XNAS:PMTI Annual Report 10-K Filing - 2/29/2012

Effective Date 2/29/2012

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

x
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2011
 
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
 
Commission file number: 1-11177
 
 
 
 
PALOMAR MEDICAL TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)

Delaware
04-3128178
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 

15 Network Drive
Burlington, Massachusetts
01803
(Address of principal executive offices)
(Zip Code)
 
 
Registrant’s telephone number, including area code: (781) 993-2300
 
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
Common Stock, $0.01 par value
Preferred Stock Purchase Rights
Name of each exchange on which registered
The NASDAQ Global Select Market
 
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  o   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 Exchange Act.  Yes  o   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 that 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  o       

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x   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 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.  o

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

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

 
 

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

The aggregate market value of the voting stock (common stock) held by non-affiliates of the registrant as of the close of business on June 30, 2011 was $169,589,081.  The number of shares outstanding of the registrant’s common stock as of the close of business on March 8, 2012 was 19,573,744.


DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates by reference certain information from the registrant’s definitive proxy statement for its 2012 annual meeting of stockholders, which is expected to be filed on or before April 30, 2012.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 

 
Table of Contents
                                            
                                                                    
   
 Page No.
 
 
 
PART I     4  
   4  
  15  
  27  
  28  
  28  
  29  
 PART II    30  
  30  
  32  
  33  
  48  
  49  
  80  
  80  
  83  
 PART III    84  
  84  
  84  
  Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 84  
  84  
  84  
 PART IV     85  
  85  
 SIGNATURES   93  
 
 
 

 
 

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
This annual report on Form 10-K and the documents incorporated by reference in this annual report on Form 10-K contain forward-looking statements that involve substantial risks and uncertainties. In some cases you can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would,” or similar words. You should read statements that contain these words carefully because they discuss future expectations, contain projections of future results of operations or of financial position or state other “forward-looking” information. The important factors listed below in the “Risk Factors” section, as well as any cautionary language elsewhere in this annual report on Form 10-K, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations described in these forward-looking statements. You should be aware that the occurrence of the events described in the “Risk Factors” section below and elsewhere in this annual report on Form 10-K could have an adverse effect on our business, results of operations and financial position.
 
Any forward-looking statements in this annual report on Form 10-K are not guarantees of future performance, and actual results, developments and business decisions may differ from those envisaged by such forward-looking statements, possibly materially. We disclaim any duty to update any forward-looking statements.
 
PART I
 
Item 1. Business
 
Introduction
 
Palomar Medical Technologies, Inc. (“we”, “Palomar” or the “Company”) is a leading researcher and developer of innovative aesthetic light-based systems for hair removal and other cosmetic procedures, including both lasers and high powered lamps. For over a decade, we have been at the forefront of technology breakthroughs in the use of laser and other light-based products for dermatology and cosmetic procedures.
 
Highlights of our leadership in the aesthetic laser industry include the following:
 
·  
In 1995, we entered into an agreement to exclusively license several hair removal patents developed by the Massachusetts General Hospital (“MGH”).
·  
In 1997, we received the first clearance from the United States Food and Drug Administration (“FDA”) for a high-powered laser for hair removal.
·  
In 1998, we entered into an agreement with Coherent, Inc. (“Coherent”) for worldwide distribution of our laser systems.
·  
In 1999, we sold our subsidiary, Star Medical Technologies, Inc., including the LightSheer diode laser system, to Coherent for $70 million and a 7.5% royalty on the LightSheer system (Coherent later sold this business to Lumenis, Inc.).
·  
In 2001, we introduced the LUX platform with multiple handpieces for various treatment applications.
·  
In 2003, we signed a Development and License Agreement with The Gillette Company (“Gillette”) to complete development and commercialization of a patented home-use, light-based hair removal device for women.
·  
In 2004, we signed a Development and License Agreement with Johnson & Johnson Consumer Companies, Inc., a Johnson & Johnson company (“Johnson & Johnson”), to develop, clinically test and potentially commercialize home-use, light-based devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne.
·  
In 2006, through a successful litigation and licensing strategy, we validated the strength of the hair removal patents exclusively licensed from MGH and entered into additional license agreements providing for payment of back-owed royalties and future royalties.
·  
In 2006, we received a 510(k) over-the-counter (“OTC”) clearance from the FDA for a patented, home-use, light-based hair removal device.
·  
In 2008, we entered into a License Agreement with The Procter & Gamble Company (“P&G”) and its wholly owned subsidiary, Gillette, under which we granted to P&G and Gillette a non-exclusive license to certain patents and technology to commercialize home-use, light-based hair removal devices for women. This License Agreement replaced the Development and License Agreement entered into with Gillette in 2003, which was amended and restated in February 2007.
 

 
  4

 
 
·  
In 2009, we completed the full launch of the Aspire™ body sculpting system and SlimLipo™ handpiece for laser-assisted lipolysis.
·  
In 2009, we received 510(k) OTC clearance from the FDA for a patented, home-use laser device for the treatment of periorbital wrinkles. We also announced that we would commercialize this device without Johnson & Johnson following termination of the Development and License Agreement pursuant to which all technology and intellectual property rights related to the light-based devices developed under the agreement were returned to us.
·  
In 2009, we further validated the strength of the hair removal patents exclusively licensed from MGH when we successfully completed reexaminations of those patents before the U.S. Patent and Trademark Office and won two opposition hearings before the European Patent Office.
·  
In 2010, we launched the Artisan™ Aesthetic System, a complete facial rejuvenation system.
·  
In 2010, we entered into an amendment to the License Agreement with P&G and Gillette (retroactively effective as of February 14, 2003) which provides additional funding from each company to meet the common goal of a successful product launch.
·  
At the end of 2010, we launched the PaloVia® Skin Renewing Laser® -- the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes.
·  
In 2011, we launched the Palomar Icon™ Aesthetic System – the next generation aesthetic system with high peak powers, state of the art cooling, built in calibration, and an intuitive user interface.
·  
In 2011, we began selling the Acleara™ Acne Clearing System – with continuous-cooling, advanced vacuum suction and filtered broadband light technology.  The Acleara System is manufactured by Theravant, Inc. and sold by Palomar under a Distribution Agreement signed in 2010.
·  
In 2011, we also began selling the Adivive™ Fat Transfer System -- an all-in-one, integrated system that uses a unique filtering mechanism and high G-force centrifugation to yield a higher quality of adipose tissue for re-injection.  The Adivive System is manufactured by Medi-Khan, Inc. and sold with Palomar under a Distribution Agreement signed in 2010.
·  
In early 2012, we also launched the Skintel™ Melanin Reader -- providing an additional element of treatment confidence by determining the average melanin density of skin, in a quantitative manner, prior to treatment with the Icon System.
 
We are continuously researching, developing and testing new innovations for a variety of cosmetic applications, such as:
 
·  
skin rejuvenation, including tone and texture;
·  
skin tightening, including laxity and lifting;
·  
pigmented lesion removal, such as sun and age spots, freckles and melasma;
·  
hair removal;
·  
vascular lesion removal, such as spider veins, cherry angiomas and rosacea;
·  
wrinkle reduction;
·  
leg vein removal;
·  
tattoo removal;
·  
acne treatment;
·  
removal of scars, including acne scars, stretch marks and warts;
·  
fat reduction, including cellulite; and
·  
body sculpting, including laser assisted liposuction.
 
Palomar, a Delaware corporation, was organized in 1987 to design, manufacture, market and sell lasers and other light-based products and related disposable items and accessories for use in medical and cosmetic procedures. We became a public company in December 1992. We obtained FDA clearance to market our EpiLaser® ruby laser hair removal system in March 1997. Under the direction of a new board and management team, we undertook a program in 1997, which was completed in May of 1998, of exiting from all non-core businesses and investments and focusing only on those businesses which we believed held the greatest promise for maximizing stockholder value. Our exclusive focus became the use of lasers and other light-based products in dermatology and cosmetic procedures.
 
In 1998, we became the first company to receive FDA clearance for a diode laser for hair removal and for leg vein treatment, the LightSheer™ diode laser system. The LightSheer was the first generation of high-powered diode lasers designed for hair removal, and like our EpiLaser and other prior hair removal products, the LightSheer incorporated technology protected by patents licensed exclusively to us from MGH.
 
 
 
5

 
 
On February 14, 2003, we entered into a Development and License Agreement with Gillette to complete development and commercialization of a home-use, light-based hair removal device for women. On June 28, 2004, we announced with Gillette that we completed the initial phase of our agreement and that both parties would move into the next phase. In conjunction with entering this next phase, the parties amended the agreement to provide for additional development funding to further technical innovations. In September 2006, we announced that Gillette had made the decision to move into the next phase of our agreement. On December 8, 2006, we became the first company to receive a 510(k) OTC clearance from the FDA for a new, patented, home-use, light-based hair removal device. OTC clearance allows the product to be marketed and sold directly to consumers without a prescription. Under our agreement, Gillette paid us $2.5 million following our receipt of the OTC clearance as we were obligated to perform additional services and remain exclusive with Gillette during a twelve month period. In February 2007, we announced an amendment to our agreement with Gillette to include the development and commercialization of an additional light-based hair removal device for home-use, and we also announced that we had executed an Amended and Restated Development and License Agreement to incorporate other prior amendments and several new amendments to allow for more open collaboration through commercialization. On December 21, 2007, we announced an amendment to our agreement with Gillette to extend the “Launch Decision” from January 7, 2008 until February 29, 2008 to enable the parties to enter into negotiations for a potential new agreement to replace the existing agreement. On March 3, 2008, we announced with P&G that we had entered into a License Agreement with P&G and Gillette, under which we granted a non-exclusive license to certain patents and technology to commercialize home-use, light-based hair removal devices for women. This License Agreement replaced the Development and License Agreement that we entered into with Gillette in 2003 and that was amended and restated in February 2007.  On December 9, 2010, we announced an amendment to the License Agreement with P&G and Gillette (retroactively effective as of February 14, 2003). The amendment provides additional funding from each company to meet the common goal of a successful product launch. The amendment does not change the scope of P&G's non-exclusive license to Palomar's broad patent portfolio as well as its non-exclusive license to the extensive technology developed by Palomar prior to February 28, 2008 for home-use, light-based hair removal devices for women.  Under the amended License Agreement, the parties agreed to reduce pre-commercial launch calendar quarterly payments from $1.25 million to $1.0 million for the calendar quarter ending December 31, 2010 and thereafter to $2.0 million per year for an agreed period, after which the payments return to $1.25 million per calendar quarter if no product has been launched. P&G will apply the savings, together with agreed minimum overall program funding, to accelerating product readiness and commercialization while Palomar will be paid an increased percentage of sales after commercial launch.  For more information, please see Amendment #1 to License Agreement filed as Exhibit 10.1 to our Current Report on Form 8-K filed December 9, 2010, the License Agreement filed as Exhibit 10.1 to our Current Report on Form 8-K filed March 3, 2008, the Development and License Agreement and subsequent amendments filed as Exhibit 10.1 to our Current Report on Form 8-K filed on February 19, 2003, Exhibits 99.1, 99.2, and 99.3 to our Current Report on Form 8-K filed on June 28, 2004, Exhibit 10.30 to our Annual Report on Form 10-K filed on March 6, 2006, and Exhibits 10.1 and 10.2 to our Current Report on Form 8-K filed on February 21, 2007.
 
On February 18, 2004, we announced that we were awarded a $2.5 million research contract by the United States Department of the Army to develop a light-based self-treatment device for Pseudofolliculitis Barbae, or PFB, commonly known as “razor bumps.” On October 25, 2005, we announced that we were awarded additional funding of $888,000 for a total of $3.4 million and a twelve month contract extension. On September 1, 2006, we were awarded additional funding of $440,000 for a total of $3.8 million and an additional five month extension until April 30, 2007. Subsequent to April 30, 2007, the contract was extended on multiple occasions, the last of which was through March 31, 2008.
 
On September 1, 2004, we entered into a Development and License Agreement with Johnson & Johnson to develop, clinically test and potentially commercialize home-use, light-based devices for (i) reducing or reshaping body fat including cellulite; (ii) reducing appearance of skin aging; and (iii) reducing or preventing acne. On August 22, 2007, we signed an amendment to the agreement to provide for additional development funding for certain development activities. On October 16, 2009, we announced the termination of the agreement and our intention to commercialize the light-based devices developed under the agreement on our own. Upon termination of the agreement, all technology and intellectual property rights related to the light-based devices developed under the agreement returned to us. For more information, please see the Joint Development and License Agreement and amendments filed as Exhibit 99.1 to our Current Report on Form 8-K filed on September 7, 2004, Exhibit 10.45 to our Quarterly Report on Form 10-Q filed on May 8, 2007, Exhibits 10.47 and 10.48 to our Quarterly Report on Form 10-Q filed on November 2, 2007, and Exhibit 10.71 to our Quarterly Report on Form 10-Q filed on August 5, 2009.
 
We have six operating subsidiaries. Palomar Medical Products, Inc. is located at our headquarters in Burlington, Massachusetts and oversees the development, manufacture, sales and marketing of our laser and lamp-based systems. Palomar Medical Technologies BV is located in Amsterdam, The Netherlands, and oversees the sales and marketing of our products in Europe, the Middle East, and Africa and provides certain servicing of our products for those regions. Palomar Medical Technologies (Australia) Pty Limited is located near Sydney, Australia and is responsible for the sales and marketing of our products in Australia and New Zealand and certain servicing of our products for those countries.  Palomar Japan K.K. is located in Tokyo, Japan and is responsible for the sales and marketing and certain servicing of our products in Japan.  Palomar Medical Technologies GmbH is located in Hamburg, Germany and oversees the sales and marketing of our products in Germany and Austria and certain servicing of our products for those countries. Palomar Medical Technologies S.L.U. is located in Madrid, Spain and oversees the sales and marketing of our products in Spain and Portugal and certain servicing of our products for those countries. Our international subsidiaries conduct business in both local and foreign currencies, and therefore, we are exposed to foreign currency exchange risk resulting from fluctuations in foreign currencies. This risk could adversely impact our results and financial condition.  We have not entered into any foreign currency exchange and option contracts to reduce our exposure to foreign currency exchange risk and the corresponding variability in operating results as a result of fluctuations in foreign currency exchange rates.
 
 
6

 
Market for Aesthetic Procedures
 
In the ten years prior to 2008, the market for light-based aesthetic procedures saw significant growth. Many factors were likely responsible for this growth, including the aging population of the United States and other industrialized nations, along with a desire to look and feel younger and a rising discretionary income with which to pay for such procedures. Consumers often undergo aesthetic procedures to improve their self-image and self-esteem, or to appear competitive in an ever-younger workforce. Another important factor to such growth was the increasing sophistication of the equipment for light-based aesthetic procedures. Technological advancements made to the equipment improved safety, ease of use, efficacy, and cost, which has in turn grown our customer base. Although our traditional customers have been plastic surgeons and dermatologists, increased consumer demand and technological advancements, as well as managed care and reimbursement restrictions in the United States and similar constraints outside the United States, motivated non-traditional customers such as general practitioners, gynecologists, surgeons, and others to offer aesthetic procedures. Such procedures have the advantage of being provided on a fee-for-service basis. In addition, technological advances reduced both treatment and recovery times and made a broader variety of treatments for different cosmetic issues possible, further increasing consumer demand.
 
Since 2008, however, the current downturn in the global economy continues to considerably affect the aesthetic laser industry. A swift and severe decrease in revenue was seen across the industry in 2008 and 2009, which was driven by the inability of many prospective customers to obtain financing and prompting others to delay their capital equipment purchases until economic conditions improve.  While we saw some improvements in 2010 and 2011 with more prospective customers being ready to make capital equipment purchases, our prospective customers are still having difficulty obtaining financing.
 
Business Strategy
 
Early in 2009, we responded to the challenging economic times by taking actions to reduce our cost structure to be more in line with current sales levels in all areas of the Company, including reductions in headcount and operating cost. We maintained this cost structure in 2010 and 2011. Early in 2012, we again took actions to reduce our cost structure to bring our research and development spend closer to industry averages. We have built a diversified business model that does not rely solely on high-priced capital equipment sales. These are volatile economic times, but we believe that we have the resources needed to navigate through them and continue as an industry leader.
 
With our strong focus on both the professional and consumer markets, we believe we will emerge as a stronger company when the economy recovers to continue capitalizing on the market for improving personal appearance. Our strategy is three-fold: growth of our professional product segment, driving our technology into the consumer markets, and enforcing our intellectual property rights.
 
Growth of Professional Product Segment.
 
Innovative Products. We grow our professional product segment by investing significant resources in research and development to allow us to continually introduce innovative products. For example, in 2009, we completed the full launch of the Aspire body sculpting system and SlimLipo handpiece. The SlimLipo handpiece was our first minimally invasive product and provides laser-assisted lipolysis during liposuction procedures.  In 2010, we launched the Artisan Aesthetic System, a complete facial rejuvenation system.  In 2011, we launched the Palomar Icon Aesthetic System, the next generation aesthetic system with high peak powers, state of the art cooling, built in calibration, and an intuitive user interface.  We also began selling two third party manufactured products: (i) the Acleara™ Acne Clearing System with continuous-cooling, advanced vacuum suction and filtered broadband light technology and (ii) the Adivive™ Fat Transfer System, an all-in-one, integrated system that uses a unique filtering mechanism and high G-force centrifugation to yield a higher quality of adipose tissue for re-injection. Our strategy is to sell these new products at attractive price points to expand our customer base and cross sell our full line of laser and light-based aesthetic systems.  In February 2012, we launched the Skintel™ Melanin Reader which provides an additional element of treatment confidence by determining the average melanin density of skin, in a quantitative manner, prior to treatment with the Icon System. We believe that these new systems provide our sales force with the right product offerings for the current economic environment. We intend to continue to lead the industry in offering platforms that allow practitioners to grow their practice by adding new platforms and handpieces for additional applications and by moving to higher power, more sophisticated systems. We will also consider selling additional third party products that we believe will supplement our product offering.  This strategy is designed to allow us to leverage our installed customer base.
 
 
7

 
Expanding Practitioner Base. We believe that our professional product segment has further growth potential through sales to non-traditional practitioners. In addition to our traditional base of plastic surgeons and dermatologists, we intend to continue to market and sell to other practitioners including general and family practitioners, gynecologists, surgeons, physicians offering cosmetic treatments in medi-spa facilities and others.
 
