the ezlase system. If HSIC has not met the minimum purchase requirement for any 12-month period ending on March 31, we will have the option, upon 30 days written notice, to (i) convert ezlase distribution rights to a non-exclusive basis for a minimum period of one year, after which period we would have the option to withdraw ezlase distribution rights, and (ii) reduce the distributor discount on ezlase products.
On March 3, 2008, we entered into a second addendum to the HSIC agreement that modifies certain terms of the initial agreement as amended. Pursuant to the second addendum, HSIC is obligated to meet certain minimum purchase requirements and is entitled to receive incentive payments if certain purchase targets are achieved. If HSIC has not met the minimum purchase requirements, we will have the option to (i) shorten the remaining term of the Agreement to one year,
(ii) grant distribution rights held by HSIC to other persons (or distribute products ourselves), (iii) reduce certain discounts on products given to HSIC under the Agreement and (iv) cease paying future incentive payments. Additionally, under certain circumstances, if HSIC has not met the minimum purchase requirements, we have the right to purchase back the exclusive distributor rights granted to HSIC under the agreement. We also agreed to actively promote Henry Schein Financial Services as our exclusive leasing and financing partner. Our recent addition to the Waterlase family of lasers, the C100, will be distributed in North America by HSIC. C100 purchases by HSIC will apply towards satisfying the aforementioned minimum purchase requirements. We intend to augment the activities of HSIC in the United States and Canada with the efforts of our direct sales force; however, our future revenue will be largely dependent upon the efforts and success of HSIC in selling our products. Since September 1, 2006, nearly all of our domestic sales were made through HSIC and we expect this to continue for the foreseeable future. We cannot assure you that HSIC will devote sufficient resources to selling our products or, even if sufficient resources are directed to our products, that such efforts will be sufficient to increase net revenue. Critical Accounting Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported. The following is a summary of those accounting policies that we believe are necessary to understand and evaluate our reported consolidated financial results.
Revenue Recognition. Effective September 1, 2006, nearly all of our domestic sales are to HSIC; prior to this date, we sold our products directly to customers through our direct sales force. Internationally, we sell products through direct sales representatives and through distributors. We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition, which requires that four basic criteria must be met before revenue can be recognized: (i) persuasive evidence of an arrangement exists;
(ii) delivery has occurred and title and the risks and rewards of ownership have been transferred to our customer, or services have been rendered; (iii) the price is fixed or determinable; and (iv) collectibility is reasonably assured.
We apply Emerging Issues Task Force, or EITF, 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, which requires us to evaluate whether the separate deliverables in our arrangements can be unbundled in our revenue recognition. Sales of our Waterlase systems include separate deliverables consisting of the product, disposables used with the Waterlase system, installation and training. For these sales, we apply the residual value method, which requires us to allocate to the delivered elements the total arrangement consideration less the fair value of the undelivered elements. Sales of our Diolase systems include separate deliverables consisting of the product, disposables and training. For these sales, we apply the relative fair value method, which requires us to allocate the total arrangement consideration to the relative fair value of each element. Revenue attributable to the undelivered elements, primarily training and installation, are included in deferred revenue when the product is shipped and are recognized when the related service is performed or upon expiration of time offered under the agreement.
The key judgment related to our revenue recognition relates to the collectibility of payment from the customer. We evaluate the customer's credit worthiness prior to the shipment of the product. Based on our assessment of the credit information available to us, we may determine the credit risk is higher than normally acceptable, and we will either decline the purchase or defer the revenue until payment is reasonably assured.
Although all sales are final, we accept returns of products in certain, limited circumstances and record a provision for sales returns based on historical experience concurrent with the recognition of revenue. The sales returns allowance is recorded as a reduction of accounts receivable and revenue.

