The following discussion of our results of operations and financial condition should be read together with the unaudited consolidated financial statements and the notes to those statements included elsewhere in this report and our audited consolidated financial statements and the notes to those statements for the year ended December 31, 2008. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from the results anticipated in any forward-looking statements as a result of a variety of factors, including those discussed in "Risk Factors" in Item 1A of this quarterly report, in our Annual Report on Form 10-K for the year ended December 31, 2008, and elsewhere in this quarterly report.
Overview
We are a medical technology company that develops, manufactures and markets lasers and related products focused on technologies for improved applications and procedures in dentistry and medicine. In particular, our principal products provide dental laser systems that allow dentists, periodontists, endodontists, oral surgeons and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures, with less pain and faster recovery times than are generally achieved with drills, scalpels and other dental instruments. We have clearance from the U.S. Food and Drug Administration, or FDA, to market our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union and certain other international markets.
We offer two categories of laser system products: (i) Waterlase systems and
(ii) Diode systems. Our flagship product category, the Waterlase system, uses a patented combination of water and laser to perform most procedures currently performed using dental drills, scalpels and other traditional dental instruments for cutting soft and hard tissue. We also offer our diode laser systems to perform soft tissue and cosmetic procedures, including tooth whitening. On August 8, 2006, we entered into a License and Distribution Agreement, or the Agreement, with Henry Schein, Inc., or HSIC, a large distributor of healthcare products to office-based practitioners, pursuant to which we granted HSIC the exclusive right to distribute our complete line of dental laser systems, accessories and services in the United States and Canada. The Agreement has an initial term of three years, following which it will automatically renew for an additional period of three years, provided that HSIC has achieved its minimum purchase requirements. Under the Agreement, HSIC was obligated to meet certain minimum purchase requirements and was entitled to receive incentive payments if certain purchase targets were achieved. If HSIC had not met the minimum purchase requirements at the midpoint of each of the first two three-year periods, we would have had the option, upon repayment of a portion of the license fee, to (i) shorten the remaining term of the agreement to one year,
(ii) grant distribution rights held by HSIC to other persons (or distribute products ourselves), (iii) reduce certain discounts on products given to HSIC under the agreement and (iv) cease paying future incentive payments. We maintain the right to grant certain intellectual property rights to third parties, but by doing so may incur the obligation to refund a portion of the upfront license fee to HSIC. On May 9, 2007, we entered into an addendum with HSIC, effective as of April 1, 2007, which modified the License and Distribution Agreement to add the terms and conditions under which HSIC has the exclusive right to distribute our ezlase diode dental laser system in the United States and Canada. In the addendum, separate minimum purchase requirements were established for the ezlasesystem. If HSIC had not met the minimum purchase requirement for any 12-month period ending on

