XNAS:PMTI Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q

x
 
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarter Ended March 31, 2012
 
¨
 
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.

A Delaware Corporation                                                                            I.R.S. Employer Identification No. 04-3128178

15 Network Drive, Burlington, Massachusetts  01803
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
NASDAQ – Global Select Market
 
Securities registered pursuant to Section 12(g) of the Act:
None.

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    ¨    

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    ¨    

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   ¨  Accelerated filer  x Non-accelerated filer   ¨   Smaller reporting company   ¨ 
 
(Do not check if a smaller
reporting company)
 
Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act.    Yes  ¨    No  x

The number of shares outstanding of the registrant’s common stock as of the close of business on May 4, 2012 was 19,530,244.


 
 

 

Palomar Medical Technologies, Inc. and Subsidiaries

Table of Contents
 
 
 
     Page No.
 
Item 1.  Financial Statements  
  Unaudited Condensed Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011  3
   4
   5
   6
Item 2.   15
Item 3.  22
Item 4.   22
 
Item 1. Legal Proceedings 23
Item 1A.  Risk Factors 24
Item 2.  Changes in Securities, Use of Proceeds and Issuer Purchases of Securities 38
Item 3.  Defaults Upon Senior Securities  38
Item 4.  38
Item 5.    Other Information 38
Item 6.   Exhibits 38
   40
   
 
 
 
 


 
 

 

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
 
   
March 31,
   
December 31,
 
   
2012
   
2011
 
             
Assets
 
Current assets
           
   Cash and cash equivalents
  $ 59,956,972     $ 63,077,178  
   Short-term investments
    24,036,525       24,739,998  
      Total cash, cash equivalents and short-term investments
    83,993,497       87,817,176  
   Accounts receivable, net
    9,525,602       9,853,682  
   Inventories
    22,822,387       21,175,754  
   Other current assets
    1,729,448       999,919  
      Total current assets
    118,070,934       119,846,531  
                 
Marketable securities and other investments
    16,139,604       21,268,777  
                 
Property and equipment, net
    36,386,996       36,713,578  
                 
Other assets
    241,671       232,594  
                 
Total assets
  $ 170,839,205     $ 178,061,480  
                 
Liabilities and Stockholders' Equity
 
                 
Current liabilities
               
   Accounts payable
  $ 3,086,455     $ 3,476,030  
   Accrued liabilities
    7,517,163       12,437,921  
   Deferred revenue
    4,126,323       4,423,980  
      Total current liabilities
    14,729,941       20,337,931  
                 
   Accrued income taxes
    3,128,100       3,082,356  
                 
      Total liabilities
  $ 17,858,041     $ 23,420,287  
                 
Commitments and contingencies (Note 11)
               
                 
Stockholders' equity
               
   Preferred stock, $0.01 par value-
               
      Authorized - 1,500,000 shares
               
      Issued -  none
    -       -  
   Common stock, $0.01 par value-
               
      Authorized - 45,000,000 shares
               
      Issued and Outstanding - 19,589,744 and 19,533,244 and 19,573,244 and 19,573,244 shares, respectively      
    195,898       195,733  
   Additional paid-in capital
    219,737,936       219,062,043  
   Accumulated other comprehensive loss
    (308,144 )     (263,849 )
   Treasury stock, at cost - 56,500 and 0 shares, respectively
    -       -  
   Accumulated deficit
    (66,644,526 )     (64,352,734 )
      Total stockholders' equity
  $ 152,981,164     $ 154,641,193  
                 
Total liabilities and stockholders’ equity
  $ 170,839,205     $ 178,061,480  
                 
 
See accompanying notes to condensed consolidated financial statements.

 
 3

 

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations and Comprehensive Loss
(Unaudited)
 
    Three Months Ended
    March 31,
   
2012
   
2011
 
 Revenues
           
    Professional product revenues
  $ 11,897,174     $ 10,546,648  
    Consumer product revenues
    978,768       -  
    Service revenues
    3,770,243       3,835,187  
    Royalty revenues
    1,798,062       3,218,339  
    Other revenues
    555,556       555,556  
       Total revenues
    18,999,803       18,155,730  
                 
 Costs and expenses
               
    Cost of professional product revenues
    4,901,098       4,303,566  
    Cost of consumer product revenues
    834,383       41,536  
    Cost of service revenues
    1,659,963       1,792,167  
    Cost of royalty revenues
    719,225       1,287,335  
    Research and development
    3,372,261       3,647,916  
    Selling and marketing
    6,681,525       5,575,771  
    General and administrative
    3,151,967       3,485,401  
       Total costs and expenses
    21,320,422       20,133,692  
                 
       Loss from operations
    (2,320,619 )     (1,977,962 )
                 
       Interest income
    89,003       113,381  
       Other income
    11,802       9,842  
                 
          Loss before income taxes
    (2,219,814 )     (1,854,739 )
                 
       Provision for income taxes
    71,978       39,253  
                 
          Net loss
  $ (2,291,792 )   $ (1,893,992 )
                 
 Net loss per share
               
    Basic
  $ (0.12 )   $ (0.10 )
    Diluted
  $ (0.12 )   $ (0.10 )
                 
Weighted average number of shares outstanding
         
    Basic
    18,858,464       18,652,038  
    Diluted
    18,858,464       18,652,038  
                 
 Comprehensive loss:
               
    Net loss
  $ (2,291,792 )   $ (1,893,992 )
    Unrealized (loss) gain on marketable securities, net of taxes
    (24,827 )     21,024  
    Foreign currency translation adjustment
    (19,468 )     (8,325 )
       Comprehensive loss
  $ (2,336,087 )   $ (1,881,293 )
                 
                 
 
See accompanying notes to condensed consolidated financial statements.