We recognize revenue for royalties under licensing agreements for our patented technology when the product using our technology is sold. We estimate and recognize the amount earned based on historical performance and current knowledge about the business operations of our licensees. Our estimates have been consistent with amounts historically reported by the licensees.
We may offer sales incentives and promotions on our products. We apply EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products), in determining the appropriate treatment of the related costs of these programs.
Commissions. Commission expense is recorded in the sales and marketing category and is recorded when the liability is incurred.
Accounting for Stock-Based Payments. Effective January 1, 2006, we adopted the provisions of Financial Accounting Standard 123 (revised), Share-Based Payment, or FAS 123R, using the modified prospective transition method. Prior to the adoption of FAS 123R, we accounted for share-based payments to employees using the intrinsic value method under Accounting Principles Board Opinion No. 25, or APB 25, Accounting for Stock Issued to Employees, and the related interpretations. Under the provisions of APB 25, stock option awards were accounted for using fixed plan accounting whereby we recognized no compensation expense for stock option awards because the exercise price of options granted was equal to the fair value of the common stock at the date of grant. In March 2005, the SEC issued Staff Accounting Bulletin 107, or SAB 107, regarding the SEC Staff's interpretation of FAS 123R, which provides the Staff's views regarding interactions between FAS 123R and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. We have incorporated the provisions of SAB 107 in our adoption of FAS 123R.
Under the modified prospective transition method, the provisions of FAS 123R apply to new awards and to awards outstanding on January 1, 2006 and subsequently modified, repurchased or cancelled. Under the modified prospective transition method, compensation expense recognized in 2006 includes compensation costs for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of FAS 123, and compensation costs for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R. Prior periods were not restated to reflect the impact of adopting the new standard.
Valuation of Accounts Receivable. We maintain an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. We evaluate our allowance for doubtful accounts based upon our knowledge of customers and their compliance with credit terms. The evaluation process includes a review of customers' accounts on a regular basis which incorporates input from sales, service and finance personnel. The review process evaluates all account balances with amounts outstanding 60 days and other specific amounts for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in general and administrative expenses. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.
Valuation of Inventory. Inventory is valued at the lower of cost, determined using the first-in, first-out method, or market. We periodically evaluate the carrying value of inventory and maintain an allowance for excess and obsolete inventory to adjust the carrying value as necessary to the lower of cost or market. We evaluate quantities on hand, physical condition and technical functionality, as these characteristics may be impacted by anticipated customer demand for current products and new product introductions. Unfavorable changes in estimates of excess and obsolete inventory would result in an increase in cost of revenue and a decrease in gross profit.
Valuation of Long-Lived Assets. Property, plant and equipment, and certain intangibles with finite lives are amortized over their useful lives. Useful lives are based on our estimate of the period that the assets will generate revenue or otherwise productively support our business goals. We monitor events and changes in circumstances which could indicate that the carrying balances of long-lived assets may exceed the undiscounted expected future cash flows from those assets. If such a condition were to exist, we would recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets.
Valuation of Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. We conducted our annual impairment analysis of our goodwill and trade names as of June 30, 2008 and 2007, and concluded there had been no impairment in trade names and no impairment in goodwill.

Warranty Cost. Waterlase systems sold are covered by a warranty against defects in material and workmanship for a period of one year while our ezlase system warranty period is up to two years. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of revenue. This estimate is recognized concurrent with the recognition of revenue. The accrual is based on our historical experience and our expectation of future conditions. An increase in warranty claims or in the costs associated with servicing those claims would result in an increase in the accrual and a decrease in gross profit.
Litigation and Other Contingencies. We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses relating to such exposures requires significant judgment about the potential range of outcomes. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of expense relating to contingencies. To be recorded as expense, a loss contingency must be both probable and reasonably estimable. If a loss contingency is material but is not both probable and estimable, we will disclose the matter in the notes to the consolidated financial statements.
Income Taxes. Based upon our operating losses during 2007 and 2006 and the available evidence, management determined that it is more likely than not that the deferred tax assets as of September 30, 2008 will not be realized, excluding the foreign deferred assets. In this determination, we considered factors such as our earnings history, future projected earnings and tax planning strategies. If sufficient evidence of our ability to generate sufficient future taxable income tax benefits becomes apparent, we may reduce our valuation allowance, resulting in tax benefits in our statement of operations and in additional paid-in-capital. Management evaluates the potential realization of our deferred tax assets and assesses the need for reducing the valuation allowance periodically.
Off-Balance Sheet Arrangements. We have no off-balance sheet financing or contractual arrangements.

