**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

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**FORM 10-Q**

 

**o****  Quarterly report pursuant to Section 13 or15(d) of the Securities Exchange Act of 1934**

 

**For the quarterly period ended December 31, 2005.**

 

**Commission file number 000-14742**

 

**CANDELA CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

Registrant’s telephonenumber, including area code: **(508) 358-7400**

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  ý    No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined by Rule 12b-2 of the Securities Exchange Act of 1934).

Yes  ý    No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule12b-2 of the Exchange Act) 

Yes  ý    No  o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule12b-2 of the Exchange Act) 

Yes  o    No  ý

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 
| **Class**                               | ** ** | **Outstanding at February 7, 2006** |
|-----------------------------------------|------------|-------------------------------------|
| Common Stock, $.01 par  value per share |       | 23,171,321                          |

 

 

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**CANDELA CORPORATION**

**Index**

 
| Part I.  | Financial  Information: |                                                                                                                                                                                                                           |
|----------|-------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |                    |                                                                                                                                                                                                                           |
|     | Item 1.                 | Financial  Statements                                                                                                                                                                                                          |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     |                    | Consolidated  Balance Sheets as of December 31, 2005 (Unaudited) and July 2, 2005                                                                                                                                              |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     |                    | Unaudited  Consolidated Statements of Operations and Comprehensive Income for the  three-month periods ended December 31, 2005 and January 1, 2005, and for the  six-month periods ended December 31, 2005 and January 1, 2005 |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     |                    | Unaudited  Consolidated Statements of Cash Flows for the six-month periods ended  December 31, 2005 and January 1, 2005                                                                                                        |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     |                    | Notes to Unaudited Consolidated Financial Statements                                                                                                                                                                           |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Item  2.                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                    |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Item  3.                | Quantitative  and Qualitative Disclosure about Market Risk                                                                                                                                                                     |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Item 4.                 | Controls  and Procedures                                                                                                                                                                                                       |   |
|     |                    |                                                                                                                                                                                                                           |   |
| Part II. | Other  Information:     |                                                                                                                                                                                                                           |
|     |                    |                                                                                                                                                                                                                           |
|     | Item 1.                 | Legal  proceedings                                                                                                                                                                                                             |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Item  4.                | Submission of Matters to a  Vote of Security Holders                                                                                                                                                                           |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Item 6.                 | Exhibits                                                                                                                                                                                                                       |   |
|     |                    |                                                                                                                                                                                                                           |   |
|     | Signatures              |                                                                                                                                                                                                                           |
|     |                    |                                                                                                                                                                                                                           |
|     | Index to Exhibits       |                                                                                                                                                                                                                           |

 

2

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**Part I.  Financial Information**

 

**Item 1 - Financial Statements**

 

**CANDELACORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                       | ** ** | **December 31,** | ** ** | **July 2,** | ** ** |
|--------------------------------------------------|------------|------------------|------------|-------------|------------|
| **(in thousands)**                               | ** ** | **2005**         | ** ** | **2005**    | ** ** |
| ** **                                       | ** ** | **(unaudited)**  | ** ** | ** **  | ** ** |
| **Assets:**                                      | ** ** |             | ** ** | ** **  | ** ** |
| Current assets:                                  |       |             |       |        |       |
| Cash and cash  equivalents                       |       | $                | 49,583     |        | $          | 56,383 |   |
| Restricted cash                                  |       | 179              |       | 199         |       |
| Marketable  securities                           |       | 2,999            |       | —      |       |
| Accounts receivable,  net                        |       | 32,762           |       | 34,866      |       |
| Notes receivable                                 |       | 516              |       | 805         |       |
| Inventories, net                                 |       | 13,860           |       | 12,676      |       |
| Other current  assets                            |       | 2,141            |       | 1,821       |       |
| Total current  assets                            |       | 102,040          |       | 106,750     |       |
| Property and equipment, net                      |       | 3,086            |       | 3,240       |       |
| Deferred tax assets                              |       | 5,950            |       | 5,743       |       |
| Prepaid licenses                                 |       | 3,640            |       | 878         |       |
| Long-term investments                            |       | 6,995            |       | —      |       |
| Other assets                                     |       | 331              |       | 205         |       |
| Total assets                                     |       | $                | 122,042    |        | $          | 116,816 |   |
|                                             |       |             |       |        |       |
| **Liabilities  and Stockholders’ Equity**   |       |             |       |        |       |
| Current liabilities:                             |       |             |       |        |       |
| Accounts payable                                 |       | $                | 7,974      |        | $          | 11,674 |   |
| Accrued payroll  and related expenses            |       | 3,234            |       | 4,830       |       |
| Accrued warranty  costs                          |       | 5,527            |       | 5,291       |       |
| Income taxes  payable                            |       | 1,429            |       | 2,073       |       |
| Sales tax  payable                               |       | 689              |       | 2,206       |       |
| Royalties  payable                               |       | 874              |       | 1,661       |       |
| Other accrued  liabilities                       |       | 3,991            |       | 1,298       |       |
| Deferred income  (current portion)               |       | 7,384            |       | 6,037       |       |
| Current  liabilities of discontinued operations  |       | 1,190            |       | 1,302       |       |
| Total current  liabilities                       |       | 32,292           |       | 36,372      |       |
| Accrued warranty costs (long-term portion)       |       | 3,363            |       | 3,355       |       |
| Deferred income (long-term portion)              |       | 1,941            |       | 2,313       |       |
| Long-term liabilities of discontinued operations |       | 324              |       | 437         |       |
| Total  liabilities                               |       | 37,920           |       | 42,477      |       |
|                                             |       |             |       |        |       |
| Stockholders’ equity:                       |       |             |       |        |       |
| Common stock                                     |       | 252              |       | 248         |       |
| Treasury stock,  at cost                         |       | (12,997          | )          | (12,997     | )          |
| Additional  paid-in capital                      |       | 56,649           |       | 54,027      |       |
| Accumulated  earnings                            |       | 40,877           |       | 33,346      |       |
| Accumulated  other comprehensive income (loss)   |       | (659             | )          | (285        | )          |
| Total  stockholders’ equity                 |       | 84,122           |       | 74,339      |       |
| Total liabilities and stockholders’ equity  |       | $                | 122,042    |        | $          | 116,816 |   |

 

***Theaccompanying notes are an integral part of the unaudited consolidated financialstatements.***

 

3

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**CANDELA CORPORATION**

**Consolidated Statements of Operations and ComprehensiveIncome**

(inthousands, except per share data)