Increasing International Presence. We are expanding our international presence in order to create additional opportunities for us. In 2007, we opened an office in Amsterdam, The Netherlands, which oversees our sales and marketing efforts in Europe, the Middle East, and Africa and provides certain servicing of our products in these regions. In 2008, we opened an office near Sydney, Australia, which is responsible for the sales and marketing of our products in Australia and New Zealand as well as certain servicing of our products for those countries. In 2010, we opened an office in Tokyo, Japan, which is responsible for the sales and marketing and certain servicing of our products in Japan.  In 2011, we opened an office in Hamburg, Germany, which is responsible for the sales and marketing of our products in Germany and Austria and certain servicing of our products for those countries, and we opened an office in Madrid, Spain, which is responsible for the sales and marketing of our products in Spain and Portugal and certain servicing of our products for those countries.  We will continue to work with our current distributors and seek new distributors to improve our international sales and marketing efforts.
 
Driving Our Technology into Consumer Markets. We direct significant resources toward driving our technology into the consumer markets with our own independent research capabilities, and, in the past, through funding provided by Johnson & Johnson, P&G, and Gillette. At the end of 2010, we independently launched the PaloVia® Skin Renewing Laser® -- the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes.  The PaloVia laser received OTC clearance from the FDA in 2009 and was developed in part with funding from Johnson & Johnson. This undertaking required and will continue to require us to make a significant investment in inventory, to establish and grow a manufacturing line for consumer products, and expand our sales and marketing support for the business. In addition, we face significant competition, including from companies which are much larger and better funded than us.  Currently the PaloVia laser is the only product of its kind on the market in the United States but another company, namely Philips Electronics, sells a similar product outside the United States and is seeking FDA clearance to sell that product in the United States. Though competition is expected to be strong, we believe the PaloVia Laser offers advantages to consumers over competing products, including, for example, laser versus light emitting diode technology and delivery of a user-independent consistent pattern of energy. We seek to gain valuable knowledge of the consumer market and collect feedback from the retail channels and our consumers.
 
Expanding Consumer Base. We believe that our consumer product segment has significant growth potential through increased consumer awareness and acceptance.  We continue to take steps to increase both of these factors, including search engine optimization and marketing, online advertising, and social marketing.
 
Increasing International Presence. We are actively exploring international distribution opportunities outside the United States for the PaloVia laser both with regional distributors and large international partners.
 
Intellectual Property Enforcement.  We have a portfolio of patents in a number of areas. In the light-based hair removal area, we have granted licenses to certain of our hair removal patents to a number of companies.  Several of these companies have become licensees following our enforcement of our patents against them. We will continue to enforce these hair removal patents. In addition, in November 2008, together with MGH and Reliant Technologies, Inc. (now Solta Medical, Inc. (“Solta”)), we announced the formation of a Fractional Technology Open Patent Program (“F-TOPP”) to offer licenses in the professional field to six key patent families in the fractional space. Our efforts to license the F-TOPP patent families have not yet been successful.
 
 
8

 
We will continue to review various strategies with additional parties, including granting additional licenses and further litigation, if necessary, to protect our intellectual property rights. (For more information about our patent litigation, see “Item 3. Legal Proceedings” and Note 6 to our consolidated financial statements included in this annual report on Form 10-K.)
 
Products
 
Principal Products
 
We research, develop, manufacture, market, sell and service light-based products used to perform procedures addressing medical and cosmetic concerns. We offer a comprehensive range of products based on proprietary technologies that address various cosmetic issues, including:
 
·  
hair removal;
·  
body sculpting, including laser-assisted liposuction;
·  
removal of vascular lesions such as rosacea, spider veins, port wine stains and hemangiomas;
·  
wrinkle reduction;
·  
removal of leg veins;
·  
removal of benign pigmented lesions such as age and sun spots, freckles and melasma;
·  
tattoo removal;
·  
acne treatment;
·  
skin resurfacing;
·  
treatment of red pigmentation in hypertrophic and keloid scars;
·  
treatment of verrucae, skin tags, seborrheic keratosis;
·  
skin tightening through soft tissue coagulation;
·  
removal of scars, including acne scars, stretch marks and warts; and
·  
soft tissue coagulation.
 
Professional Products
 
Lux Platform.  With increasing market acceptance of light-based treatments for new applications, we recognized the need for a cost effective platform that could expand with the needs of our customers by providing various detachable handpieces. In 2001, we announced the first product with the Lux Platform: the EsteLux® Pulsed Light System.  In the ensuing years, we introduced the MediLux™ Pulsed Light System, the StarLux® 300 Pulsed Light and Laser System, and the StarLux® 500 Pulsed Light and Laser System.  Each system upgrade included major advances in technology and offered significant benefits to our customers.  We also introduced many new handpieces through the years, including various laser handpieces, both fractional and non-fractional and both ablative and non-ablative, various intense pulsed light (IPL) handpieces, and infrared handpieces.
 
Customers can invest in their first Lux system with one or more handpieces, then purchase additional handpieces as their practices grow and upgrade into a more powerful Lux system when ready. The Lux platform enables us to custom tailor products to fit almost any professional medical office or spa location and provide customers with the comfort that the system is able to grow with their practice.
 
In addition to being cost effective and upgradeable, the Lux platform includes many technological advances. For example, the platform includes our Smooth Pulse technology, a safe and comfortable treatment that spreads power evenly over the entire pulse of light and provides optimal wavelengths for faster results in fewer treatments. By contrast, many competitive systems deliver a power spike at the beginning of each pulse which can cause injury at the most effective wavelengths. The Smooth Pulse technology extends the life of the light source. We sell replacement handpieces to existing customers providing us with a recurring revenue stream.
 
The Lux pulsed-light handpieces combine the latest technology with simple, streamlined engineering that is both effective and economical. Long pulse widths and AccuSpectrum™ filtering are designed to provide increased safety and efficacy. Efficacy is further improved through our Photon Recycling process which increases the effective fluence by capturing light scattered out of the skin during treatments and redirecting it back into the treatment target. Offering one of the largest spot sizes in the market and high repetition rates allows for fast coverage, which is especially important when removing hair from large areas such as legs and backs. A back or a pair of legs can be treated with a LuxR or LuxY handpiece in approximately thirty minutes, and a smaller area, such as the underarms, in even less time. The system’s simple operation opens its applications to a wider band of worldwide users.
 
 
9

 
EsteLux.  During 2001, we received FDA clearance to market and sell the Palomar EsteLux™ Pulsed Light System. In 2002 and 2003, we offered six handpieces for the EsteLux system: LuxY, LuxG, LuxR, LuxRs, LuxB and LuxV. These handpieces emit pulses of intense light to reduce future acne breakouts and treat, among other conditions, unwanted hair, solar lentigo (sunspots), rosacea, actinic bronzing, spider veins, birthmarks and telangiectasias. The LuxY handpiece is used for hair removal for large body areas and for pigmented lesion treatments. The LuxG handpiece delivers the RejuveLux™ process - photofacial treatments that remove pigmented and vascular lesions to improve skin tone and texture. The LuxR handpiece can be used to remove hair on all skin types, from the fairest to the darkest, including deep tans. Likewise, the LuxRs handpiece can be used to remove hair on all skin types, but offers concentrated power in each pulse resulting in permanent hair reduction in fewer treatments. The LuxB handpiece provides effective treatment of lighter pigmented lesions on fair skin as well as leg and spider veins, and the LuxV handpiece treats pigmented lesions and mild to moderate acne. With these complimentary handpieces, the Lux Platform is one of the most affordable and multifaceted systems in the market.
 
MediLux. In March 2003, we launched the Palomar MediLux™ Pulsed Light System with the six handpieces also available on the EsteLux. The MediLux provides increased power, a faster repetition rate and a snap-on connector making it easier to switch among handpieces and provide treatments tailored to each individual being treated.
 
StarLux 300. In February 2004, we launched the StarLux® 300 Laser and Pulsed Light System. The StarLux has a single power supply capable of operating both lasers and lamps. The StarLux 300 includes increased power, active contact cooling and a full color touch screen for easy operation. The StarLux 300 operates five of the EsteLux / MediLux handpieces, namely the LuxY, LuxG, LuxR, LuxRs, and LuxV. In addition, the increased power of the StarLux 300 allows for the operation of a long pulse Nd:YAG laser handpiece, the Lux1064™. In January 2005, the Lux1064 laser handpiece received FDA clearance for a variety of applications, including removal of pigmented and vascular lesions such as visible leg veins. The Lux1064 is a high-power laser handpiece featuring Smooth Pulse technology and Active Contact Cooling while also providing multiple spot sizes.
 
Our Active Contact Cooling technology sends a chilled water supply through the StarLux 300 handpieces, thus cooling the skin before, during, and after treatment. This feature is designed to enhance safety and comfort during treatment. The StarLux 300’s high-powered treatments deliver long-lasting and, in some cases, permanent results. The StarLux 300 full-color screen allows easy finger-touch operation and instant handpiece recognition while providing constant feedback on operating parameters.
 
In 2005, we introduced a new infrared handpiece, the LuxIR™, for deep tissue heating for relief of muscle and joint pain. In 2006, we received FDA clearance for the LuxIR handpiece for soft tissue coagulation and began marketing the LuxIR for skin tightening through soft tissue coagulation.
 
In 2006, we introduced the Lux1540™ Fractional Laser handpiece for soft tissue coagulation. In 2007, we received FDA clearance for the Lux1540 for non-ablative skin resurfacing. The Lux1540 delivers light in an array of high precision microbeams which create narrow, deep columns of tissue coagulation that penetrate well below the epidermis and into the dermis, while sparing the tissue surrounding the columns from damage.
 
In February 2007, we introduced the LuxYs™ Pulsed Light handpiece for permanent reduction of lighter, finer hair.
 
StarLux 500. In February 2007, we launched the StarLux® 500 Laser and Pulsed Light System. The StarLux 500 provides 70% more power and increased functionality and speed of treatment as compared to the StarLux 300. The StarLux 500 operates all the handpieces available for the StarLux 300 System as well as the LuxDeepIR™ handpiece. The LuxDeepIR Fractional handpiece is an upgrade of the LuxIR Fractional handpiece and includes advanced cooling, contact sensors and longer pulse duration for improved safety and efficacy. In addition, in December 2007, we launched the Lux2940™ Fractional handpiece for ablative skin resurfacing, and in February 2008, we announced the launch of the Lux1440™ Fractional handpiece for faster non-ablative skin resurfacing. In early 2009, we also announced the launch of the XD Optic for the Lux1540 and Lux1440. The XD Optic provides compression technology for extra depth of treatment which is helpful when treating difficult acne and surgical scars. We completed the full launch of the XD Optic in 2010. In November 2009, we introduced the Groove Optic for the Lux2940 which creates a unique, grooved injury pattern on the skin that increases ablative tissue coverage while preserving the benefits of the fractional approach. Also in 2009, we introduced the LuxMaxG, which provides enhanced power for closure of more difficult facial vessels. We completed the full launch of the LuxMaxG in 2010.
 
 
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Aspire. In 2009, we completed the full launch of the Aspire™ body sculpting system and SlimLipo™ handpiece. The SlimLipo handpiece is our first minimally invasive product and provides laser-assisted lipolysis during liposuction procedures. The SlimLipo handpiece is used to “melt” unwanted fat efficiently and effectively by selectively targeting adipose tissue. Our optimized wavelengths and tip designs provide excellent results with minimal downtime for the patient. Laser-assisted lipolysis can provide skin tightening, smoother skin with less contour deformities, and faster treatments with small incisions, less bruising, reduced pain, and minimal blood loss and swelling. The SlimLipo handpiece also offers numerous benefits to physicians, including less fatigue as the SlimLipo treatment tip moves easily through treatment areas, even fibrous tissue. Physicians can also treat patients in areas that are not normally treated with traditional liposuction, such as small areas and contour deformities. The SlimLipo handpiece features (i) continuous wave technology for superior control of thermal effects versus competing high peak power lasers, (ii) dual laser wavelengths of 924 nm and 975 nm for optimized fat and dermal tissue lasing, (iii) interchangeable treatment tip designs for specific treatment areas, and (iv) an aiming beam for precise visualization of the treatment tip during treatment. The SlimLipo is significantly faster than competing laser-assisted lipolysis devices.
 
Artisan.  In 2010, we launched the Artisan™ Platform, a complete facial rejuvenation system.  The Artisan platform supports the MaxG pigment and vessel clearance handpiece, the 1540 and 1440 fractional non-ablative handpieces, and the 2940 fractional ablative handpiece. This system is ideal for the busiest facial plastic, plastic, and other leading aesthetic practices performing a high volume of facial procedures and who need a cost effective package of the leading facial technologies.
 
Icon.  In February 2011, we launched our next generation aesthetic system, the Palomar Icon™ Aesthetic System.  While completely redesigned and improved, it offers the same advantages as our prior platforms, such as multiple handpieces for various treatment applications and technologies such as AccuSpectrum, Photon Recycling and Smooth Pulse.  The Icon System provides high peak powers for excellent speed and results.  In addition, the Icon System provides state of the art cooling to maintain temperature at 5 degrees Celsius during treatments for enhanced comfort.  Adjustable cooling technology keeps epidermal temperature lower to reduce treatment discomfort and minimize skin damage. The Icon System also has an intuitive user interface featuring new treatment tracking software.  A new Hexagonal XF Microlens is also available on the Icon System which allows for high speed non-ablative fractional resurfacing. The Icon System also has built in calibration for optimal pulsed light performance.  The Icon System operates five Optimized Light™ handpieces, the MaxR, MaxRs, MaxY, MaxYs and MaxG. In addition, the Icon System operates three laser handpieces, the 1540 Fractional Laser, 2940 Fractional Laser and the 1064+ Laser.  The 2940 Fractional Laser is also available with our unique Groove Optic.  The Icon System also operates the MaxIR deep infrared handpiece.  With the Palomar Icon System, aesthetic practices can provide the most popular treatments including laser skin resurfacing, laser wrinkle reduction, laser scar and stretch mark treatment, permanent hair reduction, vessel and pigment clearance, and leg vein clearance.
 
Acleara.  In 2011, we began selling the Acleara™ Acne Clearing System.  The American Academy of Dermatology reports that acne vulgaris is the most common skin condition in the United States. Approximately 80% of all people between the ages of 11 and 30 suffer from acne with many continuing to have acne into their 40s and beyond.  The Acleara System is the first continuously-cooled system to receive FDA clearance for the treatment of mild to moderate inflammatory acne (Acne Vulgaris), comedonal acne, and pustular acne. The Acleara System uses advanced vacuum suction to clean pores by extracting buildup of sebaceous material and filtered broadband light technology to provide targeted heating of sebaceous glands.  The endogenous light activates porphryns to destroy P. acnes bacteria and reduces sebum production through photodynamic action.  The Acleara System is designed and manufactured by Theravant, Inc. and sold by Palomar under a Distribution Agreement signed in 2010.
 
Adivive.  In 2011, we began working with Medi-Khan, Inc. to sell the Adivive™ Fat Transfer System and Adivive Fat Processing Units.  The Adivive system is an all-in-one, integrated system that uses a unique filtering mechanism and high G-force centrifugation to yield a higher quality of adipose tissue for re-injection. The Adivive system simplifies the amount of equipment needed and streamlines each autologous fat transfer process from infiltration all the way through the actual transfer.  The Adivive System and Adivive Fat Processing Units are designed and manufactured by Medi-Khan, Inc. and sold with Palomar under a Distribution Agreement signed in 2010 and amended at the end of 2011.
 
Skintel.  In February 2012, we launched the SkinTel™ Melanin Reader.  The Skintel reader provides practitioners with an additional element of treatment confidence by determining the average melanin density of skin, in a quantitative manner prior to a light-based aesthetic treatment, such as hair removal or photorejuvenation. Understanding how much melanin is in the skin helps the aesthetic professional to better choose the treatment settings on the Palomar Icon Aesthetic System for enhanced treatment outcomes, while minimizing the client’s downtime.  The Skintel reader is the only FDA-cleared melanin reader for use with light-based treatments.
 
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Q-YAG 5. During 2001, we received FDA clearance to market and sell the Palomar Q-YAG 5™ system for tattoo and pigmented lesion removal. The Palomar Q-YAG 5 is a Q-switched, frequency-doubled Neodymium laser. The combination of wavelengths allows users to treat a full spectrum of colors and inks, and the system’s design lowers costs and allows broader use of the instrument. The single wavelength is ideal for treating darker tattoo inks and dermal-pigmented lesions, such as Nevi of Ota common in Japan and other Pacific Rim countries. The mixed wavelength is better suited for brighter colors and epidermal-pigmented lesions, such as solar lentigines. In addition, the mixed wavelength permits brighter, more superficial and deeper and darker target areas to be treated simultaneously. The Palomar Q-YAG 5 incorporates the laser into the handpiece making it smaller and lighter than competitive systems, which is especially desirable for mobile and/or small physician offices. These attributes reduce the cost, increase the reliability of the system and eliminate costly optics and service problems that are common with other high power Q-Switched lasers.  In 2011, we made the decision to stop manufacturing the Q-YAG5 system.  We have used existing inventory to fill some sales orders for loaners and for service.
 
Legacy Products. We no longer sell the EpiLaser™ or E2000™ hair removal laser systems, the RD-1200™ Q-switched ruby laser, SLP1000® Diode Laser System or the NeoLux Pulsed Light System. However, we continue to service these systems. The service of the RD-1200, Epilaser and E2000 have been contracted out to a third party service provider, and we have the option of contracting out the service of the SLP1000 systems to this same party.
 
Consumer Product
 
PaloVia.  At the end of 2010, we launched the PaloVia® Skin Renewing Laser® -- our first consumer product.   The PaloVia laser is the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes.   With the PaloVia laser, we have taken our patented, non-ablative fractional laser technology used by professionals and adapted it for at-home use.  The product delivers a visible improvement in fine lines and wrinkles around the eyes in just one month.  This claim is supported by an independent clinical study in which a panel of doctors specializing in dermatology and plastic surgery saw a noticeable improvement in periorbital wrinkles in 92% of study participants after one month of daily use.   More information on the PaloVia laser can be found on our website –palovia.com.  We are not including the information contained on such website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K.
 
Products Under Development
 
We are engaged in developing products for the dermatology and cosmetic market. Products under development include lasers, lamps and other energy-based products for the removal of unwanted hair, body sculpting, wrinkle reduction, pigmented lesions, leg vein and other vascular lesions, acne, fat, cellulite, and skin rejuvenation, including skin resurfacing, skin tone and texture and tattoos as well as other cosmetic applications. We perform our own research as well as fund research at various institutions throughout the world. Product development is performed by scientists and engineers at our headquarters. We direct resources at both new products for existing markets such as the removal of unwanted hair, vascular and pigmented lesions, acne and skin resurfacing, tattoos and other products for new markets, such as body sculpting, fat reduction, including the treatment of cellulite.
 
