Overview

We research, develop, manufacture, market, sell, distribute, and service lasers and light-based products used to perform aesthetic and cosmetic procedures. We sell our lasers to physicians and personal care practitioners. We market our products directly and through a network of distributors to end-users. Our traditional customer base includes plastic and cosmetic surgeons and dermatologists. More recently, we have expanded our sales to a broader group of practitioners consisting of general practitioners and certain specialists including obstetricians, gynecologists and general and vascular surgeons. We derive our revenue from the sales of lasers, light-based devices, and other products, as well as product-related services.

Critical Accounting Policies

This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates and judgments on an on-going basis, including those related to revenue recognition, allowance for doubtful accounts, inventory reserves, warranty reserves, contingencies, valuation of long-lived assets, stock-based compensation, restructurings and income taxes. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and judgments under different assumptions or conditions.

A discussion of our critical accounting policies and the related estimates and judgments affecting the preparation of our consolidated financial statements is included in our Annual Report on Form 10-K for fiscal year 2008. Information with respect to changes in our Critical Accounting Policies during the six-month period ended December 27, 2008 may be found in Note 1 of the Notes to Condensed Consolidated Financial Statements (unaudited) in this Form 10-Q, which information is incorporated herein by reference.

Critical Accounting Estimates

There have been no significant changes in our critical accounting estimates during the six months ended December 27, 2008 as compared to the critical accounting estimates disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended June 28, 2008.

Recent Accounting Pronouncements

Information with respect to Recent Accounting Pronouncements may be found in Note 2 of Notes to Condensed Consolidated Financial Statements (unaudited) in this Form 10-Q, which information is incorporated herein by reference.

Results of Operations



Revenue



Revenue source by geographic region is reflected in the following table:



                                          For the three months ended:
                           December 27,      December 29,
(in thousands)                 2008              2007           Increase (Decrease)
U.S.                      $   8,637    30 % $  13,680    38 % $       (5,043 )     -37 %
All other countries          20,120    70 %    22,028    62 %         (1,908 )      -9 %
Total worldwide revenue   $  28,757   100 % $  35,708   100 % $       (6,951 )     -19 %




                                          For the six months ended:
                           December 27,      December 29,
(in thousands)                 2008              2007          Increase (Decrease)
U.S.                      $  17,503    32 % $  30,199    43 % $       (12,696 )  -42 %
All other countries          37,918    68 %    40,611    57 %          (2,693 )   -7 %
Total worldwide revenue   $  55,421   100 % $  70,810   100 % $       (15,389 )  -22 %

Consolidated revenue was $28.8 million for the three-month period ended December 27, 2008, as compared to $35.7 million for the same period ended December 29, 2007. The overall decrease in quarterly revenue of approximately $7.0 million was comprised primarily of revenue declines of $5.0 million in the U.S. and $3.0 million in Europe, offset slightly by a $0.9 million increase in Japan. The decrease in U.S. and European revenues was directly related to the slowing economy combined with the tightening credit markets.

Consolidated revenue was $55.4 million for the six-month period ended December 27, 2008, as compared to $70.8 million for the same period ended December 29, 2007. The overall decrease of $15.4 million was driven by decreases in the U.S. and Europe. The decrease in revenues was directly related to the slowing economy combined with the tightening credit markets.

Revenue source by type is reflected in the following table:

                                            For the three months ended:
                             December 27,      December 29,
(in thousands)                   2008              2007           Increase (Decrease)
Lasers and other products   $  18,784    65 % $  24,896    70 % $       (6,112 )     -25 %
Product-related services        9,973    35 %    10,812    30 %           (839 )      -8 %
Total revenue               $  28,757   100 % $  35,708   100 % $       (6,951 )     -19 %




                                            For the six months ended:
                             December 27,      December 29,
(in thousands)                   2008              2007          Increase (Decrease)
Lasers and other products   $  35,886    65 % $  51,394    73 % $       (15,508 )  -30 %
Product-related services       19,535    35 %    19,416    27 %             119      1 %
Total revenue               $  55,421   100 % $  70,810   100 % $       (15,389 )  -22 %

The decrease in revenue from lasers and other products for the three-month period ended December 27, 2008, compared to the same period ended December 29, 2007, was directly related to the general reduction in sales in the U.S. and European markets due to the slowing economy combined with the tightening credit markets.

