UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549







FORM
10-K




ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934




For
fiscal year ended December 31, 2009




Commission
file number: 000-50644









Cutera,
Inc.


(Exact
name of registrant as specified in its charter)








Delaware
            
            77-0492262(State
      or other jurisdiction of
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      Number)




3240
Bayshore Blvd.


Brisbane,
California 94005


(415)
657-5500


(Address,
including zip code, and telephone number, including area code, of registrant’s
principal executive offices)




Securities
registered pursuant to Section 12(b) of the Act:





Title
      of Each Class
            
            Name
      of Each Exchange on Which RegisteredCommon
      Stock, $0.001 par value per share
            
            The
      NASDAQ Stock Market, LLC




Securities
Registered Pursuant to Section 12(g) of the Act: None




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes  ̈  No x




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes  ̈  No x




Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period than the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes x  No  ̈




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of
this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files). Yes o   No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  ̈




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check
one):




Large accelerated
      filer   ̈
            Accelerated
      filer   ̈
            Non-accelerated
      filer (Do not check if a smaller reporting company)  x
            Smaller reporting
      company   ̈





Indicate
by check mark whether registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act).   Yes  ̈  No x




The
aggregate market value of the registrant’s common stock, held by non-affiliates
of the registrant as of June 30, 2009 (which is the last business day of
registrant’s most recently completed second fiscal quarter) based upon the
closing price of such stock on the NASDAQ Global Select Market on that
date, was $56 million. For purposes of this disclosure, shares of common stock
held by entities and individuals who own 5% or more of the outstanding common
stock and shares of common stock held by each officer and director have been
excluded in that such persons may be deemed to be “affiliates” as that term is
defined under the Rules and Regulations of the Securities Exchange Act of 1934.
This determination of affiliate status is not necessarily
conclusive.




The
number of shares of Registrant’s common stock issued and outstanding as of
February 26, 2010 was 13,436,163.




DOCUMENTS
INCORPORATED BY REFERENCE




Part III
incorporates by reference certain information from the registrant’s definitive
proxy statement for the 2010 Annual Meeting of Stockholders.













TABLE
OF CONTENTS




PagePART IItem 1.
            Business
            3Item 1A.
            Risk
    Factors
            15Item 1B.
            Unresolved Staff
      Comments
            26Item
      2.
            Properties
            26Item
      3.
            Legal
      Proceedings
            26Item
      4.
            [Reserved]
            27PART IIItem 5.
            Market for the Registrant’s
      Common Equity, Related Stockholder Matters and Issuer Purchases of
      Equity
 Securities
            27Item
      6.
            Selected Financial
      Data
            29Item
      7.
            Management’s Discussion and
      Analysis of Financial Condition and Results of
      Operations
            30Item 7A.
            Quantitative and Qualitative
      Disclosures About Market Risk
            43Item
      8.
            Financial Statements and
      Supplementary Data
            45Item
      9.
            Changes in and Disagreements with
      Accountants on Accounting and Financial Disclosure
            72Item 9A.
            Controls and
      Procedures
            72Item 9B.
            Other
      Information
            72PART IIIItem 10.
            Directors, Executive Officers and
      Corporate Governance
            73Item
      11.
            Executive
      Compensation
            73Item
      12.
            Security Ownership of Certain
      Beneficial Owners and Management and Related Stockholder
      Matters
            73Item
      13.
            Certain Relationships and Related
      Transactions, and Director Independence
            73Item 14.
            Principal Accounting Fees and
      Services
            73PART IVItem 15.
            Exhibits and Financial Statement
      Schedules
            74





2
  PART
I





ITEM 1.
            BUSINESS




We are a
global medical device company headquartered in Brisbane, California specializing
in the design, development, manufacture, marketing and servicing of laser and
other light-based aesthetics systems for practitioners worldwide. We offer
easy-to-use products based on three platforms—CoolGlide®,
Xeo® and Solera®
—which enable physicians and other qualified practitioners to perform safe and
effective aesthetic procedures for their customers.





•
            CoolGlide-Our
      first product platform, CoolGlide, was launched in March 2000. This
      Platform offers laser applications for hair removal, treatment of a range
      of vascular lesions, including leg and facial veins, and Laser Genesis—a
      skin rejuvenation procedure that reduces fine lines, reduces pore size and
      improves skin texture.





•
            Xeo-In
      2003, we introduced the Xeo platform, which can combine pulsed light and
      laser applications in a single system. The Xeo is a fully upgradeable
      platform on which a customer can use every application that we offer to
      remove unwanted hair, treat vascular lesions and rejuvenate the skin by
      treating discoloration, improving texture, reducing pore size and treating
      fine lines and laxity. This product platform represents the largest
      contributor to our Product and Upgrade
revenue.





•
            Solera-    In
      2004, we introduced our Solera platform—a compact tabletop system designed
      to support a single technology platform. Solera systems use either
      infrared (Solera Titan) or pulsed light (Solera Opus) and can be used to
      remove unwanted hair, treat vascular lesions and rejuvenate the skin. The
      Solera Opus can support one or more pulsed light applications in a single
      system.




Each of
our laser and light based platforms consists of one or more hand pieces and a
console that incorporates a universal graphic user interface, a laser or other
light-based module, control system software and high voltage electronics.
However, depending on the application, the laser or other light-based module is
sometimes instead contained in the hand piece. A description of each of our hand
pieces, and the aesthetic conditions they are designed to treat, are contained
in the section entitled “Products,” below.




We offer
our customers the ability to select the systems and applications that best fit
their practice and to subsequently upgrade their systems to add new
applications. This upgrade path allows our customers to cost-effectively build
their aesthetic practices and provides us with a source of recurring
revenue.




In
addition to systems and upgrades, we generate revenue from the sale of post
warranty service and Titan hand piece refills.




The
Structure of Skin and Conditions that Affect Appearance




The skin
is the body’s largest organ and is comprised of layers called the epidermis and
dermis. The epidermis is the outer layer, and serves as a protective barrier for
the body. It contains cells that determine pigmentation, or skin color. The
underlying layer of skin, the dermis, contains hair follicles and large and
small blood vessels that are found at various depths below the epidermis.
Collagen, also found within the dermis, provides strength and flexibility to the
skin.




Many
factors, such as age, smoking and sun damage, can result in aesthetically
unpleasant changes in the appearance of the skin. These changes can
include:





•
            Undesirable
      hair growth;





•
            Enlargement
      or swelling of blood vessels due to circulatory changes that become
      visible at the skin’s surface in the form of unsightly
    veins;





•
            Deterioration
      of collagen, which weakens the skin, leading to uneven texture, increased
      pore size, wrinkles and laxity; and





•
            Uneven
      pigmentation or sun spots due to long-term sun
  exposure.




People
with unwanted hair or any of the above-mentioned skin conditions often seek
aesthetic treatments to improve their appearance.




The
Market for Non-Surgical Aesthetic Procedures




The
market for non-surgical aesthetic procedures has grown significantly over the
past several years. The American Society of Plastic Surgeons estimates that in
2008 there were over 10 million minimally-invasive aesthetic procedures
performed, a 5% increase over 2007 and a 90% increase over 2000. We believe
there are several factors contributing to the growth of these aesthetic
procedures, including:





•
            Aging of the U.S.
      Population-The
      “baby boomer” demographic segment, ages 45 to 63 in 2009, represented
      approximately 26% of the U.S. population as of July 1, 2005. The size
      of this aging segment, and its desire to retain a youthful appearance, has
      driven the growth for aesthetic
procedures.





•
            Broader Range of Safe and
      Effective Treatments-Technical
      developments have led to safe, effective, easy-to-use and low-cost
      treatments with fewer side effects, resulting in broader adoption of
      aesthetic procedures by practitioners. In addition, technical developments
      have enabled practitioners to offer a broader range of treatments. These
      technical developments have reduced the required treatment and recovery
      times, which in turn have led to greater patient
  demand.





•
            Broader Base of
      Customers-    Managed care and government payer
      reimbursement restrictions in the United States, and similar payment
      related constraints outside the United States, may help motivate qualified
      practitioners from differing specialties to establish or expand their
      elective aesthetic practices with procedures that are paid for directly by
      patients. As a result, in addition to the core users such as
      dermatologists and plastic surgeons, many other non-core practitioners,
      such as gynecologists, family practitioners, primary care physicians,
      physicians offering aesthetic treatments in non-medical offices, and other
      qualified practitioners are offering aesthetic
  procedures.




3




Non-Surgical
Aesthetic Procedures for Improving the Skin’s Appearance and Their
Limitations




Many
alternative therapies are available for improving a person’s appearance by
treating specific structures within the skin. These procedures utilize
injections or abrasive agents to reach different depths of the dermis and the
epidermis. In addition, non-invasive and minimally-invasive treatments have been
developed that employ laser and other light-based technologies to achieve
similar therapeutic results. Some of these more common therapies and their
limitations are described below.




Hair
Removal-    Techniques for hair removal include
waxing, depilatories, tweezing, shaving, electrolysis and laser and other
light-based hair removal. The only techniques that provide a long-lasting
solution are electrolysis and light-based hair removal. Electrolysis is usually
painful, time-consuming and expensive for large areas, but is the most common
method for removing light-colored hair. During electrolysis, an electrologist
inserts a needle directly into a hair follicle and activates an electric current
in the needle. Since electrolysis only treats one hair follicle at a time, the
treatment of an area as small as an upper lip may require numerous visits and
many hours of treatment. In addition, electrolysis can cause blemishes and
infection related to needle use.




Leg and Facial
Veins-    The current aesthetic treatment methods for
leg and facial veins include sclerotherapy and laser and other light-based
treatments. With these treatments, patients seek to eliminate visible veins and
improve overall skin appearance. Sclerotherapy requires a skilled practitioner
to inject a saline or detergent-based solution into the target vein, which
breaks down the vessel causing it to collapse and be absorbed into the body. The
need to correctly position the needle on the inside of the vein makes it
difficult to treat smaller veins, which limits the treatment of facial vessels
and small leg veins. The American Society of Plastic Surgeons estimates that
nearly 375,000 sclerotherapy procedures were performed in 2008.




Skin
Rejuvenation-    Skin rejuvenation treatments include
a broad range of popular alternatives, including Botox and collagen injections,
chemical peels, microdermabrasions, radiofrequency treatments and lasers and
other light-based treatments. With these treatments, patients hope to improve
overall skin tone and texture, reduce pore size, tighten skin and remove other
signs of aging, including mottled pigmentation, diffuse redness and wrinkles.
All of these procedures are temporary solutions and must be repeated within
several weeks or months to sustain their effect, thereby increasing the cost and
inconvenience to patients. For example, the body absorbs Botox and collagen and
patients require supplemental injections every three to six months to maintain
the benefits of these treatments.




Some skin
rejuvenation treatments, such as chemical peels and microdermabrasions, can have
undesirable side effects. Chemical peels use acidic or caustic solutions to peel
away the epidermis, and microdermabrasion generally utilizes sand crystals to
resurface the skin. These techniques can lead to stinging, redness, irritation
and scabbing. In addition, more serious complications, such as changes in skin
color, can result from deeper chemical peels. Patients that undergo these deep
chemical peels are also advised to avoid exposure to the sun for several months
following the procedure. The American Society of Plastic Surgeons estimates that
in 2008, 5.0 million injections of Botox and over 1.5 million
injections of collagen and other soft-tissue fillers were administered, and
1.0 million chemical peels and over 840,000 microdermabrasion procedures
were performed.




In
radiofrequency tissue tightening, energy is applied to heat the dermis of the
skin with the goal of shrinking and tightening the collagen fibers. This
approach may result in a more subtle and incremental change to the skin than a
surgical facelift. Drawbacks to this approach may include surface irregularities
that may resolve over time, and the risk of burning the treatment
area.




Laser and
other light-based non-surgical treatments for hair removal, veins and skin
rejuvenation are discussed in the following section and in the section entitled
“Our Applications and Procedures,” below.




Laser
and Other Light-Based Aesthetic Treatments




Laser and
other light-based aesthetic treatments can achieve therapeutic results by
affecting structures within the skin. The development of safe and effective
aesthetic treatments has created a well-established market for these
procedures.




Ablative
skin resurfacing is a method of improving the appearance of the skin by removing
the outer layers of the skin. Ablative skin resurfacing procedures are
considered invasive or minimally invasive, depending on how much of the
epidermis is removed during a treatment. Non-ablative skin resurfacing is a
method of improving the appearance of the skin by treating the underlying
structure of the skin without damaging the outer layers of the skin.
Practitioners can use laser and other light-based technologies to selectively
target hair follicles, veins or collagen in the dermis, as well as cells
responsible for pigmentation in the epidermis, without damaging surrounding
tissue. They can also use these technologies to safely remove portions of the
epidermis and deliver heat to the dermis as a means of generating new collagen
growth.




Safe and
effective laser and other light-based treatments require an appropriate
combination of the following four parameters:





•
            Energy
      Level-    the amount of light emitted to heat a
      target;





•
            Pulse
      Duration-    the time interval over which the
      energy is delivered;





•
            Spot
      Size-    the diameter of the energy beam, which
      affects treatment depth and area;
and





•
            Wavelength-    the
      color of light, which impacts the effective depth and absorption of the
      energy delivered.




For
example, in the case of hair removal, by utilizing the correct combination of
these parameters, a practitioner can use a laser or other light source to
selectively target melanin within the hair follicle to absorb the laser energy
and destroy the follicle, without damaging other delicate structures in the
surrounding tissue. Wavelength and spot size permit the practitioner to target
melanin in the base of the hair follicle, which is found in the dermis. The
combination of pulse duration and energy level may vary, depending upon the
thickness of the targeted hair follicle. A shorter pulse length with a high
energy level is optimal to destroy fine hair, whereas coarse hair is best
treated with a longer pulse length with lower energy levels. If treatment
parameters are improperly set, non-targeted structures within the skin may
absorb the energy thereby eliminating or reducing the therapeutic effect. In
addition, improper setting of the treatment parameters or failure to protect the
surface of the skin may cause burns, which can result in blistering, scabbing
and skin discoloration.




4




Technology
and Design of Our Systems




Our
unique CoolGlide, Xeo and Solera platforms provide the long-lasting benefits of
laser and other light-based aesthetic treatments. Our technology allows for a
combination of a wide variety of applications available in a single system. Key
features of our solutions include:





•
            Multiple
      Applications Available in a Single System-Our
      multi-application systems enable practitioners to perform multiple
      aesthetic procedures using a single device. These procedures include hair
      removal, treatment of unsightly veins and skin rejuvenation, including the
      treatment of discoloration, laxity, fine lines, pore size and uneven
      texture. Because practitioners can use our systems for multiple
      indications, the cost of a unit may be spread across a potentially greater
      number of patients and procedures, and therefore may be more rapidly
      recovered.





•
            Technology
      and Design Leadership-We offer innovative laser and other
      light-based solutions for the aesthetic market. Our laser technology
      combines long wavelength, adjustable energy levels, variable spot sizes
      and a wide range of pulse durations, allowing practitioners to customize
      treatments for each patient and condition. Our proprietary pulsed light
      hand pieces for the treatment of discoloration, hair removal and vascular
      treatments optimize the wavelength used for treatments and incorporate a
      monitoring system to increase safety. Our Titan hand pieces utilize a
      novel light source that had not been previously used for aesthetic
      treatments. And our Pearl and Pearl Fractional hand pieces, with
      proprietary YSGG technology, represent the first application of the 2790
      nm wavelength for minimally-invasive cosmetic
  dermatology.





•
            Upgradeable
      Platform-We design our products to allow our customers to
      cost-effectively upgrade to our multi-application systems, which provide
      our customers with the option to add additional applications to their
      existing systems and provides us with a source of recurring revenue. We
      believe that product upgradeability allows our customers to take advantage
      of our latest product offerings and provide additional treatment options
      to their patients, thereby expanding the opportunities for their aesthetic
      practices.





•
            Treatments
      for Broad Range of Skin Types and Conditions-Our products
      remove hair safely and effectively on patients of all skin types,
      including harder-to-treat patients with dark or tanned skin. In addition,
      the wide parameter range of our systems allows practitioners to
      effectively treat patients with both fine and coarse hair. Practitioners
      may use our products to treat spider and reticular veins, which are
      unsightly small veins in the leg, as well as small facial veins. And they
      can treat color, texture, pore size, fine lines and laxity on any type of
      skin with our skin rejuvenation systems. The ability to customize
      treatment parameters enables practitioners to offer safe and effective
      therapies to a broad base of their
patients.





•
            Ease of
      Use-We design our products to be easy to use. Our
      proprietary hand pieces are lightweight and ergonomic, minimizing user
      fatigue, and allow for clear views of the treatment area, reducing the
      possibility of unintended damage and increasing the speed of application.
      Our control console contains a universal graphic user interface with three
      simple, independently adjustable controls from which to select a wide
      range of treatment parameters to suit each patient’s profile. The clinical
      navigation user interface on the Xeo platform provides recommended
      clinical treatment parameter ranges based on patient criteria entered. And
      our Pearl and Pearl Fractional hand pieces include a scanner with multiple
      scan patterns to allow simple and fast treatments of the face. Risks
      involved in the use of our products include risks common to other laser
      and other light-based aesthetic procedures, including the risk of burns,
      blistering and skin discoloration.





Strategy




Our goal
is to maintain and expand our position as a leading, worldwide, provider of
light-based aesthetic devices and complementary aesthetic products by executing
the following strategies:





•
            Continue to Expand our Product
      Offering-  Though we believe that our current portfolio of
      products is comprehensive, our research and development group has a
      pipeline of potential products under development that we expect to
      commercialize in the future. In the fourth quarter of 2009, we
      indefinitely postponed the launch of our TruSculpt product for the body
      contouring market. We plan to continue to refine this product and obtain
      additional clinical data until we establish
      that the clinical protocols yield the desired outcome.In
      addition to products in the laser and light based aesthetic market, we are
      expanding our product offering into other complementary aesthetic
      applications, such as dermal fillers and cosmeceuticals. Such products
      will allow us to leverage our existing customer call points, and provide
      us with new customer call points, to generate additional revenue, which
      will enhance the productivity of our distribution
  channels.





•
            Increasing
      Revenue  and Improving Productivity- We believe
      that the market for aesthetic systems will continue to offer growth
      opportunities in the future even though our revenue declined by
      36%  in 2009, compared with 2008, due to the global recession.
      We continue to build brand-recognition, add additional products to our
      international distribution channel and remain focused on enhancing our
      global distribution network, all of which we expect will increase our
      revenue. In addition, we plan to grow our U.S. revenue by leveraging our
      relationship with PSS World Medical Shared Services, Inc., or PSS─ a
      wholly-owned subsidiary of PSS World Medical ─ that operates medical
      supply distribution service centers with over 700 sales consultants
      serving physician offices throughout the United States. In 2009, we
      restructured our direct sales force with goals of managing expenses in
      line with our reduced business, and improving productivity by retaining
      our key performers and expanding their sales
  territories.





•
            Increasing Focus on
      Practitioners with Established Medical Offices-We believe
      there is growth opportunity in targeting our products to a broad customer
      base, however, due to the recent global recession, we have shifted our
      focus to the core practitioners and physicians with established medical
      offices. We believe that our customer success is largely dependent upon
      having an existing medical practice, in which our systems provide
      incremental revenue sources to augment their practice
    revenue.





•
            Leveraging our Installed Base
      with Sales of Upgrades-  Each time we have introduced a major
      new product, we have designed it to allow existing customers to upgrade
      their previously purchased systems to offer additional capabilities. We
      believe that providing upgrades to our existing installed base of
      customers continues to represent a potentially significant opportunity for
      recurring revenue. We also believe that our upgrade program aligns our
      interest in generating revenue with our customers’ interest in improving
      the return on their investment by expanding the range of applications that
      can be performed with their existing systems. In 2010, we plan on
      continuing to market upgrades to our installed base, including our Pearl
      and Pearl Fractional applications introduced in 2007 and 2008,
      respectively.




5




•
            Generating Revenue from
      Services and Refillable Hand Pieces-Our Titan hand pieces
      and pulsed-light hand pieces are refillable products, which provide us
      with a source of recurring revenue from our existing customers. We offer
      post-warranty services to our customers either through extended service
      contracts to cover preventive maintenance or through direct billing for
      parts and labor. These post-warranty services serve as additional sources
      of recurring revenue.





Products




Our
CoolGlide, Xeo and Solera platforms allow for the delivery of multiple laser and
other light-based aesthetic applications from a single system. With our Xeo and
Solera platforms, practitioners can purchase customized systems with a variety
of our multi-technology applications. The following table lists our products and
each checked box represents the incremental applications that were added to the
respective platforms in the years noted.




Applications:
              
              
              
              
              
              
              
              
              Hair
                Removal:
              
              
              Vascular
                Lesions:
              
              
              Skin
      RejuvenationSystem
                Platforms:
              
              Products:
              
              Year:
              
              Energy
                Source:
              
              
              
              
              
              
              
              
              Dyschromia:
              
              
              Texture,
                Lines
      and
                Wrinkles:
              
              
              Skin
                Laxity:CoolGlide
              
              CV
              
              2000
              
              a
              
              
              xExcel
              
              2001
              
              a
              
              
              
              
              
              xVantage
              
              2002
              
              a
              
              
              
              
              
              
              
              
              
              
              
              xXeo:
              
              Nd:YAG
              
              2003
              
              a
              
              
              x
              
              
              x
              
              
              
              
              
              xOPS600
              
              2003
              
              b
              
              
              
              
              
              
              
              
              xLP560
              
              2004
              
              b
              
              
              
              
              
              
              
              
              xTitan
      S
              
              2004
              
              c
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              xProWave
      770
              
              2005
              
              b
              
              
              xAcuTip
      500
              
              2005
              
              b
              
              
              
              
              
              xTitan V/XL
              
              2006
              
              c
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              xLimeLight
              
              2006
              
              b
              
              
              
              
              
              
              
              
              xPearl
              
              2007
              
              d
              
              
              
              
              
              
              
              
              x
              
              
              xPearl Fractional
              
              2008
              
              d
              
              
              
              
              
              
              
              
              
              
              
              xSolera
              
              Titan S
              
              2004
              
              c
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              xProWave
      770
              
              2005
              
              b
              
              
              xOPS 600
              
              2005
              
              b
              
              
              
              
              
              
              
              
              xLP560
              
              2005
              
              b
              
              
              
              
              
              
              
              
              xAcuTip
      500
              
              2005
              
              b
              
              
              
              
              
              xTitan
      V/XL
              
              2006
              
              c
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              xLimeLight
              
              2006
              
              b
              
              
              
              
              
              
              
              
              x
  Energy
Source: a. 1064nm Nd:YAG laser; b. flashlamp; c. Infrared laser; d. 2790 nm YSGG
laser





Each of
our products consists of a control console and one or more hand pieces,
depending on the model.




Control
Console




Our
control console includes a universal graphic user interface, control system
software and high voltage electronics. All CoolGlide systems, and some models of
the Xeo platform, include our laser module which consists of electronics, a
visible aiming beam, a focusing lens, and an Nd:YAG and/or flashlamp laser that
functions at wavelengths that permit penetration over a wide range of depths and
is effective across all skin types. The interface allows the practitioner to set
the appropriate laser or flashlamp parameters for each procedure through a
user-friendly format. The control system software ensures that the operator’s
instructions are properly communicated from the graphic user interface to the
other components within the system. Our high voltage electronics produce over
10,000 watts of peak laser energy, which permits therapeutic effects at short
pulse durations. Our Solera console platform comes in two configurations—Opus
and Titan—both of which include a universal graphic user interface, control
system software and high voltage electronics. The Solera Opus console is
designed specifically to drive our flashlamp hand pieces while the Solera Titan
console is designed specifically to drive the Titan hand pieces. The control
system software is designed to ensure that the operator’s instructions are
properly communicated from the graphical user interface to the other components
within the system and includes real-time calibration to control the output
energy as the pulse is delivered during the treatment.




Hand
Pieces




1064 nm Nd:YAG Hand
Piece-Our
1064nm Nd:YAG hand piece delivers laser energy to the treatment area for hair
removal, leg and facial vein treatment, and skin rejuvenation procedures to
treat skin texture and fine lines, and reduce pore size. The 1064nm Nd:YAG hand
piece consists of an energy-delivery component, consisting of an optical fiber
and lens, and a copper cooling plate with imbedded temperature monitoring. The
hand piece weighs approximately 14 ounces, which is light enough to be held with
one hand. The lightweight nature and ergonomic design of the hand piece allows
the operation of the device without user fatigue. Its design allows the
practitioner an unobstructed view of the treatment area, which reduces the
possibility of unintended damage to the skin and can increase the speed of
treatment. The 1064nm Nd:YAG hand piece also incorporates our cooling system,
providing integrated pre- and post cooling of the treatment area through a
temperature-controlled copper plate to protect the outer layer of the skin. The
hand piece is available in either a fixed 10 millimeter spot size for our
CoolGlide CV system, or a user-controlled variable 3, 5, 7 or 10 millimeter spot
size for our CoolGlide Excel and CoolGlide Vantage systems.




6




Pulsed Light Hand
Pieces-    The LP560, ProWave 770, AcuTip 500 and
LimeLight hand pieces are designed to produce a pulse of light over a wavelength
spectrum to treat discoloration, including pigmented lesions, such as age and
sun spots, hair removal and superficial facial vessels. The hand pieces each
consist of a custom flashlamp, proprietary wavelength filter, closed-loop power
control and embedded temperature monitor, and weigh approximately 13 ounces. The
filter in the AcuTip 500 eliminates long and short wavelengths, transmitting
only the therapeutic range required for safe and effective treatment. The filter
in the LP560, ProWave 770 and LimeLight eliminates short wavelengths, allowing
longer wavelengths to be transmitted to the treatment area. In addition, the
wavelength spectrum of the ProWave 770 and the LimeLight can be shifted based on
the setting of the control console. Our power control includes a monitoring
system to ensure that the desired energy level is delivered. The hand pieces
protect the epidermis by regulating the temperature of the hand piece window
through the embedded temperature monitor. These hand pieces are available on the
Xeo and Solera platforms.




Titan Hand Pieces-The
Titan hand pieces are designed to produce a sustained pulse of light over a
wavelength spectrum tailored to provide heating in the dermis to treat skin
laxity (although it is cleared in the United States by the U.S. Food and Drug
Administration, or FDA, only for deep dermal heating). The hand piece consists
of a custom light source, proprietary wavelength filter, closed-loop power
control, sapphire cooling window and embedded temperature monitor, and weighs
approximately three pounds. The temperature of the epidermis is controlled by
using a sapphire window to provide cooling before, during and after the delivery
of energy to the treatment site. We offer two different Titan hand pieces—Titan
V and Titan XL.




Titan
V-    Titan V has a treatment tip that extends beyond the
hand piece housing to provide enhanced visibility of the skin’s surface to
effectively treat delicate areas such as the skin around the eyes and
nose.




Titan
XL-Titan
XL, like the Titan V, has a treatment tip that extends beyond the housing for
improved visibility. It also has a larger treatment spot size to treat larger
body areas faster, such as the arms, abdomen and legs.




The Titan
hand pieces can be used on the Xeo and Solera platforms. The Titan hand piece
requires a periodic “refilling” process, which includes the replacement of the
optical source, after a set number of pulses have been used. This provides us
with a source of recurring revenue.




Pearl Hand
Piece-    The Pearl hand piece, introduced in 2007,
is designed to treat fine lines, uneven texture and dyschromia through the
application of proprietary YSGG laser technology. This hand piece can safely
remove a small portion of the epidermis, while coagulating the remaining
epidermis, leading to new collagen growth. The Pearl hand piece consists of a
custom monolithic laser source, scanner and power monitoring electronics. The
scanner includes multiple scan patterns to allow simple and fast treatments of
the face. The hand piece includes an attachment for a smoke evacuator, allowing
the practitioner to use one hand during treatment.




Pearl Fractional Hand
Piece-    The Pearl Fractional hand piece, introduced
in 2008, also uses proprietary YSGG technology and is designed to treat wrinkles
and deep dermal imperfections (although it is cleared in the United States by
the FDA only for skin resurfacing and coagulation). This hand piece penetrates
the deep dermis producing a series of microcolumns across the skin, which can
result in the removal of damaged tissue and the production of new collagen. The
Pearl Fractional hand piece consists of a custom monolithic laser source,
scanner and power monitoring electronics. The scanner includes multiple scan
patterns to allow simple and fast treatments of the face. The hand piece
includes an attachment for a smoke evacuator, allowing the practitioner to use
one hand during treatment.




VASER® Lipo
System




In
January 2010, we announced a strategic alliance with Sound Surgical
Technologies, LLC to distribute their VASER Lipo System in Europe and Canada.
The VASER System is an ultrasonic liposuction device that allows physicians to
perform a wide array of body contouring applications.




Upgrades




Our
products are designed to allow our customers to cost-effectively upgrade to our
newest technologies, which provides our customers the option to add applications
to their system and provides us with a source of recurring revenue. When we
introduce a new product, we notify our customers of the upgrade opportunity
through a sales call or mailing. In most cases, a field service representative
can install the upgrade at the customer site in a matter of hours, which results
in very little downtime for practitioners. In some cases, where substantial
upgrades are necessary, customers will receive fully-refurbished systems before
sending their prior systems back to our headquarters.




Service




We offer
post-warranty services to our customers either through extended service
contracts to cover preventive maintenance or replacement parts and labor, or
through direct billing for parts and labor. These post-warranty services serve
as additional sources of recurring revenue from our installed base.




Titan
Hand Piece Refills




Each
Titan hand piece is a refillable product, which provides us with a source of
recurring revenue from our existing customers.




7




Fillers
and Cosmeceuticals




In the
fourth quarter of 2008, we began to distribute BioForm’s Radiesse® dermal filler
product to physicians in the Japanese market. In January 2010, we announced a
distribution agreement with Obagi Medical Product, Inc. to distribute their
prescription-based, topical skin health systems in Japan.




Our
Applications and Procedures




Our
products are designed to allow the practitioner to select an appropriate
combination of energy level, spot size and pulse duration for each treatment.
The ability to manipulate the combinations of these parameters allows our
customers to treat the broadest range of conditions available with a single
light-based system.




Hair Removal-Our
laser technology allows our customers to treat all skin types and hair
thicknesses. Our 1064 nm Nd:YAG laser permits energy to safely penetrate through
the epidermis of any skin type and into the dermis where the hair follicle is
located. Using the universal graphic user interface on our control console, the
practitioner sets parameters to deliver therapeutic energy with a large spot
size and variable pulse durations, allowing the practitioner to treat fine or
coarse hair. Our 1064nm Nd:YAG hand piece allows our customers to treat all skin
types, while our ProWave 770 hand piece, with its pulsed light technology,
treats the majority of skin types quickly and effectively.




To remove
hair using a 1064nm Nd:YAG hand piece, the treatment site on the skin is first
cleaned and shaved. The practitioner then applies a thin layer of gel to glide
across the skin, and next applies the hand piece directly to the skin to cool
the area to be treated and then delivers a laser pulse to the pre-cooled area.
To remove hair using the ProWave 770 hand piece, mineral oil is used instead of
gel, and cooling is provided by a sapphire window placed directly on the skin,
allowing the pulse of light to be applied while the treatment area is being
cooled. In the case of both hand pieces, delivery of the energy destroys the
hair follicles and prevents hair re-growth. This procedure is then repeated at
the next treatment site on the body, and can be done in a gliding motion to
increase treatment speed. Patients receive on average three to six treatments.
Each treatment can take between five minutes and one hour depending on the size
of the area and the condition being treated. On average, there are six to eight
weeks between treatments.




Vascular
Lesions-    Our laser technology allows our customers
to treat the widest range of aesthetic vein conditions, including spider and
reticular veins and small facial veins. Our 1064nm Nd:YAG hand piece’s
adjustable spot size of 3, 5, 7 or 10 millimeters allows the practitioner to
control treatment depth to target different sized veins. Selection of the
appropriate energy level and pulse duration ensures effective treatment of the
intended target. Our AcuTip 500 hand piece, with its 6 millimeter spot size,
uses pulsed-light technology and is designed for the treatment of facial
vessels.




The vein
treatment procedure when using the 1064nm Nd:YAG hand piece is performed in a
substantially similar manner to the laser hair removal procedure. The laser hand
piece is used to cool the treatment area both before and after the laser pulse
has been applied. With the AcuTip 500 hand piece, the pulse of light is
delivered while the treatment area is being cooled with the sapphire tip. The
delivered energy damages the vein and, over time, it is absorbed by the body.
Patients receive on average between one and six treatments, with six weeks or
longer between treatments.




Skin
Rejuvenation-    Our laser and other light-based
technologies allow our customers to perform non-invasive and minimally-invasive
treatments that reduce redness, pore size, fine lines and laxity, improve skin
texture, and treat other aesthetic conditions. Our products are each designed to
minimize the risk of damage to the surrounding tissue.




Texture; Lines and
Wrinkles-    When using a 1064nm Nd:YAG laser to
improve skin texture, reduce pore size and treat fine lines, cooling is not
applied and the hand piece is held directly above the skin. A large number of
pulses are directed at the treatment site, repeatedly covering an area, such as
the cheek. By delivering many pulses of laser light to a treatment area, a
gentle heating of the dermis occurs and collagen growth is stimulated to
rejuvenate the skin and reduce wrinkles. Patients typically receive four to six
treatments for this procedure. The treatment typically takes less than a half
hour and there are typically two to four weeks between treatments.




When
treating texture and fine lines with a Pearl hand piece, the hand piece is held
at a controlled distance from the skin and the scanner delivers a preset pattern
of spots to the treatment area. Cooling is not applied to the epidermis during
the treatment. The energy delivered by the hand piece ablates a portion of the
epidermis while leaving a coagulated portion that will gently peel off over the
course of a few days. Heat is also delivered into the dermis which can result in
the production of new collagen. Treatment of the full face can usually be
performed in 15 to 30 minutes. Patients receive on average between one and three
treatments at monthly intervals.




When
treating wrinkles and deep dermal imperfections with a Pearl Fractional hand
piece, the hand piece is held at a controlled distance from the skin and the
scanner delivers a preset pattern of spots to the treatment area. Cooling is not
applied to the epidermis during the treatment. The energy delivered by the hand
piece penetrates the deep dermis producing a series of microcolumns across the
skin, which can result in the removal of damaged tissue and the production of
new collagen. Treatment of the full face can usually be performed in less than
an hour. Patients receive on average between one and three treatments at monthly
intervals.