March 31, we would have had the option, upon 30 days written notice, to
(i) convert ezlasedistribution rights to a non-exclusive basis for a minimum period of one year, after which period we would have had the option to withdraw ezlase distribution rights, and (ii) reduce the distributor discount on ezlase products. On March 3, 2008, we entered into a second addendum with HSIC that modified the License and Distribution Agreement, as amended by the first addendum. Pursuant to the second addendum, HSIC was obligated to meet certain minimum purchase requirements and was entitled to receive incentive payments if certain purchase targets were achieved. If HSIC did not meet minimum purchase requirements, we would have had the option to (i) shorten the remaining term of the Agreement to one year, (ii) grant distribution rights held by HSIC to other persons (or distribute products ourselves), (iii) reduce certain discounts on products given to HSIC under the Agreement and (iv) cease paying future incentive payments. Additionally, under certain circumstances, if HSIC did not meet the minimum purchase requirements, we would have had the right to purchase back the exclusive distributor rights granted to HSIC under the Agreement. We also agreed to actively promote Henry Schein Financial Services as our exclusive leasing and financing partner. On December 23, 2008, we entered into a brief letter agreement with HSIC which amended the initial term of the License and Distribution Agreement to December 31, 2010. On February 27, 2009, we entered into a letter agreement with HSIC which amended the License and Distribution Agreement, as amended by the first and second addendums and the brief letter agreement. This letter agreement includes certain minimum purchase requirements during the initial fourteen-month term of the agreement. In connection with the initial purchase by HSIC made under the letter agreement, on March 13, 2009 we entered into a security agreement, or Security Agreement, with HSIC, granting to HSIC a security interest in our inventory, equipment, and other assets. Pursuant to the Security Agreement, the security interest granted shall be released upon products delivered to HSIC in respect of such initial purchase. HSIC also has the option to extend the term of the letter agreement for two additional one-year terms based on certain minimum purchase requirements. In addition, HSIC has become our distributor in certain international countries including Germany, Spain, Australia and New Zealand and will have first right of refusal in new international markets that we are interested in entering. On September 10, 2009, we entered into an amendment to the License and Distribution Agreement with HSIC, wherein we agreed to provide to HSIC certain customer warranties in respect of the Company's products. We intend to augment the activities of HSIC in the United States and Canada with the efforts of our direct sales force; however, our future revenue will be largely dependent upon the efforts and success of HSIC in selling our products. Since September 1, 2006, nearly all of our domestic sales were made through HSIC and we expect this to continue for the foreseeable future. We cannot assure you that HSIC will devote sufficient resources to selling our products or, even if sufficient resources are directed to our products, that such efforts will be sufficient to increase net revenue. Critical Accounting Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported. The following is a summary of those accounting policies that we believe are necessary to understand and evaluate our reported consolidated financial results.
Revenue Recognition. Effective September 1, 2006, nearly all of our domestic sales are to HSIC; prior to this date, we sold our products directly to customers through our direct sales force. Internationally, we sell products primarily through distributors. We recognize revenue in accordance with ASC 605, Revenue Recognition, which requires that four basic criteria must be met before revenue can be recognized: (i) persuasive evidence of an arrangement exists;
(ii) delivery has occurred and title and the risks and rewards of ownership have been transferred to our customer, or services have been rendered; (iii) the price is fixed or determinable; and (iv) collectibility is reasonably assured.
We apply ASC 605-25, Accounting for Revenue Arrangements with Multiple Deliverables, which requires us to evaluate whether the separate deliverables in our arrangements can be unbundled in our revenue recognition. Sales of our laser systems include separate deliverables consisting of the product, disposables used with the laser systems, and training. For these sales, we apply the residual value method, which requires us to allocate to the delivered elements the total arrangement consideration less the fair value of the undelivered elements. Revenue attributable to the undelivered elements, primarily training, are included in deferred revenue when the product is shipped and are recognized when the related service is performed or upon expiration of time offered under the agreement.

