Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-looking statements
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than historical or current facts, including, without limitation, statements about our business strategy, plans and objectives of management and our future prospects, are forward-looking statements. Although we believe that the expectations reflected in such forward-looking statements are reasonable, such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from these expectations. Such risks and uncertainties include, without limitation, the following:

o financing of future operations, manufacturing risks, variations in our quarterly results, the occurrence of unanticipated events and circumstances and general economic conditions, including stock market volatility, results of future operations, technological difficulties in developing or introducing new products, the results of future research, lack of product demand and market acceptance for current and future products, challenges in managing joint ventures, government contracts and research with third parties, the impact of competitive products and pricing, governmental regulations with respect to medical devices, including whether FDA clearance will be obtained for future products, the results of litigation, difficulties in collecting royalties, potential infringement of third-party intellectual property rights;

o we expect to face increased competition that could result in price reductions and reduced margins, as well as loss of market share; and

o other risks contained in Item 1A under the caption "Risk Factors".

These risks and uncertainties are beyond our control and, in many cases; we cannot predict the risks and uncertainties that could cause our actual results to differ materially from those indicated by the forward-looking statements. When used in this document, the words "assumptions," "believes," "plans," "expects," "anticipates," "intends," "continue," "may," "will," "could," "should," "future," "potential," "estimate," or the negative of such terms and similar expressions as they relate to us or our management are intended to identify forward-looking statements. We undertake no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 8 of this Annual Report. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods. Critical accounting policies
Our policies are more fully described in Note 1 of Notes to our Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgments.
Revenue Recognition. We recognize revenue in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104). SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; and (4) collectibility is reasonably assured. Determination of criteria (3) and (4) is based on management's judgments regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of those fees. Should changes in conditions cause management to determine that these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We recognize product revenues upon shipment. If a product sale does not meet all of the above criteria, the revenue from the sale is deferred until all criteria are met. Provisions are made at the time of revenue recognition for any applicable warranty costs expected to be incurred.

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Periodically, we sell products together with a product upgrade option that requires that the customer pay an upgrade fee at the time of exercise, has no refund provisions and includes an expiration date on the upgrade option. In accordance with Emerging Issues Task Force Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables, we defer the fair value ascribed to the upgrade option until the expiration of the upgrade option or the exercise of the upgrade option and shipment of the product upgrade.
Revenues from the sale of service contracts is deferred and recognized on a straight-line basis over the life of the service contract. Revenues from services administered by us that are not covered by a service contract are recognized as the services are provided. In certain instances, we sell products together with service contracts. We recognize revenue on such multiple-element arrangements in accordance with SAB 104 and EITF 00-21, based on the relative fair market value of each element.
We generally recognize royalty revenue from licensees upon receipt of cash payments since the royalty amounts are not determinable at the end of a quarter. Licensees are obligated to make payments between 30 and 45 days after the end of each quarter. If at the end of a quarter royalty revenue from licensees are determinable, we record royalty revenue during the period earned. Periodically, as we sign on new licensees, we recognize back-owed royalties in the period in which it is determinable and earned. We have the right under our license agreements to engage independent auditors to review the royalty calculations. The amounts owed as a result of these audits may be higher or lower than previously recognized.
We have funded product development revenue from the development agreements with Johnson & Johnson, Procter & Gamble/Gillette, and the United States Department of the Army. For both Johnson & Johnson and Gillette, we have received payments in accordance with the work plans that were developed with both Johnson & Johnson and Gillette. Revenue is recognized under the contracts as costs are incurred and services are rendered. Any amounts received in advance of costs incurred and services rendered are recorded as deferred revenue. Payments are not refundable if the development is not successful.
We have provided services under a $3.8 million research contract with the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae or PFB. The contract was a cost plus fee arrangement whereby we were reimbursed for the expenses incurred in connection with PFB research plus an 8% fee. Revenue was recognized under the contract as the costs were incurred and the services were rendered. Our revenue from the contract is subject to government audit.
Investments. Investment securities, which primarily consist of state and municipal auction-rate securities and variable rate demand obligations, are classified as "available-for-sale" or "marketable securities" under provisions of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities and are recorded at fair market value. We generally invest in short-term investments that are highly liquid. Any unrealized gains and losses, net of income tax effects, would be computed on the basis of specific identification and reported as a component of Accumulated Other Comprehensive Income (Loss) in our Consolidated Statements of Stockholder's Equity. We evaluate unrealized losses to determine if the loss is other-than-temporary. If an unrealized loss is deemed other-than-temporary, we record the loss in the statement of operations.
Accounts Receivable Reserves. Allowances for doubtful accounts are based on estimates of losses related to customer receivable balances. In establishing the appropriate provisions for customer receivable balances, we make assumptions with respect to their future collectibility. Our assumptions are based on an individual assessment of a customer's credit quality as well as subjective factors and trends, including the aging of receivable balances. Generally, these individual credit assessments occur prior to the inception of the credit exposure and at regular reviews during the life of the exposure and consider (a) a customer's ability to meet and sustain their financial commitments; (b) a customer's current and projected financial condition; (c) the positive or negative effects of the current and projected industry outlook; and (d) the economy in general. Once we consider all of these factors, a determination is made as to the probability of default. An appropriate provision is made, which takes into account the severity of the likely loss on the outstanding receivable balance based on our experience in collecting these amounts. Our level of reserves for our customer accounts receivable fluctuates depending upon all of the factors mentioned above. We provide an additional reserve for doubtful accounts based on the aging of our accounts receivable balances, historical experiences of write-offs and defaults.

