**UNITEDSTATES****SECURITIESAND EXCHANGE COMMISSION**

**Washington, DC 20549**

** **

----

 

**FORM 10-Q**

 

**Quarterlyreport pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

**For the quarterly period ended October 2,2004.**

 

**Commission file number 000-14742**

 

**CANDELACORPORATION**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | **04-2477008**                       |
|-----------------------------------------------------------------|--------------------------------------|
| (State or other jurisdiction  of incorporation or organization) | (I.R.S. Employer Identification No.) |
|                                                            |                                 |
| **530 Boston Post Road, Wayland,  Massachusetts**               | **01778**                            |
| (Address of principal executive offices)                        | (Zip code)                           |

 

Registrant’s telephone number, including areacode:  **(508)358-7400**

 

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý   No  o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined by Rule 12b-2 of the SecuritiesExchange Act of 1934).

Yes  ý  No  o

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate.

 
| ** **                             | **Class** | ** ** | ** ** | ** ** | **Outstanding  at November 4, 2004** | ** ** |
|----------------------------------------|-----------|------------|------------|------------|--------------------------------------|------------|
| Common Stock, $.01 par value per share |      | 22,517,832 |

 

 

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**CANDELA CORPORATION**

**Index**

 
|     |                   | Page                                                                                                                                                       |
|----------|------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Part I.  | Financial Information: |                                                                                                                                                       |
|     |                   |                                                                                                                                                       |   |
|     | Item 1.                | Financial Statements                                                                                                                                       |   |
|     |                   |                                                                                                                                                       |   |
|     |                   | Unaudited Consolidated Balance Sheets as of October 2, 2004 and July  3, 2004                                                                              | 3 |
|     |                   |                                                                                                                                                       |   |
|     |                   | Unaudited Consolidated Statements of  Operations and Comprehensive Income (Loss) for the three-month periods ended  October 2, 2004 and September, 27 2003 | 4 |
|     |                   |                                                                                                                                                       |   |
|     |                   | Unaudited Consolidated Statements of Cash  Flows for the three-month periods ended October 2, 2004 and September 27,  2003                                 | 5 |
|     |                   |                                                                                                                                                       |   |
|     |                   | Notes to Unaudited Consolidated Financial Statements                                                                                                       | 6-12 |
|     |                   |                                                                                                                                                       |   |
|     | Item 2.                | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                | 12-16 |
|     |                   |                                                                                                                                                       |   |
|     | Item 3.                | Quantitative and Qualitative Disclosure  about Market Risk                                                                                                 | 17 |
|     |                   |                                                                                                                                                       |   |
|     | Item 4.                | Controls and Procedures                                                                                                                                    | 17 |
|     |                   |                                                                                                                                                       |   |
| Part II. | Other Information:     |                                                                                                                                                       |
|     | Item 1.                | Legal proceedings                                                                                                                                          | 18 |
|     | Item 6.                | Exhibits                                                                                                                                                   | 18 |
|     |                   |                                                                                                                                                       |   |
|     | Signatures             |                                                                                                                                                       | 19 |
|     | Index  to Exhibits     | 20                                                                                                                                                         |

 

2

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**PartI.  Financial Information**

 

**Item 1 -Financial Statements**

** **

**CANDELA CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

** **
| **(in thousands)**                                | ** ** | **October 2,****2004** | ** ** | **July 3,****2004** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|---------------------|------------|
| **Assets:**                                       | ** ** | ** **             | ** ** | ** **          | ** ** |
| Current assets:                                   |       |                   |       |                |       |
| Cash and cash equivalents                         | ** ** | **$**                  | **36,611** | ** **          | **$**      | **37,139** | ** ** |
| Restricted cash                                   | ** ** | **260**                | ** ** | **257**             | ** ** |
| Accounts receivable, net                          | ** ** | **32,202**             | ** ** | **34,302**          | ** ** |
| Notes receivable                                  | ** ** | **543**                | ** ** | **1,151**           | ** ** |
| Inventories, net                                  | ** ** | **14,352**             | ** ** | **13,571**          | ** ** |
| Other current assets                              | ** ** | **2,259**              | ** ** | **2,184**           | ** ** |
| Total current assets                              | ** ** | **86,227**             | ** ** | **88,604**          | ** ** |
| ** **                                        | ** ** | ** **             | ** ** | ** **          | ** ** |
| Property and equipment, net                       | ** ** | **3,338**              | ** ** | **3,406**           | ** ** |
| Deferred tax assets                               | ** ** | **5,915**              | ** ** | **5,914**           | ** ** |
| Prepaid licenses                                  | ** ** | **1,010**              | ** ** | **1,054**           | ** ** |
| Other assets                                      | ** ** | **2,452**              | ** ** | **1,501**           | ** ** |
| Total assets                                      | ** ** | **$**                  | **98,942** | ** **          | **$**      | **100,479** | ** ** |
|                                              |       |                   |       |                |       |
| **Liabilities and Stockholders’ Equity**     |       |                   |       |                |       |
| Current liabilities:                              |       |                   |       |                |       |
| Accounts payable                                  | ** ** | **$**                  | **4,940**  | ** **          | **$**      | **6,973** | ** ** |
| Accrued payroll and related expenses              | ** ** | **3,188**              | ** ** | **5,428**           | ** ** |
| Accrued warranty costs                            | ** ** | **4,468**              | ** ** | **4,946**           | ** ** |
| Income taxes payable                              | ** ** | **2,714**              | ** ** | **1,844**           | ** ** |
| Other accrued liabilities                         | ** ** | **2,767**              | ** ** | **3,586**           | ** ** |
| Deferred income (current portion)                 | ** ** | **3,702**              | ** ** | **3,421**           | ** ** |
| Current liabilities of discontinued  operations   | ** ** | **1,288**              | ** ** | **1,019**           | ** ** |
| Total current liabilities                         | ** ** | **23,067**             | ** ** | **27,217**          | ** ** |
| Other long-term liabilities                       | ** ** | **4,195**              | ** ** | **3,945**           | ** ** |
| Long-term liabilities of discontinued  operations | ** ** | **2,100**              | ** ** | **2,548**           | ** ** |
| Total liabilities                                 | ** ** | **29,362**             | ** ** | **33,710**          | ** ** |
| ** **                                        | ** ** | ** **             | ** ** | ** **          | ** ** |
| Stockholders’ equity:                        | ** ** | ** **             | ** ** | ** **          | ** ** |
| Common stock                                      | ** ** | **246**                | ** ** | **246**             | ** ** |
| Treasury stock, at cost                           | ** ** | **(12,997**            | **)**      | **(12,997**         | **)**      |
| Additional paid-in capital                        | ** ** | **53,221**             | ** ** | **53,069**          | ** ** |
| Accumulated earnings                              | ** ** | **28,869**             | ** ** | **26,023**          | ** ** |
| Accumulated other comprehensive income            | ** ** | **241**                | ** ** | **428**             | ** ** |
| Total stockholders’ equity                   | ** ** | **69,580**             | ** ** | **66,769**          | ** ** |
| Total liabilities and stockholders’ equity   | ** ** | **$**                  | **98,942** | ** **          | **$**      | **100,479** | ** ** |