The key judgment related to our revenue recognition relates to the collectibility of payment from the customer. We evaluate the customer's credit worthiness prior to the shipment of the product. Based on our assessment of the credit information available to us, we may determine the credit risk is higher than normally acceptable, and we will either decline the purchase or defer the revenue until payment is reasonably assured.
Although all sales are final, we accept returns of products in certain, limited circumstances and record a provision for sales returns based on historical experience concurrent with the recognition of revenue. The sales returns allowance is recorded as a reduction of accounts receivable and revenue.
We recognize revenue for royalties under licensing agreements for our patented technology when the product using our technology is sold. We estimate and recognize the amount earned based on historical performance and current knowledge about the business operations of our licensees. Our estimates have been consistent with amounts historically reported by the licensees.
We may offer sales incentives and promotions on our products. We apply ASC 605-50, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products), in determining the appropriate treatment of the related costs of these programs.
Accounting for Stock-Based Payments. Effective January 1, 2006, we adopted the provisions of ASC 718, Share-Based Payment, using the modified prospective transition method. Prior to the adoption of ASC 718, we accounted for share-based payments to employees using the intrinsic value method under APB Opinion No. 25, Accounting for Stock Issued to Employees, and the related interpretations. Under these provisions, stock option awards were accounted for using fixed plan accounting whereby we recognized no compensation expense for stock option awards because the exercise price of options granted was equal to the fair value of the common stock at the date of grant. In March 2005, the SEC issued Staff Accounting Bulletin 107, or SAB 107, regarding the SEC Staff's interpretation of ASC 718, which provides the Staff's views regarding interactions between ASC 718 and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. We have incorporated the provisions of SAB 107 in our adoption of ASC 718.
Under the modified prospective transition method, the provisions of ASC 718 apply to new awards and to awards outstanding on January 1, 2006 and subsequently modified, repurchased or cancelled. Under the modified prospective transition method, compensation expense recognized in 2006 includes compensation costs for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of ASC 718, and compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of ASC 718.
Valuation of Accounts Receivable. We maintain an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. We evaluate our allowance for doubtful accounts based upon our knowledge of customers and their compliance with credit terms. The evaluation process includes a review of customers' accounts on a regular basis which incorporates input from sales, service and finance personnel. The review process evaluates all account balances with amounts outstanding 90 days and other specific amounts for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in general and administrative expenses. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.
Valuation of Inventory. Inventory is valued at the lower of cost, determined using the first-in, first-out method, or market. We periodically evaluate the carrying value of inventory and maintain an allowance for excess and obsolete inventory to adjust the carrying value as necessary to the lower of cost or market. We evaluate quantities on hand, physical condition and technical functionality, as these characteristics may be impacted by anticipated customer demand for current products and new product introductions. Unfavorable changes in estimates of excess and obsolete inventory would result in an increase in cost of revenue and a decrease in gross profit.
Valuation of Long-Lived Assets. Property, plant and equipment, and certain intangibles with finite lives are amortized over their useful lives. Useful lives are based on our estimate of the period that the assets will generate revenue or otherwise productively support our business goals. We monitor events and changes in circumstances which could indicate that the carrying balances of long-lived assets may exceed the undiscounted expected future cash flows from those assets. If such a condition were to exist, we would recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets.

Valuation of Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. We conducted our annual impairment analysis of our goodwill and trade names as of June 30, 2009 and concluded there had been no impairment in trade names and no impairment in goodwill. We closely monitor our stock price and market capitalization and perform such analysis on a quarterly basis. If our stock price and market capitalization declines, we may need to impair our goodwill and other intangible assets.
Warranty Cost. Waterlase systems sold domestically are covered by a warranty against defects in material and workmanship for a period of one year while our ezlase system warranty period is up to two years from date of sale by the Distributor to the end-user. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of revenue. This estimate is recognized concurrent with the recognition of revenue on the sale to the Distributor. Effective October 1, 2009, Waterlase systems sold internationally are covered by a warranty against defects in material and workmanship for a period of sixteen months while our ezlase system warranty period is up to twenty eight months from date of sale to the Distributor. Estimated warranty expenses are recorded as an accrued liability, with a corresponding provision to cost of revenue. This estimate is recognized concurrent with the recognition of revenue on the sale to the Distributor. Our overall accrual is based on our historical experience and our expectation of future conditions. An increase in warranty claims or in the costs associated with servicing those claims would result in an increase in the accrual and a decrease in gross profit.
Litigation and Other Contingencies. We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses relating to such exposures requires significant judgment about the potential range of outcomes. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of expense relating to contingencies. To be recorded as expense, a loss contingency must be both probable and reasonably estimable. If a loss contingency is material but is not both probable and estimable, we will disclose the matter in the notes to the consolidated financial statements.
Income Taxes. Based upon our operating losses during 2008 and 2007 and the available evidence, management determined that it is more likely than not that the deferred tax assets as of September 30, 2009 will not be realized. In this determination, we considered factors such as our earnings history, future projected earnings and tax planning strategies. If sufficient evidence of our ability to generate sufficient future taxable income tax benefits becomes apparent, we may reduce our valuation allowance, resulting in tax benefits in our statement of operations and in additional paid-in-capital. Management evaluates the potential realization of our deferred tax assets and assesses the need for reducing the valuation allowance periodically.
Off-Balance Sheet Arrangements. We have no off-balance sheet financing or contractual arrangements.