 
 4

 
 
Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)

 
   
Three Months
   
Three Months
 
   
Ended
   
Ended
 
   
March 31,
   
March 31,
 
   
2012
   
2011
 
Operating activities
           
   Net loss
  $ (2,291,792 )   $ (1,893,992 )
                 
Adjustments to reconcile net loss to net cash used in operating activities:
 
      Depreciation and amortization
    357,875       342,424  
      Stock-based compensation expense
    683,908       1,139,122  
      Amortization of investments
    46,765       245,791  
      Tax benefit (charge) from exercise of stock options
    10,100       (14,629 )
      Other non-cash items
    16,817       (28,343 )
  Changes in assets and liabilities:
         
         Accounts receivable
    342,222       (713,955 )
         Inventories
    (1,661,853 )     (2,263,975 )
         Other current assets
    (722,576 )     (572,687 )
         Other assets
    -       (41,286 )
         Accounts payable
    (439,358 )     843,932  
         Accrued liabilities
    (5,000,372 )     (4,209,887 )
         Accrued income taxes
    45,744       18,972  
         Deferred revenue
    (243,235 )     774,871  
            Net cash used in operating activities
    (8,855,755 )     (6,373,642 )
                 
Investing activities
               
   Purchases of property and equipment
    (31,048 )     (461,615 )
   Purchases of short-term investments, marketable securities and other investments
    (4,000,000 )     (2,045,140 )
   Proceeds from sale of short-term investments, marketable securities and other investments
    9,750,000       2,175,000  
            Net cash from (used in) investing activities
    5,718,952       (331,755 )
                 
Financing activities
               
   Proceeds from the exercise of stock options and warrants
    2,250       164,608  
   Tax benefit (charge) from the exercise of stock options
    (10,100 )     14,629  
            Net cash (used in) from financing activities
    (7,850 )     179,237  
                 
Effect of exchange rate changes on cash and cash equivalents
    24,447       46,329  
                 
Net decrease in cash and cash equivalents
    (3,120,206 )     (6,479,831 )
Cash and cash equivalents, beginning of the period
    63,077,178       55,099,319  
Cash and cash equivalents, end of the period
  $ 59,956,972     $ 48,619,488  
                 
Supplemental disclosure of cash flow information
 
                 
     Cash paid for income taxes
  $ 140,000     $ 13,000  
                 
Supplemental noncash investing activities
         
     Unrealized (loss) gain on marketable securities, net of taxes
  $ (24,827 )   $ 21,024  
                 
                 

See accompanying notes to condensed consolidated financial statements.
 
 
5

 
Palomar Medical Technologies, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
 
Note 1 –    Basis of presentation

The accompanying unaudited condensed consolidated financial statements reflect the consolidated financial position, results of operations and comprehensive loss, and cash flows of Palomar and all of its wholly owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States for interim information.  All intercompany transactions have been eliminated in consolidation.  The consolidated balance sheet at December 31, 2011 has been derived from the audited balance sheet at that date; however, the accompanying financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  The results of operations and comprehensive loss for the interim periods shown in this report are not necessarily indicative of expected results for any future interim period or for the entire fiscal year.  We believe that the quarterly information presented includes all adjustments (consisting of normal, recurring adjustments) necessary for a fair presentation in accordance with accounting principles generally accepted in the United States.  The accompanying condensed consolidated financial statements and notes should be read in conjunction with our Form 10-K for the year ended December 31, 2011.

In 2012, we reclassified certain amounts within costs and expenses. To be consistent with the 2012 presentation, we reclassified certain 2011 amounts within costs and expenses in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Loss. The reclassifications did not have a material impact on previously reported results of operations and comprehensive loss or cash flow related to operating activities.

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 and comprehensive loss 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.

Note 2 – Segment and Geographic Information
 
In accordance with ASC 280 Segment Reporting, operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision-making group, in making decisions how to allocate resources and assess performance. Our chief decision maker, as defined under the FASB’s guidance, is a combination of the Chief Executive Officer and the Chief Financial Officer. In the fourth quarter of 2011, we changed the manner in which the Company’s financial information is evaluated.  We now view our operations and manage our business as two segments, Professional Product segment and Consumer Product segment.
 
Financial information for the three months ended March 31, 2011 has also been presented for our two reportable operating segments.
 
The table below presents the financial information for our two reportable segments.  Revenues include our professional and consumer product revenues, service revenues, royalty revenues, and other revenues.  Cost of revenues and royalties include the material, manufacturing, service, and quality control expenses related to our professional and consumer product and service revenues and the cost of royalties related to our royalty revenues.  Operating expenses include selling and marketing expenses, research and development expenses, and general and administrative expenses.
 
 
 
 
6

 
 
   
For the three months ended March 31,
 
(in thousands)
 
2012
   
2011
 
   
Professional
   
Consumer
   
Total
   
Professional
   
Consumer
   
Total
 
                                     
Revenues
  $ 18,021     $ 979     $ 19,000     $ 18,156     $ -     $ 18,156  
Cost of revenues and royalties
    7,280       835       8,115       7,403       41       7,444  
Gross profit (loss)
    10,741       144       10,885       10,753       (41 )     10,712  
Operating expenses
    12,258       948       13,206       12,063       627       12,690  
Loss from operations
  $ (1,517 )   $ (804 )   $ (2,321 )   $ (1,310 )   $ (668 )   $ (1,978 )
                                                 
 
As of March 31, 2012 and December 31, 2011, we had $165.0 million and $171.7 million, respectively, in total assets related to our Professional Product segment.  As of March 31, 2012 and December 31, 2011, we had $5.8 million and $6.3 million, respectively, in total assets related to our Consumer Product segment.
 