8




Our CE
Mark allows us to market Pearl Fractional in the European Union, Australia and
certain other countries outside the United States for the treatment of wrinkles
and deep dermal imperfections. However, in the United States we have a 510(k)
clearance for only skin resurfacing and coagulation.




Dyschromia-    Our
pulsed-light technologies allow our customers to safely and effectively treat
red and brown dyschromia, which is skin discoloration, pigmented lesions and
rosacea. The practitioner delivers a narrow spectrum of light to the surface of
the skin through our LP560 or LimeLight hand pieces. These hand pieces include
one of our proprietary wavelength filters, which reduce the energy level
required for therapeutic effect and minimize the risk of skin
injury.




In
treating pigmented lesions with a pulsed-light technology, the hand piece is
placed directly on the skin and then the light pulse is triggered. The cells
forming the pigmented lesion absorb the light energy, darken and then flake off
over the course of two to three weeks. Several treatments may be required to
completely remove the lesion. The treatment takes a few minutes per area treated
and there are typically three to four weeks between treatments.




Practitioners
can also treat dyschromia and other skin conditions with our Pearl hand piece.
During these treatments, the heat delivered by the Pearl hand piece will remove
the outer layer of the epidermis while coagulating a portion of the epidermis.
That coagulated portion will gently peel off over the course of a few days,
revealing a new layer of skin underneath. Treatment of the full face can usually
be performed in 15 to 30 minutes. Patients receive on average between one and
three treatments at monthly intervals.




Skin
Laxity-    Our Titan technology allows our customers
to use deep dermal heating to tighten lax skin. The practitioner delivers a
spectrum of light to the skin through our Titan hand piece. This hand piece
includes our proprietary light source and wavelength filter which tailors the
delivered spectrum of light to provide heating at the desired depth in the
skin.




In
treating skin laxity, the hand piece is placed directly on the skin and then the
light pulse is triggered. A sustained pulse causes significant heating in the
dermis. This heating can cause immediate collagen contraction while also
stimulating long-term collagen re-growth. Several treatments may be required to
obtain the desired degree of tightening of the skin. The treatment of a full
face can take over an hour and there are typically four weeks between
treatments.




Our CE
Mark allows us to market the Titan in the European Union, Australia and certain
other countries outside the United States for the treatment of wrinkles through
skin tightening. However, in the United States we have a 510(k) clearance for
only deep dermal heating.




Sales
and Marketing




In the
United States we market and sell our products primarily through a direct sales
organization. Generally, each direct sales employee is assigned a specific
territory. As of December 31, 2009, we had a U.S. direct sales force of 24
employees. In addition to direct sales employees, we have a distribution
relationship with PSS World Medical that operates medical supply distribution
service centers with over 700 sales representatives serving physician offices
throughout the United States. Revenue from PSS was $3.8 million in 2009, $12.1
million in 2008, and $14.6 million in 2007.




International
sales are generally made through a direct international sales force of 26
employees, as well as a worldwide distributor network in over 30 countries as of
December 31, 2009. As of December 31, 2009, we had direct sales
offices in Australia, Canada, France, Japan, Spain, Switzerland and the United
Kingdom. Our international revenue as a percentage of total revenue represented
61% in 2009, 50% in 2008, and 37% in 2007.




We
internally manage our U.S. and Canadian sales organization as one North American
sales region with 30 territories as of December 31, 2009.




We also
sell certain items like Titan hand piece refills and marketing brochures via the
internet.




Although
specific customer requirements can vary depending on applications, customers
generally demand quality, performance, ease of use, and high productivity in
relation to the cost of ownership. We have responded to these customer demands
by introducing new products focused on these requirements in the markets we
serve. Specifically, we believe that we introduce new products and applications
that are innovative, address the specific aesthetic procedures in demand, and
are upgradeable on our customers’ existing systems. In addition, we provide
attractive upgrade pricing to new product families and are responsive to our
customers’ financing preferences. To increase market penetration, in addition to
marketing to the core specialties of plastic surgeons and dermatologists, we
also market to the non-core aesthetic practices consisting of gynecologists,
primary care physicians, family practitioners, physicians offering aesthetic
treatments in non-medical offices and other qualified
practitioners.




9




We seek to establish strong ongoing
relationships with our customers through the upgradeability of our products,
sales of extended service contracts, the refilling of Titan hand pieces, ongoing
training and support, and distributing (in Japan only) a dermal filler product.
We primarily target our
marketing efforts to practitioners through office visits, workshops, trade
shows, webinars and trade journals. We also market to potential patients through
brochures, workshops and our website. In addition, we offer clinical forums with
recognized expert panelists to promote advanced treatment techniques using our
products to further enhance customer loyalty and uncover new sales
opportunities.




Competition




Our
industry is subject to intense competition. Our products compete against
conventional non-light-based treatments, such as electrolysis, Botox and
collagen injections, chemical peels, microdermabrasion and sclerotherapy. Our
products also compete against laser and other light-based products offered by
public companies, such as Cynosure, Elen (in Italy), Iridex, Palomar, Solta and
Syneron, as well as private companies, including, Alma, Lumenis, Sciton and
several other companies.




Competition
among providers of laser and other light-based devices for the aesthetic market
is characterized by extensive research efforts and innovative technology. While
we attempt to protect our products through patents and other intellectual
property rights, there are few barriers to entry that would prevent new entrants
or existing competitors from developing products that would compete directly
with ours. There are many companies, both public and private, that are
developing innovative devices that use both light-based and alternative
technologies. Some of these competitors have greater resources than we do or
product applications for certain sub-markets in which we do not participate.
Additional competitors may enter the market, and we are likely to compete with
new companies in the future. To compete effectively, we have to demonstrate that
our products are attractive alternatives to other devices and treatments by
differentiating our products on the basis of performance, brand name, service
and price. We have encountered, and expect to continue to encounter, potential
customers who, due to existing relationships with our competitors, are committed
to, or prefer the products offered by these competitors. Competitive pressures
may result in price reductions and reduced margins for our
products.




Research
and Development




Our
research and development group develops new products and applications and builds
clinical support to address unmet or underserved market needs. As of
December 31, 2009, our research and development activities were conducted
by a staff of 19 employees with a broad base of experience in lasers and
optoelectronics. We have developed relationships with outside contract
engineering and design consultants, giving our team additional technical and
creative breadth. We work closely with thought leaders and customers, to
understand unmet needs and emerging applications in aesthetic medicine. Research
and development expenses were $6.8 million in 2009, $7.6 million in 2008 and
$7.2 million in 2007.




Service
and Support




Our
products are engineered to enable quick and efficient service and support. There
are several separate components of our products, each of which can easily be
removed and replaced. We believe that quick and effective delivery of service is
important to our customers. As of December 31, 2009, we had a 35-person
global service department. Internationally, we provide direct service support
through our Australia, Canada, France, Japan, Spain and Switzerland offices, and
also through the network of distributors in over 30 countries and third-party
service providers. We provide initial warranties on our products to cover parts
and service and offer extended service plans that vary by the type of product
and the level of service desired. Our standard warranty on system consoles
covers parts and service for a standard period of one or two years. From time to
time, we also have promotions whereby we include a post-warranty service
contract with the sale of our products. Customers are notified before their
initial warranty expires and are able to choose from two different extended
service plans covering preventative maintenance or replacement parts and labor.
In the event a customer does not purchase an extended service plan, we will
offer to service the customer’s system and charge the customer for time and
materials. Our Titan hand pieces generally include a warranty for a set number
of shots instead of for a period of time. We have invested substantial financial
and management resources to develop a worldwide infrastructure to meet the
service needs of our customers worldwide.




Manufacturing




We
manufacture our products with components and subassemblies supplied by vendors.
We assemble and test each of our products at our Brisbane, California facility.
Quality control, cost reduction and inventory management are top priorities of
our manufacturing operations.




10




We
purchase certain components and subassemblies from a limited number of
suppliers. We have flexibility with our suppliers to adjust the number of
components and subassemblies as well as the delivery schedules. The forecasts we
use are based on historical demands and sales projections. Lead times for
components and subassemblies may vary significantly depending on the size of the
order, time required to fabricate and test the components or subassemblies,
specific supplier requirements and current market demand for the components and
subassemblies. We reduce the potential for disruption of supply by maintaining
sufficient inventories and identifying additional suppliers. The time required
to qualify new suppliers for some components, or to redesign them, could cause
delays in our manufacturing. To date, we have not experienced significant delays
in obtaining any of our components or subassemblies.




We use
small quantities of common cleaning products in our manufacturing operations,
which are lawfully disposed of through a normal waste management program. We do
not forecast any material costs due to compliance with environmental laws or
regulations.




We are
required to manufacture our products in compliance with the FDA’s Quality System
Regulation, or QSR. The QSR covers the methods and documentation of the design,
testing, control, manufacturing, labeling, quality assurance, packaging, storage
and shipping of our products. The FDA enforces the QSR through periodic
unannounced inspections. Our single manufacturing facility located in Brisbane,
CA, was inspected by the FDA in 2008. There were no significant findings as a
result of this audit and our responses have been accepted by the FDA. Our
failure to maintain compliance with the QSR requirements could result in the
shut down of our manufacturing operations and the recall of our products, which
would have a material adverse effect on business. In the event that one of our
suppliers fails to maintain compliance with our quality requirements, we may
have to qualify a new supplier and could experience manufacturing delays as a
result. We have opted to maintain quality assurance and quality management
certifications to enable us to market our products in the United States, the
member states of the European Union, the European Free Trade Association and
countries which have entered into Mutual Recognition Agreements with the
European Union. Our manufacturing facility is ISO 13485 certified.




Patents
and Proprietary Technology




We rely
on a combination of patent, copyright, trademark and trade secret laws, and
non-disclosure, confidentiality and invention assignment agreements to protect
our intellectual property rights. As of December 31, 2009, we had thirteen
issued U.S. patents and thirty pending U.S. patent applications. Cutera,
CoolGlide, Solera, Xeo, AcuTip, Limelight, Pearl, ProWave 770 and Titan are only
some of our trademarks. We have trademark rights to these names and others in
the United States and certain other countries. We intend to file for additional
patents and trademarks to continue to strengthen our intellectual property
rights.




We
license certain patents from Palomar and pay ongoing royalties based on sales of
applicable hair-removal products. The royalty rate on these products ranges from
3.75% to 7.50% of revenue. The patents are set to expire in February 2013 and
February 2015. Our revenue from systems that do not include hair-removal
capabilities (such as our Solera Titan) and revenue from service contracts are
not subject to these royalties. In addition, in 2006 we capitalized $1.2 million
as an intangible asset representing the ongoing license for these patents, which
is being amortized on a straight-line basis over their expected useful life of
9-10 years. We also have a technology sublicense purchased in 2002, which is
being amortized on a straight-line basis over its expected useful life of 10
years, and a trademark license purchased in 2007, that was amortized over its
expected useful lives of two years.




Our
employees and technical consultants are required to execute confidentiality
agreements in connection with their employment and consulting relationships with
us. We also require them to agree to disclose and assign to us all inventions
conceived in connection with the relationship. We cannot provide any assurance
that employees and consultants will abide by the confidentiality or
assignability terms of their agreements. Despite measures taken to protect our
intellectual property, unauthorized parties may copy aspects of our products or
obtain and use information that we regard as proprietary.




Government
Regulation




Our
products are medical devices subject to extensive and rigorous regulation by the
U.S. Food and Drug Administration, as well as other regulatory bodies. FDA
regulations govern the following activities that we perform and will continue to
perform to ensure that medical products distributed domestically or exported
internationally are safe and effective for their intended uses:





•
            Product
      design and development;





•
            Product
      testing;




•
            Product
      manufacturing;




•
            Product
      safety;




•
            Product
      labeling;




•
            Product
      storage;




•
            Recordkeeping;




•
            Pre-market
      clearance or approval;




11




•
            Advertising
      and promotion;




•
              Production;
      and
  •
            Product
      sales and distribution.






FDA’s
Pre-market Clearance and Approval Requirements




Unless an
exemption applies, each medical device we wish to commercially distribute in the
United States will require either prior 510(k) clearance or pre-market approval
from the FDA. The FDA classifies medical devices into one of three classes.
Devices deemed to pose lower risks are placed in either class I or II, which
requires the manufacturer to submit to the FDA a pre-market notification
requesting permission to commercially distribute the device. This process is
generally known as 510(k) clearance. Some low risk devices are exempted from
this requirement. Devices deemed by the FDA to pose the greatest risk, such as
life-sustaining, life-supporting or implantable devices, or devices deemed not
substantially equivalent to a previously cleared 510(k) device, are placed in
class III, requiring pre-market approval. All of our current products are class
II devices.




510(k)
Clearance Pathway




When a
510(k) clearance is required, we must submit a pre-market notification
demonstrating that our proposed device is substantially equivalent to a
previously cleared 510(k) device or a device that was in commercial distribution
before May 28, 1976 for which the FDA has not yet called for the submission
of Pre-Market Approval, or PMA, applications. By regulation, the FDA is required
to clear or deny a 510(k), pre-market notification within 90 days of submission
of the application. As a practical matter, clearance often takes significantly
longer. The FDA may require further information, including clinical data, to
make a determination regarding substantial equivalence. Laser devices used for
aesthetic procedures, such as hair removal, have generally qualified for
clearance under 510(k) procedures.




The
following table details the indications for which we received a 510(k) clearance
for our products and when these clearances were received.





FDA
      Marketing Clearances:
            
            Date
      Received:Laser-based
      products:-
      treatment of vascular lesions
            
            June 1999-
      hair removal
            
            March 2000-
      permanent hair reduction
            
            January 2001-
      treatment of benign pigmented lesions and pseudofolliculitis barbae,
      commonly referred to as razor bumps, and for the reduction of red
      pigmentation in scars
            
            June 2002-
      treatment of wrinkles
            
            October 2002Pulsed-light
      technologies:-
      treatment of pigmented lesions
            
            March 2003-
      hair removal and vascular treatments
            
            March 2005Infrared Titan
      technology for deep dermal heating for the temporary relief of
      minor muscle and joint pain and for the temporary increase in local
      circulation where applied
            
            February 2004Solera
      tabletop console:-
      for use with the Titan hand piece
            
            October 2004-
      for use with our pulsed-light hand pieces
            
            January 2005Pearl
      product for the treatment of wrinkles
            
            March
      2007Pearl
      Fractional product for skin resurfacing and coagulation
            
            August
      2008




Pre-Market
Approval (PMA) Pathway




A PMA
must be submitted to the FDA if the device cannot be cleared through the 510(k)
process. A PMA must be supported by extensive data, including but not limited
to, technical, preclinical, clinical trials, manufacturing and labeling to
demonstrate to the FDA’s satisfaction the safety and effectiveness of the
device. No device that we have developed to date has required pre-market
approval, development of  future devices or indications may require
pre-market approval.




Product
Modifications




We have
modified aspects of our products since receiving regulatory clearance, but we
believe that new 510(k) clearances are not required for these modifications.
After a device receives 510(k) clearance or a PMA, any modification that could
significantly affect its safety or effectiveness, or that would constitute a
major change in its intended use, will require a new clearance or approval. The
FDA requires each manufacturer to make this determination initially, but the FDA
can review any such decision and can disagree with a manufacturer’s
determination. If the FDA disagrees with our determination not to seek a new
510(k) clearance or PMA, the FDA may retroactively require us to seek 510(k)
clearance or pre-market approval. The FDA could also require us to cease
marketing and distribution and/or recall the modified device until 510(k)
clearance or pre-market approval is obtained. Also, in these circumstances, we
may be subject to significant regulatory fines or penalties.




12




Clinical
Trials




When FDA
approval of a class I, class II or class III device requires human clinical
trials, and if the device presents a “significant risk,” as defined by the FDA,
to human health, the device sponsor is required to file an Investigational
Device Exemption, or IDE, application with the FDA and obtain IDE approval prior
to commencing the human clinical trial. If the device is considered a
“non-significant” risk, IDE submission to the FDA is not required. Instead, only
approval from the Institutional Review Board, or IRB, overseeing the clinical
trial is required. Human clinical studies are generally required in connection
with approval of class III devices and may be required for class I and II
devices. The IDE application must be supported by appropriate data, such as
animal and laboratory testing results, showing that it is safe to test the
device in humans and that the testing protocol is scientifically sound. The IDE
must be approved in advance by the FDA for a specified number of patients.
Clinical trials for a significant risk device may begin once the application is
reviewed and cleared by the FDA and the appropriate institutional review boards
at the clinical trial sites. Future clinical trials of our products may require
that we submit and obtain clearance of an IDE from the FDA prior to commencing
clinical trials. The FDA, and the IRB at each institution at which a clinical
trial is being performed, may suspend a clinical trial at any time for various
reasons, including a belief that the subjects are being exposed to an
unacceptable health risk.




In
addition, in 2009, we began performing clinical trials for a new body contouring
product called TruSculpt. Though the launch of this product was indefinitely
postponed in the fourth quarter of 2009, we continue to develop this product and
obtain clinical data to prove efficacy. Our clinical department continues to
work with physicians and other experts in the medical aesthetic market to gather
additional data that may provide the basis for physician-authored white papers,
the promotion of our existing products, or seeking the approval for additional
indications on our existing and any future products.




Pervasive
and Continuing Regulation





After a
device is placed on the market, numerous regulatory requirements apply. These
include:





•
            Quality
      system regulations, which require manufacturers, including third-party
      manufacturers, to follow stringent design, testing, control, documentation
      and other quality assurance procedures during all aspects of the
      manufacturing process;





•
            Labeling
      regulations and FDA prohibitions against the promotion of products for
      un-cleared, unapproved or “off-label”
uses;





•
            Medical
      device reporting regulations, which require that manufacturers report to
      the FDA if their device may have caused or contributed to a death or
      serious injury or malfunctioned in a way that would likely cause or
      contribute to a death or serious injury if the malfunction were to recur;
      and





•
            Post-market
      surveillance regulations, which apply when necessary to protect the public
      health or to provide additional safety and effectiveness data for the
      device.




The FDA
has broad post-market and regulatory enforcement powers. We are subject to
unannounced inspections by the FDA and the Food and Drug Branch of the
California Department of Health Services, or CDHS, to determine our compliance
with the QSR and other regulations, and these inspections may include the
manufacturing facilities of our subcontractors. In the past, our prior facility
has been inspected, and observations were noted. There were no findings that
involved a material violation of regulatory requirements. Our responses to these
observations have been accepted by the FDA and CDHS, and we believe that we are
in substantial compliance with the QSR. Our current manufacturing facility has
been inspected by the FDA and the CDHS. The FDA and the CDHS noted observations,
but there were no findings that involved a material violation of regulatory
requirements. Our responses to those observations have been accepted by the FDA
and CDHS.




We are
also regulated under the Radiation Control for Health and Safety Act, which
requires laser products to comply with performance standards, including design
and operation requirements, and manufacturers to certify in product labeling and
in reports to the FDA that their products comply with all such standards. The
law also requires laser manufacturers to file new product and annual reports,
maintain manufacturing, testing and sales records, and report product defects.
Various warning labels must be affixed and certain protective devices installed,
depending on the class of the product.




Failure
to comply with applicable regulatory requirements can result in enforcement
action by the FDA, which may include any of the following
sanctions:




•
            Warning
      letters, fines, injunctions, consent decrees and civil
      penalties;





•
            Repair,
      replacement, recall or seizure of our
products;





•
            Operating
      restrictions or partial suspension or total shutdown of
      production;




13




•
            Refusing
      our requests for 510(k) clearance or pre-market approval of new products,
      new intended uses, or modifications to existing
  products;





•
            Withdrawing
      510(k) clearance or pre-market approvals that have already been granted;
      and





•
            Criminal
      prosecution.




The FDA
also has the authority to require us to repair, replace or refund the cost of
any medical device that we have manufactured or distributed. If any of these
events were to occur, they could have a material adverse effect on our
business.




We are
also subject to a wide range of federal, state and local laws and regulations,
including those related to the environment, health and safety, land use and
quality assurance. We believe that compliance with these laws and regulations as
currently in effect will not have a material adverse effect on our capital
expenditures, earnings and competitive and financial position.




International




International
sales of medical devices are subject to foreign governmental regulations, which
vary substantially from country to country. The time required to obtain
clearance or approval by a foreign country may be longer or shorter than that
required for FDA clearance or approval, and the requirements may be
different.




The
primary regulatory environment in Europe is that of the European Union, which
consists of a number of countries encompassing most of the major countries in
Europe. The member states of the European Free Trade Association have
voluntarily adopted laws and regulations that mirror those of the European Union
with respect to medical devices. Other countries, such as Switzerland, have
entered into Mutual Recognition Agreements and allow the marketing of medical
devices that meet European Union requirements. The European Union has adopted
numerous directives and European Standardization Committees have promulgated
voluntary standards regulating the design, manufacture, clinical trials,
labeling and adverse event reporting for medical devices. Devices that comply
with the requirements of a relevant directive will be entitled to bear CE
conformity marking, indicating that the device conforms with the essential
requirements of the applicable directives and, accordingly, can be commercially
distributed throughout the member states of the European Union, the member
states of the European Free Trade Association and countries which have entered
into a Mutual Recognition Agreement. The method of assessing conformity varies
depending on the type and class of the product, but normally involves a
combination of self-assessment by the manufacturer and a third-party assessment
by a Notified Body, an independent and neutral institution appointed by a
country to conduct the conformity assessment. This third-party assessment may
consist of an audit of the manufacturer’s quality system and specific testing of
the manufacturer’s device. An assessment by a Notified Body in one member state
of the European Union, the European Free Trade Association or one country which
has entered into a Mutual Recognition Agreement is required in order for a
manufacturer to commercially distribute the product throughout these countries.
ISO 9001 and ISO 13845 certification are voluntary harmonized standards.
Compliance establishes the presumption of conformity with the essential
requirements for a CE Marking. In February 2000, our facility was awarded the
ISO 9001 and EN 46001 certification. In March 2003, we received our ISO 9001
updated certification (ISO 9001:2000) as well as our certification for ISO
13485:1996 which replaced our EN 46001 certification. In March 2004, we received
our ISO 13485:2003 certification, which is the most current ISO certification
for medical device companies, and in March 2006 and 2009, we passed our ISO
13485 recertification audit.




Employees


As of
December 31, 2009, we had 186 employees, compared to 244 employees as of
December 31, 2008. This reduction in employees resulted primarily from a
company-wide reduction in force in January and April 2009. Of the 186 employees
at December 31, 2009, 78 were in sales and marketing, 31 in manufacturing
operations, 35 in technical service, 19 in research and development and 23 in
general and administrative. We believe that our future success will depend in
part on our continued ability to attract, hire and retain qualified personnel.
None of our employees is represented by a labor union, and we believe our
employee relations are good.




Available
Information




We are
subject to the reporting requirements under the Securities Exchange Act of 1934.
Consequently, we are required to file reports and information with the
Securities and Exchange Commission, or SEC, including reports on the following
forms: annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934.
These reports and other information concerning the company may be accessed
through the SEC’s website at http://www.sec.gov.
Such filings, as well as our charters for our Audit and Compensation Committees
and our Code of Ethics are available on our website at http://www.cutera.com. In
the event that we grant a waiver under our Code of Ethics to any of our officers
and directors, we will publish it on our website.





14





ITEM 1A.
            RISK
      FACTORS





We
are in a difficult economic period, and the uncertainty in the economy may
further reduce customer demand for our products, cause potential customers to
delay their purchase decisions and make it more difficult for some potential
customers to obtain credit financing, all of which would adversely affect our
business and may increase the volatility of our stock price.





In 2009,
our revenue decreased by 36%,compared to 2008. The general economic difficulties being experienced by
our customers, reduced end consumer demand for procedures, the lack of
availability of consumer credit for some of our customers, and the general
reluctance of many of our current and prospective customers to spend significant
amounts of money on capital equipment during these unstable economic times, are
adversely affecting the market in which we operate. In times of economic
uncertainty individuals often reduce the amount of money that they spend on
discretionary items, including aesthetic procedures. This economic uncertainty
may cause potential customers to further delay their capital equipment purchase
decisions, and may make it more difficult for some potential customers to obtain
credit financing necessary to purchase our products or make timely payments to
us, each of which can have a material adverse effect on our revenue,
profitability and business and may increase the volatility of our stock
price.





We
rely heavily on our sales professionals to market and sell our products
worldwide. If we are unable to effectively train, retain and manage the sales
professionals, our business will be harmed, which would impair our future
revenue and profitability.





Our
success largely depends on our ability to manage and improve the productivity
levels of our sales professionals worldwide. Measures we implement in an effort
to retain, train and manage our sales professionals and improve their
productivity may not be successful. Our direct sales professionals earn a
material portion of their compensation through commissions. Unless revenue
improves, their total compensation may remain low, which could result in higher
turnover. In response to reduced commission earnings resulting from the decrease
in revenue, some of our sales professionals left the industry entirely or left
our company to work for our competitors. We are selectively hiring new sales
professionals in key territories to fill vacant positions. The replacement or
absence of seasoned sales professionals may adversely affect our revenue.
Following the resignation of our Vice President of Sales in June 2009, we
promoted our General Manager for our Japan operations to the Vice President of
North American Sales position in July 2009. If the North American sales team
does not align with our new Vice President of North American Sales, we could
experience more turnover in the future. If we experience significant levels of
attrition, or reductions in productivity among our sales professionals or our
sales managers, our revenue and profitability may be adversely affected and this
could materially harm our business.





The
initiatives that we are implementing in an effort to improve revenue and
profitability could be unsuccessful, which could harm our business.





In 2009,
our total revenue decreased 36%, U.S. revenue decreased by 50% and international
revenue decreased by 22%, compared to 2008. In an effort to improve our revenue
and profitability, we have implemented several strategic initiatives focusing on
our worldwide sales and marketing infrastructure, product introductions and
expense management. For example, we had company-wide reductions in force in
January 2009 and April 2009 resulting in a total net reduction of approximately
22% of our workforce from December 31, 2008, and we reduced or eliminated
certain employee benefit programs. Further, following the resignation of our
Vice President of Sales in June 2009, we promoted our General Manager for our
Japan operations to the position of Vice President of North American Sales in
July 2009. These initiatives are intended to improve our revenue and
profitability; however, they may instead contribute to employee turnover,
instability to our operations, or further reduction in our revenue and harm to
our business.





A
lack of customer demand for our products in any of our markets would harm our
revenue.





Most of
our products are marketed to established dermatology and plastic surgeon medical
offices, as well as the non-core businesses, such as family practitioners,
primary care physicians, gynecologists, and non-medical models. Our most recent
product introductions, Pearl and Pearl Fractional are targeted at dermatologists
and plastic surgeons. Continuing to achieve and maintain penetration into each
of our markets is a material assumption of our business strategy.





Demand
for our products in any of our markets could be weakened by several factors,
including:





•
              Current
      lack of credit financing for some of our potential
    customers;





•
              Poor
      financial performance of market segments that try introducing aesthetic
      procedures to their
businesses;





•
              The
      inability to differentiate our products from those of our
      competitors;





•
              Reduced
      patient demand for elective aesthetic
  procedures;





•
              Failure
      to build and maintain relationships with opinion leaders within the
      various market segments;





•
              An
      increase in malpractice lawsuits that result in/or higher insurance costs;
      and





•
              Our
      ability to develop and market our products to the core market specialties
      of dermatologists and plastic
surgeons.





If we do
not achieve anticipated demand for our products our revenue may be adversely
impacted.





15




If
there is not sufficient consumer demand for the procedures performed with our
products, practitioner demand for our products could be inhibited, resulting in
unfavorable operating results and reduced growth potential.





Continued
expansion of the global market for laser and other energy-based aesthetic
procedures is a material assumption of our business strategy. Most procedures
performed using our products are elective procedures not reimbursable through
government or private health insurance, with the costs borne by the patient. The
decision to utilize our products may therefore be influenced by a number of
factors, including:


•
              Consumer
      disposable income and access to consumer credit, which as a result of the
      unstable economy, may have been significantly
    impacted;
 
 •
              The
      cost of procedures performed using our
products;
 
 •
              The
      cost, safety and effectiveness of alternative treatments, including
      treatments which are not based upon laser or other energy-based
      technologies and treatments which use pharmaceutical
    products;
 
 •
              The
      success of our sales and marketing efforts;
and
 
 •
              The
      education of our customers and patients on the benefits and uses of our
      products, compared to competitors’ products and
    technologies.


If, as a
result of these factors, there is not sufficient demand for the procedures
performed with our products, practitioner demand for our products could be
reduced, which could have a material adverse effect on our business, financial
condition, revenue and result of operations.





We
offer credit terms to some qualified customers and also to leasing companies to
finance the purchase of our products. In the event that any of these customers
default on the amounts payable to us, our earnings may be adversely
affected.





While we
qualify customers to whom we offer credit terms (generally net 30 to 60 days),
we cannot provide any assurance that the financial position of these customers
will not change adversely before we receive payment. For example, in early 2009,
one leasing company that we provided credit, based on their historical payment
history and good credit standing, defaulted on their payment of
$473,000 due to experiencing significant financial difficulties. As a
result, our general and administrative expenses, and therefore net loss, for
2009, were negatively impacted by an increase in the allowance for doubtful
accounts. In the event that there is a default by any other customers to whom we
have provided credit terms, this could further negatively affect our earnings
and results of operations in the future.




Product
liability suits could be brought against us due to a defective design, material
or workmanship or misuse of our products and could result in expensive and
time-consuming litigation, payment of substantial damages and an increase in our
insurance rates.





If our
products are defectively designed, manufactured or labeled, contain defective
components or are misused, we may become subject to substantial and costly
litigation by our customers or their patients. Misusing our products or failing
to adhere to operating guidelines could cause significant eye and skin damage,
and underlying tissue damage. In addition, if our operating guidelines are found
to be inadequate, we may be subject to liability. We have been involved, and may
in the future be involved, in litigation related to the use of our products.
Product liability claims could divert management’s attention from our core
business, be expensive to defend and result in sizable damage awards against us.
We may not have sufficient insurance coverage for all future claims. We may not
be able to obtain insurance in amounts or scope sufficient to provide us with
adequate coverage against all potential liabilities. Any product liability
claims brought against us, with or without merit, could increase our product
liability insurance rates or prevent us from securing continuing coverage, could
harm our reputation in the industry and could reduce product sales. In addition,
we historically experienced steep increases in our product liability insurance
premiums as a percentage of revenue. If our premiums continue to rise, we may no
longer be able to afford adequate insurance coverage.





If we are
unable to maintain adequate insurance coverage, or we have product liability
claims in excess of our insurance coverage, claims would be paid out of cash
reserves, thereby harming our financial condition, operating results and
profitability.





Healthcare
reform legislation and changes occurring at U.S. Food and Drug Administration,
or FDA, could adversely affect our revenue and financial condition.





In recent
years, there have been numerous initiatives on the federal and state levels for
comprehensive reforms affecting the payment for, the availability of and
reimbursement for healthcare services in the United States. These initiatives
have ranged from proposals to fundamentally change federal and state healthcare
reimbursement programs, including providing comprehensive healthcare coverage to
the public under governmental funded programs, to minor modifications to
existing programs. Recently, the current administration and members of Congress
have proposed significant reforms to the U.S. healthcare system. Both the U.S.
Senate and House of Representatives have conducted hearings about U.S.
healthcare reform. Our products are not reimbursed by insurance companies or
federal or state governments and some of this proposed legislation will
therefore not affect us. This proposed legislation, however, includes a tax on
manufacturers of medical devices and diagnostic products which would be
applicable to us and, if passed, would decrease our net income.




16




In
addition, there are several changes occurring at FDA that may lengthen the
regulatory approval process for medical devices and require additional clinical
data to support regulatory clearance for the sale and marketing of our new
products. These changes in the FDA regulatory approval process may delay or
prevent the approval of new products and could result in lost market
opportunity. Changes in FDA regulations may require additional safety
monitoring, labeling changes, restrictions on product distribution or use, or
other measures after the introduction of our products to market, which could
increase our costs of doing business, adversely affect the future permitted uses
of approved products, or otherwise adversely affect the market for our
products.





The
ultimate content or timing of any future healthcare reform legislation, and its
impact on us, is impossible to predict. If significant reforms are made to the
healthcare system in the United States, or in other jurisdictions, those reforms
may have an adverse effect on our financial condition and results of
operations.




We have recently entered into
strategic alliances to distribute third party products internationally. To
successfully market and sell these products, we must address many issues that
are unique to these businessesand could reduce our available cash
reserves and negatively impacting our profitability.





Recently,
we have entered into distribution arrangements pursuant to which we utilize our
sales force and distributors to sell products manufactured by other companies.
We entered into an agreement with Obagi Medical Products, Inc. (Obagi), to
distribute certain of their proprietary cosmeceuticals, or skin care products,
in Japan. This agreement requires us to purchase a minimum dollar amount of
Obagi products of $1.25 million in 2010, and the purchase commitments for 2011
and beyond have yet to be determined. In addition, we entered into an agreement
with Sound Surgical Technologies, Inc. to distribute their VASER® Lipo
System in certain European countries and Canada. Finally, we also have an
agreement with BioForm Medical Inc., to distribute their Radiesse®
dermal filler product in Japan. Each of these distribution agreements presents
its own unique risks and challenges. For example, to sell products in
partnership with Obagi we need to invest in creating a sales structure that is
experienced in the sale of cosmeceuticals and not in capital equipment. We need
to commit resources to training this sales force, obtaining regulatory licenses
in Japan and developing new marketing materials to promote the sale of Obagi
products. For each of these distribution arrangements, until we can develop our
own experienced sales force, we may need to pay third party distributors to sell
the products which will result in higher fees and lower margins than if we sell
direct to customers. In addition, the minimum commitments and other costs of
distributing products manufactured by these companies may exceed the incremental
revenue that we derive from the sale of their products thereby reducing our
available cash reserves and negatively impacting our profitability.





To
successfully market and sell our products internationally, we must address many
issues that are unique to our international business.





Our
international revenue was $32.7 million in 2009, which represented 61% of our
total revenue. International revenue is a material component of our business
strategy. We depend on third-party distributors and a direct sales force to sell
our products internationally, and if they underperform we may be unable to
increase or maintain our level of international revenue. To grow our business,
we will need to improve productivity in current sales territories and expand
into new territories. However, direct sales productivity may not improve and
distributors may not accept our business or commit the necessary resources to
market and sell our products to the level of our expectations. As a result, we
may not be able to increase or maintain international revenue
growth.