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

                                                Three Months Ended           Nine Months Ended
                                                   September 30,               September 30,
Consolidated Statements of Operations Data:      2009          2008          2009          2008
Net revenue                                        100.0 %      100.0 %        100.0 %      100.0 %
Cost of revenue                                     51.7         50.7           52.4         48.6

Gross profit                                        48.3         49.3           47.6         51.4

Operating expenses:
Sales and marketing                                 18.5         36.7           24.4         30.7
General and administrative                          14.0         20.7           18.2         18.2
Engineering and development                          8.3          8.6            9.7          7.7
Legal settlement and fees                                         8.1                         2.3

Total operating expenses                            40.8         74.1           52.3         58.9

Income (loss) from operations                        7.5        (24.8 )         (4.7 )       (7.5 )
Non-operating income (loss), net                    (0.4 )       (4.3 )          0.4          0.4

Income (loss) before income tax provision            7.1        (29.1 )         (4.3 )       (7.1 )
Income tax provision                                 0.0          0.3            0.2          0.2

Net income (loss)                                    7.1 %      (29.4 )%        (4.5 )%      (7.3 )%

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

                            Three Months Ended September 30,                        Nine Months Ended September 30,
                             2009                        2008                       2009                        2008
Waterlase
systems             $    7,060           58 %    $ 10,654          70 %    $   18,008           55 %    $ 33,631          63 %
Diode systems            1,767           15 %       1,989          13 %         5,969           18 %       9,876          19 %
Non-laser
systems                  2,969           25 %       1,775          11 %         7,825           24 %       6,743          13 %

Products and
services                11,796           98 %      14,418          94 %        31,802           97 %      50,250          95 %
License fee and
royalty                    289            2 %         868           6 %         1,194            3 %       2,740           5 %

Net revenue         $   12,085          100 %    $ 15,286         100 %    $   32,996          100 %    $ 52,990         100 %

Three months ended September 30, 2009 and 2008 Net Revenue. Net revenue for the three months ended September 30, 2009 was $12.1 million, a decrease of $3.2 million or 21% as compared with net revenue of $15.3 million for the three months ended September 30, 2008.
Laser system net revenue decreased by approximately 30% in the quarter ended September 30, 2009 compared to the same quarter of 2008. Our Diode family of products decreased $222,000 or 11% in the third quarter of 2009 compared to the same quarter of 2008. Sales of our Waterlase systems decreased $3.6 million or 34% in the quarter ended September 30, 2009 compared to the same period in 2008 due to initial orders of our C-100 product line launched in the third quarter of 2008 and lower realized average selling prices on both domestic and international sales in the third quarter of 2009.
Non-laser system net revenue, which includes consumable products, as well as services revenues including advanced training programs, installation charges and extended service contracts, increased by approximately $1.2 million or 67% for the three months ended September 30, 2009 as compared to the same period of 2008. Consumable products revenue increased $898,000 or 98% as compared to the same period in 2008 primarily due to sales of our Waterlase MD Turbo ™Handpiece Upgrade Kit for existing MD users both domestically and internationally. Services revenues increased $296,000 or 34% as compared to the same period of 2008.
License fees and royalty revenue decreased $579,000 or 67% in the quarter ended September 30, 2009 compared to the same quarter of 2008. The 2008 period included $375,000 of amortization of the license fee from The Proctor & Gamble Company which was fully amortized as of December 31, 2008.