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We also record a provision for estimated sales returns and allowances on product and service related sales in the same period as the related revenues are recorded. These estimates are based on the specific facts and circumstances of particular orders, analysis of credit memo data, and other known factors. If the data we use to calculate these estimates do not properly reflect reserve requirements, then a change in the allowances would be made in the period in which such a determination is made and revenues in that period could be adversely affected.
Inventory Reserves. As a designer and manufacturer of high technology equipment, we may be exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, reliability and replacement of and the availability of key components from our suppliers. Our policy is to establish inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. Included in our inventory are demonstration products that are used by our sales organization. We account for such products as we do with any other finished goods item in our inventory in accordance with the review of our entire inventory. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new product introductions. Assumptions used in determining our estimates of future product demand may prove to be incorrect, in which case the provision required for excess and obsolete inventory would have to be adjusted in the future. If inventory is determined to be overvalued, we would be required to recognize such as cost of goods sold at the time of such determination. Although we perform a detailed review of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our reported operating results. Additionally, purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value.
Warranty Provision. We typically offer either a one or three-year warranty for our base products. We provide for the estimated cost of product warranties at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs and the cost per repair. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our estimated warranty obligation is affected by ongoing product failure rates, specific product class failures outside of our baseline experience, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Assumptions and historical warranty experience are evaluated to determine the appropriateness of such assumptions. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.
Stock-Based Compensation. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard SFAS
123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires share-based payments to employees, including grants of employee stock options and stock-settled stock appreciation rights (SAR), to be recognized in the income statement based on their fair values at the date of grant. Pro forma disclosure is no longer an alternative. On January 1, 2006, we adopted SFAS 123(R) using the modified prospective method as permitted under SFAS 123(R). Under this transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to but not yet vested as of December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123. In accordance with the modified prospective method of adoption, our results of operations and financial position for prior periods have not been restated.

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As permitted under SFAS 123 and SFAS 123(R), we use the Black-Scholes option pricing model to estimate the fair value of stock option and SAR grants. Key input assumptions used to estimate the fair value of stock options and SARs include the exercise price of the award, the expected option term, the expected volatility of our stock over the option or SAR's expected term, the risk-free interest rate over the option or SAR's expected term and our expected annual dividend yield. Expected volatilities are based on historical volatilities of our common stock; the expected life represents the weighted average period of time that options or SARs granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option or SAR. Our assumed dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends.
If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods, or if we decide to use a different valuation model, the stock-based compensation expense we recognize in future periods may differ significantly from what we have recorded in the current period and could materially affect our income from operations, net income, and earnings per share. It may also result in a lack of comparability with other companies that use different models, methods, and assumptions. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. These characteristics are not present in our option and SAR grants. Existing valuation models, including the Black-Scholes model, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options and SARs, may expire with little or no intrinsic value compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, the value realized from these instruments may be significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. The guidance in SFAS 123(R) is relatively new and the application of these principles may be subject to further interpretation and refinement over time.
Fair Value Measurements. The performance of fair value measurements is an integral part of the preparation of financial statements in accordance with generally accepted accounting principles. Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants to sell or transfer such an asset or liability. Selection of the appropriate valuation technique, as well as determination of assumptions, risks and estimates used by market participants in pricing the asset or liability requires significant judgment. Although we believe that the inputs used in our valuation techniques are reasonable, a change in one or more of the inputs could result in an increase or decrease in the fair value of certain assets and certain liabilities and could have an impact on both our Consolidated Balance Sheets and Consolidated Statements of Operations.
To value our auction-rate securities, we determined the present value of the auction-rate securities at the balance sheet date by discounting the estimated future cash flows based on a fair value rate of interest and an expected time horizon to liquidity. As there is currently no active market for these investments, their valuation required management's judgment.
Income taxes. We record deferred tax assets and liabilities based on the net tax effects of tax credits, operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
We regularly review deferred tax assets for recoverability taking into consideration such factors as historical losses, projected future taxable income and the expected timing of the reversals of existing temporary differences. SFAS No. 109, Accounting for Income Taxes, requires us to maintain a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. For 2006, we removed the valuation allowance related to deferred tax assets based on the conclusion that there was sufficient positive evidence to support that it was more likely than not that the deferred tax asset would be realized. This resulted in a non-cash, $7.6 million tax benefit recorded through our 2006 provision for income taxes. In 2008, we incurred operating losses in foreign jurisdictions. We believe that it is more likely than not that the associated tax asset will expire prior to utilization. Therefore, we have established a full valuation allowance in 2008 against this deferred tax asset.