Results of Operations
   The following table presents certain data from our consolidated statements of
operations expressed as percentages of revenue:

                                                      Three Months Ended                Nine Months Ended
                                                        September 30,                     September 30,
                                                    2008             2007             2008             2007
Consolidated Statements of Operations Data:
Net revenue                                         100.0 %          100.0 %          100.0 %          100.0 %
Cost of revenue                                      50.7             48.6             48.6             46.3

Gross profit                                         49.3             51.4             51.4             53.7

Operating expenses:
Sales and marketing                                  36.7             49.1             30.7             42.6
General and administrative                           20.7             20.3             18.2             16.9
Engineering and development                           8.6             10.0              7.7              8.0
Legal settlement and fees                             8.1                -              2.3                -

Total operating expenses                             74.1             79.4             58.9             67.5

Loss from operations                                (24.8 )          (28.0 )           (7.5 )          (13.8 )
Non-operating income, net                            (4.3 )            0.9              0.4              1.0

Loss before income tax provision                    (29.1 )          (27.1 )           (7.1 )          (12.8 )
Income tax provision                                  0.3              0.3              0.2              0.5

Net loss                                            (29.4 )%         (27.4 )%          (7.3 )%         (13.3 )%

The following table summarizes our net revenue by category (dollars in thousands):

                            Three Months Ended September 30,                        Nine Months Ended September 30,
                             2008                        2007                       2008                        2007
Waterlase
systems             $   10,654           70 %    $  7,906          62 %    $   33,631           63 %    $ 31,186          68 %
Diolase systems          1,989           13 %       1,985          15 %         9,876           19 %       5,830          13 %
Non-laser
systems                  1,775           11 %       2,019          16 %         6,743           13 %       6,142          13 %

Products and
services                14,418           94 %      11,910          93 %        50,250           95 %      43,158          94 %
License fee and
royalty                    868            6 %         902           7 %         2,740            5 %       2,891           6 %

Net revenue         $   15,286          100 %    $ 12,812         100 %    $   52,990          100 %    $ 46,049         100 %

Three months ended September 30, 2008 and 2007 Net Revenue. Net revenue for the three months ended September 30, 2008 was $15.3 million, an increase of $2.5 million, or 19%, as compared with net revenue of $12.8 million for the three months ended September 30, 2007.
Laser system net revenue increased by approximately 28% in the quarter ended September 30, 2008 compared to the same quarter of 2007. Sales of our Waterlase systems increased $2.7 million, or 35%, in the quarter ended September 30, 2008 compared to the same period in 2007. Our Waterlase C100 system, which was released in the third quarter of 2008, accounted for the increase. Our Diolase family of products remained level in the third quarter of 2008 compared to the third quarter of 2007.
Non-laser system net revenue, which includes consumable products, as well as services revenues including advanced training programs, installation charges and extended service contracts, decreased by approximately $244,000, or 12%, for the three months ended September 30, 2008 as compared to the same period of 2007. Consumable products revenue decreased $170,000, or 16%, and services revenues decreased $74,000, or 8%. The decrease in consumable products was due in part to special promotions on our tips and our newly launched gold hand pieces in the 2007 period.
License fees and royalty revenue decreased $34,000, or 4%, in the quarter ended September 30, 2008 compared to the same quarter of 2007 resulting from lower estimated royalty revenue in the 2008 quarter.
Domestic revenues were $11.9 million, or 78% of net revenue, for the three months ended September 30, 2008 versus $9.4 million, or 73% of net revenue, for the three months ended September 30, 2007. The strengthened relationship and