Our total revenues are attributed to geographic areas based on the location of the end customer.  The following table presents total revenues and long-lived assets for the three months ended March 31, 2012 and 2011.
 
(in thousands)
 
2012
   
2011
 
   
Total Revenues
   
Long-lived assets
   
Total Revenues
   
Long-lived assets
 
                         
United States
  $ 10,545     $ 36,240     $ 10,988     $ 37,186  
Europe
    3,182       101       2,416       24  
Canada
    1,757       -       851       -  
South and Central America
    1,133       -       949       -  
Japan
    861       46       515       74  
Middle East
    823       -       915       -  
Asia / Pacific Rim
    354       -       716       -  
Australia
    345       -       806       -  
                                 
Total
  $ 19,000     $ 36,387     $ 18,156     $ 37,284  
                                 
 
In the fourth quarter of 2010, we launched the PaloVia® Skin Renewing Laser® – our first consumer product.  Our Consumer Product segment consists of the business activities related to the PaloVia laser. Upon launch, we were selling the PaloVia laser through retail channels with which we had no history and, as such, we were unable to estimate the customer return rates and the expected warranty accrual needed on sales of our consumer product. Therefore, 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.  In the first quarter of 2012, we recognized $1.0 million of consumer product revenues.  At March 31, 2012 and December 31, 2011, we had no deferred revenue related to the PaloVia laser.  Included in our consolidated inventory balances at March 31, 2012 and December 31, 2011 is approximately $5.2 million and $5.3 million, respectively, of consumer product inventory.  At March 31, 2012 and December 31, 2011, we had $0.4 million and $0.8 million, respectively, of inventory on consignment in finished goods.
 
Note 3 – Stock-based compensation
 
We recognize stock-based compensation expense in accordance with the share-based payment guidance.  This guidance requires share-based payments to employees, including grants of employee stock options, stock-settled stock appreciation rights (“SARs”), restricted stock awards, and restricted stock units to be recognized in the statement of operations and comprehensive loss based on their fair values at the date of grant.

 
7

 
 
Stock-based compensation expense recorded was $0.7 million and $1.1 million for the three months ended March 31, 2012 and March 31, 2011, respectively.  As of March 31, 2012, there was $6.4 million of unrecognized compensation expense related to non-vested share awards.  The expense is expected to be recognized over a weighted-average period of 3.0 years.

During the three months ended March 31, 2012, we granted 16,000 restricted stock awards.
 
Note 4 – Inventories
 
Inventories are valued at the lower of cost (first-in, first-out method) or market, and include material, labor and manufacturing overhead. At March 31, 2012 and December 31, 2011, inventories consisted of the following:

   
March 31,
   
December 31,
 
   
2012
   
2011
 
Raw materials
  $ 9,364,005     $ 10,068,589  
Work in process
    2,483,567       1,217,968  
Finished goods
    10,974,815       9,889,197  
   Total
  $ 22,822,387     $ 21,175,754  
                 
 
Our policy is to establish inventory reserves to write down inventory to its net realizable value when conditions exist that suggest that inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for products and market conditions. Included in our finished goods inventory at March 31, 2012 and December 31, 2011, are $2.8 million and $2.7 million, respectively, of demonstration products that are used by our sales organization. We regularly evaluate the ability to realize the value of 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 costs 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 this demand could have a significant impact on the value of our inventory and our reported operating results.
 
At March 31, 2012 and December 31, 2011, we had $0.4 million and $0.8 million, respectively of consumer product inventory held on consignment in finished goods.  Please see Note 2 for further information about our consumer product inventory.
 

 
8

 
 
Note 5 – Property and equipment
 
Property and equipment are recorded at cost.  Repairs and maintenance costs are expensed as incurred. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of property and equipment.  Land is not depreciated.  At March 31, 2012 and December 31, 2011, property and equipment consisted of the following:
 
   
March 31,
     December 31,
 
   
2012
   
2011
 
Estimated useful life
Land
  $ 10,680,000     $ 10,680,000    
Building
    24,505,574       24,505,574  
39 years
Machinery and equipment
    3,248,088       3,231,920  
3-7 years
Furniture and fixtures
    5,850,044       5,836,744  
7 years
Leasehold improvements
    98,623       99,243  
Shorter of estimated useful life or term of lease
    $ 44,382,329     $ 44,353,481    
Accumulated depreciation
    (7,995,333 )     (7,639,903 )  
   Total
  $ 36,386,996     $ 36,713,578    
                   

Note 6 – Warranty costs

We typically offer a one year warranty for our base professional and consumer products, but some of our professional products have a two year warranty.  Warranty coverage provided is for labor and parts necessary to repair products during their warranty period.  We account for the estimated warranty cost of the standard warranty coverage as a charge to cost of revenue when revenue is recognized.  Factors that affect our warranty reserves include the number of units sold, historical and anticipated product performance, 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.

The following table provides the detail of the change in our product warranty accrual, which is a component of accrued liabilities on the Condensed Consolidated Balance Sheets as of March 31, 2012 and 2011:

   
March 31,
   
March 31,
 
   
2012
   
2011
 
Warranty accrual, beginning of period
  $ 785,412     $ 529,374  
Charges to cost and expenses relating to new sales
    398,181       278,625  
Costs of product warranty claims/change of estimate
    (290,673 )     (227,547 )
Warranty accrual, end of period
  $ 892,920     $ 580,452  
                 
 
Note 7 – Fair Value of Financial Instruments

 In September 2006, the FASB issued new guidance on fair value measurements.  This guidance defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements.  The guidance applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements.  This guidance was effective for financial statements issued for fiscal years beginning after November 15, 2007, and we adopted this guidance on January 1, 2008.  In February 2008, the FASB issued an update to the fair value measurement guidance.  This guidance permitted the delayed application of the fair value measurement guidance for all non-recurring fair value measurements of non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008.  In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (ASC Topic 820)Improving Disclosures About Fair Value Measurements. The ASU requires new disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. The new disclosures and clarifications of existing disclosures were effective for our first quarter of 2010, except for the disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements, which were effective for our first quarter of fiscal year 2011. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value.

