
     
     
2,070
 
U.S. government agencies
   
24,088
     
17
     
(18
)
   
24,087
 
Municipal securities
   
15,029
     
2
     
(20
)
   
15,011
 
Commercial Paper
   
11,459
     
7
     
(1
)
   
11,465
 
Corporate debt securities
   
24,825
     
55
     
(29
)
   
24,851
 
Total marketable investments
   
77,470
     
82
     
(68
)
   
77,484
 
                                 
Long-term investment in ARS
   
8,325
     
     
(1,541
)
   
6,784
 
Total cash, cash equivalents, marketable investments and long-term investments
 
$
98,314
   
$
82
   
$
(1,609
)
 
$
96,787
 

The following table summarizes the estimated fair value of our marketable investments and long-term investments classified by the contractual maturity date of the security as of September 30, 2011 (in thousands):

   
Amount
 
Due in less than one year
 
$
47,336
 
Due in 1 to 3 years
   
27,166
 
Due in 3 to 5 years
   
 
Due in 5 to 10 years
   
 
Due in greater than 10 years
   
3,014
 
   
$
77,516
 

Fair Value of Financial Instruments:
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

·
Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities.
·
Level 2: Directly or indirectly observable inputs as of the reporting date through correlation with market data, including quoted prices for similar assets and liabilities in active markets and quoted prices in markets that are not active. Level 2 also includes assets and liabilities that are valued using models or other pricing methodologies that do not require significant judgment since the input assumptions used in the models, such as interest rates and volatility factors, are corroborated by readily observable data from actively quoted markets for substantially the full term of the financial instrument.
·
Level 3: Unobservable inputs that are supported by little or no market activity and reflect the use of significant management judgment. These values are generally determined using pricing models for which the assumptions utilize management’s estimates of market participant assumptions.

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, 2011, 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):

   
Level 1
   
Level 2
   
Level 3
   
Total
 
Cash equivalents
 
$
13,874
   
$
   
$
   
$
13,874
 
Short-term marketable investments:
                               
Available-for-sale securities
   
     
74,502
     
     
74,502
 
Long-term investments:
                               
Available-for-sale ARS
   
     
     
3,014
     
3,014
 
Total assets at fair value
 
$
13,874
   
$
74,502
   
$
3,014
   
$
91,390
 
 
 
The Company’s Level 1 financial assets are money market funds, highly liquid debt instruments of U.S. federal and municipal governments and their agencies and commercial paper with stated maturities of three months or less from the date of purchase, whose fair values are based on quoted market prices. The Company’s Level 2 financial assets are highly liquid debt instruments of U.S. federal and municipal governments and their agencies, as well as commercial paper and corporate bonds. These securities have stated maturities of greater than three months, whose fair values are obtained from readily-available pricing sources for the identical underlying security that may, or may not, be actively traded.

At September 30, 2011, observable market information was not available to determine the fair value of the Company’s ARS investments. Therefore, the fair value was based on valuation models that relied on Level 3 inputs including those that are based on expected cash flow streams and collateral values, assessments of counterparty credit quality, default risk underlying the security, market discount rates and overall capital market liquidity. The valuation of the Company’s ARS investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact the valuations in the future include changes to credit ratings of the securities, as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates, counterparty risk and ongoing strength and quality of market credit and liquidity. These financial instruments are classified within Level 3 of the fair value hierarchy.

The table presented below summarizes the change in carrying value associated with Level 3 financial assets, which represents the Company’s investment in ARS for the nine months ended September 30, 2011 (in thousands):

   
September 30, 2011
 
Balance at December 31, 2010
 
$
6,784
 
Total gains or losses (realized or unrealized):
       
Included in earnings (or changes in net assets)
   
 
Included in other comprehensive income (loss)
   
655
 
Purchases and issuances
   
 
Settlements
   
(4,425
)
Transfers in and/or out of Level 3
   
 
Balance at September 30, 2011
 
$
3,014
 

Inventories:
Inventories consist of the following (in thousands):

   
September 30, 2011
   
December 31, 2010
 
Raw materials
 
$
5,867
   
$
4,204
 
Finished goods
   
3,792
     
2,244
 
Total
 
$
9,659
   
$
6,448
 
 
Intangible Assets:
Intangible assets comprise a patent sublicense acquired from Palomar in 2006 and a technology sublicense acquired in 2002. The components of intangible assets were as follows (in thousands):

   
September 30, 2011
 
   
Gross
Carrying
Amount
   
Accumulated
Amortization
Amount
   
Net
Carrying
Amount
 
Patent sublicense
 
$
1,218
   
$
758
   
$
460
 
Technology sublicense
   
538
     
505
     
33
 
Total
 
$
1,756
   
$
1,263
   
$
493
 
 
 
   
December 31, 2010
 
   
Gross
Carrying
Amount
   
Accumulated
Amortization
Amount
   
Net
Carrying
Amount
 
Patent sublicense
 
$
1,218
   
$
656
   
$
562
 
Technology sublicense
   
538
     
463
     
75
 
Total
 
$
1,756
   
$
1,119
   
$
637
 

Amortization expense for intangible assets was $144,000 for each of the nine-month periods ended September 30, 2011 and 2010.

