Overview

IRIDEX Corporation is a leading worldwide provider of therapeutic based laser systems and delivery devices used to treat eye diseases in ophthalmology and skin conditions in aesthetics. In January 2007, the Company acquired Laserscope's aesthetics business, including its subsidiaries in France and the United Kingdom (UK) from American Medical Systems Holdings (AMS). Laserscope aesthetics treatments encompass minimally invasive surgical treatments for pigmented and vascular lesions, skin rejuvenation, skin tightening, hair reduction, leg veins, and acne. Our previous dermatology lasers were incorporated with the Laserscope aesthetics product offering to create an expanded aesthetics business.

Our products are sold in the United States (US) predominantly through a direct sales force and internationally through approximately 100 independent distributors into 107 countries except for our aesthetics products which are sold, marketed and serviced directly in the UK and France. In June 2008, we signed an agreement which transferred the responsibility for sales and service of our aesthetics products in the UK to an independent distributor along with the transfer of associated assets.

We manage and evaluate our business in two segments-ophthalmology and aesthetics. We further break down these segments by geography-Domestic (US) and International (the rest of the world). In addition, within ophthalmology, we review trends by laser system sales (consoles and durable delivery devices) and recurring sales (single use consumable laser probes ("consumables"), service and support).

Our ophthalmology revenues arise primarily from the sale of our OcuLight and IQ 810 laser systems, consumables and revenues from service and support activities. Our current family of OcuLight systems includes the OcuLight TX, the OcuLight Symphony (Laser Delivery System), OcuLight SL, OcuLight SLx, OcuLight GL and OcuLight GLx laser photocoagulation systems as well as the IQ 810 laser system. We also produce the Millennium Endolase module which is sold exclusively to Bausch & Lomb and incorporated into their Millennium Microsurgical System.

Our aesthetics revenues arise primarily from the sales our Laserscope aesthetics products including: the Gemini, Venus-i, Lyra-i and Aura-i Laser Systems, the VersaStat 10 mm, VersaStat-i, and Dermastat handpieces along with an articulated arm for the Venus-i Laser System, as well as our IRIDEX VariLite and DioLite XP laser systems.

Sales to international distributors are made on open credit terms or letters of credit and are currently denominated in United States dollars and accordingly, are not subject to risks associated with currency fluctuations. Sales of aesthetics products to end customers from our French subsidiary are denominated in Euros.

Cost of revenues consists primarily of the cost of purchasing components and sub-systems, assembling, packaging, shipping and testing components at our facility, direct labor and associated overhead and beginning in 2007, amortization of intangible assets acquired in the Laserscope acquisition, and the addition of the field service organization in the US in support of the Laserscope aesthetics products.

Research and development expenses consist primarily of personnel costs, materials to support new product development and research support provided to clinicians at medical institutions developing new applications which utilize our products and regulatory expenses. Research and development costs have been expensed as incurred.

Sales, general and administrative expenses consist primarily of costs of personnel, sales commissions, travel expenses, advertising and promotional expenses, legal, accounting and other public company costs, insurance and other expenses not allocated to other departments.

Results of Operations-2008, 2007 and 2006

Our fiscal year always ends on the Saturday closest to December 31. Fiscal 2008 ended on January 3, 2009, fiscal 2007 ended on December 29, 2007, and fiscal 2006 ended on December 30, 2006. Consequently, fiscal 2008 included 53 weeks of operations while fiscal years 2007 and 2006 included only 52.

The following table sets forth certain operating data as a percentage of revenue for the periods included.

                                                            Percentage of Revenue Years Ended
                                                  Jan 3, 2009         Dec 29, 2007         Dec 30, 2006
Revenues                                                100.0 %              100.0 %              100.0 %
Cost of revenues                                         59.4                 56.3                 47.6

Gross margin                                             40.6                 43.7                 52.4
Operating expenses:
Research and development                                  8.2                 10.4                 15.3
Sales, general and administrative                        36.8                 50.3                 50.3
Impairment of goodwill and intangible assets             11.1                 26.5                   -

Total operating expense                                  56.1                 87.2                 65.6

Loss from operations                                    (15.5 )              (43.4 )              (13.3 )
Legal settlement                                          1.6                  4.5                   -
Interest and other (expense) income, net                 (1.0 )               (1.2 )                2.1

Other income, net                                         0.6                  3.3                  2.1

Loss before income taxes                                (14.9 )              (40.1 )              (11.2 )
Provision for income taxes                               (0.3 )               (0.0 )               (4.8 )

Net loss                                                (15.2 )%             (40.1 )%             (16.0 )%

Acquisitions.

