Summary of CUTERA INC - Yahoo! Finance

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, 2008. 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 19. 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 pronouncements- This section describes the issuance and effect of new accounting pronouncements that may be applicable to us.

• Results of operations- This section provides our analysis and outlook for the significant line items in our Consolidated Statement 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, 2008.

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 products on three platforms-CoolGlide, Xeo 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, where we conduct our manufacturing, warehousing, research, regulatory, sales, service, marketing and administrative activities. In the

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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, Product 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 instead contained in the hand piece, such as with our Pearl and Pearl Fractional products, 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 product upgrade revenue. Service revenue relates to amortization of prepaid 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 have been used.

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

• Investments made in our global sales and marketing infrastructure.

• Continuing introduction of new aesthetic products and applications.

• Continuing 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, Product upgrade and Titan hand piece refill revenue from our growing installed base of customers.

In 2008, compared to 2007, our U.S. revenue declined 35% and our international revenue grew 11%. In 2007, compared to 2006, our U.S. revenue declined 8%, while our international revenue grew 22%. We believe that the greater decline in U.S. revenue growth from 2007 to 2008, as compared from 2006 to 2007, was primarily attributable to a U.S. recession that is causing our prospective customers to delay their purchase decisions. We also believe that those prospects who do not have established medical offices are finding it more difficult to obtain credit financing. The weaker international revenue growth in 2008, compared to international revenue growth in 2007, was primarily attributable to the global recession, which adversely affected our international revenue in the second half of 2008. We experienced greater revenue growth in many of our international markets in 2008, compared with 2007, with particular strength in Australia and Japan. As a result of this continuing international revenue growth, international revenue as a percentage of total revenue increased to 50% in 2008, compared with 37% in 2007.

For 2008, our gross margin declined to 61%, compared to 66% in 2007. This decrease was primarily attributable to reduced leverage of our manufacturing and service expenses due to lower than expected revenue, and lower introductory margins for our Pearl Fractional-enabled systems and upgrades that started shipping in September 2008, and lower average selling prices for our Products and Product upgrades in 2008, compared with 2007.

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Sales and marketing expenses as a percentage of net revenue increased to 42% in 2008, compared to 38% in 2007, but decreased in total dollars to $35.4 million. The increase in percentage was primarily caused by lower revenue in 2008, compared with 2007. The decrease in total dollars in 2008, compared with 2007, was primarily caused by reduced personnel expenses in the United States due to lower sales commissions, resulting from lower revenue, and lower headcount.

Research and development expenses as a percentage of net revenue increased to 9% in 2008, compared to 7% in 2007, and increased in total dollars to $7.6 million. These increases were primarily attributable to lower revenue in 2008, compared with 2007, and higher personnel expenses associated with increased headcount.

General and administrative expenses as a percentage of net revenue increased to 14% in 2008, compared to 12% in 2007, due primarily to lower revenue in 2008, compared with 2007. In absolute dollars, G&A expenses decreased by $451,000 to $11.3 million in 2008, compared with 2007.

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 develop new products 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, or 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. See Note 1 "Summary of Significant Accounting Policies" in the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for a summary of our significant accounting policies.

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 distributor and non-distributor revenue in accordance with the SEC's Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104). SAB No. 104 requires that four basic criteria must be met before revenue can be recognized:

• 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.

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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.

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 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 ARS investments and auctions for our investments in these securities have failed to settle on their respective settlement dates. Consequently, the 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 issuer refinances their debt. Maturity dates for these ARS investments range from 2028 to 2043.

As of December 31, 2008, we had $9.6 million in long-term ARS investments. Given observable ARS market information was not available to determine the fair value of our ARS portfolio we compared the fair value of our securities to a discounted cash flow model as well as transaction data and bid-ask spread data for other similar illiquid securities from a secondary market. Expected future cash flows were calculated using estimates for interest rates ranging from 1.55% to 4.08%, timing and amount of cash flows through the maturity of the ARS. Our most significant assumption made in the present value calculations was the estimated required rates of return used to discount the estimated future cash flows. The rate selected to value each of the investments considered and assigned an expected yield premium based on several factors, including:

• Lack of liquidity due to failing auctions;

• Default risk arising from whether the security was issued by a federal backed agency (Federal Family Education Loan Program) or a municipal agency (Maine Education Loan Authority);

• Underlying collateral coverage of the loan trust that issued the security;

• Underlying credit rating; and

• Liquidation preferences based on the capital structure of the loan trust.