Based on intangible assets recorded at September 30, 2011, and assuming no subsequent additions to, or impairment of the underlying assets, the remaining estimated annual amortization expense is expected to be as follows (in thousands):

Fiscal Year Ending December 31,
 
Amount
 
2011 (remainder)
 
$
48
 
2012
   
158
 
2013
   
138
 
2014
   
138
 
2015
   
11
 
Thereafter
   
 
Total
 
$
493
 

Note 3. Warranty and Service Contract

Warranty Obligations
The Company provides a standard one-year warranty on all systems. Warranty coverage provided is for labor and parts necessary to repair the systems during the warranty period. The Company accounts for the estimated warranty cost of the standard warranty coverage as a charge to costs of revenue when revenue is recognized. The estimated warranty cost is based on historical product performance. To determine the estimated warranty reserve, the Company utilizes actual service records to calculate the average service expense per system and applies this to the equivalent number of units exposed under warranty. The Company updates these estimated charges every quarter.

The following table provides the changes in the product warranty accrual for the nine-month period ended September 30, 2011 and 2010 (in thousands):

   
September 30,
 
   
2011
   
2010
 
Beginning Balance
 
$
796
   
$
1,049
 
Add: Accruals for warranties issued during the period
   
2,918
     
2,058
 
Less: Settlements made during the period
   
(2,710
)
   
(2,447
)
Ending Balance
 
$
1,004
   
$
660
 

Deferred Service Contract revenue

Service contract revenue is recognized on a straight-line basis over the period of the applicable extended warranty contract.

The following table provides changes in deferred service contract revenue for the nine-month period ended September 30, 2011 and 2010 (in thousands):

   
September 30,
 
   
2011
   
2010
 
Beginning Balance
 
$
6,765
   
$
8,128
 
Add: Payments received
   
6,332
     
6,004
 
Less: Revenue recognized
   
(7,024
)
   
(7,210
)
Ending Balance
 
$
6,073
   
$
6,922
 

Costs incurred under service contracts were $3.1 million for the nine-month period ended September 30, 2011 and $3.2 million for the nine-month period ended September 30, 2010 and are recognized as incurred.
 

Note 4. Stock-based Compensation Expense

Stock-based compensation expense by department recognized during the three and nine-month periods ended September 30, 2011 and 2010 was as follows (in thousands):

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Cost of revenue
 
$
179
   
$
191
   
$
505
   
$
566
 
Sales and marketing
   
210
     
214
     
625
     
476
 
Research and development
   
184
     
316
     
524
     
904
 
General and administrative
   
321
     
360
     
1,451
     
1,724
 
Total stock-based compensation expense
 
$
894
   
$
1,081
   
$
3,105
   
$
3,670
 

Note 5. Net Loss Per Share

Basic net loss per share is calculated by dividing net loss by the weighted-average number of common shares outstanding during the year. Diluted net loss per common share is the same as basic net loss per common share, as the effect of the potential common stock equivalents is anti-dilutive and as such is excluded from the calculations of the diluted net loss per share.

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

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Numerator:
                               
Net loss
 
$
(2, 863
)
 
$
(3,459
)
 
$
(9,174
)
 
$
(9,238
)
Denominator:
                               
Weighted-average number of common shares outstanding used in computing basic and diluted net loss per share
   
13,862
     
13,589
     
13,765
     
13,512
 

Anti-dilutive securities
The following number 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 periods presented because including them would have had an anti-dilutive effect (in thousands):

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Options to purchase common stock
   
3,990
     
3,484
     
3,619
     
3,110
 
Restricted stock units
   
56
     
72
     
62
     
40
 
Employee stock purchase plan shares
   
30
     
23
     
51
     
45
 
Total
   
4,076
     
3,579
     
3,732
     
3,195
 

Note 6. Income Taxes

The Company’s income tax provision for the three and nine months ended September 30, 2011 and 2010 was primarily related to income taxes of the Company’s non U.S. operations and other discrete items as explained below. The Company recorded a 100% valuation allowance against its U.S. deferred tax assets and as such did not record any income tax benefit related to its U.S. loss for the three and nine-month periods ended September 30, 2011 and 2010.

For the three months ended September 30, 2011, the Company’s income tax provision was $326,000, compared to a provision of less than $1,000 for the three months ended September 30, 2010. Included in the $326,000 provision for the three moths ended September 30, 2011, was a discrete charge of $262,000 for the clearing of disproportionate tax effects in accumulated other comprehensive loss related to unrealized gains and losses on marketable and long term investments.
 

For the nine months ended September 30, 2011, the Company’s income tax provision was $150,000, compared to a provision of $129,000 for the nine months ended September 30, 2010. Included in the $150,000 provision for the nine months ended September 30, 2011 was a discrete net charge of $194,000 for the clearing of disproportionate tax effects in other comprehensive income related to unrealized gains and losses on marketable investments, offset by a discrete tax benefit of $246,000 resulting from the carry-back of fiscal year 2010 federal losses to obtain a refund of alternative minimum taxes paid for fiscal year 2008.

The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. As of September 30, 2011 and December 31, 2010, the Company had a 100% valuation allowance against its U.S. deferred tax assets. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferred tax assets, the Company considered available positive and negative evidence giving greater weight to its recent cumulative losses and its ability to carry-back losses against prior taxable income and lesser weight to its projected financial results due to the challenges of forecasting future periods. The Company also considered, commensurate with its objective verifiability, the forecast of future taxable income including the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies.

As of September 30, 2011, there were no material changes to either the nature or the amounts of the uncertain tax positions previously determined and disclosed pursuant to FASB ASC Topic 740 as of December 31, 2010.