(unaudited)

 
| ** **                                                                                                                     | ** ** | **For the three months ended:** | ** ** | **For the six months ended:** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                     | ** ** | **December 31,**                | ** ** | **January 1,**                | ** ** | **December 31,** | ** ** | **January 1,** | ** ** |
| ** **                                                                                                                     | ** ** | **2005**                        | ** ** | **2005**                      | ** ** | **2005** | ** ** | **2005** | ** ** |
| **Revenue**                                                                                                                    | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Lasers and other  products                                                                                                     |       | $                               | 31,657     |                          | $          | 23,539 |   | $ | 53,882 |   | $ | 41,882 |   |
| Product-related  service                                                                                                       |       | 6,063                           |       | 4,665                         |       | 11,925 |   | 8,713 |   |
| Total revenue                                                                                                                  |       | 37,720                          |       | 28,204                        |       | 65,807 |   | 50,595 |   |
| **Cost of sales**                                                                                                              |       |                            |       |                          |       |   |   |   |   |
| Lasers and other  products                                                                                                     |       | 14,062                          |       | 9,833                         |       | 23,547 |   | 17,386 |   |
| Product-related  service                                                                                                       |       | 4,683                           |       | 4,395                         |       | 8,732 |   | 7,192 |   |
| Total cost of  sales                                                                                                           |       | 18,745                          |       | 14,228                        |       | 32,279 |   | 24,578 |   |
| **Gross profit**                                                                                                               |       | 18,975                          |       | 13,976                        |       | 33,528 |   | 26,017 |   |
| **Operating expenses:**                                                                                                        |       |                            |       |                          |       |   |   |   |   |
| Selling, general  and administrative                                                                                           |       | 10,537                          |       | 9,997                         |       | 19,255 |   | 16,657 |   |
| Research and  development                                                                                                      |       | 1,800                           |       | 1,621                         |       | 3,442 |   | 2,956 |   |
| Total operating  expenses                                                                                                      |       | 12,337                          |       | 11,618                        |       | 22,697 |   | 19,613 |   |
| **Income from operations**                                                                                                     |       | 6,638                           |       | 2,358                         |       | 10,831 |   | 6,404 |   |
| **Other income (expense):**                                                                                                    |       |                            |       |                          |       |   |   |   |   |
| Interest income                                                                                                                |       | 262                             |       | 141                           |       | 510 |   | 237 |   |
| Other income  (expense), net                                                                                                   |       | (65                             | )          | 75                            |       | (3 | ) | 118 |   |
| Total other  income                                                                                                            |       | 197                             |       | 216                           |       | 507 |   | 355 |   |
| **Income from continuing operations before income  taxes**                                                                     |       | 6,835                           |       | 2,574                         |       | 11,338 |   | 6,759 |   |
| **Provision for income taxes**                                                                                                 |       | 2,325                           |       | 824                           |       | 3,811 |   | 2,163 |   |
| **Income from continuing operations**                                                                                          |       | 4,510                           |       | 1,750                         |       | 7,527 |   | 4,596 |   |
| **Discontinued operations:**                                                                                                   |       |                            |       |                          |       |   |   |   |   |
| Gain on closure  of skin care center including a revision of leasehold obligations of $1,374,  less income tax expense of $515 |       | 0                               |       | 859                           |       | 0 |   | 859 |   |
| **Net income**                                                                                                                 |       | $                               | 4,510      |                          | $          | 2,609 |   | $ | 7,527 |   | $ | 5,455 |   |
|                                                                                                                           |       |                            |       |                          |       |   |   |   |   |
| **Net income per share of common stock**                                                                                       |       |                            |       |                          |       |   |   |   |   |
| **Basic:**                                                                                                                     |       |                            |       |                          |       |   |   |   |   |
| Income from  continuing operations                                                                                             |       | $                               | 0.20       |                          | $          | 0.08 |   | $ | 0.33 |   | $ | 0.20 |   |
| Gain from  discontinued operations                                                                                             |       | 0                               |       | 0.04                          |       | 0 |   | 0.04 |   |
| Net income                                                                                                                     |       | $                               | 0.20       |                          | $          | 0.12 |   | $ | 0.33 |   | $ | 0.24 |   |
| **Diluted:**                                                                                                                   |       |                            |       |                          |       |   |   |   |   |
| Income from  continuing operations                                                                                             |       | $                               | 0.19       |                          | $          | 0.07 |   | $ | 0.32 |   | $ | 0.20 |   |
| Gain from  discontinued operations                                                                                             |       | 0                               |       | 0.04                          |       | 0 |   | 0.04 |   |
| Net income                                                                                                                     |       | $                               | 0.19       |                          | $          | 0.11 |   | $ | 0.32 |   | $ | 0.24 |   |
|                                                                                                                           |       |                            |       |                          |       |   |   |   |   |
| **Weighted  average shares outstanding:**                                                                                      |       |                            |       |                          |       |   |   |   |   |
| Basic                                                                                                                          |       | 22,680                          |       | 22,363                        |       | 22,598 |   | 22,356 |   |
| Diluted                                                                                                                        |       | 23,498                          |       | 23,063                        |       | 23,366 |   | 23,058 |   |
|                                                                                                                           |       |                            |       |                          |       |   |   |   |   |
| **Net income**                                                                                                                 |       | $                               | 4,510      |                          | $          | 2,609 |   | $ | 7,527 |   | $ | 5,455 |   |
| **Other comprehensive income (loss), net of tax:**                                                                             |       |                            |       |                          |       |   |   |   |   |
| Foreign currency  translation adjustment                                                                                       |       | (356                            | )          | 1,210                         |       | (374 | ) | 1,023 |   |
|                                                                                                                           |       | $                               | 4,154      |                          | $          | 3,819 |   | $ | 7,153 |   | $ | 6,478 |   |

 

***Theaccompanying notes are an integral part of the unaudited consolidated financialstatements.***

 

4

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**CANDELA CORPORATION**

**Consolidated Statements of Cash Flows**

(inthousands)

(unaudited)

 
| ** **                                                                              | ** ** | **For the six months ended:** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                              | ** ** | **December 31,**              | ** ** | **January 1,** | ** ** |
| ** **                                                                              | ** ** | **2005**                      | ** ** | **2005** | ** ** |
| **Cash flows from operating activities:**                                               | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Net income                                                                              |       | $                             | 7,527      |   | $ | 5,455 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:      |       |                          |       |   |   |
| Revision of  disposal of discontinued operations                                        |       | —                        |       | (1,374 | ) |
| Amortization of  share-based compensation expense                                       |       | 172                           |       | — |   |
| Depreciation and  amortization                                                          |       | 324                           |       | 362 |   |
| Provision for  bad debts                                                                |       | 300                           |       | 300 |   |
| Effect of  exchange rate changes on foreign currency denominated assets and liabilities |       | 59                            |       | 59 |   |
| Increase  (decrease) in cash from working capital:                                      |       |                          |       |   |   |
| Accounts  receivable                                                                    |       | 1,424                         |       | 4,245 |   |
| Notes receivable                                                                        |       | 351                           |       | (327 | ) |
| Inventories                                                                             |       | (1,190                        | )          | 397 |   |
| Other current  assets                                                                   |       | (342                          | )          | (1,865 | ) |
| Other assets                                                                            |       | (2,887                        | )          | 369 |   |
| Accounts payable                                                                        |       | (3,988                        | )          | (975 | ) |
| Accrued payroll  and related expenses                                                   |       | (1,581                        | )          | (2,157 | ) |
| Deferred revenue                                                                        |       | 1,442                         |       | 1,714 |   |
| Accrued warranty  costs                                                                 |       | (124                          | )          | (218 | ) |
| Income taxes  payable                                                                   |       | (815                          | )          | 1,787 |   |
| Other accrued  liabilities                                                              |       | 426                           |       | (122 | ) |
| Change in  restricted cash                                                              |       | 20                            |       | (3 | ) |
| Net cash provided by operating activities                                               |       | 1,118                         |       | 7,647 |   |
|                                                                                    |       |                          |       |   |   |
| **Cash flows from investing activities:**                                               |       |                          |       |   |   |
| Purchases of  property and equipment                                                    |       | (260                          | )          | (468 | ) |
| Purchases of  held-to-maturity marketable securities                                    |       | (9,994                        | )          | — |   |
| Net cash used for investing activities                                                  |       | (10,254                       | )          | (468 | ) |
|                                                                                    |       |                          |       |   |   |
| **Cash flows from financing activities:**                                               |       |                          |       |   |   |
| Proceeds from  the issuance of common stock                                             |       | 2,454                         |       | 419 |   |
| Net cash provided by financing activities                                               |       | 2,454                         |       | 419 |   |
|                                                                                    |       |                          |       |   |   |
| Effect of exchange rates on cash and cash  equivalents                                  |       | (118                          | )          | 1,061 |   |
|                                                                                    |       |                          |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                               |       | (6,800                        | )          | 8,659 |   |
| **Cash and cash equivalents at beginning of period**                                    |       | 56,383                        |       | 37,139 |   |
| **Cash and cash equivalents at end of period**                                          |       | $                             | 49,583     |   | $ | 45,798 |   |

 

***Theaccompanying notes are an integral part of the unaudited consolidated financialstatements.***

 

5

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**1.****                   Basis ofPresentation**

 

The accompanying unaudited consolidated financialstatements and notes do not include all of the disclosures made in the AnnualReport on Form 10-K of Candela Corporation (the “Company”, or “Candela”) forfiscal year 2005, 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 2, 2005, which was derived from the audited consolidatedbalance sheet dated July 2, 2005. 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 and six-month periods ended December 31,2005 are not necessarily indicative of the results to be expected for the fullyear.

