The overall cost of high-power lasers may be partially offset by improved absorption of fixed overhead costs associated with sales of larger volumes of higher-power products.
Due to the fact that we have high fixed costs, our costs are difficult to adjust in response to changes in demand. In addition, our fixed costs will increase as we expand our capacity. Gross margins generally have improved because of greater absorption of fixed overhead costs associated with an increase in sales. In addition, absorption of fixed costs can benefit gross margins due to an increase in production that is not sold and placed into inventory. Absorption of fixed costs can adversely impact gross margins if there is lower production and a decrease in inventory that is sold. If the rate at which our fixed costs increases is greater than the growth rate of our net sales or if we have production issues or inventory write-downs, our gross margins could be negatively affected. We regularly review our inventory for items that are slow-moving, have been rendered obsolete or determined to be excess, and any write-off of such slow-moving, obsolete or excess inventory affects our gross margins.
Sales and marketing expense. We expect to continue to expand our worldwide direct sales organization, build and expand applications centers, hire additional personnel involved in marketing in our existing and new geographic locations, increase the number of units used for demonstration purposes and otherwise increase expenditures on sales and marketing activities in order to support the growth in our net sales. As such, we expect that our sales and marketing expenses will increase in the aggregate.
Research and development expense. We plan to continue to invest in research and development to improve our existing components and products and develop new components and products. We plan to increase the personnel involved in research and development and expect to increase other research and development expenses. As such, we expect that our research and development expenses will increase in the aggregate.
General and administrative expense. We expect our general and administrative expenses to continue to increase as we expand headcount to support the growth of our company, comply with public company reporting obligations and regulatory requirements and continue to invest in our financial reporting systems. We expect future increases in these expenses to be more moderate than those that we experienced in 2007. Legal expenses vary based upon the stage of litigation, including patent re-examinations and termination of litigation stays, and are expected to increase in the pending litigations as the discovery and trial phases of these litigations occur. Litigation expenses also may increase in response to any future litigation or intellectual property matters, the timing and amount of which may vary substantially from quarter to quarter.
Major customers. We have historically depended on a few customers for a large percentage of our annual net sales. The composition of this group can change from year to year. Net sales derived from our five largest customers as a percentage of our annual net sales were 37% in 2005, 29% in 2006, 20% in 2007 and 20% for the nine months ended September 30, 2008. Sales to our largest customer accounted for 13%, 10%, 7% and 7% of our net sales in 2005, 2006, 2007 and the nine months ended September 30, 2008, respectively. We seek to add new customers and to expand our relationships with existing customers. We anticipate that the composition of our net sales to our significant customers will continue to change. If any of our significant customers were to substantially reduce their purchases from us, our results would be adversely affected.
Results of operations for the three months ended September 30, 2008, compared to the three months ended September 30, 2007 Net sales. Net sales increased by $14.1 million, or 29.4%, to $62.0 million for the three months ended September 30, 2008 from $47.9 million for the three months ended September 30, 2007. The increase was attributable to higher sales of fiber lasers in materials processing applications, where net sales increased by $16.3 million, or 47.0%. This increase was partially offset by decreased sales in medical application of $1.0 million, or 40.6%, in advanced applications of $0.8 million, or 12.7%, and in communications applications, where net sales decreased by $0.4 million, or 8.4%. The growth in materials processing applications sales resulted primarily from