Note 7. Comprehensive Loss

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

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
    2011    
2010
   
2011
   
2010
 
Net loss
 
$
 (2,863
)
 
$
(3,459
)
 
$
(9,174
)
 
$
(9,238
)
Net change in unrealized gain (loss) on available-for sale-securities, net of tax
   
297
     
 (54
)
   
 919
     
(142
)
Comprehensive loss
 
$
 (2,566
)
 
$
 (3,513
)
 
$
 (8,255
)
 
$
 (9,380
)
 
Note 8. Commitments and Contingencies

Facility Leases
The Company leases its Brisbane, California, office and manufacturing facility under a non-cancelable operating lease which expires on December 31, 2017. In addition, the Company has leased office facilities in certain international countries, including: Japan, Switzerland, France, and Spain. As of September 30, 2011, 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):

Fiscal Year Ending December 31,
 
Amount
 
2011 (remainder)
 
$
454
 
2012
   
1,674
 
2013
   
1,737
 
2014
   
1,782
 
2015
   
1,367
 
Thereafter
   
2,654
 
Future minimum rental payments
 
$
9,668
 

Purchase Commitments
The Company maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply for key components. The Company’s liability in these purchase commitments is generally restricted to a forecasted time-horizon as agreed between the parties. These forecasted time-horizons can vary among different suppliers.
In the first quarter of 2010, the Company entered into an agreement with Obagi to distribute certain of their proprietary cosmeceuticals, or skin care products, in Japan. In order to maintain an exclusive right to distribute Obagi products in the physician dispensed channel in Japan, the Company needs to purchase a minimum of $1.75 million of products in 2011 and $2.0 million in 2012. The Company’s other open inventory purchase commitments were not material at September 30, 2011.
 

Litigation
The Company is named from time to time as a party to product liability and other claims and lawsuits in the normal course of its business. As of September 30, 2011, the Company was not a party to any material pending litigation.
 
Indemnifications
In the normal course of business, the Company enters into agreements that contain a variety of representations, warranties, and indemnification obligations. For example, the Company has entered into indemnification agreements with each of its directors and executive officers. The Company’s exposure under its various indemnification obligations is unknown and not reasonably estimable as they involve future claims that may be made against the Company. As such, the Company has not accrued any amounts for such obligations.

ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Caution Regarding Forward-Looking Statements

The following discussion should be read in conjunction with the attached condensed consolidated financial statements and notes thereto, and with our audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2010 as contained in our annual report on Form 10-K filed with the SEC on March 15, 2011. This quarterly report, including the following sections, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Throughout this report, and particularly in this Item 2, the forward-looking statements are based upon our current expectations, estimates and projections and reflect our beliefs and assumptions based upon information available to us at the date of this report. In some cases, you can identify these statements by words such as “may,” “might,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue,” and other similar terms. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Our actual results, performance or achievements could differ materially from those expressed or implied by the forward-looking statements. These forward-looking statements include, but are not limited to, statements relating to our future financial performance, the ability to grow our business, increase our revenue, manage expenses, generate additional cash, achieve and maintain profitability, develop and commercialize existing and new products and applications, and improve the performance of our worldwide sales and distribution network, and the outlook regarding long term prospects. These forward-looking statements involve risks and uncertainties. The cautionary statements set forth below and those contained in Part II, Item 1A – “Risk Factors” commencing on page 24, identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution you to not place undue reliance on these forward-looking statements, which reflect management’s analysis and expectations only as of the date of this report. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.
 
Introduction

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

 
·
Executive Summary. This section provides a general description and history of our business, a brief discussion of our product lines and the opportunities, trends, challenges and risks we focus on in the operation of our business.
 
·
Critical Accounting Policies and Estimates. This section describes the key accounting policies that are affected by critical accounting estimates.
 
·
Recent Accounting Pronouncements. This section describes the issuance and effect of new accounting pronouncements that may be applicable to us.
 
·
Results of Operations. This section provides our analysis and outlook for the significant line items on our Consolidated Statements of Operations.
 
·
Liquidity and Capital Resources. This section provides an analysis of our liquidity and cash flows, as well as a discussion of our commitments.

Executive Summary

Company Description

We are a global medical device company specializing in the design, development, manufacture, marketing and servicing of laser and light-based aesthetics systems for practitioners worldwide. We offer easy-to-use products based on five platforms — CoolGlide®, Xeo®, Solera®, GenesisPlusTM and Excel VTM — each of which enables physicians and other qualified practitioners to perform safe and effective aesthetic procedures for their customers. Commencing in the fourth quarter of 2011, we plan to launch a new Q-switched laser product called myQTM in Japan, that Cutera shall be sourcing from a third party original equipment manufacturer (OEM). In addition to systems and upgrade revenue, we generate revenue from the sale of post warranty service contracts, providing services for products that are out of warranty, Titan hand piece refills, and dermal fillers and cosmeceuticals.
 
 
Our corporate headquarters and U.S. operations are located in Brisbane, California, from where we conduct our manufacturing, warehousing, research and development, regulatory, sales and marketing, service, and administrative activities. In the United States, we market, sell and service our products through direct sales and service employees, and a distribution relationship with PSS World Medical Shared Services, Inc. (“PSS”), a wholly owned subsidiary of PSS World Medical which has over 700 sales representatives serving physician offices throughout the United States. We also sell certain items such as our Titan hand piece refills and marketing brochures online.
 