We
believe as we continue to manage our international operations and develop
opportunities in additional international territories, our international revenue
will be subject to a number of risks, including:





•
              Difficulties
      in staffing and managing our foreign
  operations;





•
              Export
      restrictions, trade regulations and foreign tax
  laws;





•
              Fluctuating
      foreign currency exchange
rates;





•
              Foreign
      certification and regulatory
requirements;





•
              Lengthy
      payment cycles and difficulty in collecting accounts
      receivable;





•
              Customs
      clearance and shipping
delays;





•
              Political
      and economic
instability;


•
                Lack
      of awareness of our brand in international
      markets;
 
 •
                Preference
      for locally-produced products;
and
 
 •
                Reduced
      protection for intellectual property rights in some
      countries.


If one or
more of these risks were realized, it could require us to dedicate significant
resources to remedy the situation; and if we were unsuccessful at finding a
solution, we may not be able to sell our products in a particular market and, as
a result, our revenue may decline.





17




We
compete against companies that have longer operating histories, newer and
different products, and greater resources, each of which may result in a
competitive disadvantage to us and harm our business.





Our
industry is subject to intense competition. Our products compete against similar
products offered by public companies, such as Cynosure, Elen (in Italy), Iridex,
Palomar, Solta, and Syneron and as well as private companies such as Alma,
Lumenis, Sciton and several other companies. We are likely to compete with new
companies in the future. Competition with these companies could result in
reduced selling prices, reduced profit margins and loss of market share, any of
which would harm our business, financial condition and results of operations. We
also face competition from medical products, such as Botox, an injectable
compound used to reduce wrinkles, and collagen injections. Other alternatives to
the use of our products include sclerotherapy, a procedure involving the
injection of a solution into the vein to collapse it, electrolysis, a procedure
involving the application of electric current to eliminate hair follicles, and
chemical peels. We may also face competition from manufacturers of
pharmaceutical and other products that have not yet been developed. Our ability
to compete effectively depends upon our ability to distinguish our company and
our products from our competitors and their products, and includes such factors
as:


•
                Success
      and timing of new product development and
      introductions;
 
 •
                Product
      performance;
 
 •
                Product
      pricing;
 
 •
                Quality
      of customer
support;
 
 •
                Development
      of successful distribution channels, both domestically and
      internationally;
and
 
 •
                Intellectual
      property
protection.


To
compete effectively, we have to demonstrate that our products are attractive
alternatives to other devices and treatments by differentiating our products on
the basis of such factors as performance, brand name, service and price, and
this is difficult to do in a crowded aesthetic market. Some of our competitors
have newer or different products and more established customer relationships
than we do, which could inhibit our market penetration efforts. For example, we
have encountered, and expect to continue to encounter, situations where, due to
pre-existing relationships, potential customers decided to purchase additional
products from our competitors. Potential customers also may need to recoup the
cost of products that they have already purchased from our competitors and may
decide not to purchase our products, or to delay such purchases. If we are
unable to achieve continued market penetration, we will be unable to compete
effectively and our business will be harmed.





In
addition, some of our current and potential competitors have greater financial,
research and development, business development, manufacturing, and sales and
marketing resources than we have. Our competitors could utilize their greater
financial resources to acquire other companies to gain enhanced name recognition
and market share, as well as new technologies or products that could effectively
compete with our existing product lines. Recently there has been some
consolidation in the aesthetic industry leading to companies combining their
resources. For example, Thermage acquired Reliant in December 2008 and renamed
the combined company, Solta. In addition, in September 2009, Syneron acquired
Candela. Our competitors could also form strategic alliances with other
companies to develop products and solutions that effectively compete with our
products. For example, Syneron has entered into agreements with Proctor and
Gamble for the proposed development of home-use aesthetic devices. Business
combinations and alliances by our competitors could increase competition, which
could harm our business.





The
aesthetic equipment market is characterized by rapid innovation. To compete
effectively, we must develop and/or acquire new products, market them
successfully, and identify new markets for our technology.





We have
created products to apply our technology to hair removal, treatment of veins and
skin rejuvenation, including the treating of diffuse redness, skin laxity, fine
lines, wrinkles, skin texture, pore size and pigmented lesions. Currently, these
applications represent the majority of offered laser and other energy-based
aesthetic procedures. We have recently started distributing topical skin creams
and dermal fillers in the Japanese market and an ultrasonic liposuction device
for the body contouring market in Europe and Canada. To grow in the future, we
must develop and acquire new and innovative aesthetic products and applications,
identify new markets, and successfully launch the newly acquired or developed
product offerings.




To
successfully expand our product offerings, we must, among other
things:





•
                  Develop
      and acquire new products that either add to or significantly improve our
      current product
offerings;
 
 •
                  Convince
      our existing and prospective customers that our product offerings would be
      an attractive revenue-generating addition to their
      practice;
 
 •
                  Sell
      our product offerings to a broad customer
      base;
  18
  •
                  Identify
      new markets and alternative applications for our
      technology;
 
 •
                  Protect
      our existing and future products with defensible intellectual property;
      and
 
 •
                  Satisfy
      and maintain all regulatory requirements for
      commercialization.


With the
exception of 2009, we have introduced at least one new product every year since
2000. In November 2009, we announced that we postponed indefinitely the release
of our TruSculpt body contouring product. Historically, product introductions
have generally been a significant component of our financial performance. Our
business strategy is based, in part, on our expectation that we will continue to
increase our product offerings that we can sell to new and existing customers.
However, even with a significant investment in research and development, we may
be unable to continue to develop, acquire or effectively launch and market new
products and technologies regularly, or at all, which could adversely affect our
business.





In
addition, our former Executive Vice President of Research &
Development, who is also one of our founders, resigned from his employment with
us effective March 2009 to pursue personal interests. Although we have appointed
a new Vice President of Research & Development and our founder continues to
provide consulting services to us, our founder’s full-time employment,
experience and leadership contributed to our historical product development
initiatives. As a result, we may not be able to continue our trend of regular
new product introductions. Also, we may need additional research and development
resources to make new product introductions, which may be more costly and time
consuming to our organization.





Some of
our competitors release new products more often and more successfully than we
do. We believe that, to increase revenue from sales of new products and related
upgrades, we need to continue to develop our clinical support, further expand
and nurture relationships with industry thought leaders and increase market
awareness of the benefits of our new products. If we fail to successfully
commercialize any of our new products, our business could be
harmed.





While we
attempt to protect our products through patents and other intellectual property,
there are few barriers to entry that would prevent new entrants or existing
competitors from developing products that compete directly with ours. For
example, while our CoolGlide product was the first long-pulse Nd:YAG, or long
wavelength, laser system cleared by the FDA for permanent hair reduction on all
skin types, competitors have subsequently introduced systems that utilize Nd:YAG
lasers, and received FDA clearances to market these products as treating all
skin types. We expect that any competitive advantage we may enjoy from other
current and future innovations, such as combining multiple hand pieces in a
single system to perform a variety of applications, may diminish over time as
companies successfully respond to our, or create their own, innovations.
Consequently, we believe that we will have to continuously innovate and improve
our products and technology to compete successfully. If we are unable to
innovate successfully, our products could become obsolete and our revenue could
decline as our customers and prospects purchase our competitors’
products.




If
PSS World Medical fails to perform to our expectations, we may fail to achieve
anticipated operating results.





We have a
distribution agreement with PSS World Medical. PSS sales professionals work in
coordination with our sales force to locate new customers for our products
throughout the United States. Revenue from PSS declined significantly in 2009,
compared to 2008. Our revenue from PSS as a percentage of U.S. revenue was 18%
in 2009, 29% in 2008 and 23% in 2007. Although we continue to work closely with,
and focus our attention on, our PSS relationship, there is no assurance that
this will translate into increased revenue for us. Further, if PSS does not
perform adequately under the arrangement, or terminates our relationship, it may
have a material adverse effect on our business, financial condition and results
of operations.





We
depend on skilled and experienced personnel to operate our business effectively.
If we are unable to recruit, hire and retain these employees, our ability to
manage and expand our business will be harmed, which would impair our future
revenue and profitability.





Our
success largely depends on the skills, experience and efforts of our officers
and other key employees. Except for Change of Control and Severance Agreements
for our executive officers, we do not have employment contracts with any of our
officers or other key employees. Any of our officers and other key employees may
terminate their employment at any time. We do not have a succession plan in
place for each of our officers and key employees. In addition, we do not
maintain “key person” life insurance policies covering any of our employees. The
loss of any of our senior management team members could weaken our management
expertise and harm our business.




Our
ability to retain our skilled labor force and our success in attracting and
hiring new skilled employees are critical factors in determining whether we will
be successful in the future. We may not be able to meet our future hiring needs
or retain existing personnel. We may face particularly significant challenges
and risks in hiring, training, managing and retaining engineering and sales and
marketing employees. Failure to attract and retain personnel, particularly
technical and sales and marketing personnel, would materially harm our ability
to compete effectively and grow our business.





19




We
may incur substantial expenses if our practices are shown to have violated the
Telephone Consumer Protection Act, and defending ourselves against the related
litigation could distract management and harm our business




A
Telephone Consumer Protection Act, or TCPA, class action lawsuit was filed
against us in January 2008 in the Illinois Circuit Court, Cook County, by
Bridgeport Pain Control Center, Ltd., seeking monetary damages, injunctive
relief, costs and other relief. On August 25, 2009, following negotiations
between the parties, the parties entered into a settlement agreement that would
resolve the case on a class-wide basis. The Court gave its preliminary approval
to the proposed settlement on August 27, 2009, and a final hearing on the
settlement is scheduled for April 6, 2010. Under the terms of the settlement, we
will cause to be paid a total of $950,000 in exchange for a full release of
facsimile-related claims. See “Item 3 – Legal Proceedings” set forth in
Part III, Item 1 for further details.





If the
proposed settlement does not receive final approval and the matter is certified
as a class action and goes to trial, we may incur substantial additional
expenses defending ourselves and, if our practices are shown to have violated
the TCPA, this could result in an award of substantial damages, which may have a
material adverse effect on our profitability and business.




Two
securities class action lawsuits were filed against us in April and May 2007,
respectively, based upon the decreases in our stock price following the
announcement of our preliminary first quarter 2007 revenue and earnings, and the
announcement of our revised 2007 guidance. Defending ourselves against this
litigation could distract management and harm our business.





Two class
action lawsuits were filed against us following declines in our stock price in
the spring of 2007. On November 1, 2007, the court ordered the two cases
consolidated. These consolidated cases have been on appeal since November 2008
and both parties presented oral arguments to the Court of Appeals in February
2010. No decision has yet been rendered by the Court of Appeals. See “Item 3 –
Legal Proceedings” set forth in Part III, Item 1 of this annual report
on Form 10-K for further details.





Although
we retain director and officer liability insurance, there can be no guarantee
that such insurance will cover the claims that are made or will insure us fully
for all losses on covered claims. This litigation may distract our management
and consume resources that would otherwise have been directed toward operating
our business. Each of these factors could harm our business.




Adverse
conditions in the global banking industry and credit markets may adversely
impact the value of our investments or impair our liquidity.





We invest
our excess cash primarily in money market funds and in highly liquid debt
instruments (including auction rare securities) of the U.S. government and its
agencies, and U.S. municipalities. As of December 31, 2009, our balance in
marketable investment was $76.8 million. The longer the duration of a security,
the more susceptible it is to changes in market interest rates and bond yields.
As yields increase, those securities with a lower yield-at-cost show a
mark-to-market unrealized loss. For example, assuming a hypothetical increase in
interest rates of one percentage point, the fair value of our total investment
portfolio as of December 31, 2009 would have potentially decreased by
approximately $421,000, resulting in an unrealized loss that would subsequently
adversely impact our earnings. As a result, changes in the market interest rates
will affect our future net income (loss).




We
may be required to record impairment charges in future quarters as a result of
the decline in value of our investments in auction rate securities
(ARS).





Included
under the caption of “Long-term investments” in the Consolidated Balance Sheet
as of December 31, 2009, are $7.3 million of ARS. These ARS are designed to
provide liquidity through an auction process that resets the applicable interest
rate at predetermined calendar intervals, generally every 35 days. Though
approximately $4.4 million (par value) of our original holdings of $13.4 million
(par value) of ARS, have been redeemed at full par value in 2009, auctions for
the majority of the remaining ARS in our portfolio at December 31, 2009 have
continued to fail since February 2008 due to the lack of liquidity and overall
credit concerns in capital markets. Upon an auction failure, the interest rates
do not reset at a market rate but instead reset based on a formula contained in
the security, which rate is generally higher than the current market rate. The
failure of the auctions impacts our ability to readily liquidate our ARS into
cash until a future auction of these investments is successful, a buyer is found
outside of the auction process or the ARS is refinanced by the issuer into
another type of debt instrument.





If the
auctions for our ARS investments continue to fail, and there is a further
decline in the valuation, then we would have to: (i) record additional
reductions to the fair value of our ARS investments; and (ii) record unrealized
losses in our accumulated comprehensive income (loss) for the losses in value
that are associated with market risk. If the decline in fair value is considered
other-than-temporary then we would have to record an impairment charge in our
Consolidated Statement of Operations for the loss in value associated with the
worsening of the credit worthiness (credit losses) of the issuer, which would
reduce future earnings, harm our business and may cause our stock price to
decline.




20




The
price of our common stock may fluctuate substantially. We have a limited number
of shares of common stock outstanding, a large portion of which is held by a
small number of investors, which could result in the increase in volatility of
our stock price.





As of
December 31, 2009, approximately 58% of our outstanding shares of common stock
were held by 10 institutional investors. As a result of our relatively small
public float, our common stock may be less liquid than the stock of companies
with broader public ownership. Among other things, trading of a relatively small
volume of our common stock may have a greater impact on the trading price for
our shares than would be the case if our public float were larger.





The
public market price of our common stock has in the past fluctuated substantially
and, due to the current concentration of stockholders, it may continue to do so
in the future. The market price for our common stock could also be affected by a
number of other factors, including:




•
              The
      general market conditions unrelated to our operating
      performance;





•
              Sales
      of large blocks of our common stock, including sales by our executive
      officers, directors and our large institutional
      investors;





•
              Quarterly
      variations in our, or our competitors’, results of
      operations;





•
              Changes
      in analysts’ estimates, investors’ perceptions, recommendations by
      securities analysts or our failure to achieve analysts’
      estimates;





•
              The
      announcement of new products or service enhancements by us or our
      competitors;





•
              The
      announcement of the departure of a key employee or executive officer by us
      or our
competitor;





•
              Regulatory
      developments or delays concerning our, or our competitors’ products;
      and


•
                The
      initiation of litigation by us or against
us.
 
 Actual or
perceived instability in our stock price could reduce demand from potential
buyers of our stock, thereby causing our stock price to either remain depressed
or to decline further.





We
may be involved in future costly intellectual property litigation, which could
impact our future business and financial performance.





Our
competitors or other patent holders may assert that our present or future
products and the methods we employ are covered by their patents. In addition, we
do not know whether our competitors own or will obtain patents that they may
claim prevent, limit or interfere with our ability to make, use, sell or import
our products. Although we may seek to resolve any potential future claims or
actions, we may not be able to do so on reasonable terms, or at all. If,
following a successful third-party action for infringement, we cannot obtain a
license or redesign our products, we may have to stop manufacturing and selling
the applicable products and our business would suffer as a result. In addition,
a court could require us to pay substantial damages, and prohibit us from using
technologies essential to our products, any of which would have a material
adverse effect on our business, results of operations and financial
condition.





We may
become involved in litigation not only as a result of alleged infringement of a
third party’s intellectual property rights but also to protect our own
intellectual property. For example, we have been, and may hereafter become,
involved in litigation to protect the trademark rights associated with our
company name or the names of our products. Infringement and other intellectual
property claims, with or without merit, can be expensive and time-consuming to
litigate, and could divert management’s attention from our core
business.




Intellectual
property rights may not provide adequate protection for some or all of our
products, which may permit third parties to compete against us more
effectively.





We rely
on patent, copyright, trade secret and trademark laws and confidentiality
agreements to protect our technology and products. At December 31, 2009, we had
thirteen issued U.S. patents. Some of our components, such as our laser module,
electronic control system and high-voltage electronics, are not, and in the
future may not be, protected by patents. Additionally, our patent applications
may not issue as patents or, if issued, may not issue in a form that will be
advantageous to us. Any patents we obtain may be challenged, invalidated or
legally circumvented by third parties. Consequently, competitors could market
products and use manufacturing processes that are substantially similar to, or
superior to, ours. We may not be able to prevent the unauthorized disclosure or
use of our technical knowledge or other trade secrets by consultants, vendors,
former employees or current employees, despite the existence generally of
confidentiality agreements and other contractual restrictions. Monitoring
unauthorized uses and disclosures of our intellectual property is difficult, and
we do not know whether the steps we have taken to protect our intellectual
property will be effective. Moreover, the laws of many foreign countries will
not protect our intellectual property rights to the same extent as the laws of
the United States.





21




The
absence of complete intellectual property protection exposes us to a greater
risk of direct competition. Competitors could purchase one of our products and
attempt to replicate some or all of the competitive advantages we derive from
our development efforts, design around our protected technology, or develop
their own competitive technologies that fall outside of our intellectual
property rights. If our intellectual property is not adequately protected
against competitors’ products and methods, our competitive position and our
business could be adversely affected.





If
we fail to obtain or maintain necessary FDA clearances for our products and
indications, if clearances for future products and indications are delayed or
not issued, if there are federal or state level regulatory changes or if we are
found to have violated applicable FDA marketing rules, our commercial operations
would be harmed.





Our
products are medical devices that are subject to extensive regulation in the
United States by the FDA for manufacturing, labeling, sale, promotion,
distribution and shipping. Before a new medical device, or a new use of or
labeling claim for an existing product, can be marketed in the United States, it
must first receive either 510(k) clearance or pre-marketing approval from the
FDA, unless an exemption applies. Either process can be expensive and lengthy.
In the event that we do not obtain FDA clearances or approvals for our products,
our ability to market and sell them in the United States and revenue derived
there from may be adversely affected.





Medical
devices may be marketed in the United States only for the indications for which
they are approved or cleared by the FDA. For example, we have FDA clearance to
market our Titan product in the United States only for deep heating for the
temporary relief of muscle aches and pains; and to market our Pearl Fractional
product in the United States only for skin resurfacing. Therefore we are
prevented from promoting or advertising Titan in the United States and Pearl
Fractional in the United Statesfor any other
indications. If we fail to comply with these regulations, it could result in
enforcement action by the FDA which could lead to such consequences as warning
letters, adverse publicity, criminal enforcement action and/or third-party civil
litigation, each of which could adversely affect us.





We have
obtained 510(k) clearance for the indications for which we market our products.
However, our clearances can be revoked if safety or effectiveness problems
develop. We also are subject to Medical Device Reporting regulations, which
require us to report to the FDA if our products cause or contribute to a death
or serious injury, or malfunction in a way that would likely cause or contribute
to a death or serious injury. Our products are also subject to state
regulations, which are, in many instances frequently changing. Changes in state
regulations may impede sales. For example, federal regulations allow our
products to be sold to, or on the order of, “licensed practitioners,” as
determined on a state-by-state basis. As a result, in some states,
non-physicians may legally purchase our products. However, a state could change
its regulations at any time, thereby disallowing sales to particular types of
end users. We cannot predict the impact or effect of future legislation or
regulations at the federal or state levels.





The
FDA and state authorities have broad enforcement powers. If we fail to comply
with applicable regulatory requirements, it could result in enforcement action
by the FDA or state agencies, which may include any of the following
sanctions:





•
                    Warning
      letters, fines, injunctions, consent decrees and civil
      penalties;
 
 •
                    Repair,
      replacement, recall or seizure of our
      products;
 
 •
                    Operating
      restrictions or partial suspension or total shutdown of
      production;
 
 •
                          Refusing
      our requests for 510(k) clearance or pre-market approval of new products,
      new intended uses, or modifications to existing
  products;
 
 •
                          Withdrawing
      510(k) clearance or pre-market approvals that have already been granted;
      and
 
 •
                          Criminal
      prosecution.


If any of
these events were to occur, it could harm our business.





If
we fail to comply with the FDA’s Quality System Regulation and laser performance
standards, our manufacturing operations could be halted, and our business would
suffer.





We are
currently required to demonstrate and maintain compliance with the FDA’s Quality
System Regulation, or QSR. The QSR is a complex regulatory scheme that covers
the methods and documentation of the design, testing, control, manufacturing,
labeling, quality assurance, packaging, storage and shipping of our products.
Because our products involve the use of lasers, our products also are covered by
a performance standard for lasers set forth in FDA regulations. The laser
performance standard imposes specific record-keeping, reporting, product testing
and product labeling requirements. These requirements include affixing warning
labels to laser products, as well as incorporating certain safety features in
the design of laser products. The FDA enforces the QSR and laser performance
standards through periodic unannounced inspections. Our failure to take
satisfactory corrective action in response to an adverse QSR inspection or our
failure to comply with applicable laser performance standards could result in
enforcement actions, including a public warning letter, a shutdown of our
manufacturing operations, a recall of our products, civil or criminal penalties,
or other sanctions, such as those described in the preceding paragraph, which
would cause our sales and business to suffer.





22




If
we modify one of our FDA-approved devices, we may need to seek re-approval,
which, if not granted, would prevent us from selling our modified products or
cause us to redesign our products.





Any
modifications to an FDA-cleared device that would significantly affect its
safety or effectiveness or that would constitute a major change in its intended
use would require a new 510(k) clearance or possibly a pre-market approval. We
may not be able to obtain additional 510(k) clearance or pre-market approvals
for new products or for modifications to, or additional indications for, our
existing products in a timely fashion, or at all. Delays in obtaining future
clearance would adversely affect our ability to introduce new or enhanced
products in a timely manner, which in turn would harm our revenue and future
profitability.





We have
made modifications to our devices in the past and may make additional
modifications in the future that we believe do not or will not require
additional clearance or approvals. If the FDA disagrees, and requires new
clearances or approvals for the modifications, we may be required to recall and
to stop marketing the modified devices, which could harm our operating results
and require us to redesign our products.





We
may be unable to obtain or maintain international regulatory qualifications or
approvals for our current or future products and indications, which could harm
our business.





Sales of
our products outside the United States are subject to foreign regulatory
requirements that vary widely from country to country. In addition, exports of
medical devices from the United States are regulated by the FDA. Complying with
international regulatory requirements can be an expensive and time-consuming
process and approval is not certain. The time required to obtain clearance or
approvals, if required by other countries, may be longer than that required for
FDA clearance or approvals, and requirements for such clearances or approvals
may significantly differ from FDA requirements. We may be unable to obtain or
maintain regulatory qualifications, clearances or approvals in other countries.
We may also incur significant costs in attempting to obtain and in maintaining
foreign regulatory approvals or qualifications. If we experience delays in
receiving necessary qualifications, clearances or approvals to market our
products outside the United States, or if we fail to receive those
qualifications, clearances or approvals, we may be unable to market our products
or enhancements in international markets effectively, or at all, which could
have a material adverse effect on our business and growth strategy.





Any
acquisitions that we make could disrupt our business and harm our financial
condition.





We expect
to evaluate potential strategic acquisitions of complementary businesses,
products or technologies. We may also consider joint ventures and other
collaborative projects. We may not be able to identify appropriate acquisition
candidates or strategic partners, or successfully negotiate, finance or
integrate any businesses, products or technologies that we acquire. Furthermore,
the integration of any acquisition and management of any collaborative project
may divert management’s time and resources from our core business and disrupt
our operations and we may incur significant legal, accounting and banking fees
in connection with such a transaction. In addition, if we purchase a company
that is not profitable, our cash balances may be reduced or depleted. We do not
have any experience as a team with acquiring companies or products. If we decide
to expand our product offerings beyond laser and other energy-based products, we
may spend time and money on projects that do not increase our revenue. Any cash
acquisition we pursue would diminish our available cash balances to us for other
uses, and any stock acquisition could be dilutive to our
stockholders.





While we
from time to time evaluate potential acquisitions of businesses, products and
technologies, and anticipate continuing to make these evaluations, we have no
present understandings, commitments or agreements with respect to any material
acquisitions or collaborative projects.





The
expense and potential unavailability of insurance coverage for our customers
could adversely affect our ability to sell our products, and therefore our
financial condition.





Some of
our customers and prospective customers have had difficulty in procuring or
maintaining liability insurance to cover their operation and use of our
products. Medical malpractice carriers are withdrawing coverage in certain
states or substantially increasing premiums. If this trend continues or worsens,
our customers may discontinue using our products and potential customers may opt
against purchasing laser and other energy based products due to the cost or
inability to procure insurance coverage. The unavailability of insurance
coverage for our customers and prospects could adversely affect our ability to
sell our products, and that could harm our financial condition.




23




Because
we do not require training for users of our products, and sell our products at
times to non-physicians, there exists an increased potential for misuse of our
products, which could harm our reputation and our business.





Federal
regulations allow us to sell our products to or on the order of “licensed
practitioners.” The definition of “licensed practitioners” varies from state to
state. As a result, our products may be purchased or operated by physicians with
varying levels of training, and in many states, by non-physicians, including
nurse practitioners, chiropractors and technicians. Outside the United States,
many jurisdictions do not require specific qualifications or training for
purchasers or operators of our products. We do not supervise the procedures
performed with our products, nor do we require that direct medical supervision
occur. We and our distributors generally offer but do not require product
training to the purchasers or operators of our products. In addition, we
sometimes sell our systems to companies that rent our systems to third parties
and that provide a technician to perform the procedures. The lack of training
and the purchase and use of our products by non-physicians may result in product
misuse and adverse treatment outcomes, which could harm our reputation and our
business, and, in the event these result in product liability litigation,
distract management and subject us to liability, including legal
expenses.





Our
manufacturing operations are dependent upon third-party suppliers, making us
vulnerable to supply shortages and price fluctuations, which could harm our
business.





Many of
the components and materials that comprise our products are currently
manufactured by a limited number of suppliers. A supply interruption or an
increase in demand beyond our current suppliers’ capabilities could harm our
ability to manufacture our products until a new source of supply is identified
and qualified. Our reliance on these suppliers subjects us to a number of risks
that could harm our business, including:





•
                    Interruption
      of supply resulting from modifications to or discontinuation of a
      supplier’s
  operations;
 
 •
                    Delays
      in product shipments resulting from uncorrected defects, reliability
      issues or a supplier’s variation in a
      component;
 
 •
                    A
      lack of long term supply arrangements for key components with our
      suppliers;
 
 •
                          Inability
      to obtain adequate supply in a timely manner, or on reasonable
      terms;
 
 •
                          Difficulty
      locating and qualifying alternative suppliers for our components in a
      timely
manner;
 
 •
                          Production
      delays related to the evaluation and testing of products from alternative
      suppliers and corresponding regulatory qualifications;
  and


•
                Delay
      in supplier deliveries.


Any
interruption in the supply of components or materials, or our inability to
obtain substitute components or materials from alternate sources at acceptable
prices in a timely manner, could impair our ability to meet the demand of our
customers, which would have an adverse effect on our business.





Any
defects in the design, material or workmanship of our products may not be
discovered prior to shipment to customers, which could result in warranty
obligations that may reduce our future revenue and increase our
cost.





The
design of our products is complex. To manufacture them successfully, we must
procure quality components and employ individuals with a significant degree of
technical expertise. If our designs are defective, if suppliers fail to deliver
components to specification, or if our employees fail to properly assemble, test
and package our products, the reliability and performance of our products will
be compromised.





If our
products contain defects that cannot be repaired easily and inexpensively, we
may experience:





•
                      Loss
      of customer orders and delay in order
      fulfillment;
 
 •
                      Damage
      to our brand
    reputation;
 
 •
                      Increased
      cost of our warranty program due to product repair or
      replacement;
 
 •
                            Inability
      to attract new
customers;
 
 •
                            Diversion
      of resources from our manufacturing and research and development
      departments into our service department;
      and
 
 •
                            Legal
      action.


The
occurrence of any one or more of the foregoing could materially harm our
business.





24




We
forecast sales to determine requirements for components and materials used in
our products and if our forecasts are incorrect, we may experience either delays
in shipments or increased inventory costs.





We keep
limited materials and components on hand. To manage our manufacturing operations
with our suppliers, we forecast anticipated product orders and material
requirements to predict our inventory needs up to twelve months in advance and
enter into purchase orders on the basis of these requirements. Our experience of
materials usage may not provide us with enough data to accurately predict future
demand. If our sales demand decreases significantly, or if we overestimate our
component and material requirements, we will have excess inventories and incur
costs associated with the termination of existing purchase order commitments,
which would increase our expenses. If our business expands, or if we
underestimate our component and material requirements, we may have inadequate
inventories, which could interrupt, delay or prevent delivery of our products to
our customers. Any of these occurrences would negatively affect our financial
performance and the level of satisfaction our customers have with our
business.





Our
gross and operating margins may vary over time.





Our gross
and operating margins may be adversely affected by a number of factors,
including decreases in our shipment volume, reductions in, or obsolescence of,
our inventory, shifts in our product mix and increased expenses associated with
repairing defective products covered by our warranty program. In addition, the
competitive market environment in which we operate may adversely affect pricing
for our products. Because we own most of our manufacturing capacity, a
significant portion of our operating costs are fixed. If we experience a
decrease in shipment volume, or have to reduce our pricing to remain
competitive, or experience a greater than expected failure rate for any of our
products, our gross and operating margins will be adversely
impacted.





We
are subject to fluctuations in the exchange rate of the U.S. dollar and foreign
currencies.





As a
result of recent fluctuations in currency markets and the strong dollar relative
to many other major currencies, our products priced in U.S. dollars may be more
expensive relative to products of our foreign competitors, which could result in
lower revenue. We do not actively hedge our exposure to currency rate
fluctuations. While we transact business primarily in U.S. Dollars, and a
significant proportion of our revenue is denominated in U.S. Dollars, a portion
of our costs and revenue is denominated in other currencies, such as the Euro,
Japanese Yen, Australian Dollar, Canadian Dollar and British Pound Sterling. As
a result, changes in the exchange rates of these currencies to the
U.S. Dollar will affect our net income (loss).





Anti-takeover
provisions in our Amended and Restated Certificate of Incorporation and Bylaws,
and Delaware law, contain provisions that could discourage a
takeover.





Our
Amended and Restated Certificate of Incorporation and Bylaws, and Delaware law,
contain provisions that might enable our management to resist a takeover, and
might make it more difficult for an investor to acquire a substantial block of
our common stock. These provisions include:





•
                        A
      classified board of
      directors;
 
 •
                        Advance
      notice requirements to stockholders for matters to be brought at
      stockholder
      meetings;
 
 •
                        A
      supermajority stockholder vote requirement for amending certain provisions
      of our Amended and Restated Certificate of Incorporation and
      bylaws;
 
 •
                              Limitations
      on stockholder actions by written consent;
      and
 
 •
                              The
      right to issue preferred stock without stockholder approval, which could
      be used to dilute the stock ownership of a potential hostile
      acquirer.


These
provisions, as well as Change of Control and Severance Agreements entered into
with each of our executive officers, might discourage, delay or prevent a change
in control of our company or a change in our management. The existence of these
provisions could adversely affect the voting power of holders of common stock
and limit the price that investors might be willing to pay in the future for
shares of our common stock.





25




ITEM 1B.
            UNRESOLVED
      STAFF COMMENTS




Not
applicable.





ITEM 2.
            PROPERTIES




Our
corporate headquarters and U.S. operations are located in a 66,000 square foot
facility in Brisbane, California. We lease these premises under a non-cancelable
operating lease which expires in 2013. In addition, we have leased office
facilities in certain international countries as follows:





Country
            
            Square
      Footage
            
            Lease
      termination or ExpirationJapan
            
            Approximately 5,790
            
            Three
      leases of which two expire in May 2010, and one expires in July
      2010.Switzerland
            
            Approximately
      2,885
            
            Two
      leases expire in March and April 2010. The company entered into a lease
      agreement for 3,174 square feet effective April 2010, which expires in
      March 2013.France
            
            Approximately
      450
            
            Lease
      expires in November 2011, but may be cancelled at any time with a
      three-month notice.Spain
            
            Approximately
      175
            
            Lease
      automatically renews at the end of each six-month period.





We
believe that these facilities are adequate for our current and future needs for
at least the next twelve months.





ITEM 3.
            LEGAL
      PROCEEDINGS





Two
securities class action lawsuits were filed against us and two of our executive
officers in April 2007 and May 2007, respectively, in the U.S. District Court
for the Northern District of California following declines in the Company’s
stock price. The plaintiffs claim to represent purchasers of our common stock
from January 31, 2007 through May 7, 2007. The complaints generally allege that
materially false statements and omissions were made regarding our financial
prospects, and seek unspecified monetary damages. On November 1, 2007, the Court
ordered the two cases consolidated. On December 17, 2007, the plaintiffs filed a
consolidated, amended complaint, and on January 31, 2008, we filed a motion to
dismiss that complaint. On September 30, 2008, in response to our motion, the
Court issued an order dismissing the plaintiffs’ amended complaint without
prejudice. On October 28, 2008, the plaintiffs filed a Notice Of Intention Not
to File A Second Amended Consolidated Complaint. On November 25, 2008, the Court
closed the case on its own initiative. On November 26, 2008, the plaintiffs
filed a Notice of Appeal to the U.S. Court of Appeals for the Ninth Circuit, on
April 16, 2009 the plaintiffs filed their opening brief with that Court, on June
17, 2009 we filed our response to plaintiffs' brief, on July 1, 2009 the
plaintiffs filed their response to our brief, and on February 11, 2010 both
parties presented oral argument to the Court of Appeals. No decision has yet
been rendered by the Court of Appeals. We intend to continue to defend this case
vigorously, regardless of the stage of litigation. Although we retain director
and officer liability insurance, there is no assurance that such insurance will
cover the claims that are made or will insure us fully for all losses on covered
claims. Since we do not believe that a significant adverse result in this
litigation is probable and since the amount of potential damages in the event of
an adverse result is not reasonably estimable, no expense has been recorded with
respect to the contingent liability associated with this matter.