Business Segments and Geographic Information
 
We conduct business in two segments, professional medical and cosmetic products and services (“Professional Product segment”) and consumer medical and cosmetic products and services (“Consumer Product segment”). Starting in the fourth quarter of 2011, we determined that the Consumer Product segment represented a separate operating segment.  As such, we began breaking out our financial results between our Professional Product segment which includes all of our light-based products and services for the professional market and our Consumer Product segment which includes PaloVia.  See Note 2 for further discussion on how we evaluate and determine our operating segments.  In our Professional Product segment, we currently employ a global network of strategic distributors throughout Europe, Japan, South and Central America, the Far East, and the Middle East.  As of December 31, 2011, we utilized 45 distributors in 71 countries.  To further improve our international sales and marketing efforts, in 2011, we opened subsidiaries in Germany and Spain.  The German subsidiary is responsible for the sales and marketing of our products in Germany and Austria and certain servicing of our products for those countries, and the Spanish subsidiary is responsible for the sales and marketing of our products in Spain and Portugal, and certain servicing of our products for those countries.  In 2010, we opened a subsidiary in Japan, which is responsible for the sales and marketing and certain servicing of our products in Japan.  In 2008, we opened a subsidiary in Australia, which oversees the sales and marketing of our products in Australia and New Zealand and provides certain servicing of our products for those countries. In 2007, we opened a subsidiary in The Netherlands, which coordinates various sales and marketing activities in Europe, the Middle East, and Africa as well as provides certain servicing of our products for those regions.  In our Consumer Product segment, we currently sell in the United States through cable television shopping, high end department stores, online retailers, physician’s offices, spas, and direct through our website, palovia.com.  We are actively exploring international distribution opportunities outside the United States for the PaloVia laser both with regional distributors and large international partners.
 
 
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The following table shows percentages of our Professional Product segment’s product and service revenues during each of the last three fiscal years by geographic region:

Year ended December 31,
2011
2010
2009
       
North America
58%
59%
61%
Europe
16%
19%
18%
Middle East
6%
4%
3%
Asia / Pacific Rim
6%
3%
2%
South and Central America
5%
6%
7%
Australia
5%
5%
6%
Japan
4%
4%
3%
       
Total
100%
100%
100%

All Consumer Product segment revenues are currently derived solely from sales in the United States.
 
For more segment and geographic information, see our consolidated financial statements included elsewhere in this annual report on Form 10-K, including Note 2 thereto.
 
Production, Sources and Availability of Materials
 
Our manufacturing operations are located in Burlington, Massachusetts. We maintain control of and manufacture most key subassemblies in-house. Manufacturing consists of the assembly and testing of components and certain subassemblies purchased from outside suppliers and contract manufacturers. Each fully assembled system is subjected to a rigorous set of tests prior to shipment to the end user. We have obtained ISO 13485 2003, CDN MDR, and Council Directive 93/42/EEC approvals. We are registered with the FDA.
 
We depend and expect to continue in the future to depend upon a number of outside suppliers for components used in our manufacturing process. Most of our components and raw materials are available from a number of qualified suppliers, with the exception of some components which are available from single suppliers.  We depend exclusively on single source suppliers for scanner subassemblies and diode laser subassemblies, which we use in the manufacturing of our PaloVia Skin Renewing Laser and for diode laser subassemblies, which we use in the manufacture of our Aspire™ body sculpting system with SlimLipo™ handpiece.  To date, we have been able to obtain adequate supplies of scanner and diode laser subassemblies from our third party suppliers in a timely manner. However, if our suppliers are unable to meet our requirements on a timely basis, production could be interrupted until an alternative source of supply is obtained. We believe that over time alternative component and subassembly manufacturers and suppliers can be identified if our current third party manufacturers and suppliers fail to fulfill our requirements.  See “Item 1A. Risk Factors.”
 
Patents and Licenses
 
Our success and ability to compete are dependent on our ability to develop and maintain proprietary technology and operate without infringing on the proprietary rights of others. We rely on a combination of patents, trademarks, trade secret and copyright laws and contractual restrictions to protect our proprietary technology. These legal protections afford only limited protection for our technology. We are presently the exclusive licensee and the non-exclusive licensee of several United States patents as well as corresponding foreign patents and pending applications owned by MGH, and we are the joint owner with MGH and, in some cases, the exclusive licensee, of other United States patents as well as corresponding United States pending applications and foreign patents and pending applications. In addition, we are the sole owner of over twenty-five United States patents as well as many corresponding and non-corresponding United States pending applications and foreign patents and pending applications. We also have rights to other patents under exclusive and non-exclusive licenses. In November 2008, we entered into a Non-Exclusive Patent Cross-License Agreement with Reliant Technologies, Inc. (now Solta) under which Reliant granted to us non-exclusive licenses and other intellectual property rights in the professional field to certain fractional technology owned and licensed by Reliant. Similarly, we granted to Reliant non-exclusive licenses and other intellectual property rights in the professional field to certain of our fractional technology. In addition to the license agreement, in November 2008, together with MGH and Reliant, we announced the formation of a Fractional Technology Open Patent Program (“F-TOPP”) to offer licenses to third parties in the professional field to six key patent families in the fractional space.
 
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We seek to limit disclosure of our intellectual property by requiring employees, consultants and any third party with access to our proprietary information to execute confidentiality agreements with us and often agreements that include assignment of rights provisions to us. Due to rapid changes in technology, we believe that factors such as the technological and creative skills of our personnel, new product developments and enhancements to existing products are as important as the various legal protections of our technology to establishing and maintaining a leadership position.
 
Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. Litigation may be necessary to enforce intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Any such resulting litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that our means of protecting proprietary rights will be adequate or that our competitors will not independently develop similar technology. Any failure by us to meaningfully protect our proprietary rights could have a material adverse effect on our business, operating results, and financial condition.
 
Our management believes that none of our current products infringe upon valid claims of patents owned by third parties of which we are aware. However, there have been claims made against us and there can be no assurance that third parties will not make further claims of infringement with respect to our current or future products. Any such claims, with or without merit, could be time-consuming to defend, result in costly litigation, divert our attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. A successful claim of intellectual property infringement against us and our failure or inability to license the infringed technology or develop or license technology with comparable functionality could have a material adverse effect on our business, financial condition and operating results. (For more information about our patent litigation, see “Item 3. Legal Proceedings” and Note 6 to our consolidated financial statements included in this annual report on Form 10-K.)
 
Backlog
 
Generally, we do not maintain a high level of backlog. As a result, we do not believe that our backlog at any particular time is indicative of future sales levels.
 
Competition
 
The Professional Product segment in which we are engaged is subject to intense competition and rapid technological change. Our competitors include: Cutera, Inc., Cynosure, Inc., Solta, Syneron, Inc. (which merged with Candela Corporation in January 2010), Lumenis, Inc., Alma, Inc. and other smaller competitors. The Consumer Product segment in which we have entered is also expected to have intense competition. Currently our only consumer product, the PaloVia Skin Renewing Laser®, is the only product of its kind on the market in the United States but another company, namely Philips Electronics, sells a similar product outside the United States based on Fraxel® laser technology owned by Solta, and is seeking FDA clearance to sell that product in the United States.  Other competitors of ours have also announced their intention to enter the Consumer Product segment. Some of our competitors have greater financial, marketing, and technical resources than we have. Moreover, some competitors have developed, and others may attempt to develop, products with applications similar to ours. We expect that there may be further consolidation of companies within the light-based aesthetic treatment industry via acquisitions, partnering arrangements or joint ventures. We compete primarily on the basis of technology, product performance, price, quality, reliability, distribution and customer service. To remain competitive, we will be required to continue to develop new products and periodically enhance our existing products.
 
 
 
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Food and Drug Administration Regulations
 
All of our current products are light-based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution, and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA. The types of medical devices that we seek to market in the United States generally must receive either “510(k) clearance” or “PMA approval” in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer. To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that most of our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product we propose to market and failure to do so could adversely affect our ability to sell products.
 
Number of Employees

As of December 31, 2011, we employed approximately 260 people.  We are not subject to any collective bargaining agreements, have not experienced a work stoppage, and consider our relations with our employees to be good.

Available Information

Our internet site is www.palomarmedical.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. You can access our Investor Relations webpage through our internet site by clicking on the “Investors” link under “About Palomar”. We make available free of charge, on or through our Investor Relations webpage, under the “SEC Filings” link, our proxy statements, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. We also make available via a link to the SEC’s internet site, statements of beneficial ownership of our equity securities filed by our directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act. We have also made our Code of Business Conduct and Ethics, our Corporate Governance Guidelines, and the charters for our Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee available through our internet site on our “Corporate Governance” page found by clicking on the “Investors” link under “About Palomar”.
 
Item 1A. Risk Factors
 
Disruptions which began in 2008 in the global economy, the financial markets, and currency markets, as well as government responses to these disruptions, continue to adversely impact our business and results of operations.

A slowdown in economic activity caused by the recession has reduced worldwide demand for our products.  The general economic difficulties being experienced by our customers, reduced consumer demand for our 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.  Our total revenues declined by 29% and 31% from 2007 to 2008 and 2008 to 2009, respectively. Our total revenues increased by 5% from 2009 to 2010 and 62% from 2010 to 2011 (revenues in 2011 includes $29.8 million of royalty revenues from the settlement of the Candela/Syneron litigation described in “Item 3. Legal Proceedings”), but they may not continue to increase in future years.
 
Distress in the financial markets has had an adverse impact on the availability of credit and liquidity resources.  Certain preferred lessors have exited from our industry or declared bankruptcy.  Many of our customers or potential customers are facing issues gaining access to sufficient credit, which is resulting or may result in an impairment of their ability to make timely payments to us or to get financing at all.  Lack of availability of consumer credit, a decrease in consumer confidence, and the general economic downturn is adversely impacting the market in which we operate.  These factors are causing some customers to postpone buying decisions until economic conditions improve.

The severity of the European sovereign debt crisis has caused the price of the euro to fluctuate widely over the past several years, and volatility increased in 2011 due in part to concerns over the sovereign debt levels of certain European Union members (e.g. Greece, Ireland, Portugal) and the value of the euro.  Approximately 16% of our Professional Product segment’s product and service revenues in 2011 were from European countries, most of them affected by the euro.  A continued crisis could adversely impact our business and results of operations.

 
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We may not be successful in commercializing home-use, light-based devices on our own or with third parties.  Managing the development and launch of home-use, light-based devices on our own or with third parties diverts the attention of key personnel and management from our Professional Product segment.   If we are unsuccessful, it could have a material adverse impact on our business and our stock price could fall.
 
At the end of 2010, we launched the PaloVia® Skin Renewing Laser® -- the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes.  The commercialization of a home-use, light-based device has been one of our goals for many years, and our future growth is dependent on our ability to do so.  In the future, we could receive substantial revenue from sales of the PaloVia Laser and other home-use, light-based devices as well as consumable components sold for use therewith.  Our success will depend on a number of factors, including our ability to successfully launch home-use, light-based devices, the timing of such commercial launches and the market acceptance of such consumer products.  Our ability to achieve these goals may be adversely affected by difficulties or delays in bringing home-use, light-based devices to market and keeping them on the market, the inability to obtain or enforce intellectual property protection, market acceptance of our new products, adverse events, product changes and high rates of customer returns. In addition, we face significant competition, including from companies that are much larger and better funded than us.  Currently the PaloVia laser is the only product of its kind on the market in the United States, but another company, namely Philips Electronics, sells a similar product outside the United States and is seeking FDA clearance to sell such product in the United States.  Competing against such systems will be difficult. Other competitors have publicly announced their intent to enter the consumer market.  Significant resources and the attention of key personnel and management have been and will likely continue to be directed to the development and commercialization of home-use devices.  There are no guarantees that the PaloVia Laser or any future home-use products will prove to be commercially successful.
 
In addition, the consumer product market is known for high rates of product returns and we have experienced high rates of product returns since our entrance into the consumer product market.  To achieve our objectives, we must determine how to best realize value from such returned products.  The consumer product market is also known for product liability lawsuits.  While we have not yet been subject to such lawsuits, if we were to be sued, litigation is unpredictable and we may not prevail in successfully defending our position. If we do not prevail in such litigation, we may be ordered to pay substantial damages. In addition, following litigation loss or an increase in adverse events or other problems among consumers, we could also decide to stop selling such products.  Even if we prevail in litigation, significant legal costs and the distraction of management could negatively impact our business, results of operations and financial condition.
 
Our past Development and License Agreement with Gillette, a wholly owned subsidiary of P&G was replaced by a non-exclusive License Agreement with P&G in February 2008, as amended in 2010, under which we granted a non-exclusive license to certain patents and technology to commercialize home-use, light-based hair removal devices for women.  During the term of the agreement, P&G has the ability to choose not to continue and may terminate the non-exclusive License Agreement.  If P&G should terminate their non-exclusive License Agreement with us, we will not receive certain payments pursuant to such agreement, and the price of our common stock could fall significantly.  These payments include the Technology Transfer Payments (“TTP”) which were initially $1.25 million per quarter, but decreased by the 2010 amendment to $1.0 million for the calendar quarter ending December 31, 2010 and thereafter to $2.0 million per year for an agreed period, after which the payments return to $1.25 million per calendar quarter if no product has been launched.  If P&G continues the commercialization of such devices, P&G is required to pay us a percentage of net sales of such devices. Certain of these percentages of net sales are only owed if the devices are covered by valid patents.  There can be no assurance that valid patents will cover the devices in any or all countries in which the devices will be manufactured, used or sold.  In addition, a portion of the proceeds received on such sales may be owed to MGH.  This could have a material adverse effect on our business, results of operations, and financial condition.
 
We cannot be sure that P&G or any future third party development partner will agree with our interpretation of the terms of the non-exclusive License Agreement, that the agreement will provide us with marketable products in the future or that we will receive payments for any of the products developed under the agreement. 
 
We have limited experience manufacturing the PaloVia® Skin Renewing Laser® and consumable PaloVia Gel in commercial quantities, which could adversely impact our business.
 
We began manufacturing our PaloVia Skin Renewing Laser and consumable PaloVia Gel during the second half of 2010. Because we have only limited experience in manufacturing in commercial quantities, we may encounter unforeseen situations that would result in delays or shortfalls. We face significant challenges and risk in manufacturing the PaloVia Laser and consumable PaloVia Gel, including that production processes may have to change to accommodate any significant future expansion of our manufacturing operations and growth; key components are currently provided by single suppliers or a limited number of suppliers, and we do not maintain large inventory levels of these components; and we have limited experience manufacturing the PaloVia Laser and consumable PaloVia Gel in compliance with FDA’s Quality System Regulation.  If we are unable to keep up with demand for the PaloVia Laser and consumable PaloVia Gel, our revenue could be impaired, market acceptance for the PaloVia Laser and consumable PaloVia Gel could be adversely affected and our customers might instead purchase competitors’ products.
 
 
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We have limited experience in operating in the consumer medical device market, which could adversely impact our business.
 
    We entered the consumer medical device market in the fourth quarter of 2010.  Our limited experience in operating in this market could negatively impact our business.  We are selling our consumer medical device through new channels of distribution in which management does not have a significant amount of experience.  Additionally, we may encounter actual or perceived product quality, safety, or reliability problems, significant changes in consumer demand, high levels of product returns, and product liability issues which would divert management’s attention from our core business.  Entering the consumer medical device market has presented management with new accounting issues related to revenue recognition  andestimating customer return rates at the end of each reporting period for future customer returns related to sales recorded prior to the end of the period.  These accounting issues have warranted considerable management attention and additional accounting issues related to the consumer medical device market could divert management’s attention from our core business.  Also, we may face challenges in being able to recover our investment related to the returned consumer product inventory.
 
Our Aspire system with SlimLipo handpiece requires the use of consumable treatment tips and fiber delivery assemblies.  These products could fail to generate significant revenue or achieve market acceptance.
 
In 2009, we completed the launch of the Aspire body sculpting system and SlimLipo handpiece.  The SlimLipo handpiece is our first minimally invasive product and provides laser-assisted lipolysis.  The SlimLipo handpiece requires the use of consumable, single-use treatment tips and a limited-use fiber delivery assembly.  The future success of the Aspire system will depend on a number of factors, including our ability to increase and maintain sales of the Aspire system with SlimLipo handpiece as well as the consumable components.  Several competing systems also require the use of consumable components, while others do not or their consumable components allow for more usage before needing to be replaced.  Competing against such systems may be more difficult.

 
If third parties are able to supply our customers with consumable treatment tips and fiber delivery assemblies for the Aspire system with SlimLipo handpiece, our business could be adversely impacted.
 
To ensure the proper operation of our products, our consumable treatment tips and fiber delivery assemblies are protected by an encryption technology that is designed to authenticate that the tips are supplied by us or by a supplier authorized by us. It is possible that a third party may be able to find methods of circumventing our encryption technology and other technological requirements which ensure that only authorized tips are used with the Aspire system with SlimLipo handpiece.  If a third party is able to supply consumable treatment tips and fibers to our customers, this could lead to a reduction in the safety or efficacy of treatments performed with the Aspire system and SlimLipo handpiece as we cannot control the quality or operation of such third party products.  This could lead to an increase in product liability lawsuits, damage the Aspire brand, or result in loss of confidence in our products.  In addition, a third party supply of consumable treatment tips and fibers to our customers could result in a reduction in the rate of sales and price of our consumable treatment tips and fiber delivery assemblies.

If we do not continue to develop and commercialize new products and identify new markets for our products and technology, we may not remain competitive, and our revenues and operating results could suffer.

The aesthetic light-based (both lasers and lamps) treatment system industry is subject to continuous technological development and product innovation.  If we do not continue to be innovative in the development of new products and applications, our competitive position will likely deteriorate as other companies successfully design and commercialize new products and applications.  We compete in the development, manufacture, marketing, sales and servicing of light-based devices with numerous other companies, some of which have substantially greater direct worldwide sales capabilities. Our products also face competition from medical treatments and products, prescription drugs and cosmetic topicals and procedures, such as electrolysis and waxing. If we are unable to develop and commercialize new products and identify new markets for our products and technology, our products and technology could become obsolete and our revenues and operating results could be adversely affected.
 
Product liability suits could be brought against us due to a defective design, material or workmanship or due to misuse of our products. These lawsuits could be expensive and time consuming and result in substantial damages to us and increases in our insurance rates.
 
 
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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 or clients.  Furthermore, in the event that any of our products prove to be defectively designed and manufactured, we may be required to recall and redesign such products. Misusing our products or failing to adhere to operating guidelines for our products can cause severe burns or other damage to the eyes, skin or other tissue. We are routinely involved in claims 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. Our current insurance coverage may not be sufficient to cover these claims. Moreover, in the future, we may not be able to obtain insurance in amount or scope sufficient to provide us with adequate coverage against 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 reduce product sales. We would need to pay any product losses in excess of our insurance coverage out of cash reserves, harming our financial condition and adversely affecting our operating results.
 