 
9

 
 
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.  The adoption of this guidance did not materially impact our financial statements or disclosures.
 
We performed an analysis of our investments held at March 31, 2012 and December 31, 2011 to determine the significance and character of all inputs to their fair value determination. The standard requires additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in fair value for each reporting period.
 
The FASB’s fair value measurement guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into the following three broad categories.
 
·  
Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
·  
Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.
·  
Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
 
Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations.  The following table presents our assets measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011.

Assets
   Fair Value as of March 31, 2012  
(in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
   Cash and cash equivalents
  $ 59,957     $ -     $ -     $ 59,957  
   Short-term investments*
    24,037       -       -       24,037  
   Other investments*
    15,177       -       -       15,177  
   Auction-rate municipal securities
    -       -       962       962  
   Total
  $ 99,171     $ -     $ 962     $ 100,133  
                                 
 
* The amortized cost of these investments approximates fair market value.
 
 
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Assets
  Fair Value as of December 31, 2011  
(in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
   Cash and cash equivalents
  $ 63,077     $ -     $ -     $ 63,077  
   Short-term investments*
    24,740       -       -       24,740  
   Other investments*
    20,271       -       -       20,271  
   Auction-rate municipal securities
    -       -       998       998  
   Total
  $ 108,088     $ -     $ 998     $ 109,086  
                                 
 
* The amortized cost of these investments approximates fair market value.

At March 31, 2012, we held $24.0 million of short-term investments classified as held-to-maturity which included $15.0 million in commercial paper, $5.0 million in U.S agency bonds, and $4.0 million in corporate bonds.  As of March 31, 2012, the remaining maturity dates for commercial paper, U.S agency bonds, and corporate bonds range from 2 days to 0.5 years, 0.5 to 1 year, and 0.3 to 0.9 years, respectively.  At December 31, 2011, we held $24.7 million of short-term investments classified as held-to-maturity which included $18.7 million in commercial paper, $4.0 million in U.S agency bonds, and $2.0 million in corporate bonds.  As of December 31, 2011, the maturity dates for commercial paper, U.S agency bonds, and corporate bonds range from 9 days to 0.6 years, 13 days to 0.7 years, and 0.6 years, respectively.  The amortized cost of these investments approximates fair market value.
 
At both March 31, 2012 and December 31, 2011, the par value of the auction-rate municipal securities (“ARS”) was $1.3 million, respectively.  As described in more detail below, all of our ARS have unrealized losses which have been recorded in accumulated other comprehensive loss.  The maturity date for our auction-rate municipal securities is in December 2045.

In addition to the auction-rate municipal securities discussed above, at March 31, 2012, we had $15.2 million of other investments classified as held-to-maturity securities which included $8.2 million in corporate bonds, $5.0 million in U.S. agency bonds, and $2.0 million in U.S. Treasuries.  These other investments are recorded at amortized cost.  As of March 31, 2012, the maturity dates for the corporate bonds, U.S. agency bonds, and U.S. Treasuries range from 1.0 to 1.3 years, 1.2 to 1.7 years, and 1.3 years, respectively.  At December 31, 2011, we had $20.3 million of other investments classified as held-to-maturity securities which included $10.2 million in commercial paper, $8.1 million in U.S. agency bonds, and $2.0 million in U.S. Treasuries.  These other investments are recorded at amortized cost.  As of December 31, 2011, the maturity dates for the commercial paper, U.S. agency bonds, and U.S. Treasuries range from 1.1 to 1.6 years, 1.2 to 1.9 years, and 1.6 years, respectively.    The amortized cost of these investments approximates fair market value.
 
Level 3 Gains and Losses

The table presented below summarizes the change in balance sheet carrying values associated with Level 3 financial instruments for the three months ended March 31, 2012.
 
 
 
 
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Auction-rate
       
(in thousands)
 
municipal securities
   
Total
 
Balance at December 31, 2011
  $ 998     $ 998  
   Purchases
    -       -  
   Settlements (at par)
    -       -  
   Transfers in/out of Level 3
    -       -  
   Gains
               
      Realized
    -       -  
      Unrealized
            -  
   Losses
               
      Realized
    -       -  
      Unrealized
    (36 )     (36 )
Balance at March 31, 2012
  $ 962     $ 962  
                 
 
All of the above ARS have been in a continuous unrealized loss position for 12 months or longer.  We continue to receive regular dividends from each of our ARS at current market rates.
 
Historically, the ARS market was an active and liquid market where we could purchase and sell our ARS on a regular basis through auctions. As such, we classified our ARS as Level 1 investments in accordance with the FASB’s guidance at December 31, 2007. Beginning in February 2008, several of our ARS 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 all of our investments in ARS currently lack short-term liquidity, we have classified these investments as non-current investments as of March 31, 2012 and December 31, 2011.
 
The estimated fair value of our holdings of ARS at March 31, 2012 was $1.0 million. To value our ARS, we determined the present value of the ARS 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. We also evaluated the credit rating of the issuer and found them all to be investment grade securities. There was no change in our valuation method during the three months ended March 31, 2012 as compared to prior reporting periods. Our valuation analysis showed that our ARS have nominal credit risk. The impairment is due to liquidity risk. Additionally, as of March 31, 2012, we do not intend to sell the ARS, 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, and we expect to recover the full amortized cost basis of these securities. As a result of our valuation analysis, our investment strategy, recurring dividend stream from these investments, and our strong cash and cash equivalents position, we have determined that the fair value of our ARS was temporarily impaired as of March 31, 2012.
 