 

**Recent Accounting Pronouncements**:

 

In December 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standards No. 123(Revised 2004) (SFAS No. 123R), “Share-Based Payment”. SFAS No. 123R is arevision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” andsupersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees” and its related implementation guidance. TheStatement focuses primarily on accounting for transactions in which an entityobtains employee services through share-based payment transactions. The Companyadopted the standard as of July 3, 2005 (see Note 3).

 

In November 2004, the FASB issued SFAS No. 151, “InventoryCosts”. The Statement amends Accounting Research Bulletin No. 43 to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and spoilage. The Statement also requires that the allocation of fixedproduction overheads to inventory be based on normal production capacity. TheCompany adopted the standard as of July 3, 2005. The adoption did not have animpact on the Company’s consolidated financial statements.

 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections.” The Statement replaces APB Opinion No. 20, “AccountingChanges” and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatements.” SFAS No. 154 requires companies to apply voluntary changes inaccounting principles retrospectively whenever practicable. The requirementsare effective for the Company beginning in fiscal 2007. Adoption of theStatement is not expected to have a significant impact on the Company’sconsolidated financial statements.

 

6

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**2.****                   DiscontinuedOperations**

 

On September 27, 2003,management initiated a plan to close its only remaining skin care center. Theclosure is accounted for as a discontinued operation in accordance with SFAS No. 144 “*Accountingfor the Impairment or Disposal of Long-Lived Assets*” and SFAS No. 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.

 

During the three-month period ended October 2, 2004,the landlord for the Boston facility secured a sublease for that property.  The Company was not able to determine thefuture economic benefit of the sublease at that time. The sublessee commencedmaking payments to the landlord during December of 2004.  As a result of these and future payments scheduledunder the sublease, the Company revised the estimated future costs associatedwith the Boston facility and, in the quarter ended January 1, 2005, reversedapproximately $859 of the restructuring reserve. This reversal represents theaforementioned anticipated economic benefit due to sublessee payments of $1,703,net of legal and other fees of approximately $329 and income taxes ofapproximately $515, and was recognized in the three-month period ended January1, 2005.

 

The following table reflects the combinedrestructuring charges incurred in the six month period ended December 31, 2005:

 
| ** **                       | ** ** | **Leasehold**    | ** ** | ** **   | ** ** | ** ** | ** ** |
|----------------------------------|------------|------------------|------------|--------------|------------|------------|------------|
| ** **                       | ** ** | **Improvements** | ** ** | ** **   | ** ** | ** ** | ** ** |
| ** **                       | ** ** | **and Fixed**    | ** ** | **Facility** | ** ** | ** ** | ** ** |
| **(in thousands)**               | ** ** | **Assets**       | ** ** | **Costs**    | ** ** | **Total**  | ** ** |
| **Balance at July 2, 2005**      | ** ** | **$**            | **97**     | ** **   | **$**      | **898**    | ** ** | **$** | **995** | ** ** |
| **Non-cash amortization**        | ** ** | **50**           | ** ** | **225**      | ** ** | **275**    | ** ** |
| **Balance at December 31, 2005** | ** ** | **$**            | **47**     | ** **   | **$**      | **673**    | ** ** | **$** | **720** | ** ** |

 

At December 31, 2005, thediscontinued segment had a net liability of approximately $1.5 million consistingprimarily of a reserve of $0.7 million and deferred gift certificate revenue of$0.8 million.

 

**3.****              Stock-basedCompensation**

 

Effective July 3, 2005, theCompany implemented the fair value recognition provisions of SFAS No. 123R andStaff Accounting Bulletin 107 (“SAB 107”) for all share-based compensation thatwas not vested as of July 2, 2005. The Company adopted SFAS No. 123R using amodified prospective application, as permitted under SFAS No. 123R.Accordingly, prior period amounts have not been restated. Under this application, the Company isrequired to record compensation expense for all awards granted after the dateof adoption and for the unvested portion of previously granted awards thatremain outstanding at the date of adoption.

 

The application of SFAS No. 123Rand SAB 107 during the six-month period ended December 31, 2005 resulted in therecognition of share-basedcompensation expense of approximately $172. This expense was divided betweenoperating expense cost centers based upon the functional responsibilities ofthe individual holding the respective options.

 

7

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The fair value of eachoption award is estimated on the date of grant using the Black-Scholes-Mertonoption-pricing model incorporating the assumptions noted in the followingtable. Expected volatilities are based on historical volatility of the Company’sstock price over the last ten years and other factors. The expected term of theoptions is based on historical observations of the Company’s stock over thepast ten years, considering average years to exercise for all optionsexercised, average years to cancellation for all options cancelled and averageyears remaining for outstanding options, which was calculated based on theweighted-average vesting period plus the weighted-average of the differencebetween the vesting period and average years to exercise and cancellation. Therisk-free rate used is the U.S. Treasury rate based on the expected life forthe stock options.

 
| ** **                                      | ** ** | **2006**   | ** ** |
|-------------------------------------------------|------------|------------|------------|
| **Risk-free interest rate**                     | ** ** | **4.25**   | **%**      |
| **Estimated volatility**                        | ** ** | **73**     | **%**      |
| **Expected life for stock options (yrs)**       | ** ** | **3.42**   | ** ** |
| **Expected life for stock purchase plan (yrs)** | ** ** | **0.5**    | ** ** |
| **Expected dividends**                          | ** ** | **—** | ** ** |

 

Prior to July 3, 2005, theCompany followed the provisions of SFAS No. 123, “Accounting forStock-Based Compensation”. The provisions of SFAS No. 123 allowed companies toeither expense the estimated fair value of stock options or to continue tofollow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”), but disclose the pro forma effectson net income (loss) had the fair value of the options been expensed.Candela elected to apply APB 25 in accounting for its stock option incentiveplans.

 

In accordance with APB 25and related interpretations, compensation expense for stock options wasrecognized 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 was equal to the fair market value of Candela common stock at the date ofgrant, thereby resulting in no recognition of compensation expense by Candelaprior to July 3, 2005.