 

***The accompanying notes are an integral partof the unaudited consolidated financial statements.***

 

3

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**CANDELA CORPORATIONConsolidated Statements ofOperations and Comprehensive Income (loss)**(in thousands, exceptper share data)(unaudited)

 
| ** **                                                                                       | ** ** | **For the three months ended:** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                       | ** ** | **October 2,  2004**            | ** ** | **September 27,  2003** | ** ** |
| **Revenue**                                                                                      | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Lasers and other products**                                                                    | ** ** | **$**                           | **18,343** | ** ** | **$** | **15,357** | ** ** |
| **Product-related service**                                                                      | ** ** | **4,048**                       | ** ** | **3,329** | ** ** |
| **Total revenue**                                                                                | ** ** | **22,391**                      | ** ** | **18,686** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cost of sales**                                                                                | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Lasers and other products**                                                                    | ** ** | **7,553**                       | ** ** | **7,630** | ** ** |
| **Product-related service**                                                                      | ** ** | **2,797**                       | ** ** | **1,743** | ** ** |
| **Total cost of sales**                                                                          | ** ** | **10,350**                      | ** ** | **9,373** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Gross profit**                                                                                 | ** ** | **12,041**                      | ** ** | **9,313** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Operating expenses:**                                                                          | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Selling, general and administrative**                                                          | ** ** | **6,660**                       | ** ** | **5,403** | ** ** |
| **Research and development**                                                                     | ** ** | **1,335**                       | ** ** | **1,076** | ** ** |
| **Total operating expenses**                                                                     | ** ** | **7,995**                       | ** ** | **6,479** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Income from operations**                                                                       | ** ** | **4,046**                       | ** ** | **2,834** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Other income (expense):**                                                                      | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Interest income**                                                                              | ** ** | **96**                          | ** ** | **79** | ** ** |
| **Interest expense**                                                                             | ** ** | **—**                      | ** ** | **(4** | **)** |
| **Other income, net**                                                                            | ** ** | **43**                          | ** ** | **32** | ** ** |
| **Total other income, net**                                                                      | ** ** | **139**                         | ** ** | **107** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Income from continuing operations before  income taxes**                                       | ** ** | **4,185**                       | ** ** | **2,941** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Provision for income taxes**                                                                   | ** ** | **1,339**                       | ** ** | **1,152** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Income from continuing operations**                                                            | ** ** | **2,846**                       | ** ** | **1,789** | ** ** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Discontinued operations:**                                                                     | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Loss from discontinued Skin Care Center  operations of $473, less income tax benefit of $175** | ** ** | **—**                      | ** ** | **(298** | **)** |
| **Loss on closure of Skin Care Center, of  $3,348 less income tax benefit of $1,253**            | ** ** | **—**                      | ** ** | **(2,095** | **)** |
| ** **                                                                                       | ** ** | **—**                      | ** ** | **(2,393** | **)** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Net (loss) income**                                                                            | ** ** | **$**                           | **2,846**  | ** ** | **$** | **(604** | **)** |
| **Net income (loss) per share of common  stock:**                                                | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Basic:**                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Income from continuing operations**                                                            | ** ** | **$**                           | **0.13**   | ** ** | **$** | **0.08** | ** ** |
| **Loss from discontinued operations**                                                            | ** ** | **—**                      | ** ** | **(0.11** | **)** |
| **Net (loss) income**                                                                            | ** ** | **$**                           | **0.13**   | ** ** | **$** | **(0.03** | **)** |
| **Diluted:**                                                                                     | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Income from continuing operations**                                                            | ** ** | **$**                           | **0.12**   | ** ** | **$** | **0.08** | ** ** |
| **Loss from discontinued operations**                                                            | ** ** | **—**                      | ** ** | **(0.11** | **)** |
| **Net (loss) income**                                                                            | ** ** | **$**                           | **0.12**   | ** ** | **$** | **(0.03** | **)** |
| ** **                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Weighted average shares outstanding**                                                          | ** ** | **22,326**                      | ** ** | **21,388** | ** ** |
| **Adjusted weighted average shares  outstanding**                                                | ** ** | **23,031**                      | ** ** | **22,188** | ** ** |
| **Net income (loss)**                                                                            | ** ** | **$**                           | **2,846**  | ** ** | **$** | **(604** | **)** |
| **Other comprehensive income (loss) net of  tax:**                                               | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Foreign currency translation adjustment**                                                      | ** ** | **(187**                        | **)**      | **(153** | **)** |
| **Total  comprehensive income (loss)**                                                           | ** ** | **$**                           | **2,659**  | ** ** | **$** | **(757** | **)** |

 

***The accompanying notes are an integral partof the unaudited consolidated financial statements.***

 

4

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**CANDELA CORPORATIONConsolidated Statements of Cash Flows**(in thousands)(unaudited)