International sales are generally made through direct sales employees and a worldwide distributor network in over 35 countries. Outside of the United States, we have a direct sales presence in Australia, Canada, France, Japan, Spain, Switzerland (however, beginning October 1, 2011 we engaged a distributor in Switzerland instead of selling directly) and the United Kingdom.

Products

Our revenue is derived from the sale of Products, Upgrades, Service, Titan hand piece refills, and Dermal fillers and cosmeceutical products. Product revenue represents the sale of a system. A system consists of a console that incorporates a universal graphic user interface, a laser and/or light-based module, control system software and high voltage electronics; as well as one or more hand pieces. However, depending on the application, the laser or light-based module is sometimes contained in the hand piece such as with our Pearl and Pearl Fractional applications instead of within the console. Commencing in the fourth quarter of 2011, we plan to launch a new Q-switched laser system called myQ.

We offer our customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications to their system as their practice grows. This provides customers the flexibility to upgrade their systems whenever they want and provides us with a source of recurring revenue which we classify as Upgrade revenue. Service revenue relates to amortization of prepaid service contract revenue and receipts for time and materials services on out-of-warranty products. Titan hand piece refill revenue is associated with our Titan hand piece which requires replacement of the optical source after a set number of pulses have been used. In Japan, we distribute Merz Pharma GmbH’s (Merz) Radiesse® dermal filler product and Xeomin®; and Obagi Medical Products, Inc.’s (Obagi) cosmeceutical products.

Significant Business Trends

Growth
We believe that our ability to grow revenue will be primarily dependent on the following:

 
·
Continuing to expand our product offerings ─ both through internal development and sourcing from other vendors.
 
·
Ongoing investment in our global sales and marketing infrastructure.
 
·
Use of clinical results to support new aesthetic products and applications.
 
·
Enhanced luminary development and reference selling efforts (to develop a location where our products can be displayed and used to assist in selling efforts).
 
·
Customer demand for our products.
 
·
Consumer demand for the application of our products.
 
·
Marketing to physicians in the core dermatology and plastic surgeon specialties, as well as outside those specialties.
 
·
Generating ongoing revenue from our growing installed base of customers through the sale of Service, Upgrade, Titan hand piece refills, and Dermal fillers and cosmeceutical products.
 
U.S. Revenue
Our U.S. revenue increased by $1.8 million, or 43%, in the three-month period ended September 30, 2011 and by $2.4 million, or 18%, in the nine-month period ended September 30, 2011, compared to the same periods in 2010, respectively. This increase was primarily attributable to an increase in product revenue due to the:
 
·
FDA clearance of our GenesisPlus system for onychomycosis, or toenail fungus, in April 2011;
 
·
Commencement of Excel V shipments in the second quarter of 2011; and
 
·
Result of effective U.S. sales management changes implemented in early 2011.
 
 
International Revenue
International revenue increased by $1.3 million or 17%, in the three-month period ended September 30, 2011 and by $1.3 million or 5% in the nine-month period ended September 30, 2011, compared to the same periods in 2010, respectively. This increase was primarily attributable to:

 
·
Higher product revenue from Canada, Australia and several of our distributor countries as a result of new products and a general improved economic environment in the three and nine-month period ended September 30, 2011, compared to the same period in 2010;
 
·
An increase in our Dermal filler and cosmeceuticals revenue in Japan, due primarily to a higher number of customers purchasing Obagi products, which we began distributing in the first quarter of 2010, and due to the expansion of product lines being distributed; which was partly offset by
 
·
A decline in our direct and distributor revenue from European countries due primarily to a restructuring of our sales team.
Product Revenue
Products revenue increased by $3.2 million or 56%, in the three-month period ended September 30, 2011 and by $3.6 million, or 19%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. These increases in revenue were due primarily to the U.S. FDA clearance of our GenesisPlus system for toenail fungus in April 2011 and the commencement of Excel V shipments in the second quarter of 2011. This was offset by a decline in revenue for the nine-month period ended September 30, 2011, compared to the same period in 2010, due to the catastrophic earthquake in Japan in March 2011 and a decline in our European revenue due to the European debt crisis and sales employee turnover.

Upgrade Revenue
Upgrades revenue decreased by $727,000, or 51%, in the three-month period ended September 30, 2011 and by $1.6 million, or 40%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. In the past, we introduced new products that allowed existing customers to upgrade their previously purchased systems to obtain benefits from the additional capabilities, which drove our Upgrade revenue. However, since 2008 we have not introduced any new products that our customers could purchase as an upgrade to their previously purchased system. Instead, we have launched new stand alone products (GenesisPlus and Excel V), which has resulted in a decline of our upgrade revenue since 2009.

Voluntary Titan XL Recall
In the second quarter of 2010, we initiated a voluntary recall of our Titan XL hand pieces. As part of the voluntary recall program, we provided our customers with a fully “refilled” Titan XL hand piece. As a result, our Titan hand piece refills revenue was negatively impacted since the announcement of the recall and as of the third quarter ended September 30, 2011, it has not recovered to the pre-recall revenue level of approximately $1.3 to $1.4 million per quarter. Cost of revenue for the nine months ended September 30, 2010, included an expense of $487,000 for the estimated cost of this voluntary recall.

Factors that May Impact Future Performance.