In order to more fully understand the comparison of the results of operations for the year ended January 3, 2009 to the years ended December 29, 2007 and December 30, 2006, it is important to note that we acquired Laserscope's aesthetics business from AMS in January 2007, which had a material impact on our financial position and results of operations in fiscal 2008 and fiscal 2007.

Impairment of Goodwill and Intangible Assets.

As a result of the acquisition of the Laserscope aesthetics business from AMS in January 2007, the Company recorded $16.4 million of intangible assets and $10.1 million of Goodwill. The intangible assets are being amortized over their useful lives with $1.8 million and $1.8 million being charged to cost of revenues and $0.5 million and $1.0 million being charged to Sales, General and Administrative expense for 2008 and 2007, respectively. Please refer to the following for additional information on the impairment charges incurred in 2008 and 2007.

In December 2008, the Company performed its annual impairment test in accordance with SFAS 142-Goodwill and Other Intangible Assets. We identified the Laserscope Aesthetics reporting unit as the appropriate reporting unit for this analysis. Reporting units are operating segments or components of operating segments for which discrete financial information is available. Based on operating results for 2008 and the outlook for the aesthetics business for 2009 and beyond, management concluded that the carrying value of the reporting unit exceeded its fair value. Management subsequently determined the fair value of the assets and liabilities of the reporting unit to measure the amount of impairment loss. By establishing the fair value of the reporting unit and the fair value of assets and liabilities within the reporting unit, the Company determined the amount of impairment to goodwill. Consequently, in December 2008, an impairment loss to goodwill of $3.2 million was

recognized and goodwill was reduced from $3.2 million to $0. In addition the operating results for 2008 and the outlook for the aesthetics business for 2009 indicated that the carrying amount of the intangible assets may not be recoverable from future undiscounted cash flows in accordance with SFAS 144-Accounting for the Impairment or Disposal of Long-Lived Assets. As a result, management tested the intangible assets to determine recoverability and consequently, in December 2008, a write down to the gross carrying value of intangible assets of $2.1 million was recorded reducing the gross carrying value from $8.6 million to $6.5 million. The net carrying value of all intangible assets including non-Laserscope related intangible assets as of January 3, 2009 was $1.5 million.

A similar review was conducted at the end of fiscal 2007. The consequence was to write down goodwill by $6.9 million from $10.1 million to $3.2 million and write down the gross carrying value of the intangible assets by $7.8 million from $16.4 million to $8.6 million in fiscal 2007. The net carrying value of all intangible assets including non-Laserscope related intangible assets as of December 29, 2007 was $5.9 million.

Comparison of 2008 and 2007

Revenues.

Total revenues in 2008 were $48.5 million as compared with $55.5 million in 2007, a decrease of $7.0 million or 12.6%. The decrease is directly attributable to the decrease in aesthetics revenues. The decline is primarily due to the global economic environment which significantly affected demand for aesthetic products during fiscal 2008.

Ophthalmology revenues in total remained constant. Ophthalmology recurring revenues consisting of consumables and service increased $1.3 million, or 8.4%, from $15.7 million to $17.0 million. Domestic ophthalmology systems decreased $0.3 million, or 4.8%, from $6.3 to $6.0 million. International ophthalmology systems decreased $1.3 million, or 14.9%, from $8.7 million to $7.4 million. OEM revenues increased $0.3 million or 20.3% from $1.6 million to $1.9 million. OEM revenues are generated from a long standing relationship and the demand for this product is dependent on the OEM's market demand.

Aesthetics revenues in total decreased $7.1 million or 30.4%, from $23.2 million to $16.1 million. Service revenues increased $0.1 million or 2.6%, from $7.0 million to $7.1 million. International aesthetics system revenues decreased $3.4 million or 33.4%, from $10.2 million to $6.8 million, domestic aesthetics system revenues decreased $3.8 million or 63.6%, from $6.0 million to $2.2 million.

Gross profit.

Gross profit decreased $4.6 million from $24.3 million in 2007 to $19.7 million in 2008. The decrease in gross profit is attributable to the overall reduction in revenues as mentioned above and a reduction in the gross margin obtained on revenues.