 
| ** **                                                                                  | ** ** | **For the three months ended:** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                  | ** ** | **October 2,  2004**            | ** ** | **September 27,  2003** | ** ** |
| **Cash flows from operating activities:**                                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Net income (loss)**                                                                       | ** ** | **$**                           | **2,846**  | ** ** | **$** | **(604** | **)** |
| **Adjustments to reconcile net income (loss)  to net cash used for operating activities:**  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Provision for disposal of discontinued  operations**                                      | ** ** | **—**                      | ** ** | **2,095** | ** ** |
| **Loss from discontinued operations**                                                       | ** ** | **—**                      | ** ** | **298** | ** ** |
| **Depreciation and amortization**                                                           | ** ** | **177**                         | ** ** | **159** | ** ** |
| **Provision for bad debts**                                                                 | ** ** | **(137**                        | **)**      | **(28** | **)** |
| **Effect of exchange rate changes on foreign  currency denominated assets and liabilities** | ** ** | **8**                           | ** ** | **9** | ** ** |
| **Increase (decrease) in cash from working  capital:**                                      | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Accounts receivable**                                                                     | ** ** | **2,237**                       | ** ** | **(21** | **)** |
| **Notes receivable**                                                                        | ** ** | **591**                         | ** ** | **(16** | **)** |
| **Inventories**                                                                             | ** ** | **(817**                        | **)**      | **(1,027** | **)** |
| **Other current assets**                                                                    | ** ** | **(1,019**                      | **)**      | **(272** | **)** |
| **Other assets**                                                                            | ** ** | **43**                          | ** ** | **62** | ** ** |
| **Accounts payable**                                                                        | ** ** | **(2,571**                      | **)**      | **60** | ** ** |
| **Accrued payroll and related expenses**                                                    | ** ** | **(1,878**                      | **)**      | **(1,935** | **)** |
| **Deferred revenue**                                                                        | ** ** | **296**                         | ** ** | **42** | ** ** |
| **Accrued warranty costs**                                                                  | ** ** | **(482**                        | **)**      | **392** | ** ** |
| **Income taxes payable**                                                                    | ** ** | **882**                         | ** ** | **(711** | **)** |
| **Long-term portion of deferred revenue**                                                   | ** ** | **247**                         | ** ** | **(795** | **)** |
| **Other accrued liabilities**                                                               | ** ** | **(814**                        | **)**      | **324** | ** ** |
| **Change in restricted cash**                                                               | ** ** | **(3**                          | **)**      | **—** | ** ** |
| **Net cash used for operating activities**                                                  | ** ** | **(394**                        | **)**      | **(1,968** | **)** |
| ** **                                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from investing activities:**                                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Purchases of property and equipment**                                                     | ** ** | **(119**                        | **)**      | **(17** | **)** |
| **Net cash used for investing activities**                                                  | ** ** | **(119**                        | **)**      | **(17** | **)** |
| ** **                                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from financing activities:**                                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Proceeds from the issuance of common stock**                                              | ** ** | **108**                         | ** ** | **531** | ** ** |
| **Net cash provided by financing activities**                                               | ** ** | **108**                         | ** ** | **531** | ** ** |
| ** **                                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Effect of exchange rates on cash and cash  equivalents**                                  | ** ** | **(123**                        | **)**      | **(270** | **)** |
| ** **                                                                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Net decrease in cash and cash equivalents**                                               | ** ** | **(528**                        | **)**      | **(1,724** | **)** |
| **Cash and cash equivalents at beginning of  period**                                       | ** ** | **37,139**                      | ** ** | **31,870** | ** ** |
| **Cash and cash equivalents at end of period**                                              | ** ** | **$**                           | **36,611** | ** ** | **$** | **30,146** | ** ** |

 

***The accompanying notes are anintegral part of the unaudited consolidated financial statements****.*

 

5

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**1.****                   Basis of Presentation**

 

The accompanying unaudited consolidatedfinancial statements and notes do not include all of the disclosures made inthe Annual Report on Form 10-K of Candela Corporation (the “Company”, or “Candela”)for fiscal year 2004, which should be read in conjunction with these financialstatements.  The financial informationincluded herein is unaudited, with the exception of the consolidated balancesheet as of July 3, 2004, which was derived from the audited consolidatedbalance sheet dated July 3, 2004. However, in the opinion of management, thefinancial statements include all necessary adjustments, consisting of normalrecurring accruals, for a fair presentation of the quarterly results and areprepared and presented in a manner consistent with the Company’s Annual Reporton Form 10-K. The results for the three-month period ended October 2, 2004 arenot necessarily indicative of the results to be expected for the full year.

 

**2.****                   DiscontinuedOperations**

 

OnSeptember 27, 2003 management initiated a plan to close its only remaining skincare center. The closure is accounted for as a discontinued operation inaccordance with Statement of Financial Accounting Standards (“SFAS”) 144 “*Accounting for the Impairment or Disposal of Long-Lived Assets*”and SFAS 146 “*Accounting for Costs Associated with Exit orDisposal Activities*”. As a result, in the fiscal quarter endedSeptember 27, 2003, the Company recorded a $2,095 charge for the accrual of$3,000 of future occupancy costs, primarily relating to future lease paymentsfor the Boston facility, and $348 of severance obligations and other relatedcosts of closure, net of anticipated tax benefits of $1,253. Approximately 45positions have been eliminated as a result of this restructuring plan, and 44 employeeshave been terminated as of October 2, 2004.

 

Prior to fiscal 2002, the Company recordedcombined restructuring charges of $3,721 resulting from management’s decisionto close the skin care center located in Scottsdale, Arizona. During thethree-month period ended December 29, 2001, the Company secured a sublease forthe Scottsdale facility.  The sublesseecommenced making payments to the landlord on behalf of the Company on April 1,2002.  As a result of the sublease, theCompany revised the estimate of future costs associated with the Scottsdalefacility and, in the quarter ended March 30, 2002, reversed $693 of therestructuring reserve which represents primarily the amount of futurecontractual sublease payments as well as revisions to the net realizable valueof certain leasehold improvements.

 

The following table reflects the combinedrestructuring charges incurred in the three-month period ended October 2, 2004:

 
| **(in  thousands)**                           | ** ** | **Payroll and  Severance** | ** ** | **Leasehold  Improvements  and Fixed  Assets** | ** ** | **Facility  Costs** | ** ** | **Total**  | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|---------------------|------------|------------|------------|
| **Balance  at July 3, 2004**                  | ** ** | **$**                      | **0**      | ** **                                     | **$**      | **197**             | ** ** | **$**      | **2,809**  | ** ** | **$** | **3,006** | ** ** |
| **Reduction of reserve due to cash payments** | ** ** | **—**                 | ** ** | **—**                                     | ** ** | **220**             | ** ** | **220**    | ** ** |
| **Non-cash amortization**                     | ** ** | **—**                 | ** ** | **26**                                         | ** ** | **—**          | ** ** | **26**     | ** ** |
| ** **                                    | ** ** | ** **                 | ** ** | ** **                                     | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance at October 2, 2004**                | ** ** | **$**                      | **0**      | ** **                                     | **$**      | **171**             | ** ** | **$**      | **2,589**  | ** ** | **$** | **2,760** | ** ** |
|                                               |            |                            |            |                                                |            |                     |            |            |            |  |  |  |  |  |

 

6

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**2.****                   DiscontinuedOperations, continued**

 

AtOctober 2, 2004, thediscontinued segment had a net liability of approximately $3.4 millionconsisting primarily of the aforementioned reserve of $2.8 million and deferredgift certificate revenue of $0.8 million partially offset by fixed assets ofapproximately $0.2 million.  Revenues fordiscontinued operations for the quarter ended September 27, 2003 were approximately $0.4 million. There havebeen no subsequent revenues.