Our industry is impacted by numerous competitive, regulatory, macroeconomic and other significant factors. The March 2011 earthquake and tsunami in Japan had a negative impact on our Japanese business and operations. Our industry is highly competitive and our future performance depends on our ability to compete successfully. Additionally, our future performance is dependent upon our ability to continue to expand our product offerings, develop innovative technologies, obtain regulatory clearances for our products, protect the proprietary technology of our products and our manufacturing processes, manufacture our products cost-effectively, and successfully market and distribute our products in a profitable manner. If we fail to execute on the aforementioned initiatives, our business would be adversely affected. A detailed discussion of these and other factors that could impact our future performance are provided in Part II, Item 1A “Risk Factors” section below.

Critical Accounting Policies and Estimates.

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

Critical accounting estimates, as defined by the Securities and Exchange Commission (SEC), are those that are most important to the portrayal of our financial condition and results of operations and require our management’s most difficult and subjective judgments and estimates of matters that are inherently uncertain. The accounting policies and estimates that we consider to be critical, subjective, and requiring judgment in their application are summarized in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with theSEC on March 15, 2011. There have been no significant changes to the accounting policies and estimates disclosed in our Form 10-K,except for revenue recognition as described in Note 1.
 

Recent Accounting Pronouncements

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

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

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Operating Ratio:
                       
Net revenue
   
100
%
   
100
%
   
100
%
   
100
%
Cost of revenue
   
44
%
   
47
%
   
44
%
   
44
%
Gross margin
   
56
%
   
53
%
   
56
%
   
56
%
                                 
Operating expenses:
                               
Sales and marketing
   
42
%
   
48
%
   
45
%
   
49
%
Research and development
   
16
%
   
16
%
   
17
%
   
13
%
General and administrative
   
15
%
   
19
%
   
17
%
   
19
%
Total operating expenses
   
73
%
   
83
%
   
79
%
   
81
%
                                 
Loss from operations
   
(17
)%
   
(30
)%
   
(23
)%
   
(25
)%
Interest and other income, net
   
0
%
   
1
%
   
1
%
   
1
%
Loss before income taxes
   
(17
)%
   
(29
)%
   
(22
)%
   
(24
)%
Provision for income taxes
   
2
%
   
%
   
%
   
%
Net loss
   
(19
)%
   
(29
)%
   
(22
)%
   
(24
)%

Percentages in this table and throughout our discussion and analysis of financial condition and results of operations may reflect rounding adjustments.

Total Net Revenue
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
Revenue mix by geography:
                                   
United States
  $ 6,037       43 %   $ 4,214     $ 15,941       18 %   $ 13,545  
International
    9,195       17 %     7,878       25,807       5 %     24,513  
Consolidated total revenue
  $ 15,232       26 %   $ 12,092     $ 41,748       10 %   $ 38,058  
                                                 
United States as a percentage of total revenue
    40 %             35 %     38 %             36 %
International as a percentage of total revenue
    60 %             65 %     62 %             64 %
Revenue mix by product category:
                                               
Products
  $ 8,975       56 %   $ 5,767     $ 22,462       19 %   $ 18,888  
Upgrades
    687       (51 % )     1,414       2,364       (40 % )     3,955  
Service
    3,227       2 %     3,166       10,149       2 %     9,917  
Titan hand piece refills
    1,031       59 %     647       3,336       14 %     2,929  
Dermal fillers and cosmeceuticals
    1,312       19 %     1,098       3,437       45 %     2,369  
Consolidated total revenue
  $ 15,232       26 %   $ 12,092     $ 41,748       10 %     38,058  
 
 
Discussion of Revenue by Product Type:

Products Revenue
As explained in more detail in the Products section of the Executive Summary above, some of our products consist of a configurable system platform that includes a console and one or more hand pieces. Each product is configured to give our customers the ability to select the combination of platform and hand pieces that provides the applications that best fit their practice.

Products revenue increased by $3.2 million, or 56%, in the three-month period ended September 30, 2011 and by $3.6 million, or 19%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. These increases in revenue were due primarily to the U.S. FDA clearance of our GenesisPlus system for toenail fungus in April 2011 and the commencement of Excel V shipments in the second quarter of 2011. This was offset by a decline in revenue for the nine-month period ended September 30, 2011, compared to the same period in 2010, due to the catastrophic earthquake in Japan in March 2011 and a decline in our European revenue due to the European debt crisis and sales employee turnover.  

Upgrades Revenue
As explained in more detail in the Products section of the Executive Summary above, our configurable system platforms allow customers to add applications to their existing systems to meet the changing needs of their practices. In some cases, when certain applications are desired that are only available on a platform other than the one owned by the customer, the upgrades revenue will include a platform exchange and additional hand pieces.

Upgrades revenue decreased by $727,000, or 51%, in the three-month period ended September 30, 2011 and by $1.6 million, or 40%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. In the past, we introduced new products that allowed existing customers to upgrade their previously purchased systems to obtain benefits from the additional capabilities, which drove our Upgrade revenue. However, since 2008 we have not introduced any new products that our customers could purchase as an upgrade to their previously purchased system. Instead we have launched new stand alone products (GenesisPlus and Excel V), which has resulted in a decline of our upgrade revenue since 2009.
 
Service Revenue
Our worldwide service revenue increased by $61,000, or 2%, in the three-month period ended September 30, 2011 and by $232,000 or 2% in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. This increase was the result of higher international service revenue being partially offset by a decline in U.S. service revenue. The increase in international service revenue is due to an increased installed base and a higher number of purchased service contracts. The decline in our U.S. service revenue was primarily attributable to lower contract amortizations as a result of fewer customers purchasing extended service contracts.