A
Telephone Consumer Protection Act, or TCPA, class action lawsuit was filed
against us in January 2008 in the Illinois Circuit Court, Cook County, by
Bridgeport Pain Control Center, Ltd., seeking monetary damages, injunctive
relief, costs and other relief. The complaint alleges that we violated the TCPA
by sending unsolicited advertisements by facsimile to the plaintiff and other
recipients nationwide during the four-year period preceding the lawsuit without
the prior express invitation or permission of the recipients. Two state law
claims, limited to Illinois recipients, allege a class period of three and five
years, respectively. Under the TCPA, recipients of unsolicited facsimile
advertisements may be entitled to damages of $500 per violation for inadvertent
violations and $1,500 per violation for knowing or willful violations. On
February 22, 2008, we removed the case to federal court in the Northern District
of Illinois. On August 25, 2009, following negotiations between the parties, the
parties entered into a settlement agreement that would resolve the case on a
class-wide basis. The Court gave its preliminary approval to the proposed
settlement on August 27, 2009, and a final hearing on the settlement is
scheduled for April 6, 2010. Under the terms of the settlement, we will cause to
be paid a total of $950,000 in exchange for a full release of facsimile-related
claims. We included $850,000 for the estimated cost of the settlement, net of
administrative expenses and amounts that are expected to be recoverable from our
insurance carrier, in our Consolidated Statement of Operations in 2009. If the
proposed settlement does not receive final approval and the matter is certified
as a class action and goes to trial, we may incur substantial additional
expenses defending ourselves and, if our practices are shown to have violated
the TCPA, this could result in an award of substantial damages, which may have a
material adverse effect on our profitability and business. If the proposed
settlement does not receive final approval, we intend to defend this case
vigorously.





26




ITEM 4.
            [RESERVED]








PART
II





ITEM 5.
            MARKET
      FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES




Stock
Exchange Listing




Our
common stock trades on The NASDAQ Global Select Market under the symbol “CUTR.”
As of February 26, 2010, the closing sale price of our common stock was $9.40
per share.




Common
Stockholders




We had 10
stockholders of record as of February 26, 2010. Since many stockholders choose
to hold their shares under the name of their brokerage firm, we believe, the
actual number of stockholders was approximately 4,200.




Stock
Prices




The
following table sets forth quarterly high and low closing sales prices of our
common stock for the indicated fiscal periods:





Common
      Stock2009
            
            2008High
            
            Low
            
            High
            
            Low4th
      Quarter
            
            $
            9.63
            
            
            $
            7.97
            
            
            $
            10.58
            
            
            $
            7.473rd
      Quarter
            
            
            9.40
            
            
            
            7.85
            
            
            
            12.28
            
            
            
            9.102nd
      Quarter
            
            
            9.03
            
            
            
            5.93
            
            
            
            13.91
            
            
            
            8.981st
      Quarter
            
            
            8.71
            
            
            
            5.57
            
            
            
            15.53
            
            
            
            11.70




27




Performance
Graph




Below is
a graph showing the cumulative total return to our stockholders during the
period from December 31, 2004 through December 31, 2009 in comparison to the
cumulative return on the NASDAQ Composite Index (U.S.) and the NASDAQ Medical
Equipment Index during that same period. (1) The results assume that $100 was
invested on December 31, 2004.







The
information under “Performance Graph” is not deemed filed with the Securities
and Exchange Commission and is not to be incorporated by reference in any filing
of Cutera under the Securities Act of 1933, as amended, or the Securities
Exchange Act of 1934, as amended, whether made before or after the date of this
10-K and irrespective of any general incorporation language in those
filings.




Dividend
Policy




We have
never paid a cash dividend and have no present intention to pay cash dividends
in the foreseeable future. We intend to retain any future earnings for use in
our business.




We did
not sell any unregistered securities during the period covered by this Annual
Report on Form 10-K.




The
information required by this Item regarding equity compensation plans is
incorporated by reference to the information set forth in Part III Item 12
of this Annual Report on Form 10-K.




Securities
Authorized for Issuance under Equity Compensation Plans




See Part
III, Item 12 for information regarding securities authorized for issuance
under equity compensation plans.





28







ITEM 6.
            SELECTED
      FINANCIAL DATA




The table
set forth below contains certain consolidated financial data for each of our
last five fiscal years. This data should be read in conjunction with the
detailed information, financial statements and related notes, as well as
Management’s Discussion and Analysis of Financial Condition and Results of
Operations included elsewhere herein.





Year
      Ended December 31,Consolidated
      Statements of Operations Data (in thousands, except per share
      data):
              
              2009
              
              
              2008
              
              2007
              
              
              2006
              
              2005Net
      revenue
              
              $
              53,682
              
              
              $
              83,379
              
              
              $
              101,726
              
              
              $
              100,692
              
              
              $
              75,620Cost
      of revenue
              
              
              21,759
              
              
              
              32,358
              
              
              
              35,002
              
              
              
              29,859
              
              
              
              19,792Gross
      profit
              
              
              31,923
              
              
              
              51,021
              
              
              
              66,724
              
              
              
              70,833
              
              
              
              55,828Operating
      expenses:Sales
      and marketing
              
              
              24,286
              
              
              
              35,354
              
              
              
              38,277
              
              
              
              32,890
              
              
              
              25,021Research
      and development
              
              
              6,810
              
              
              
              7,550
              
              
              
              7,169
              
              
              
              6,473
              
              
              
              5,353General
      and administrative
              
              
              10,320
              
              
              
              11,270
              
              
              
              11,721
              
              
              
              15,192
              
              
              
              8,782Litigation
      settlement
              
              
              850
              
              
              
              —
              
              
              
              —
              
              
              
              18,935
              
              
              
              —Total
      operating expenses
              
              
              42,266
              
              
              
              54,174
              
              
              
              57,167
              
              
              
              73,490
              
              
              
              39,156Income
      (loss) from operations
              
              
              (10,343
              )
              
              
              (3,153
              )
              
              
              9,557
              
              
              
              (2,657
              )
              
              
              16,672Interest
      and other income, net
              
              
              1,572
              
              
              
              3,046
              
              
              
              4,207
              
              
              
              3,596
              
              
              
              2,034Other-than-temporary
      impairments of long-term investments
              
              
              —
              
              
              
              (3,554
              )
              
              
              —
              
              
              
              —
              
              
              
              —Income
      (loss) before income taxes
              
              
              (8,771
              )
              
              
              (3,661
              )
              
              
              13,764
              
              
              
              939
              
              
              
              18,706Provision
      (benefit) for income taxes
              
              
              8,908
              
              
              
              (792
              )
              
              
              3,260
              
              
              
              (1,184
              )
              
              
              4,905Net
      income (loss)
              
              $
              (17,679
              )
              
              $
              (2,869
              )
              
              $
              10,504
              
              
              $
              2,123
              
              
              $
              13,801Net
      income (loss) available to common stockholders used in basic net income
      per share
              
              $
              (17,679
              )
              
              $
              (2,869
              )
              
              $
              10,504
              
              
              $
              2,123
              
              
              $
              13,801Net
      income (loss) per share:Basic
              
              $
              (1.33
              )
              
              $
              (0.22
              )
              
              $
              0.80
              
              
              $
              0.17
              
              
              $
              1.20Diluted
              
              $
              (1.33
              )
              
              $
              (0.22
              )
              
              $
              0.74
              
              
              $
              0.15
              
              
              $
              1.00Weighted-average
      number of shares used in per share calculations:Basic
              
              
              13,279
              
              
              
              12,770
              
              
              
              13,153
              
              
              
              12,558
              
              
              
              11,535Diluted
              
              
              13,279
              
              
              
              12,770
              
              
              
              14,228
              
              
              
              14,278
              
              
              
              13,864
  As
      of December 31,Consolidated
      Balance Sheet Data (in thousands):
              
              2009
              
              
              2008
              
              2007
              
              
              2006
              
              2005Cash
      and cash equivalents
              
              $
              22,829
              
              
              $
              36,540
              
              $
              11,054
              
              
              $
              11,800
              
              $
              5,260Marketable
      investments
              
              
              76,780
              
              
              
              60,653
              
              
              88,510
              
              
              
              96,285
              
              
              86,736Long-term
      investments
              
              
              7,275
              
              
              
              9,627
              
              
              7,429
              
              
              
              —
              
              
              —Working
      capital (current assets less current liabilities)
              
              
              96,015
              
              
              
              101,644
              
              
              106,894
              
              
              
              111,999
              
              
              98,318Total
      assets
              
              
              121,352
              
              
              
              137,476
              
              
              138,653
              
              
              
              133,875
              
              
              111,958Retained
      earnings
              
              
              17,254
              
              
              
              31,410
              
              
              34,279
              
              
              
              23,866
              
              
              21,743Total
      stockholders’ equity
              
              
              100,853
              
              
              
              112,108
              
              
              109,353
              
              
              
              109,732
              
              
              97,177







29




ITEM 7.
            MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS




The
following discussion should be read in conjunction with our audited financial
statements and notes thereto for the fiscal year ended December 31, 2009.
This Annual Report on Form 10-K, including the following sections, contains
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Throughout this Report, and particularly in this
Item 7, the forward-looking statements are based upon our current
expectations, estimates and projections and that reflect our beliefs and
assumptions based upon information available to us at the date of this Report.
In some cases, you can identify these statements by words such as “may,”
“might,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,”
“estimates,” “predicts,” “potential” or “continue,” and other similar terms.
These forward-looking statements are not guarantees of future performance and
are subject to risks, uncertainties, and assumptions that are difficult to
predict. Our actual results, performance or achievements could differ materially
from those expressed or implied by the forward-looking statements. The
forward-looking statements include, but are not limited to, statements relating
to our future financial performance, the ability to grow our business, increase
our revenue, manage expenses, generate additional cash, achieve and maintain
profitability, develop and commercialize existing and new products and
applications, improve the performance of our worldwide sales and distribution
network, and to the outlook regarding long term prospects. We caution you not to
place undue reliance on these forward-looking statements, which reflect
management’s analysis only as of the date of this Annual Report on
Form 10-K. We undertake no obligation to update forward-looking statements
to reflect events or circumstances occurring after the date of this Form
10-K.




Some
of the important factors that could cause our results to differ materially from
those in our forward-looking statements, and a discussion of other risks and
uncertainties, are discussed in Item 1A—Risk Factors commencing on
page 15. We encourage you to read that section carefully as well as other
risks detailed from time to time in our filings with the SEC.





Introduction





The
Management’s Discussion and Analysis, or MD&A, is organized as
follows:




•
              Executive Summary. This
      section provides a general description and history of our business, a
      brief discussion of our product lines and the opportunities, trends,
      challenges and risks we focus on in the operation of our
      business.
 
 •
              Critical Accounting Policies
      and Estimates. This section describes the key accounting policies
      that are affected by critical accounting
  estimates.
 
 •
              Recent Accounting
      Guidance. This section describes the issuance and effect of new
      accounting pronouncements that are and may be applicable to
      us.
 
 •
              Results of Operations.
      This section provides our analysis and outlook for the significant line
      items on our Consolidated Statements of
  Operations.


•
              Liquidity and Capital
      Resources. This section provides an analysis of our liquidity and
      cash flows, as well as a discussion of our commitments that existed as of
      December 31, 2009.
 
 Executive
Summary





Company
Description. We are a global medical device company engaged in the
design, development, manufacture, marketing and servicing of laser and other
light-based aesthetics systems for practitioners worldwide. We offer aesthetic
systems on three platforms—Xeo, CoolGlide, and Solera— for use by physicians and
other qualified practitioners to allow our customers to offer safe and effective
aesthetic treatments to their customers.





Our
corporate headquarters and U.S. operations are located in Brisbane, California,
from where we conduct our manufacturing, warehousing, research and development,
regulatory, sales and marketing, service, and administrative activities. In the
United States, we market, sell and service our products primarily through direct
sales and service employees and through a distribution relationship with PSS
World Medical Shared Services, Inc., a wholly owned subsidiary of PSS World
Medical, or PSS, which has over 700 sales representatives serving physician
offices throughout the United States. In addition, we also sell certain items,
like Titan hand piece refills and marketing brochures, through the
internet.





International
sales are generally made through direct sales employees and through a worldwide
distributor network in over 30 countries. Outside the United States, we have a
direct sales presence in Australia, Canada, France, Japan, Spain, Switzerland
and the United Kingdom.





Products.
Our revenue is derived from the sale of Products, Upgrades, Service and Titan
hand piece refills. Product revenue represents the sale of a system, which
consists of one or more hand pieces and a console that incorporates a universal
graphic user interface, a laser and/or other light-based module, control system
software and high voltage electronics. However, depending on the application,
the laser or other light-based module is sometimes contained in the hand piece,
such as with our Pearl and Pearl Fractional applications, instead of in the
console. We offer our customers the ability to select the system that best fits
their practice at the time of purchase and then to cost-effectively add
applications to their system as their practice grows. This enables customers to
upgrade their systems whenever they want and provides us with a source of
recurring revenue, which we classify as Upgrade revenue. Service revenue relates
to amortization of pre-paid service contract revenue and receipts for services
on out-of-warranty products. Titan hand piece refill revenue is associated with
our Titan hand piece which requires replacement of the optical source after a
set number of pulses has been used. In addition, we distribute BioForm, Inc.’s
(BioForm) Radiesse®
dermal filler product in Japan.





30




Significant
Business Trends. We believe that our ability to grow revenue has been,
and will continue to be, primarily dependent on the following:


•
                Continuing
      to expand our product
offerings.
 
 •
                Investments
      made in our global sales and marketing
      infrastructure.
 
 •
                Use
      of clinical results to support new aesthetic products and
      applications.
 
 •
                Enhanced
      luminary development and reference selling efforts (to develop a location
      where our products can be displayed and used to assist in selling
      efforts).
 •
                Customer
      demand for our products and consumer demand for the applications they
      offer.
 •
                  Marketing
      to physicians in the core dermatology and plastic surgeon specialties, as
      well as outside those
specialties.
 
 •
                    Generating
      Service, Upgrade, and Titan hand piece refill revenue from our growing
      installed base of
customers.


Our U.S.
revenue decreased 50% and our international revenue decreased 22% in 2009,
compared to 2008. International revenue as a percent of total revenue was 61% in
2009 and 50% in 2008. We believe that the decline in U.S. and international
revenue was primarily attributable to the global recession that has caused our
prospective customers to be reluctant to spend significant amounts of money on
capital equipment during these unstable economic times. Historically a
significant portion of our U.S. revenue was sourced from the non-core market of
practitioners such as primary care physicians, gynecologists and physicians
offering aesthetic treatments in spa environments. We believe our U.S. revenue
declined greater than our international revenue, because the recession impacted
the U.S. market, and particularly the non-core market, more severely than our
international market, which is primarily comprised of core physicians. Further,
we also believe that those prospective customers who do not have established
medical offices, are finding it more difficult to obtain credit financing, which
also contributed to the reduced U.S. revenue.





Our
service revenue increased 16% in 2009, compared to 2008. Service contract
amortization is the primary component of our total service revenue. Due to an
increasing installed base of customers, our revenue from contract amortization
has consistently increased. However, our deferred service revenue balance
decreased by $3.5 million, or 30%, to $8.1 million as of December 31, 2009,
compared to December 31, 2008. We believe this decline was primarily
attributable to: (i) fewer customers purchasing extended service contracts in
response to improved product reliability and the tougher economy; (ii) a
decrease in unit sales volume in the U.S. that historically included an element
of deferred revenue for service contracts beyond our standard warranty terms;
(iii) a shift by customers towards purchasing more quarterly, rather than
annual or multi-year, service contracts; and (iv) a reduction of our
service contract pricing, but including prorated charges for hand piece usage
(only in the first nine months of 2009), which resulted in a reduction of
our deferred service revenue balance as of December 31, 2009.





Our gross
margin decreased slightly to 59% for 2009, compared to 61% in 2008. This
decrease, was due primarily to: (i) lower overall revenue, due to lower volume,
which resulted in reduced leverage of our manufacturing and service department
expenses; (ii) higher Service and Titan refill revenue as a percentage of our
total revenue, which has a lower gross margin than our total revenue; and (iii)
higher international distributor revenue as a percentage of total revenue, which
has a lower gross margin than our direct business; partially offset by (iv)
reduced manufacturing expenses resulting primarily from headcount reductions and
improved product reliability.





Our sales
and marketing expenses, as a percentage of net revenue, increased to 45% in
2009, compared to 42% in 2008. This increase in expenses as a percentage of net
revenue in 2009, was due primarily to lower revenue in 2009, compared to 2008.
In absolute dollars, sales and marketing expenses decreased by $11.1 million to
$24.3 million in 2009, compared to 2008. The decrease in absolute dollars was
due primarily to reduced personnel expenses in the United States, attributable
to lower headcount, and reduced sales commission expenses resulting from lower
revenue.





Our
research and development (R&D) expenses, as a percentage of net revenue,
increased to 13% in 2009, compared to 9% in 2008. The increase in expenses as a
percentage of net revenue was due primarily to lower revenue in 2009, compared
to 2008. In absolute dollars, R&D expenses decreased by $740,000 to $6.8
million in 2009, compared to 2008. The decrease in absolute dollars was due
primarily to lower headcount (partially resulting from a reduction-in-force that
we implemented in the first-half of 2009) and consulting services of
$689,000.





General
and administrative (G&A) expenses, as a percentage of net revenue, increased
to 19% in 2009, compared to 14% in 2008. The increase in expenses as a
percentage of net revenue was due primarily to lower revenue in 2009, compared
to 2008. In absolute dollars, G&A expenses decreased by $950,000 to $10.3
million in 2009, compared to 2008. The decrease in G&A expenses in 2009, was
due primarily to a decrease in legal, audit, tax, and consulting
fees.





We are a
defendant in a Telephone Consumer Protection Act class action lawsuit. See “Item
3 - Legal Proceedings” in Part 1, of this Form 10-K. We have included $850,000
in our Consolidated Statement of Operations in 2009, for the estimated cost of
the tentative settlement, net of administrative expenses and amounts that are
expected be recoverable from our insurance carrier.





In
response to the economic environment and our reduced revenue in 2008 and 2009,
we reduced our company-wide workforce by approximately 18% and implemented other
cost-reduction measures in the first half of 2009. The headcount reductions
impacted all departments and functions and resulted in restructuring charges of
approximately $880,000 in first half of 2009. As of June 30, 2009, there
were no service requirements outstanding from the employees who were affected.
As a result of these cost-reduction measures our operating expenses declined in
2009, compared to 2008.





31




We
recognized an income tax provision of $8.9 million in 2009, despite losses
before taxes. The provision is primarily due to the recording of a valuation
allowance at the end of the third quarter of 2009 to reduce certain U.S. federal
and state net deferred tax assets to their anticipated realizable value, of
which $10.2 million related to our U.S. deferred tax assets as of December
31, 2008. This valuation allowance was offset by $1.3 million of certain tax
benefits resulting from losses generated during fiscal 2009 that can be
carried-back to prior periods. See “Provision (Benefit) for Income Taxes” below
for further discussion. We also performed an evaluation as of December 31, 2009,
and determined the full valuation allowance was still required.




Factors
that May Impact Future Performance




Our
industry is impacted by numerous competitive, regulatory and other significant
factors. Our industry is highly competitive and our future performance depends
on our ability to compete successfully. Additionally, our future performance is
dependent upon our ability to continue to expand our product offerings and
innovative technologies, obtain regulatory clearances for our products, protect
the proprietary technology of our products and our manufacturing processes,
manufacture our products cost-effectively, and successfully market and
distribute our products in a profitable manner. If we fail to execute on the
aforementioned initiatives, our business would be adversely affected. A detailed
discussion of these and other factors that could impact our future performance
are provided in Part I, Item 1A “Risk Factors.”




Critical
Accounting Policies and Estimates




The
preparation of our Consolidated Financial Statements and related disclosures in
conformity with generally accepted accounting principles in the United States
(GAAP) requires us to make estimates, judgments and assumptions that affect the
reported amounts of assets, liabilities, revenue and expenses. These estimates,
judgments and assumptions are based on historical experience and on various
other factors that we believe are reasonable under the circumstances. We
periodically review our estimates and make adjustments when facts and
circumstances dictate. To the extent that there are material differences between
these estimates and actual results, our financial condition or results of
operations will be affected.




Critical
accounting estimates, as defined by the Securities and Exchange Commission
(SEC), are those that are most important to the portrayal of our financial
condition and results of operations and require our management’s most difficult
and subjective judgments and estimates of matters that are inherently uncertain.
Our critical accounting estimates are as follows:




Revenue
Recognition




We
recognize Product revenue, including Upgrade revenue, and revenue from Titan
hand piece refills, when title and risk of ownership has been transferred,
provided that:





•
            Persuasive
      evidence of an arrangement exists;





•
            Delivery
      has occurred or services have been
rendered;





•
            The
      fee is fixed or determinable; and





•
            Collectability
      is reasonably assured.





Determination
of whether persuasive evidence of an arrangement exists and whether delivery has
occurred or services have been rendered, are based on management’s judgments
regarding the fixed nature of the fee charged for services rendered and products
delivered, and the collectability of those fees. In instances where final
acceptance of the product is specified by the customer or collectability has not
been reasonably assured, revenue is deferred until all acceptance criteria have
been met. Revenue under service contracts is recognized on a straight-line basis
over the period of the applicable service contract. Service revenue, not under a
service contract, is recognized as the services are provided. Should changes in
conditions cause management to determine these criteria are not met for certain
future transactions, revenue recognized for any reporting period could be
adversely affected.




Fair
Value Measurement of our Long Term Auction Rate Securities
Investments




We hold a
variety of interest bearing auction rate securities (ARS) that represent
investments in pools of student loan assets. At the time of acquisition, these
ARS investments were intended to provide liquidity through an auction process
that resets the applicable interest rate at predetermined calendar intervals,
allowing investors to either roll over their holdings or gain immediate
liquidity by selling such interests at par. Since February 2008, uncertainties
in the credit markets affected our ARS investments and auctions for some of ARS
have continued to fail to settle on their respective settlement dates while some
have been redeemed in full at their respective par values. The current portfolio
of investments shown as “Long term investments” in our Consolidated Financial
Statements represents those investments that are not currently liquid and we
will not be able to access these funds until a future auction of these
investments is successful, a buyer is found outside of the auction process or
the issuer refinances their debt. Maturity dates for these ARS investments range
from to 2028 to 2043.




At
December 31, 2009, total financial assets measured and recognized at fair value
were $103.4 million and of these assets, $7.3 million, or 7%, were ARS that were
measured and recognized using significant unobservable inputs (Level 3). During
2009, $4.4 million of ARS were redeemed at their full par value, as a result, we
transferred $2.3 million from Level 3 assets to cash and $100,000 of Level 3
assets into marketable investments (Level 2). This redemption resulted in a gain
of $1.9 million being recorded to accumulated comprehensive income (loss) in
2009.




32




As of
December 31, 2009, we had $8.9 million par value ($7.3 million fair value) of
long-term ARS investments and $100,000 par value of ARS recorded in marketable
investments. The aggregate loss in value is included as an unrealized loss in
accumulated other comprehensive income (loss). Given observable market
information was not available to determine the fair values of our ARS portfolio,
we valued these investments based on a discounted cash flow model. While our ARS
valuation model was based on both Level 2 (credit quality and interest rates)
and Level 3 inputs (pricing models), we determined that the Level 3 inputs were
the most significant to the overall fair value measurement, particularly the
estimates of risk adjusted discount rates. The expected future cash flows of the
ARS were discounted using a risk adjusted discount rate that compensated for the
illiquidity. Projected future cash flows over the economic life of the ARS were
modeled based on the contractual penalty rates for the security added to a tax
adjusted LIBOR interest rate curve. The discount rates that were applied to the
cash flows were based on a premium over the projected yield curve and included
an adjustment for credit, illiquidity, and other risk factors. See Note 2
“Balance Sheet Details- Fair Value of Financial Instruments” in Notes to
Consolidated Financial Statement in Part II, Item 8 of this Form 10-K for more
information.




The
valuation of our investment portfolio is subject to uncertainties that are
difficult to predict. Factors that may impact the valuation include duration of
time that the ARS remain illiquid, changes to credit ratings of the securities,
rates of default of the underlying assets, changes in the underlying collateral
value, market discount rates for similar illiquid investments, and ongoing
strength and quality of credit markets. If the auctions for our ARS investments
continue to fail, and there is a further decline in their valuation, then we
would have to: (i) record additional reductions to the fair value of our ARS
investments; and (ii) record unrealized losses in our accumulated comprehensive
income (loss) for the losses in value that are associated with market risk. If
the decline in fair value is considered other-than-temporary then we would have
to record an impairment charge in our Consolidated Statement of Operations for
the loss in value associated with the worsening of the credit worthiness (credit
losses) of the issuer, which would reduce future earnings and harm our
business.




Recognition
and Presentation of Other-Than-Temporary-Impairments




We review
any impairments on a quarterly basis in order to determine the classification of
the impairment as “temporary” or “other-than-temporary.” Beginning April 1,
2009, if an entity intends to sell or if it is more likely than not that it will
be required to sell an impaired debt security prior to recovery of its cost
basis, the security is other-than-temporarily impaired and the full amount of
the impairment is required to be recognized as a loss through earnings.
Otherwise, losses on securities which are other-than-temporarily impaired are
separated into: (i) the portion of loss which represents the credit loss; or
(ii) the portion which is due to other factors. The credit loss portion is
recognized as a loss through earnings while the loss due to other factors is
recognized in other comprehensive income (loss), net of taxes and related
amortization. Prior to April 1, 2009, all declines in fair value deemed to be
other-than-temporary were reflected in earnings as realized losses.




With
respect to the ARS that we held as of April 1, 2009, we determined that the
cumulative effect adjustment required to reclassify the non-credit portion of
previously recognized other-than-temporarily impaired adjustments was $3.5
million. Therefore, we increased our accumulated earnings and decreased our
accumulated other comprehensive income (loss) by the $3.5 million cumulative
effect adjustment. With respect to the $9.0 million of par value ARS investments
held as of December 31, 2009, the unrealized losses included in accumulated
comprehensive income (loss) was $1.6 million.




Stock-based
Compensation Expense




Employee
stock-based compensation is estimated at the date of grant based on the employee
stock award’s fair value using the Black-Scholes option-pricing model and is
recognized as expense ratably over the requisite service period in a manner
similar to other forms of compensation paid to employees. The Black-Scholes
option-pricing model requires the use of certain subjective assumptions. The
most significant of these assumptions are our estimates of the expected
volatility of the market price of our stock and the expected term of the award.
The expected volatility is a 50%/50% blend of implied and historical volatility.
We have determined that this is a more reflective measure of market conditions
and a better indicator of expected volatility, than its limited historical
volatility since the initial public offering of our common stock. When
establishing an estimate of the expected term of an award, we consider
historical experience of similar awards, giving consideration to the contractual
terms of the awards, vesting requirements, and expectation of future employee
behavior, including post-vesting terminations. As required under GAAP, we review
our valuation assumptions at each grant date, and, as a result, our valuation
assumptions used to value employee stock-based awards granted in future periods
may change.




As of
December 31, 2009, the unrecognized compensation cost, net of expected
forfeitures, related to stock options and employee stock purchase plan awards
was $7.2 million and $40,000, respectively, which will be recognized using the
straight-line attribution method over an estimated weighted-average amortization
period of 2.73 years and 0.33 years, respectively. See Note 5 “Stockholders’
equity, Stock Plans and Stock-Based Compensation Expense,” in the Notes to
Consolidated Financial Statement in Part II, Item 8 of this Form 10-K for
more information.




33




Valuation
of Inventories




We state
our inventories at the lower of cost or market, computed on a standard cost
basis, which approximates actual cost on a first-in, first-out basis and market
being determined as the lower of replacement cost or net realizable value.
Standard costs are monitored and updated quarterly or as necessary, to reflect
changes in raw material costs, labor to manufacture the product and overhead
rates. We provide for excess and obsolete inventories when conditions indicate
that the selling price could be less than cost due to physical deterioration,
usage, obsolescence, reductions in estimated future demand and reductions in
selling prices. Inventory provisions are measured as the difference between the
cost of inventory and estimated market value and charged to cost of revenue to
establish a lower cost basis for the inventories. We balance the need to
maintain strategic inventory levels with the risk of obsolescence due to
changing technology and customer demand levels. Unfavorable changes in market
conditions may result in a need for additional inventory provisions that could
adversely impact our gross margins. Conversely, favorable changes in demand
could result in higher gross margins when product that has previously been
reserved is sold.




Warranty
Obligations




We
historically provided a standard one-year or two-year warranty coverage on our
systems. Beginning in September 2009, we changed our warranty policy to a
one-year standard warranty on all systems. Warranty coverage provided is for
labor and parts necessary to repair the systems during the warranty period. We
provide for the estimated future costs of warranty obligations in cost of
revenue when the related revenue is recognized. The accrued warranty costs
represent our best estimate at the time of sale, and as reviewed and updated
quarterly, of the total costs that we expect to incur in repairing or replacing
product parts that fail while still under warranty. Accrued warranty costs
include costs of material, technical support labor and associated overhead. The
amount of accrued estimated warranty costs obligation for established products
is primarily based on historical experience as to product failures adjusted for
current information on repair costs.. Actual warranty costs could differ from
the estimated amounts. On a quarterly basis, we review the accrued balances of
our warranty obligations and update the historical warranty cost trends. If we
were required to accrue additional warranty cost in the future due to actual
product failure rates, material usage, service delivery costs or overhead costs
differing from our estimates, revisions to the estimated warranty liability
would be required, which would negatively impact our operating
results.




Provision
for Income Taxes




We are
subject to taxes on earnings in both the United States and numerous foreign
jurisdictions. As a global taxpayer, significant judgments and estimates are
required in evaluating our uncertain tax positions and determining our provision
for income taxes on earnings. We perform a two-step approach to recognizing and
measuring uncertain tax positions. The first step is to
evaluate the tax position for recognition by determining if the weight of
available evidence indicates that it is more likely than not that the position
will be sustained on audit, including resolution of related appeals or
litigation processes, if any. The second step is to measure the tax benefit as
the largest amount that is more than 50% likely of being realized upon
settlement. Although we believe we have adequately reserved for our uncertain
tax positions, no assurance can be given that the final tax outcome of these
matters will not be different. We adjust these reserves in light of changing
facts and circumstances, such as the closing of a tax audit or the refinement of
an estimate. To the extent that the final tax outcome of these matters is
different than the amounts recorded, such differences will impact the provision
for income taxes in the period in which such determination is made. The
provision for income taxes includes the impact of reserve provisions and changes
to reserves that are considered appropriate, as well as the related net
interest.




Our
effective tax rates have differed from the statutory rate primarily due to the
tax impact of tax-exempt interest income, foreign operations, research and
development tax credits, state taxes, certain benefits realized related to stock
option activity, and changes in valuation allowance. Our current effective tax
rate does not assume U.S. taxes on undistributed profits of foreign
subsidiaries. These earnings could become subject to incremental foreign
withholding or U.S. federal and state taxes, should they either be deemed or
actually remitted to the United States. The effective tax rate was (102)% in
2009, 22% in 2008, and 24% in 2007. Our future effective tax rates could be
affected by earnings being lower than anticipated in countries where we have
lower statutory rates and being higher than anticipated in countries where we
have higher statutory rates, or by changes in tax laws, accounting principles,
interpretations thereof, net operating loss carryback, research and development
tax credits, and due to changes in the valuation allowance of our U.S. deferred
tax assets. In addition, we are subject to the examination of our income tax
returns by the Internal Revenue Service and other tax authorities. We regularly
assess the likelihood of adverse outcomes resulting from these examinations to
determine the adequacy of our provision for income taxes.




Our
deferred tax assets are recognized for the expected future tax consequences of
temporary differences between the financial reporting and tax bases of assets
and liabilities, and for operating losses and tax credit carryforwards. A
valuation allowance reduces deferred tax assets to estimated realizable value,
which assumes that it is more likely than not that we will be able to generate
sufficient future taxable income in certain tax jurisdictions to realize the net
carrying value. The four sources of taxable income to be considered in
determining whether a valuation allowance is required include:





•
            Future
      reversals of existing taxable temporary differences (i.e., offset gross
      deferred tax assets against gross deferred tax
    liabilities);





•
            Future
      taxable income exclusive of reversing temporary differences and
      carryforwards;





•
            Taxable
      income in prior carryback years;
and





•
            Tax
      planning strategies.




34




Determining
whether a valuation allowance for deferred tax assets is necessary requires an
analysis of both positive and negative evidence regarding realization of the
deferred tax assets. In general, positive evidence may include:





•
            A
      strong earnings history exclusive of the loss that created the deductible
      temporary differences, coupled with evidence indicating that the loss is
      the result of an aberration rather than a continuing condition;
      and





•
            An
      excess of appreciated asset value over the tax basis of our net assets in
      an amount sufficient to realize the deferred tax
  asset.




In
general, negative evidence may include:





•
            A
      history of operating loss or tax credit carryforwards expiring
      unused;





•
            An
      expectation of being in a cumulative loss position in a future reporting
      period;





•
            The
      existence of cumulative losses in recent years;
  and





•
            A
      carryback or carryforward period that is so brief that it would limit the
      realization of tax benefits.




The
weight given to the potential effect of negative and positive evidence should be
commensurate with the extent to which it can be objectively verified and
judgment must be used in considering the relative impact of positive and
negative evidence.





In
evaluating the ability to recover deferred tax assets, we considered available
positive and negative evidence, giving greater weight to our recent cumulative
losses and our ability to carry-back losses against prior taxable income and
lesser weight to its projected financial results due to the challenges of
forecasting future periods. We also considered, commensurate with its objective
verifiability, the forecast of future taxable income including the reversal of
temporary differences. At the end of the quarter ended September 30, 2009,
changes in previously anticipated expectations and continued operating losses
resulted in a valuation allowance against our tax benefits since we no longer
considered them “more-likely-than-not” realizable. We also performed this
evaluation as of the year ended December 31, 2009 and determined the full
valuation allowance was still required.




Long-Lived
Asset Impairment




Long-lived
assets, such as property and equipment and intangible assets, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of such assets may not ultimately be recoverable. Determination
of recoverability is based on an estimate of undiscounted future cash flows
resulting from the use of the asset and its ultimate disposition. If the sum of
the expected future cash flows is less than the carrying amount of those assets,
we recognize an impairment loss based on the excess of the carrying amount over
the fair value of the assets. Through December 31, 2009, there have been no such
impairments.




Litigation




We have
been, and may in the future become, subject to legal proceedings related to
securities litigation, intellectual property and other matters such as the TCPA
litigation and the securities class Action Lawsuit described in
Item 3—Legal Proceedings. Based on all available information at the balance
sheet dates, we assess the likelihood of any adverse judgments or outcomes for
these matters, as well as potential ranges of probable loss. If losses are
probable and reasonably estimable, we record a reserve. See “Item 3 - Legal
Proceedings” in Part I, of this Form 10-K.