Our products are subject to numerous medical device regulations. Compliance is expensive and time-consuming. Without necessary clearances, we may be unable to sell products and compete effectively. 

All of our current products are light-based devices, which are subject to FDA regulations for clinical testing, manufacturing, labeling, sale, distribution and promotion. Before a new product or a new use of or claim for an existing product can be marketed in the United States, we must obtain clearance from the FDA.  In the event that we do not obtain FDA clearances, our ability to market products in the United States and revenue derived therefrom may be adversely affected.  The types of medical devices that we seek to market in the U.S. generally must receive either “510(k) clearance” or “PMA approval” in advance from the FDA pursuant to the Federal Food, Drug, and Cosmetic Act. The FDA’s 510(k) clearance process can be expensive and usually takes from three to twelve months, but it can last longer. The process of obtaining PMA approval is much more costly and uncertain and generally takes from one to three years or even longer from the time the pre-market approval application is submitted to the FDA until an approval is obtained.

In order to obtain pre-market approval and, in some cases, a 510(k) clearance, a product sponsor must conduct well-controlled clinical trials designed to test the safety and effectiveness of the product. Conducting clinical trials generally entails a long, expensive and uncertain process that is subject to delays and failure at any stage. The data obtained from clinical trials may be inadequate to support approval or clearance of a submission. In addition, the occurrence of unexpected findings in connection with clinical trials may prevent or delay obtaining approval or clearance. If we conduct clinical trials, they may be delayed or halted, or be inadequate to support approval or clearance, for numerous reasons, including:
 
·  
FDA, other regulatory authorities or an institutional review board may place a clinical trial on hold;
·  
patients may not enroll in clinical trials, or patient follow-up may not occur, at the rate we expect;
·  
patients may not comply with trial protocols;
·  
institutional review boards and third party clinical investigators may delay or reject our trial protocol;
·  
third party clinical investigators may decline to participate in a trial or may not perform a trial on our anticipated schedule or consistent with the clinical trial protocol, good clinical practices, or other FDA requirements;
·  
third party organizations may not perform data collection and analysis in a timely or accurate manner;
·  
regulatory inspections of our clinical trials or manufacturing facilities may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials, or invalidate our clinical trials;
·  
governmental regulations may change or administrative actions may occur that cause delays; and
·  
the interim or final results of the clinical trials may be inconclusive or unfavorable as to safety or effectiveness.
 
 
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Medical devices may be marketed only for the indications for which they are approved or cleared. The FDA may not approve or clear indications that are necessary or desirable for successful commercialization, or may refuse our requests for 510(k) clearance or pre-market approval of new products, new intended uses or modifications to existing products. Our clearances can be revoked if safety or effectiveness problems develop.

To date, the FDA has deemed our products eligible for the 510(k) clearance process. We believe that our products in development will receive similar treatment. However, we cannot be sure that the FDA will not impose the more burdensome PMA approval process upon one or more of our future products, nor can we be sure that 510(k) clearance or PMA approval will ever be obtained for any product we propose to market, and our failure to do so could adversely affect our ability to sell our products.

We often seek FDA clearance for additional indications for use.  Clinical trials in support of such clearances for additional indications may be costly and time-consuming. In the event that we do not obtain additional FDA clearances, our ability to market products in the United States and revenue derived therefrom may be adversely affected.  Medical devices may be marketed only for the indications for which they are approved or cleared, and if we are found to be marketing our products for off-label or non-approved uses we might be subject to FDA enforcement action or have other resulting liability.
 
 
Our products are subject to similar regulations in many international markets. Complying with these regulations is necessary for our strategy of expanding the markets for sales of our products into these countries. Compliance with the regulatory clearance process in any country is expensive and time consuming.  Regulatory clearances may necessitate clinical testing, limitations on the number of sales and limitations on the type of end user, among other things.  In certain instances, these constraints can delay planned shipment schedules as design and engineering modifications are made in response to regulatory concerns and requests.  We may not be able to obtain clearances in each country in a timely fashion or at all, and our failure to do so could adversely affect our ability to sell our products in those countries.

After clearance or approval of our products, we are subject to continuing regulation by the FDA, and if we fail to comply with FDA regulations, our business could suffer.

Even after clearance or approval of a product, we are subject to continuing regulation by the FDA, including the requirements that our facility be registered and our devices listed with the agency. We are subject to Medical Device Reporting regulations, which require us to report to the FDA if our products may have caused or contributed to a death or serious injury or malfunction in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur. We must report corrections and removals to the FDA where the correction or removal was initiated to reduce a risk to health posed by the device or to remedy a violation of the Federal Food, Drug, and Cosmetic Act caused by the device that may present a risk to health, and we must maintain records of other corrections or removals. The FDA closely regulates promotion and advertising and our promotional and advertising activities could come under scrutiny. If the FDA objects to our promotional and advertising activities or finds that we failed to submit reports under the Medical Device Reporting regulations, for example, the FDA may allege our activities resulted in violations.

The FDA and state authorities have broad enforcement powers. Our failure to comply with applicable regulatory requirements could result in enforcement action by the FDA or state agencies, which may include any of the following sanctions:
 
·  
letters, warning letters, fines, injunctions, consent decrees and civil penalties;
·  
repair, replacement, refunds, recall or seizure of our products;
·  
operating restrictions or partial suspension or total shutdown of production;
·  
refusing or delaying our requests for 510(k) clearance or pre-market approval of new products or new intended uses; and
·  
criminal prosecution.

If any of these events were to occur, they could harm our business.
 
 Achieving complete compliance with FDA regulations is difficult, and if we fail to comply, we could be subject to FDA enforcement action or our business could suffer.
 
We are subject to inspection and market surveillance by the FDA to determine compliance with regulatory requirements. The FDA’s regulatory scheme is complex, especially the Quality System Regulation, which requires manufacturers to follow elaborate design, testing, control, documentation, and other quality assurance procedures. Because some of our products involve the use of lasers, those 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 Quality System Regulation and laser performance standards through periodic unannounced inspections. We have been, and anticipate in the future being, subject to such inspections.  The complexity of the Quality System Regulation makes complete compliance difficult to achieve. Also, the determination as to whether a Quality System Regulation violation has occurred is often subjective. If the FDA finds that we have failed to comply with the Quality System Regulation or other applicable requirements or failed to take satisfactory corrective action in response to an adverse Quality System Regulation inspection or comply with applicable laser performance standards, the agency can institute a wide variety of enforcement actions, including a public warning letter or other stronger remedies, such as fines, injunctions, criminal and civil penalties, recall or seizure of our products, operating  restrictions, partial suspension, or total shutdown of our production, refusing to permit the import or export of our products, delaying or refusing our requests for 510(k) clearance or PMA approval of new products, withdrawing product approvals already granted or criminal prosecution, any of which could cause our business and operating results to suffer.
 
 
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We have modified some of our products and sold them under prior 510(k) clearances. The FDA could retroactively decide the modifications required new 510(k) clearances and require us to cease marketing and/or recall the modified products.

Any modification to one of our 510(k) cleared devices that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance.  We may be required to submit pre-clinical and clinical data depending on the nature of the changes. We may not be able to obtain additional 510(k) clearances or pre-market approvals for modifications to, or additional indications for, our existing products in a timely fashion, or at all. Delays in obtaining future clearances or approvals would adversely affect our ability to introduce new or enhanced products into the market in a timely manner, which in turn would harm our revenue and operating results. We have modified some of our marketed devices, but we believe that new 510(k) clearances are not required. We cannot be certain that the FDA would agree with any of our decisions not to seek new 510(k) clearance. If the FDA requires us to seek new 510(k) clearance for any modification, we also may be required to cease marketing and/or recall the modified device until we obtain such 510(k) clearance.

Federal regulatory reforms may adversely affect our ability to sell our products profitably.

From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the clearance or approval, manufacture and marketing of a device. In addition, FDA regulations and guidance are often revised or reinterpreted by the agency in ways that may significantly affect our business and our products. It is impossible to predict whether legislative changes will be enacted or FDA regulations, guidance or interpretations changed, and what the impact of such changes, if any, may be.

We may also be subject to state regulations.   State regulations, and changes to state regulations, may prevent sales to particular end users or may restrict use of professional products to particular end users or under particular supervision which may decrease revenues or prevent growth of revenues.

Our Professional Products segment’s products may also be subject to state regulations. Federal regulation allows our professional products to be sold to and used by licensed practitioners as determined on a state-by-state basis which complicates monitoring compliance.  As a result, in some states, non-physicians may purchase and operate our professional products. In most states, it is within a physician’s discretion to determine whom they can supervise in the operation of our professional products and the level of supervision.  However, some states have specific regulations as to appropriate supervision and who may be supervised.  A state could disagree with our decision to sell to a particular type of end user, change regulations to prevent sales or restrict use of our professional products to particular types of end users or change regulations as to supervision requirements.  In several states, applicable regulations are in flux.  Thus, state regulations and changes to state regulations may decrease revenues or prevent growth of revenues. 
 
Because we do not require training for all users of our products, and sell our products 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 Professional Products segment’s products to or on the order of practitioners licensed by state law. The definition of “licensed practitioners” varies from state to state. As a result, our professional 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.  Our products come with an operator’s manual.  We and our distributors offer professional product training sessions, but neither we nor our distributors require purchasers or operators of our products to attend training sessions. The lack of required 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 expose us to costly product liability litigation.

 
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Failure to manage our relationships with third party researchers effectively may limit our access to new technology, increase the cost of licensing new technology, and divert management attention from our core business.
 
We work with third-party researchers over whom we do not have absolute control to satisfactorily conduct and complete research on our behalf.  When we work with third-party researchers we are also dependent upon them to grant us licensing terms, which may or may not be favorable, for products and technology they may develop. We provide research funding, light technology and optics know-how in return for licensing rights with respect to specific dermatologic and cosmetic applications and patents. In return for certain exclusive license rights, we have been and may in the future be subject to due diligence obligations in order to maintain such exclusivity.  Our success will be dependent upon the results of research with our partners and meeting due diligence obligations. We cannot be sure that third-party researchers will agree with our interpretation of the terms of our agreements, that we will meet our due diligence obligations, or that such research agreements will provide us with marketable products in the future or that any of the products developed under these agreements will be profitable for us. 

If our new products do not gain market acceptance, our revenues and operating results could suffer.

The commercial success of the Professional Product segment’s products and technology we develop will depend upon the acceptance of these products by providers of aesthetic procedures and their patients and clients.  The commercial success of the consumer products and technology we develop will depend on the acceptance of these products by consumers.  It is difficult for us to predict how successful recently introduced products, or products we are currently developing, will be over the long term. If the products we develop do not gain market acceptance, our revenues and operating results could suffer.

We expect that many of the products we develop will be based upon new technologies or new applications of existing technologies. It may be difficult for us to achieve market acceptance of some of our products, particularly the first products that we introduce to the market based on new technologies or new applications of existing technologies.

If demand for our professional aesthetic treatment systems by non-traditional physician customers and demand for our consumer products by consumers does not develop as we expect, our revenues will suffer and our business will be harmed.

We believe, and our growth expectations assume, that we and other companies selling professional and consumer light-based (lasers and lamps) aesthetic treatment systems have only begun to penetrate these markets and that our revenues from selling to these markets will continue to increase. If our expectations as to the size of these markets and our ability to sell our products to participants in these markets are not correct, our revenues will suffer and our business will be harmed.

If there is not sufficient consumer demand for the procedures performed with our products, practitioner and consumer demand for our products could decline, which would adversely affect our operating results.

Most procedures performed using our professional aesthetic treatment systems are elective procedures that are not reimbursable through government or private health insurance. The cost of these elective procedures and the cost of our consumer products must be borne by the client. As a result, the decision to undergo a procedure that utilizes our products may be influenced by a number of factors, including:
 
·  
consumer awareness of and demand for procedures and treatments;
·  
the cost, safety and effectiveness of the procedure and of alternative treatments;
·  
the success of our and our customers’ sales and marketing efforts to purchasers of these procedures; and
·  
consumer confidence, which may be affected by short-term or long-term economic and other conditions.
 
       If there is not sufficient demand for the procedures performed with our products, a weakening in the economy, or other factors, practitioner and consumer demand for our products may be reduced or buying decisions postponed, which would adversely affect our operating results.
 
 
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Our business and operations are experiencing rapid change. If we fail to effectively manage the changing market, our business and operating results could be harmed.

 We have experienced rapid change in the scope of our operations and the industry in which we operate.  This change has placed significant demands on our management, as well as our financial and operational resources. If we do not effectively manage the changing market and its effect on our business, the efficiency of our operations and the quality of our products could suffer, which could adversely affect our business and operating results. To effectively manage this change, we will need to continue to:
 
·  
implement appropriate operational, financial and management controls, systems and procedures;
·  
change our manufacturing capacity and scale of production;
·  
change our sales, marketing and distribution infrastructure and capabilities; and
·  
provide adequate training and supervision to maintain high quality standards.
 
Failure to receive shipments of critical components, some of which are from single suppliers, could reduce revenues and reduced reliability of critical components could increase expenses.

                We develop light-based systems that incorporate third-party components and we purchase some of these components from small, specialized vendors that are not well capitalized. We do not have long-term contracts with some of these third parties for the supply of parts.  With regard to single source suppliers, we use scanner subassemblies and diode laser subassemblies to manufacture our PaloVia® Skin Renewing Laser®, we use diode laser subassemblies to manufacture our Aspire™ body sculpting system with SlimLipo™ handpiece, and we use 1540nm laser rods to manufacture our Lux1540 handpiece.  We depend exclusively on sole source suppliers for these components, and we are aware of no alternative suppliers.  The scanner and diode laser subassemblies and the 1540nm laser rods are important to our business.  A disruption in the delivery of these key components, or our inability to obtain substitute components or subassemblies from alternate sources at acceptable prices in a timely manner, or our inability to obtain assembly or testing services could prevent us from manufacturing products and result in a decrease in revenue.  We depend on an acceptable level of reliability for purchased components.  Reliability below expectations for key components could have an adverse effect on inventory and inventory reserves.  Any extended interruption in our supplies of third-party components could materially harm our business.

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.

To manage our manufacturing operations with our suppliers, we forecast anticipated product orders and material requirements to predict our inventory needs and enter into purchase orders on the basis of these requirements.  Our limited historical experience may not provide us with enough data to accurately predict future demand.  If our business expands, our demand for components and materials would increase and our suppliers may be unable to meet our demand.  If we overestimate our component and material requirements, we will have excess inventories, which would increase our expenses.  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.
 
Our proprietary technology has only limited protections which may not prevent competitors from copying our new developments.  This may impair our ability to compete effectively.  We may expend significant resources enforcing our intellectual property rights to prevent such copying, or our intellectual property could be determined to be not infringed, invalid or unenforceable.
 
                   Our business could be materially and adversely affected if we are not able to adequately protect our intellectual property rights. We rely on a combination of patent, copyright, trademark and trade secret laws, licenses and confidentiality agreements to protect our proprietary rights. We own and license a variety of patents and patent applications in the United States and corresponding patents and patent applications in many foreign jurisdictions. Our pending and future patent applications may not issue as patents or, if issued, may not issue in a form that will be advantageous to us. Even if issued, patents may be challenged, narrowed, invalidated or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. Changes in either patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property or narrow the scope of our patent protection. 
 
 
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                   We have granted certain patent licenses to several competitors, and in return for those license grants, we receive a significant ongoing royalty revenue stream.  A few of these competitors entered into license agreements only after we sued them for patent infringement.  We are currently enforcing certain of our patents against Tria Beauty, Inc. and Asclepion Laser Technologies GmbH and intend to enforce against other competitors in the future.  We do not know how successful we will be in asserting our patents against Tria, Asclepion or other suspected infringers.  Whether or not we are successful in the pending lawsuits, litigation consumes substantial amounts of our financial resources and diverts management's attention away from our core business. Public announcements concerning these lawsuits that are unfavorable to us may in the future result in significant declines in our stock price. An adverse ruling or judgment in these lawsuits could result in a loss of our significant ongoing royalty revenue stream and could also have a material adverse effect on license agreements with other companies both of which could have a material adverse effect on our business and results of operation and cause our stock price to decline significantly.  (For more information about our patent litigation, see “Item 3. Legal Proceedings.”)
 
                    In addition to patented technology, we rely upon unpatented proprietary technology, processes and know-how. We generally enter into agreements with our employees and third parties with whom we work, including but not limited to consultants and vendors, to restrict access to, and distribution of, our proprietary information and define our intellectual property ownership rights. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology, proprietary information and know-how and we may not have adequate remedies for any such breach. Monitoring unauthorized use of our technology is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. If competitors are able to use our proprietary technology, our ability to compete effectively could be harmed and the value of our technology and products could be adversely affected.  Costly and time consuming lawsuits may be necessary to enforce and defend patents issued or licensed exclusively to us, to protect our trade secrets and/or know-how or to determine the enforceability, scope and validity of others’ intellectual property rights. Such lawsuits may result in patents issued or licensed exclusively to us to be found invalid and unenforceable.  In addition, our trade secrets may otherwise become known or our competitors also may independently develop technologies that are substantially equivalent or superior to our technology and which do not infringe our patents.

Claims by others that our products infringe their patents or other intellectual property rights could prevent us from manufacturing and selling some of our products or require us to pay royalties or incur substantial costs from litigation or development of non-infringing technology.

                In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights.  The light-based cosmetic and dermatology industry in particular is characterized by a large number of patents and related litigation regarding patents and other intellectual property rights. Because our resources are limited and patent applications are maintained in secrecy for a period of time, we can conduct only limited searches to determine whether our technology infringes any patents or patent applications. Any claims for patent infringement, regardless of merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause shipment delays, require us to develop non-infringing technology or to enter into royalty or licensing agreements. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace.  Although patent and intellectual property disputes in the light-based industry have often been settled through licensing or similar arrangements, costs associated with such arrangements may be substantial and often require the payment of ongoing royalties, which could have a negative impact on gross margins. There can be no assurance that necessary licenses would be available to us on satisfactory terms, or that we could redesign our products or processes to avoid infringement, if necessary. Accordingly, an adverse determination in a judicial or administrative proceeding or failure to obtain necessary licenses could prevent us from manufacturing and selling some of our product. Although we believe a loss is remote at the time of this filing, an unfavorable outcome could have a material adverse effect on our business, results of operations, and financial condition.

 
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We may not be able to successfully collect licensing royalties.

            Material portions of our revenues consist of royalties from sub-licensing patents licensed to us on an exclusive basis by MGH.  These patents expire on February 1, 2015.  If we are unable to collect our licensing royalties, our revenues will decline.  In addition, our revenues will decline following expiration of such patents as we will no longer receive any royalties from such patents.
 