 

**3.      Stock-based Compensation**

 

In December 2002, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 148, “Accountingfor Stock-Based Compensation, Transition and Disclosure” (“FAS 148”). FAS 148provides alternative methods of transition for a voluntary change to therecognition of the cost of the options in the statement of operations. FAS 148also requires that disclosures of the pro forma effect of using the fair valuemethod of accounting for stock-based employee compensation be displayed moreprominently and in a tabular format. Additionally, FAS 148 requires disclosureof the pro forma effect in interim financial statements. The transition andannual disclosure requirements of FAS 148 were effective for fiscal years endedafter December 15, 2002. The interim disclosure requirements of FAS 148are effective for interim periods beginning after December 15, 2002. Theadoption of the provisions of FAS 148 did not have an impact on the Company’sconsolidated financial statements; however, the Company has modified itsdisclosures as provided for in the new standard.

 

The Company follows theprovisions of FASB Statement No. 123, “Accounting for Stock-BasedCompensation” (“FAS 123”). The provisions of FAS 123 allow companies to eitherexpense the estimated fair value of stock options or to continue to follow theintrinsic value method set forth in Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (“APB 25”), butdisclose the pro forma effects on net income (loss) had the fair value ofthe options been expensed. Candela has elected to continue to apply APB 25 inaccounting for its stock option incentive plans.

 

In accordance with APB 25and related interpretations, compensation expense for stock options isrecognized in income based on the excess, if any, of the quoted market price ofthe stock at the grant date of the award or other measurement date over theamount an employee must pay to acquire the stock. Generally, the exercise pricefor stock options granted to employees equals or exceeds the fair market valueof Candela common stock at the date of grant, thereby resulting in norecognition of compensation expense by Candela. For awards that generatecompensation expense as defined under APB 25, the Company calculates the amountof compensation expense and recognizes the expense over the vesting period ofthe award.

 

7

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**3.      Stock-based Compensation, continued**

 

Had compensation cost forCandela’s stock option plans been determined based on the fair value method setforth in FAS 123, Candela’s net income and basic and diluted netincome per common share would have been changed to the pro forma amountsindicated below:

 
| **(in thousands, except per share  data)**                                                                                                         | ** **           | **For the three months ended:** | ** **              |
|----------------------------------------------------------------------------------------------------------------------------------------------------|----------------------|---------------------------------|-------------------------|
| ** **                                                                                                                                         | **October 2,  2004** | ** **                      | **September 27,  2003** | ** ** |
| ** **                                                                                                                                         | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Net income (loss), as reported**                                                                                                                 | ** **           | **$**                           | **2,846**               | ** ** | **$** | **(604** | **)** |
| ** **                                                                                                                                         | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Add: stock-based employee compensation  expense included in reported net income, net of related tax effects**                                    | ** **           | **—**                      | ** **              | **—** | ** ** |
| ** **                                                                                                                                         | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Deduct: total stock-based employee  compensation expense, determined under fair value based method for all  awards, net of related tax effects** | ** **           | **(745**                        | **)**                   | **(363** | **)** |
| ** **                                                                                                                                         | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Pro forma net income (loss)**                                                                                                                    | ** **           | **$**                           | **2,101**               | ** ** | **$** | **(967** | **)** |
| **Net income (loss) per share of common stock**                                                                                                    | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Basic - as reported**                                                                                                                            | ** **           | **$**                           | **0.13**                | ** ** | **$** | **(0.03** | **)** |
| **Basic - pro forma**                                                                                                                              | ** **           | **$**                           | **0.09**                | ** ** | **$** | **(0.04** | **)** |
| **Diluted - as reported**                                                                                                                          | ** **           | **$**                           | **0.12**                | ** ** | **$** | **(0.03** | **)** |
| **Diluted - pro forma**                                                                                                                            | ** **           | **$**                           | **0.09**                | ** ** | **$** | **(0.04** | **)** |

 

In computing this pro-formaamount, the Company has used the Black-Scholes pricing model using thefollowing assumptions for options granted in fiscal years 2005 and 2004:

 
| ** **                                      | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| **Risk-free interest rate**                     | ** ** | **4.25**   | **%**      | **4.25**   | **%**      |
| **Estimated volatility**                        | ** ** | **79**     | **%**      | **76**     | **%**      |
| **Expected life for stock options (yrs)**       | ** ** | **2.88**   | ** ** | **2.99**   | ** ** |
| **Expected life for stock purchase plan (yrs)** | ** ** | **0.5**    | ** ** | **0.5**    | ** ** |
| **Expected dividends**                          | ** ** | **—** | ** ** | **—** | ** ** |

 

**4.****                   Earnings PerShare**

 

Basic earnings per share is computed bydividing net income by the weighted average number of shares of common stockoutstanding for the period and, if there are dilutive securities, dilutedearnings per share is computed by including common stock equivalentsoutstanding for the period in the denominator.

 

8

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**4.****                   Earnings PerShare, continued**

 

Common stock equivalents include sharesissuable upon the exercise of stock options or warrants, net of shares assumedto have been purchased with the proceeds, using the treasury stock method.

 
| **(in thousands, except per share  data)**                                        | ** **           | **For the three months ended:** | ** **              |
|-----------------------------------------------------------------------------------|----------------------|---------------------------------|-------------------------|
| ** **                                                                        | **October 2,  2004** | ** **                      | **September 27,  2003** | ** ** |
| ** **                                                                        | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Basic shares used in the calculation of  earnings per share**                   | ** **           | **22,326**                      | ** **              | **21,388** | ** ** |
| ** **                                                                        | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Effect of dilutive securities:**                                                | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Stock options**                                                                 | ** **           | **705**                         | ** **              | **751** | ** ** |
| **Stock warrants**                                                                | ** **           | **—**                      | ** **              | **49** | ** ** |
| ** **                                                                        | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Diluted shares used in the calculation of  earnings per share**                 | ** **           | **23,031**                      | ** **              | **22,188** | ** ** |
| ** **                                                                        | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Per share effect of dilutive securities on  income from continuing operations** | ** **           | **$**                           | **0.01**                | ** ** | **$** | **0.00** | ** ** |
| ** **                                                                        | ** **           | ** **                      | ** **              | ** ** | ** ** |
| **Per share effect of dilutive securities on net  income**                        | ** **           | **$**                           | **0.01**                | ** ** | **$** | **0.00** | ** ** |

 

During the three-month period ended October2, 2004, options to purchase 639,891 shares of common stock were excluded fromthe calculation of diluted earnings per share because the exercise price ofsuch options was greater than the average market price of the common stock forthe period.  During the three-monthperiod ended September 27, 2003, all options to purchase shares of common stockwere included in the calculation of diluted earnings per share.