We continue to monitor the market for ARS and consider its impact, if any, on the fair value of our investments. If current market conditions deteriorate further, we may be required to record additional unrealized losses in accumulated other comprehensive (loss) income. If the credit rating of the security issuers deteriorates, the anticipated recovery in market values does not occur, or we stop receiving dividends, we may be required to adjust the carrying value of these investments through impairment charges in our Consolidated Statements of Operations and Comprehensive Loss.
 
Note 8 – Net loss per common share

Basic net loss per share was determined by dividing net loss by the weighted average common shares outstanding during the period.  Diluted net loss per share was determined by dividing net loss by the diluted weighted average shares outstanding. Diluted weighted average shares reflect the dilutive effect, if any, of stock options, stock appreciation rights (“SARs”) and restricted stock awards (“RSAs”) based on the treasury stock method.
 
 
 
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A reconciliation of basic and diluted shares for the three months ended March 31, 2012 and 2011 is as follows:

   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
Basic weighted average number of shares outstanding
    18,858,464       18,652,038  
Potential common shares pursuant to stock options, SARs, restricted stock awards and warrants
    -       -  
Diluted weighted average number of shares outstanding
    18,858,464       18,652,038  
                 
 
For the three months ended March 31, 2012 and 2011, 2.6 million and 1.0 million, respectively, weighted average stock options, SARs, and RSAs to purchase shares of our common stock were excluded from the computation of diluted earnings per share because the effect of including the options, SARs and RSAs would have been antidilutive.

Note 9 – Income Taxes

We provide for income taxes under the liability method in accordance with the FASB’s guidance on accounting for income taxes.  Under this guidance, we only recognize a deferred tax asset for the future benefit of our tax losses, temporary differences and tax credit carry forwards to the extent that it is more likely than not that these assets will be realized. We consider 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 in assessing the need for the valuation allowance.
 
For the three months ended March 31, 2012 and 2011, our effective tax rate was 3% and 2%, respectively.  In both periods, our effective tax rate consisted primarily of minimum state income taxes as the company generated operating losses during the period.
 
The Company does not have any remaining federal net operating loss carryforwards to offset against tax expense, but continues to have other net deferred tax assets.  In 2012 and 2011, we have maintained 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.  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 the three months ended March 31, 2012 and 2011, the impact to paid-in capital resulting from the exercise and expiration of employee stock options was a charge of $10,000 and a credit of $15,000, respectively.
 
At March 31, 2012, we had available, subject to review and possible adjustment by the Internal Revenue Service, federal net operating loss and tax credit carry forwards generated by excess tax deductions from the exercise of employee stock options of approximately $39.1 million and $3.9 million, respectively, to be used to offset future taxable income. We also have state net operating loss and tax credit carryforwards of approximately $7.1 million and $2.0 million, respectively, to be used to offset future taxable income.  These net operating loss carry forwards and tax credits are primarily attributable to the excess tax deductions from the exercise of employees’ stock options and will expire through 2031. We also have $6.4 million of foreign net operating loss carry forwards.
 
We establish reserves for uncertain tax positions based on our assessment of exposures associated with tax deductions, permanent tax differences and tax credits. The tax reserves are analyzed periodically and adjustments are made as events occur to warrant adjustment to the reserves.  At March 31, 2012, we have $3.1 million of unrecognized tax benefits, including related accrued interest.
 
 
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                We recognize interest and penalties related to uncertain tax positions in income tax expense. As of both March 31, 2002 and March 31, 2011, we had approximately $0.2 million of accrued interest and penalties related to uncertain tax positions.
 
The tax years 2008-2011 remain open to examination by the major taxing jurisdictions to which we are subject. We file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions.
 
Note 10 – Settlement of Candela/Syneron Litigation
 
On September 16, 2011, we announced the resolution of our patent infringement lawsuits against Syneron, Inc., Syneron Medical Ltd., and Candela Corporation through the execution of a comprehensive Settlement Agreement. 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 (the “Anderson Patents”) for their professional laser- and lamp-based hair removal systems.  Under this Agreement, Candela and Syneron paid Palomar $31.0 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.
 
The $31.0 million payment that we received from Candela/Syneron on September 19, 2011 was 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 the Anderson Patents in February 2015.  The $31.0 million payment is irrevocable, non-refundable, and Palomar has no future obligations under the Settlement Agreement.  Pursuant to our license agreement with the MGH, we paid $5 million to the MGH.  This represents 40% of all royalty payments from Candela/Syneron, after deducting our related outside legal expenses.
 
We have accounted for the settlement with Candela and Syneron under ASC 605-25, Multiple-Element Arrangements.  In accordance with the multiple-element guidance, we have accounted for each of the elements by determining the relative fair value for each.  During the year ended December 31, 2011, we recorded $29.8 million of royalty revenues, $11.1 million of costs of royalty revenues, a $6.6 million reduction to general and administrative expenses, and $0.7 million of imputed interest income.  Since we met all revenue recognition criteria established by SAB 104, Topic 13, we recorded $29.8 million of royalty revenue, which represents the fair value allocated to the estimated back-owed and future royalties, as described above, relating to the commercial application of the Anderson patents.  In accordance with ASC 605-50, Revenue Recognition – Customer Payments and Incentives, we recorded a $6.6 million of reduction to general and administrative expenses, which represents partial reimbursement of our outside legal expenses in accordance with the MGH license agreement mentioned above.  The remaining reimbursed amount of legal expenses of $0.8 million under the MGH license agreement was recorded as a reduction of costs of royalty revenues resulting in a total net amount of $11.1 million recorded as costs of royalty revenues.  We recorded $0.7 million of imputed interest income which is net of the 40% of interest owed to MGH.
 