 

Had compensation cost forCandela’s stock option plans been determined based on the fair value method setforth in SFAS No. 123 during the prior year, Candela’s net income andbasic and diluted net income per common share would have been changed tothe pro forma amounts indicated below:

 
| ** **                                                                                                                                         | ** ** | **For the three months ended:** | ** ** | **For the six months ended:** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **January 1,**                  | ** ** | **January 1,**                | ** ** |
| **(in thousands, excepts per  share data)**                                                                                                        | ** ** | **2005**                        | ** ** | **2005**                      | ** ** |
| **Net  income, as reported**                                                                                                                       | ** ** | **$**                           | **2,609**  | ** **                    | **$**      | **5,455** | ** ** |
| **Deduct:  total stock-based employee compensation expense, determined under fair value  based method for all awards, net of related tax effects** | ** ** | **(138**                        | **)**      | **(289**                      | **)**      |
| **Pro  forma net income**                                                                                                                          | ** ** | **$**                           | **2,471**  | ** **                    | **$**      | **5,166** | ** ** |
| **Net  income per share of common stock**                                                                                                          | ** ** | ** **                      | ** ** | ** **                    | ** ** |
| **Basic -  as reported**                                                                                                                           | ** ** | **$**                           | **0.12**   | ** **                    | **$**      | **0.24** | ** ** |
| **Basic -  pro forma**                                                                                                                             | ** ** | **$**                           | **0.11**   | ** **                    | **$**      | **0.23** | ** ** |
| **Diluted  - as reported**                                                                                                                         | ** ** | **$**                           | **0.11**   | ** **                    | **$**      | **0.24** | ** ** |
| **Diluted  - pro forma**                                                                                                                           | ** ** | **$**                           | **0.11**   | ** **                    | **$**      | **0.22** | ** ** |

 

8

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

 
| ** **                                      | ** ** | **2005**   | ** ** |
|-------------------------------------------------|------------|------------|------------|
| **Risk-free interest rate**                     | ** ** | **4.25**   | **%**      |
| **Estimated volatility**                        | ** ** | **78**     | **%**      |
| **Expected life for stock options (yrs)**       | ** ** | **2.96**   | ** ** |
| **Expected life for stock purchase plan (yrs)** | ** ** | **0.5**    | ** ** |
| **Expected dividends**                          | ** ** | **—** | ** ** |

 

**StockPlans**

 

### **1990 Candela Corporation Employee Stock PurchasePlan**

 

The 1990 Employee StockPurchase Plan (the “Purchase Plan”) provides for the sale of up to 1,500,000shares of common stock to eligible employees. The shares are issued at 85% of the market price on the last day ofsemi-annual periods.  Substantially allfull-time employees are eligible to participate in the Purchase Plan.  At December 31, 2005 there were 707,081shares available for sale.  Compensationexpense for the purchase plan is recognized over the vesting period.

 

**1998Candela Corporation Stock Option Plan**

 

Effective October 5, 2005, the1998 Stock Option Plan (the “Stock Option Plan”) was amended for granting ofincentive stock options, non-qualified stock options, and stock appreciationrights (SARS).  The stock options providethe holder the right to purchase common stock at an exercise price not lessthan the fair market value of the stock on the date of grant.  SARS provide the holder the right to receivean amount, payable in stock, cash or in any combination of these, equal to theexcess of the market value of our common shares on the date of exercise overthe base price at the time of the grant. The base price may not be less than the market price of our commonshares on the date of the grant.

 

Options and rights granted under the 1998 Stock Option Plan becomeexercisable on the date of grant or in installments, as specified by aCommittee established by the Board of Directors, and expire ten years from thedate of the grant.  The maximum number ofshares for which options and rights may be granted under the 1998 Stock OptionPlan is 5,300,000. Where payment upon exercise of a SAR is made in shares ofCommon Stock, only the net number of shares of Common Stock issued inconnection with such exercise shall be deemed “issued” for this purposes.

 

9

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The following is a summaryof stock option activity under the Plans:

 
| ** **                                       | ** ** | **Number of  Shares** | ** ** | **Weighted Avg.  Exercise Price  per Share** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted Avg.  Contractual  Term** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|
|                                             |       |                  |       |                                         |       |                            |       |                                 |       |
| Balance outstanding at July 2, 2005              |       | 2,484,560             |       |                                         |       |                            |       |                                 |       |
|                                             |       |                  |       |                                         |       |                            |       |                                 |       |
| Granted                                          |       | —                |       |                                         |       |                            |       |                                 |       |
| Exercised                                        |       | (332,236              | )          |                                         |       |                            |       |                                 |       |
| Forfeited                                        |       | (27,568               | )          |                                         |       |                            |       |                                 |       |
| Balance outstanding at December 31, 2005         |       | 2,124,756             |       | $                                            | 7.82       |                            | $          | 14,385,537                           |       | 7.33 years |   |
|                                             |       |                  |       |                                         |       |                            |       |                                 |       |
| Options exercisable at December 31, 2005         |       | 1,868,506             |       | $                                            | 8.14       |                            | $          | 12,093,262                           |       | 7.30 years |   |
|                                             |       |                  |       |                                         |       |                            |       |                                 |       |
| Options available for grant at December 31, 2005 |       | 1,073,222             |       |                                         |       |                            |       |                                 |       |

 

There were no options orSARS granted during the six-month period ended December 31, 2005. The totalintrinsic value of options exercised during the six-month period ended December31, 2005 was $5.4 million.

 

A summary of the status of non-vested stock options asof December 31, 2005, and changes during the fiscal quarter then ended issummarized below:

 
| ** **                              | ** ** | **Number of  Shares** | ** ** | **Weighted Avg.  Grant Date  Fair Value** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-------------------------------------------|------------|
|                                    |       |                  |       |                                      |       |
| Non-vested options at July 2, 2005      |       | 332,500               |       | $                                         | 3.74       |   |
|                                    |       |                  |       |                                      |       |
| Granted                                 |       | —                |       | —                                    |       |
| Vested                                  |       | (76,250               | )          | $                                         | 3.22       |   |
| Forfeited                               |       | —                |       | —                                    |       |
| Non-vested balance at December 31, 2005 |       | 256,250               |       | $                                         | 3.87       |   |

 

As of December 31, 2005,there was approximately $319 thousand of total unrecognized compensation costrelated to non-vested stock options granted under our incentive plans. Thiscost is expected to be recognized over a weighted-average period of 1.7 years.

 

The amount of cash receivedfrom the exercise of stock options during the six-month ended December 31, 2005was approximately $2.5 million.

 

10

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**4.****                   Earnings perShare**

 

Basic earnings per share is computed by dividing netincome by the weighted average number of shares of common stock outstanding forthe period and, if there are dilutive securities, diluted earnings per share iscomputed by including common stock equivalents outstanding for the period inthe denominator.

 

Common stock equivalents include shares issuable uponthe exercise of stock options or warrants, net of shares assumed to have beenpurchased with the proceeds, using the treasury stock method.

 
| ** **                                                                        | ** ** | **For the three months ended:** | ** ** | **For the six months ended:** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                        | ** ** | **December 31,**                | ** ** | **January 1,**                | ** ** | **December 31,** | ** ** | **January 1,** | ** ** |
| **(in thousands, except per share  data)**                                        | ** ** | **2005**                        | ** ** | **2005**                      | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic shares used in the calculation of earnings  per share**                   | ** ** | **22,680**                      | ** ** | **22,363**                    | ** ** | **22,598** | ** ** | **22,356** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Effect of dilutive securities:**                                                | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Stock options**                                                                 | ** ** | **818**                         | ** ** | **700**                       | ** ** | **768** | ** ** | **702** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Diluted shares used in the calculation of  earnings per share**                 | ** ** | **23,498**                      | ** ** | **23,063**                    | ** ** | **23,366** | ** ** | **23,058** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per  share effect of dilutive securities on income from continuing operations** | ** ** | **$**                           | **.01**    | ** **                    | **$**      | **.01** | ** ** | **$** | **.01** | ** ** | **$** | **.00** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per share effect of dilutive securities on net  income**                        | ** ** | **$**                           | **.01**    | ** **                    | **$**      | **.01** | ** ** | **$** | **.01** | ** ** | **$** | **.00** | ** ** |

 

During the six-month period ended December 31, 2005,options to purchase 4 thousand shares of common stock were excluded from thecalculation of diluted earnings per share because the exercise price of suchoptions was greater than the average market price of the common stock for theperiod.  During the three-months period endedDecember 31, 2005, the average market price of the common stock was greaterthan the exercise price of such options; therefore all options were included inthe calculation of diluted earnings per share.