 

 

**5.****                   Inventories**

** **
| **(in thousands)**  | ** ** | **October 2,  2004** | ** ** | **July 3,  2004** | ** ** |
|---------------------|------------|----------------------|------------|-------------------|------------|
| ** **          | ** ** | ** **           | ** ** | ** **        | ** ** |
| **Raw materials**   | ** ** | **$**                | **3,891**  | ** **        | **$**      | **4,833** | ** ** |
| **Work in process** | ** ** | **447**              | ** ** | **556**           | ** ** |
| **Finished goods**  | ** ** | **10,014**           | ** ** | **8,182**         | ** ** |
| ** **          | ** ** | **$**                | **14,352** | ** **        | **$**      | **13,571** | ** ** |

 

**6.      SegmentInformation**

 

The Company operates principally in oneindustry segment: the design, manufacture, sale, and service of medical devicesand related equipment. The results in this segment have been presented in theConsolidated Statements of Operations for the appropriate periods.

 

9

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**7.      Guarantees**

 

The Company’sproducts generally carry a standard one-year warranty, except for Vbeamproducts which typically carry a three-year warranty. The Company records areserve based on anticipated warranty claims at the time product revenue isrecognized. In anticipation of actual warranty claims, the Company amortizesthe reserve ratably over the life of the warranty, thereby offsetting actualwarranty claims incurred. Actual warranty claims incurred and charged toproduct costs of sales during an interim period may be more or less than theamount of amortized warranty reserve allocated against them. Factors thataffect the Company’s product warranty liability include the number of installedunits, the anticipated cost of warranty repairs, and historical and anticipatedrates of warranty claims.

 

The followingtable reflects changes in the Company’s accrued warranty account during thethree-month period ended October 2, 2004:

 
| **(in thousands)**                             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------|------------|
| **Beginning balance July 3, 2004**             | ** ** | **$**      | **8,257**  | ** ** |
| **Plus accruals related to new sales**         | ** ** | **931**    | ** ** |
| **Less amortization of prior period accruals** | ** ** | **1,888**  | ** ** |
| **Ending balance on October 2, 2004**          | ** ** | **$**      | **7,300**  | ** ** |

 

The Companyalso offers extended service contracts that may be purchased after a standardwarranty has expired. Service contracts may be purchased for periods from oneto five years. The Company recognizes service contract revenue ratably over thelife of the contract. Actual service contract expenses incurred and charged toservice costs of sales during an interim period may be more or less than the amountof amortized service contract revenue recognized in that period.

 

The followingtable reflects changes in the Company’s deferred revenue account during thethree-month period ended October 2, 2004:

 
| **(in thousands)**                              | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|------------|------------|
| **Beginning balance July 3, 2004**              | ** ** | **$**      | **4,055**  | ** ** |
| **Plus deferral of new service contract sales** | ** ** | **2,531**  | ** ** |
| **Less recognition of deferred revenue**        | ** ** | **1,521**  | ** ** |
| **Ending balance on October 2, 2004**           | ** ** | **$**      | **5,065**  | ** ** |

 

The Companyhas an agreement (the “Agreement”) with an independent leasing company wherebythe Company will purchase delinquent leases (the “UNL Provision”) relating toCompany products purchased by customers and financed through the leasingcompany.  The Company is required tohonor the UNL Provision when the leasing company’s aggregate losses reach levelsspecified in the Agreement.  The UNLProvision of the Agreement was recently eliminated for any lease initiatedafter December 31, 2002.  Since theinception of the Agreement, the cumulative amounts paid to the leasing companyunder the UNL Provision have not been significant.

 

**8.      Asset Acquisition**

 

On January 8,2003, the Company acquired substantially all of the assets of AppliedOptronics, the diode division of Schwartz Electro-Optics, Inc., forapproximately $1.2 million in cash. Applied Optronics was a leadingmanufacturer of high-powered, pulsed lasers, and was a component supplier tothe OEM market that serves a variety of industries including the military,medical, industrial, research and robotics fields. Applied Optronics was thelead supplier of the diodes for the Company’s SmoothbeamTM diode laser system.In accordance with SFAS No. 141 “*Business Combinations*,”the Company records acquisitions under the purchase method of accounting.Accordingly, the purchase price is allocated to the tangible assets andliabilities and intangible assets acquired, based on their estimated fairvalues.

 

The assetacquisition consisted primarily of fixed assets, including production andoffice equipment, and inventory located at the division’s facility in New Jersey.The acquisition increased the Company’s net property and equipment byapproximately $0.8 million and inventory by approximately $0.4 million. For thethree months ended October 2, 2004, the Applied Optronics operation generatedapproximately $0.4 million in revenue from diode sales to third-partycustomers.

 

10

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**9.             Stock split**

 

OnJanuary 28, 2004, the Company announced that its Board of Directors approved atwo-for-one stock split of the Company’s common stock effected in the form of astock dividend paid on March 16, 2004. As a result of this action 13.3 millionshares were issued to shareholders of record as of February 16, 2004. Par valueof the stock remains at $.01 per share and accordingly, $133 was transferredfrom additional paid-in capital to common stock. All references to the numberof common shares and per common share amounts have been restated to giveretroactive effect to the stock split for all periods presented.

 

**10.          Commitments and Contingencies**

 

TheCompany has an Amended and Restated License Agreement (the “License”) with TheRegents of the University of California (“The Regents”) pursuant to which theCompany licenses certain patent rights to its dynamic cooling device (“DCD”)from The Regents.  The Company sells itsDCD as a component part of its Smoothbeam ® laser system and as an accessory toits other laser systems.  In April of2004, The Regents issued a notice of default under the License, asserting,among other things, that the Company is in breach of the License for thealleged failure to make required royalty payments and to make requireddisclosures.  The Regents’ April noticeasserted that the total underpaid royalties, interest and other charges for theperiod from August of 2000 through September 2003 are $1,128,000.  The Regents issued a subsequent notice ofdefault, dated June 30, 2004, relating to the quarterly periods endedDecember 27, 2003 and March 27, 2004, for which The Regents assertedthat the Company underpaid additional royalties amounting to $1,350,000.  The Company and The Regents differ in theirrespective interpretations of which products sold by the Company give rise to aroyalty-bearing obligation to The Regents. The Company believes it has made all payments it was required to make.

 

11

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**10.          Commitments and Contingencies, continued**

** **

Underthe License, disputes are to be settled by binding arbitration through amutually acceptable single arbitrator. On June 14, 2004, the Company filed a Demand for Arbitration toadjudicate the differing interpretations of the License Agreement held by theCompany and The Regents.  On July 8,2004, The Regents filed their response and counterclaim for breach of contractand declaratory relief.  Candeladeposited approximately $1.0 million in June of 2004, and an additional $1.0million in August of 2004, into an escrow fund to be paid in whole or in partto the Company or The Regents as determined by the arbitrator.  As a result of the establishment of theescrow fund, The Regents will not terminate or purport to terminate the LicenseAgreement based on any alleged breach by the Company related to any matter nowbefore the arbitrator.  The $2.0million deposited in the escrow fund has been included in Other Assets on theaccompanying balance sheet, and no expense has or will be recorded with respectto the escrow fund or any additional contingent liabilities while the matter isbeing arbitrated. A finaldecision of the arbitrator in this matter is presently expected to be deliveredduring the second or third quarter of fiscal 2005.