Note 11 – 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.
 
 
14 

 
 
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 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 in which they are incurred.

Item 2.        Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth previously under the caption “Risk Factors” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2012 and those included in Item 1A below.  This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report.

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. A discussion of our critical accounting policies and the related judgments and estimates affecting the preparation of our consolidated financial statements is included in the Annual Report on our Form 10-K fiscal year 2011.  There have been no material changes to our critical accounting policies as of March 31, 2012.
 
 
15

 
 
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.  The adoption of this guidance did not materially impact our financial statements or disclosures.

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 and comprehensive loss 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.
 
Overview
 
We are a global leader in laser and other light-based systems for aesthetic 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.
 
Results of operations

Revenues for the quarter ended March 31, 2012 were $19.0 million, a 5 percent increase over the $18.2 million reported in the first quarter of 2011.  Excluding the $1.1 million back-owed royalty payment recognized in the first quarter of 2011, revenues for the quarter ended March 31, 2012, were 11 percent greater than in the same quarter in 2011.  We believe that the use of this non-GAAP revenues disclosure enhances our ability to conduct period-to-period analyses of our results.  Professional product revenues for the quarter ended March 31, 2012 were $11.9 million, an increase of 13 percent over the first quarter of 2011.  Professional product gross margins were 59% in both the first quarter of 2012 and 2011.  Consumer product revenues were $1.0 million for the quarter ended March 31, 2012.  A majority of the 2011 consumer product revenues were deferred until the fourth quarter of 2011.  Consumer product revenues gross margin was 15% in the first quarter of 2012.  Loss before taxes for the quarter ended March 31, 2012 was $2.2 million.  Loss before taxes for the quarter ended March 31, 2011 was $1.9 million, which included $0.7 million positive effect from the receipt of a $1.1 million back-owed royalty payment.  Net loss for the quarter ended March 31, 2012 was $2.3 million, or $0.12 per share, as compared to a net loss for the quarter ended March 31, 2011 of $1.9 million, or $0.10 per share.  As of March 31, 2012, the balance sheet continues to be strong with $100.1 million in cash, cash equivalents, short-term investments, and marketable securities and other investments with no borrowings.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
16

 
 
The following table contains selected income statement information, which serves as the basis of the discussion of our results of operations for the three months ended March 31, 2012 and 2011, respectively (in thousands, except for percentages):

   
Three Months Ended March 31,
             
   
2012
   
2011
             
          As a % of        
As a % of
             
         
Total
         
Total
   
Change
 
   
Amount
   
Revenue
   
Amount
   
Revenue
     $     %  
Revenues
                                   
   Professional product revenues
  $ 11,897       63 %   $ 10,547       58 %   $ 1,350     13 %
   Consumer product revenues
    979       5 %     -       0 %     979     0 %
   Service revenues
    3,770       20 %     3,835       21 %     (65 )   (2 %)
   Royalty revenues
    1,798       9 %     3,218       18 %     (1,420 )   (44 %)
   Other revenues
    556       3 %     556       3 %     -     0 %
   Total revenues
    19,000       100 %     18,156       100 %     844     5 %
                                               
Costs and expenses
                                             
   Cost of professional product revenues
    4,902       26 %     4,303       24 %     599     14 %
   Cost of consumer product revenues
    834       4 %     42       0 %     792     1886 %
   Cost of service revenues
    1,660       9 %     1,792       10 %     (132 )   (7 %)
   Cost of royalty revenues
    719       4 %     1,287       7 %     (568 )   (44 %)
   Research and development
    3,372       18 %     3,648       20 %     (276 )   (8 %)
   Selling and marketing
    6,682       35 %     5,576       31 %     1,106     20 %
   General and administrative
    3,152       17 %     3,486       19 %     (334 )   (10 %)
   Total costs and expenses
    21,321       112 %     20,134       111 %     1,187     6 %
                                               
   Loss from operations
    (2,321 )     (12 %)     (1,978 )     (11 %)     (343 )   17 %
                                               
   Interest income
    89       0 %     113       1 %     (24 )   (21 %)
   Other income
    12       0 %     10       0 %     2     20 %
                                               
Loss before income taxes
    (2,220 )     (12 %)     (1,855 )     (10 %)     (365 )   20 %
                                               
Provision for income taxes
    72       0 %     39       0 %     33     85 %
                                               
Net loss
  $ (2,292 )     (12 %)   $ (1,894 )     (10 %)   $ (398 )   21 %
                                               
 
Professional product revenues.  During the three months ended March 31, 2012, our professional product revenues increased 13%, as compared to the corresponding period in the prior year, primarily due to the Icon Aesthetic System, our new flagship platform, which we launched during the second half of 2011.  More than 50% of our professional product revenues in the first quarter of 2012 were from Icon sales.  We are still in the registration process for many countries and will continue to sell the StarLux 500® system.  In the first three months of 2012, as compared to the corresponding period in 2011, professional product revenues were favorably impacted by the Icon, 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 a majority of our 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.  During the three months ended March 31, 2012, we recognized $1.0 million of consumer product revenues.
 
 
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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. During the three months ended March 31, 2012, service revenues decreased 2%, as compared to the corresponding period in the prior year.  The decrease in the three months ended March 31, 2012 was primarily due to slightly lower sales from ongoing service contracts.
 