increased sales of pulsed lasers and medium-power lasers and continued market penetration for high-power fiber lasers, which increased by 41.6%, 101.5% and 36.5%, respectively. The decrease in sales of medical applications and low-power lasers was due to lower sales to our largest medical application customer in the United States. Sales of advanced applications can vary from quarter to quarter due to the timing of large orders. The third quarter of 2007 benefited from the shipment of $1.9 million of high-power lasers related to a single order. The decrease in communications applications sales was due to a slight decline in total volume of sales to our two largest customers.
Cost of sales and gross margin. Cost of sales increased by $6.4 million, or 24.4%, to $32.6 million for the three months ended September 30, 2008 from $26.2 million for the three months ended September 30, 2007 as a result of increased sales volume. Our gross margin increased to 47.4% for the three months ended September 30, 2008 from 45.3% for the three months ended September 30, 2007. The increase in gross margin for the three months ended September 30, 2008 was the result of favorable absorption of our fixed manufacturing costs due to high production volumes and favorable product mix related to the increase in sales of pulsed and medium-power lasers. These products have a higher selling price of output power per watt and higher gross margins. These benefits were partially offset by inventory write downs of $1.4 million and an increase in depreciation related to facilities and equipment of $0.5 million for the three months ended September 30, 2008.
Sales and marketing expense. Sales and marketing expense increased by $1.2 million, or 50.1%, to $3.7 million for the three months ended September 30, 2008 from $2.5 million for the three months ended September 30, 2007, primarily as a result of an increase in personnel costs of $0.7 million and in premises expenses of $0.2 million related to the expansion of our worldwide direct sales organization and associated sales personnel in the United States, Germany and Japan. In addition, depreciation related to facilities and demonstration units increased by $0.3 million. As a percentage of sales, sales and marketing expense increased to 6.0% for the three months ended September 30, 2008 compared to 5.2% for the three months ended September 30, 2007.
Research and development expense. Research and development expense increased by $1.7 million, or 75.4%, to $4.1 million for the three months ended September 30, 2008 from $2.4 million for the three months ended September 30, 2007. This increase was primarily due to an increase of $1.1 million in personnel costs and $0.6 million in materials used for research and development projects. During 2008, we increased the number of personnel performing research and development activities in the United States, Germany and Russia, our three principal research locations. Approximately $0.3 million of the increase related to employees transferred from production to research and development activities. Increases in material used for research and development related primarily to new product development in the United States. Research and development activity continues to focus on enhancing the performance of our internally manufactured components, refining production processes to improve manufacturing yields and the development of new products operating at different wavelengths and at higher output powers. As a percentage of sales, research and development expense increased to 6.7% for the three months ended September 30, 2008 from 4.9% for the three months ended September 30, 2007.
General and administrative expense. General and administrative expense increased by $0.5 million, or 10.3%, to $4.5 million for the three months ended September 30, 2008 from $4.0 million for the three months ended September 30, 2007, primarily due to an increase in expenses related to bad debt reserves of $0.6 million in the third quarter of 2008 compared to no expenses related to bad debt reserves in the third quarter of 2007. Expenses related to accounting, legal and consulting fees increased by $0.2 million. These increases were offset by an increase in the benefit related to exchange rate gains on foreign currency transactions, which increased by $1.0 million to $1.6 million in the third quarter of 2008 from a benefit of $0.6 million in the third quarter of 2007. In the third quarter of 2008, the benefit related to exchange rates included a $0.5 million gain recorded in relation to a foreign exchange forward rate contract. As a percentage of sales, general and administrative expense decreased to 7.2% for the three months ended September 30, 2008 from 8.5% for the three months ended September 30, 2007. Excluding the benefit related to foreign currency transactions, general and administrative expenses increased by $1.5 million, or 32.6%, to $6.1 million in the three months ended September 30, 2008 from $4.6 million in the three months ended September 30, 2007.

Interest (expense) income, net. Interest (expense) income, net was $0.2 million of net interest expense for the three months ended September 30, 2008 compared to $0.2 million of net interest income for the three months ended September 30, 2007. The change in interest (expense) income, net resulted from higher interest expense due to utilization of credit lines.
Other (expense) income, net. Other (expense) income, net was $0.1 million of net other expense for the three months ended September 30, 2008 compared to $0.3 million of net other income for the three months ended September 30, 2007. The change related primarily to the impact of foreign exchange rates on certain non-operating assets in Russia.
Provision for income taxes. Provision for income taxes increased by $1.8 million to $5.3 million for the three months ended September 30, 2008 from $3.5 million for the three months ended September 30, 2007, representing an effective tax rate of 31.6% for the three months ended September 30, 2008 as compared to an effective tax rate of 26.3% for the three months ended September 30, 2007. The increase in the provision for income taxes resulted from an increase in pre-tax income and a higher effective tax rate in the third quarter of 2008. The effective tax rate in the third quarter of 2007 benefited from a $1.0 million reduction in the carrying value of German net deferred tax liabilities due to a reduction in income tax rates in Germany from approximately 38% to 30% which became effective January 1, 2008.
Net income. Net income increased by $2.3 million, or 27.3%, to $10.9 million for the three months ended September 30, 2008 from $8.6 million for the three months ended September 30, 2007. Net income as a percentage of our net sales decreased by 0.3 percentage points to 17.6% for the three months ended September 30, 2008 from 17.9% for the three months ended September 30, 2007 due to the aforementioned factors.
Results of operations for the nine months ended September 30, 2008, compared to the nine months ended September 30, 2007 Net sales. Net sales increased by $37.3 million, or 27.9%, to $170.9 million for the nine months ended September 30, 2008 from $133.6 million for the nine months ended September 30, 2007. The increase was attributable to higher sales of fiber lasers in materials processing applications, where net sales increased by $41.5 million, or 41.2%, communications applications, where net sales increased by $0.8 million, or 9.1%, and advanced applications, where net sales increased by $0.5 million, or 3.5%. These increases were partially offset by a decrease in sales in medical applications of $5.6 million, or 65.6%. The growth in materials processing applications and advanced applications sales resulted primarily from increased sales of pulsed lasers and medium-power lasers and continued market penetration for high-power fiber lasers, which increased by 67.2%, 76.3% and 34.8%, respectively. The increase in communications applications sales was due to higher sales of telecommunications systems in Russia. The decrease in sales of medical applications and low-power lasers was due to lower sales to our largest medical application customer in the United States.
Cost of sales and gross margin. Cost of sales increased by $17.8 million, or 24.7%, to $90.1 million for the nine months ended September 30, 2008 from $72.3 million for the nine months ended September 30, 2007 as a result of increased sales volume. Our gross margin increased to 47.3% for the nine months ended September 30, 2008 from 45.9% for the nine months ended September 30, 2007. In the nine months ended September 30, 2008, the increase in gross margin was the result of favorable absorption of our fixed manufacturing costs due to higher production volumes and favorable product mix, particularly related to pulsed and medium-power lasers. These products have a higher selling price of output power per watt and higher gross margins. These benefits were partially offset by inventory write downs of $3.0 million and an increase in depreciation related to facilities and equipment of $1.9 million for the nine months ended September 30, 2008.