Quarterly revenue or operating results could cause the price of our common stock to fall.
 
Our quarterly revenue and operating results are difficult to predict and may swing sharply from quarter to quarter.  If our quarterly revenue or operating results fall below the expectations of investors or public market analysts, the price of our common stock could fall substantially. Our quarterly revenue is difficult to forecast for many reasons, some of which are outside of our control.  For example, many factors are related to market supply and demand, including potential increases in the level and intensity of price competition between our competitors and us, potential decrease in demand for our products and possible delays in market acceptance of our new products.  Other factors are related to our customers and include changes in or extensions of our customers' budgeting and purchasing cycles and changes in the timing of product sales in anticipation of new product introductions or enhancements by us or our competitors.   Factors related to our operations may also cause quarterly revenue or operating results to fall below expectations, including our effectiveness in our manufacturing process, unsatisfactory performance of our distribution channels, service providers, or customer support organizations, and timing of any acquisitions and related costs.
 
Our effective income tax rate may vary significantly.
 
Unanticipated changes in our tax rates could affect our future results of operations.  Our future effective tax rates could be unfavorably affected by changing interpretations of existing tax laws or regulations, changes in estimates of prior years’ items, changes in our deferred tax assets and related valuation allowances, future levels of research and development spending, stock option grants, deductions for employee stock option exercises being different than what we projected, and changes in overall levels of income before taxes.
 
We may have exposure to additional tax liabilities which could negatively impact our income tax provision, net income (loss), and cash flow.

We are subject to income taxes and other taxes in both the U.S. and the foreign jurisdictions in which we currently operate or have historically operated. The determination of our worldwide provision for income taxes and current and deferred tax assets and liabilities requires judgment and estimation. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are subject to regular review and audit by both domestic and foreign tax authorities and to the prospective and retrospective effects of changing tax regulations and legislation. Although we believe our tax estimates are reasonable, the ultimate tax outcome may materially differ from the tax amounts recorded in our Consolidated Financial Statements and may materially affect our income tax provision, net income (loss), and cash flows in the period in which such determination is made.

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. We review our deferred tax assets and valuation allowance on a quarterly basis. As part of our review, we consider positive and negative evidence, including cumulative results in recent years. As a result of our review in 2011, 2010, and 2009, we provided for a full valuation allowance against our U.S. and foreign deferred tax assets. This resulted in a material income tax charge in the fourth quarter of 2009.

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 may be unable to attract and retain key executives and research and development personnel that we need to succeed.
 
               As a small company with approximately 260 employees, our success depends on the services of key employees in executive and research and development positions. The loss of the services of one or more of these employees could have a material adverse effect on our business.  Our future success will depend in large part upon our ability to attract, retain, and motivate highly skilled employees. We cannot be certain that we will be able to do so.
 
 
 
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We face risks associated with product warranties.         
 
We could incur substantial costs as a result of product failures for which we are responsible under warranty obligations.
 
Because we derive a significant amount of our revenue from international sales, we are susceptible to currency fluctuations, long payment cycles, credit risks, and other risks associated with conducting business overseas.
 
                We sell a significant amount of our products and services outside the United States. International product revenue consists of sales from our Australian, Japanese, German and Spanish subsidiaries, distributors in Japan, Europe, Asia, the Pacific Rim, and South and Central America and sales shipped directly to international locations from the United States. We expect that international sales will continue to be significant.  As a result, a major part of our revenues and operating results could be adversely affected by risks associated with international sales, including but not limited to political and economic instability and difficulties in managing our foreign operations.  In particular, longer payment cycles common in foreign markets, credit risk and delays in obtaining necessary import or foreign certification or regulatory approvals for products may occur.  In addition, significant fluctuations in the exchange rates between the U.S. dollar and foreign currencies could cause us to lower our prices and thus reduce our profitability, or could cause prospective customers to push out orders to later dates because of the increased relative cost of our products in the aftermath of a currency devaluation or currency fluctuation.
 
We are subject to fluctuations in the exchange rate of the U.S. dollar and foreign currencies.
 
 
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, Australian dollar, and Japanese Yen. As a result, changes in the exchange rates of these currencies to the U.S. dollar will affect our results of operations.
 
To successfully grow our international presence, we must address many issues with which we have little or no experience. We may not be able to properly manage our foreign subsidiaries which may have an adverse effect on our business and operating results.
 
                   We have five international subsidiaries which are located in The Netherlands, Australia, Japan, Germany, and Spain. In managing foreign operations, we must address many issues with which we have little or no experience which exposes our business to additional risk. Our foreign operations redirect management’s time from other operating issues. We may not be successful in operating our foreign subsidiaries. If we are unsuccessful in managing our foreign subsidiaries, the foreign subsidiaries could be unprofitable and negatively impact our resources and financial position.

We may not be able to sustain or increase profitability and we may seek additional financing to grow the business.

                Although we have generated profits during the periods of 2002 to 2007 and in the third quarter of 2011, we have incurred losses from 2008 through the second quarter of 2011, as well as in the fourth quarter of 2011, and have a history of losses.  We may not be able to regain, sustain or increase profitability on a quarterly or annual basis due to many factors including lower demand for our products by practitioners, for example, due to the weakening economy, the tightening of the credit market, and other factors. If our operating results fall below the expectations of investors or public market analysts, the price of our common stock could decline.

We may determine, depending upon the opportunities available, to seek additional debt or equity financing to fund the costs of expansion.  Additionally, if we incur indebtedness to fund increased levels of accounts receivable, finance the acquisition of capital equipment, or issue debt securities in connection with any acquisition, we will be subject to risks associated with incurring substantial additional indebtedness.
 
The liquidity and market value of our investments may decrease.
 
As of December 31, 2011, we held approximately $1.0 million of auction-rate securities (ARS). There have been disruptions in the market for auction-rate securities related to liquidity which has caused substantially all auctions to fail. All of our securities held as of December 31, 2011 failed in their last auction. We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until we sell the securities in a secondary market. In the event that we are unable to sell the underlying securities at or above par, these securities may not provide us a liquid source of cash in the future. At December 31, 2011, due to the uncertainty and illiquidity in this market, we have classified our auction-rate securities as non-current assets and have recorded a cumulative unrealized loss of $0.2 million, net of taxes in accumulated other comprehensive (loss) income. The recovery of these investments is based upon market factors which are not within our control. As of December 31, 2011, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.

 
25

 
Our common stock could be further diluted by the conversion of outstanding options, stock appreciation rights, restricted stock awards, and restricted stock units.
 
In the past, we have issued and still have outstanding convertible securities in the form of options, stock appreciation rights, restricted stock awards and restricted stock units.  We may continue to issue options, stock appreciation rights, restricted stock awards, restricted stock units, and other equity rights as compensation for services and incentive compensation for our employees, directors and consultants or others who provide services to us. We have a substantial number of shares of common stock reserved for issuance upon the conversion and exercise of these securities. Such a conversion would dilute our stockholders and could adversely affect the market price of our common stock.

Our business and operating results could be adversely affected if our third party data protection measures are not seen as adequate, there are breaches of our security measures, or unintended disclosures of our third party data.

As we conduct transactions online directly with customers and perform other processes necessary to operate our business, we may be the victim of fraudulent transactions, including credit card fraud, which presents a risk to our revenues and potentially disrupts service to our customers. In addition, we are collecting third party information, including personal information and credit card information. We take measures to protect and safeguard our third party data from unauthorized access or disclosure. Despite our best efforts, it is possible that our security controls over third party data may not prevent the improper access or disclosure of personally identifiable information. A security breach that leads to disclosure of third party information (including personally identifiable information) could harm our reputation, compel us to comply with disparate state breach notification laws and otherwise subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. A resulting perception that our company does not adequately protect the privacy of personal information could result in a loss of current or potential customers for our online offerings that require the collection of customer data. Our key business partners also face these same risks and we have no control over their security measures.  Any security breaches of these key business partners’ systems could adversely impact our ability to offer our products and services through their platforms, resulting in a loss of meaningful revenues.

If we are unable to protect our information technology infrastructure against service interruptions, data corruption, cyber-based attacks or network security breaches, our business and operating results may suffer.

We rely on information technology networks and systems, including the Internet, to process and transmit sensitive electronic information and to manage or support a variety of business processes and activities, including procurement and supply chain, manufacturing, distribution, and invoicing and collection of payments for our products. We use enterprise information technology systems to record, process, and summarize financial information and results of operations for internal reporting purposes and to comply with regulatory financial reporting, legal, and tax requirements. Our information technology systems, some of which are managed by third-parties, may be susceptible to damage, disruptions or shutdowns due to failures during the process of upgrading or replacing software, databases or components thereof, power outages, hardware failures, computer viruses, attacks by computer hackers, telecommunication failures, user errors or catastrophic events.  If our information technology systems suffer severe damage, disruption or shutdown and we are unable to effectively resolve the issues in a timely manner, our business and operating results may suffer.
 
Our charter documents, Delaware law and our shareholder rights plan may discourage potential takeover attempts.

                Our Second Restated Certificate of Incorporation and our Second Amended and Restated By-laws contain provisions that could discourage takeover attempts or make more difficult the acquisition of a substantial block of our common stock. Our By-laws require a stockholder to provide to our Secretary advance notice of director nominations and business to be brought by such stockholder before any annual or special meeting of stockholders, as well as certain information regarding such nomination and/or business, the stockholder and others known to support such proposal and any material interest they may have in the proposed business. They also provide that a special meeting of stockholders may be called only by the chairman of the board of directors, the affirmative vote of a majority of the board of directors or the chief executive officer. These provisions could delay any stockholder actions that are favored by the holders of a majority of our outstanding stock until the next stockholders’ meeting. In addition, the board of directors is authorized to issue shares of our common stock and preferred stock that, if issued, could dilute and adversely affect various rights of the holders of common stock and, in addition, could be used to discourage an unsolicited attempt to acquire control of us.

 
26

 

We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person becomes an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 may limit the ability of stockholders to approve a transaction that they may deem to be in their best interests. These provisions of our Second Restated Certificate of Incorporation, Second Amended and Restated By-laws and the Delaware General Corporation Law could deter certain takeovers or tender offers or could delay or prevent certain changes in control or our management, including transactions in which stockholders might otherwise receive a premium for their shares over the then current market price.

In April 1999, we adopted a shareholder rights agreement or “poison pill.”  This is intended to protect shareholders from unfair or coercive takeover practices. On October 28, 2008, we amended and restated the April 1999 shareholder rights agreement to (i) extend the expiration date to October 28, 2018, (ii) increase the purchase price to $200.00, (iii) amend the definition of “Acquiring Person” to exclude a “Person” qualified to file Schedule 13G as provided in the definition, (iv) amend the recitals to take account of the “Recapitalization” that occurred May 7, 1999, and (v) make any other additional changes deemed necessary.  For more information, please see the Amended and Restated Rights Agreement dated October 28, 2008 filed as an exhibit to our Current Report on Form 8-K filed October 31, 2008.

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

From time to time, we evaluate potential strategic acquisitions of complementary businesses, products or technologies, as well as 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. Any acquisition we pursue could diminish our cash available to us for other uses or be dilutive to our stockholders, and could divert management’s time and resources from our core operations.

Our stock price may be volatile.

Our common stock price may be volatile. The stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. The market price for our common stock may be influenced by many factors, including:
 
·  
acceptance and success of new products or technologies;
·  
the success of competitive products or technologies;
·  
regulatory developments in the United States and foreign countries;
·  
developments or disputes concerning patents or other foreign countries;
·  
the recruitment or departure of key personnel;
·  
variations in our financial results or those of companies that are perceived to be similar to us;
·  
market conditions in our industry and issuance of new or changed securities analyst’s reports or recommendations; and
·  
general economic, industry and market conditions.

Item 1B. Unresolved Staff Comments
 
None.
 
 
 
 
27

 
 
 
 
Item 2. Properties
 
Our corporate headquarters, which has approximately 130,000 square feet of office, manufacturing, and research space, is located in Burlington, Massachusetts.

As of December 31, 2011, we also lease the following space as office and service space for our foreign subsidiaries:

Location
Lease Expiration
Square Footage
     
The Netherlands
April 2013
1,500
Australia
October 2012
1,700
Japan
April 2012
2,150
Germany
April 2014
1,850
Spain
December 2013
4,400

We believe that all facilities are in good condition and are suitable and adequate for our current operations.

Item 3. Legal Proceedings
 
Candela Corporation, Massachusetts Litigation

On August 9, 2006, we commenced an action for patent infringement against Candela Corporation (acquired in 2010 by Syneron, Inc.) in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. During the course of this lawsuit, we and MGH alleged that certain Candela products, which use laser and lamp technology for hair removal willfully infringe U.S. Patent Nos. 5,735,844 (the “’844 patent”) and 5,595,568 (the “’568 patent”), which are exclusively licensed to us by MGH.

On September 15, 2011, Palomar and MGH entered into a comprehensive settlement agreement with Syneron, Inc., Syneron Medical Ltd., and Candela Corporation which ended the patent disputes between the companies, including this patent dispute.  The settlement agreement includes two Non-exclusive Patent License Agreements by Palomar with Candela and Syneron.  Under the first Agreement, Palomar granted to Candela and Syneron a non-exclusive, worldwide, fully paid-up, irrevocable license to U.S. Patent Nos. 5,735,844 and 5,595,568 and foreign counterparts for their professional laser- and lamp-based hair removal systems.  Under this Agreement, Candela and Syneron paid Palomar $31 million and granted to Palomar a royalty-free license to U.S. Patent Nos. 6,743,222 and 5,312,395 and U.S. and foreign counterparts for professional laser- and lamp-based systems.  Under the second Agreement, Palomar will grant to Syneron and affiliates a non-exclusive, royalty bearing, license in the United States to U.S. Patent Nos. 5,735,844 and 5,595,568 for consumer home-use lamp-based hair removal products.  Syneron will pay Palomar on sales in the United States a 5.0 percent royalty up to an undisclosed amount of cumulative sales, then 6.5 percent up to the next undisclosed amount of cumulative sales, and 7.5 percent on all cumulative sales thereafter.  In addition, Palomar will receive a royalty-free license to certain Syneron and Candela patents.

On August 10, 2006, Candela Corporation (acquired in 2010 by Syneron, Inc.) commenced an action for patent infringement against us in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief.  During the course of the lawsuit, Candela alleged that certain of our products infringed U.S. Patent No. 6,743,222 (the “’222 patent”) which is directed to acne treatment, and U.S. Patent No. 5,312,395 which is directed to treatment of pigmented lesions.  On September 15, 2011, Palomar and MGH entered into a comprehensive settlement agreement with Syneron, Inc., Syneron Medical Ltd., and Candela Corporation which ended the patent disputes between the companies, including this patent dispute.  The settlement agreement includes two Non-Exclusive Patent License Agreements under which, among other provisions, Candela and Syneron granted to Palomar a royalty-free license to the ‘222 and ‘395 patents and U.S. and foreign counterparts.

Syneron, Inc., Massachusetts Litigation

On November 14, 2008, we commenced an action for patent infringement against Syneron, Inc. in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. During the course of this lawsuit, we alleged that certain Syneron products, which use light-based technology for hair removal, willfully infringe the ‘568 patent and the ‘844 patent, which are exclusively licensed to us by MGH.  On September 15, 2011, Palomar and MGH entered into a comprehensive settlement agreement with Syneron, Inc., Syneron Medical Ltd., and Candela Corporation which ended the patent disputes between the companies, including this patent dispute.  The settlement agreement includes two Non-Exclusive Patent License Agreements by Palomar with Candela and Syneron.  Under the first Agreement, Palomar granted to Candela and Syneron a non-exclusive, worldwide, fully paid-up, irrevocable license to U.S. Patent Nos. 5,735,844 and 5,595,568 and foreign counterparts for their professional laser- and lamp-based hair removal systems.  Under this Agreement, Candela and Syneron paid Palomar $31 million and granted to Palomar a royalty-free license to certain Candela patents.  Under the second Agreement, Palomar will grant to Syneron and affiliates a non-exclusive, royalty bearing license in the United States to U.S. Patent Nos. 5,735,844 and 5,595,568 for consumer home-use lamp-based hair removal products.  Syneron will pay Palomar on sales in the United States a 5.0 percent royalty up to an undisclosed amount of cumulative sales, then 6.5 percent up to the next undisclosed amount of cumulative sales, and 7.5 percent on all cumulative sales thereafter.  In addition, Palomar will receive a royalty-free license to certain Syneron and Candela patents.

 
28

 
Tria Beauty, Inc., Massachusetts Litigation

On June 24, 2009, we commenced an action for patent infringement against Tria Beauty, Inc. (previously named Spectragenics, Inc.), in the United States District Court for the District of Massachusetts seeking both monetary damages and injunctive relief. The complaint alleged that the Tria System, which uses light-based technology for hair removal, willfully infringes the ‘844 patent, which is exclusively licensed to us by MGH.  Tria answered the complaint denying that its products infringe valid claims of the asserted patent and filing a counterclaim seeking a declaratory judgment that the asserted patent is not infringed, is invalid and not enforceable.  We filed a reply denying the material allegations of the counterclaims.  On September 21, 2009, following successful re-examination of the ‘568 patent, we filed a motion to amend our complaint to add a claim for willful infringement of the ‘568 patent, which is also exclusively licensed to us by MGH.  Our motion also included adding MGH as a plaintiff in the lawsuit.  A claim construction hearing (also known as a Markman hearing) was held on August 10, 2010, and we received what we consider to be a favorable ruling on October 13, 2010.  On January 25, 2011, Tria filed a second amended answer and counterclaim including another claim that the patents are unenforceable for inequitable conduct.  The parties are in discovery.  No trial date has yet been set.

Asclepion Laser Technologies GmbH, German Litigation

On October 13, 2010, we commenced an action for patent infringement against Asclepion Laser Technologies GmbH in the District Court of Düsseldorf, Germany seeking both monetary damages and injunctive relief.  The complaint alleged that Asclepion's MeDioStar and RubyStar products infringe European Patent Number EP 0 806 913, which is the first issued European patent corresponding to U.S. Patent Numbers 5,595,568 and 5,735,844.  On October 29, 2010, Asclepion asked the court to stay its proceedings until a final decision is rendered by the Court of Rome in Italy (see Asclepion Laser Technologies GmbH, Italian Litigation below) and until a final decision in the opposition proceedings is rendered by the European Patent Office.  On December 16, 2010, Asclepion filed an intervention to the opposition appeal proceedings concerning patent EP 0 806 913 requesting that the patent be revoked in its entirety.  On January 20, 2011, we agreed to Asclepion’s request for a stay of this lawsuit.  On January 31, 2011, the District Court of Düsseldorf stayed this lawsuit until a final decision is rendered by the Court of Rome in Italy.