The following table sets forth, for the periods indicated, information about our total Professional Product segment’s product and service revenues, by geographic region:

   
Three Months Ended
 
   
March 31,
 
   
2012
   
2011
 
North America
    57 %     56 %
Europe
    21 %     17 %
South and Central America
    7 %     7 %
Japan
    6 %     4 %
Middle East
    5 %     6 %
Australia
    2 %     5 %
Asia/Pacific Rim
    2 %     5 %
Total
    100 %     100 %
                 
 
In the first quarter of 2012, 85% of our Consumer Product segment revenues were derived from sales in the United States and 15% were from Europe.

Royalty revenues.  Royalty revenues decreased for the three months ended March 31, 2012 by 44% as compared to the corresponding period in the prior year.  The decrease is mainly attributed to lower on-going royalty payments from our licensees and a $1.1 million back-owed royalty payment received in the first quarter of 2011.

Other revenues.  During the three months ended March 31, 2012, other revenues remained consistent as compared to the corresponding period in the prior year.  For the three months ended March 31, 2012 and 2011, other revenues consisted of the recognition of $0.6 million related to payments received under an amendment to our license agreement (“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.

 Cost of professional product revenues. For the three months ended March 31, 2012 and 2011, the cost of professional product revenues increased in absolute dollars, but remained consistent as a percentage of professional product revenues at 41% in both 2012 and 2011. 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.

Cost of consumer product revenues. The cost of consumer product revenues relates to the PaloVia® Skin Renewing Laser®.  For the three months ended March 31, 2012, cost of consumer product revenues was $0.8 million, or 85% 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.  For the three months ended March 31, 2012 and 2011, the cost of service revenues decreased in absolute dollars and as a percentage of service revenues to 44% in 2012 from 47% in 2011. The decrease is due to shipping expenses, offset by an increase in labor costs as headcount has grown to be in line with our growing product base and the opening of our new offices in Germany and Spain during 2011.

 
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Cost of royalty revenues.  The cost of royalty revenues were 40% of royalty revenues at the end of each period and decreased for the three months ended March 31, 2012 by 44% as compared to the corresponding period in the prior year.  The decrease is mainly attributed to lower 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 decreased by $0.3 million, or 8%, for the three months ended March 31, 2012 over the corresponding period in 2011.  The decrease in research and development expense was due to reorganizing these departments while maintaining our continued commitment to introducing new products and enhancing our current family of products through our continued substantial investment in research and development.

Research and development expenses relating to our Professional Product segment decreased by 9% for the three months ended March 31, 2012, as compared to the corresponding period in 2011. 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 12% for the three months ended March 31, 2012, as compared to the corresponding period in 2011. This decrease in research and development expense related to our Consumer Product segment includes decreases in materials and consultants, offset by increases in payroll and payroll related and clinical expenses related directly to our consumer products as compared to 2011.
 
 For the three months ended March 31, 2012 and 2011, research and development expense included $0.2 million and $0.5 million, respectively, of stock-based compensation expense.

Selling and marketing expense.  Selling and marketing expense increased by $1.1 million, or 20%, for the three months ended March 31, 2012 over the corresponding period in 2011.  Selling and marketing expenses relating to our Professional Product segment increased by 16% in the three months ended March 31, 2012 as compared to corresponding period in 2011.   The increase was primarily driven by increases of $0.7 million from our foreign subsidiaries in Germany and Spain that we established in 2011.   Selling and marketing expenses related to our Consumer Product segment increased by 68% in the three months ended March 31, 2012 as compared to corresponding period in 2011.  The increase was primarily driven by increases of $0.2 million in direct marketing expenses.

For the three months ended March 31, 2012 and 2011, selling and marketing expense included $0.2 million and $0.3 million, respectively, of stock-based compensation expense.

General and administrative expense.  General and administrative expense decreased by $0.3 million, or 10%, for the three months ended March 31, 2012 over the corresponding period in 2011.  The decrease in general and administrative expense was driven by lower legal expenses and stock-based compensation expense, partially offset by higher payroll and payroll related expenses.

For the three months ended March 31, 2012 and 2011, general and administrative expense included $0.1 million and $0.2 million, respectively, of stock-based compensation expense.

Interest income. Interest income for the three months ended March 31, 2012 decreased by 21% as compared to the corresponding periods in 2011 primarily due to lower interest rates, offset by a higher average cash and cash equivalents, short-term investments, and marketable securities and other investments balance during the three months ended March 31, 2012 as compared to the corresponding period in 2011.

Other income.  Other income for the three months ended March 31, 2012 and 2011 includes the foreign exchange gain resulting from transactions in currencies other than the U.S. dollar.

Provision for income taxes.  Our effective tax rate for the three months ended March 31, 2012 and 2011 was 3% and 2%, respectively. Our 2012 and 2011 effective tax rates are primarily related to minimum state income taxes as the Company was in an operating loss in both periods.  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.

 
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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):

   
Three months ended
  Three months ended          
   
March 31,
 
March 31,
 
Change
 
   
2012
 
2011
   $       %  
Cash flows used in operating activities
  $ (8,856 )   $ (6,374 )     2,482       39 %
Cash flows from (used in) investing activities
    5,719       (332 )     6,051       1823 %
Cash flows (used in) from financing activities
    (8 )     179       (187 )     (104 %)
Capital expenditures
    31       462       (431 )     (93 %)
                                 
                                 
 
Additionally, our cash and cash equivalents, short-term investments, accounts receivable, inventories, marketable securities and other investments, and working capital are shown below for the periods indicated (in thousands).
 

   
March 31,
    December 31,  Change  
   
2012
   
2011
   $     %
Cash and cash equivalents
  $ 59,957     $ 63,077     (3,120 )     (5 %)
Short-term investments
    24,037       24,740     (703 )     (3 %)
Accounts receivable, net
    9,526       9,854     (328 )     (3 %)
Inventories
    22,822       21,176     1,646       8 %
Marketable securities and other investments
    16,140       21,269     (5,129 )     (24 %)
Working capital
    103,341       99,509     3,832       4 %
                               
 
As of March 31, 2012, we had $100.1 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 March 31, 2012, we had no debt outstanding.