 

Fromtime to time, the Company is a party to various legal proceedings incidental toits business.  Except for the pendingarbitration proceedings with The Regents, the Company believes that none of thelegal proceedings that are presently pending, if adversely decided to theCompany, will have a material adverse effect upon its financial position,results of operations, or liquidity.

 

**CANDELACORPORATION**

 

**Item 2****- Management’s Discussion and Analysis ofFinancial Condition and Results of Operations Overview**

 

We research, develop,manufacture, market and service lasers used to perform aesthetic and cosmeticprocedures. We sell our lasers to physicians and personal carepractitioners.  We market our productsdirectly and through a network of distributors to end-users. Our traditionalcustomer base includes plastic and cosmetic surgeons and dermatologists. Morerecently we have expanded our sales to a broader group of practitionersconsisting of general practitioners and certain specialists includingobstetricians, gynecologists and general and vascular surgeons.  We derive our revenue from the sales oflasers and other products, and the provision of product-related services.

 

**CriticalAccounting Policies**

 

****This discussion and analysis ofour financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities. We evaluate ourestimates and judgments on an on-going basis, including those related torevenue recognition, bad debts, inventories, warranty obligations,contingencies, restructurings and income taxes. We base our estimates andjudgments on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying value of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these estimates and judgments under different assumptions or conditions. Adiscussion of our critical accounting policies and the related estimates andjudgments affecting the preparation of our consolidated financial statements isincluded in our Annual Report on Form 10-K for fiscal year 2004.****

**** ****

****12****

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**** ****

**Results ofOperations**

 

***Revenue.***

 

Revenue source by geographic region isreflected in the following table:

 
| **(in thousands)**  | ** **           | **For the three months ended:** | ** **              |
|---------------------|----------------------|---------------------------------|-------------------------|
| ** **          | **October 2,  2004** | ** **                      | **September 27,  2003** | ** ** | **Change** | ** ** |
| ** **          | ** **           | ** **                      | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **US revenue**      | ** **           | **$**                           | **9,424**               | ** ** | **42** | **%** | **$** | **7,852** | ** ** | **42** | ** ** | **$** | **1,572** | ** ** | **20** | **%** |
| **Foreign revenue** | ** **           | **12,967**                      | ** **              | **58** | **%** | **10,834** | ** ** | **58** | **%** | **2,133** | ** ** | **20** | **%** |
| ** **          | ** **           | ** **                      | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**   | ** **           | **$**                           | **22,391**              | ** ** | **100** | **%** | **$** | **18,686** | ** ** | **100** | **%** | **$** | **3,705** | ** ** | **20** | **%** |

 

Consolidated Overview

 

Consolidated revenue increased $3.7 million, to $22.4 million for thethree months ended October 2, 2004, from $18.7 million for the three monthsended September 27, 2003.  The increasewas due primarily to uniform increase in demand for our products and relatedservice on a worldwide basis, coupled with our emerging ability to reach intonew markets.

 

Foreign revenue increased20% to $13.0 million for the three-month period ended October 2, 2004, ascompared to the three-month period ended September 27, 2003. Foreign revenueincreased across all countries with South America and Europe showing the moststrength. Revenues in South America increased over 400 percent, accounting forapproximately $0.6 million or 29% of this comparative increase while Europeanrevenues increased approximately $1.2 million accounting for 57% of thiscomparative increase. Increases in Japan were more modest, totalingapproximately $0.3 million for the quarter or approximately 14% of the quarterover quarter increase.

 

US revenue increased 20% to $9.4 million for the three-month periodended October 2, 2004, as compared to the three-month period ended September 272003.  The revenue increase in the US wasuniform across all regions denoting solid demand for our products and relatedservices.

 

Revenue source by type is reflected in thefollowing table:

 
| ** **                    | ** ** | **For the three months ended:** | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| **(in thousands)**            | ** ** | **October 2,  2004**            | ** ** | **September 27,  2003** | ** ** | **Change** | ** ** |
| **Revenue**                   | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Lasers and other products** | ** ** | **$**                           | **18,343** | ** ** | **82** | **%** | **$** | **15,357** | ** ** | **82** | ** ** | **$** | **2,986** | ** ** | **19** | **%** |
| **Product-related service**   | ** ** | **4,048**                       | ** ** | **18** | **%** | **3,329** | ** ** | **18** | **%** | **719** | ** ** | **22** | **%** |
| ** **                    | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**             | ** ** | **$**                           | **22,391** | ** ** | **100** | **%** | **$** | **18,686** | ** ** | **100** | **%** | **$** | **3,705** | ** ** | **20** | **%** |

 

Theincrease in revenue from lasers and other products for the three months endedOctober 2, 2004, compared to the three-month period ended September 27, 2003resulted primarily from an increase in the sales volume of our new GentleYagTMproduct. The increase in revenue from product-related service for the threemonths ended October 2, 2004 compared to the three months ended September 27,2003 resulted primarily from an increase in the number of service relatedcontracts sold in addition to an increase in the number of consumables andaccessories sold to support our installed base.

 

13

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*** ***

***Cost of Sales. ***Costof sales increased 10% to $10.4 million for the three months ended October 2,2004 as compared to cost of sales of $9.4 million for the three months ended September 27,2003.** As a percentage of revenue, cost of salesdecreased almost 4% on a comparative basis, quarter over quarter.

 

***Gross Profit. ***Gross profit was approximately $12.0 million or54% of revenues for the three-month period ended October 2, 2004, compared togross profit of approximately $9.3 million or 50% for the same period one yearearlier. This increase in gross profit results principally from the increase insales volume of our GentleYagTM product line.

 

***Selling, General and Administrative Expense.***  Selling, general and administrative expensesincreased 23%, to approximately $6.7 million for the three-month period endedOctober 2, 2004 from approximately $5.4 million for the three-month periodended September 27, 2003. As a percentage of revenue, selling, general andadministrative expenses increased to 30% from 29% of revenues for the samerespective periods. This increase was due primarily to commission and employeerelated expense of approximately $0.5 million in the US and $0.5 millioninternationally, coupled with increased administrative costs in Spain as aresult of our expansion effort into Portugal.