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In addition to the tax assets described above, we have deferred tax assets totaling $22 million, resulting from the exercise of employee stock options. In accordance with SFAS 109 and SFAS 123(R), recognition of these assets would occur upon utilization of these deferred tax assets to reduce taxes payable and would result in a credit to additional paid-in capital within stockholders' equity rather than the provision for income taxes. For 2008, 2007 and 2006, the impact to paid-in capital resulting from the exercise of employee stock options was $1.8 million, $4.8 million and $1.2 million, respectively.
In evaluating the potential exposure associated with the various tax filing positions, we accrue charges for possible exposures. Based on the annual evaluations of tax positions, we believe we have appropriately filed our tax returns and accrued for possible exposures. To the extent we were to prevail in matters for which accruals have been established or be required to pay amounts in excess of reserves, our effective tax rate in a given financial period might be materially impacted.
Contingencies. In accordance with SFAS No. 5, Accounting for Contingencies, we accrue for all direct costs associated with the estimated resolution of contingencies at the earliest date at which it is deemed probable that a liability has been incurred and the amount of such liability can be reasonably estimated. At December 31, 2008, we have not recorded any material loss contingencies.
Overview
We are engaged in research, development, manufacturing and distribution of proprietary light-based systems for medical and cosmetic treatments. Since our inception, we have been able to develop a differentiated product mix of light-based systems for various treatments through our research and development as well as with our partnerships throughout the world. We are continually developing and testing new indications to further the advancement in light-based treatments.
Our total revenues for the year ended December 31, 2008, decreased by 29% as compared to the same period in 2007. The factors driving this decrease were threefold: 1) a decline in product revenues was the result of challenging economic conditions which have caused many prospective customers to be unable to obtain financing and prompting others to delay their capital equipment purchases until economic conditions improve; 2) a decline in royalty revenues was due to a smaller back-owed royalties payment received of $0.7 million in 2008 as compared to $3.1 million in 2007 as well as our competitors being affected by the same challenging economic conditions which have depressed their product revenue sales which decreases the amount of royalties they owe us; and 3) a decline in funded product development revenues occurred as since January 2008, we are no longer receiving such payments from Procter & Gamble. Offsetting the decrease in product, royalty, and funded product development revenues, other revenues increased by 487% as compared to the same period in 2007 due to $5 million of technology transfer payments in 2008 from Procter & Gamble.
Although 2008 was a very challenging year, we were able to maintain a strong balance sheet. As of December 31, 2008, we had $122.6 million of cash and cash equivalents and $4.5 million in marketable securities. As of December 31, 2007, we had $132.4 million of cash, cash equivalents, and available-for-sale securities. Our stockholders' equity increased year over year. Our current ratio is 6.9x, down from 8.2x at the end of 2007. We had $6.0 million of short-term debt as of December 31, 2008. At December 31, 2007, we had no borrowings.
Sales from our Lux family of products weakened throughout 2008 due to the tightening of the credit market and prospective customers delaying buying decisions due to the downturn of the global economy. The Lux line of products consists of the StarLux Laser and Pulsed Light System, the MediLux and the EsteLux Pulsed Light Systems, including a base unit and multiple, optional handpieces. During the third quarter of 2008, we began shipping our latest technology platform, the Aspire body sculpting system coupled with the SlimLipo handpiece. The SlimLipo handpiece is our first minimally invasive product designed to provide laser-assisted lipolysis.

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Results of operations
Year 2008 Compared to Year 2007
The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the years ended December 31, 2008 and 2007 (in thousands, except for percentages):

2008 2007 2008 vs. 2007 ------------------------------ ----------------------------- ---------------------- As a % of Total As a % of Total $ % Amount Revenues Amount Revenues Change Change ----------- ------------------ ----------- ----------------- ------------ --------- Revenues: Product revenues $ 69,379 79 % $ 103,221 83 % $ (33,842 ) (33 %) Royalty revenues 10,520 12 % 13,005 11 % (2,485 ) (19 %) Funded product development revenues 2,434 3 % 6,698 5 % (4,264 ) (64 %) Other revenues 5,248 6 % 894 1 % 4,354 487 % ----------- ------------------ ----------- ----------------- ------------ Total revenues 87,581 100 % 123,818 100 % (36,237 ) (29 %) Cost and expenses: Cost of product revenues 25,218 29 % 33,391 27 % (8,173 ) (24 %) Cost of royalty revenues 4,208 5 % 5,202 4 % (994 ) (19 %) Research and development 17,693 20 % 16,673 14 % 1,020 6 % Selling and marketing 23,340 27 % 24,886 20 % (1,546 ) (6 %) General and administrative 20,516 23 % 17,495 14 % 3,021 17 % ----------- ------------------ ----------- ----------------- ------------ Total costs and expenses 90,975 104 % 97,647 79 % (6,672 ) (7 %) ----------- ------------------ ----------- ----------------- ------------ (Loss) income from operations (3,394 ) (4 %) 26,171 21 % (29,565 ) (113 %) Interest income 3,653 4 % 6,399 5 % (2,746 ) (43 %) Other (loss) income (317 ) 0 % 513 0 % (830 ) (162 %) ----------- ------------------ ----------- ----------------- ------------ (Loss) income before income taxes (58 ) 0 % 33,083 26 % (33,141 ) (100 %) . . .