Asclepion Laser Technologies GmbH, Italian Litigation

On October 22, 2010, we were served with an International Summons for a lawsuit filed September 20, 2010 by Asclepion Laser Technologies GmbH in the Court of Rome in Italy.  In this suit, Asclepion asks the Italian court to declare that Asclepion's MedioStar and RubyStar products do not infringe either the Italian or German portions of EP 0 806 913 B1 or EP 1 230 900 B1, which are the first two issued European patents corresponding to U.S. Patent numbers 5,595,568 and 5,735,844.  We believe the Court of Rome lacks jurisdiction over the German claims of these European Patents and have filed a request to the Italian Supreme Court challenging the international jurisdiction of the Italian Courts for deciding infringement of the non-Italian parts of the European patents.

Item 4. Mine Safety Disclosures.
 
Not applicable.


 
 29

 

PART II
 
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Our common stock is currently traded on the NASDAQ Global Select Market under the symbol PMTI. The following table sets forth the high and low sales prices of our common stock, as reported on the NASDAQ Global Select Market, for the periods indicated. Such quotations reflect inter-dealer prices, without retail markup, markdown or commission and do not necessarily represent actual transactions.

   
Fiscal Year 2010
 
   
High
   
Low
 
Quarter ended March 31, 2010
  $ 11.66     $ 8.92  
Quarter ended June 30, 2010
    13.47       9.70  
Quarter ended September 30, 2010
    11.71       8.73  
Quarter ended December 31, 2010
    14.94       10.22  

 
   
Fiscal Year 2011
 
   
High
   
Low
 
Quarter ended March 31, 2011
  $ 16.48     $ 13.33  
Quarter ended June 30, 2011
    16.01       9.65  
Quarter ended September 30, 2011
    11.81       7.31  
Quarter ended December 31, 2011
    9.36       7.50  

As of March 8, 2012, we had 2,789 holders of record of common stock.  This does not include holdings in street or nominee names.

We have not paid dividends to our common stockholders since our inception and do not plan to pay dividends to our common stockholders in the foreseeable future.  We intend to retain substantially all earnings to finance our operations.  On August 13, 2007, we announced the approval of a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock.  As of December 31, 2011, we have repurchased 675,500 shares of common stock at an average price of $13.68 per share under this program.  We repurchased 0, 0, and 35,000 shares during fiscal 2011, 2010, and 2009, respectively.  We may buy back additional shares of our common stock on the open market from time to time.
 
 
 

 
30 

 

Performance Graph
 
The following graph compares our cumulative total stockholder return (common stock price appreciation plus dividends, on a reinvested basis) over the last five fiscal years with the NASDAQ Stock Market Total Return Index and the NASDAQ Medical Devices Stocks Index.
 
Comparison of Five Year Cumulative Total Return *
Palomar Medical Technologies, Inc., NASDAQ Stock
Market Total Return, and NASDAQ Medical Devices Stocks
 
 
 
 
 
 
   
For the years ended December 31,
 
   
2006
   
2007
   
2008
   
2009
   
2010
   
2011
 
Palomar Medical Technologies, Inc.
  $ 100     $ 30     $ 23     $ 20     $ 28     $ 18  
NASDAQ Stock Market Total Return
  $ 100     $ 108     $ 66     $ 95     $ 113     $ 114  
NASDAQ Medical Devices Stocks
  $ 100     $ 127     $ 68     $ 100     $ 106     $ 122  

 
 
* Hypothetical $100 invested on December 31, 2006 in Palomar Medical Technologies, Inc. Stock, NASDAQ Stock Market Total Return Index, and NASDAQ Medical Devices Stock Index, assuming reinvestment of dividends, if any.
 
The information included under the heading “Performance Graph” in Item 5 of this Annual Report on Form 10-K is “furnished” and not “filed” and shall not be deemed to be “soliciting material” or subject to Regulation 14A, shall not be deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act.
 
 
 
 

 
 
  31

 

Item 6. Selected Financial Data
 
The following table sets forth selected consolidated financial data for each of the 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 in this annual report on Form 10-K. The historical results are not necessarily indicative of the results of operations to be expected in the future.
 
   
For the years ended December 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
 
   
(In thousands, except per share data)
 
Consolidated Statements of Operations Data:
                             
                               
Revenues:
                             
Professional product revenues
  $ 44,429     $ 38,269     $ 34,134     $ 55,650     $ 92,312  
Consumer product revenues
    3,554       -       -       -       -  
Service revenues
    15,135       15,248       14,711       13,729       10,909  
Royalty revenues
    38,097       5,898       4,891       10,520       13,005  
Funded product development revenues
    -       -       1,835       2,434       6,698  
Other revenues
    2,222       4,306       5,000       5,248       894  
Total revenues
    103,437       63,721       60,571       87,581       123,818  
                                         
Costs and expenses:
                                       
Cost of professional product revenues
    18,179       14,697       13,557       17,858       26,799  
Cost of consumer product revenues
    3,267       -       -       -       -  
Cost of service revenues
    6,838       5,835       7,112       7,360       6,592  
Cost of royalty revenues
    14,420       2,359       1,956       4,208       5,202  
Research and development
    15,644       15,458       14,679       17,693       16,673  
Selling and marketing
    25,624       20,013       19,337       23,340       24,886  
General and administrative
    8,728       14,550       11,254       20,516       17,495  
Total cost and expenses
    92,700       72,912       67,895       90,975       97,647  
                                         
Income (loss) from operations
    10,737       (9,191 )     (7,324 )     (3,394 )     26,171  
                                         
Interest income
    1,096       422       760       3,633       6,399  
Other (loss) income, net
    (299 )     297       544       (297 )     513  
                                         
Income (loss) before income taxes
    11,534       (8,472 )     (6,020 )     (58 )     33,083  
                                         
Provision for income taxes
    4,106       303       4,439       10       12,575  
                                         
Net income (loss)
  $ 7,428     $ (8,775 )   $ (10,459 )   $ (68 )   $ 20,508  
                                         
Net income (loss) per common share:
                                       
Basic
  $ 0.40     $ (0.47 )   $ (0.58 )   $ -     $ 1.12  
Diluted
  $ 0.39     $ (0.47 )   $ (0.58 )   $ -     $ 1.07  
                                         
Weighted average number of common shares outstanding:
                                       
                                         
Basic
    18,696       18,549       18,095       18,161       18,277  
Diluted
    18,942       18,549       18,095       18,161       19,254  
                                         
 
                                         
   
As of December 31,
 
      2011    
2010
 (restated)
      2009       2008       2007  
Consolidated Balance Sheet Data:
 
(In thousands)
 
                                         
Cash and cash equivalents
  $ 63,077     $ 55,099     $ 81,948     $ 122,601     $ 90,460  
Short-term investments
    24,740       34,017       25,000       -       -  
Available-for-sale investments, at estimated fair value
    -       -       -       -       41,910  
Working capital
    99,509       90,913       107,812       129,703       145,861  
Marketable securities, at fair value and other investments
    21,269       13,850       4,024       4,487       -  
Total assets
    178,061       159,578       163,470       171,722       167,607  
Debt
    -       -       -       6,000       -  
Total stockholders' equity
    154,641       139,294       143,627       146,805       144,690  
                                         
 

 
  32

 

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
We are a global medical device company engaged in research, development, manufacturing and distribution of proprietary light-based systems for medical and cosmetic treatments. Since our inception, we have been able to develop a differentiated product mix of light-based systems for various treatments through our research and development as well as with our partnerships throughout the world. We are continually developing and testing new indications to further the advancement in light-based treatments.
 
Our corporate headquarters and United States operations are located in Burlington, Massachusetts, where we conduct our manufacturing, warehousing, research and development, regulatory, sales, customer service, marketing and administrative activities.  In the United States, Australia, Canada, Japan, Germany, and Spain, we market, sell, and service our products primarily through our direct sales force and customer service employees.  In the rest of the world, sales are generally made through our worldwide distribution network in over 70 countries.
 
Financial Information
 
Consolidated revenues in 2011 were $103.4 million, up 62% from revenues of $63.7 million in 2010.  Consolidated revenues for 2011 include $29.8 million in royalty revenues as a result of the settlement of the Candela/Syneron litigation. We had operating income of $10.7 million and net income of $7.4 million, or $0.39 per diluted share, in 2011. These results compared with operating loss of $9.2 million and net loss of $8.8 million, or $0.47 per share, in 2010.
 
We generate revenues from the sales of our professional and consumer products, sales made from customer services, royalty payments received from our competitors, non-exclusive technology rights payments, and revenues received from funded product development.  The following table provides revenue percentage data for the years ended December 31, 2011, 2010, and 2009:
 
Year ended December 31,
 
2011
 
2010
 
2009
                   
Professional product revenues
    43 %     60 %     57 %
Consumer product revenues
    3 %     0 %     0 %
Service revenues
    15 %     24 %     24 %
Royalty revenues
    37 %     9 %     8 %
Other revenues
    2 %     7 %     8 %
Funded product development revenues
    0 %     0 %     3 %
                         
Total revenues
    100 %     100 %     100 %
 

 
 
  33

 

Geographic Information
 
We sell our Professional Product segment’s products directly in North America, Australia, Canada, Japan, Germany, and Spain and use distributors to sell our products in other countries where we do not have a direct presence. The following table provides the Professional Product segment’s product and service revenue data by geographical region for the years ended December 31, 2011, 2010, and 2009:

 
Year ended December 31,
2011
2010
2009
       
North America
58%
59%
61%
Europe
16%
19%
18%
Middle East
6%
4%
3%
Asia / Pacific Rim
6%
3%
2%
South and Central America
5%
6%
7%
Australia
5%
5%
6%
Japan
4%
4%
3%
       
Total
100%
100%
100%
       
 
All Consumer Product segment revenues are currently derived solely from sales in the United States.
 
Although 2011 was another challenging year, we were able to maintain a strong balance sheet.  As of December 31, 2011, we had $109.1 million of cash, cash equivalents, short-term investments, and marketable securities and other investments.  As of December 31, 2010, we had $103.0 million of cash, cash equivalents, short-term investments, and marketable securities and other investments.  Our stockholders’ equity increased year over year, mainly driven by our $7.4 million net income. Our current ratio (defined as current assets divided by current liabilities) is 5.9x, down from 6.2x at the end of 2010.  At December 31, 2011, we had no borrowings.
 
Critical accounting policies
 
Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which are prepared in accordance with accounting principles that are generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, related disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We continually evaluate our estimates and judgments, the most critical of which are those related to revenue recognition, available for sale and marketable securities valuation, accounts receivable valuation, inventory valuation, warranty provision, stock-based compensation, fair value measurements, income tax valuation, and contingencies. We base our estimates and judgments on historical experience and other factors that we believe to be reasonable under the circumstances. Materially different results can occur as circumstances change and additional information becomes known.
 
Revenue Recognition.  We recognize revenue in accordance with Securities and Exchange Commission (“SEC”) guidance on revenue recognition. The SEC’s guidance requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) is 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. Should changes in conditions cause management to determine that these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. We generally recognize product revenues upon shipment. If a product sale does not meet all of the above criteria, the revenue from the sale is deferred until all criteria are met. Provisions are made at the time of revenue recognition for any estimated return and applicable warranty costs expected to be incurred.
 
In our consumer products business, customer returns are recorded on an actual basis throughout the year and also include an estimate at the end of each reporting period for future customer returns related to sales recorded prior to the end of the period.  We generally estimate customer returns based upon the time lag that historically occurs between the date of the sale and the date of the return, while also factoring in any new business conditions that might impact the historical analysis, such as a new consumer product introduction.  We believe that our procedures for estimating such return amounts are reasonable.
 
 
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Periodically, we sell products together with a product upgrade option that requires that the customer pay an upgrade fee at the time of exercise, has no refund provisions and includes an expiration date on the upgrade option. In accordance with Accounting Standards Update No. 2009-13, Multiple-Delivery Revenue Arrangements (ASU 2009-13) , we defer the estimated selling price ascribed to the upgrade option until the expiration of the upgrade option or the exercise of the upgrade option and shipment of the product upgrade.
 
Revenues from the sale of service contracts is deferred and recognized on a straight-line basis over the life of the service contract. Revenues from services administered by us that are not covered by a service contract are recognized as the services are provided. In certain instances, we sell products together with service contracts. We recognize revenue on such multiple-element arrangements in accordance with ASU 2009-13, based on the estimated selling price of each element. In accordance with ASU 2009-13, we use vendor-specific objective evidence or VSOE, if available, to determine the selling price of each element.  If VSOE is not available, we use third-party evidence, or TPE to determine the selling price.  If TPE is not available, we use our best estimate to develop the estimated selling price.
 
We generally recognize royalty revenue from licensees upon receipt of cash payments since the royalty amounts are not determinable at the end of each quarter. Licensees are obligated to make payments to us between 30 and 45 days after the end of each quarter. If at the end of a quarter royalty revenue from licensees are determinable, we record royalty revenue during the period earned. Periodically, as we sign on new licensees, we recognize back-owed royalties in the period in which it is determinable and earned. We have the right under our license agreements to engage independent auditors to review the royalty calculations. The amounts owed as a result of these audits may be higher or lower than previously recognized.
 
We have other revenues which consist of quarterly technology transfer payments (“TTP Quarterly Payment” as defined in the License Agreement with Proctor & Gamble). TTP Quarterly Payments are being made by P&G during the term of the License Agreement up to and including the quarter in which P&G launches the first Licensed Product (as defined in the License Agreement). Thereafter, TTP and royalty payments will be based on product sales as set forth in the License Agreement. TTPs, including the TTP Quarterly Payments, are non-creditable and non-refundable and there is no right of offset.  On December 9, 2010, we announced an amendment to the License Agreement with P&G and Gillette. The amendment provides additional funding from each company to meet the common goal of a successful product launch. The amendment does not change the scope of P&G's non-exclusive license to Palomar's broad patent portfolio as well as its non-exclusive license to the extensive technology developed by Palomar prior to February 28, 2008 for home-use, light-based hair removal devices for women.  Under the amended License Agreement, the parties agreed to reduce pre-commercial launch calendar quarterly payments from $1.25 million to $1.0 million for the calendar quarter ending December 31, 2010 and thereafter to $2.0 million per year for an agreed period, after which the payments return to $1.25 million per calendar quarter if no product has been launched. P&G will apply the savings, together with agreed minimum overall program funding, to accelerating product readiness and commercialization while Palomar will be paid an increased percentage of sales after commercial launch.   The payments under the amended license agreement are being recognized ratably through the expected launch term.
 
In the past, we have had funded product development revenue from development agreements with Johnson & Johnson and P&G/Gillette. For both Johnson & Johnson and Gillette, we have received payments in accordance with the work plans that were developed with each of Johnson & Johnson and Gillette. Revenue was recognized under the contracts as costs were incurred and services were rendered. Any amounts received in advance of costs incurred and services rendered were recorded as deferred revenue. Payments were not refundable if the development was not successful.
 
    Marketable Securities and Other Investments. Marketable securities, which primarily consist of auction-rate preferred securities and auction-rate municipal securities are classified as “marketable securities” under Debt and Equity Securities Topic of the FASB Accounting Standards Codification and are recorded at fair market value. Any unrealized gains and losses, net of income tax effects, would be computed on the basis of specific identification and reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity. We evaluate unrealized losses to determine if the loss is other-than-temporary. If the loss is other-than-temporary, it is separated into two amounts, one amount representing a credit loss and the other representing an impairment due to all other factors. The amount representing a credit loss is recorded in earnings, while the remaining impairment is recorded as a component of accumulated other comprehensive income (loss), as we do not have the intent to sell the impaired investments, nor do we believe that it is more likely than not that we will be required to sell these investments before the recovery of their cost basis. We determined that the fair value of our auction-rate securities (“ARS”) was temporarily impaired as of December 31, 2011 and 2010.
 
In addition to the auction-rate preferred securities and auction-rate municipal securities discussed above, our other investments primarily consisted of corporate bonds, U.S. agency bonds, and U.S. Treasuries and were classified as held-to-maturity securities.  These other investments are recorded at amortized cost.  The amortized cost of these investments approximates fair market value.
 
 
 
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Accounts Receivable Reserves. Allowances for doubtful accounts are based on estimates of losses related to customer receivable balances. In establishing the appropriate provisions for customer receivable balances, we make assumptions with respect to their future collectability. Our assumptions are based on an individual assessment of a customer’s credit quality as well as subjective factors and trends, including the aging of receivable balances. Generally, these individual credit assessments occur prior to the inception of the credit exposure and at regular reviews during the life of the exposure and consider (a) a customer’s ability to meet and sustain their financial commitments; (b) a customer’s current and projected financial condition; (c) the positive or negative effects of the current and projected industry outlook; and (d) the economy in general. Once we consider all of these factors, a determination is made as to the probability of default. An appropriate provision is made, which takes into account the severity of the likely loss on the outstanding receivable balance based on our experience in collecting these amounts. Our level of reserves for our customer accounts receivable fluctuates depending upon all of the factors mentioned above. We provide an additional reserve for doubtful accounts based on the aging of our accounts receivable balances, historical experiences of write-offs, and defaults.
 
Inventory Reserves. As a designer and manufacturer, we may be exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, reliability and replacement of and the availability of key components from our suppliers. Our policy is to establish inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. Included in our inventory are demonstration products that are used by our sales organization. We account for such products as we do with any other finished goods item in our inventory in accordance with the review of our entire inventory. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values, and new product introductions. Assumptions used in determining our estimates of future product demand may prove to be incorrect, in which case the provision required for excess and obsolete inventory would have to be adjusted in the future. If inventory is determined to be overvalued, we would be required to recognize such as cost of goods sold at the time of such determination. Although we perform a detailed review of our forecasts of future product demand, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our reported operating results. Additionally, purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value.
 
Warranty Provision. We typically offer a one year warranty for our base professional and consumer products. We provide for the estimated cost of product warranties at the time product revenue is recognized. Factors that affect our warranty reserves include the number of units sold, historical and anticipated rates of warranty repairs and the cost per repair. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our estimated warranty obligation is affected by ongoing product failure rates, specific product class failures outside of our baseline experience, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Assumptions and historical warranty experience are evaluated to determine the appropriateness of such assumptions. We assess the adequacy of the warranty provision and we may adjust this provision if necessary.
 
Stock-Based Compensation. We recognize stock-based compensation expense in accordance with FASB Codification Topic regarding Stock Compensation.  This guidance requires share-based payments to employees, including grants of employee stock options, restricted stock awards, restricted stock units, and stock-settled stock appreciation rights (SARs) to be recognized in the statement of operations based on their fair values at the date of grant.