 

***Research and Development Expense.***  Research and development spending increasedto $1.3 million for the three-month period ended October 2, 2004 from $1.1million for the three-month period ended September 27, 2003 due primarily to anincrease in project related expenses.

 

***Other Income/Expense.***  Net other income for the current periodremained relatively unchanged as compared to the three months ended September27, 2003.

 

***Income Taxes.***  The provision for income taxes results from acombination of activities of both the domestic operations and foreignsubsidiaries of the Company.  We recordeda 32% effective tax rate for the three-month period ended October 2, 2004.  This compares to the three-month period endedSeptember 27, 2003, in which we recorded a 31.5% effective tax rate.  The provision for income taxes for the threemonths ended October 2, 2004 differs from the U.S. statutory rate as a resultof tax provisions calculated for income generated by foreign subsidiaries at arate that differs from the U.S. statutory rate.

 

**DiscontinuedOperations**

 

On September 27, 2003, we permanently closedour only remaining skin care center, which was located in Boston. The closureof the Boston skin care center, together with the earlier closing of ourScottsdale, Arizona spa, and the associated cessation of this line of business,is accounted for as discontinued operations. As a result of the closure of theBoston skin care center, in the fiscal quarter ended September 27, 2003, werecorded a $2.1 million charge for the accrual of $3.0 million of futureoccupancy costs and $0.3 million of severance obligations and other relatedcosts of closure, net of anticipated tax benefits of $1.3 million. In addition,both the financial statements for the three months ended October 2, 2004 andall prior financial statements have been restated to reflect skin care centeroperations as discontinued.  The Companybelieves that the size of the accrual that it has established is sufficient tocover all future leasehold expenses for the remainder of the lease term.Leasehold expenses could potentially be mitigated through the sublease of theproperty. The landlord has notified the Company that it has re-let thepremises. The Company has elected not to reverse any portion of the accrual atthis time because the potential economic benefits are not yet known.

 

14

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**Liquidity and Capital Resources**

 

Cash used in operating activities was $0.4million for the three months ended October 2, 2004, in comparison to cash usedin operating activities of $2.0 million for the same period in the prior year.This decrease in cash used by operating activities primarily reflects strongeroverall operating results combined with the replenishment of cash due to thecollection of accounts receivable. This was partially offset by an increase inaccruals and accounts payable due to the timing of our current quarter end ascompared to the prior year.  In addition,the Company deposited $1.0 million during the current quarter into an escrowaccount which is being carried as an other asset at the current balance sheetdate. Cash used by investing activities remained relatively flat for the threemonths ended October 2, 2004, as the Company continued its conservative policytowards capital outlays for property, plant and equipment.

 

Our outstanding contractual obligations as ofOctober 2, 2004, are reflected in the following table:

 
| **(in thousands)**   | ** ** | **Total** | ** ** | **Maturity****Less than  1 year** | ** ** | **Maturity****1-3 years** | ** ** | **Maturity****4-5 years** | ** ** | **Maturity****in excess of  5 years** | ** ** |
|----------------------|------------|-----------|------------|-----------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------------------|------------|
| **Operating leases** | ** ** | **2,152** | ** ** | **742**                           | ** ** | **981**                   | ** ** | **350**                   | ** ** | **79**                                | ** ** |

 

We also maintain a renewable $10,000,000revolving credit agreement with a major bank with interest at the bank’s baserate, or LIBOR plus 2.25%.  Anyborrowings outstanding under the line of credit are due on demand or accordingto a payment schedule established at the time funds are borrowed.  The line of credit is unsecured.  The agreement contains restrictive covenantslimiting the establishment of new liens, and the purchase of margin stock.  No amounts were outstanding under the line ofcredit as of October 2, 2004.

 

We believe that our current cash balanceswill be sufficient to meet anticipated cash requirements for the next twelvemonths.  However, we cannot be sure thatwe will not require additional capital beyond the amounts currently forecastedby us, or that any such required additional capital will be available onreasonable terms, if at all, when such capital becomes required.

 

**CautionaryStatements**

 

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. Forward-looking statements are not promises or guarantees and aresubject to risks and uncertainties that could cause our actual results todiffer materially from those anticipated. Such statements may relate to, among other things, the future of theindustry, product development, business strategy (including the possibility offuture acquisitions), anticipated operational and capital expenditure levels,continued acceptance and growth of our products, and dependence on significantcustomers and suppliers.  Forward-lookingstatements may also include, without limitation, any statement relating tofuture events, conditions or circumstances or using words such as or similarto:  anticipate; believe; continue;could; estimate; expect; intend; plan; predict; project; may; or will.  The risks and uncertainties that may affectforward-looking statements and/or our business include, among others, thosediscussed in “Cautionary Statements” in our Annual Report filed on Form 10-Kfor the fiscal year ended July 3, 2004, as well as other risks anduncertainties referenced in this Quarterly Report.  These risks and uncertainties include, butare not limited to, the following:

 

15

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**Cautionary Statements, continued**

 

•                  Ourprincipal source of liquidity is our current cash and equivalents. Our abilityto generate cash from operations is dependant upon our ability to generaterevenue from selling our lasers and other products and providingproduct-related services. A decrease in demand for our products and relatedservices or increases in operating costs would likely have an adverse effect onour liquidity.

 

•                  Becausewe typically derive more than half of our revenue from international sales, weare susceptible to currency fluctuations, negative economic changes takingplace in foreign marketplaces, and other risks associated with conductingbusiness overseas.

 

•                  Thefailure to obtain alexandrite rods for certain laser systems from our solesupplier would impair our ability to manufacture and sell these laser systems,which has accounted for a substantial portion of our revenue in certain recentperiods.

 

•                  Anadverse result in the arbitration proceeding pending against The Regents of theUniversity of California would result in additional expenditures and wouldnegatively impact our operating results.

 

•                  Ourfailure to respond to rapid changes in technology and intense competition inthe laser industry could make our lasers obsolete.

 

•                  Likeother companies in our industry, we are subject to a regulatory review processand our failure to receive necessary government clearances or approvals couldaffect our ability to sell our products and remain competitive.

 

•                  Achievingcomplete compliance with FDA regulations is difficult, and if we fail tocomply, we could be subject to FDA enforcement action.

 

•                  Claimsby others that our products infringe their patents or other intellectualproperty rights, or that the patents which we own or have licensed rights toare invalid, could prevent us from manufacturing and selling some of ourproducts or require us to incur substantial costs from litigation ordevelopment of non-infringing technology.

 

•                  Wecould incur substantial costs as a result of product liability claims.

 

•                  Wemay be unable to attract and retain management and other personnel we need tosucceed.

 

•                  Ourfailure to manage acquisitions and joint ventures effectively may divertmanagement attention from our core business and cause us to incur additionaldebt, liabilities or costs.