Sales and marketing expense. Sales and marketing expense increased by $3.4 million, or 46.3%, to $10.6 million for the nine months ended September 30, 2008 from $7.2 million for the nine months ended September 30, 2007, primarily as a result of an increase of $1.6 million in personnel costs and $0.5 million in premises costs related to the expansion of our worldwide direct sales organization, including our new sales office in China and additional sales personnel in the United States, Germany and Japan. Additionally, the increase resulted from a $0.9 million increase in depreciation related to facilities and units used for demonstration purposes. As a percentage of sales, sales and marketing expense increased to 6.2% for the nine months ended September 30, 2008 compared to 5.4% for the nine months ended September 30, 2007.
Research and development expense. Research and development expense increased by $4.6 million, or 66.7%, to $11.5 million for the nine months ended September 30, 2008 from $6.9 million for the nine months ended September 30, 2007. This increase was primarily due to an increase of $2.8 million in personnel costs and $1.6 million in materials used for research and development projects. During 2008, we have increased the number of personnel performing research and development activities in the United States, Germany and Russia. Approximately $0.6 million of the increase related to employees transferred from production to research and development activities. Increases in material used for research and development related primarily to the United States and Russia. In the United States, material use was driven by activities related to new product development, and in Russia, the increase was driven primarily by supplies related to a new research lab. Research and development activity continues to focus on enhancing the performance of our internally manufactured components, refining production processes to improve manufacturing yields and the development of new products operating at different wavelengths and at higher output powers. As a percentage of sales, research and development expense increased to 6.7% for the nine months ended September 30, 2008 from 5.1% for the nine months ended September 30, 2007.
General and administrative expense. General and administrative expense increased by $3.0 million, or 23.0%, to $16.3 million for the nine months ended September 30, 2008 from $13.3 million for the nine months ended September 30, 2007, primarily due to an increase of $1.4 million in personnel expenses as we expanded the general and administrative function to support the growth of the business, $1.1 million in accounting and legal costs due to patent litigation defense fees and $0.8 million related to higher consulting fees. These increases were offset by an increase in gains on foreign currency transactions, which increased to $1.9 million in the nine months ended September 30, 2008 from $1.1 million for the same period in 2007. As a percentage of sales, general and administrative expense remained reasonably consistent at 9.6% for the nine months ended September 30, 2008 compared to 9.9% for the nine months ended September 30, 2007.
Interest (expense) income, net. Interest (expense) income, net was $0.5 million of net interest expense for the nine months ended September 30, 2008 compared to $0.7 million of net interest income for the nine months ended September 30, 2007. The change in interest (expense) income, net resulted from higher interest expense due to utilization of credit lines.
Other (expense) income, net. Other (expense) income , net was $0.4 million of net other income for the nine months ended September 30, 2008 compared to $0.3 million of net other income for the nine months ended September 30, 2007.
Provision for income taxes. Provision for income taxes increased $1.8 million, or 15.0%, to $13.4 million for the nine months ended September 30, 2008 from $11.6 million for the same period in 2007. The effective tax rate was 31.5% for the nine months ended September 30, 2008 as compared to an effective tax rate of 33.2% for the nine months ended September 30, 2007. The increase in the provision for income taxes resulted from an increase in pre-tax income partially offset by a decrease in the effective tax rate. The decrease in the effective tax rate for the nine months ended September 30, 2008 was primarily due to a reduction in German income tax rates from approximately 38% in 2007 to approximately 30% in 2008, which became effective January 1, 2008.
Net income. Net income increased by $6.0 million, or 28.0%, to $27.6 million for the nine months ended September 30, 2008 from $21.6 million for the nine months ended September 30, 2007. Net income as a percentage