Domestic revenues were $8.5 million, or 71% of net revenue, for the three months ended September 30, 2009 versus $11.9 million, or 78% of net revenue, for the three months ended September 30, 2008. International revenues for the quarter ended September 30, 2009 were $3.5 million, or 29% of net revenue, as compared with $3.4 million, or 22% of net revenue, for the quarter ended September 30, 2008.
Gross Profit. Gross profit for the three months ended September 30, 2009 decreased by $1.7 million from $7.5 million to $5.8 million, and slightly decreased to 48% of net revenue as compared with 49% of net revenue for the three months ended September 30, 2008. The overall decrease in gross profit quarter over quarter was due to lower revenues overall as well as a lower average selling price and related profit on a greater volume of international sales.
Operating Expenses. Operating expenses for the three months ended September 30, 2009 decreased by $6.4 million, or 56%, to $4.9 million as compared to $11.3 million for the three months ended September 30, 2008, and decreased as a percentage of net revenue to 41% from 74%. In the quarter ended September 30, 2008, we recorded a $1.2 million patent infringement legal settlement. Additionally, in late 2008 and continuing into 2009, we implemented significant cost reductions to help offset the negative impact of current economic conditions.
Sales and Marketing Expense. Sales and marketing expenses for the three months ended September 30, 2009 decreased by $3.4 million, or approximately 60%, to $2.2 million, or 18% of net revenue, as compared with $5.6 million, or 37% of net revenue, for the three months ended September 30, 2008. Payroll and related expenses decreased by $558,000 in the quarter ended September 30, 2009 as compared to the same quarter in 2008 primarily as a result of closing our foreign sales operations and restructuring our domestic sales and marketing departments. Convention and seminars expenses decreased by $527,000, travel and entertainment expenses decreased by $428,000, commission expense decreased $355,000 and regional meeting and speaker related expenses decreased by $709,000 in the quarter ended September 30, 2009 compared with the same quarter of 2008. While we expect to continue investing in sales and marketing expenses and programs in order to grow our revenues, we believe it is likely that these expenses, excluding commissions, will decrease in 2009 as compared to 2008.
General and Administrative Expense. General and administrative expenses for the three months ended September 30, 2009 decreased by $1.5 million, or 46%, to $1.7 million, or 14% of net revenue, as compared with $3.2 million, or 21% of net revenue, for the three months ended September 30, 2008. The decrease in general and administrative expenses resulted primarily from decreased legal and consulting fees of $729,000, decreased payroll related expenses of $365,000 and a decrease in accrued audit fees of $193,000. We believe that our general and administrative expenses are likely to decrease in 2009 as compared to 2008.
Engineering and Development Expense. Engineering and development expenses for the three months ended September 30, 2009 decreased by $314,000, or 24%, to $1.0 million, or 8% of net revenue, as compared with $1.3 million, or 9% of net revenue, for the three months ended September 30, 2008. The decrease is primarily related to decreased payroll related expenses of $57,000 and a reduction in intangible asset amortization expense of $60,000. We expect to continue to invest in development projects and personnel in 2009, however, we expect the overall expense to decrease in 2009 as compared to 2008.
Non-Operating Income (Loss)
Gain on Foreign Currency Transactions. We recognized a $40,000 loss on foreign currency transactions for the three months ended September 30, 2009, compared to a $637,000 loss on foreign currency transactions for the three months ended September 30, 2008 due to the changes in exchange rates between the U.S. dollar and the Euro, the Australian dollar and the New Zealand dollar. As we have now transitioned most of our sales from our foreign subsidiaries to sales through distributors, the amount of inter-company transactions and related balances should be reduced in the future.
Interest Income. Interest income resulted from interest earned on our cash and investments balances. Interest income for the three months ended September 30, 2009 was $1,000 as compared with $26,000 for the three months ended September 30, 2008. The decrease is the result of lower average cash balances during the 2009 period compared to the same period in 2008.
Interest Expense. Interest expense consists primarily of interest on the financing of our business insurance premiums and interest on outstanding balances on our line of credit. Interest expense for the quarter ended September 30, 2009 was $7,000

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