The decrease in revenue from lasers and other products for the six-month period ended December 27, 2008, compared to the same period ended December 29, 2007, was directly related to the general reduction in sales in the U.S. and European markets due to the slowing economy combined with the tightening credit markets.

Product-related services decreased approximately $0.8 million or 8% in the three-month period ended December 27, 2008 as compared to the same period ended December 29, 2007. The decrease is primarily related to fluctuating consumable sales.

Product-related services increased approximately $100,000 or 1% in the six-month period ended December 27, 2008 as compared to the same period ended December 29, 2007. The slight increase is primarily related to the increase in the number of service-related contracts sold.

Gross Profit. Gross profit was approximately $10.2 million or 35.3% for the three-month period ended December 27, 2008 as compared to $16.5 million or 46.2% for the same period ended December 29, 2007. The decrease in gross profit for the three-month period ended December 27, 2008 as compared to the same period in the previous fiscal year is primarily due to changes in product mix, changes in regional mix, and a greater proportion of revenues being derived from the sale of product-related services in the current period which carry a lower margin than sales of lasers. It was also affected by an increase in our inventory reserve of approximately $1.2 which was determined to be necessary due to the current economic conditions.

Gross profit was approximately $20.6 million or 37.2% for the six-month period ended December 27, 2008 as compared to $33.6 million or 47.4% for the same period ended December 29, 2007. The decrease in gross profit for the six-month period ended December 27, 2008 as compared to the same period in the previous fiscal year is due to changes in product mix and a greater proportion of revenues being derived from the sale of product-related services in the current period. It was also affected by an increase in our inventory reserve of approximately $1.2 which was determined to be necessary due to the current economic conditions.

Selling, General and Administrative Expense. Selling, general and administrative (SG&A) expenses were approximately $15.7 million for the three-month period ended December 27, 2008 compared to $17.7 million for the three-month period ending December 29, 2007. As a percentage of revenue, SG&A expenses increased to 54.6% from 49.5% of revenues in the comparative prior-year period. The $2.0 million decrease was primarily comprised of a $0.9 million reduction in sales-related costs, a $1.2 million in decreased legal and audit fees, and decreases in labor and labor related costs of $0.8 million, offset by an increase in accounts receivable and sales reserves of approximately $0.9 million.

For the six-month period ended December 27, 2008, S,G&A expenses decreased to approximately $30.4 million from approximately $32.3 million for the same period ended December 29, 2007. As a percentage of revenue, S,G&A expenses increased to 54.8% from 45.6% of revenues in the comparative prior year period. The $2.0 million decrease was primarily comprised of a $1.4 million reduction in sales-related costs, a $0.6 million in decreased legal and audit fees, and decreases in labor and labor related costs of $1.0 million, offset by an increase in accounts receivable and sales reserves of approximately $1.0 million.

Research and Development Expense. Research and development (R&D) spending increased to approximately $3.6 million for the three-month period ended December 27, 2008, from approximately $2.8 million for the comparative prior-year period. The increase was primarily driven by the write-off of certain intellectual property. The Company had acquired certain patents and rights in an attempt to commercialize a light-based product. Based on current economic and market conditions, management decided to indefinitely suspend all future development efforts relative to this technology and its underlying product potential.

For the six-month period ended December 27, 2008, Research and development (R&D) expenses increased to approximately $5.9 million from approximately $5.2 million for the same period ended December 29, 2007. Again, the increase was primarily driven by the write-off of certain intellectual property. The Company had acquired certain patents and rights in an attempt to commercialize a light-based product. Based on current economic and market conditions, management decided to indefinitely suspend all future development efforts relative to this technology and its underlying product potential.

Other Income/Expense. Other expense was approximately $0.1 million for the three-months ended December 27, 2008, as compared to approximately $2.0 million for the same period ended December 29, 2007. The year-over-year decrease of approximately $1.9 million from the prior-year comparable period is due to the recognition of a $2.5 million loss on the other-than-temporary impairment of our holdings of common shares of OccuLogix, Inc. (Note 17) in the comparable fiscal period, combined with a $0.3 million decrease in interest income earned and a $0.3 million increase in foreign currency expense during the current fiscal quarter.