We use the Black-Scholes option pricing model to estimate the fair value of stock option and SAR grants. Key input assumptions used to estimate the fair value of stock options and SARs include the exercise price of the award, the expected option term, the expected volatility of our stock over the option or SAR’s expected term, the risk-free interest rate over the option or SAR’s expected term and our expected annual dividend yield. Expected volatilities are based on historical volatilities of our common stock; the expected life represents the weighted average period of time that options or SARs granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option or SAR. Our assumed dividend yield of zero is based on the fact that we have never paid cash dividends and currently have no intention to pay cash dividends.
 
 
36

 
 
If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods, or if we decide to use a different valuation model, the stock-based compensation expense we recognize in future periods may differ significantly from what we have recorded in the current period and could materially affect our income from operations, net income, and earnings per share. It may also result in a lack of comparability with other companies that use different models, methods, and assumptions. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. These characteristics are not present in our stock option and SAR grants. Existing valuation models, including the Black-Scholes model, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that our estimates of the fair values of our stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options and SARs, may expire with little or no intrinsic value compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, the value realized from these instruments may be significantly higher than the fair values originally estimated on the grant date and reported in our financial statements.
 
Fair Value Measurements. The performance of fair value measurements is an integral part of the preparation of financial statements in accordance with generally accepted accounting principles. Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants to sell or transfer such an asset or liability. Selection of the appropriate valuation technique, as well as determination of assumptions, risks and estimates used by market participants in pricing the asset or liability requires significant judgment. Although we believe that the inputs used in our valuation techniques are reasonable, a change in one or more of the inputs could result in an increase or decrease in the fair value of certain assets and certain liabilities and could have an impact on both our consolidated balance sheets and consolidated statements of operations.
 
To value our auction-rate securities, we determined the present value of the auction-rate securities at the balance sheet date by discounting the estimated future cash flows based on a fair value rate of interest and an expected time horizon to liquidity. As the secondary market for these investments is not currently very active or liquid, their valuation required management’s judgment.
 
Income taxes. Under FASB Accounting Standards Codification Topic regarding Income Taxes, we can only recognize a deferred tax asset for future benefit of our tax loss, temporary differences and tax credit carry forwards to the extent that it is more likely than not that these assets will be realized. Since 2008, we incurred operating losses in foreign jurisdictions. We believe that it is more likely than not that the associated tax asset will not be utilized. Therefore, we have established a full valuation allowance in 2010 and 2011 on this deferred tax asset.
 
In 2011 and 2010, we recorded a valuation allowance against our U.S. deferred tax assets. In evaluating the ability to recover these deferred tax assets, we considered all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies.  As a result of the resolution of the patent infringement lawsuits against Syneron, Inc., Syneron Medical Ltd., and Candela Corporation, we generated profits in the U.S. in 2011 which were partially offset by U.S. net operating loss carryforwards.  In assessing the need for a valuation allowance, we looked to our historic losses and our future profitability. We do not believe it is more likely than not that the net deferred tax assets will be realized.
  
In addition to the tax assets described above, we have deferred tax assets totaling approximately $18.5 million, related to excess tax deductions from the exercise of employee stock options. Recognition of these assets would occur upon utilization of these deferred tax assets to reduce taxes payable and would result in a credit to additional paid-in capital within stockholders’ equity. For 2011, 2010, and 2009, the impact to paid-in capital resulting from the exercise and expiration of employee stock options was $3.2 million, $0.2 million, and $0.4 million, respectively.
 
In evaluating the potential exposure associated with the various tax filing positions, we accrue charges for possible exposures. Based on the annual evaluations of tax positions, we believe we have appropriately filed our tax returns and accrued for possible exposures. To the extent we were to prevail in matters for which accruals have been established or be required to pay amounts in excess of reserves, our effective tax rate in a given financial period might be materially impacted.
 
 
37

 
 
Contingencies. The medical device market in which we participate is largely technology driven. As a result, intellectual property rights, particularly patents, play a significant role in product development and differentiation. However, intellectual property litigation is inherently complex and unpredictable. Furthermore, appellate courts can overturn lower court patent decisions.
 
In addition, competing parties may file suits to balance risk and exposure between the parties. Adverse outcomes in proceedings against us could limit our ability to sell certain products in certain jurisdictions, or reduce our operating margin on the sale of these products and could have a material adverse effect on our financial position, results of operations or liquidity.

In addition, although monetary and injunctive relief is typically sought, remedies and restitution are generally not determined until the conclusion of the trial court proceedings and can be modified on appeal. Accordingly, the outcomes of individual cases are difficult to time, predict or quantify.
 
We are not insured with respect to intellectual property infringement and maintain an insurance policy providing limited coverage against securities claims and product liability claims. The absence of significant third-party insurance coverage increases our potential exposure to unanticipated claims or adverse decisions.

We continually assess litigation to determine if an unfavorable outcome would lead to a probable loss or reasonably possible loss which could be estimated.  In accordance with the FASB’s guidance on accounting for contingencies, we accrue for all direct costs associated with the estimated resolution of contingencies at the earliest date at which it is deemed probable that a liability has been incurred and the amount of such liability can be reasonably estimated.  If the estimate of a probable loss is a range and no amount within the range is more likely, we accrue the minimum amount of the range.  In the cases where we believe that a reasonably possible loss exists, we disclose the facts and circumstances of the litigation, including an estimable range, if possible.  In management’s opinion, we are not currently involved in any legal proceedings which, individually or in the aggregate, could have a material effect on our financial statements.  Losses associated with any of our current litigation as discussed in detail in “Item 3. Legal Proceedings” were remote at the time of the filing and as such, we have not recorded any material loss contingencies related to such litigation.
 
We expense patent defense costs, costs for pursuing patent infringements, and external legal costs related to intangible assets in the period which they are incurred.
 
 
 
 
 
 
38

 
 
Results of operations
 
Year 2011 Compared to Year 2010
 
     
2011
 
2010
 
2011 vs. 2010
   
Amount
 
As a % of
Total Revenues
   
Amount
   
As a % of
Total Revenues
   
Change
   
%
Change
 
Revenues:
                                 
Professional product revenues
  $ 44,429     43 %   $ 38,269       60 %    $ 6,160       16 %
Consumer product revenues
    3,554     3 %     -       0 %     3,554       N/A  
Service revenues
    15,135     15 %     15,248       24 %     (113 )     (1 %)
Royalty revenues
    38,097     37 %     5,898       9 %     32,199       546 %
Other revenues
    2,222     2 %     4,306       7 %     (2,084 )     (48 %)
                                               
Total revenues
    103,437     100 %     63,721       100 %     39,716       62 %
                                               
Cost and expenses:
                                             
Cost of professional product revenues
    18,179     18 %     14,697       23 %     3,482       24 %
Cost of consumer product revenues
    3,267     3 %     -       0 %     3,267       N/A  
Cost of service revenues
    6,838     7 %     5,835       9 %     1,003       17 %
Cost of royalty revenues
    14,420     14 %     2,359       4 %     12,061       511 %
Research and development
    15,644     15 %     15,458       24 %     186       1 %
Selling and marketing
    25,624     25 %     20,013       31 %     5,611       28 %
General and administrative
    8,728     8 %     14,550       23 %     (5,822 )     (40 %)
                                               
Total costs and expenses
    92,700     90 %     72,912       114 %     19,788       27 %
                                               
Income (loss) from operations
    10,737     10 %     (9,191 )     (14 %)     19,928       217 %
                                               
Interest income
    1,096     1 %     422       1 %     674       160 %
Other (loss) income
    (299 )   0 %     297       0 %     (596 )     (201 %)
                                               
Income (loss) before income taxes
    11,534     11 %     (8,472 )     (13 %)     20,006       236 %
                                               
Provision for income taxes
    4,106     4 %     303       0 %     3,803       1255 %
                                               
Net income (loss)
  $ 7,428     7 %   $ (8,775 )     (14 %)    $ 16,203       185 %
 
    Professional product revenues. Throughout 2011, the aesthetic laser industry and our professional product revenues continued to be negatively affected by the downturn in the global economy. In both 2011 and 2010, professional sales of our StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces remained the leading contributor to our product revenues.  We launched the Acleara™ Acne Clearing System during the first half of 2011 and the Icon Aesthetic System during the second half of 2011.  More than 40% of our professional product revenues in the fourth quarter were from Icon sales.  We are still in the registration process for many countries and will continue to sell the StarLux 500® system. In 2010, we launched the Artisan Platform, a complete facial rejuvenation system.  Shipments began in the second quarter of 2010.  In 2011, as compared to 2010, professional product revenues were favorably impacted by the introduction of the Icon and Acleara, but this impact was partially offset by a decrease in sales related to the StarLux Laser and Pulsed Light System as some potential StarLux customers opted to purchase the new Icon.
 
Consumer product revenues. During the fourth quarter of 2010, we launched the PaloVia® Skin Renewing Laser® -- our first consumer product.  Since we were selling the PaloVia laser through retail channels with which we had no history and were unable to estimate the customer return rates and the expected warranty accrual needed on sales of our consumer product, we deferred all consumer product revenues from the PaloVia laser until the fourth quarter of 2011.  During the fourth quarter of 2011, we determined that we had sufficient history to be able to estimate our customer return rates and the expected warranty accrual needed on sales of our consumer product.  In the fourth quarter of 2011, we recognized $3.5 million of consumer product revenues related to the PaloVia laser.
 
Service revenues. Service revenues are primarily comprised of revenue generated from our service organization to provide ongoing service, sales of replacement handpieces, sales of consumables and accessories, and billable repairs of our professional products. Customer service revenues decreased by 1% in 2011 as compared to 2010, primarily due to lower sales from replacement handpieces, consumables, and accessories.
 
 
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The following table sets forth, for the periods indicated, information about our total Professional Product segment’s product and service revenues, by geographic region:
 
Year ended December 31,
 
2011
 
2010
         
North America
    58%     59%
Europe
    16%     19%
Middle East
    6%     4%
Asia / Pacific Rim
    6%     3%
South and Central America
    5%     6%
Australia
    5%     5%
Japan
    4%     4%
             
Total
    100%     100%
             

All Consumer Product segment revenues are currently derived solely from sales in the United States.
 
In March 2011, Japan experienced an earthquake and tsunami which has had a significant impact on Japan’s economy and infrastructure. During 2011, 4% of our product and service revenue was generated from Japan. Since the earthquake and tsunami occurred toward the end of the first quarter, we believe that these events did not seriously impact our consolidated financial statements for the first quarter of 2011. None of our assets were damaged.  We also believe that these events did not seriously impact our consolidated financial statements for any of the quarters during the year ended December 31, 2011. However, in the coming quarters, we may experience a decrease in demand for our products and services in Japan and an insignificant impact on our consolidated financial statements and continuing operations as Japan struggles to rebuild its economy and infrastructure. The decrease in demand will be difficult to quantify, but is currently not expected to have a significant impact on our consolidated financial statements. We will continue to assess the effect of the earthquake and tsunami on the Company’s consolidated financial statements and will disclose any significant effects as necessary.
 
Royalty revenues. Royalty revenues increased by 546% in 2011 as compared to 2010.  The increase was mainly attributable to the $29.8 million in royalty revenues we received from Candela/Syneron as a result of the resolution of the patent infringement lawsuits against Syneron, Inc., Syneron Medical Ltd., and Candela Corporation.  The $29.8 million is compensation for back-owed royalties for sales of professional laser-and lamp-based systems beginning with Candela and Syneron’s sales in August 2000 through September 30, 2011 plus estimated future royalties owed through the expiration of U.S. Patent 5,595,568 and 5,735,844 and corresponding foreign counterparts (“the Anderson Patents”) in February 2015.  Excluding the $29.8 million, royalty revenues increased 41% for the year ended December 31, 2011 over the year ended December 31, 2010.  We believe that the use of this non-GAAP revenues disclosure enhances our ability to conduct period-to-period analyses for our results.  The increase is a result of an increase in on-going royalty payments from our licensees and a $1.1 million back-owed royalty payment in the first quarter of 2011.
 
Other revenues. Other revenues decreased by 48% in 2011 as compared to 2010. In 2011, other revenues of $2.2 million related to payments received under an amendment to our license agreement with P&G (“the License Agreement”) that was signed in the fourth quarter of 2010.  The payments under the amended License Agreement are being recognized ratably through the expected launch term.  In 2010, other revenues consisted of three quarterly payments of $1.25 million pursuant to a license agreement with P&G plus the recognition of $0.6 million of the $1.0 million payment pursuant to the amendment to the License Agreement with P&G in the fourth quarter.
 
Cost of professional product revenues. The cost of professional product revenues increased in absolute dollars and as a percentage of professional product revenues to 41% in 2011 from 38% in 2010. The increase in absolute dollars was attributable to higher product revenues. Our cost of professional product revenues consists primarily of material, labor and manufacturing overhead expenses. Cost of professional product revenues also includes royalties incurred on certain products sold, warranty expenses, as well as payroll and payroll-related expenses, including stock-based compensation, and quality control.
 
 
 
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        Cost of consumer product revenues. The cost of consumer product revenues relates to the PaloVia® Skin Renewing Laser®.  For the year ended December 31, 2011, cost of consumer product revenues was $3.3 million, or 92% of consumer product revenues.  Since we were selling the PaloVia laser through retail channels with which we had no history and were unable to estimate the customer return rates and the expected warranty accrual needed on sales of our consumer product, we deferred all consumer product revenues from the PaloVia laser until the fourth quarter of 2011.  During the fourth quarter of 2011, we determined that we had sufficient history to be able to estimate our customer return rates and the expected warranty accrual needed on sales of our consumer product.  In the fourth quarter of 2011, we recognized $3.5 million of consumer product revenues related to the PaloVia laser and the related expenses.
 
Cost of service revenues. The cost of service revenues increased in absolute dollars and as a percentage of service revenues to 45% in 2011 from 38% in 2010. The increase is due to an increase in labor costs as headcount has grown to be in line with our growing product base, the opening of our new offices in Germany and Spain, and higher shipping expenses during 2011.
 
Cost of royalty revenues. The cost of royalty revenues increased in absolute dollars, but decreased as a percentage of royalty revenues to 38% in 2011 from 40% in 2010.  The increase in absolute dollars is mainly attributed to the royalty revenues received from Candela/Syneron as a result of the resolution of the patent infringement lawsuits against Syneron, Inc., Syneron Medical Ltd., and Candela Corporation.  Excluding the effect of the royalty revenues received from Candela/Syneron of $11.1 million, cost of royalty revenues increased by 41% for the year ended December 31, 2011 as compared to the year ended December 31, 2010. We believe that the use of this non-GAAP cost of royalty revenues disclosure enhances our ability to conduct period-to-period analyses for our results.  The increase is a result of an increase in on-going royalty payments from our licensees and a $1.1 million back-owed royalty payment in the first quarter of 2011.
 
Research and development expense. Research and development expense increased in absolute dollars, but decreased as a percentage of total revenues to 15% in 2011 from 24% in 2010.   Excluding the effect of the $29.8 million in royalty revenues received from Candela/Syneron, research and development expense decreased as a percentage of total revenues to 21% in 2011 from 24% in 2010.  We believe that the use of this non-GAAP research and development expense disclosure enhances our ability to conduct period-to-period analyses for our results.  The increase in research and development expense was a direct result of our continued commitment to introducing new products and enhancing our current family of products.
 
Research and development expenses relating to our Professional Product segment increased by 58% for the year ended December 31, 2011, as compared to 2010. Research expenses relating to our Professional Product segment include internal research and development projects relating to the introduction of new professional products and enhancements to our current line of professional products.  Research and development expense relating to our Consumer Product segment decreased by 87% for the year ended December 31, 2011, as compared to 2010. This decrease in research and development expense related to our Consumer Product segment includes decreases in payroll and payroll related expense, materials, consultants, and other overhead expenses related directly to our consumer products as compared to 2010.
 
For the years ended December 31, 2011 and 2010, research and development expense included $1.5 million and $1.8 million, respectively, of stock-based compensation expense.
 
Selling and marketing expense. Selling and marketing expense increased in absolute dollars, but decreased as a percentage of total revenues to 25% in 2011 from 31% in 2010.  Excluding the effect of the $29.8 million in royalty revenues received from Candela/Syneron, selling and marketing expense increased as a percentage of total revenues to 35% in 2011 from 31% in 2010.  We believe that the use of this non-GAAP selling and marketing expense disclosure enhances our ability to conduct period-to-period analyses for our results.  Selling and marketing expenses relating to our Professional Product segment increased by 24% in 2011 as compared to 2010.   The increase was primarily driven by increases of $2.1 million from our foreign subsidiaries in Germany and Spain that we established in 2011, $0.7 million in commissions due to higher revenues, and $0.7 million in higher payroll and payroll related expenses.   Selling and marketing expenses related to our Consumer Product segment increased by 70% in 2011 over 2010.  The increase was primarily driven by increases of $0.8 million in direct marketing expenses and $0.3 million in payroll and payroll related expenses.
 
For the years ended December 31, 2011 and 2010, selling and marketing expense included $1.0 million and $0.9 million, respectively, of stock-based compensation expense.
 
General and administrative expense.  General and administrative expense decreased in absolute dollars and as a percentage of total revenues to 8% in 2011 from 23% in 2010. Excluding the effect of the $29.8 million in royalty revenues received from Candela/Syneron and the $6.6 million of partial legal reimbursement, general and administrative expense decreased as a percentage of total revenues to 21% in 2011 from 23% in 2010.  We believe that the use of this non-GAAP general and administrative expense disclosure enhances our ability to conduct period-to-period analyses for our results.  The decrease in general and administrative expense as a percentage of total revenues was driven by the inclusion of both the remaining lease obligation at our old facility and the depreciation and other expenses related to our new facility during the year ended December 31, 2010.
 

 
 41

 
 
For the years ended December 31, 2011 and 2010, general and administrative expense included $0.7 million and $0.7 million, respectively, of stock-based compensation expense.
 
Interest income. Interest income increased by 160% in 2011 as compared to 2010 primarily from $0.7 million in imputed interest income, net of 40% owed to MGH, received as a result of the resolution of the patent infringement lawsuits against Syneron, Inc., Syneron Medical Ltd., and Candela Corporation.  Excluding the $0.7 million in imputed interest income, for the year ended December 31, 2011, interest income decreased by 15% as compared to the year ended December 31, 2010.  We believe that the use of this non-GAAP interest income disclosure enhances our ability to conduct period-to-period analyses for our results.  This is primarily due to a lower average cash and cash equivalents, short-term investments, and marketable securities and other investments balance in 2011 as compared to 2010.
 
Other (loss) income. Other (loss) income for the years ended December 31, 2011 and 2010 includes the foreign exchange (loss) gain as a result of transactions in currencies other than the U.S. dollar.
 