 

We caution readers not to placeundue reliance upon any forward-looking statements, which speak only as of thedate made.  We expressly disclaim anyobligation or undertaking to release publicly any updates or revisions to anysuch statements to reflect any change in our expectations or any change inevents, conditions or circumstances on which any such statement is based.

 

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**Item 3****- Quantitative and Qualitative Disclosures AboutMarket Risk**

 

We have foreign subsidiaries in Japan, Spain,France and Germany.  Approximately 58% ofour revenues for the three months ended October 2, 2004 were from operationsoutside the United States.  Thesesubsidiaries transact business in bothlocal and foreign currency. Therefore, we are exposed to foreign currency exchange risks andfluctuations in foreign currencies, which could adversely impact our resultsand financial condition.  However, salesfrom the United States made directly to customers or distributors in foreigncountries are invoiced in U.S. dollars and are not exposed to foreign currencyrisk.

From time to time, we may enter into foreigncurrency exchange and option contracts to reduce our exposure to foreigncurrency risk and variability in operating results due to fluctuation inexchange rates underlying the value of current transactions and anticipatedtransactions denominated in foreign currencies. These contracts obligate us toexchange predetermined amounts of specified foreign currencies at specifiedexchange rates on specified dates.  Thesecontracts are denominated in the same currency in which the 

underlyingtransactions are denominated and bear a contract value and maturity date thatapproximate the value and expected settlement date, respectively, of theunderlying transactions.We do not engage in foreign currency speculation.

 

We have cash equivalents that primarilyconsist of commercial paper, overnight repurchase agreements and money marketaccounts.  We believe that any near termchanges in interest rates will be immaterial to any potential losses in futureearnings, cash flow and fair values.

 

**Item 4****- Controls and Procedures**

 

(a) Evaluation of disclosurecontrols and procedures. An evaluation was performed under the supervision andwith the participation of members of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our “disclosure controls and procedures” (as defined inthe Securities Exchange Act of 1934 Rules 13a-15(e)) as of October 2, 2004 (the“Evaluation Date”).  Based on thatevaluation, members of our management, including our Chief Executive Officerand our Chief Financial Officer, have concluded that, as of the EvaluationDate, our disclosure controls and procedures were effective in enabling us torecord, process, summarize and report the information required to be includedin this quarterly report within the required time period.

 

(b) Changes to internal controls.  There were no changes in our internalcontrols over financial reporting during the fiscal quarter ended October 2,2004 that have materially affected, or are reasonably likely to materially affect,our internal controls over financial reporting.

 

17

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**CANDELA CORPORATION**

 

**PartII.  Other Information**

 

**Item1.  Legal Proceedings.**

 

The Company has an Amended andRestated License Agreement (the “License”) with The Regents of the Universityof California (“The Regents”) pursuant to which the Company licenses certainpatent rights to its dynamic cooling device (“DCD”) from The Regents.  The Company sells its DCD as a component partof its Smoothbeam ® laser system and as an accessory to its other lasersystems.  In April of 2004, The Regentsissued a notice of default under the License, asserting, among other things,that the Company is in breach of the License for the alleged failure to makerequired royalty payments and to make required disclosures.  The Regents’ April notice asserted that thetotal underpaid royalties, interest and other charges for the period fromAugust of 2000 through September 2003 are $1,128,000.  The Regents issued a subsequent notice ofdefault, dated June 30, 2004, relating to the quarterly periods endedDecember 27, 2003 and March 27, 2004, for which The Regents assertedthat the Company underpaid additional royalties amounting to $1,350,000.  The Company and The Regents differ in theirrespective interpretations of which products sold by the Company give rise to aroyalty-bearing obligation to The Regents. The Company believes it has made all payments it was required to make.

 

Under the License, disputes areto be settled by binding arbitration through a mutually acceptable singlearbitrator.  On June 14, 2004, theCompany filed a Demand for Arbitration to adjudicate the differinginterpretations of the License Agreement held by the Company and The Regents.  On July 8, 2004, The Regents filed theirresponse and counterclaim for breach of contract and declaratory relief.  Candela deposited approximately $1.0 millionin June of 2004, and an additional $1.0 million in August of 2004, into anescrow fund to be paid in whole or in part to the Company or The Regents asdetermined by the arbitrator.  As aresult of the establishment of the escrow fund, The Regents will not terminate orpurport to terminate the License Agreement based on any alleged breach by theCompany related to any matter now before the arbitrator.  A final decision of the arbitrator in thismatter is presently expected to be delivered during the second or third quarterof fiscal 2005.

 

From time to time, we are aparty to various legal proceedings incidental to our business.  Except for the pending arbitrationproceedings with The Regents, we believe that none of the legal proceedingsthat are presently pending, if adversely decided to the Company, will have amaterial adverse effect upon our financial position, results of operations, orliquidity.

 

**Item 6. Exhibits**

 

|   | (a)          | Exhibits                                                                                                                                                |
|--------|--------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |         |                                                                                                                                                    |
|   | Exhibit 31.1 | Rule  13a-14(a)/15d-14(a) Certification of the Chief Executive Officer                                                                                  |
|   |         |                                                                                                                                                    |
|   | Exhibit 31.2 | Rule  13a-14(a)/15d-14(a) Certification of the Chief Financial Officer                                                                                  |
|   |         |                                                                                                                                                    |
|   | Exhibit 32.1 | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|   |         |                                                                                                                                                    |
|   | Exhibit 32.2 | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|        |              |                                                                                                                                                         |  |

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|   |              |   | CANDELA  CORPORATION                               |
|--------|-------------------|--------|----------------------------------------------------|
|   |              |   |                                               |
|   |              |   |                                               |
| Date:  | November 5,  2004 |   |                                               | /s/ F. Paul  Broyer |   |
|   |              |   | F. Paul  Broyer                                    |
|   |              |   | Senior Vice  President, Finance and Administration |
|   |              |   | and Chief  Financial Officer                       |
|        |                   |        |                                                    |  |  |

 

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**Candela Corporation**

 

**INDEX TOEXHIBITS**

 

| **Exhibit  No.** | ** ** | **Description**                                                                                                                                         |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                    |
| Exhibit 31.1     |       | Rule  13a-14(a)/15d-14(a) Certification of the Chief Executive Officer                                                                                  |
|             |       |                                                                                                                                                    |
| Exhibit 31.2     |       | Rule  13a-14(a)/15d-14(a) Certification of the Chief Financial Officer                                                                                  |
|             |       |                                                                                                                                                    |
| Exhibit 32.1     |       | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|             |       |                                                                                                                                                    |
| Exhibit 32.2     |       | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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