Titan Hand Piece Refill Revenue
Our Titan hand piece refill revenue increased by $384,000 or 59% in the three-month period ended September 30, 2011 and by $407,000 or 14% in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. This increase was due primarily to the partial recovery of our Titan refill revenue following the voluntary recall of our Titan XL hand piece commencing in the second quarter of 2010, in which we provided our eligible customers with a fully “refilled” Titan XL hand piece, which delayed their purchase of a refill.

Dermal Filler and Cosmeceuticals Revenue
Our Dermal fillers and cosmeceuticals revenue increased by $214,000, or 19%, in the three-month period ended September 30, 2011 and by $1.1 million, or 45%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. This increase was due primarily to the higher number of customers purchasing Obagi products, which we began distributing in Japan in the first quarter of 2010, and due to the expansion of product lines being distributed.

Discussion of Revenue by Geography:

U.S. Revenue
Our U.S. revenue increased by $1.8 million, or 43%, in the three-month period ended September 30, 2011 and by $2.4 million, or 18%, in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. This increase was primarily attributable to an increase in product revenue due to the:
 
·
FDA clearance of our GenesisPlus system for onychomycosis, or toenail fungus, in April 2011;
 
·
Commencement of Excel V shipments in the second quarter of 2011; and
 
·
Result of effective US sales management changes implemented in early 2011.

 
International Revenue
International revenue increased by $1.3 million, or 17%, in the three-month period ended September 30, 2011 and by $1.3 million or 5% in the nine-month period ended September 30, 2011, compared to the respective periods in 2010. This increase was primarily attributable to:
 
·
Higher Product revenue from Canada, Australia and several of our distributor countries as a result of new products and a general improved economic environment in the three and nine-month periods ended September 30, 2011, compared to the same periods in 2010;
 
·
An increase in our Dermal filler and cosmeceuticals revenue in Japan, due primarily to additional Obagi and Merz product lines being added and a higher number of customers purchasing such products from Cutera as we started distributing Obagi products in Japan in the first quarter of 2010; which was partly offset by
 
·
A decline in our direct and distributor revenue from European countries due primarily to a restructuring of our sales team.
 
Gross Profit
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
Gross profit
 
$
8,460
     
32
%
 
$
6,431
   
$
23,276
     
10
%
 
$
21,233
 
As a percentage of total net revenue
   
56
%
           
53
%
   
56
%
           
56
%

Our cost of revenue consists primarily of material, personnel expenses, royalty expense, warranty and manufacturing overhead expenses. Gross margin (which is gross profit divided by net revenue) was 56% in the three-month period ended September 30, 2011, compared to 53% for the same period in 2010. Gross margin was 56% in the nine-month period ended September 30, 2011, and 56% for the same period in 2010. Our gross margins were impacted primarily by the following factors:

 
·
Our gross margin was favorably impacted in the three and nine-month periods ended September 30, 2011, due to the leverage of our relatively fixed manufacturing costs as a result of higher Product volume;
 
·
Our Titan refill gross margin was favorably impacted given we did not incur any expenses related to the voluntary Titan XL recall in the nine months ended September 30, 2011, compared to $487,000 of expenses recorded in the nine months ended September 30, 2010;.
 
·
Higher direct revenue as a percentage of total revenue, in the three and nine months ended September 30, 2011, compared to the same periods in 2010, resulted in an improvement of our margins because direct business has a better gross margin than our distributor business; and
 
·
Our gross margins in the three and nine months ended September 30, 2011, compared to the same periods in 2010, were adversely impacted by an unfavorable product mix towards lower margin products.

Sales and Marketing
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
 
% Change
   
2010
   
2011
 
% Change
   
2010
 
Sales and marketing
 
$
6,426
 
11
%
 
$
5,799
   
$
18,720
 
1
%
 
$
18,612
 
As a percentage of total net revenue
   
42
%
       
48
%
   
45
%
       
49
%

Sales and marketing expenses consist primarily of personnel expenses, expenses associated with customer-attended workshops and trade shows, post-marketing studies, and advertising. Sales and marketing expenses increased $627,000, and represented 42% of total net revenue, in the three-month period ended September 30, 2011, compared to 48% in the same period in 2010. This increase was due primarily to: (i) increased personnel expenses of $351,000 attributable primarily to higher commission expenses relating primarily to the higher revenue; and (ii) increased travel, entertainment and sales meeting expenses by $332,000 due to the increased sales activity.

Sales and marketing expenses increased $108,000, and represented 45% of total net revenue, in the nine-month period ended September 30, 2011, compared to 49% in the same period in 2010. This increase was due primarily to: (i) increased personnel expenses of $609,000 attributable primarily to higher commission expenses relating to the higher revenue; (ii) increased travel, entertainment and sales meeting expenses of $474,000 due primarily to increased sales activity; offset by (iii) reduced promotional and marketing related spending of approximately $789,000 attributable to fewer workshops, and lower spending on public relation and other marketing activities.

Research and Development (R&D)
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
Research and development
 
$
2,352
     
26
%
 
$
1,871
   
$
6,828
     
41
%
 
$
4,831
 
As a percentage of total net revenue
   
16%
             
16
%
   
17
%
           
13
%
 
 
R&D expenses consist primarily of personnel expenses, clinical research, regulatory and material costs. R&D expenses increased by $481,000, and represented 16% of total net revenue, in the three-month period ended September 30, 2011, compared to 16% for the same period in 2010. The increase in expenses was due primarily to: (i) higher personnel expenses of $414,000 due to higher headcount to ramp up the research, development and clinical support of our new products (iii) higher consulting services related to our product development efforts of $98,000; offset by (iv) a decrease in material expenses of $106,000 primarily due to significant spending in the three months ended September 30, 2010 related to new product development expenses.