agreement with Henry Schein was a key component of the growth as well as our recently released Waterlase C100 laser system. International revenues for the quarter ended September 30, 2008 were $3.4 million, or 22% of net revenue, as compared with $3.5 million, or 27% of net revenue, for the quarter ended September 30, 2007.
Gross Profit. Gross profit for the three months ended September 30, 2008 increased by $947,000 to $7.5 million, or 49% of net revenue, as compared with gross profit of $6.6 million, or 51% of net revenue, for the three months ended September 30, 2007. The decrease in gross margin is the result of discounts on sales of demonstration units of Waterlase C100. The margins were also reduced by sales mix of Waterlase C100 which have lower margins compared to the Waterlase MD.
Operating Expenses. Operating expenses for the three months ended September 30, 2008 increased by $1.2 million, or 11%, to $11.3 million as compared to $10.2 million for the three months ended September 30, 2007, and decreased as a percentage of net revenue to 74% from 79%. The increase is primarily due to legal settlement and fees associated with the Diodem matter of $1.2 million in the third quarter of 2008. We continue to work on reducing expenses, but are also reinvesting in programs to drive sales.
Sales and Marketing Expense. Sales and marketing expenses for the three months ended September 30, 2008 decreased by $677,000, or approximately 11%, to $5.6 million, or 37% of net revenue, as compared with $6.3 million, or 49% of net revenue, for the three months ended September 30, 2007. The largest decreases were in convention and seminars expenses which decreased by $616,000.
General and Administrative Expense. General and administrative expenses for the three months ended September 30, 2008 increased by $563,000, or 22%, to $3.2 million, or 21% of net revenue, as compared with $2.6 million, or 20% of net revenue, for the three months ended September 30, 2007. The increase in general and administrative expenses resulted primarily from higher legal expenses from various lawsuits and payroll expenses including non-cash stock based compensation and heightened patent activity.
Engineering and Development Expense. Engineering and development expenses for the three months ended September 30, 2008 increased by $34,000, or 3%, to $1.3 million, or 9% of net revenue, as compared with $1.3 million, or 10% of net revenue, for the three months ended September 30, 2007. The increase is primarily related to building an internal team for new product introductions.
Non-Operating Income (Loss)
(Loss) gain on Foreign Currency Transactions. We recognized a $637,000 loss on foreign currency transactions for the three months ended September 30, 2008, compared to a $34,000 loss on foreign currency transactions for the three months ended September 30, 2007 due to the treatment of intercompany balances as short term. The increase is due to changes in exchange rates between the U.S. dollar and the Euro, the Australian dollar and the New Zealand dollar and an increase in foreign currency denominated transactions and balances. We have not engaged in hedging transactions to offset foreign currency fluctuations. Therefore, we are at risk of changes in the value of the U.S. dollar relative to the value of these foreign currencies. In mid-October 2008, we significantly reduced the inter-company payable due from the foreign subsidiaries to us by making an approximately equal capital contribution which did not result in a significant change in global cash positions. Through the mid-October 2008 contribution date, foreign currency gains and losses continued. However, subsequent to the contribution date, foreign currency transactions gains and losses recorded on the remaining inter-company balances are expected to be significantly reduced. Interest Income. Interest income resulted from interest earned on our cash and investments balances. Interest income for the three months ended September 30, 2008 was $26,000 as compared with $156,000 for the three months ended September 30, 2007. The decrease is the result of lower average cash balances during the 2008 period compared to the same period in 2007. Interest Expense. Interest expense consists primarily of interest on the financing of our business insurance premiums and interest on outstanding balances on our line of credit. Interest expense for the quarter ended September 30, 2008 was $35,000 as compared to $3,000 for the quarter ended September 30, 2007.

Income Taxes. An income tax provision of $50,000 was recognized for the three months ended September 30, 2008 as compared with an income tax provision of $38,000 for the three months ended September 30, 2007. As a result of the implementation of FIN 48, we recognized a $156,000 liability for unrecognized tax benefits, including related estimates of penalties and interest, which was accounted for as an increase in the January 1, 2007 accumulated deficit balance. For the three months ended September 30, 2008 and 2007, we recorded an increase of $2,000 and an increase of $5,000, respectively, in the liability for unrecognized tax benefits, including related estimates of penalties and interest. As of September 30, 2008, we have a valuation allowance against our net deferred tax assets, excluding foreign operations, in the amount of $27.3 million. Based upon our operating losses and the weight of the available evidence, management believes it is more likely than not that we will not realize all of these deferred tax assets. Nine months ended September 30, 2008 and 2007 Net Revenue. Net revenue for the nine months ended September 30, 2008 was $53.0 million, an increase of $6.9 million or 15% as compared with net revenue of $46.0 million for the nine months ended September 30, 2007. . . .