 

During the three-and six-month periods ended January1, 2005, options to purchase 335 thousand and 351 thousand shares of commonstock, respectively, were excluded from the calculation of diluted earnings pershare because the exercise prices of such options were greater than the averagemarket price of the common stock for the period.

 

**5.****                   CashEquivalent, Marketable Securities and Long-term Investments**

 

Cash equivalents are stated at cost, whichapproximates market value, and have remaining maturities of three months orless at the date of purchase.

 

The Company invests in high quality debtsecurities.  As of December 31, 2005, theCompany held marketable debt securities of $10 million as marketable securitiesof which $3 million is classified as short-term and $7 million is classified aslong-term investments.  These investmentsare classified as held-to-maturity, as the Company has the intent and abilityto hold them to maturity. Held-to-maturity debt securities are reported at amortized cost whichapproximates fair value.  Currentmarketable securities include investments that are expected to mature in morethan three months and up to twelve months from the date of purchase.

 

11

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Long-term investments have remaining maturities ofone-to three years from the date of purchase. Unrealized gains and losses related to the marketable securities are notconsidered a permanent decline in the market value of such securities.  There have been no material realized gains orlosses as of December 31, 2005.

 

**6.****                   Inventories**

** **
| ** **          | ** ** | **December 31,** | ** ** | **July 2,** | ** ** |
|---------------------|------------|------------------|------------|-------------|------------|
| **(in thousands)**  | ** ** | **2005**         | ** ** | **2005**    | ** ** |
| ** **          | ** ** | ** **       | ** ** | ** **  | ** ** |
| **Raw materials**   | ** ** | **$**            | **5,019**  | ** **  | **$**      | **3,968** | ** ** |
| **Work in process** | ** ** | **866**          | ** ** | **166**     | ** ** |
| **Finished goods**  | ** ** | **7,975**        | ** ** | **8,542**   | ** ** |
| ** **          | ** ** | **$**            | **13,860** | ** **  | **$**      | **12,676** | ** ** |

 

**7.****                  SegmentInformation**

 

The Company operates in one industry segment: thedesign, manufacture, sale, and service of medical devices and relatedequipment.

 

**8.****                   Guarantees**

 

The Company’s products generally carry astandard warranty. The Company sets aside a reserve based on anticipatedwarranty claims at the time product revenue is recognized. In anticipation ofactual warranty claims, the Company amortizes the reserve ratably over the lifeof the warranty thereby offsetting actual warranty claims incurred. Actualwarranty claims incurred and charged to product cost of sales during an interimperiod may be more or less than the amount of amortized warranty reserveallocated against them. Factors that affect the Company’s product warrantyliability include the number of installed units, the anticipated cost ofwarranty repairs and historical and anticipated rates of warranty claims.

 

The following table reflects changes in the Company’saccrued warranty account during the six-month period ended December 31, 2005:

 
| **(in thousands)**                             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------|------------|
| **Beginning balance July 2, 2005**             | ** ** | **$**      | **8,646**  | ** ** |
| **Plus  accruals related to new sales**        | ** ** | **3,686**  | ** ** |
| **Less amortization of prior period accruals** | ** ** | **3,442**  | ** ** |
| **Ending balance on December 31, 2005**        | ** ** | **$**      | **8,890**  | ** ** |

 

The Company also offers extended service contractsthat may be purchased after a standard warranty has expired. Service contractsmay be purchased for periods from one to five years. The Company recognizesservice contract revenue ratably over the life of the contract. Actual servicecontract expenses incurred and charged to service cost of sales during aninterim period may be more or less than the amount of amortized servicecontract revenue recognized in that period.

 

12

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Revenues are recognized when a signed non-cancelablepurchase order exists, the product is shipped, title and risk have passed tothe customer, the fee is fixed or determinable, and collection is considered probable.Circumstances which generally preclude the immediate recognition of revenueinclude shipping terms of FOB destination or the existence of a customeracceptance clause in a contract based upon customer inspection of the product.In these instances, revenue is deferred until adequate documentation isobtained to ensure that these criteria have been fulfilled.

 

The following table reflects changes in the Company’sdeferred revenue account during the six-month period ended December 31, 2005:

 
| **(in thousands)**                       | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| **Beginning balance July 2, 2005**       | ** ** | **$**      | **8,350**  | ** ** |
| **Plus deferral of new sales**           | ** ** | **6,511**  | ** ** |
| **Less recognition of deferred revenue** | ** ** | **5,536**  | ** ** |
| **Ending balance on December 31, 2005**  | ** ** | **$**      | **9,325**  | ** ** |

 

The Company has anagreement (the “Agreement”) with an independent leasing company whereby theCompany 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 reachlevels specified in the Agreement.  TheUNL Provision of the Agreement was eliminated for any lease initiated afterDecember 31, 2002.  Since the inceptionof the Agreement, the cumulative amounts paid to the leasing company under theUNL Provision have not been significant.

 

**9.****                  ****Commitments and Contingencies**

 

In August 2000, the Companyentered into an agreement to amend its license agreement with The Regents ofthe University of California (the “Regents”) whereby in exchange for anexclusivity fee of approximately $1.7 million, which was prepaid in full,Candela obtained exclusive license rights to the DCD (subject to certainlimited license rights of Cool Touch, Inc. (“Cool Touch”)) in the followingfields of use:  procedures that involveskin resurfacing and rejuvenation, vascular skin lesions, and laser hairremoval.  Cool Touch, a subsidiary of NewStar Technology, Inc., obtained a license to the DCD on a co-exclusive basiswith Candela, in certain narrower fields of use.  Cool Touch is restricted in its ability toassign its license rights to certain existing competitors of Candela.  Candela is entitled to one-half of allroyalty income payable to the Regents from Cool Touch.  Under the amended agreement, Candela nolonger is required by the Regents to negotiate sublicenses to thirdparties.  However, Candela is entitled toone-half of all royalties due from any other entity that licenses the DCDtechnology from the Regents in other fields of use.  The Company recognized royalty expense of$9.2, $2.6, and $3.4 million for fiscal 2005, 2004, and 2003, respectively,based on the license agreement with the Regents. Included in the fiscal 2005expense of $9.2 million is $4.8 of expense taken in the third quarter as a chargetaken related to the Regents arbitration decision. Of that $4.8 million, $1.3million related to fiscal 2005, $3.0 million related to fiscal 2004 and 0.5million related to fiscal 2003.

 

EffectiveJuly 3, 2005, the Company amended certain portions of its agreement with theRegents whereby for the annual license fee of $0.3 million, the Company’sroyalty obligation was reduced to 3% from its prior level of 6%. The annual feeof $0.3 million is payable by a lump sum of $3.0 million and is being amortizedover the remaining life of the patent agreement, which as of July 3, 2005 was10 years. This reduced royalty rate and the amortization of the annual licensefee payment is reflected in the Company’s financial statements as of December 31,2005. The unamortized portion of the license fee payment is reflected inprepaid licenses on the December 31, 2005 balance sheet.