R&D expenses increased by $2.0 million in the nine-month period ended September 30, 2011, compared to the same period in 2010. R&D expenses, as a percentage of total net revenue, increased to 17% for the nine-month period ended September 30, 2011, compared to 13% for the same period in 2010. The increase in expenses was due primarily to: (i) higher personnel expenses of $1.4 million due to higher headcount and higher consulting fees of $176,000, both, to ramp up the research, development and clinical support of our new products; and (ii) higher material expenses of $252,000 related to spending on prototype product development related primarily to our Excel V product launch. 

General and Administrative (G&A)
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
General and Administrative
 
$
2,310
     
(2
%)
 
$
2,352
   
$
7,226
     
(2
%)
 
$
7,338
 
As a percentage of total net revenue
   
15
%
           
19
%
   
17
%
           
19
%

General and administrative expenses consist primarily of personnel expenses, legal fees, accounting, audit and tax consulting fees, and other general and administrative expenses. G&A expenses decreased $42,000 in the three-month period ended September 30, 2011, compared to the same period in 2010. This decrease was due primarily to: (i) lower personnel expenses of $86,000 attributable to reduced headcount; (ii) lower accounting and tax services fees of $74,000; offset by (iii) an increase of $92,000 related to higher facility costs due to the planned relocation of our offices in Tokyo, Japan.

G&A expenses decreased by $112,000 in the nine-month period ended September 30, 2011, compared to the same period in 2010. G&A expenses, as a percentage of net revenue, decreased to 17% for the nine-month periods ended September 30, 2011, compared to 19% for the same period in 2010. This decrease was due primarily to: (i) lower personnel expenses of $244,000 attributable to reduced headcount; (ii) lower accounting and tax services fee of $96,000; offset by (iii) a $108,000 increase attributable to a reduced benefit associated with doubtful debt recoveries in the nine months ended September 30, 2010, that did not recur in the nine months ended September 30, 2011; and (iv) $92,000 of expenses related to higher facility costs due to the planned relocation of our offices in Tokyo, Japan.
 
Interest and Other Income, Net

Interest and other income, net consist of the following:
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
 
2010
Interest income
 
$
139
     
34
 %
 
$
104
   
$
457
     
12
$
407
Other income (expense), net
   
(48
 )
   
(271
%) 
   
28
     
17
     
(47
%) 
 
32
Total interest and other income, net
 
$
91
     
(31
%) 
 
$
132
   
$
474
     
8
 %
$
439

Interest and other income, net, decreased $41,000 for the three-month period ended September 30, 2011, compared to the same period in 2010, and increased $35,000 for the nine-month period ended September 30, 2011, compared to the same period in 2010. The increases in interest income in the three and nine months ended September 30, 2011, compared to the same periods in 2010, were primarily attributable to improved yields on our investments as a result of shifting some investments to higher yielding corporate debt instruments, versus municipal bonds. The reduction in other income (expense), net, in the three months ended September 30, 2011, compared to the same period in 2010, was due primarily to an increase in foreign exchange losses of $68,000.

Provision for Income Taxes
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
Loss before income taxes
 
$
(2,537
)
   
27
%
 
$
(3,459
)
 
$
(9,024
)
   
1
%
 
$
(9,109
)
Provision for income taxes
   
326
     
NA
     
     
150
     
16
   
129
 
Effective tax rate
   
(13
%)
           
%
   
(2
%)
           
(1
%)

Our income tax provision for the three and nine months ended September 30, 2011 and 2010 was primarily related to income taxes of our non U.S. operations and other discrete items as explained below. We have recorded a 100% valuation allowance against our U.S. deferred tax assets and as such we did not record any income tax benefits related to our U.S. loss.
 

For the three months ended September 30, 2011, our income tax provision was $326,000, compared to a provision of less than $1,000 for the three months ended September 30, 2010. Included in the $326,000 provision for the three months ended September 30, 2011, was a discrete charge of $262,000 for the clearing of disproportionate tax effects in accumulated other comprehensive loss related to unrealized gains and losses on marketable and long-term investments.

For the nine months ended September 30, 2011, our income tax provision was $150,000, compared to a provision of $129,000 for the nine months ended September 30, 2010. Included in the $150,000 provision for the nine months ended September 30, 2011 was a discrete net charge of $194,000 for the clearing of disproportionate tax effects in accumulated other comprehensive loss related to unrealized gains and losses on marketable and long term investments, offset by a discrete tax benefit of $246,000 relating to the carry-back of fiscal year 2010 federal losses to obtain a refund of alternative minimum taxes paid for fiscal year 2008.
 
Net Loss per Diluted Share
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
(Dollars in thousands)
 
2011
   
% Change
   
2010
   
2011
   
% Change
   
2010
 
Net loss
 
$
(2,863
)
   
17%
   
$
(3,459
)
 
$
(9,174
)
   
1%
   
$
(9,238
)
Net loss per diluted share
 
$
(0.21
)
   
16%
 
 
$
(0.25
)
 
$
(0.67
)
   
1%
   
$
(0.68
)
 
Net loss per diluted share decreased $0.04, or 16%, in the three-month period ended September 30, 2011, compared to the same period in 2010, due primarily to:

 
·
Higher net revenue of $3.1 million;
 
·
Improved gross margin from 53% to 56%;
 
·
Reduction in general and administrative expenses by $42,000; which was partially offset by
 
·
Increased sales and marketing expenses of $627,000;
 
·
Increased R&D expenses of $481,000;
 
·
Reduction in interest and other income, net, by $41,000; and
 
·
An increase in the income tax provision by $326,000.
 