Recent
Accounting Pronouncements




For a
full description of recent accounting pronouncements, including the respective
expected dates of adoption and effects on results of operations and financial
condition see Note 1 “Summary of Significant Accounting Policies—Recent
Accounting Pronouncement” in the Notes to Consolidated Financial Statements in
Part II, Item 8 of this Form 10-K.





35




Results
of Operations




The
following table sets forth selected consolidated financial data for the periods
indicated, expressed as a percentage of net total revenue.





Year Ended
      December 31,2009
            
            
            2008
            
            
            2007Operating
      Ratios:Net
      revenue
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %Cost
      of revenue
            
            
            41
            %
            
            
            39
            %
            
            
            34
            %Gross
      profit
            
            
            59
            %
            
            
            61
            %
            
            
            66
            %Operating
      expenses:Sales
      and marketing
            
            
            45
            %
            
            
            42
            %
            
            
            38
            %Research
      and development
            
            
            13
            %
            
            
            9
            %
            
            
            7
            %General
      and administrative
            
            
            19
            %
            
            
            14
            %
            
            
            12
            %Litigation
      settlement
            
            
            1
            %
            
            
            —
            %
            
            
            —
            %Total
      operating expenses
            
            
            78
            %
            
            
            65
            %
            
            
            57
            %Income
      (loss) from operations
            
            
            (19
            )%
            
            
            (4
            )%
            
            
            9
            %Interest
      and other income, net
            
            
            3
            %
            
            
            4
            %
            
            
            4
            %Other-than-temporary
      impairment of long-term investments
            
            
            —
            %
            
            
            (4
            )%
            
            
            —
            %Income
      (loss) before income taxes
            
            
            (16
            )%
            
            
            (4
            )%
            
            
            13
            %Provision
      (benefit) for income taxes
            
            
            17
            %
            
            
            (1
            )%
            
            
            3
            %Net
      income (loss)
            
            
            (33
            )%
            
            
            (3
            )%
            
            
            10
            %




Total
Revenue





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            
            2007Revenue
      mix by geography:United
      States
            
            $
            21,019
            
            (50
            )%
            
            $
            41,683
            
            (35
            )%
            
            $
            64,084Japan
            
            
            9,636
            
            (12
            )%
            
            
            10,929
            
            29
            %
            
            
            8,453Asia,
      excluding Japan(1)
            
            
            4,727
            
            (17
            )%
            
            
            5,713
            
            (5
            )%
            
            
            6,009Europe
            
            
            7,087
            
            (33
            )%
            
            
            10,522
            
            14
            %
            
            
            9,258Rest
      of the world(1)
            
            
            11,213
            
            (23
            )%
            
            
            14,532
            
            4
            %
            
            
            13,922Total
      international revenue
            
            
            32,663
            
            (22
            )%
            
            
            41,696
            
            11
            %
            
            
            37,642Consolidated
      total revenue
            
            $
            53,682
            
            (36
            )%
            
            $
            83,379
            
            (18
            )%
            
            $
            101,726United
      States as a percentage of total revenue
            
            
            39
            %
            
            
            
            
            50
            %
            
            
            
            
            63
            %International
      as a percentage of total revenue
            
            
            61
            %
            
            
            
            
            50
            %
            
            
            
            
            37
            %Revenue
      mix by product category:Products
            
            $
            28,554
            
            (51
            )%
            
            $
            57,998
            
            (22
            )%
            
            $
            74,502Upgrades
            
            
            6,343
            
            (24
            )%
            
            
            8,361
            
            (37
            )%
            
            
            13,342Service
            
            
            13,186
            
            16
            %
            
            
            11,358
            
            24
            %
            
            
            9,128Titan
      hand piece refills
            
            
            5,599
            
            (1
            )%
            
            
            5,662
            
            19
            %
            
            
            4,754Consolidated
      total revenue
            
            $
            53,682
            
            (36
            )%
            
            $
            83,379
            
            (18
            )%
            
            $
            101,726







(1)
            Beginning
      in 2009, we classified revenue from Australia and New Zealand in the
      geography category ‘Rest of the world’, previously we classified revenue
      from Australia and New Zealand in the geography category ‘Asia, excluding
      Japan’; as such we reclassified the 2008 and 2007 revenue from Australia
      and New Zealand from ‘Asia, excluding Japan’ to ‘Rest of the
      world’





Our U.S.
revenue decreased 50% in 2009, compared to 2008, and 35% in 2008, compared to
2007. Our International revenue decreased 22% in 2009, compared to 2008. We
believe that the decline in U.S. and international revenue was primarily
attributable to the global recession that has caused our prospective customers
to be reluctant to spend significant amounts of money on capital equipment
during these unstable economic times. Historically a significant portion of our
U.S. revenue was sourced from the non-core market of practitioners such as
primary care physicians, gynecologists and physicians offering aesthetic
treatments in spa environments. International sales increased 11% in 2008,
compared to 2007. The increase in 2008 was primarily attributable to continuing
investments in building our international sales distribution channels.
International revenue as a percent of total revenue was 61% in 2009, 50% in 2008
and 37% in 2007. We believe our U.S. revenue declined greater than our
international revenue, because the recession impacted the U.S. market, and
particularly the non-core market, more severely than our international market.
Further, we also believe that those prospective customers who do not have
established medical offices, are finding it more difficult to obtain credit
financing, which also contributed to the reduced U.S. revenue.




Our
Product revenue decreased 51% in 2009, compared to 2008, and 22% in
2008, compared to 2007. Our Upgrade revenue decreased 24% in 2009, compared
to 2008, and 37% in 2008, compared to 2007. We believe these decreases in
Product and Upgrade revenue were primarily driven by the global recession that
has caused our prospective customers to be reluctant on spending significant
amounts of money on capital equipment during these unstable economic times. We
also believe that those prospects who do not have established medical offices
are finding it more difficult to obtain credit financing. Product revenue
included BioForm’s Radiesse®
dermal filler product sales in Japan.




36




Our
Service revenue increased 16% in 2009, compared to 2008, and 24% in 2008,
compared to 2007. Service contract amortization is the primary component of our
total service revenue. These increases were due primarily to an increasing
installed base of customers.




Our Titan
hand piece refill revenue decreased 1% in 2009, compared to 2008. We believe
that this slight decrease was due primarily to a decline in consumer spending in
2009 on Titan procedures as a result of the global recession.Our Titan hand piece
refill revenue increased 19% in 2008, compared to 2007. We believe that this
increase was due primarily to an increase in the installed base and as a result
of greater utilization of this application.




Gross
Profit





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            2007Gross
      Profit
            
            $
            31,923
            
            (37
            )%
            
            $
            51,021
            
            (24
            )%
            $
            66,724As
      a percentage of total revenue
            
            
            59
            %
            
            
            
            
            61
            %
            
            
            
            66
            %





Our cost
of revenue consists primarily of: material, personnel expenses, royalty expense,
warranty and manufacturing overhead expenses. Gross margin as a percentage of
net revenue was 59% in 2009, 61% in 2008 and 66% in 2007. We believe the
decrease in gross margin in 2009, compared to 2008, and the decrease in gross
margin in 2008, compared to 2007 was primarily attributable to:





•
            Lower
      overall revenue, which reduced the leverage of our manufacturing and
      service department expenses and was dilutive to our gross margin
      percentage;





•
            Higher
      Service and Titan refill revenue, as a percentage of total revenue, which
      have a lower gross margin than our Product and Upgrade revenue categories;
      and





•
            Increased
      level of international distributor revenue as a percent of total revenue,
      which has slightly lower gross margins than our direct
      business.




Sales
and Marketing





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            
            2007Sales
      and marketing
            
            $
            24,286
            
            (31
            )%
            
            $
            35,354
            
            (8
            )%
            
            $
            38,277As
      a percentage of total revenue
            
            
            45
            %
            
            
            
            
            42
            %
            
            
            
            
            38
            %





Sales and
marketing expenses consist primarily of: personnel expenses, expenses associated
with customer-attended workshops and trade shows, and advertising. Sales and
marketing expenses decreased $11.1 million in 2009, compared to 2008. This
decrease was due primarily to the following:





(i)
            A
      decrease in personnel expenses of $5.4 million in 2009, compared to 2008,
      due primarily to lower headcount (partially resulting from a
      reduction-in-force that the we implemented in the first-half of 2009) and
      reduced sales commission expenses resulting from lower
      revenue;





(ii)
            A
      decrease in travel and related expense of $1.8 million in 2009, compared
      to 2008, due primarily to lower headcount;
and





(iii)
            A
      decrease in marketing expenses of $983,000 in 2009, compared to 2008,
      associated with lower spending on workshops, advertising and other
      promotional activities.





Sales and
marketing expenses as a percentage of total revenue, increased to 45% in 2009,
compared with 42% in 2008, due primarily to lower revenue in
2009.




Sales and
marketing expenses decreased $2.9 millionin 2008, compared to
2007. This decrease was primarily attributable to lower personnel expenses for
North America of $3.3 million, resulting from lower sales commission expenses
(resulting from lower sales) and a reduction in head count. Sales and marketing
expenses as a percentage of total revenue, increased to 42% in 2008, compared
with 38% in 2007, due primarily to lower revenue in 2008.




Research
and Development (R&D)





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            
            2007Research
      and development
            
            $
            6,810
            
            (10
            )%
            
            $
            7,550
            
            5
            %
            
            $
            7,169As
      a percentage of total revenue
            
            
            13
            %
            
            
            
            
            9
            %
            
            
            
            
            7
            %




37




Research
and development expenses consist primarily of’ personnel expenses, clinical,
regulatory and material costs. R&D expenses decreased by $740,000 in 2009,
compared to 2008. This decrease was due primarily to lower headcount (partially
resulting from a reduction-in-force that we implemented in the first-half of
2009) and consulting services of $689,000. R&D expenses as a percentage of
total revenue, increased to 13% in 2009, compared with 9% in 2008, due primarily
to lower revenue in 2009.




R&D
expenses increased by $381,000 in 2008, compared to 2007. This increase was
primarily attributable to higher materials and consultant fees of $362,000,
relating primarily to the research and development activities of our Pearl
Fractional product and other projects in development. R&D expenses as a
percentage of total revenue, increased to 9% in 2008, compared with 7% in 2007,
due primarily to lower U.S. revenue in 2008.




General
and Administrative (G&A)





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            
            2007General
      and administrative
            
            $
            10,320
            
            (8
            )%
            
            $
            11,270
            
            (4
            )%
            
            $
            11,721As
      a percentage of total revenue
            
            
            19
            %
            
            
            
            
            14
            %
            
            
            
            
            12
            %




General
and administrative expenses consist primarily of: personnel expenses, legal
fees, accounting, audit and tax consulting fees, and other general and
administrative expenses.G&A expenses decreased
by $950,000 in 2009, compared to 2008. This decrease was due mainly to the
following:





(i)
            A
      decrease in legal, audit and tax consulting fees of $587,000, due to
      reduced fees from the consulting firms, partially offset by higher
      consulting fees related to our 2009 Option Exchange Program;
      and





(ii)
            A
      decrease in personnel expenses of $206,000 in 2009, compared to 2008, due
      primarily to lower headcount (resulting from a reduction-in-force that the
      we implemented in the first-half of 2009); partly offset
  by





(iv)
            An
      increase in bad debt expense of $392,000, resulting primarily from one
      leasing company that defaulted on its payment in the second quarter of
      2009 due to it having significant financial
  problems.





G&A
expenses as a percentage of total revenue, increased to 19% in 2009, compared
with 14% in 2008, due primarily to lower revenue in 2009.




G&A
expenses decreased $451,000 in 2008, compared to 2007. This decrease was
primarily attributable to lower personnel expenses for North America of
$998,000, partially offset by higher North America professional consulting fees
related to legal, accounting and tax related matters of $508,000. G&A
expenses as a percentage of total revenue increased, to 14% in 2008, compared
with 12% in 2007, due primarily to lower U.S. revenue in 2008.




Litigation
Settlement




We are a
defendant in a Telephone Consumer Protection Act class action lawsuit. See “Item
3 - Legal Proceedings,” in Part I, of this Form 10-K. We have included
$850,000 in our Consolidated Statement of Operations in 2009 for the estimated
cost of the tentative settlement, net of administrative expenses and amounts
that may be recoverable from our insurance carrier.




Interest
and Other Income, Net





The
components of “Interest and Other Income, Net” are as follows:





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            
            2007Interest
      income
            
            $
            1,383
            
            (56
            )%
            
            $
            3,170
            
            (22
            )%
            
            $
            4,083Other
      income (expense), net
            
            
            189
            
            NA
            %
            
            
            (124
            )
            NA
            
            
            
            124Total
      Interest and other income, net
            
            $
            1,572
            
            (48
            )%
            
            $
            3,046
            
            (28
            )%
            
            $
            4,207




Interest
income decreased 56 % in 2009, compared to 2008, and decreased 22% in 2008,
compared to 2007. These decreases were due primarily to reduced tax-exempt
interest yields as a result of the Federal Reserve cutting interest rates. Our
cash, cash equivalents, marketable investments and long-term investments
measured and recognized at fair value were $106.9 million at December 31,
2009, $106.8 million at December 31, 2008 and $107.0 million
December 31, 2007.




38




Other-Than-Temporary
Impairments of Long-Term Investments





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            % Change
            
            2008
            
            % Change
            
            
            2007Other-than-temporary
      impairment of long-term investments
            
            $
            —
            
            (100
            )%
            $
            3,554
            
            NA
            
            
            $
            —




For the
year ended December 31, 2008, we determined there was a decline in the fair
value of our ARS investments for which we recorded a $3.6 million
other-than-temporary impairment charge. See the ‘Critical Accounting Estimates’
section above, for additional details relating to the charge.




Provision
(Benefit) for Income Taxes





Year
      Ended December 31,(Dollars
      in thousands)
            
            2009
            
            
            $
      Change
            
            
            2008
            
            $
      Change
            
            2007Income
      (loss) before income taxes
            
            $
            (8,771
            )
            
            $
            (5110
            )
            
            $
            (3,661
            )
            $
            (17,425
            )
            $
            13,764Provision
      (benefit) for income taxes
            
            
            8,908
            
            
            
            9,700
            
            
            
            (792
            )
            
            (4,052
            )
            
            3,260Effective
      tax rate
            
            
            (102
            )%
            
            
            
            
            
            
            22
            %
            
            
            
            
            24
            %




We
recognized an income tax provision of $8.9 million in 2009, despite losses
before taxes. The provision is primarily due to the recording of a valuation
allowance at the end of the third quarter of 2009 to reduce certain U.S. federal
and state net deferred tax assets to their anticipated realizable value, of
which $10.2 million related to our U.S. deferred tax assets as of December
31, 2008. This valuation allowance was offset by $1.3 million of certain tax
benefits resulting from losses generated during fiscal 2009 that can be
carried-back to prior periods.




ASC 740
requires the consideration of a valuation allowance to reflect the likelihood of
realization of deferred tax assets. Significant management judgment is required
in determining any valuation allowance recorded against deferred tax assets. In
evaluating the ability to recover deferred tax assets, we considered available
positive and negative evidence, giving greater weight to our recent cumulative
losses and our ability to carry-back losses against prior taxable income and
lesser weight to our projected financial results due to the challenges of
forecasting future periods. We also considered, commensurate with its objective
verifiability, the forecast of future taxable income including the reversal of
temporary differences. At the end of the quarter ended September 30,
2009, revisions in previously anticipated expectations and continued
operating losses resulted in a valuation allowance against our tax
benefits  since they were no longer considered “more-likely-than-not”
realizable. We also performed this evaluation as of the year ended December 31,
2009 and determined the full valuation allowance was still required. We also
performed this evaluation as of December 31, 2009, and determined the full
valuation allowance was still required. Under current tax laws, this valuation
allowance will not limit our ability to utilize federal and state deferred tax
assets provided we can generate sufficient future taxable income in the
U.S.




We
anticipate we will continue to record a valuation allowance against the losses
of certain jurisdictions, primarily federal and state, until such time as we are
able to determine it is “more-likely-than-not” the deferred tax asset will be
realized. Such position is dependent on whether there will be sufficient future
taxable income to realize such deferred tax assets. We expect our future tax
provisions (benefits), during the time such valuation allowances are recorded,
will consist primarily of the tax expense of our non-US jurisdictions that are
profitable. Our effective tax rate may vary from period to period based on
changes in estimated taxable income or loss by jurisdiction, changes to the
valuation allowance, changes to federal, state or foreign tax laws, future
expansion into areas with varying country, state, and local income tax rates,
deductibility of certain costs and expenses by jurisdiction.




Net
Income (Loss) and Net Income (Loss) per Diluted Share





Year
      Ended December 31,(Dollars
      in thousands, except per share data)
            
            2009
            
            % Change
            
            
            2008
            
            % Change
            
            2007Net
      income (loss)
            
            $
            (17,679
            )
            516
            %
            
            $
            (2,869
            )
            NA
            
            $
            10,504Net
      income (loss) per diluted share
            
            $
            (1.33
            )
            505
            %
            
            $
            (0.22
            )
            NA
            
            $
            0.74




The $14.8
million increase in net loss, and $1.11 increase in net loss per diluted share,
in 2009, compared to 2008, was primarily attributable to lower revenue of $29.7
million, partially offset by a decrease of $11.9 million in operating expenses
in 2009, compared to 2008.




The $13.4
million decrease in net income (loss), and $0.96 decrease in net income (loss)
per diluted share, in 2008, compared with 2007, was primarily attributable to
$22.4 million in lower U.S. revenue and $3.6 million in an other-than-temporary
impairment of long-term investments.




39




Liquidity
and Capital Resources




Liquidity
is the measurement of our ability to meet potential cash requirements, fund the
planned expansion of our operations and acquire businesses. Our sources of cash
include operations, stock option exercises, and employee stock purchases. We
actively manage our cash usage and investment of liquid cash to ensure the
maintenance of sufficient funds to meet our daily needs. The majority of our
cash and investments are held in U.S. banks and our foreign subsidiaries
maintain a limited amount of cash in their local banks to cover their short-term
operating expenses.




The
following table summarizes our cash and cash equivalents, marketable investments
and long-term investments (in thousands):





As
      of December 31,(Dollars
      in thousands)
            
            2009
            
            
            2008
            
            
            ChangeCash,
      cash equivalents and marketable securities:Cash
      and cash equivalents
            
            $
            22,829
            
            
            $
            36,540
            
            
            $
            (13,711
            )Marketable
      investments
            
            
            76,780
            
            
            
            60,653
            
            
            
            16,127Long-term
      investments
            
            
            7,275
            
            
            
            9,627
            
            
            
            (2,352
            )Total
            
            $
            106,884
            
            
            $
            106,820
            
            
            $
            64




Cash
Flows





In
summary, our cash flows were as flows:





Year
      ended December 31,(Dollars
      in thousands)
            2009
            
            
            2008
            
            2007Cash
      flows provided by (used in):Operating
      activities
            $
            41
            
            
            $
            4,340
            
            $
            16,890Investing
      activities
            
            (14,360
            )
            
            
            20,644
            
            
            (426
            )Financing
      activities
            
            608
            
            
            
            502
            
            
            (17,210
            )Net
      increase (decrease) in cash and cash equivalents
            $
            (13,711
            )
            
            $
            25,486
            
            $
            (746
            )




Cash
Flows From Operating Activities





We
generated net cash from operating activities of $41,000 in 2009, which was
primarily attributable to:





•
            $849,000
      used from net loss of $17.7 million after adjusting for non-cash related
      items of $16.8 million, consisting primarily of a valuation allowance on
      our deferred tax asset of $10.5 million, stock-based compensation expense
      of $4.2 million, net increase in the allowance for doubtful accounts of
      $525,000 due primarily to one leasing company that has defaulted on its
      payment, and an increase in the provision for excess and obsolete
      inventories of $611,000 resulting from the reduced future demand for our
      products; and





•
            $3.5
      million used as a result of a decrease in deferred revenue due primarily
      to a decrease in unit sales volume of Products and Upgrades that included
      purchases of extended service contracts, a reduction in our service
      contract pricing beginning in 2009, a shift by customers towards
      purchasing shorter term contracts, and fewer customers purchasing extended
      service contracts in response to improved product reliability and to a
      tougher economy; offset by





•
            $2.9
      million of cash generated by the decrease in gross inventory balance from
      December 31, 2008 to December 31, 2009, that resulted from slowing our
      inventory build to better match the reduced sales of our products;
      and





•
            $1.9
      of cash generated by the decrease in gross accounts receivable balance
      from December 31, 2008 to December 31, 2009 that resulted from the
      collection of the higher 2008 year-end accounts receivable
      balances.




40


We
generated net cash from operating activities of $4.3 million in 2008, which
was primarily attributable to:





•
            $5.1
      million generated from net loss of $2.9 million after adjusting for
      non-cash related items of $8.0 million, primarily consisting of $5.2
      million of stock-based compensation and $3.6 million of
      other-than-temporary impairment of long-term investments, partially offset
      by $1.9 million increase in deferred tax assets resulting from unutilized
      deductions for stock-based compensation expenses;
  and





•
            $4.8
      million of cash generated from the collection of the higher accounts
      receivable balance as of December 31, 2007; offset
  by





•
            $4.7 million
      used to pay down the higher 2007 year-end accrued liabilities relating
      primarily to personnel expenses of $2.0 million, reduction of the income
      taxes payable balance by $849,000, reduction of accrued warranty expenses
      by $809,000 due primarily to fewer units remaining under warranty, and net
      reduction of $424,000 of accrued royalties due to the reduced revenue in
      the fourth quarter of 2008, compared with the fourth quarter of 2007,
      and





•
            $2.8
      million cash used as a result of the increase in inventories following the
      lower than expected revenue in the fourth quarter of
  2008.




Cash
Flows From Investing Activities





We used
net cash of $14.4 million from investing activities in 2009, which was primarily
attributable to:





•
            $53.7
      million of cash used to purchase marketable investments; partially offset
      by





•
            $39.4
      million in net proceeds from the sales and maturities of marketable
      investments.





We
generated net cash of $20.6 million from investing activities in 2008, which was
primarily attributable to:





•
            $85.2
      million in net proceeds from the sales and maturities of marketable
      investments due to an attempt to reduce our exposure to the auction rate
      and variable rate demand note markets during 2008; partially offset
      by





•
            $63.8
      million of cash used to purchase marketable and long-term investments;
      and





•
            $703,000
      of cash used to purchase property and equipment primarily for research and
      development activities.




Cash
Flows From Financing Activities




Net cash
provided by financing activities in 2009 was $608,000, which resulted from
$585,000 of cash generated by the issuance of stock through our stock option and
employee stock purchase plans and $23,000 of excess tax benefits related to
stock-based compensation expenses reclassified from operating activities to
financing activities in accordance with FAS 123(R).




Net cash
provided by financing activities in 2008 was $502,000, which resulted from
$458,000 of cash generated by the issuance of stock through our stock option and
employee stock purchase plans and $44,000 of excess tax benefits related to
stock-based compensation expenses reclassified from operating activities to
financing activities in accordance with FAS 123(R).




41




Adequacy
of cash resources to meet future needs




We had
cash, cash equivalents, marketable and long-term investments of $106.9 million
as of December 31, 2009. Of this amount, we had $7.3 million invested in
long-term ARS investments (see‘Critical Accounting Policies and Estimates’ section above, for a full
description of our long-term investments in ARS). We believe that our existing
cash resources are sufficient to meet our anticipated cash needs for working
capital and capital expenditures for at least the next 12 months.




Off-Balance
Sheet Arrangements




We do not
participate in transactions that generate relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance, variable interest or special purpose entities, which would
have been established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes.




We have
certain contractual arrangements that create potential risk for us and are not
recognized in our Consolidated Balance Sheets. Discussed below are off-balance
sheet arrangements that have or are reasonably likely to have a material current
or future effect on our financial condition, changes in financial condition,
revenue or expenses, results of operations, liquidity, capital expenditures, or
capital resources.




We lease
various real properties under operating leases that generally require us to pay
taxes, insurance, maintenance, and minimum lease payments. Some of our leases
have options to renew.




Commitments




In
December 2009, we entered into an agreement with Obagi Medical Products, Inc.,
to distribute certain of their proprietary skin care products in Japan (Obagi
Agreement). Our Obagi Agreement requires us to purchase a minimum of $1.25
million of Obagi products  in 2010. The minimum purchase requirement
for 2011 and beyond has yet to be determined.




See also
Note 11, “Commitments, and Contingencies,” in the Notes to Consolidated
Financial Statements in Part II, Item 8 of this Form 10-K.




Contractual
Obligations




The
following are our obligations for future minimum lease commitments related to
facility leases as of December 31, 2009:





Payments
      Due by Period ($’000’s)Contractual
      Obligations
            
            Total
            
            
            Less Than
              1
      Year
            
            
            1-3
      Years
            
            
            3-5
      Years
            
            
            More Than
              5
      YearsOperating
      leases
            
            $
            6,001
            
            
            $
            1,520
            
            
            $
            2,918
            
            
            $
            1,563
            
            
            $
            —Purchase
      Obligations (1)
            
            
            1,250
            
            
            
            1,250
            
            
            
            —
            
            
            
            —
            
            
            
            —Total
            
            $
            7,251
            
            
            $
            2,770
            
            
            $
            2,918
            
            
            $
            1,563
            
            
            $
            —








(1)
            In
      December 2009, we entered into an agreement with Obagi Medical Products,
      Inc., to distribute certain of their proprietary skin care products in
      Japan (Obagi Agreement). Our Obagi Agreement requires us to purchase a
      minimum dollar amount of Obagi Medical Products, Inc. product of $1.25
      million in 2010. The minimum purchase requirement for 2011 and beyond has
      yet to be determined.




Purchase
Commitments




We
maintain certain open inventory purchase commitments with our suppliers to
ensure a smooth and continuous supply for key components. Our liability in these
purchase commitments is generally restricted to a forecasted time-horizon as
agreed between the parties. These forecasted time-horizons can vary among
different suppliers. Our open inventory purchase commitments were not material
at December 31, 2009. As a result, this amount is not included in the
contractual obligations table above.




42




Income
Tax Liability




We have
included in our Consolidated Balance Sheet $749,000
in long-term income tax liability with respect to
unrecognized tax benefits and accrued interest as of December 31,
2009. At this time, we are unable to make a reasonably reliable estimate of
the timing of payments in individual years beyond 12 months due to uncertainties
in the timing of tax audit outcomes. As a result, this amount is not included in
the contractual obligations table above.




Indemnifications




In the
normal course of business, we enter into agreements that contain a variety of
representations, warranties, and indemnification obligations. For example, we
have entered into indemnification agreements with each of our directors and
executive officers. In 2007, two of our officers were named as defendants in
securities class action litigation—see also “Item 3 - Legal Proceedings,” in
Part I, of this Form 10-K. Our exposure under the various indemnification
obligations, including those under the indemnification agreements with our
directors and officers, is unknown since the outcome of the securities
litigation is unpredictable and the amount that could be payable thereunder is
not reasonably estimable, and since other indemnification obligations involve
future claims that may be made against us. We have not accrued or paid any
amounts for any such indemnification obligations. However, we may record charges
in the future as a result of these potential indemnification obligations,
including those related to the securities class action litigation.




ITEM 7A.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Interest
Rate Sensitivity




Our
exposure to interest rate risk relates primarily to our investment portfolio.
Fixed rate securities may have their fair market value adversely impacted due to
fluctuations in interest rates, while floating rate securities may produce less
income than expected if interest rates fall. Due in part to these factors, our
future investment income may fall short of expectation due to changes in
interest rates or we may suffer losses in principal if forced to sell securities
which have declined in market value due to changes in interest rates. The
primary objective of our investment activities is to preserve principal while at
the same time maximizing yields without significantly increasing risk. To
achieve this objective, we invest in debt instruments of the U.S. Government and
its agencies and municipal bonds, and, by policy, restrict our exposure to any
single type of investment or issuer by imposing concentration limits. To
minimize the exposure due to adverse shifts in interest rates, we maintain
investments at a weighted average maturity (interest reset date for ARS) of
generally less than eighteen months. Assuming a hypothetical increase in
interest rates of one percentage point, the fair value of our total investment
portfolio would have potentially declined by approximately $421,000 as of
December 31, 2009.




We hold
interest bearing ARS that represent investments in pools of student loans issued
by the Federal Family Education Loan Program. At the time of acquisition, these
ARS investments were intended to provide liquidity via an auction process that
resets the applicable interest rate at predetermined calendar intervals,
allowing investors to either roll over their holdings or gain immediate
liquidity by selling such interests at par. Since February 2008, uncertainties
in the credit markets affected our holdings in ARS investments and auctions for
all of our investments in these securities failed until December 31, 2008. In
2009, approximately $4.4 million of our original $13.4 million par value
portfolio has been redeemed in full and as of December 31, 2009 we had $8.9
million par value (fair value of $7.3 million) of long-term ARS, whose auctions
continue to fail. These investments are not currently liquid and we will not be
able to access these funds until a future auction of these investments is
successful, a buyer is found outside of the auction process or the ARS is
refinanced by the issuer into another type of debt instrument. Maturity dates
for these ARS investments range from 2028 to 2043. We currently classify all of
these investments as long-term investments in our Consolidated Balance Sheet
because of our continuing inability to determine when these investments will
settle. We have also modified our current investment strategy and increased our
investments in more liquid money market investments, United States Treasury
securities, municipal bonds, and eliminated investments in corporate debt. The
valuation of our ARS investment portfolio is subject to uncertainties that are
difficult to predict. Factors that may impact its valuation include, duration of
time that the ARS remain illiquid, changes to credit ratings of the securities,
rates of default of the underlying assets, changes in the underlying collateral
value, market discount rates for similar illiquid investments, ongoing strength
and quality of credit markets. If the auctions for our ARS investments continue
to fail, and there is a further decline in the valuation, then we would have to:
(i) record additional reductions to the fair value of our ARS investments; and
(ii) record unrealized losses in our accumulated comprehensive income (loss) for
the losses in value that are associated with market risk. If the decline in fair
value is considered other-than-temporary then we would have to record an
impairment charge in our Consolidated Statement of Operations for the loss in
value associated with the worsening of the credit worthiness (credit losses) of
the issuer, which would reduce future earnings and harm our
business.




43




Foreign
Currency Exchange Risk




We have
international subsidiaries and operations and are, therefore, subject to foreign
currency rate exposure. Although the majority of our revenue and purchases are
denominated in U.S. dollars, we have revenue to certain international customers
and expenses denominated in the Japanese Yen, Euro, Pounds Sterling, Australian
Dollars, Swiss Francs and Canadian Dollars. The net gains and losses from the
revaluation of foreign denominated assets and liabilities was a gain of
approximately $134,000 in 2009, which is included in our Consolidated Statements
of Operations. Movements in currency exchange rates could cause variability in
our revenues, expenses or interest and other income (expense). Though to date
our exposure to exchange rate volatility has not been significant, we cannot
assure that there will not be a material impact in the future. Future
fluctuations in the value of the U.S. dollar may affect the price
competitiveness of our products. We do not believe, however, that we currently
have significant direct foreign currency exchange rate risk and have not hedged
exposures denominated in foreign currencies.




We do not
utilize derivative financial instruments, derivative commodity instruments or
other market risk sensitive instruments.





44


ITEM 8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA




CUTERA,
INC. AND SUBSIDIARY COMPANIES




ANNUAL
REPORT ON FORM 10-K




INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS




The
following Consolidated Financial Statements of the Registrant and its
subsidiaries are required to be included in Item 8:





PageReport of Independent Registered
      Public Accounting Firm
            46Consolidated Balance
      Sheets
            47Consolidated Statements of
      Operations
            48Consolidated Statements of
      Stockholders’ Equity
            49Consolidated Statements of Cash
      Flows
            50Notes to Consolidated Financial
      Statements
            51




The
following Consolidated Financial Statement Schedule of the Registrant and its
subsidiaries for the years ended December 31, 2009, 2008 and 2007 is filed
as a part of this Report as required to be included in Item 15(a) and
should be read in conjunction with the Consolidated Financial Statements of the
Registrant and its subsidiaries:





Schedule
            
            
            PageII
            
            Valuation and Qualifying
      Accounts
            71




All other
required schedules are omitted because of the absence of conditions under which
they are required or because the required information is given in the
Consolidated Financial Statements or the Notes thereto.





45






REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Stockholders of


Cutera,
Inc.:




In our
opinion, the consolidated financial statements listed in the accompanying index
present fairly, in all material respects, the financial position of Cutera, Inc.
and its subsidiaries at December 31, 2009 and December 31, 2008, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2009 in conformity with accounting principles
generally accepted in the United States of America. In addition, in our opinion,
the financial statement schedule listed in the accompanying index presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. Also in our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2009, based on criteria
established in Internal Control - Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). The Company's
management is responsible for these financial statements and financial statement
schedule, for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting, included in Management's Report on Internal Control over Financial
Reporting under item 9A. Our responsibility is to express opinions on these
financial statements, on the financial statement schedule, and on the Company's
internal control over financial reporting based on our integrated audits. We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects. Our audits of the financial statements included examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, assessing the risk
that a material weakness exists, and testing and evaluating the design and
operating effectiveness of internal control based on the assessed risk. Our
audits also included performing such other procedures as we considered necessary
in the circumstances. We believe that our audits provide a reasonable basis for
our opinions.




As
discussed in Note 1 to the consolidated financial statements, the Company
changed the manner in which it accounts for other-than-temporary impairments in
2009.




A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial
statements.




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





/S/    PRICEWATERHOUSECOOPERS LLP





San Jose,
California


March 15,
2010








46




CUTERA,
INC.