 

13

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**10.****           ****Commitments and Contingencies**

 

On August 20, 2005, DVIInc., DVI Financial Services, Inc., and DVI Business Credit CorporationLiquidating Trust (collectively, the “DVI Entities”) filed a complaint againstthe Company in the United States Bankruptcy Court for the District ofDelaware.  The DVI Entities filedvoluntary petitions for relief under Chapter 11 of the United States BankruptcyCode on August 25, 2003 (the “Petition Date”). The complaint asserts, among other things, that (i) on or within 90 daysbefore the Petition Date, one or more of the DVI Entities transferred propertyto or for the benefit of the Company in an aggregate amount not less than$1,878,921.75, (ii) at the time of the transfers the DVI Entities wereinsolvent, (iii) the transfers enabled the Company to receive more than theCompany was entitled to under the United States Bankruptcy Code, and (iv) thetransfers constitute an avoidable preference.  The complaint seeks avoidance and recovery ofthe transfers, plus interest and costs of the proceeding.  The complaint also seeks, among other things,to disallow the Company’s claims against the DVI Entities until the Company haspaid the recovery amount to the DVI Entities. As previously disclosed in the Company’s periodic reports, prior to thefiling of the complaint, the Company had received demands for paymentof the recovery amount.  The Companybelieves that it received all transfers from the DVI Entities in theordinary course of business and that the allegations in the complaint arewithout merit.

 

From time to time, theCompany is a party to various legal proceedings incidental to itsbusiness.  Except for the bankruptcypreference claims in the DVI matter, 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.

 

14

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**CANDELACORPORATION**

 

**Item 2 -****Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

**Overview**

 

We research, develop, manufacture, market and service lasers used toperform aesthetic and cosmetic procedures. We sell our lasers to physicians andpersonal care practitioners.  We marketour products directly and through a network of distributors to end-users. Ourtraditional customer base includes plastic and cosmetic surgeons anddermatologists. More recently, we have expanded our sales to a broader group ofpractitioners consisting of general practitioners and certain specialistsincluding obstetricians, gynecologists and general and vascular surgeons.  We derive our revenue from the sales oflasers and other products and the provision of product-related services.

 

**Critical Accounting 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 2005.****

 

15

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**Results of Operations**

 

***Revenue.***

 

Revenue source by geographic region is reflected in the followingtable:

 
| ** **          | ** ** | **For the three months ended:** | ** ** |
|---------------------|------------|---------------------------------|------------|
| **(in thousands)**  | ** ** | **31-Dec-05**                   | ** ** | **1-Jan-05** | ** ** | **Change** | ** ** |
| ** **          | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **US revenue**      | ** ** | **$**                           | **18,469** | ** ** | **49** | **%** | **$** | **13,156** | ** ** | **47** | **%** | **$** | **5,313** | ** ** | **40** | **%** |
| **Foreign revenue** | ** ** | **19,251**                      | ** ** | **51** | **%** | **15,048** | ** ** | **53** | **%** | **4,203** | ** ** | **28** | **%** |
| ** **          | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**   | ** ** | **$**                           | **37,720** | ** ** | **100** | **%** | **$** | **28,204** | ** ** | **100** | **%** | **$** | **9,516** | ** ** | **34** | **%** |

 
| ** **          | ** ** | **For the  six months ended:** | ** ** |
|---------------------|------------|--------------------------------|------------|
| ** **          | ** ** | **31-Dec-05**                  | ** ** | **1-Jan-05** | ** ** | **Change** | ** ** |
| ** **          | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **US revenue**      | ** ** | **$**                          | **28,737** | ** ** | **44** | **%** | **$** | **22,580** | ** ** | **45** | **%** | **$** | **6,157** | ** ** | **27** | **%** |
| **Foreign revenue** | ** ** | **37,070**                     | ** ** | **56** | **%** | **28,015** | ** ** | **55** | **%** | **9,055** | ** ** | **32** | **%** |
| ** **          | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**   | ** ** | **$**                          | **65,807** | ** ** | **100** | **%** | **$** | **50,595** | ** ** | **100** | **%** | **$** | **15,212** | ** ** | **30** | **%** |

 

Consolidated Overview

 

Consolidated revenue increased 34% and 30% for a total of $9.5 and $15.2million, to $37.7 and $65.8 million for the three and six-month periods, respectively,ended December 31, 2005, as compared to the three and six-month periods endedJanuary 1, 2005. The increase was due primarily to an increase in demand forour products and product-related service on a worldwide basis, coupled with ouremerging ability to reach into new markets.

 

Foreign revenue accounted for approximately 51% of the consolidatedtotal revenue for the three-month period ended December 31, 2005.  The increase of 28% to $19.3 million for thethree-month period ended December 31, 2005, as compared to the three-month periodended January 1, 2005, was spread across all regions except for Germany whichshowed a decrease of $0.7 million while Latin America showed the most strength.Latin America revenue increased by 203% for the three-month period endedDecember 31, 2005, compared to the three-month period ended January 1, 2005, accountingfor approximately $3.1 million or 75% of the comparative increase whileincreases in the Far East and Europe were modest.

 

Foreign revenue accounted for approximately 56% of the consolidatedtotal revenue for the six-month period ended December 31, 2005.  Foreign revenue increased 32% to $37.1 millionfor the six-month period ended December 31, 2005, as compared to the six-monthperiod ended January 1, 2005. Year-to-date foreign revenue increased across allcountries with the exception of Germany which showed a decrease of $0.7 millionwhile Latin America showed the most strength. Year-to-date revenues in LatinAmerica increased by 460%, accounting for approximately $7.2 million or 79% ofthe year-over-year comparative increase while increases in the Far East andEurope were modest.

 

US revenue increased 40% and 27% for a total of $5.3 and $6.1 million,respectively, for the three-and six-month periods ended December 31, 2005, ascompared to the same periods during the prior fiscal year.

 

16

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Revenue source by type is reflected in the following table:

 
| ** **                     | ** ** | **For the three months ended:** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| **(in thousands)**             | ** ** | **31-Dec-05**                   | ** ** | **1-Jan-05** | ** ** | **Change** | ** ** |
| **Revenue**                    | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Lasers  and other products** | ** ** | **$**                           | **31,657** | ** ** | **84** | **%** | **$** | **23,539** | ** ** | **83** | **%** | **$** | **8,118** | ** ** | **34** | **%** |
| **Product-related  service**   | ** ** | **6,063**                       | ** ** | **16** | **%** | **4,665** | ** ** | **17** | **%** | **1,398** | ** ** | **30** | **%** |
| ** **                     | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**              | ** ** | **$**                           | **37,720** | ** ** | **100** | **%** | **$** | **28,204** | ** ** | **100** | **%** | **$** | **9,516** | ** ** | **34** | **%** |

 
| ** **                     | ** ** | **For the six months ended:** | ** ** |
|--------------------------------|------------|-------------------------------|------------|
| ** **                     | ** ** | **31-Dec-05**                 | ** ** | **1-Jan-05** | ** ** | **Change** | ** ** |
| **Revenue**                    | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Lasers  and other products** | ** ** | **$**                         | **53,882** | ** ** | **82** | **%** | **$** | **41,882** | ** ** | **83** | **%** | **$** | **12,000** | ** ** | **29** | **%** |
| **Product-related  service**   | ** ** | **11,925**                    | ** ** | **18** | **%** | **8,713** | ** ** | **17** | **%** | **3,212** | ** ** | **37** | **%** |
| ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Total revenue**              | ** ** | **$**                         | **65,807** | ** ** | **100** | **%** | **$** | **50,595** | ** ** | **100** | **%** | **$** | **15,212** | ** ** | **30** | **%** |

 

Theincrease in revenue from lasers and other products for the three-month periodended December 31, 2005, compared to the three-month period ended January 1, 2005, resultedprimarily from an increase in the sales volume of our GentleYagTM product line,continued strength of our GentleLaseTM line, and the introduction during thethird quarter of last year of the EllipseTM product line. Theincrease in revenue from product-related service for the three-month periodended December 31, 2005, compared to the three-month period ended January 1,2005, and 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.