Gross margin represented 40.6% of revenues in 2008 compared with 43.7% of revenues in 2007. Gross margins were negatively impacted by: amortization of intangible assets, 3.8%; expensing of previously capitalized manufacturing overhead costs associated with applying overhead burden to closing inventory, as a consequence of reducing inventory levels during 2008, 2.5%; and increases in inventory reserves, primarily relating to aesthetics inventory, 2.0%. The aggregate impact of these items was to reduce gross margins by 8.3%. Going forward we see the amount of expense attributable to these items trending lower and as a consequence would expect to see our gross margins trending higher to a range of 45% to 50% assuming similar revenue levels and product mix.

Research and development.

Research and development (R&D) expenses decreased $1.8 million or 30.6%, from $5.8 million in 2007 to $4.0 million in 2008. The decrease in R&D spending is primarily attributable to decreases in salary, benefits,

consulting and temporary help and related costs including stock compensation charges of $1.2 million and a reduction of material costs consumed in engineering development projects of $0.3 million as a result of reduced headcount, mostly management and our focus on cost control. In line with our overall Company strategy for fiscal 2009, we expect to target our level of R&D spending at approximately 10% of revenues.

Sales, general and administrative.

Sales, general and administrative (SG&A) expenses decreased $10.1 million or 36.1%, from $27.9 million in 2007 to $17.8 million in 2008. The decrease in SG&A spending, in general, was a result of the Company's objective to return the Company to operating stability by carefully managing expenses. The decrease in SG&A spending is primarily attributable to decreases in salary, benefits, consulting and temporary help and related costs including stock compensation and travel expenses of $4.0 million as a result of a reduction in headcount. Commissions decreased $0.6 million as a result of reduced revenues and marketing expenses decreased $1.8 million. Legal fees, as a result of a settlement of litigation in 2007, decreased $1.5 million. The overall UK subsidiary spending decreased $1.2 million as a result of transferring the responsibility for sales and service in the UK to an independent distributor.

Legal settlement and Interest and other (expense) income, net.

Income from the settlement with Synergetics of legal claims related to patents infringement amounted to $0.8 million and $2.5 million for 2008 and 2007, respectively. The Company anticipates receiving an additional $3.2 million in other income from the settlement, to be paid to the Company in four annual installments of $0.8 million on each April 16th until 2012. Interest and other expense, net of $0.5 million is primarily interest expense on bank debt.

Income Taxes.

We recorded a provision for income taxes of $127 thousand and an effective tax rate of 2% for the year ended January 3, 2009 compared to a provision for income taxes of $13 thousand for the year ended December 29, 2007. The increase in the provision for income taxes is primarily attributable to the increase in taxable income in the U.S.

Comparison of 2007 and 2006

Revenues.

Total revenues in 2007 were $55.5 million as compared with $35.9 million in 2006, an increase of $19.6 million or 54.6%. The increase was primarily the result of the Laserscope acquisition.

Aesthetics revenues in total increased $18.1 million or 355%, from $5.1 million to $23.2 million. International aesthetics system revenues increased from $8.9 million to $10.2 million, domestic aesthetics system revenues increased from $3.0 million to $6.0 million and service revenues increased from $0.8 million to $7.0 million. The increase was primarily the result of the Laserscope acquisition.

Ophthalmology revenues in total increased $1.5 million or 4.9%. The increase is primarily attributable to an increase in Ophthalmology recurring revenues consisting of consumables and service, an increase in international ophthalmology system revenues, partially offset by a decrease in domestic ophthalmology product revenues. Ophthalmology recurring revenues increased $1.9 million or 13.8%, from $13.8 million to $15.7 million. International ophthalmology system revenues increased $0.8 million or 10.6%, from $7.9 million to $8.7 million. Domestic ophthalmology product revenues decreased $0.6 million or 8.7%, from $6.9 million to $6.3 million. OEM revenues decreased $0.6 million or 27.3%, from $2.2 million to $1.6 million.

Gross profit.

Gross profit increased to $24.3 million in 2007 from $18.8 million in 2006. The increase in gross profit was primarily the result of the increased revenues derived from aesthetics systems and services acquired from AMS.

Gross margin represented 43.7% of revenues in 2007 and 52.4% of revenues in 2006. The major components that contributed to the change in overall gross margin were: changes in direct margins; addition of amortization expense for intangibles; and absorption of manufacturing costs.