For the year ended December 31, 2008, using this assessment of fair value, we determined there was a decline in the fair value of our ARS investments of approximately $3.6 million, which was recognized as a pre-tax other-than-temporary impairment charge with a corresponding decrease in accumulated other comprehensive loss. The primary cause of the decline in fair value of our long-term ARS was an increase in the estimated required rates of return used to discount the estimated future cash flows over the life of each security.

We review our impairments on a quarterly basis in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, and related guidance issued by the Financial Accounting Standards Board (FASB), and the SEC in order to determine the classification of the impairment as "temporary" or "other-than-temporary." A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive loss component of stockholders' equity. Such an unrealized loss does not affect net loss for the applicable accounting period. An other-than-temporary impairment charge is

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recorded as an unrealized loss in the Consolidated Statement of Operations and is a component of the net loss for the applicable accounting period. Once an other-than-temporary impairment is recorded, a new cost basis in the investment is established. The primary differentiating factors we considered to classify our impairments between temporary and other-than-temporary impairments are the length of the time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuers and our intent and ability to retain our investment in the issuer to maturity to allow for any anticipated recovery in market value.

The valuation of our 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, and ongoing strength and quality of credit markets. If the current market conditions deteriorate further, or the recovery in market values does not occur, we may be required to record additional other-than-temporary impairment charges in future quarters.

Factors that may impact its valuation 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, liquidity and ongoing strength and quality of credit markets. If the current market conditions deteriorate further, or the recovery in market values does not occur, we may be required to record additional other-than-temporary impairment charges in future quarters.

Fair Value Measurements

On January 1, 2008, we adopted fair value measurement provisions of Statement SFAS, No. 157 Fair Value Measurements, which established a framework for measuring fair value under GAAP and clarified the definition of fair value within that framework. SFAS 157 does not require assets and liabilities that were previously recorded at cost to be recorded at fair value. For assets and liabilities that are already required to be disclosed at fair value, SFAS 157 introduced, or reiterated, a number of key concepts that form the foundation of the fair value measurement approach to be used for financial reporting purposes. The fair values of our financial instruments reflect the amounts that we estimate we would receive in connection with the sale of an asset or that we would pay in connection with the transfer of a liability in an orderly transaction between market participants at the measurement date (exit price). SFAS 157 also established a fair value hierarchy that prioritizes the inputs used in valuation techniques into the following three levels:

Level 1 Prices in active markets for identical assets and liabilities

Level 2 Observable inputs other than quoted prices in active markets for identical assets and liabilities

Level 3 Unobservable inputs

The adoption of SFAS 157 did not have an effect on our financial condition or results of operations, but SFAS 157 introduced new disclosures about how we value certain assets and liabilities. Much of the disclosure focuses on the inputs used to measure fair value, particularly in instances in which the measurement uses significant unobservable (Level 3) inputs. A substantial majority of our financial instruments are Level 1 and Level 2 assets.

At December 31, 2008, total financial assets measured and recognized at fair value were $105.0 million and of these assets, $9.6 million, or 9%, were ARS that were measured and recognized using significant unobservable inputs (Level
3). There were no non-financial assets or liabilities measured at fair value as of December 31, 2008.

While our ARS valuation model was based on both Level 2 (credit quality and interest rates) and Level 3 inputs, 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. See Note 2 "Investment Securities," in the Notes to Consolidated Financial Statement in Part II, Item 8 of this Form 10-K for more information.

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Stock-based Compensation Expense

Under the provisions of FAS No. 123(R), "Share-Based Payment" (FAS 123R), 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, 2008, the unrecognized compensation cost, net of expected forfeitures, related to stock options, restricted stock unit awards and employee stock purchase plan awards was $6.9 million, $108,000 and $57,000, which will be recognized using the straight-line attribution method over an estimated weighted-average amortization period of 2.50 years, 0.42 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.

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 provide a standard one-year or two-year warranty coverage on our 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. For new products, estimates will include historical experience of similar products, as well as reasonable allowance for start-up expenses. 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.

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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. Effective January 1, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109, Accounting for Income Taxes. 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, and certain benefits realized related to stock option activity. Our current effective tax rate does not assume U.S. taxes on undistributed profits of foreign subsidiaries. These earnings could become . . .