Provision for income taxes. Our effective tax rate for 2011 was 36% as compared to an effective tax rate of 4% for 2010. Our 2011 effective tax rate is greater than the statutory rate primarily due to our profits in 2011 in the U.S. and generating current federal and state taxes. We were only able to partially offset our U.S income tax with our remaining net operating loss carryforwards available in 2011.  We continue to maintain a full valuation allowance in all jurisdictions and have available net operating losses in foreign jurisdictions to offset future income in those jurisdictions.  In 2010, our effective tax rate consisted of an expense related to a reduction of a previously recorded federal tax refund claim and state income taxes.
 
 
 
 
 
 
 
 
42

 
 

 Year 2010 Compared to Year 2009

   
2010
 
2009
 
2010 vs. 2009
   
Amount
 
As a % of Total Revenues
   
Amount
As a % Total
 Revenues
 
Change
%
Change
Revenues:
                             
Professional product revenues
  $ 38,269   60 %   $ 34,134   56 %   $ 4,135   12 %
Service revenues
    15,248   24 %     14,711   24 %     537   4 %
Royalty revenues
    5,898   9 %     4,891   8 %     1,007   21 %
Funded product development revenues
    -   0 %     1,835   3 %     (1,835 ) (100 %)
Other revenues
    4,306   7 %     5,000   8 %     (694 ) (14 %)
                                     
Total revenues
    63,721   100 %     60,571   100 %     3,150   5 %
                                     
Cost and expenses:
                                   
Cost of professional product revenues
    14,697   23 %     13,557   22 %     1,140   8 %
Cost of service revenues
    5,835   9 %     7,112   12 %     (1,277 ) (18 %)
Cost of royalty revenues
    2,359   4 %     1,956   3 %     403   21 %
Research and development
    15,458   24 %     14,679   24 %     779   5 %
Selling and marketing
    20,013   31 %     19,337   32 %     676   3 %
General and administrative
    14,550   23 %     11,254   19 %     3,296   29 %
                                     
Total costs and expenses
    72,912   114 %     67,895   112 %     5,017   7 %
                                     
Loss from operations
    (9,191 ) (14 %)     (7,324 ) (12 %)     (1,867 ) 25 %
                                     
Interest income
    422   1 %     760   1 %     (338 ) (44 %)
Other income
    297   0 %     544   1 %     (247 ) (45 %)
                                     
Loss before income taxes
    (8,472 ) (13 %)     (6,020 ) (10 %)     (2,452 ) 41 %
                                     
Provision for income taxes
    303   0 %     4,439   7 %     (4,136 ) (93 %)
                                     
Net loss
  $ (8,775 ) (14 %)   $ (10,459 ) (17 %)   $ 1,684   (16 %)

Professional product revenues. Throughout 2010, the aesthetic laser industry and our professional product revenues continued to be negatively affected by the downturn in the global economy. In both 2010 and 2009, sales of our StarLux Laser and Pulsed Light Systems, including a base unit and multiple, optional handpieces remained the leading contributor to our professional product revenues.  In 2010, we launched the Artisan Platform, a complete facial rejuvenation system.  Shipments began in the second quarter of 2010.  In 2010, professional product revenues were favorably impacted by an increase of 14% in sales related to the StarLux Laser and Pulsed Light System, an increase of 48% in sales related to our other “Lux” family of products, which includes the MediLux and EsteLux, and the introduction of the Artisan Platform, offset in part by a decrease of 21% from sales related to the Aspire body sculpting system and SlimLipo handpiece and a decrease of 8% from sales related to the Q-Yag 5 product line as compared to 2009.
 
During the fourth quarter of 2010, we launched the PaloVia™ Skin Renewing Laser™ -- our first consumer product.  The PaloVia laser is the first FDA-cleared, at-home laser clinically proven to reduce fine lines and wrinkles around the eyes. Since we were selling the PaloVia laser through retail channels with which we had no history and were unable to better estimate the customer return rates and the expected warranty accrual needed on sales of our consumer product, we deferred all consumer product revenues from the PaloVia laser as of December 31, 2010.
 
Service revenues. Service revenues are primarily comprised of revenue generated from our service organization to provide ongoing service, sales of replacement handpieces, sales of consumables and accessories, and billable repairs of our products. Customer service revenues increased by 4% in 2010 as compared to 2009, primarily in sales from replacement handpieces, consumables, and accessories.
 
 
43

 
 
The following table sets forth, for the periods indicated, information about our total Professional Product segment product and service revenues, by geographic region:
 
Year ended December 31,
2010
2009
     
North America
59%
61%
Europe
19%
18%
South and Central America
6%
7%
Australia
5%
6%
Japan
4%
3%
Middle East
4%
3%
Asia / Pacific Rim
3%
2%
     
Total
100%
100%
     
 
Royalty revenues. Royalty revenues increased by 21% in 2010 as compared to 2009, due to our licensed competitors’ increasing product revenues, resulting in increased royalties.
 
Funded product development revenues. Funded development revenues were $0 and $1.8 million for 2010 and 2009, respectively.  Funded product development revenues in 2009 were generated from our development agreements with Johnson & Johnson.  The Joint Development and License Agreement with Johnson & Johnson terminated in the fourth quarter of 2009.
 
Other revenues. Other revenues decreased by 14% in 2010 as compared to 2009. In 2010, other revenues of $4.3 million consisted of three quarterly payments of $1.25 million relating to a license agreement with P&G plus the recognition of $0.6 million of the $1.0 million payment related to an amendment to the license agreement with P&G which was signed in the fourth quarter of 2010.  The payments under the amended license agreement are being recognized ratably through the expected launch term.  In 2009, other revenues of $5.0 million consisted of four quarterly payments of $1.25 million relating to a license agreement with P&G.
 
Cost of professional product revenues. The cost of professional product revenues increased in absolute dollars, but decreased as a percentage of professional product revenues to 38% in 2010 from 40% in 2009. The increase in absolute dollars was attributed to higher professional product revenues. The decrease as a percentage of professional product revenues was due to higher professional product sales which resulted in higher overhead absorption, offset by a shift in professional product sales to outside North America, where we have lower margins.
 
Cost of service revenues. The cost of service revenues decreased in absolute dollars and as a percentage of service revenues to 38% in 2010 from 48% in 2009. The decrease is due in part to the improved absorption of fixed service costs and the continued growth of service contract revenue. We have been able to convert a high percentage of our domestic installed base to service contracts upon the expiration of the warranty periods. In addition, the failure rates in certain of our products have decreased.
 
Cost of royalty revenues. As a percentage of royalty revenues, the cost of royalty revenues was consistent at 40% in accordance with our license agreement with MGH for 2010 and 2009. The increase in the cost of royalty revenues in absolute dollars during 2010 as compared to 2009 was due to our licensed competitors’ increasing product revenues, resulting in increased royalties they owe to us.
 
Research and development expense. Research and development expense increased in absolute dollars, but remained consistent as a percentage of total revenues at 24% in 2010 and 2009.  The increase in research and development expense was a direct result of our continued commitment to introducing new products and enhancing our current family of products.
 
Research and development expenses relating to our Professional Product segment decreased by 13% for the year ended December 31, 2010, as compared to 2009. Research expenses relating to our Professional Product segment include internal research and development projects relating to the introduction of new professional products and enhancements to our current line of professional products.  Research and development expense relating to our Consumer Product segment increased by 58% for the year ended December 31, 2010, as compared to 2009. This increase in research and development expense related to our Consumer Product segment includes increases in payroll and payroll related expense, materials, consultants, and other overhead expenses related directly to our consumer products as compared to 2009.
 
 
44

 
 
For the years ended December 31, 2010 and 2009, research and development expense included $1.8 million and $2.5 million, respectively, of stock-based compensation expense.
 
Selling and marketing expense. Selling and marketing expense increased in absolute dollars, but decreased as a percentage of total revenues to 31% in 2010 from 32% in 2009.  The increase in selling and marketing expense was primarily due to our expenses related to our Consumer Product segment.  We did not incur any selling and marketing expenses related to our Consumer Product segment in 2009.  We also had an increase of $0.7 million in commissions related to our Professional Product segment due to increased revenues.  Partially offsetting the increase were decreases of $1.1 million in direct marketing expenses, $0.4 million from tradeshows, seminars, and workshops, and $0.3 million from payroll and payroll related expenses.
 
For the years ended December 31, 2010 and 2009, selling and marketing expense included $0.9 million and $1.7 million, respectively, of stock-based compensation expense.
 
General and administrative expense.  General and administrative expense increased in absolute dollars and as a percentage of total revenues to 23% in 2010 from 19% in 2009. The increase in general and administrative expense was mainly attributed to increases in our corporate legal expenses of $2.5 million, $0.8 million in incentive compensation, and $0.2 million in bad debt expense.  The year ended December 31, 2010 includes the remaining lease obligation at our old facility in addition to depreciation and other expenses related to our new facility.
 
For the years ended December 31, 2010 and 2009, general and administrative expense included $0.7 million and $2.1 million, respectively, of stock-based compensation expense.
 
Interest income. Interest income decreased in 2010 as compared to 2009 primarily from lower cash and cash equivalents, short-term investments, and marketable securities and other investments balances and lower interest rates.  The decline in our cash and cash equivalents, short-term investments, and marketable securities and other investments balance is primarily from costs associated with the construction of our new operational facility in 2009 and 2010 and our investment in our entrance into the consumer product market in 2010.
 
Other income. Other income for the years ended December 31, 2010 and 2009 includes the foreign exchange gain as a result of transactions in currencies other than the U.S. dollar.
 
Provision for income taxes. Our effective tax rate for 2010 was 4% as compared to an effective tax rate of 74% for 2009. In 2009, our effective tax rate was more than the combined federal and state statutory rates primarily due to a valuation allowance established against our U.S. deferred tax assets. In evaluating the ability to recover these deferred tax assets, we considered available positive and negative evidence, giving greater weight to the recent current loss, the absence of taxable income in the carry back period, and the uncertainty regarding our ability to project financial results in future periods.
 
Liquidity and capital resources
 
The following table sets forth, for the periods indicated, a year-over-year comparison of key components of our liquidity and capital resources (in thousands).
 
               
2011 to 2010
         
Restated
     $      
Year ended December 31,
 
2011
   
2010
   
Change
   
Change
 
                         
Cash flows from (used in) operating activities
  $ 4,136     $ (4,204 )   $ 8,340     198 %
Cash flows from investing activities
    407       23,021       (22,614 )   (98 %)
Cash flows from financing activities
    3,402       267       3,135     1174 %
Capital expenditures, including construction in process
    979       3,841       (2,862 )   (75 %)
                               
                               
 
 
 
45

 
 
Additionally, our cash, cash equivalents and short-term investments, accounts receivable, inventories, marketable securities and other investments, and working capital are shown below for the periods indicated (in thousands).
 
               
2011 to 2010
         
Restated
     $  
At December 31,
 
2011
   
2010
   
Change
 
Change
                       
Cash, cash equivalents and short-term investments
  $ 87,817     $ 89,116     $ (1,299 ) (1 %)
Accounts receivable, net
    9,854       5,350       4,504   84 %
Inventories, net
    21,176       13,021       8,155   63 %
Marketable securities and other investments
    21,269       13,850       7,419   54 %
Working capital
    99,509       90,913       8,596   9 %
                             

As of December 31, 2011, we had $109.1 million in cash, cash equivalents, short-term investments, and marketable securities and other investments.  We believe that our current cash balances and expected future cash flows will be sufficient to meet our anticipated cash needs for working capital, capital expenditures, and other activities for at least the next twelve months. As of December 31, 2011, we had no debt outstanding.

At December 31, 2011, we held $1.0 million in auction-rate securities (“ARS”) all of which were preferred municipal securities. The ARS we invest in are high quality securities, none of which are mortgage-backed. Beginning in February 2008, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets.  We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market. As our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current as of December 31, 2011 and 2010. During 2011, 2010, and 2009, we sold $0.9 million, $2.1 million, and $0.7 million of our ARS at par, respectively.
 
We have determined that the fair value of our ARS was temporarily impaired as of December 31, 2011 and 2010. For the years ended December 31, 2011 and 2010, we marked to market our ARS and recorded an unrealized gain of $0.1 million and unrealized loss of $0.1 million, respectively, net of taxes in accumulated other comprehensive (loss) income in stockholder’s equity to reflect the temporary impairment of our ARS. The recovery of these investments is based upon market factors which are not within our control. As of December 31, 2011, we do not intend to sell the ARS and it is not more likely than not that we will be required to sell the ARS before recovery of their amortized cost bases, which may be at maturity.
 
Cash from (used in) operating activities increased for the year ended December 31, 2011 as compared to the year ended December 31, 2010. This increase primarily reflects the effects of moving from a net loss to a net income position, partially offset by increases in the non-cash tax benefit from the exercise of equity and the working capital requirements. Cash used in investing activities decreased during 2011 compared to 2010. These amounts primarily reflect less cash used for purchases of property and equipment (including construction in progress) and purchases of and proceeds from the sale of short-term investments and marketable securities. Cash provided by financing activities increased for the year ended December 31, 2011 as compared to the year ended December 31, 2010. This increase was primarily due to an increase in the tax benefit from the exercise of equity.
 
We anticipate that capital expenditures for 2012 will total approximately $1.0 million, consisting primarily of expenditures for the purchase of information technology equipment, furniture and fixtures, software, and machinery. We expect to finance these expenditures with cash on hand.
 
On August 13, 2007, our board of directors approved a stock repurchase program under which our management is authorized to repurchase up to one million shares of our common stock. At December 31, 2011, 675,500 shares of common stock had been repurchased under this program, leaving 324,500 remaining to be repurchased, if desired. The timing and actual number of shares purchased will depend on a variety of factors such as price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. Stock repurchases under this program, if any, will be made using our cash resources, and may be commenced or suspended at any time or from time to time at management’s discretion without prior notice.  During the year ended December 31, 2011, we did not purchase any of our common stock.
 
 
46

 

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 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. As of December 31, 2011, we were not involved in any unconsolidated transactions.
 
Contractual obligations
 
We are a party to three patent license agreements with MGH under which we are obligated to pay royalties to MGH for sales of certain products as well as a percentage of royalties received from third parties. Royalty expense for 2011, 2010 and 2009 totaled approximately $15.0 million, $2.9 million, and $2.4 million, respectively.  For more information, please see the Amended and Restated License Agreement (MGH Case Nos. 783, 912, 2100), the License Agreement (MGH Case No. 2057) and the License Agreement (MGH Case No. 1316) filed as Exhibits 10.1, 10.2, and 10.3 to our Current Report on Form 8-K filed on March 20, 2008.
 
We have obligations related to the adoption of FASB Accounting Standards Codification Topic regarding Income Taxes. Further information about changes in these obligations can be found in Note 3 to our consolidated financial statements included in this annual report on Form 10-K.

We are obligated to make future payments under various contracts, including non-cancelable inventory purchase commitments.
 
On November 19, 2008, we purchased land for $10.7 million on which we built our new operational facility.  Construction of the building was completed and the building was placed in service during the first quarter of 2010.  We financed the project by using cash on hand.  We vacated our old facility during the first quarter of 2010 and incurred a charge of $1.2 million relating to the write-off of our remaining lease obligation.
 
The following table summarizes our estimated contractual cash obligations as of December 31, 2011, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):
 
 
 
Payments due by period
 
Contractual obligations
   
Total
Less than
1 year
1-3
years
3-5
years
More than
5 years
Purchase commitments
$
8,174
$
8,174
$
-
$
-
$
-
Operating leases
 
380
 
233
 
146
 
-
 
-
Total contractual obligations
$
8,554
$
8,407
$
146
$
-
$
-

Our purchase commitments, which are primarily inventory related, have increased from recent years due to our entry into the consumer market.
 
Recently issued accounting standards
 
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. The amendments intend to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards.  The guidance changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements.  The new amendments will be effective for interim and annual periods beginning after December 15, 2011.  We are currently evaluating the impact of this guidance on our financial statements.
 
In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income.  In this ASU, the FASB amended its guidance on the presentation of comprehensive income in financial statements to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items that are recorded in other comprehensive income.  The new accounting guidance requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements.  The provisions of this new guidance are effective for interim and annual periods beginning after December 15, 2011.  We retroactively adopted this guidance during the third quarter of 2011 and the impact on our financial statements was not material.  ASU 2011-05 addresses the presentation of comprehensive income (loss) in consolidated financial statements and footnotes. The adoption impacts presentation only and had no effect on the Company’s financial condition, results of operations or cash flows. The Company did not adopt the provisions of the reclassification requirements, which were deferred by ASU 2011-12, Comprehensive Income: Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05,  in December 2011.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
47

 
 
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
 
Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange rates, interest rates, and a decline in the stock market. The current turbulence in the U.S. and global financial markets has caused a decline in stock values across all industries. We are exposed to market risks related to changes in interest rates and foreign currency exchange rates.
 
Our investment portfolio of cash equivalents, short-term investments, municipal debt securities, and variable demand obligations is subject to interest rate fluctuations, but we believe this risk is immaterial because of the historically short-term nature of these investments. At December 31, 2011, we held $1.0 million in ARS. The ARS we invest in are high quality securities, none of which are mortgage-backed. Beginning in February 2008, our securities failed at auction due to a decline in liquidity in the ARS and other capital markets.  We will not be able to access our investments in ARS until future auctions are successful, ARS are called for redemption by the issuers, or until sold in a secondary market.  As our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current as of December 31, 2011 and 2010. During fiscal 2011, 2010, and 2009, we sold $0.9 million, $2.1 million, and $0.7 million, respectively, of our ARS.  The recovery of the remaining $1.0 million ARS held is based upon market factors which are not within our control.

Our international subsidiaries in The Netherlands, Australia, Japan, Germany, and Spain conduct business in both local and foreign currencies and therefore, we are exposed to foreign currency exchange risk resulting from fluctuations in foreign currencies. This risk could adversely impact our results and financial condition.  We have not entered into any foreign currency exchange and option contracts to reduce our exposure to foreign currency exchange risk and the corresponding variability in operating results as a result of fluctuations in foreign currency exchange rates.
 
 
 
 
48

 

Item 8. Financial Statements and Supplementary Data
 
Palomar Medical Technologies, Inc. and Subsidiaries
Index to Consolidated Financial Statements
 
 
 
 Page
 
Report of Independent Registered Public Accounting Firm 
 50
Consolidated Balance Sheets – December 31, 2011 and 2010 (restated) 
 51
Consolidated Statements of Operations and Comprehensive Income (Loss) – Years ended December 31, 2011, 2010 and 2009 
 52
Consolidated Statements of Stockholders’ Equity – Years ended December 31, 2011, 2010 and 2009 
 53
Consolidated Statements of Cash Flows – Years ended December 31, 2011, 2010 (restated) and 2009&#