Direct margins as a percentage of revenue remained constant for the Ophthalmology business. Direct margins as a percentage of revenue decreased for the Aesthetics business with the addition of the Laserscope products to our product portfolio, as a result of those products having lower direct margins. Service margins decreased with the additional costs associated with the addition of the field service organization required to support the Laserscope products. The impact of these changes in direct margins was a reduction to overall gross margin of 11.5%.

In addition, overall gross margin was reduced by the inclusion in cost of revenues of $1.8 million of amortization expense in 2007 for intangible assets acquired in the Laserscope acquisition. This cost was not present in 2006. The impact of this change was a reduction to overall gross margin of approximately 3.3%.

Overall gross margin was improved by a decrease in manufacturing costs of $0.3 million and the consequence of total manufacturing costs being spread over increased production. The impact of these changes was an increase in overall gross margin of 6.1%.

Research and development.

Research and development expenses increased by 4.9% to $5.8 million in 2007 from $5.5 million in 2006. $0.1 million of this increase was attributable to increased salary and benefit expense associated with increased headcount resulting from the Laserscope acquisition, although by the end of 2007 the number of employees in Research and development decreased year over year. Expenses for consulting and temporary help increased $0.2 million.

Sales, general and administrative.

Sales, general and administrative expense increased in 2007 by 54.7% to $27.9 million from $18.1 million in 2006. Selling, general and administrative expenses increased 9.7% or $2.7 million because of the addition of the UK and French subsidiaries as a result of the Laserscope acquisition. US selling expenses increased 37.2% or $3.6 million. This increase was largely the result of headcount costs increasing $2.7 million. The increase in costs included increased payroll, commissions and travel expenditure associated with the addition of the US Laserscope aesthetics business sales force. In addition, selling expense increased $0.6 million related to the expenses associated with the addition of Laserscope demonstration units used in the sales process. Marketing expense increased $3.4 million primarily as a result of the inclusion of $1 million of amortization expense for intangible assets acquired in the Laserscope acquisition. (this cost was not present in 2006), an additional $1.9 million spent in support of the aesthetics products acquired from Laserscope and $0.3 million of additional expenses related to increased headcount, although by the end of 2007 the number of employees in Marketing decreased year over year. US General and administrative expenses increased $0.1 million. Legal expenses decreased $1.2 million due to the settlement of litigation early in 2007 and stock compensation costs decreased $0.4 million. These decreases were offset by a $0.4 million increase in auditing and accounting services and $1.2 million increase in consulting and temporary help resulting from the Laserscope acquisition.

Legal Settlement and Interest and other (expense) income, net.

Income from the settlement that occurred in 2007 with Synergetics of legal claims related to patents infringement amounted to $2.5 million. The Company anticipates receiving an additional $4.0 million in other

income from the settlement, to be paid to the Company in four annual installments of $0.8 million on each April 16th until 2012. Interest and other expense, net of $0.6 million is primarily interest expense on bank debt. In 2006, interest and other income was primarily the result of interest received on cash, cash equivalents and available for sale securities.

Income Taxes.

Significant components affecting the effective tax rate include pre-tax net loss, changes in valuation allowance, federal and state research and development tax credits, income from tax-exempt securities, the state composite tax rate and recognition of certain deferred tax assets subject to valuation allowance. We recorded a tax provision of $13 thousand in 2007. In 2006 we recorded a tax provision of $1.7 million resulting from the establishment of a valuation allowance with respect of our deferred tax assets based on past losses and uncertainty regarding our ability to project taxable income.

Liquidity and Capital Resources

Comparison of 2008 to 2007.

Liquidity is our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments. In addition, liquidity includes the ability to obtain appropriate financing or to raise capital.

As of January 3, 2009, we had cash and cash equivalents of $5.3 million and working capital of $9.2 million compared with cash and cash equivalents of $5.8 million and working capital of $7.7 million as of December 29, 2007.

Net cash used in operating activities in 2008 was $0.1 million compared with $0.5 million in 2007. During 2008 we made repayments to AMS of $6.3 million including interest as a result of the settlement agreement reached in August of 2007. As of January 3, 2009 all amounts owed to AMS have been repaid. Excluding these payments, cash from operations was positive $6.2 million. See Note 10 of Notes to Consolidated Financial Statements in this report for more information regards the AMS Settlement.