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except share and per share data)





December 31,2009
            
            
            2008AssetsCurrent
      assets:Cash
      and cash equivalents
            
            $
            22,829
            
            
            $
            36,540Marketable
      investments
            
            
            76,780
            
            
            
            60,653Accounts
      receivable, net of allowance for doubtful accounts in 2009 and 2008 of
      $586 and $61, respectively
            
            
            3,327
            
            
            
            5,792Inventories
            
            
            6,408
            
            
            
            9,927Deferred
      tax asset
            
            
            175
            
            
            
            4,257Other
      current assets and prepaid expenses
            
            
            2,785
            
            
            
            1,771Total
      current assets
            
            
            112,304
            
            
            
            118,940Property
      and equipment, net
            
            
            847
            
            
            
            1,357Long-term
      investments
            
            
            7,275
            
            
            
            9,627Intangibles,
      net
            
            
            829
            
            
            
            1,025Deferred
      tax asset, net of current portion
            
            
            97
            
            
            
            6,527Total
      assets
            
            $
            121,352
            
            
            $
            137,476Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Accounts
      payable
            
            $
            1,081
            
            
            $
            1,690Accrued
      liabilities
            
            
            9,048
            
            
            
            8,848Deferred
      revenue
            
            
            6,160
            
            
            
            6,758Total
      current liabilities
            
            
            16,289
            
            
            
            17,296Deferred
      rent
            
            
            1,493
            
            
            
            1,713Deferred
      revenue, net of current portion
            
            
            1,968
            
            
            
            4,907Income
      tax liability
            
            
            749
            
            
            
            1,452Total
      liabilities
            
            
            20,499
            
            
            
            25,368Commitments
      and contingencies (Note 11)Stockholders’
      equity:Convertible
      preferred stock, $0.001 par valueAuthorized:
      5,000,000 shares; none issued and outstanding
            
            
            —
            
            
            
            —Common
      stock, $0.001 par value:Authorized:
      50,000,000 shares;
              Issued
      and outstanding: 13,436,163 and 12,806,035 shares in 2009 and 2008,
      respectively
            
            
            13
            
            
            
            13Additional
      paid-in capital
            
            
            85,248
            
            
            
            80,318Retained
      earnings
            
            
            17,254
            
            
            
            31,410Accumulated
      other comprehensive income (loss)
            
            
            (1,662
            )
            
            
            367Total
      stockholders’ equity
            
            
            100,853
            
            
            
            112,108Total
      liabilities and stockholders’ equity
            
            $
            121,352
            
            
            $
            137,476




The
accompanying notes are an integral part of these consolidated financial
statements.




47





CUTERA,
INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


(in
thousands, except per share data)





Year
      Ended December 31,2009
            
            2008
            
            2007Net
      revenue
            
            $
            53,682
            
            $
            83,379
            
            $
            101,726Cost
      of revenue
            
            
            21,759
            
            
            32,358
            
            
            35,002Gross
      profit
            
            
            31,923
            
            
            51,021
            
            
            66,724Operating
      expenses:Sales
      and marketing
            
            
            24,286
            
            
            35,354
            
            
            38,277Research
      and development
            
            
            6,810
            
            
            7,550
            
            
            7,169General
      and administrative
            
            
            10,320
            
            
            11,270
            
            
            11,721Litigation
      settlement
            
            
            850
            
            
            —
            
            
            —Total
      operating expenses
            
            
            42,266
            
            
            54,174
            
            
            57,167Income
      (loss) from operations
            
            
            (10,343
            )
            
            (3,153
            )
            
            9,557Interest
      and other income, net
            
            
            1,572
            
            
            3,046
            
            
            4,207Other-than-temporary
      impairments of long-term investments
            
            
            —
            
            
            (3,554
            )
            
            —Income
      (loss) before income taxes
            
            
            (8,771
            )
            
            (3,661
            )
            
            13,764Provision
      (benefit) for income taxes
            
            
            8,908
            
            
            (792
            )
            
            3,260Net
      income (loss)
            
            $
            (17,679
            )
            $
            (2,869
            )
            $
            10,504Net
      income (loss) per share:Basic
            
            $
            (1.33
            )
            $
            (0.22
            )
            $
            0.80Diluted
            
            $
            (1.33
            )
            $
            (0.22
            )
            $
            0.74Weighted-average
      number of shares used in per share calculations:Basic
            
            
            13,279
            
            
            12,770
            
            
            13,153Diluted
            
            
            13,279
            
            
            12,770
            
            
            14,228













The
accompanying notes are an integral part of these consolidated financial
statements.






48





CUTERA,
INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


(in
thousands, except share amounts)





Common
      Stock
            
            
            Additional
              Paid-in
            
            
            Deferred
              Stock-Based
            
            
            Retained
            
            
            Accumulated
              Other
              Comprehensive
            
            
            Total
              Stockholders’Shares
            
            
            Amount
            
            
            Capital
            
            
            Compensation
            
            
            Earnings
            
            
            Income (loss)
            
            
            EquityBalance
      at December 31, 2006
            
            12,939,389
            
            
            
            13
            
            
            
            86,242
            
            
            
            (331
            )
            
            
            23,866
            
            
            
            (58
            )
            
            
            109,732Issuance
      of common stock for employee purchase plan
            
            42,868
            
            
            
            —
            
            
            
            954
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            954Exercise
      of stock options
            
            854,147
            
            
            
            1
            
            
            
            3,321
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            3,322Issuance
      of common stock in settlement of restricted stock units, net of shares
      withheld for employee taxes
            
            9,901
            
            
            
            —
            
            
            
            (138
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (138
            )Repurchase
      of common stock
            
            (1,107,856
            )
            
            
            (1
            )
            
            
            (24,999
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (25,000
            )Share-based
      compensation expense
            
            —
            
            
            
            —
            
            
            
            5,305
            
            
            
            322
            
            
            
            —
            
            
            
            —
            
            
            
            5,627Change
      in deferred stock-based compensation, net of terminations
            
            —
            
            
            
            —
            
            
            
            (9
            )
            
            
            9
            
            
            
            —
            
            
            
            —
            
            
            
            —Tax
      benefit from exercises of stock-based payment awards
            
            —
            
            
            
            —
            
            
            
            4,195
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,195Change
      in accounting principle (Uncertain Tax Positions)
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (91
            )
            
            
            —
            
            
            
            (91
            )Components
      of other comprehensive income:Net
      income
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            10,504
            
            
            
            —
            
            
            
            10,504Other
      comprehensive income
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            248
            
            
            
            248Comprehensive
      income
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            10,752Balance
      at December 31, 2007
            
            12,738,449
            
            
            
            13
            
            
            
            74,871
            
            
            
            —
            
            
            
            34,279
            
            
            
            190
            
            
            
            109,353Issuance
      of common stock for employee purchase plan
            
            50,693
            
            
            
            —
            
            
            
            464
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            464Exercise
      of stock options
            
            8,449
            
            
            
            —
            
            
            
            45
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            45Issuance
      of common stock in settlement of restricted stock units, net of shares
      withheld for employee taxes
            
            8,444
            
            
            
            —
            
            
            
            (51
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (51
            )Share-based
      compensation expense
            
            —
            
            
            
            —
            
            
            
            5,220
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            5,220Tax
      benefit from exercises of stock-based payment awards
            
            —
            
            
            
            —
            
            
            
            (231
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (231
            )Components
      of other comprehensive loss:Net
      loss
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (2,869
            )
            
            
            —
            
            
            
            (2,869
            )Other
      comprehensive income, net of tax of $230
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            177
            
            
            
            177Comprehensive
      loss
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (2,692
            )Balance
      at December 31, 2008
            
            12,806,035
            
            
            $
            13
            
            
            $
            80,318
            
            
            $
            —
            
            
            $
            31,410
            
            
            $
            367
            
            
            $
            112,108Issuance
      of common stock for employee purchase plan
            
            59,365
            
            
            
            —
            
            
            
            326
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            326Exercise
      of stock options
            
            527,721
            
            
            
            —
            
            
            
            291
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            291Issuance
      of common stock in settlement of restricted stock units, net of shares
      withheld for employee taxes, and stock awards
            
            43,042
            
            
            
            —
            
            
            
            (32
            )
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (32
            )Share-based
      compensation expense
            
            —
            
            
            
            —
            
            
            
            4,236
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,236Tax
      benefit from exercises of stock-based payment awards
            
            —
            
            
            
            —
            
            
            
            109
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            109Change
      in accounting principle (see Note 1)
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            3,523
            
            
            
            (3,523
            )
            
            
            —Components
      of other comprehensive loss:Net
      loss
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (17,679
            )
            
            
            —
            
            
            
            (17,679
            )Other
      comprehensive income, net of tax of $230
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,494
            
            
            
            1,494Comprehensive
      loss
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (16,185
            )Balance
      at December 31, 2009
            
            13,436,163
            
            
            $
            13
            
            
            $
            85,248
            
            
            $
            —
            
            
            $
            17,254
            
            
            $
            (1,662
            )
            
            $
            100,853






The
accompanying notes are an integral part of these consolidated financial
statements.




49





CUTERA,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)





Year Ended December 31,2009
            
            
            2008
            
            
            2007Cash
      flows from operating activities:Net
      income (loss)
            
            $
            (17,679
            )
            
            $
            (2,869
            )
            
            $
            10,504Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Stock-based
      compensation
            
            
            4,236
            
            
            
            5,220
            
            
            
            5,627Tax
      benefit (deficit) from stock-based compensation
            
            
            109
            
            
            
            (231
            )
            
            
            4,195Excess
      tax benefit related to stock-based compensation
            
            
            (23
            )
            
            
            (44
            )
            
            
            (3,652
            )Depreciation
      and amortization
            
            
            860
            
            
            
            904
            
            
            
            913Provision
      for excess and obsolete inventories
            
            
            611
            
            
            
            409
            
            
            
            279Other-than-temporary
      impairments of long-term investments
            
            
            —
            
            
            
            3,554
            
            
            
            —Change
      in allowance for doubtful accounts
            
            
            525
            
            
            
            52
            
            
            
            (25
            )Change
      in deferred tax asset net of valuation allowance
            
            
            10,512
            
            
            
            (1,892
            )
            
            
            (2,662
            )Other
            
            
            —
            
            
            
            6
            
            
            
            (6
            )Changes
      in assets and liabilities:Accounts
      receivable
            
            
            1,940
            
            
            
            4,848
            
            
            
            (1,066
            )Inventories
            
            
            2,908
            
            
            
            (2,803
            )
            
            
            (2,592
            )Other
      current assets
            
            
            911
            
            
            
            1,348
            
            
            
            747Accounts
      payable
            
            
            (609
            )
            
            
            (660
            )
            
            
            138Accrued
      liabilities
            
            
            42
            
            
            
            (4,739
            )
            
            
            367Deferred
      rent
            
            
            (62
            )
            
            
            74
            
            
            
            215Deferred
      revenue
            
            
            (3,537
            )
            
            
            1,101
            
            
            
            3,792Income
      tax liability
            
            
            (703
            )
            
            
            62
            
            
            
            116Net
      cash provided by operating activities
            
            
            41
            
            
            
            4,340
            
            
            
            16,890Cash
      flows from investing activities:Acquisition
      of property and equipment
            
            
            (154
            )
            
            
            (703
            )
            
            
            (1,000
            )Purchase
      of intangibles
            
            
            —
            
            
            
            —
            
            
            
            (20
            )Proceeds
      from sales of marketable and long-term investments
            
            
            27,914
            
            
            
            55,104
            
            
            
            69,103Proceeds
      from maturities of marketable investments
            
            
            11,535
            
            
            
            30,065
            
            
            
            31,508Purchase
      of marketable and long-term investments
            
            
            (53,655
            )
            
            
            (63,822
            )
            
            
            (100,017
            )Net
      cash provided by (used in) investing activities
            
            
            (14,360
            )
            
            
            20,644
            
            
            
            (426
            )Cash
      flows from financing activities:Proceeds
      from exercise of stock options and employee stock purchase
      plan
            
            
            585
            
            
            
            458
            
            
            
            4,138Repurchase
      of common stock
            
            
            —
            
            
            
            —
            
            
            
            (25,000
            )Excess
      tax benefit related to stock-based compensation
            
            
            23
            
            
            
            44
            
            
            
            3,652Net
      cash provided by (used in) financing activities
            
            
            608
            
            
            
            502
            
            
            
            (17,210
            )Net
      increase (decrease) in cash and cash equivalents
            
            
            (13,711
            )
            
            
            25,486
            
            
            
            (746
            )Cash
      and cash equivalents at beginning of year
            
            
            36,540
            
            
            
            11,054
            
            
            
            11,800Cash
      and cash equivalents at end of year
            
            $
            22,829
            
            
            $
            36,540
            
            
            $
            11,054Supplemental
      and non-cash disclosure of cash flow information:Change
      in deferred stock-based compensation, net of terminations
            
            $
            —
            
            
            $
            —
            
            
            $
            (9
            )Cash
      paid (received) for income taxes
            
            $
            (578
            )
            
            $
            2,098
            
            
            $
            (808
            )




The
accompanying notes are an integral part of these consolidated financial
statements.




50





CUTERA,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




NOTE
1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES




Description
of Operations and Principles of Consolidation.




Cutera,
Inc. (Cutera or the Company) is a global provider of laser and other light-based
aesthetic systems for practitioners worldwide. The Company designs, develops,
manufactures, and markets the CoolGlide, Xeo and Solera product platforms for
use by physicians and other qualified practitioners to allow its customers to
offer safe and effective aesthetic treatments to their customers. The Xeo and
Solera platforms offer multiple hand pieces and applications, which allow
customers to upgrade their systems (Upgrade revenue). In addition to systems and
upgrade revenue, the Company generates revenue from the sale of post warranty
service contracts, providing services for products that are out of warranty,
Titan hand piece refills, and dermal fillers.




Headquartered
in Brisbane, California, the Company has wholly-owned subsidiaries in Australia,
Canada, France, Japan, Spain, Switzerland and United Kingdom that market, sell
and service its products outside of the United States. The Consolidated
Financial Statements include the accounts of the Company and its subsidiaries.
All inter-company transactions and balances have been eliminated.




Use
of Estimates.




The
preparation of Consolidated Financial Statements in conformity with generally
accepted accounting principles in the United States of America (GAAP) requires
the Company’s management to make estimates and assumptions that affect the
amounts reported and disclosed in the financial statements and the accompanying
notes. Actual results could differ materially from those estimates. On an
ongoing basis, the Company evaluates their estimates, including those related to
the, warranty obligation, sales commission, accounts receivable and sales
allowances, fair values of long-term investments, fair values of acquired
intangible assets, useful lives of intangible assets and property and equipment,
fair values of options to purchase the Company’s common stock, recoverability of
deferred tax assets, and effective income tax rates, among others. Management
bases their estimates on historical experience and on various other assumptions
that are believed to be reasonable, the results of which form the basis for
making judgments about the carrying values of assets and
liabilities.




Cash,
Cash Equivalents, Marketable Investments, and Long-Term
Investments.




The
Company invests its cash primarily in money market funds and in highly liquid
debt instruments of U.S. federal and municipal governments and their agencies.
All highly liquid investments with stated maturities of three months or less
from date of purchase are classified as cash equivalents; all highly liquid
investments with stated maturities of greater than three months are classified
as marketable investments. The majority of the Company’s cash and investments
are held in U.S. banks and its foreign subsidiaries maintain a limited amount of
cash in their local banks to cover their short term operating
expenses.




The
Company determines the appropriate classification of its investments in
marketable securities at the time of purchase and re-evaluates such designation
at each balance sheet date. The Company’s marketable securities have been
classified and accounted for as available-for-sale. The Company may, or may not,
hold securities with stated maturities greater than 12 months until maturity. In
response to changes in the availability of and the yield on alternative
investments as well as liquidity requirements, it occasionally sells these
securities prior to their stated maturities. As these securities are viewed by
the Company as available to support current operations, based on the provisions
of the Financial Accounting Standards Board Accounting Standards Codification
(ASC) topic 210, subtopic 10, securities with maturities beyond 12 months (such
as variable rate demand notes) are classified as current assets under the
caption marketable investments in the accompanying Consolidated Balance Sheets.
These securities are carried at fair value, with the unrealized gains and losses
reported as a component of stockholders’ equity. Any realized gains or losses on
the sale of marketable securities are determined on a specific identification
method, and such gains and losses are reflected as a component of interest and
other income, net.




The
Company holds a variety of interest bearing auction rate securities (ARS) that
represent investments in pools of student loan assets issued by the Federal
Family Education Loan Program (FELP). At the time of acquisition, the majority
of ARS investments were intended to provide liquidity via an auction process
that resets the applicable interest rate at predetermined calendar intervals,
allowing investors to either roll over their holdings or gain immediate
liquidity by selling such interests at par. Since February 2008, uncertainties
in the credit markets affected the majority of ARS investments and auctions for
the Company’s investments in these securities have failed to settle on their
respective settlement dates. However, in 2009 $4.4 million of ARS were redeemed
at full par value. Maturity dates for the ARS investments in the Company’s
portfolio range from 2028 to 2043.




As of
December 31, 2009, the Company had $7.3 million of ARS classified as
long-term investments and $100,000 included in marketable investments
representing the ARS that were refinanced by the issuers at par in January 2010.
The Company has classified its non-refinanced ARS investment balance as
long-term investments in the accompanying Consolidated Balance Sheet because of
the Company’s belief that it could take more than one year before they are
readily marketable. The Company’s ARS have been classified and accounted for as
available-for-sale. These securities are carried at fair value with the
unrealized gains and losses reported as a component of stockholders’ equity. The
estimated fair value of the Company’s ARS investments was $7.4 million at
December 31, 2009 and $9.9 million at December 31, 2008.





The
Company reviews the impairment of its investments on a quarterly basis in order
to determine the classification of the impairment as “temporary” or
“other-than-temporary.” Beginning April 1, 2009, if the fair value of a debt
security is less than its amortized cost, the Company assesses whether the
impairment is other-than-temporary. An impairment is considered
other-than-temporary if: (i) the Company has the intent to sell the security;
(ii) it is more likely than not that the Company will be required to sell the
security before recovery of the entire amortized cost basis; or (iii) the
Company does not expect to recover the entire amortized cost basis of the
security. If an impairment is considered other than temporary based on condition
(i) or (ii) described above, the entire difference between the amortized cost
and the fair value of the debt security is recognized in earnings. If an
impairment is considered other than temporary based on condition (iii) described
above, the amount representing credit losses (defined as the difference between
the present value of the cash flows expected to be collected and the amortized
cost basis of the debt security) will be recognized in earnings and the amount
relating to all other factors will be recognized in OCI.Prior to April 1, 2009,
declines in the fair value of debt securities deemed to be
other-than-temporary were reflected in earnings as realized losses. Once an
other-than-temporary impairment is recorded, a new cost basis in the investment
is established.




51




With
respect to the ARS that were held as of April 1, 2009, The Company determined
that the cumulative effect adjustment required to reclassify the non-credit
portion of previously recognized other-than-temporarily impaired adjustments was
$3.5 million. Therefore, the Company increased its accumulated earnings and
decreased its accumulated other comprehensive income (loss) by the $3.5 million
cumulative effect adjustment. With respect to the $9.0 million of par value ARS
investments held as of December 31, 2009, the unrealized losses included in
accumulated comprehensive income (loss) was $1.6 million.




Fair
Value Measurements.




Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at
the measurement date. The fair value hierarchy distinguishes between (1) market
participant assumptions developed based on market data obtained from independent
sources (observable inputs) and (2) an entity’s own assumptions about market
participant assumptions developed based on the best information available in the
circumstances (unobservable inputs). The fair value hierarchy consists of three
broad levels, which gives the highest priority to unadjusted quoted prices in
active markets for identical assets or liabilities (Level 1) and the lowest
priority to unobservable inputs (Level 3). The three levels of the fair value
hierarchy are described below:





•
              Level
      1: Quoted prices (unadjusted) in active markets that are accessible at the
      measurement date for assets or
liabilities.





•
              Level
      2: Directly or indirectly observable inputs as of the reporting date
      through correlation with market data, including quoted prices for similar
      assets and liabilities in active markets and quoted prices in markets that
      are not active. Level 2 also includes assets and liabilities that are
      valued using models or other pricing methodologies that do not require
      significant judgment since the input assumptions used in the models, such
      as interest rates and volatility factors, are corroborated by readily
      observable data from actively quoted markets for substantially the full
      term of the financial
instrument.





•
              Level
      3: Unobservable inputs that are supported by little or no market activity
      and reflect the use of significant management judgment. These values are
      generally determined using pricing models for which the assumptions
      utilize management’s estimates of market participant
      assumptions.




In
determining fair value, the Company utilizes valuation techniques that maximize
the use of observable inputs and minimize the use of unobservable inputs to the
extent possible as well as considers counterparty credit risk in its assessment
of fair value.




Fair
Value of Financial Instruments.




Carrying
amounts of the Company’s financial instruments, including cash and cash
equivalents, marketable investments, accounts receivable, accounts payable and
accrued liabilities, approximate their fair values as of the balance sheet dates
because of their generally short maturities. The fair value of marketable
investments is based on quoted market prices.




Concentration
of Credit Risk and Other Risks and Uncertainties.


Financial instruments that potentially
subject the Company to concentrations of risk consist principally of cash, cash
equivalents, marketable investments and accounts receivable. The Company’s cash
and cash equivalents are primarily invested in deposits and
money market accounts with two major banks in the United States. In addition,
the Company has operating cash balances in banks in each of the international
locations in which it operates. Deposits in these banks may exceed the amount of
insurance provided on such deposits, if any. Management believes that these
financial institutions are financially sound and, accordingly, believes that
minimal credit risk exists. The Company has not experienced any losses on its
deposits of cash and cash equivalents. Accounts receivable are typically
unsecured and are derived from revenue earned from worldwide customers. The
Company performs credit evaluations of its customers and maintains reserves for
potential credit losses. Concentrations of accounts receivable balances are
presented in Note 3 and segment, geographic and major customer information is
presented in Note 10.




The
Company invests in debt instruments—including bonds and ARS—of the U.S.
Government, its agencies and municipalities. By policy, the Company restricts
its exposure to any single issuer by imposing concentration limits. To minimize
the exposure due to adverse shifts in interest rates, the Company maintains
investments at an average maturity (interest reset date for auction-rate
securities and variable rate demand notes) of generally less than eighteen
months.




The
Company is subject to risks common to companies in the medical device industry,
including, but not limited to, new technology innovations, dependence on key
personnel, dependence on key suppliers, protection of proprietary technology,
product liability and compliance with government regulations. To continue
profitable operations, the Company must continue to successfully design,
develop, acquire, manufacture and market its products. There can be no assurance
that current or recently acquired products will continue to be accepted in the
marketplace. Nor can there be any assurance that any future products can be
developed or manufactured at an acceptable cost and with appropriate performance
characteristics, or that such products will be successfully marketed, if at all.
These factors could have a material adverse effect on the Company’s future
financial results and cash flows.




Future
products developed or acquired by the Company may require additional approvals
from the Food and Drug Administration or international regulatory agencies prior
to commercial sales. There can be no assurance that the Company’s products will
continue to meet the necessary regulatory requirements. If the Company was
denied such approvals or such approvals were delayed, it may have a materially
adverse impact on the Company.




Inventories.




Inventories
are stated at the lower of cost or market, cost being determined on a standard
cost basis (which approximates actual cost on a first-in, first-out basis) and
market being determined as the lower of replacement cost or net realizable
value.




52




The
Company includes demonstration units within inventories. Demonstration units are
carried at cost and amortized over their estimated economic life of two years.
Amortization expense related to demonstration units is recorded in cost of
revenue or in the respective operating expense line based on which function and
purpose it is being used for. Proceeds from the sale of demonstration units are
recorded as revenue and all costs incurred to refurbish the systems prior to
sale are charged to cost of revenue.




Property
and Equipment.




Property
and equipment are stated at cost and depreciated on a straight-line basis over
the estimated useful lives of the related assets, which is generally three
years. Amortization of leasehold improvements is computed using the
straight-line method over the shorter of the remaining lease term or the
estimated useful life of the related assets. Upon sale or retirement of assets,
the costs and related accumulated depreciation and amortization are removed from
the balance sheet and the resulting gain or loss is reflected in operating
expenses. Maintenance and repairs are charged to operations as
incurred.




Intangible
Assets.




Purchased
technology sublicense and other intangible assets are presented at cost, net of
accumulated amortization. The technology licenses are being amortized on a
straight-line basis over their expected useful life of 9-10 years and the other
intangibles are being amortized over their expected useful life of two
years.




Impairment
of Long-lived Assets.




The
Company reviews long-lived assets, including property and equipment, and
intangible assets, for impairment whenever events or changes in business
circumstances indicate that the carrying amount of the assets may not be fully
recoverable. The Company would recognize an impairment loss when estimated
undiscounted future cash flows expected to result from the use of the asset and
its eventual disposition is less than its carrying amount. Impairment, if any,
is measured as the amount by which the carrying amount of a long-lived asset
exceeds its fair value. Through December 31, 2009, there have been no such
impairments.




Warranty
Obligations.




The
Company historically provided a standard one-year or two-year warranty coverage
on its systems. Beginning in September 2009, the Company changed its warranty
policy to a one-year standard warranty on all systems. Warranty coverage
provided is for labor and parts necessary to repair the systems during the
warranty period. The Company accounts for the estimated warranty cost of the
standard warranty coverage as a charge to costs of revenue when revenue is
recognized. The estimated warranty cost is based on historical product
performance. To determine the estimated warranty reserve, the Company utilizes
actual service records to calculate the average service expense per system and
applies this to the equivalent number of units exposed under warranty. The
Company updates these estimated charges every quarter.




Revenue
Recognition.




Product,
Upgrade, and Titan hand piece refill revenue, is recognized when title and risk
of ownership has been transferred, provided that:





•
            Persuasive
      evidence of an arrangement exists;





•
            The
      price is fixed or determinable;





•
            Delivery
      has occurred or services have been rendered;
and





•
            Collectability
      is reasonably assured.




Transfer
of title and risk of ownership occurs when the product is shipped to the
customer or when the customer receives the product, depending on the nature of
the arrangement. Revenue is recorded net of customer and distributor discounts.
For sales transactions when collectability is not reasonably assured, the
Company recognizes revenue upon receipt of cash payment. Sales to customers and
distributors do not include any return or exchange rights. In addition the
Company’s distributor agreements obligate the distributor to pay the Company for
the sale regardless of whether the distributor is able to resell the product.
Shipping and handling charges are invoiced to customers based on the amount of
products sold. Shipping and handling fees are recorded as revenue and the
related expense as a component of cost of revenue.




The
Company also offers customers extended service contracts. Revenue under service
contracts is recognized on a straight-line basis over the period of the
applicable service contract. Service revenue, from customers whose systems are
not under a service contact, is recognized as the services are provided. Service
revenue for the years ended December 31, 2009, 2008, and 2007 was $13.2
million, $11.4 million, and $9.1 million, respectively




Research
and Development Expenditures.




Costs
related to research, design, development and testing of products are charged to
research and development expense as incurred. Expenses incurred primarily relate
to employees, facilities, material, third party contractors and clinical and
regulatory fees.




53




Advertising
Costs.




Advertising
costs are included as part of sales and marketing expense and are expensed as
incurred. Advertising expense were $891,000 in 2009, $1.9 million in 2008 and
$2.1 million in 2007.




Stock-based
Compensation.




The
Company elected to use the Black-Scholes-Merton (BSM) pricing model to determine
the fair value of stock options on the dates of grant. Restricted stock units
(RSUs) and stock awards are measured based on the fair market values of the
underlying stock on the dates of grant. Shares are issued on the vesting dates,
net of the statutory withholding requirements to be paid by the Company on
behalf of its employees. As a result, the actual number of shares issued will be
fewer than the actual number of RSUs outstanding. Furthermore, the Company
records the liability for withholding amounts to be paid by us as a reduction to
additional paid-in capital when the shares are issued. Also, the Company
recognizes stock-based compensation using the straight-line method.




The
Company includes as part of cash flows from financing activities the benefits of
tax deductions in excess of the tax-effected compensation of the related
stock-based awards for options exercised and RSUs vested during the period. The
amount of cash received from the exercise of stock options and employee stock
purchases was $585,000 in 2009, $458,000 in 2008 and $4.1 million in 2007, and
the total direct tax benefit (deficit) realized, including the excess tax
benefit (deficit), from stock-based award activity was $109,000 in 2009,
($231,000) in 2008, and $4.2 million in 2007. The Company elected to account for
the indirect effects of stock-based awards—primarily the research and
development tax credit—through the Statement of Operations.




Income
Taxes.




The
Company recognizes income taxes under the liability method. The Company
recognizes deferred income taxes for differences between the financial reporting
and tax bases of assets and liabilities at enacted statutory tax rates in effect
for the years in which differences are expected to reverse. The Company
recognizes the effect on deferred taxes of a change in tax rates in income in
the period that includes the enactment date. The Company has determined that its
future taxable income will be sufficient to recover all of the deferred tax
assets. However, should there be a change in their ability to recover the
deferred tax assets, the Company could be required to record a valuation
allowance against its deferred tax assets. This would result in an increase to
the Company’s tax provision in the period in which they determined that the
recovery was not probable.




The
measurement of deferred taxes often involves an exercise of judgment related to
the computation and realization of tax basis. The deferred tax assets and
liabilities reflect management’s assessment that tax positions taken, and the
resulting tax basis, are more likely than not to be sustained if they are
audited by taxing authorities. Also, assessing tax rates that the Company
expects to apply and determining the years when the temporary differences are
expected to affect taxable income requires judgment about the future
apportionment of our income among the states in which the Company operates.
These matters, and others, involve the exercise of significant judgment. Any
changes in our practices or judgments involved in the measurement of deferred
tax assets and liabilities could materially impact our financial condition or
results of operations.




Valuation
allowances are established when necessary to reduce deferred income tax assets
to amounts that the Company believes are more likely than not to be recovered.
The Company evaluates its deferred tax assets quarterly to determine whether
adjustments to our valuation allowance are appropriate. In making this
evaluation, the Company relies on its recent history of pre-tax earnings,
estimated timing of future deductions and benefits represented by the deferred
tax assets, and its forecasts of future earnings, the latter two of which
involve the exercise of significant judgment. As of September 30, 2009, the
Company could not sustain a conclusion that it was more likely than not that the
Company would realize any of its deferred tax assets resulting from its
cumulative losses reported in the recent past as well as other factors.
Consequently, the Company established a valuation allowance against those
deferred tax assets. The Company also performed this evaluation as of December
31, 2009, and determined the full valuation allowance was still
required.




The
Company establishes reserves for uncertain tax positions in accordance with the
Income Taxes subtopic of the ASC. The subtopic prescribes the minimum
recognition threshold a tax position is required to meet before being recognized
in the financial statements. Additionally, the subtopic provides guidance on
derecognition, measurement, classification, interest and penalties, and
transition of uncertain tax positions. The impact of an uncertain income tax
position on income tax expense must be recognized at the largest amount that is
more-likely-than-not to be sustained. An uncertain income tax position will not
be recognized if it has less than a 50% likelihood of being sustained. The
Company has provided taxes and related interest and penalties due for potential
adjustments that may result from examinations of open U.S. Federal, state and
foreign tax years. If the Company ultimately determines that payment of these
amounts are not more-likely-than-not, the Company will reverse the liability and
recognize a tax benefit during the period in which the Company makes the
determination. The Company will record an additional charge in the Company’s
provision for taxes in the period in which the Company determines that the
recorded tax liability is less than the Company expects the ultimate assessment
to be.




54




Comprehensive
Income (loss).


Comprehensive
income (loss) generally represents all changes in stockholders’ equity except
those resulting from investments or contributions by stockholders. The Company’s
unrealized gains and losses on marketable investments represent the only
component of other comprehensive income that is excluded from net income
(loss).





On April
1, 2009, the Company adopted updates issued by the FASB to the recognition and
presentation of other-than-temporary impairments. A cumulative effect adjustment
was required to accumulated earnings and a corresponding adjustment to
accumulated other comprehensive income (loss) to reclassify the non-credit
portion of previously other-than-temporarily impaired securities which were held
at the beginning of the period of adoption and for which the Company does not
intend to sell and it is more likely than not that the Company will not be
required to sell such securities before recovery of the amortized cost basis. As
a result of the implementation of this pronouncement, the Company reclassified
the cumulative effect of the non-credit portion of previously recognized
other-than-temporarily impaired adjustments of $3.5 million by increasing
accumulated earnings and decreasing accumulated other comprehensive income
(loss).




Foreign
Currency.




The U.S.
dollar is the functional currency of the Company’s subsidiaries. Monetary and
non-monetary assets and liabilities are remeasured into U.S. dollars at period
end and historical exchange rates, respectively. Sales and operating expenses
are remeasured at average exchange rates in effect during each period, except
for those expenses related to non-monetary assets which are remeasured at
historical exchange rates. Gains or losses resulting from foreign currency
transactions are included in net income (loss) and are insignificant for each of
the three years ended December 31, 2009. The effect of exchange rate
changes on cash and cash equivalents was insignificant for each of the three
years presented in the period ended December 31, 2009.




Recent
Accounting Pronouncements.


Updates issued and
adopted


On
September 30, 2009, the Company adopted updates issued by the Financial
Accounting Standards Board (FASB) to the authoritative hierarchy of GAAP. These
changes establish the FASB Accounting Standards CodificationTM
(ASC) as the source of authoritative accounting principles recognized by the
FASB to be applied by nongovernmental entities in the preparation of financial
statements in conformity with GAAP. Rules and interpretive releases of the
Securities and Exchange Commission (SEC) under authority of federal securities
laws are also sources of authoritative GAAP for SEC registrants. The FASB will
no longer issue new standards in the form of Statements, FASB Staff Positions,
or Emerging Issues Task Force Abstracts; instead the FASB will issue Accounting
Standards Updates. Accounting Standards Updates will not be authoritative in
their own right as they will only serve to update the Codification. These
changes and the Codification itself do not change GAAP. Other than the manner in
which new accounting guidance is referenced, the adoption of these changes had
no impact on the Consolidated Financial Statements.





In August
2009, the FASB issued updates to fair value accounting for liabilities. These
changes clarify existing guidance that in circumstances in which a quoted price
in an active market for the identical liability is not available, an entity is
required to measure fair value using either a valuation technique that uses a
quoted price of either a similar liability or a quoted price of an identical or
similar liability when traded as an asset, or another valuation technique that
is consistent with the principles of fair value measurements, such as an income
approach (e.g., present value technique). This guidance also states that both a
quoted price in an active market for the identical liability and a quoted price
for the identical liability when traded as an asset in an active market when no
adjustments to the quoted price of the asset are required are Level 1 fair value
measurements. These changes are effective for the Company’s Consolidated
Financial Statements for the year ended December 31, 2009. The adoption of these
changes had no impact on the Consolidated Financial Statements.





On
June 30, 2009, the Company adopted updates issued by the FASB to accounting
for and disclosure of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued, otherwise known
as “subsequent events.” Specifically, these changes set forth the period after
the balance sheet date during which management of a reporting entity should
evaluate events or transactions that may occur for potential recognition or
disclosure in the financial statements, the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date
in its financial statements, and the disclosures that an entity should make
about events or transactions that occurred after the balance sheet date. The
adoption of these changes had no impact on the Consolidated Financial
Statements.