of our net sales remained the same at 16.1% for the nine months ended September 30, 2008 as compared to 16.1% for the nine months ended September 30, 2007.
Liquidity and Capital Resources
Our principal sources of liquidity as of September 30, 2008 consisted of cash and cash equivalents of $44.3 million, unused credit lines and overdraft facilities of $44.7 million and working capital (excluding cash) of $79.6 million. This compares to cash and cash equivalents of $38.0 million, marketable securities of $7.0 million, unused overdraft facilities of $39.9 million and working capital (excluding cash) of $83.2 million as of December 31, 2007. The increase in cash and cash equivalents of $6.4 million from December 31, 2007 relates primarily to cash provided by operating activities during the nine months ended September 30, 2008 of $25.0 million, sales of marketable securities of $5.5 million and net proceeds from our credit lines of $4.4 million, partially offset by capital expenditures and the acquisition of intangible assets totaling $29.5 million.
We held approximately $1.4 million in auction-rate securities (ARSs) at September 30, 2008, all of which is included in other long-term assets, as compared to $7.0 million at December 31, 2007, which was included in marketable securities. Our investments in ARSs at September 30, 2008 consisted solely of taxable municipal debt securities. None of the ARSs in our portfolio are collateralized debt obligations (CDOs) or mortgage-backed securities.
As a result of recent auction failures, we continue to hold the ARSs not subject to redemption and the issuers are required to pay interest on the ARSs at the maximum contractual rate. As these auction failures have affected our ability to access these funds in the near term, we have classified these as long-term available for sale securities. Additionally, we have assessed the fair value of these instruments and have identified a temporary decline in their market value related to the lack of liquidity. As a result, we carry these ARSs at 95% of their face value and recorded a temporary impairment charge to other comprehensive income during the second quarter of 2008. These ARSs are insured and are rated A2 and AA by Moody's and Standard & Poor's, respectively. If the credit rating of the issuer of the ARSs were to deteriorate, we may be required to further adjust the carrying value of these investments by recording additional impairment charges, or impairment could be considered other than temporary, in which case impairment charges would be reflected in current income. Based on our ability to access our cash, our expected operating cash flows and our available credit lines, we do not expect that the current lack of liquidity in our investments in ARSs will have a material impact on our overall liquidity, financial condition or results of operations.
In June 2008, we refinanced our $20.0 million subordinated notes with long-term debt consisting of a $20.0 million secured, variable-rate term note described in Note 4 to our consolidated financial statements, which matures in July 2013. As part of this refinancing, we also increased our existing U.S. revolving line of credit from $20 million to $35 million and extended its maturity to July 2011. We expect that the existing cash and marketable securities, our cash flows from operations and our existing lines of credit will be sufficient to meet our liquidity and capital needs for the foreseeable future. Our future long-term capital requirements will depend on many factors including our rate of net sales growth, the impact of economic recessions on our sales levels, the timing and extent of spending to support development efforts, the expansion of our sales and marketing activities, the timing and introductions of new products, the need to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. We have made no arrangements to obtain additional financing, and there is no assurance that such additional financing, if required or desired, will be available in amounts or on terms acceptable to us, if at all.

The following table details our line-of-credit facilities as of September 30, 2008:

Description        Available Principal      Interest Rate          Maturity        Security

U.S. Revolving     Up to $35 million      LIBOR plus 0.8% to    July 2011        Unsecured
Line of Credit                            1.2%, depending on
                                            the Company's
                                             performance

Euro Credit        Euro 15.0 million      Euribor + 1.0% or     June 2010        Unsecured,
Facility           ($21.7 million)           EONIA + 1.0%                        guaranteed
(Germany) (1)                                                                    by
                                                                                 parent
                                                                                 company

Euro Overdraft     Euro 3.2 million           6.95%-7.2%        Between          Common pool
Facilities         ($4.6 million)                               March 2009 and   of assets of
                                                                September 2009   German and
                                                                                 Italian
                                                                                 subsidiaries

(1) $4.3 million of this credit facility is available to our Russian subsidiary and bears interest at base rate of Central Bank of Russia+ 1.5%

. . .