In March 2008, the Company terminated the credit agreement with Mid-Peninsula Bank, part of Greater Bay Bank N.A. and entered into a new credit agreement with Wells Fargo Bank. See Note 9 of Notes to Consolidated Financial Statements in this report for more information regarding bank borrowings. The Company's credit facility with Wells Fargo Bank is an asset-based revolving line of credit. The amount of money the Company may borrow at any particular time is determined by the amount of eligible accounts receivables and inventory the Company has on hand at that particular time (the Borrowing Base). If at any time the amount outstanding under the credit line exceeds the Borrowing Base, the Company will be required to pay the difference between the outstanding amount and the Borrowing Base immediately. With the current problems experienced in the global economy, it is possible that customers will take longer to pay and or default on their payments. Under such circumstances, the Borrowing Base may be reduced significantly which will reduce the Company's ability to borrow and will have a direct negative impact on the Company's cash position.

Management is of the opinion that the Company's current cash and cash equivalents, together with its credit facility with Wells Fargo Bank, provide sufficient liquidity to operate for the next 12 months; that the covenants contained in the credit facility with Wells Fargo Bank are reasonable; and management expects to be able to meet these covenants based on its operating plan for 2009. However, recent operating results indicate that there is risk in achieving the operating plan. If the Company is not able to perform according to the Company's operating plan for 2009 and is unable to maintain compliance with its debt covenants, Wells Fargo Bank would be entitled to exercise its remedies which include declaring all outstanding obligations due and payable, and disposing of the collateral if obligations are not paid. For example, in August 2008 the Company was not in compliance with the debt service covenant contained in the credit facility with Wells Fargo Bank; however, the Company has

obtained a waiver from the bank and was in compliance with the covenants in September 2008. As of January 3, 2009, the Company was in compliance with the loan covenants contained in the amended Agreement. See Note 9 of Notes to Consolidated Financial Statements in this report for more information regarding the amended credit facility.

Comparison of 2007 to 2006.

As of December 29, 2007, we had cash and cash equivalents of $5.8 million and working capital of $7.7 million compared with cash and cash equivalents of $21.1 million and working capital of $29.8 million as of December 30, 2006. In order to complete the Laserscope acquisition concluded in January 2007, the Company entered into financing arrangements and used the majority of our liquid resources and ended the year with bank debt of $6.1 million (net of $3.8 million restricted cash). Previously we had no debt outstanding. In addition, during the year we raised an additional $4.9 million through the issuance of Series A Preferred Stock and warrants to purchase common stock. See Note 11 of Notes to Consolidated Financial Statements in this report for more information regarding share issuance.

Contractual Payment Obligations.

Our contractual payment obligations that were fixed and determinable as of
January 3, 2009 were as follows:



                                                         Payments Due by Period
                                                                                       2013 and
                                         Total      2009     2010    2011    2012     thereafter
 Contractual Obligations
 Balance on revolving credit facility   $  6,000   $ 6,000   $   0   $   0   $   0   $          0
 Operating Leases Payments              $  4,292   $   643   $ 675   $ 676   $ 689   $      1,609

 Total Contractual Cash Obligations     $ 10,292   $ 6,643   $ 675   $ 676   $ 689   $      1,609

Critical Accounting Policies

The preparation of our condensed consolidated financial statements in conformity with United States Generally Accepted Accounting Principles (GAAP) requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, net sales and expenses, and the related disclosures. We base our estimates on historical experience, our knowledge of economic and market factors and various other assumptions we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies are affected by significant estimates, assumptions, and judgments used in the preparation of our consolidated financial statements.

Revenue Recognition.

Our revenues arise from the sale of laser consoles, delivery devices, consumables and service and support activities. Revenue from product sales is recognized upon receipt of a purchase order and product shipment provided that no significant obligations remain and collection of the receivables is reasonably assured. Shipments are generally made with Free-On-Board (FOB) shipping point terms, whereby title passes upon shipment from our dock. Any shipments with FOB receiving point terms are recorded as revenue when the shipment arrives at the receiving point. Cost is recognized as product sales revenue is recognized. The Company's sales may include post-sales obligations for training or other deliverables. When these obligations are fulfilled after product shipment, the Company recognizes revenue in accordance with the multiple element accounting guidance set forth in Emerging Issues Task Force No. 00-21, "Revenue Arrangements with Multiple Deliverables." When the

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