On
June 30, 2009, the Company adopted updates issued by the FASB to fair value
accounting. These changes provide additional guidance for estimating fair value
when the volume and level of activity for an asset or liability have
significantly decreased and includes guidance for identifying circumstances that
indicate a transaction is not orderly. This guidance is necessary to maintain
the overall objective of fair value measurements, which is that fair value is
the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date under current market conditions. The adoption of these changes
had no impact on the Consolidated Financial Statements.





On April
1, 2009, the Company adopted updates issued by the FASB to the recognition and
presentation of other-than-temporary impairments. These changes amend existing
other-than-temporary impairment guidance for debt securities to make the
guidance more operational and to improve the presentation and disclosure of
other-than-temporary impairments on debt and equity securities. The recognition
provision applies only to fixed maturity investments that are subject to the
other-than-temporary impairments. If an entity intends to sell, or if it is more
likely than not that it will be required to sell an impaired security prior to
recovery of its cost basis, the security is other-than-temporarily impaired and
the full amount of the impairment is recognized as a loss through earnings.
Otherwise, losses on securities which are other-than-temporarily impaired are
separated into: (i) the portion of loss which represents the credit loss; or
(ii) the portion which is due to other factors.




55




The
credit loss portion is recognized as a loss through earnings, while the loss due
to other factors is recognized in other comprehensive income (loss), net of
taxes and related amortization. A cumulative effect adjustment is required to
accumulated earnings and a corresponding adjustment to accumulated other
comprehensive income (loss) to reclassify the non-credit portion of previously
other-than-temporarily impaired securities which were held at the beginning of
the period of adoption and for which the Company does not intend to sell and it
is more likely than not that the Company will not be required to sell such
securities before recovery of the amortized cost basis. These changes were
effective for interim and annual periods ending after June 15, 2009, with early
adoption permitted for periods ending after March 15, 2009. The Company adopted
these changes effective April 1, 2009. As a result of the implementation of this
pronouncement, the Company reclassified the cumulative effect of the non-credit
portion of previously recognized other-than-temporarily impaired adjustments of
$3.5 million by increasing accumulated earnings and decreasing accumulated other
comprehensive income (loss).





On
June 30, 2009, the Company adopted updates issued by the FASB to fair value
disclosures of financial instruments. These changes require a publicly traded
company to include disclosures about the fair value of its financial instruments
whenever it issues summarized financial information for interim reporting
periods. Such disclosures include the fair value of all financial instruments,
for which it is practicable to estimate that value, whether recognized or not
recognized in the statement of financial position; the related carrying amount
of these financial instruments; and the method(s) and significant assumptions
used to estimate the fair value. Other than the required disclosures, the
adoption of these changes had no impact on the Consolidated Financial
Statements.





On
January 1, 2009, the Company adopted updates issued by the FASB to fair
value accounting and reporting as it relates to nonfinancial assets and
nonfinancial liabilities that are not recognized or disclosed at fair value in
the financial statements on at least an annual basis. These changes define fair
value, establish a framework for measuring fair value in GAAP, and expand
disclosures about fair value measurements. This guidance applies to other GAAP
that require or permit fair value measurements and is to be applied
prospectively with limited exceptions. The adoption of these changes, as it
relates to nonfinancial assets and nonfinancial liabilities, had no impact on
the Consolidated Financial Statements. These provisions will be applied at such
time a fair value measurement of a nonfinancial asset or nonfinancial liability
is required, which may result in a fair value that is materially different than
would have been calculated prior to the adoption of these changes.





On
January 1, 2009, the Company adopted updates issued by the FASB to
accounting for intangible assets. These changes amend the factors that should be
considered in developing renewal or extension assumptions used to determine the
useful life of a recognized intangible asset in order to improve the consistency
between the useful life of a recognized intangible asset outside of a business
combination and the period of expected cash flows used to measure the fair value
of an intangible asset in a business combination. The adoption of these changes
had no impact on the Consolidated Financial Statements.





On
January 1, 2009, the Company adopted updates issued by the FASB to the
calculation of earnings per share. These changes state that unvested share-based
payment awards that contain nonforfeitable rights to dividends or dividend
equivalents (whether paid or unpaid) are participating securities and shall be
included in the computation of earnings per share pursuant to the two-class
method for all periods presented. The adoption of these changes had no impact on
the Consolidated Financial Statements.





Updates issued but not yet
adopted


In
October 2009, the FASB issued updates to revenue recognition guidance. These
changes provide application guidance on whether multiple deliverables exist, how
the deliverables should be separated and how the consideration should be
allocated to one or more units of accounting. This update establishes a selling
price hierarchy for determining the selling price of a deliverable. The selling
price used for each deliverable will be based on vendor-specific objective
evidence, if available, third-party evidence if vendor-specific objective
evidence is not available, or estimated selling price if neither vendor-specific
or third-party evidence is available. The Company will be required to apply this
guidance prospectively for revenue arrangements entered into or materially
modified after January 1, 2011; however, earlier application is permitted. The
Company has not determined the impact that this update may have on its
Consolidated Financial Statements.





In
January 2010, the FASB issued guidance to amend the disclosure requirements
related to recurring and nonrecurring fair value measurements. The guidance
requires new disclosures on the transfers of assets and liabilities between
Level 1 (quoted prices in active market for identical assets or liabilities) and
Level 2 (significant other observable inputs) of the fair value measurement
hierarchy, including the reasons and the timing of the transfers. Additionally,
the guidance requires a roll forward of activities on purchases, sales,
issuance, and settlements of the assets and liabilities measured using
significant unobservable inputs (Level 3 fair value measurements). The guidance
will become effective for us with the reporting period beginning January 1,
2010, except for the disclosure on the roll forward activities for Level 3 fair
value measurements, which will become effective for us with the reporting period
beginning January 1, 2011. Other than requiring additional disclosures, adoption
of this new guidance will not have a material impact on our financial
statements.




NOTE
2—INVESTMENT SECURITIES:




Cash and
cash equivalents, marketable investments and long-term investments at
December 31, 2009 and 2008 consist of the following (in
thousands):





December 31,
      2009
              
              Amortized
                Cost
              
              
              Gross
                Unrealized
                Gains
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
                Market
                ValueCash
      and cash equivalents
              
              $
              22,829
              
              
              $
              —
              
              
              $
              —
              
              
              $
              22,829Marketable
      investments:Municipal
      securities
              
              
              76,512
              
              
              
              182
              
              
              
              (14
              )
              
              
              76,680ARS
              
              
              100
              
              
              
              —
              
              
              
              —
              
              
              
              100Total
      marketable investments
              
              
              76,612
              
              
              
              182
              
              
              
              (14
              )
              
              
              76,780Long-term
      investments in ARS
              
              
              8,875
              
              
              
              —
              
              
              
              (1,600
              )
              
              
              7,275$
              108,316
              
              
              $
              182
              
              
              $
              (1,614
              )
              
              $
              106,884
  56
  December 31,
      2008
              
              Amortized
                Cost
              
              
              Gross
                Unrealized
                Gains
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
                Market
                ValueCash
      and cash equivalents
              
              $
              36,540
              
              
              $
              —
              
              
              $
              —
              
              
              $
              36,540Marketable
      investments:Municipal
      securities
              
              
              59,837
              
              
              
              566
              
              
              
              —
              
              
              
              60,403ARS
              
              
              219
              
              
              
              31
              
              
              
              —
              
              
              
              250Total
      marketable investments
              
              
              60,056
              
              
              
              597
              
              
              
              —
              
              
              
              60,653Long-term
      investments in ARS
              
              
              9,627
              
              
              
              —
              
              
              
              —
              
              
              
              9,627$
              106,223
              
              
              $
              597
              
              
              $
              —
              
              
              $
              106,820




The
municipal securities and auction rate securities, both debt securities, that are
in an unrealized loss position for which other-than-temporary impairments have
not been recognized at December 31, 2009, have been in an unrealized loss
position for less than twelve months.




The
contractual maturities of marketable investment in municipal securities and ARS
classified as available for sale as of December 31, 2009, are as follows
(in thousands):





December 31,
      2009
            
            AmountDue
      in less than one year (fiscal year 2010)
            
            $
            65,047Due
      in 1 to 3 years (fiscal year 2011- 2012)
            
            
            11,733Due
      in 3 to 5 years (fiscal year 2013-2014)
            
            
            —Due
      in 5 to 10 years (fiscal year 2015-2024)
            
            
            —Due
      in greater than 10 years (fiscal year 2025 and beyond)
            
            
            7,275$
            84,055





Fair
Value Measurements




As of
December 31, 2009, financial assets measured and recognized at fair value on a
recurring basis and classified under the appropriate level of the fair value
hierarchy as described above was as follows (in thousands):





Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            TotalCash
      equivalents
            
            $
            19,346
            
            
            $
            —
            
            
            $
            —
            
            
            $
            19,346Short
      term marketable investments:Available-for-sale
      securities
            
            
            —
            
            
            
            76,780
            
            
            
            —
            
            
            
            76,780Long-term
      investments:Available-for-sale
      ARS
            
            
            —
            
            
            
            —
            
            
            
            7,275
            
            
            
            7,275Total
      assets at fair value
            
            $
            19,346
            
            
            $
            76,780
            
            
            $
            7,275
            
            
            $
            103,401





The
Company’s Level 1 financial assets are money market funds and highly liquid debt
instruments of U.S. federal and municipal governments and their agencies with
stated maturities of three months or less from the date of purchase, whose fair
values are based on quoted market prices. The Company’s Level 2 financial assets
are highly liquid debt instruments of U.S. federal and municipal governments and
their agencies with stated maturities of greater than three months, whose fair
values are obtained from readily-available pricing sources for the identical
underlying security that may, or may not, be actively traded.




At
December 31, 2009, observable market information was not available to
determine the fair value of the Company’s ARS investments. Therefore, the fair
value is based on broker-provided valuation models that relied on Level 3 inputs
including those that are based on expected cash flow streams and collateral
values, assessments of counterparty credit quality, default risk underlying the
security, market discount rates and overall capital market liquidity. The
valuation of the Company’s ARS investment portfolio is subject to uncertainties
that are difficult to predict. Factors that may impact the valuations in the
future include changes to credit ratings of the securities, as well as to the
underlying assets supporting those securities, rates of default of the
underlying assets, underlying collateral value, discount rates, counterparty
risk and ongoing strength and quality of market credit and liquidity. These
financial instruments are classified within Level 3 of the fair value
hierarchy.




57




The table
presented below summarizes the change in carrying value associated with Level 3
financial assets, which represents the Company’s investment in ARS and
classified as long-term investments, for the year ended December 31, 2009
(in thousands):





December 31,
              2009Balance
      at December 31, 2008
            
            $
            9,627Total
      gains or losses (realized or unrealized)Included
      in earnings (or changes in net assets)
            
            
            —Included
      in other comprehensive income (loss)
            
            
            19Purchases,
      issuance, and settlements
            
            
            (2,271
            )Transfers
      in and/or out of Level 3
            
            
            (100
            )Balance
      at December 31, 2009
            
            $
            7,275




NOTE
3—BALANCE SHEET DETAIL:




Accounts
Receivable:




Trade
accounts receivable are recorded at the invoiced amount and do not bear
interest. The allowance for doubtful accounts is the Company’s best estimate of
the amount of probable credit losses existing in accounts receivable and is
based on historical write-off experience and any specific customer issues that
have been identified. Account balances are charged off against the allowance
when it is probable the receivable will not be recovered. The Company had one
customer who accounted for 29% at December 31, 2009, and 25% at December 31,
2008, of the Company’s total accounts receivable balance.




Inventories:





Inventories
consist of the following (in thousands):





December 31,2009
            
            
            2008Raw
      materials
            
            $
            3,775
            
            
            $
            5,071Finished
      goods
            
            
            2,633
            
            
            
            4,856$
            6,408
            
            
            $
            9,927




Property
and Equipment, net:





Property
and equipment, net consists of the following (in thousands):





December 31,2009
            
            
            2008Leasehold
      improvements
            
            $
            347
            
            
            $
            347Office
      equipment and furniture
            
            
            2,610
            
            
            
            2,572Machinery
      and equipment
            
            
            2,519
            
            
            
            2,4035,476
            
            
            
            5,322Less:
      Accumulated depreciation
            
            
            (4,629
            )
            
            
            (3,965
            )Property
      and equipment, net
            
            $
            847
            
            
            $
            1,357




Depreciation
expense related to property and equipment was $664,000 in 2009, $702,000 in
2008, and $674,000 in 2007.




58




Intangible
Assets:




Intangible
assets were principally comprised of a patent sublicense acquired from Palomar
in 2006, a technology sublicense acquired in 2002 and other intangible assets
acquired in 2007. The components of intangible assets at December 31, 2009
and 2008 were as follows (in thousands):





Gross
              Carrying
              Amount
            
            
            Accumulated
              Amortization
              Amount
            
            
            Net
              AmountDecember 31,
      2009Patent
      sublicense
            
            $
            1,218
            
            
            $
            517
            
            
            $
            701Technology
      sublicense
            
            
            538
            
            
            
            410
            
            
            
            128Other
      intangibles
            
            
            20
            
            
            
            20
            
            
            
            —Total
            
            $
            1,776
            
            
            $
            947
            
            
            $
            829December 31,
      2008Patent
      sublicense
            
            $
            1,218
            
            
            $
            379
            
            
            $
            839Technology
      sublicense
            
            
            538
            
            
            
            356
            
            
            
            182Other
      intangibles
            
            
            20
            
            
            
            16
            
            
            
            4Total
            
            $
            1,776
            
            
            $
            751
            
            
            $
            1,025





Amortization
expense for intangible assets was $196,000 in 2009, $202,000 in 2008, and
$239,000 in 2007.




Based on
intangible assets recorded at December 31, 2009, and assuming no subsequent
additions to, or impairment of the underlying assets, the remaining estimated
annual amortization expense is expected to be as follows (in
thousands):





Year
      ending December 31,
            
            Amount2009
            
            $
            1922010
            
            
            1922011
            
            
            1582012
            
            
            1382013
            
            
            1382014
      and thereafter
            
            
            11Total
            
            $
            829




Accrued
Liabilities:





Accrued
liabilities consist of the following (in thousands):





December 31,2009
            
            
            2008Payroll
      and related expenses
            
            $
            3,216
            
            
            $
            3,523Warranty
            
            
            1,049
            
            
            
            1,916Litigation
      accrual - Telephone Consumer Protection Act (see Note 11)
            
            
            950
            
            
            
            —Other
            
            
            884
            
            
            
            838Sales
      tax
            
            
            748
            
            
            
            806Professional
      fees
            
            
            733
            
            
            
            432Customer
      deposits
            
            
            667
            
            
            
            225Royalty
            
            
            476
            
            
            
            623Sales and
      marketing accruals
            
            
            325
            
            
            
            200Income
      tax payable
            
            
            —
            
            
            
            285$
            9,048
            
            
            $
            8,848




59




NOTE
4—WARRANTY AND SERVICE CONTRACTS:




The
Company has a direct field service organization in the United States.
Internationally, the Company provides direct service support through its
wholly-owned subsidiaries in Australia, Canada, France, Japan, Spain and
Switzerland as well as through a network of distributors and third-party service
providers in several other countries where it does not have a direct presence.
The Company provides a warranty with its products, depending on the type of
product. After the original warranty period, maintenance and support are offered
on a service contract basis or on a time and materials basis. The Company
currently provides for the estimated cost to repair or replace products under
warranty at the time of sale.





Warranty
Accrual (in thousands):





December 31,2009
            
            
            2008Balance
      at beginning of year
            
            $
            1,916
            
            
            $
            2,725Add:
      Accruals for warranties issued during the year
            
            
            2,059
            
            
            
            4,560Less:
      Settlements made during the year
            
            
            (2,926
            )
            
            
            (5,369
            )Balance
      at end of year
            
            $
            1,049
            
            
            $
            1,916




Deferred
Service Contract Revenue (in thousands):





December 31,2009
            
            
            2008Balance
      at beginning of year
            
            $
            11,665
            
            
            $
            10,564Add:
      Payments received
            
            
            6,585
            
            
            
            9,915Less:
      Revenue recognized
            
            
            (10,122
            )
            
            
            (8,814
            )Balance
      at end of year
            
            $
            8,128
            
            
            $
            11,665




Costs
incurred under service contracts amounted to $4.7 million in 2009, $4.4 million
in 2008, and $2.4 million in 2007, and are recognized as incurred.




NOTE
5—STOCKHOLDERS’ EQUITY, STOCK PLANS AND STOCK-BASED COMPENSATION
EXPENSE:




Stock Option
Plans.





As of
December 31, 2009, the Company had the following stock-based employee
compensation plans.




2004
Employee Stock Purchase Plan.




On
January 12, 2004, the Board of Directors adopted the 2004 Employee Stock
Purchase Plan. A total of 200,000 shares of common stock were reserved for
issuance pursuant to the 2004 Employee Stock Purchase Plan. Under the 2004
Employee Stock Purchase Plan, or 2004 ESPP, eligible employees are permitted to
purchase common stock at a discount through payroll deductions. The 2004 ESPP
offering and purchase periods are for approximately six months. Shares of common
stock eligible for purchase are increased on the first day of each fiscal year
by an amount equal to the lesser of (i) 600,000 shares, (ii) 2.0% of
the outstanding shares of common stock on such date or (iii) an amount as
determined by the Board of Directors. The Company’s Board of Directors voted not
to increase the shares available for future grant on January 1, 2010. The
Company added 256,121 reserved shares on January 1, 2009 and 254,769 reserved
shares on January 1, 2008. The price of the common stock purchased is the
lower of 85% of the fair market value of the common stock at the beginning of an
offering period or at the end of the offering period. Under the 2004 ESPP the
Company issued 59,365 shares in 2009 and 50,693 shares in 2008. At
December 31, 2009, 1,145,956 shares remained available for future
issuance.





2004
Equity Incentive Plan and 1998 Stock Plan.




In 1998,
the Company adopted the 1998 Stock Plan, or 1998 Plan, under which 4,650,000
shares of the Company’s common stock have been reserved for issuance to
employees, directors and consultants.




On
January 12, 2004, the Board of Directors adopted the 2004 Equity Incentive
Plan. A total of 1,750,000 shares of common stock were originally reserved for
issuance pursuant to the 2004 Equity Incentive Plan. In addition, the shares
reserved for issuance under the 2004 Equity Incentive Plan included shares
reserved but un-issued under the 1998 Plan and shares returned to the 1998 Plan
as the result of termination of options or the repurchase of
shares.




Shares of
common stock approved under the 2004 Equity Incentive Plan was increased on the
first day of each fiscal year, commencing in 2005, by an amount equal to the
lesser of: (i) 5% of the outstanding shares on the first day of such year;
(b) 2 million shares; or, (c) an amount determined by the Board
of Directors. The Company added 636,922 shares to the 2004 Equity Incentive Plan
on January 1, 2008. During 2008, the 2004 Equity Incentive Plan was amended
to remove this feature beginning in 2009.




60




Options
granted under the 1998 Plan and 2004 Equity Incentive Plan may be incentive
stock options or non-statutory stock options. Stock purchase rights may also be
granted under the 2004 Equity Incentive Plan. Incentive stock options may only
be granted to employees. The Board of Directors determines the period over which
options become exercisable, however, except in the case of options granted to
officers, directors and consultants, options shall become exercisable at a rate
of no less than 20% per year over five years from the date the options are
granted. Options are to be granted at an exercise price not less than the fair
market value per share on the grant date for incentive options or 85% of fair
market value for nonqualified stock options. For employees holding more than 10%
of the voting rights of all classes of stock, the exercise price shall not be
less than 110% of the fair market value per share on the grant date. Options
granted under the Plan to employees generally become exercisable 25% on the
first anniversary of the vesting commencement date and an additional 1/48th of
the total number of shares subject to the option shares shall become exercisable
on the last day of each calendar month thereafter until all of the shares have
become exercisable. Unvested options that have been exercised are subject to
repurchase upon termination of the holder’s status as an employee, director or
consultant. The contractual term of the options granted is either five, seven or
ten years. In June 2009, the Company granted stock awards to non-employee Board
of Directors that vested upon grant. In June 2008, the Company granted options
to non-employee Board of Directors that become exercisable 100% on the first
anniversary of the vesting commencement date.




During
the year ended December 31, 2006, under the 2004 Equity Incentive Plan, the
Company’s Board of Directors approved the grant of 71,500 shares of RSUs to
certain members of the Company’s management. The RSUs generally vest in four
equal, annual installments on the anniversaries of the date of grant. The
Company measured the fair market values of the underlying stock on the dates of
grant and recognizes the share-based compensation expense using the
straight-line method over the vesting period.




The
Company issues new shares upon the exercise of options, restricted stock units
and ESPP shares.





Option
Exchange Program




In July
2009, the Company completed its Option Exchange Program for its employees to
exchange certain options outstanding for new options to purchase shares of the
Company’s common stock. As a result, options to purchase 864,373 shares of the
Company’s common stock were cancelled and new options to purchase up to 447,841
shares of the Company’s common stock were issued in exchange. The new options
have an exercise price per share of $8.49, the closing price of the Company’s
common stock as reported on the Nasdaq Global Select Market on the date that the
offer expired and Option Exchange Program was completed, are unvested as of the
grant date, and subject to an additional six (6) months of vesting over and
above the vesting schedule of the surrendered options.




Given the
Option Exchange Program was designed to be approximately a “value-for-value”
exchange, the Company did not incur any significant additional non-cash
compensation charges as the fair value of the replacement options was
approximately equal to or less than the fair value of the surrendered options.
The Company determined the fair value of stock options using the Black Scholes
valuation model.





Option
Activity.





Activity
under the 1998 Plan and 2004 Equity Incentive Plan is summarized as
follows:




Options
      OutstandingShares
                Available
                For
      Grant
              
              
              Number
      of
                Shares
              
              
              Weighted-
                Average
                Exercise
                Price
              
              
              Weighted-
                Average
                Remaining
                Contractual
                Life
                (in years)
              
              
              Aggregate
                Intrinsic
                Value
                (in $ millions)(1)Balances
      as of December 31, 2006
              
              
              1,682,746
              
              
              
              2,985,531
              
              
              $
              10.16Additional
      shares reserved
              
              
              646,969
              
              
              
              —
              
              
              
              —Options
      granted
              
              
              (397,500
              )
              
              
              397,500
              
              
              $
              24.68Options
      exercised
              
              
              —
              
              
              
              (854,147
              )
              
              $
              3.89Options
      cancelled or forfeited
              
              
              111,309
              
              
              
              (111,309
              )
              
              $
              21.94Restricted
      stock units cancelled or forfeited
              
              
              4,125
              
              
              
              —
              
              
              
              —Balances
      as of December 31, 2007
              
              
              2,047,649
              
              
              
              2,417,575
              
              
              $
              14.22
              
              
              
              5.03
              
              
              
              12.6Additional
      shares reserved
              
              
              636,922
              
              
              
              —
              
              
              
              —Options
      granted
              
              
              (888,150
              )
              
              
              888,150
              
              
              $
              10.77Options
      exercised
              
              
              —
              
              
              
              (8,449
              )
              
              $
              5.39Options
      cancelled or forfeited
              
              
              215,543
              
              
              
              (215,543
              )
              
              $
              18.69Restricted
      stock units cancelled or forfeited
              
              
              1,125
              
              
              
              —
              
              
              
              —Balances
      as of December 31, 2008
              
              
              2,013,089
              
              
              
              3,081,733
              
              
              $
              12.94
              
              
              
              4.58
              
              
              $
              6.0Additional
      shares reserved
              
              
              —
              
              
              
              —
              
              
              
              —Options
      granted (2)
              
              
              (1,409,371
              )
              
              
              1,409,371
              
              
              $
              8.51Options
      exercised
              
              
              —
              
              
              
              (527,721
              )
              
              $
              0.55Options
      cancelled (expired or forfeited)(2)
              
              
              1,270,828
              
              
              
              (1,270,828
              )
              
              $
              17.55Stock
      awards granted
              
              
              (36,540
              )
              
              
              —
              
              
              
              —Restricted
      stock units cancelled (expired or forfeited)
              
              
              2,375
              
              
              
              —
              
              
              
              —Balances
      as of December 31, 2009
              
              
              1,840,381
              
              
              
              2,692,555
              
              
              $
              10.87
              
              
              
              5.05
              
              
              $
              1.6Exercisable
      as of December 31, 2009
              
              
              
              
              
              
              1,253,360
              
              
              $
              12.54
              
              
              
              4.12
              
              
              $
              1.5





(1)
            Based
      on the closing stock price of $8.51, $8.87 and $15.70 for the
      Company’s common stock on December 31, 2009, December 31, 2008, and
      December 31, 2007, respectively, the last day of trading for the 2009,
      2008 and 2007 fiscal year, respectively.(2)
            Included
      in options granted and options cancelled are shares granted and cancelled
      in connection with the Company’s Option Exchange Program in 2009 (see
      ‘Option Exchange Program’ above for more
  details).




61




The
aggregate intrinsic value in the table above represents the total pre-tax
intrinsic value (the aggregate difference between the Company’s closing stock
price on the last trading day of the fiscal year 2009 and the exercise price,
multiplied by the number of in-the-money options) that would have been received
by the option holders had all option holders exercised their options on
December 31, 2009. The aggregate intrinsic amount changes based on the fair
market value of the Company’s common stock. Total intrinsic value of options
exercised was $3.2 million in 2009, $57,000 in 2008, and $23.9 million in
2007.




The
options outstanding and exercisable at December 31, 2009 were in the
following exercise price ranges:





Options
      Outstanding
            
            Options
      ExercisableRange
      of Exercise Prices
            
            Number
              Outstanding
            
            Weighted-
              Average
              Remaining
              Contractual
              Life (in years)
            
            Number
              Outstanding
            
            
            Weighted-
              Average
              Exercise
              Price$
            0.50–$ 5.50
            
            
            279,062
            
            
            2.29
            
            
            279,062
            
            
            $
            3.35$
            6.00–$ 8.02
            
            
            107,267
            
            
            5.58
            
            
            31,340
            
            
            
            6.88$
            8.49–$ 8.49
            
            
            498,234
            
            
            4.91
            
            
            255,382
            
            
            
            8.49$
            8.56–$ 8.56
            
            
            3,750
            
            
            6.56
            
            
            —
            
            
            
            —$
            8.66–$ 8.66
            
            
            809,167
            
            
            6.43
            
            
            —
            
            
            
            —$
            8.85–$10.43
            
            
            315,600
            
            
            5.48
            
            
            78,791
            
            
            
            10.11$
            12.14–$14.78
            
            
            279,408
            
            
            4.63
            
            
            259,221
            
            
            
            13.89$
            16.25–$24.46
            
            
            352,942
            
            
            4.08
            
            
            305,418
            
            
            
            22.47$
            24.60–$26.32
            
            
            45,125
            
            
            4.80
            
            
            42,688
            
            
            
            25.48$
            34.45–$34.45
            
            
            2,000
            
            
            7.09
            
            
            1,458
            
            
            
            34.45$
            0.50–$34.45
            
            
            2,692,555
            
            
            5.05
            
            
            1,253,360
            
            
            $
            10.87




As of
December 31, 2008 there were 1,842,485 options that were exercisable at a
weighted average exercise price of $11.44.





Restricted Stock Units and
Stock Awards.




Information
with respect to restricted stock units and stock awards activity is as follows
(in thousands):





Number
              of
              Shares
            
            
            Weighted
              Average
              Grant-
              Date
      Fair
              Value
            
            
            Aggregate
              Fair
      Value(1)
              (in thousands)Outstanding
      at December 31, 2008
            
            
            12,811
            
            
            $
            20.25Granted
            
            
            36,540
            
            
            $
            8.21Vested(2)
            
            
            (46,976
            )
            
            $
            10.88
            
            
            $
            385
            (3)Forfeited
            
            
            (2,375
            )
            
            $
            20.25Outstanding
      at December 31, 2009
            
            
            —
            
            
            $
            —





(1)
            Represents
      the value of the Company’s stock on the date that the restricted stock
      units vest.(2)
            The
      number of restricted stock units vested includes shares that the Company
      withheld on behalf of the employees to satisfy the statutory tax
      withholding requirements.(3)
            On
      the grant date, the fair value for these vested awards was
      $511,000.




62




Stock-Based
Compensation.




Stock-based
compensation expense for stock options, restricted stock units, stock awards and
ESPP shares for the year ended December 31, 2009, 2008 and 2007 was as
follows (in thousands):





Year
      Ended
              December 31,2009
            
            
            2008
            
            
            2007Stock
      options
            
            $
            3,763
            
            
            $
            4,783
            
            
            $
            4,982RSUs
      and Stock awards
            
            
            360
            
            
            
            257
            
            
            
            294ESPP
            
            
            113
            
            
            
            180
            
            
            
            351Total
      share-based compensation expense
            
            
            4,236
            
            
            
            5,220
            
            
            
            5,627Tax
      effect on share-based compensation at the marginal tax
    rates
            
            
            (1,452
            )
            
            
            (1,788
            )
            
            
            (1,963
            )Net
      share-based compensation expense
            
            $
            2,784
            
            
            $
            3,432
            
            
            $
            3,664




Total
pre-tax stock-based compensation expense by department recognized during the
year ended December 31, 2009, 2008 and 2007 was as follows (in
thousands):





Year
      Ended
              December 31,2009
            
            
            2008
            
            
            2007Cost
      of revenue
            
            $
            717
            
            
            $
            846
            
            
            $
            891Sales
      and marketing
            
            
            1,044
            
            
            
            1,657
            
            
            
            1,678Research
      and development
            
            
            473
            
            
            
            628
            
            
            
            752General
      and administrative
            
            
            2,002
            
            
            
            2,089
            
            
            
            2,306Total
      share-based compensation expense
            
            $
            4,236
            
            
            $
            5,220
            
            
            $
            5,627




As of
December 31, 2009, the unrecognized compensation cost, net of expected
forfeitures, related to stock options and ESPP was $7.2 million and $40,000,
respectively, which will be recognized using the straight- line attribution
method over an estimated weighted-average amortization period of 2.73 years and
0.33 years, respectively.





Valuation
Assumptions and Fair Value of Stock Option and ESPP Grants.




The
Company uses the Black-Scholes option pricing model to estimate the fair value
of options granted under its equity incentive plans and rights to acquire stock
granted under its employee stock purchase plan. The Company based the weighted
average estimated values of employee stock option grants and rights granted
under the employee stock purchase plan, as well as the weighted average
assumptions used in calculating these values, on estimates at the date of grant,
as follows:





Stock
      Options
            
            
            Stock
      Purchase Plan2009
            
            
            2008
            
            
            2007
            
            
            2009
            
            
            2008
            
            
            2007Estimated
      fair value of grants during the year
            
            $
            3.93
            
            
            $
            5.29
            
            
            $
            11.42
            
            
            $
            2.39
            
            
            $
            4.52
            
            
            $
            9.20Expected term (in
      years)(1)
            
            
            4.23
            
            
            
            4.68
            
            
            
            3.76
            
            
            
            0.50
            
            
            
            0.50
            
            
            
            0.62Risk-free interest
      rate(2)
            
            
            2.6
            %
            
            
            3.2
            %
            
            
            4.9
            %
            
            
            0.1
            %
            
            
            1.9
            %
            
            
            4.7
            %Volatility(3)
            
            
            55
            %
            
            
            55
            %
            
            
            56
            %
            
            
            52
            %
            
            
            51
            %
            
            
            59
            %Dividend yield(4)
            
            
            —
            %
            
            
            —
            %
            
            
            —
            %
            
            
            —
            %
            
            
            —
            %
            
            
            —
            %





(1)
            The
      expected term represents the period during which the Company’s stock-based
      awards are expected to be outstanding. The estimated term is based on
      historical experience of similar awards, giving consideration to the
      contractual terms of the awards, vesting requirements, and expectation of
      future employee behavior, including post-vesting terminations. Prior to
      2008, the Company used the simplified method of calculating expected life
      described in SAB 107,Share Based
      Payment , due to significant differences in the vesting and
      contractual life of current option grants compared to its historical
      grants, as well as limited data of historical exercise patterns since the
      Initial Public Offering (IPO) of its common stock.(2)
            The
      risk-free interest rate is based on U.S. Treasury debt securities with
      maturities close to the expected term of the option as of the date of
      grant.(3)
            Expected
      volatility is a 50%/50% blend of implied and historical volatility. The
      Company has determined that this is a more reflective measure of market
      conditions and a better indicator of expected volatility, than its limited
      historical volatility since the IPO, of its common
  stock.(4)
            The
      Company has not historically issued any dividends and does not expect to
      do so in the foreseeable future.




63




The
Company periodically estimates forfeiture rates based on its historical
experience within separate groups of employees and adjusts the share-based
payment expense accordingly.




NOTE
6: COMMON STOCK REPURCHASES




Restricted
Stock Unit Withholdings




The
Company issues restricted stock units as part of its equity incentive plans,
which are described more fully in “Note 5—Stockholders’ Equity, Stock Plans and
Stock-Based Compensation Expense.” For the majority of restricted stock units
granted, the number of shares issued on the date the restricted stock units vest
is net of the statutory withholding requirements paid on behalf of the
employees. The Company withheld 3,934 in 2009, 4,992 in 2008, and 5,288 in 2007,
shares of common stock to satisfy its employees’ tax obligations of $32,000 in
2009, $51,000 in 2008, and $139,000 in 2007. The Company paid this amount in
cash to the appropriate taxing authorities.





Although
shares withheld are not issued, they are treated as common stock repurchases for
accounting and disclosure purposes, as they reduce the number of shares that
would have been issued upon vesting.




Common
Stock Repurchase Program




In the
year ended December 31, 2007, the Company repurchased 1,107,856 shares of
its common stock at an average price of $22.57. The stock repurchased under the
Rule 10b5-1 trading plan was cancelled and returned to authorized share
status.