Other expense was approximately $0.2 million for the six-months ended December 27, 2008, as compared to approximately $0.8 million for the same period ended December 29, 2007. The year-over-year decrease is primarily due to the Company having recognized the above-referenced $2.5 million loss offset by higher interest income in the six-month period ended December 29, 2007 as compared to decreased interest income offset by losses on certain foreign currency positions experienced during the six-month period ended December 27, 2008.

The decrease in interest income earned during the six-month period ended December 27, 2008, as compared to the same period in the prior fiscal year, is primarily related to a decrease in cash and cash equivalents and in investments during the trailing twelve-month period ended December 27, 2008 combined with decreasing market interest rates.

Income Taxes. The (benefit) provision for income taxes results from a combination of activities of the Company and its domestic and foreign subsidiaries. We recorded effective tax rates of approximately 36% and 30% for each of the six-month periods ended December 27, 2008 and December 29, 2007, respectively. The effective tax rate for the period ended December 27, 2008 differs from the statutory rate primarily due to differences in foreign tax rates, R&D credits and other permanent items. The effective rate for the period ended December 29, 2007 differs from the statutory rate primarily due to differences in foreign tax rates and other permanent items. The foreign rate difference is due to income reported in a high tax rate jurisdiction combined with losses benefited in a jurisdiction with a lower tax rate.

The Company also recorded a discrete tax benefit during the six months ended December 27, 2008 for the effect of the reinstatement of the R&D credit in the US. During the six month period ended December 29, 2007 the Company reported a discrete expense item of $0.1 million resulting from a change in the statutory tax rate in Germany. The effect of the change in the German statutory rate on current earnings is fully reflected in our effective tax rate indicated above.

Liquidity and Capital Resources

Our cash and cash equivalents and our investment in short and long-term marketable securities at December 27, 2008 totaled approximately $27.3 million compared with approximately $46.1 million at December 29, 2007. Principal components of the decrease include growth in our inventory over the trailing twelve months, the use of cash for our stock repurchase program, and the general funding of operations. We continue to have no long-term debt. We believe that the combination of existing cash and cash equivalents, and marketable securities on hand, along with cash to be generated by future operations and amounts available under our line of credit, will be sufficient to meet our ongoing operating and capital expenditure requirements for the foreseeable future. However, we cannot be sure that we will not require additional capital beyond the amounts currently forecasted by us, or that any such required additional capital will be available on reasonable terms, if at all, as it becomes required.

Cash used by operating activities amounted to approximately $7.1 million for the six-month period ended December 27, 2008 as compared to cash provided by operating activities of approximately $0.9 million for the same period in the prior year. The increase in cash used by operating activities is primarily attributable to our year-to-date net loss combined with an overall decrease in current liabilities in the normal course of business.

Off-Balance Sheet Arrangements

Our only off-balance sheet arrangements consist of non-cancelable operating leases entered into in the ordinary course of business and the license agreement with the Regents. The table below in the next section titled "Contractual Obligations" shows the amounts of our operating lease commitments and purchase commitments payable by year.

Contractual Obligations



Outstanding contractual obligations of the Company are reflected in the
following table:



                                               Less than                                         After
(in thousands)                     Total        1 year        1 - 3 years      3 - 5 years      5 years
Royalty commitments              $   3,250    $     1,000    $       1,250    $         500    $      500
Operating leases                     2,806          1,363            1,150              187           106
Total contractual obligations    $   6,056    $     2,363    $       2,400    $         687    $      606

Cautionary Statements

Certain statements contained herein may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 ("Reform Act"). We may also make forward-looking statements in other reports filed with the Securities and Exchange Commission, in materials delivered to stockholders and in press releases. In addition, our representatives may from time to time make oral forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as "anticipates," "believes," "expects," "estimates," "intends," "plans," "projects," and similar expressions, may identify such forward-looking statements. Such forward-looking statements include but are not limited to: that we have the necessary infrastructure in place to capitalize on expansion; the affordability of our products will allow for expansion; that we can lower production costs; or that the market will expand beyond baby boomers. We assume no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. The risks and uncertainties that may affect forward-looking statements and/or our business include, among others, those discussed in "Cautionary Statements" in our Annual Report filed on Form 10-K for the fiscal year ended June 28, 2008, as well as other risks and uncertainties referenced in this Quarterly Report on Form 10-Q, and the following:

† On August 9, 2006, one of our competitors, Palomar Medical Technologies, Inc. ("Palomar"), alleged that the manufacture, use and sale of our products for laser hair removal willfully infringe certain United States patents. Public announcements concerning this and related litigation between the two parties that are unfavorable to us may result in significant declines in our stock price. An adverse ruling or judgment in this matter is likely to cause our stock price to decline significantly. Litigation with Palomar is expensive and is likely to be protracted, and our intellectual property position as well as our cash position may be weakened as a result of an adverse ruling or judgment. Whether or not we are successful in the pending lawsuit, litigation may consume substantial amounts of our financial resources and divert management's attention away from our core business. Please see Part II, Item 1 (Legal Proceedings) for a further discussion of the Palomar litigation.

† Claims by others that our products infringe their patents or other intellectual property rights, or that the patents which we own or have licensed rights to are invalid, could prevent us from manufacturing and selling some of our products or could require us to incur substantial costs from litigation, licenses or the development of non-infringing technology.

† Our receipt of final approval from the respective courts in the Western Pa, Caballero and Forlenzo lawsuits. Please see Part II, Item 1 (Legal Proceedings) for a further discussion of the Western Pa, Caballero and Forlenzo litigation.

† Our principal source of liquidity is our current cash and equivalents and marketable investments. Our ability to generate cash from operations is dependant upon our ability to generate revenue from selling our lasers and other products and providing product-related services. A decrease in demand for our products and related services or increases in operating costs would likely have an adverse effect on our liquidity.

† Disappointing quarterly revenue or operating results could cause the price of our common stock to fall.

† Because we typically derive more than half of our revenue from international sales, we are susceptible to currency fluctuations, negative economic changes taking place in foreign marketplaces, and other risks associated with conducting business overseas.

† The failure to obtain alexandrite rods for certain laser systems from our sole supplier would impair our ability to manufacture and sell these laser systems, which has accounted for a substantial portion of our revenue in certain recent periods.

† Our failure to respond to rapid changes in technology and intense competition in the laser industry could make our lasers obsolete.

† Like other companies in our industry, we are subject to a regulatory review process and our failure to receive necessary government clearances or approvals could affect our ability to sell our products and remain competitive.

† We have modified some of our products without FDA clearance. The FDA could retroactively decide the modifications were improper and require us to cease marketing and/or recall the modified products.

† Achieving complete compliance with FDA regulations is difficult, and if we fail to comply, we could be subject to FDA enforcement action.

† We could incur substantial costs as a result of product liability claims, including but not limited to costs as a result of product failures for which we are responsible under warranty obligations and as a result of our customer's potential unavailability of liability insurance coverage.

† We may be unable to attract and retain management and other personnel we need to succeed.

† Our failure to maintain effective internal control over financial reporting could have a material adverse effect on our business, operating results, and stock price.

† Our failure to manage acquisitions and joint ventures effectively may divert management attention from our core business and cause us to incur debt, liabilities or costs.

† Our business could also be negatively impacted if our customers or suppliers experience disruptions resulting from tighter capital and credit markets, or a slowdown in the general economy. As a result, customers may modify, delay or cancel plans to purchase our products or services, and suppliers may increase their prices, reduce their output or change their terms of sale. Additionally, if customers' or suppliers' operating and financial performance deteriorates, or if they are unable to make scheduled payments or obtain credit, customers may not be able to pay, or may delay payment of, accounts receivable owed to us and suppliers may restrict credit or impose different payment terms. Any inability of customers to pay us for our products and services, or any demands by suppliers for different payment terms, may adversely affect the Company's earnings and cash flow.

We caution readers not to place undue reliance upon any forward-looking statements, which speak only as of the date made. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any such statements to reflect any change in our expectations or any change in events, conditions or circumstances on which any such statement is based.