Net loss per diluted share decreased $0.01, or 1%, in the nine-month period ended September 30, 2011, compared to the same period in 2010, due primarily to:

 
·
Higher net revenue of $3.7 million;
 
·
Reduction in general and administrative expenses by $112,000;
 
·
Increase in interest and other income, net, by $35,000; which was partly offset by
 
·
Increased R&D expenses of $2.0 million;
 
·
Increased sales and marketing expenses of $108,000; and
 
·
An increase in the income tax provision by $21,000.

Liquidity and Capital Resources

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

Liquidity Ratios

(Dollars in thousands)
 
September 30, 2011
   
December 31, 2010
 
Working Capital(1)
 
$
89,041
   
$
90,339
 
Current Ratio(2)
 
7.0:1
   
7.9:1
 
 
(1)
Working capital is defined as the difference between current assets and current liabilities and represents how much a company has in liquid assets available to operate its business.
(2)
The current ratio is a financial ratio that measures a Company’s resources to pay its current liabilities and is defined as current assets divided by current liabilities.
 
 
Cash and Cash Equivalents, Marketable Investments and Long-Term Investments Summary
 
The following table summarizes our cash and cash equivalents, marketable investments and long-term investments:

(Dollars in thousands)
 
September 30,
2011
   
December 31,
2010
   
Change
 
Cash and cash equivalents
 
$
13,874
   
$
12,519
   
$
1,355
 
Marketable investments
   
74,502
     
77,484
     
(2,982
)
Long-term investments
   
3,014
     
6,784
     
(3,770
)
Total
 
$
91,390
   
$
96,787
   
$
(5,397
)

Cash Flows

   
Nine Months Ended
September 30,
 
(Dollars in thousands)
 
2011
   
2010
 
Net cash flow provided by (used in):
           
Operating activities
 
$
(5,753
)
 
$
(7,631
)
Investing activities
   
6,042
     
6,125
 
Financing activities
   
1,066
     
380
 
Net increase (decrease) in cash and cash equivalents
 
$
1,355
   
$
(1,126

Cash Flows from Operating Activities

Net cash used in operating activities in the nine-month period ended September 30, 2011 was $5.8 million, which was due primarily to:

 
·
$5.6 million used by the net loss of $9.2 million after adjusting for non-cash related items of $3.6 million consisting primarily of stock-based compensation expense of $3.1 million, depreciation and amortization of $483,000 and the tax on unrealized gains of marketable and long term investments of $194,000, partially offset by the provision for excess and obsolete inventories of $174,000;
 
·
$3.0 million used to increase inventory relating primarily to raw materials and finished goods associated with the ramp up of our recently introduced products — GenesisPlus and Excel V;
 
·
$698,000 used as a result of a decrease in deferred revenue due primarily to a decrease in unit sales volume of Products and Upgrades that included purchases of extended service contracts, a reduction in our service contract pricing, a shift by customers towards purchasing shorter term contracts, and fewer customers purchasing extended service contracts;
 
·
$493,000 used in other long-term assets, which was primarily related to a $443,000 lease deposit for our Japan facility; which was offset by
 
·
$2.0 million generated from the reduction of other current assets primarily from the receipt of a U.S. income tax refund of $1.2 million and $1.1 million amortization of discounts and purchased interest relating to our marketable investments, offset by an increase in prepaid expenses of $212,000;
 
·
$1.1 million generated by an increase in accrued liabilities relating primarily to an increase in customer deposits of $453,000, an increase in accrued royalties by $178,000,and accrued but unpaid personnel costs of $464,000; and
 
·
$855,000 generated by an increase in accounts payable due primarily to higher inventory purchases.
 
Net cash used in operating activities in the nine-month period ended September 30, 2010 was $7.6 million, which was due primarily to:

 
·
$5.0 million used by the net loss of $9.2 million after adjusting for non-cash related items of $4.2 million; consisting primarily of stock-based compensation expense of $3.7 million and other items of $583,000;
 
·
$3.1 million used to pay down the higher 2009 year-end accrued liabilities relating primarily to: (i) a reduction of professional and legal fees of $1.4 million resulting primarily from a settlement payment of $950,000 relating to our TCPA litigation matter and $369,000 related primarily to payment of other legal settlements, (ii) reduction of customer deposits by $588,000, resulting from converting customer prepayments to sales, (iii) reduction of accrued warranty expenses of $389,000 due primarily to fewer units remaining under warranty, (iv) reduction of accrued personnel expenses by $279,000 resulting primarily from the pay-down of year-end commissions and bonuses, and a (v) net reduction of $208,000 for accrued sales and marketing expenses;
 
·
$1.1 million used as a result of a decrease in deferred revenue due primarily to a decrease in unit sales volume of Products and Upgrades that included purchases of extended service contracts, a reduction in our service contract pricing, a shift by customers towards purchasing shorter term contracts, and fewer customers purchasing extended service contracts; and
 
·
$953,000 used to purchase inventory, which primarily resulted from our distribution agreements with Obagi and Merz; partially offset by
 
·
$1.8 million amortization of discounts and purchased interest relating to our marketable and long-term investments.

 
20
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