 

Theincrease in laser and other product revenue for the six month period endedDecember 31, 2005, compared to the six month period ended January 1, 2005,resulted primarily from an increase in the sales volume of our GentleYagTMproduct line of approximately $6.7 million and GentleLaseTM product line of $3.4million. Product-related service increased $3.2 million during the six-monthperiod ended December 31, 2005, compared to the comparative January 1, 2005,period, and 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.

 

***Gross Profit. ***Grossprofit increased to approximately $19 million or 50.3% of revenues for the three-monthperiod ended December 31, 2005, compared to gross profit of approximately $14.0million or 49.6% for the same period one year earlier.  Gross profit increased to approximately $33.5million or 51.0% of revenues for the six-month period ended December 31, 2005,compared to gross profit of approximately $26.0 million or 51.4% for the sameperiod one year earlier.  The increasesin gross profit result principally from the increase in sales volume.

 

***Selling, General and Administrative Expense. ***Selling,general and administrative expenses increased to approximately $10.5 millionfor the three-month period ended December 31, 2005, from approximately $10.0million for the three-month period ended January 1, 2005.  As a percentage of revenue, selling, generaland administrative expenses decreased to 27.9% from 35.4% of revenues from thecomparative prior year period.  Thisdecrease was due to legal fees related to the settlement of the Regent lawsuitand fees related to implementation requirements of Section 404 of theSarbanes-Oxley Act for the three month end January 1, 2005.  For the six-month period ended December 31,2005, selling, general and administrative expenses increased to approximately $19.3million from approximately $16.7 million for the six-month period ended January1, 2005.  As a percentage of revenue,selling, general and administrative expenses decreased to 29.3% from 32.9%.  The decrease is due to legal fees related tothe settlement of the Regents lawsuit and

 

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feesincurred as a result in the implementation of Section 404 of the Sarbanes-OxleyAct for the six-month period ended January 1, 2005.

 

***Research and Development Expense. ***Research and development spending increased to $1.8million for the three-month period ended December 31, 2005, from $1.6 million forthe three-month period ended January 1, 2005, due primarily to an increase inthe number of active projects and an increase in employee costs. Spending inthis area increased to $3.4 million for the six-month period ended December 31,2005, from $3.0 million for the six-month period ended January 1, 2005 dueprimarily to the aforementioned increase in project spending and an increase inemployee-related costs.

 

***Other Income/Expense. ***Otherincome was approximately $0.2 million for the three-months ended December 31,2005, and January 1, 2005. For the six-month period ended December 31, 2005,other income was approximately $0.5 million compared to other income ofapproximately $0.4 million for the six-month period ended January 1, 2005. Theseamounts principally represent interest income on our cash and cash equivalents,marketable securities and long-term securities.

 

***Income Taxes. ***Theprovision for income taxes results from a combination of activities of both thedomestic and foreign subsidiaries of the Company.  Excluding discontinued operations, werecorded approximately a 34% effective tax rate for both the three and six-monthperiods ended December 31, 2005, compared to the three and six-month periodsended January 1, 2005, in which we recorded a 32% effective tax rate.  The provision for income taxes differs fromthe U.S. statutory rate as a result of tax provisions calculated for incomegenerated by foreign subsidiaries at a rate that differs from the U.S.statutory rate.

 

**Discontinued Operations**

 

On September 27, 2003, we permanently closed our only remaining skincare center, which was located in Boston. The closure of the Boston skin carecenter, together with the earlier closing of our Scottsdale, Arizona spa, andthe associated cessation of this line of business, is accounted for asdiscontinued operations. As a result of the closure of the Boston skin carecenter, in the fiscal quarter ended September 27, 2003, we recorded a $2.1million charge for the accrual of $3.0 million of future occupancy costs and$0.3 million of severance obligations and other related costs of closure, netof anticipated tax benefits of $1.3 million. In addition, both the financialstatements for the three months ended October 2, 2004 and all prior financialstatements have been restated to reflect skin care center operations asdiscontinued.  During the three-monthperiod ended October 2, 2004, the landlord for the Boston facility secured asublease for that property.  The Companywas not able to determine the future economic benefit of the sublease at thattime. The sublessee commenced making payments to the landlord during Decemberof 2004.  As a result of these and futurepayments scheduled under the sublease, the Company revised the estimated futurecosts associated with the Boston facility and, in the quarter ended January 1,2005, reversed approximately $0.9 million of the restructuring reserve. Thisreversal represents the anticipated economic benefit due to sublessee paymentsof $1.7 million, net of legal and other fees of approximately $0.3 million, andincome taxes of approximately $0.5 million.

 

The Company believes that the remaining accrual is sufficient to coverall future leasehold expenses for the remainder of the lease term. Theseexpenses could potentially increase if the sublessee were not to honor itsobligation.

 

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**Liquidity and Capital Resources**

 

Cash provided by operating activities amounted to $1.1 million for thesix-month period ended December 31, 2005, in comparison to cash provided byoperating activities of $7.6 million for the same period in the prior year.This decrease in cash provided by operating activities is primarily the paymentof liabilities and the lump sum payment of an annual licensing fee offset bythe increase in revenue.  Cash used byinvesting activities reflected the purchase of held-to-maturity investmentsduring the six-month period ended December 31, 2005.  Cash provided by financing activitiesamounted to $2.5 million for the six-month period ended December 31, 2005, incomparison to cash provided of $0.4 million for the same period during theprior year.  The increase reflects proceedsfor the issuance of stock by the Company, primarily to employees under theexisting stock option plan and purchase plan.

 

**Off-Balance Sheet Arrangements**

 

The Company did not have any off-balancesheet arrangements that have or are reasonably likely to have a current orfuture effect on the Company’s financial condition, changes in financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

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

 
| ** **                         | ** ** | ** ** | ** ** | **Less than** | ** ** | ** **    | ** ** | ** **    | ** ** | **After**   | ** ** |
|------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|---------------|------------|-------------|------------|
| **(in thousands)**                 | ** ** | **Total**  | ** ** | **1 year**    | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **5 years** | ** ** |
|                               |       |       |       |          |       |          |       |          |       |        |       |
| Royalty commitments                |       | $          | 5,750      |          | $          | 1,000         |       | $             | 2,000      |        | $          | 1,625 |   | $ | 1,125 |   |
|                               |       |       |       |          |       |          |       |          |       |        |       |
| Operating leases                   |       | $          | 3,375      |          | $          | 1,292         |       | $             | 1,819      |        | $          | 244 |   | $ | 20 |   |
|                               |       |       |       |          |       |          |       |          |       |        |       |
| Total contractual cash obligations |       | $          | 9,125      |          | $          | 2,292         |       | $             | 3,819      |        | $          | 1,869 |   | $ | 1,145 |   |

 

We also maintain a renewable $10,000,000 revolving credit agreementwith a major bank with interest at the bank’s base rate, or LIBOR plus2.25%.  Any borrowings outstanding underthe line of credit are due on demand or according to a payment scheduleestablished at the time funds are borrowed. The line of credit is unsecured. The agreement contains restrictive covenants limiting the establishmentof new liens, and the purchase of margin stock. No amounts were outstanding under the line of credit as of December 31,2005.