At March 31, 2012, 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 March 31, 2012 and 2011. During the three months ended March 31, 2012 and 2011, we sold $0 and $0.2 million of our ARS at par, respectively.
 
We have determined that the fair value of our ARS was temporarily impaired as of March 31, 2012 and 2011.  For the three months ended March 31, 2012 and 2011, we marked to market our ARS and recorded an unrealized loss of $23,000 and unrealized gain of $21,000, 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 March 31, 2012, 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 used in operating activities increased for the period ended March 31, 2012 as compared to the corresponding period in 2011. This increase primarily reflects the effects of a larger net loss, lower stock-based compensation expense, and greater working capital requirements in 2012 than in 2011. Cash from (used in) investing activities increased during the period ended March 31, 2012 as compared to the corresponding period in 2011. 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 (used in) from financing activities increased for period ended March 31, 2012 as compared to the corresponding period in 2011. This change was primarily due to a decrease in the proceeds from the exercise of stock options.
 
 
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We anticipate that capital expenditures for 2012 will total approximately $1.0 million consisting primarily 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 March 31, 2012, 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 three months ended March 31, 2012, we did not purchase any of our common stock through the stock repurchase program.

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 March 31, 2012, 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 the three months ended March 31, 2012, totaled approximately $0.7 million. 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 FASB Accounting Standards Codification Topic 740 regarding Income Taxes. Further information about changes in these obligations can be found in Note 3 to our consolidated financial statements included in our annual report on Form 10-K.
 
We are obligated to make future payments under various contracts, including non-cancelable inventory purchase commitments.
 
The following table summarizes our estimated contractual cash obligations as of March 31, 2012, excluding royalty and employment obligations because they are variable and/or subject to uncertain timing (in thousands):

  Payments due by period  
         
Less than
     1-3      3-5    
After 5
 
   
Total
   
1 year
   
Years
   
Years
   
Years
 
Operating leases
  $ 529     $ 309     $ 220     $ -     $ -  
Purchase commitments
    10,311       10,311       -       -       -  
Total contractual cash obligations
  $ 10,840     $ 10,620     $ 220     $ -     $ -  
                                         
 
 
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Our purchase commitments, which are primarily inventory related, have increased from recent years due to our entry into the consumer market and the introduction of new product lines.

Item 3.  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 March 31, 2012, 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 March 31, 2012 and 2011.  In the three months ended March 31, 2012 and 2011, we sold $0 and $0.2 million, respectively of our ARS held at December 31, 2011.  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.

Item 4.  Controls and procedures

Under the direction of the principal executive officer and principal financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) as of March 31, 2012. Based on that evaluation, we have concluded that our disclosure controls and procedures were effective.

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

There were no significant changes in our internal controls over financial reporting or in other factors that could significantly affect these controls during the quarter ended March 31, 2012, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
 
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PART II – Other information
 
Item 1.    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.


 
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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 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.

 
 
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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 17% 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.

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.
 
 
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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.
 
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 and estimating 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.

 
 
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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.
 
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.
 
 
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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.

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.
 

 
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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.

 
 
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 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.

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 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 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 2012, 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.

 
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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 250 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.
 
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.
 
 
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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 first quarter of 2012, 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 March 31, 2012, 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 March 31, 2012 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 March 31, 2012, 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 March 31, 2012, 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.
 
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.

 
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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.

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.

 
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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 2.    Changes in securities, use of proceeds and issuer purchases of securities

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.  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.  As of March 31, 2012, we have repurchased 675,500 shares of common stock at an average price of $13.68 per share under this program.  All 675,500 shares have since been used to fulfill option exercises and equity grants.  We may buy back additional shares of our common stock on the open market from time to time.  We did not repurchase any shares through this program during the three month period ended March 31, 2012 and 2011.

Item 3.    Defaults upon senior securities

None.

Item 4.    Mine Safety Disclosures

None.

Item 5.    Other information
 
None.
 
Item 6.    Exhibits
 
 
31.1
Certification of Joseph P. Caruso, President and Chief Executive Officer of the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2
Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the Company, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
 
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32
Certification of Joseph P. Caruso, President and Chief Executive Officer of the Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
32
Certification of Paul S. Weiner, Vice President and Chief Financial Officer of the Company, pursuant to 18 United States Code Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
101.INS
XBRL Instance Document
 
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
Attached as Exhibit 101 to this report are the following formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets at March 31, 2012 and December 31, 2011, (ii) Consolidated Statements of Operations and Comprehensive Loss for the three months ended March 31, 2012 and March 31, 2011, (iii) Consolidated Statements of Cash Flows for the three months ended March 31, 2012 and March 31, 2011, and (iv) Notes to Condensed Consolidated Financial Statements.
 
In accordance with Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to this Quarterly Report on Form 10-Q is deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act, is deemed not filed for purposes of section 18 of the Exchange Act, and otherwise is not subject to liability under these sections.
 
 

 
 
39 

 

Signatures

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 

 
Palomar Medical Technologies, Inc.
(Registrant)
   
   
 
Date: May 8, 2012
 /s/  Joseph P. Caruso     
   Joseph P. Caruso
 
 President, Chief Executive Officer, Director, and Chairman of the Board of Directors
   
   
Date:  May 8, 2012
 /s/  Paul S. Weiner      
   Paul S. Weiner
 
 Chief Financial Officer
 
 
 








 
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XNAS:PMTI Quarterly Report 10-Q Filling

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XNAS:PMTI Quarterly Report 10-Q Filing - 3/31/2012
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