NOTE
7—INCOME TAXES:




The
Company files income tax returns in the U.S. federal and various state and local
jurisdictions and foreign jurisdictions. The components of the provision for
income taxes are as follows (in thousands):





Year
      Ended December 31,2009
            
            
            2008
            
            
            2007Current:Federal
            
            $
            (1,973
            )
            
            $
            1,009
            
            
            $
            4,904State
            
            
            32
            
            
            
            305
            
            
            
            626Foreign
            
            
            338
            
            
            
            382
            
            
            
            260(1,603
            )
            
            
            1,696
            
            
            
            5,790Deferred:Federal
            
            
            9,686
            
            
            
            (2,313
            )
            
            
            (2,052
            )State
            
            
            871
            
            
            
            (78
            )
            
            
            (416
            )Foreign
            
            
            (46
            )
            
            
            (97
            )
            
            
            (62
            )10,511
            
            
            
            (2,488
            )
            
            
            (2,530
            )Provision
      (benefit) for income taxes
            
            $
            8,908
            
            
            $
            (792
            )
            
            $
            3,260




The
Company’s deferred tax asset consists of the following (in
thousands):




December 31,2009
              
              
              2008Credits
              
              $
              1,184
              
              
              $
              922Accrued
      warranty
              
              
              401
              
              
              
              737Other
      accruals and reserves
              
              
              4,631
              
              
              
              4,458Stock-based
      compensation
              
              
              4,499
              
              
              
              4,056Other
              
              
              78
              
              
              
              514Foreign
              
              
              272
              
              
              
              226Capital
      loss
              
              
              539
              
              
              
              1,133Net
      operating loss
              
              
              3,494
              
              
              
              —Deferred
      tax asset
              
              
              15,098
              
              
              
              12,046Depreciation
      and amortization
              
              
              103
              
              
              
              105Net
      deferred tax asset before valuation allowance
              
              
              15,201
              
              
              
              12,151Valuation
      allowance
              
              
              (14,929
              )
              
              
              (1,367
              )Net
      deferred tax asset after valuation allowance
              
              $
              272
              
              
              $
              10,784




64




The
differences between the U.S. federal statutory income tax rate to the Company’s
effective tax are as follows:





Year Ended December 31,2009
            
            
            2008
            
            
            2007U.S.
      federal statutory income tax rate
            
            35.00
            %
            
            35.00
            %
            
            35.00
            %State
      tax rate, net of federal benefit
            
            (0.86
            )
            
            (2.38
            )
            
            4.58Meals
      and entertainment
            
            (0.76
            )
            
            (3.45
            )
            
            0.92Benefit
      for research and development credit
            
            1.06
            
            
            11.07
            
            
            (10.62
            )Stock-based
      compensation
            
            (1.82
            )
            
            (5.65
            )
            
            1.90Tax-exempt
      interest
            
            5.42
            
            
            27.85
            
            
            (9.61
            )Valuation
      allowance
            
            (154.62
            )
            
            (37.34
            )
            
            —Refund
            
            11.00
            
            
            —
            
            
            —Other
            
            4.01
            
            
            (3.47
            )
            
            1.51Effective
      tax rate
            
            (101.57
            )%
            
            21.63
            %
            
            23.68
            %




The
Company recognizes deferred tax assets for the expected future tax consequences
of temporary differences between the financial reporting and tax bases of assets
and liabilities, and for operating losses and tax credit carryforwards. The
Company records a valuation allowance to reduce the deferred tax assets to their
estimated realizable value, when it is more likely than not that it will not be
able to generate sufficient future taxable income to realize the net carrying
value. The Company reviews the deferred tax asset and valuation allowance on a
quarterly basis, and considers whether positive and negative evidence exists to
effect the realization of deferred tax assets. After considering both the
positive and negative evidence as of September 30, 2009, the Company determined
that it was not more-likely-than-not that it would realize the full value of its
deferred tax assets. As a result, the Company established a valuation allowance
of $10.2 million against the net deferred tax asset balance as of December 31,
2008. In addition, the Company recorded a valuation allowance against its
deferred tax assets generated in 2009, which resulted in a valuation allowance
of $14.9 million as of December 31, 2009.




As of
December 31, 2009, the Company had cumulative net operating loss
carry-forwards for federal and state income tax reporting purposes of
approximately $6.6 million and $2.0 million, respectively. The federal net
operating loss carry-forwards expire through the year 2029 and the state net
operating loss carry-forwards expire at various dates through the year 2018.
Such net operating losses consist of excess tax benefits from employee stock
option exercises and have not been recorded in the Company’s deferred tax
assets. The Company will record $3.4 million as a credit to additional paid in
capital as and when such excess tax benefits are ultimately
realized.




As of
December 31, 2009, the Company had research and development tax credits for
federal and state income tax purposes of approximately $2.7 million and
$671,000, respectively. These federal research and development tax credits
expire through the year 2028. The state research and development credits
can be carried forward indefinitely, except for $284,000, which will expire at
various dates through the year 2020. The Company expanded a valuation allowance
against these tax credits at December 31, 2009.




Undistributed
earnings of the Company’s foreign subsidiaries of approximately $2.5 million at
December 31, 2009, are considered to be indefinitely reinvested and,
accordingly, no provision for federal and state income taxes has been provided
thereon. Upon distribution of those earnings in the form of dividends or
otherwise, the Company would be subject to both U.S. income taxes (subject to an
adjustment for foreign tax credits) and withholding taxes payable to various
foreign countries.




During
2008, the IRS completed its examination of the Company’s U.S. income tax returns
for 2005 and 2006. The net adjustment resulting from the examination did not
have a significant effect on the Company’s net loss or financial position and
has been reflected in the 2008 tax provision.




Uncertain
Tax Positions




The
Company establishes reserves for uncertain tax positions in accordance with the
ASC. The subtopic prescribes the minimum recognition threshold a tax position is
required to meet before being recognized in the financial statements.
Additionally, the subtopic provides guidance on derecognition, measurement,
classification, interest and penalties, and transition of uncertain tax
positions. The impact of an uncertain income tax position on income tax expense
must be recognized at the largest amount that is more-likely-than-not to be
sustained. An uncertain income tax position will not be recognized if it has
less than a 50% likelihood of being sustained. The Company has provided taxes
and related interest and penalties due for potential adjustments that may result
from examinations of open U.S. Federal, state and foreign tax years. If the
Company ultimately determines that payment of these amounts are not
more-likely-than-not, the Company will reverse the liability and recognize a tax
benefit during the period in which the Company makes the determination. The
Company will record an additional charge in the Company’s provision for taxes in
the period in which the Company determines that the recorded tax liability is
less than the Company expects the ultimate assessment to be. The Company’s
policy to include interest and penalties related to gross unrecognized tax
benefits within the provision for income taxes did not change.




65




The
following table summarizes the activity related to the Company’s gross
unrecognized tax benefits in December 31, 2008 to December 31, 2009
(in thousands):





Year Ended
      December 31,2009
            
            
            2008
            
            
            2007Balance
      at beginning of year
            $
            1,640
            
            
            $
            1,500
            
            
            $
            1,067Increases
      related to prior year tax positions
            
            88
            
            
            
            —
            
            
            
            588Decreases
      related to prior year tax positions
            
            (857
            )
            
            
            (98
            )
            
            
            (59
            )Increases
      related to current year tax positions
            
            29
            
            
            
            258
            
            
            
            —Decreases
      related to settlements with taxing authorities
            
            —
            
            
            
            —
            
            
            
            —Decreases
      related to lapsing of statute of limitations
            
            (113
            )
            
            
            (20
            )
            
            
            (96
            )Balance
      at end of year
            $
            787
            
            
            $
            1,640
            
            
            $
            1,500




The
Company’s total unrecognized tax benefits that, if recognized, would affect its
effective tax rate were approximately $737,000 and $810,000 as of
December 31, 2009 and 2008, respectively. The Company had accrued
approximately $117,000 and $104,000 for payment of interest as of
December 31, 2009 and 2008, respectively. Interest included in the
provision for income taxes was not significant in all the periods presented. The
Company has not accrued any penalties related to its uncertain tax positions as
it believes that it is more likely than not that there will not be any
assessment of penalties. The Company expects that the amount of unrecognized tax
benefits will not change within the next 12 months.




NOTE
8—NET INCOME (LOSS) PER SHARE:




Basic net
income (loss) per share is calculated by dividing net income (loss) by the
weighted-average number of common shares outstanding during the year. Diluted
net income per share is calculated by using the weighted-average number of
common shares outstanding during the year increased to include the number of
additional shares of common stock that would have been outstanding if the
dilutive potential shares of common stock had been issued. The dilutive effect
of outstanding options, Employee Stock Purchase Plan shares and restricted stock
units is reflected in diluted net income per share by application of the
treasury stock method, which includes consideration of stock-based
compensation.




For years
presented with a net diluted net loss per common share is the same as basic net
loss per common share, as the effect of the potential common stock equivalents
is anti-dilutive and as such is excluded from the calculations of the diluted
net loss per share.





The
following table sets forth the computation of basic and diluted net income
(loss) and the weighted average number of shares used in computing basic and
diluted net income (loss) per share (in thousands):





Year
      Ended December 31,2009
            
            
            2008
            
            2007Numerator:Net
      income (loss)—Basic and Diluted
            
            $
            (17,679
            )
            
            $
            (2,869
            )
            $
            10,504Denominator:Weighted-average
      number of common shares outstanding used in computing basic net income
      (loss) per share
            
            
            13,279
            
            
            
            12,770
            
            
            13,153Dilutive
      potential common shares used in computing diluted net income (loss) per
      share
            
            
            —
            
            
            
            —
            
            
            1,075Total
      weighted-average number of shares used in computing diluted net income
      (loss) per share
            
            
            13,279
            
            
            
            12,770
            
            
            14,228




Anti-dilutive
Securities




The
following number of weighted shares outstanding, prior to the application of the
treasury stock method, were excluded from the computation of diluted net income
(loss) per common share for the years presented because including them would
have had an anti-dilutive effect (in thousands):





Year Ended December 31,2009
            
            
            2008
            
            
            2007Options
      to purchase common stock
            
            
            2,746
            
            
            
            2,882
            
            
            
            —Restricted
      stock units
            
            
            5
            
            
            
            19
            
            
            
            —Employee
      stock purchase plan shares
            
            
            84
            
            
            
            94
            
            
            
            8292,835
            
            
            
            2,995
            
            
            
            829




66




NOTE
9—DEFINED CONTRIBUTION PLAN:




In the
United States, the Company has an employee savings plan (401(k) Plan) that
qualifies as a deferred salary arrangement under Section 401(k) of the
Internal Revenue Code. Eligible employees may make voluntary contributions to
the 401(k) Plan up to 100% of their annual compensation, subject to statutory
annual limitations. Since April 1999, the Company has made discretionary
matching contributions of 50% to 75% of all employees’ contributions in each
401(k) Plan year. The Company did not make a discretionary contribution in 2009,
under the 401(k) Plan and made discretionary contributions of $572,000 in 2008,
and $597,000 in 2007, under the 401(k) Plan.




For the
Company’s Japanese subsidiary, it has established an employee retirement plan at
its discretion. In addition, for some of the Company’s other foreign
subsidiaries, the Company deposits funds with insurance companies, third-party
trustees, or into government-managed accounts consistent with the requirements
of local laws. The Company has fully funded or accrued for its obligations as of
December 31, 2009, and the related expense was not significant in each of
the years ended December 31, 2009, 2008, and 2007.





NOTE
10—SEGMENT, GEOGRAPHIC AND MAJOR CUSTOMER INFORMATION:




The
Company operates in one business segment, which encompasses the designing,
developing, manufacturing, marketing and servicing of aesthetic laser and other
light-based systems for physicians and other qualified practitioners worldwide.
Management uses one measurement of profitability and does not segregate its
business for internal reporting.




The
Company’s long-lived assets maintained outside the United States are
insignificant.




Revenue
is attributed to geographical regions based on the shipping location of where
the product is delivered.




The
Company had one customer that represented net revenue of 7% in 2009 and 14% in
2008 and 2007, and accounted for 29% at December 31, 2009, and 25% at December
31, 2008, of the Company’s total accounts receivable balance.




The
following table summarizes revenue by geographic region and product category (in
thousands):





Year Ended December 31,2009
            
            
            2008
            
            
            2007Revenue
      mix by geography:United
      States
            
            $
            21,019
            
            
            $
            41,683
            
            
            $
            64,084Japan
            
            
            9,636
            
            
            
            10,929
            
            
            
            8,453Asia,
      excluding Japan(1)
            
            
            4,727
            
            
            
            5,713
            
            
            
            6,009Europe
            
            
            7,087
            
            
            
            10,522
            
            
            
            9,258Rest
      of the world(1)
            
            
            11,213
            
            
            
            14,532
            
            
            
            13,922Consolidated
      total
            
            $
            53,682
            
            
            $
            83,379
            
            
            $
            101,726Revenue
      mix by product category:Products
            
            $
            28,554
            
            
            $
            57,998
            
            
            $
            74,502Upgrades
            
            
            6,343
            
            
            
            8,361
            
            
            
            13,342Service
            
            
            13,186
            
            
            
            11,358
            
            
            
            9,128Titan
      hand piece refills
            
            
            5,599
            
            
            
            5,662
            
            
            
            4,754Consolidated
      total
            
            $
            53,682
            
            
            $
            83,379
            
            
            $
            101,726





(1)Beginning in 2009, the Company classified revenue from Australia and New
Zealand in the geography category ‘Rest of world’. Previously it classified
revenue from Australia and New Zealand in the geography category ‘Asia,
excluding Japan’; as such, the Company reclassified the 2008 and 2007 revenue
from Australia and New Zealand from ‘Asia, excluding Japan’ to ‘Rest of
world’.




67




NOTE
11—COMMITMENTS AND CONTINGENCIES:




Facility
Leases.




The
Company leases its Brisbane, California, office and manufacturing facility under
a non-cancelable operating lease which expires in 2013. In addition, the Company
has leased office facilities in certain international countries as
follows:





Country
            
            Square
      Footage
            
            Lease
      termination or ExpirationJapan
            
            Approximately 5,790
            
            Three
      leases, of which two expire in May 2010, and one expires in July
      2010.Switzerland
            
            Approximately
      2,885
            
            Two
      leases expire in March and April 2010. The company entered into a lease
      agreement for 3,174 square feet effective April 2010, which expires in
      March 2013.France
            
            Approximately
      450
            
            Lease
      expires in November 2011, but may be cancelled at any time with a
      three-month notice.Spain
            
            Approximately
      175
            
            Lease
      automatically renews at the end of each six-month period.





As of
December 31, 2009, the Company was committed to minimum lease payments for
facilities and other leased assets under long-term non-cancelable operating
leases as follows (in thousands):





Year
      Ending December 31,
            
            Amount2010
            
            $
            1,5202011
            
            
            1,4132012
            
            
            1,5052013
            
            
            1,5632014
      and thereafter
            
            
            —Future
      minimum rental payments
            
            $
            6,001




Gross
rent expense was $1.6 million in 2009, $1.7 million in 2008 and $1.5 million in
2007.




Purchase
Commitments.




The
Company maintains certain open inventory purchase commitments with its suppliers
to ensure a smooth and continuous supply for key components. The Company’s
liability in these purchase commitments is generally restricted to a forecasted
time-horizon as agreed between the parties. These forecasted time-horizons can
vary among different suppliers. The Company’s open inventory purchase
commitments with its suppliers were not significant at December 31,
2009.




In
December 2009, the Company entered into an agreement with Obagi Medical
Products, Inc., to distribute certain of their proprietary skin care products in
Japan (Obagi Agreement). The Obagi Agreement requires the Company to purchase a
minimum of $1.25 million of Obagi products in 2010. The minimum purchase
requirement for 2011 and beyond has yet to be determined.




Indemnifications




In the
normal course of business, the Company enters into agreements that contain a
variety of representations, warranties, and indemnification obligations. For
example, the Company has entered into indemnification agreements with each of
its directors and executive officers. In 2007, two of the Company’s executive
officers were named as defendants in securities class action litigation—see
“Litigation” and “Litigation Settlement” below. The Company’s exposure under its
various indemnification obligations, including those under the indemnification
agreements with its directors and executive officers, is unknown since the
outcome of that securities litigation is unpredictable and the amount that could
be payable thereunder is not reasonably estimable, and since other
indemnification obligations involve future claims that may be made against the
Company. The Company has not accrued or paid any amounts for any such
indemnification obligations. However, the Company may record charges in the
future as a result of these potential indemnification obligations, including
those related to the securities class action litigation.




68




Litigation


Two
securities class action lawsuits were filed against the Company and two of the
Company’s executive officers in April 2007 and May 2007, respectively, in the
U.S. District Court for the Northern District of California following declines
in the Company’s stock price. The plaintiffs claim to represent purchasers of
the Company’s common stock from January 31, 2007 through May 7, 2007. The
complaints generally allege that materially false statements and omissions were
made regarding the Company’s financial prospects, and seek unspecified monetary
damages. On November 1, 2007, the Court ordered the two cases consolidated. On
December 17, 2007, the plaintiffs filed a consolidated, amended complaint, and
on January 31, 2008, the Company filed a motion to dismiss that complaint. On
September 30, 2008, in response to the Company’s motion, the Court issued an
order dismissing the plaintiffs’ amended complaint without prejudice. On October
28, 2008, the plaintiffs filed a Notice Of Intention Not to File A Second
Amended Consolidated Complaint. On November 25, 2008, the Court closed the case
on its own initiative. On November 26, 2008, the plaintiffs filed a Notice of
Appeal to the U.S. Court of Appeals for the Ninth Circuit, on April 16, 2009 the
plaintiffs filed their opening brief with that Court, on June 17, 2009 the
Company filed its response to Plaintiff’s brief, on July 1, 2009 the plaintiffs
filed their response to the Company’s brief, and on February 11, 2010 both
parties presented oral argument to the Court of Appeals. No decision has yet
been rendered by the Court of Appeals. The Company intends to continue to defend
this case vigorously, regardless of the stage of litigation. Although the
Company retains director and officer liability insurance, there is no assurance
that such insurance will cover the claims that are made or will insure the
Company fully for all losses on covered claims. Since the Company does not
believe that a significant adverse result in this litigation is probable and
since the amount of potential damages in the event of an adverse result is not
reasonably estimable, no expense has been recorded in the Company’s Consolidated
Financial Statements with respect to the contingent liability associated with
this matter.




A
Telephone Consumer Protection Act, or TCPA, class action lawsuit was filed
against the Company in January 2008 in the Illinois Circuit Court, Cook County,
by Bridgeport Pain Control Center, Ltd., seeking monetary damages, injunctive
relief, costs and other relief. The complaint alleges that the Company violated
the TCPA by sending unsolicited advertisements by facsimile to the plaintiff and
other recipients nationwide during the four-year period preceding the lawsuit
without the prior express invitation or permission of the recipients. Two state
law claims, limited to Illinois recipients, allege a class period of three and
five years, respectively. Under the TCPA, recipients of unsolicited facsimile
advertisements may be entitled to damages of $500 per violation for inadvertent
violations and $1,500 per violation for knowing or willful violations. On
February 22, 2008, the Company removed the case to federal court in the Northern
District of Illinois. On August 25, 2009, following negotiations between the
parties, the parties entered into a settlement agreement that would resolve the
case on a class-wide basis. The Court gave its preliminary approval to the
proposed settlement on August 27, 2009, and a final hearing on the settlement is
scheduled for April 6, 2010. Under the terms of the settlement, the Company will
cause to be paid a total of $950,000 in exchange for a full release of
facsimile-related claims. The Company included $850,000 for the estimated cost
of the settlement, net of administrative expenses and amounts that are expected
to be recoverable from its insurance carrier, in the Company’s Consolidated
Statement of Operations in 2009. If the proposed settlement does not receive
final approval, the Company intends to defend this case vigorously.




Other
Legal Matters




In
addition to the foregoing lawsuits, the Company is named from time to time as a
party to product liability and contractual lawsuits in the normal course of its
business. As of December 31, 2009, the Company was not a party to any
material pending litigation other than those described above in the “Litigation”
section.




69




NOTE
12—SUBSEQUENT EVENT:


Management evaluated all activity of
the Company and concluded that no subsequent events have occurred that would
require recognition in the Consolidated Financial Statements or disclosure in
Notes to Consolidated Financial Statements as of December 31,
2009.





SUPPLEMENTARY
FINANCIAL DATA (UNAUDITED)


(In
thousands, except per share amounts)





Quarter
      ended:
            
            Dec. 31,
              2009
            
            
            Sept. 30,
              2009
            
            June 30,
              2009
            
            March 31,
              2009
            
            
            Dec. 31,
              2008
            
            
            Sept. 30,
              2008
            
            June 30,
              2008
            
            March 31,
              2008Net
      revenue
            
            $
            15,416
            
            
            $
            12,171
            
            $
            11,665
            
            $
            14,430
            
            
            $
            17,897
            
            
            $
            19,110
            
            $
            24,754
            
            $
            21,618Cost
      of revenue
            
            
            5,783
            
            
            
            4,910
            
            
            5,130
            
            
            5,936
            
            
            
            7,045
            
            
            
            7,823
            
            
            9,271
            
            
            8,219Gross
      profit
            
            
            9,633
            
            
            
            7,261
            
            
            6,535
            
            
            8,494
            
            
            
            10,852
            
            
            
            11,287
            
            
            15,483
            
            
            13,399Operating
      expenses:Sales
      and marketing
            
            
            6,100
            
            
            
            5,112
            
            
            6,071
            
            
            7,003
            
            
            
            6,568
            
            
            
            8,076
            
            
            10,361
            
            
            10,349Research
      and development
            
            
            1,888
            
            
            
            1,684
            
            
            1,495
            
            
            1,743
            
            
            
            1,933
            
            
            
            1,828
            
            
            2,004
            
            
            1,785General
      and administrative
            
            
            2,063
            
            
            
            2,121
            
            
            3,616
            
            
            2,520
            
            
            
            2,723
            
            
            
            2,583
            
            
            3,023
            
            
            2,941Litigation
      settlement
            
            
            —
            
            
            
            —
            
            
            —
            
            
            850
            
            
            
            —
            
            
            
            —
            
            
            —
            
            
            —Total
      operating expense
            
            
            10,051
            
            
            
            8,917
            
            
            11,182
            
            
            12,116
            
            
            
            11,224
            
            
            
            12,487
            
            
            15,388
            
            
            15,075Income
      (loss) from operations
            
            
            (418
            )
            
            
            (1,656
            )
            
            (4,647
            )
            
            (3,622
            )
            
            
            (372
            )
            
            
            (1,200
            )
            
            95
            
            
            (1,676
            )Interest
      and other income, net
            
            
            174
            
            
            
            288
            
            
            511
            
            
            599
            
            
            
            555
            
            
            
            733
            
            
            857
            
            
            901Other-than-temporary
      impairment of long-term investments
            
            
            —
            
            
            
            —
            
            
            —
            
            
            —
            
            
            
            (1,182
            )
            
            
            (2,372
            )
            
            —
            
            
            —Income
      (loss) before income taxes
            
            
            (244
            )
            
            
            (1,368
            )
            
            (4,136
            )
            
            (3,023
            )
            
            
            (999
            )
            
            
            (2,839
            )
            
            952
            
            
            (775
            )Provision
      (benefit) for income taxes
            
            
            (251
            )
            
            
            12,126
            
            
            (1,772
            )
            
            (1,195
            )
            
            
            (764
            )
            
            
            (86
            )
            
            291
            
            
            (233
            )Net
      income (loss)
            
            $
            7
            
            
            $
            (13,494
            )
            $
            (2,364
            )
            $
            (1,828
            )
            
            $
            (235
            )
            
            $
            (2,735
            )
            $
            661
            
            $
            (542
            )Net
      income (loss) per share—basic
            
            $
            0.00
            
            
            $
            (1.01
            )
            $
            (0.18
            )
            $
            (0.14
            )
            
            $
            (0.02
            )
            
            $
            (0.22
            )
            $
            0.05
            
            $
            (0.04
            )Net
      income (loss) per share—diluted
            
            $
            0.00
            
            
            $
            (1.01
            )
            $
            (0.18
            )
            $
            (0.14
            )
            
            $
            (0.02
            )
            
            $
            (0.22
            )
            $
            0.05
            
            $
            (0.04
            )Weight-average
      number of shares used in per share calculations:Basic
            
            
            13,427
            
            
            
            13,317
            
            
            13,317
            
            
            13,120
            
            
            
            12,797
            
            
            
            12,780
            
            
            12,764
            
            
            12,740Diluted
            
            
            13,610
            
            
            
            13,317
            
            
            13,317
            
            
            13,120
            
            
            
            12,797
            
            
            
            12,780
            
            
            13,465
            
            
            12,740








70




SCHEDULE II




CUTERA,
INC.




VALUATION
AND QUALIFYING ACCOUNTS


(in
thousands)


For
the Year Ended December 31, 2009, 2008 and 2007







Balance at
              Beginning
              of
      Year
            
            
            Additions
            
            
            Deductions
            
            
            Balance
              at End of
              YearAllowance
      for doubtful accounts receivableYear
      ended December 31, 2009
            
            $
            61
            
            
            $
            675
            
            
            $
            150
            
            
            $
            586Year
      ended December 31, 2008
            
            $
            9
            
            
            $
            191
            
            
            $
            139
            
            
            $
            61Year
      ended December 31, 2007
            
            $
            34
            
            
            $
            222
            
            
            $
            247
            
            
            $
            9Valuation
      allowance for deferred tax assetsYear
      ended December 31, 2009
            
            $
            1,367
            
            
            $
            14,222
            
            
            $
            660
            
            
            $
            14,929Year
      ended December 31, 2008
            
            $
            —
            
            
            $
            1,367
            
            
            $
            —
            
            
            $
            1,367Year
      ended December 31, 2007
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —








71




ITEM 9.
            CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE




None.





ITEM 9A.
            CONTROLS
      AND PROCEDURES




Evaluation
of Disclosure Controls and Procedures




Attached
as exhibits to this Annual Report are certifications of the Company’s Chief
Executive Officer (CEO) and Chief Financial Officer (CFO), which are required in
accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended
(Exchange Act). This Controls and Procedures section includes the information
concerning the controls evaluation referred to in the certifications, and it
should be read in conjunction with the certifications for a more complete
understanding of the topics presented.




The
Company conducted an evaluation of the effectiveness of the design and operation
of its disclosure controls and procedures (as defined in the Rules 13a-15(e) and
15d-15(e) under the Exchange Act) (Disclosure Controls) as of the end of the
period covered by this Report required by Exchange Act Rules 13a-15(b) or
15d-15(b). The controls evaluation was conducted under the supervision and with
the participation of the Company’s management, including the CEO and CFO. Based
on this evaluation, the CEO and our CFO have concluded that as of the end of the
period covered by this report the Company’s disclosure controls and procedures
were effective at a reasonable assurance level.




Definition
of Disclosure Controls




Disclosure
Controls are controls and procedures designed to reasonably assure that
information required to be disclosed in the Company’s reports filed under the
Exchange Act, such as this Report, is recorded, processed, summarized and
reported within the time periods specified in the SEC’s rules and forms.
Disclosure Controls are also designed to reasonably assure that such information
is accumulated and communicated to the Company’s management, including the CEO
and CFO, as appropriate to allow timely decisions regarding required disclosure.
The Company’s Disclosure Controls include components of its internal control
over financial reporting, which consists of control processes designed to
provide reasonable assurance regarding the reliability of its financial
reporting and the preparation of financial statements in accordance with
generally accepted accounting principles in the U.S. To the extent that
components of the Company’s internal control over financial reporting are
included within its Disclosure Controls, they are included in the scope of the
Company’s annual controls evaluation.




Management’s
Report on Internal Control over Financial Reporting




The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act. Under the supervision and with the
participation of the Company’s management, including the CEO and CFO, the
Company conducted an evaluation of the effectiveness of its internal control
over financial reporting based on criteria established in the framework inInternal
Control—Integrated Framework  issued by the Committee of
Sponsoring Organizations of the Treadway Commission. Based on this evaluation,
the Company’s management concluded that the Company’s internal control over
financial reporting was effective as of December 31, 2009. The
effectiveness of our internal control over financial reporting as of
December 31, 2009 has been audited by PricewaterhouseCoopers LLP, an
Independent Registered Public Accounting Firm, as stated in their report, which
is included herein.




Limitations
on the Effectiveness of Controls




The
Company’s management, including the CEO and CFO, does not expect that the
Company’s disclosure controls or internal control over financial reporting will
prevent all error and all fraud. A control system, nomatter how well designed
and operated, can provide only reasonable, not absolute, assurance that the
control system’s objectives will be met. Further, the design of a control system
must reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision making can be faulty and that breakdowns
can occur because of simple error or mistake. Controls can also be circumvented
by the individual acts of some persons, by collusion of two or more people, or
by management override of the controls. The design of any system of controls is
based in part on certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions. Over time, controls may become
inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.




Changes
in Internal Control over Financial Reporting




There
were no changes in the Company’s internal control over financial reporting that
occurred during the most recent fiscal quarter that have materially affected, or
are reasonably likely to materially affect, the Company’s internal control over
financial reporting.





ITEM 9B.
            OTHER
      INFORMATION




The
Company has established that the 2010 Annual Meeting of Stockholders will be
held at their principal executive offices located at 3240 Bayshore Blvd.,
Brisbane, CA 94005-1021 on May 19, 2010 at 10:00 a.m. and the record date
for the purposes of voting in that meeting shall be March 24,
2010.





72





PART
III




Certain
information required by Part III is omitted from this Annual Report on Form 10-K
because we will file a Definitive Proxy Statement (the “Proxy Statement”) for
our 2010 Annual Meeting of Stockholders with the Securities and Exchange
Commission within 120 days after the end of our fiscal year ended
December 31, 2009.





ITEM 10.
            DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE




The
information required by this Item is incorporated herein by reference to the
Proxy Statement.





ITEM 11.
            EXECUTIVE
      COMPENSATION




The
information required by this Item is incorporated herein by reference to the
Proxy Statement.





ITEM 12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS




The
information required by this Item is incorporated herein by reference to the
Proxy Statement.





ITEM 13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE




The
information required by this Item is incorporated herein by reference to the
Proxy Statement.





ITEM 14.
            PRINCIPAL
      ACCOUNTING FEES AND SERVICES




The
information required by this Item is incorporated herein by reference to the
Proxy Statement.







73


PART
IV





ITEM 15.
            EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES





(1)
            The
      financial statements required by Item 15(a) are filed as Item 8
      of this annual report.





(2)
            The
      financial statement schedule required by Item 15(a) filed as
      Item 8 of this annual report.





(3)
            Exhibits.





Exhibit No.
            
            Description3.2(1)
            
            Amended
      and Restated Certificate of Incorporation of the Registrant
      (Delaware).3.4(1)
            
            Bylaws
      of the Registrant.4.1(4)
            
            Specimen
      Common Stock certificate of the Registrant.10.1(1)
            
            Form
      of Indemnification Agreement for directors and executive
      officers.10.2(1)
            
            1998
      Stock Plan.10.3(1)
            
            2004
      Equity Incentive Plan.10.4(5)
            
            2004
      Employee Stock Purchase Plan.10.6(1)
            
            Brisbane
      Technology Park Lease dated August 5, 2003 by and between the Registrant
      and Gal-Brisbane, L.P. for office space located at 3240 Bayshore
      Boulevard, Brisbane, California.10.10(2)
            
            Settlement
      Agreement and Non-Exclusive Patent License, each between the Registrant
      and Palomar Medical Technologies, Inc. dated June 2,
  2006.10.11(3)
            
            Form
      of Performance Unit Award Agreement.10.13(4)†
            
            Distribution
      Agreement between the Registrant and PSS World Medical Shared Services,
      Inc., a subsidiary of PSS World Medical dated October 1,
    2006.10.14(6)
            
            Cutera,
      Inc. 2004 Equity Incentive Plan, as amended by its Board of Directors on
      April 25, 2008.10.18(7)
            
            Consulting
      Agreement dated March 2, 2009 by and between the Company and David A.
      Gollnick.23.1
            
            Consent
      of Independent Registered Public Accounting Firm.24.1
            
            Power
      of Attorney (see page 75).31.1
            
            Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
            
            Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
            
            Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.





(1)
              Incorporated
      by reference from our Registration Statement on Form S-1 (Registration
      No. 333-111928) which was declared effective on March 30,
      2004.(2)
              Incorporated
      by reference from our Current Report on Form 8-K filed on June 2,
      2006.(3)
              Incorporated
      by reference from our Quarterly Report on Form 10-Q filed on
      November 14, 2005.(4)
              Incorporated
      by reference from our Quarterly Report on Form 10-Q filed on
      November 8, 2006.(5)
              Incorporated
      by reference from our 2006 Annual Report on Form 10-K filed on
      March 16, 2007.(6)
              Incorporated
      by reference from our Definitive Proxy Statement on Form 14A filed with
      the SEC on April 28, 2008.(7)
              Incorporated
      by reference from our Current Report on Form 8-K filed on March 4,
      2009.†
              Confidential
      Treatment has been requested for certain portions of this
      exhibit.





74




SIGNATURES


Pursuant
to the requirements of Section 13 or 15(d) of The Securities Exchange Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized, in the city of Brisbane, State of
California, on the 15th day of March, 2010.
 
 CUTERA,
      INC.By:
                    /s/ KEVINP.
      CONNORSKevin
      P. ConnorsPresident
      and Chief Executive Officer
  Power
of Attorney
  KNOW
ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Kevin P. Connors, his attorney-in-fact, for him
or her in any and all capacities, to sign any amendments to this Annual Report
on Form 10-K, and to file the same, with exhibits thereto and other documents in
connection therewith, with the U.S. Securities and Exchange Commission, hereby
ratifying and confirming all that said attorney-in-fact, or his substitute, may
do or cause to be done by virtue thereof.
  Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
 
 Signature
                  
                  Title
                  
                  Date/s/    KEVINP. CONNORS
                    Kevin
      P. Connors
                  
                  President,
      Chief Executive Officer and Director (Principal Executive
      Officer)
                  
                  March 15,
      2010/s/    RONALDJ. SANTILLI
                    Ronald
      J. Santilli
                  
                  Chief
      Financial Officer and Executive Vice President (Principal Financial and
      Accounting Officer)
                  
                  March 15,
      2010/s/    DAVIDA. GOLLNICK
                      David
      A. Gollnick
                  
                  Director
                  
                  March 15,
      2010/s/    DAVIDB. APFELBERG
                    David
      B. Apfelberg
                  
                  Director
                  
                  March
      15, 2010/s/    ANNETTEJ. CAMPBELL-WHITE
                      Annette
      J. Campbell-White
                  
                  Director
                  
                  March 15,
      2010/s/    MARKLORTZ
                    Mark
      Lortz
                  
                  Director
                  
                  March 15,
      2010/s/    TIMO’SHEA
                    Tim
      O’Shea
                  
                  Director
                  
                  March 15,
      2010/s/    JERRYP. WIDMAN
                    Jerry
      P. Widman
                  
                  Director
                  
                  March 15,
      2010
 
 75