 

We believe that our current cash balances will be sufficient to meetanticipated cash requirements for the next twelve months.  However, we cannot be sure that we will notrequire additional capital beyond the amounts currently forecasted by us, orthat any such required additional capital will be available on reasonableterms, if at all, when such capital becomes required.

 

#### **CautionaryStatements**

 

This Quarterly Report on Form 10-Q contains forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of1995.  Forward-looking statements are notpromises or guarantees and are subject to risks and uncertainties that couldcause our actual results to differ materially from those anticipated.  Such statements may relate to, among otherthings, the future of the industry, product development, business strategy(including the possibility of future acquisitions), anticipated operational andcapital expenditure levels, continued acceptance and growth of our products,and dependence on significant customers and suppliers.  Forward-looking statements may also include,without limitation, any statement relating to future events, conditions orcircumstances or using words such as or similar to:  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 

 

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July 2, 2005, as well as other risks and uncertainties referenced inthis Quarterly Report.  These risks anduncertainties include, but are not limited to, the following:

 

•                  Ourprincipal source of liquidity is our cash and cash equivalents and marketablesecurities. Our ability to generate cash from operations is dependant upon ourability to generate revenue from selling our lasers and other products andproviding product-related services. A decrease in demand for our products andrelated services or increases in operating costs would likely have an adverseeffect on our 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.

 

•                  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.

 

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

 

•                  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 place undue reliance uponany forward-looking statements, which speak only as of the date made.  We expressly disclaim any obligation orundertaking to release publicly any updates or revisions to any such statementsto reflect any change in our expectations or any change in events, conditionsor circumstances on which any such statement is based.

 

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**Item 3 - Quantitative andQualitative Disclosures about Market Risk**

 

We have foreign subsidiaries in Japan, Spain, France, Germany, Italyand Portugal.  Approximately 56% of ourrevenues for the six-months ended December 31, 2005, 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 foreign currency exchange andoption contracts to reduce our exposure to foreign currency risk andvariability in operating results due to fluctuation in exchange ratesunderlying the value of current transactions and anticipated transactionsdenominated in foreign currencies.  These contracts obligate us to exchangepredetermined amounts of specified foreign currencies at specified exchangerates 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 currencyspeculation.

 

We are exposed to a variety of market risks, including changes ininterest rate affecting the return on its investments.  We generally place our marketable securitiesin high-quality debt instruments.  Wehave not experienced any material losses from our marketable securityinstruments and therefore believe that our potential interest rate exposure isnot material.

 

**Item 4 -Controls and Procedures**

 

Under the direction of our Chief ExecutiveOfficer and Chief Financial Officer, we evaluated our disclosure controls andprocedures and internal control over financial reporting and concluded that ourdisclosure controls and procedures were effective as of December 31, 2005.

 

During the six-month period ended December 31,2005, the Company remediated the material weakness in internal controls overfinancial reporting that arose from the existence of control deficiencies thatadversely impacted the Company’s ability to accurately and timely complete theCompany’s year-end close process which was reported in Candela’s Annual Reporton Form 10-K for the year ended July 2, 2005. More specifically, theCompany has implemented new procedures including providing for additionallevels of senior level review for accruals, certain judgmental estimates, and salesof demonstration units, and created additional management reports used for theanalysis of results.

 

Except as discussed above, there were nochanges in the Company’s internal control over financial reporting during thequarter ended December 31, 2005, that have materially affected, or arereasonably likely to materially affect, the Company’s internal controls overfinancial reporting

 

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**CANDELA CORPORATION**

 

**Part II.  Other Information**

 

**Item 1 -Legal Proceedings**

 

On August 20, 2005, DVI Inc., DVI Financial Services, Inc., and DVIBusiness Credit Corporation Liquidating Trust (collectively, the “DVI Entities”)filed a complaint against the Company in the United States Bankruptcy Court forthe District of Delaware.  The DVIEntities filed voluntary petitions for relief under Chapter 11 of the UnitedStates Bankruptcy Code on August 25, 2003 (the “Petition Date”).  The complaint asserts, among other things,that (i) on or within 90 days before the Petition Date, one or more of the DVIEntities transferred property to or for the benefit of the Company in anaggregate amount not less than $1,878,921.75, (ii) at the time of the transfersthe DVI Entities were insolvent, (iii) the transfers enabled the Company toreceive more than the Company was entitled to under the United StatesBankruptcy Code, and (iv) the transfers constitute an avoidablepreference.  The complaint seeksavoidance and recovery of the transfers, plus interest and costs of the proceeding.  The complaint also seeks, among other things,to disallow the Company’s claims against the DVI Entities until the Company haspaid the recovery amount to the DVI Entities. As previously disclosed in the Company’s periodic reports, prior to thefiling of the complaint, the Company had received demands for paymentof the recovery amount.  The Companybelieves that it received all transfers from the DVI Entities in theordinary course of business and that the allegations in the complaint arewithout merit.  While the Company intendsto vigorously contest the allegations, the litigation process is inherentlyuncertain and unpredictable and there can be no guarantee as to the ultimateoutcome of this pending lawsuit.  An adverse outcome in the litigationcould hurt our business, results of operations, and financial condition.

 

From time to time, the Company is a party tovarious legal proceedings incidental to its business.  Except for the bankruptcy preference claimsin the DVI matter, the Company believes that none of the legal proceedings thatare presently pending, if adversely decided to the Company, will have amaterial adverse effect upon its financial position, results of operations, orliquidity

 

**Item 4. Submission of Matters to a Vote of SecurityHolders**

 

On December 13, 2005, theCompany held its annual meeting of shareholders and voted on two proposals.

 

1)                                      At the Meeting, the vote on the election of seven(7) directors to hold office until the Company’s next****annual meeting, was as follows:

 
| ** **            | ** ** | **FOR**    | ** ** | **WITHHOLD** | ** ** |
|-----------------------|------------|------------|------------|--------------|------------|
|                  |       |       |       |         |       |
| George A. Abe         |       | 18,969,070 |       | 89,789       |       |
| Ben Bailey III        |       | 18,968,870 |       | 89,989       |       |
| Dr. Eric F. Bernstein |       | 18,957,658 |       | 101,201      |       |
| Nancy Nager           |       | 18,896,735 |       | 162,124      |       |
| Gerard E. Puorro      |       | 18,942,743 |       | 116,113      |       |
| Kenneth D. Roberts    |       | 18,969,143 |       | 89,716       |       |
| Douglas W. Scott      |       | 18,968,543 |       | 90,316       |       |

 

2)                                      At the Meeting, the vote on a proposal toratify the selection of BDO Seidman, LLP, was as follows:

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 18,979,240 |       | 39,793      |       | 39,826      |       |

 

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**ITEM 6 - Exhibits**

 

(a)                                  Exhibits

 
| Exhibit 10.1 |   | Second Amended and Restated 1998 Stock Plan                                                                                                             |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                    |
| 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 the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                   |   | CANDELA CORPORATION                                                              |
|------------------------|--------|----------------------------------------------------------------------------------|
|                   |   |                                                                             |
|                   |   |                                                                             |
| Date: February 7, 2006 |   | /s/ F. Paul Broyer                                                               |   |
|                   |   | F. Paul Broyer                                                                   |
|                   |   | (Senior Vice President, Finance and Administration  and Chief Financial Officer) |

 

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**CandelaCorporation**

 

**INDEX TO EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                         |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                    |
| Exhibit 10.1    |       | Second Amended and Restated 1998 Stock Plan                                                                                                             |
|            |       |                                                                                                                                                    |
| 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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