XNAS:PMTI Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012


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 June 30, 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 August 3, 2012 was 19,567,677.


 

 

Palomar Medical Technologies, Inc. and Subsidiaries

Table of Contents
 
 
     Page No.
 
Item 1.   
   3
   4
   5
   6
Item 2.   15
Item 3.  23
Item 4.   24
 
Item 1. Legal Proceedings 24
Item 1A.  Risk Factors 26
Item 2.  Changes in Securities, Use of Proceeds and Issuer Purchases of Securities 40
Item 3.  Defaults Upon Senior Securities  40
Item 4. 40
Item 5.    Other Information 40
Item 6.   Exhibits 40
   42
   
 



 
 2

 

Palomar Medical Technologies, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Unaudited)
 
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
Assets
 
Current assets
           
   Cash and cash equivalents
  $ 56,049,622     $ 63,077,178  
   Short-term investments
    30,142,552       24,739,998  
      Total cash, cash equivalents and short-term investments
    86,192,174       87,817,176  
   Accounts receivable, net
    10,478,984       9,853,682  
   Inventories
    25,241,532       21,175,754  
   Other current assets
    1,096,392       999,919  
      Total current assets
    123,009,082       119,846,531  
                 
Marketable securities and other investments
    12,484,167       21,268,777  
                 
Property and equipment, net
    36,458,792       36,713,578  
                 
Other assets
    440,135       232,594  
                 
Total assets
  $ 172,392,176     $ 178,061,480  
                 
Liabilities and Stockholders' Equity
 
                 
Current liabilities
               
   Accounts payable
  $ 2,831,664     $ 3,476,030  
   Accrued liabilities
    9,951,349       12,437,921  
   Deferred revenue
    4,010,724       4,423,980  
      Total current liabilities
    16,793,737       20,337,931  
                 
   Accrued income taxes
    3,129,577       3,082,356  
                 
      Total liabilities
  $ 19,923,314     $ 23,420,287  
                 
Commitments and contingencies (Note 12)
               
                 
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 - 19,590,244 and 19,542,677 and 19,573,244 and 19,573,244 shares, respectively
    195,903       195,733  
   Additional paid-in capital
    220,482,245       219,062,043  
   Accumulated other comprehensive loss
    (93,120 )     (263,849 )
   Treasury stock, at cost - 47,567 and 0 shares, respectively
    -       -  
   Accumulated deficit
    (68,116,166 )     (64,352,734 )
      Total stockholders' equity
  $ 152,468,862     $ 154,641,193  
                 
Total liabilities and stockholders’ equity
  $ 172,392,176     $ 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     Six Months Ended  
    June 30,      June 30,  
   
2012
   
2011
   
2012
   
2011
 
 Revenues
                       
    Professional product revenues
  $ 13,030,019     $ 10,053,867     $ 24,927,193     $ 20,600,515  
    Consumer product revenues
    900,409       -       1,879,177       -  
    Service revenues
    3,545,564       3,907,312       7,315,807       7,742,499  
    Royalty revenues
    1,527,203       1,748,510       3,325,265       4,966,849  
    Other revenues
    666,664       555,556       1,222,220       1,111,112  
       Total revenues
    19,669,859       16,265,245       38,669,662       34,420,975  
                                 
 Costs and expenses
                               
    Cost of professional product revenues
    5,045,188       3,970,251       9,946,286       8,273,817  
    Cost of consumer product revenues
    776,364       14,444       1,610,747       55,980  
    Cost of service revenues
    1,654,401       1,663,738       3,314,364       3,455,905  
    Cost of royalty revenues
    610,881       699,404       1,330,106       1,986,739  
    Research and development
    2,836,041       3,880,308       6,208,302       7,528,224  
    Selling and marketing
    7,074,465       6,315,511       13,755,990       11,891,282  
    General and administrative
    2,941,484       3,782,204       6,093,444       7,267,605  
       Total costs and expenses
    20,938,824       20,325,860       42,259,239       40,459,552  
                                 
       Loss from operations
    (1,268,965 )     (4,060,615 )     (3,589,577 )     (6,038,577 )
                                 
       Interest income
    85,989       88,691       174,992       202,072  
       Other (loss) income
    (270,528 )     29,476       (258,726 )     39,318  
                                 
          Loss before income taxes
    (1,453,504 )     (3,942,448 )     (3,673,311 )     (5,797,187 )
                                 
       Provision for income taxes
    18,143       56,473       90,121       95,726  
                                 
          Net loss
  $ (1,471,647 )   $ (3,998,921 )   $ (3,763,432 )   $ (5,892,913 )
                                 
 Net loss per share
                               
    Basic
  $ (0.08 )   $ (0.21 )   $ (0.20 )   $ (0.32 )
    Diluted
  $ (0.08 )   $ (0.21 )   $ (0.20 )   $ (0.32 )
                                 
Weighted average number of shares outstanding
                 
    Basic
    18,821,644       18,699,608       18,835,623       18,688,202  
    Diluted
    18,821,644       18,699,608       18,835,623       18,688,202  
                                 
 Comprehensive loss:
                               
    Net loss
  $ (1,471,647 )   $ (3,998,921 )   $ (3,763,432 )   $ (5,892,913 )
    Unrealized gain (loss) on marketable securities, net of taxes
    748       4,124       (24,079 )     25,148  
    Foreign currency translation adjustment
    214,276       (34,905 )     194,808       (43,230 )
       Comprehensive loss
  $ (1,256,623 )   $ (4,029,702 )   $ (3,592,703 )   $ (5,910,995 )
                                 

 
See accompanying notes to condensed consolidated financial statements.
 
 
4

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


   
Six Months
   
Six Months
 
   
Ended
   
Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
 
Operating activities
           
   Net loss
  $ (3,763,432 )   $ (5,892,913 )
                 
Adjustments to reconcile net loss to net cash used in operating activities:
 
      Depreciation and amortization
    713,993       702,491  
      Stock-based compensation expense
    1,389,830       2,133,477  
      Amortization of investments
    97,663       424,899  
      Tax benefit from exercise of stock options
    (15,242 )     (22,524 )
      Other non-cash items
    137,266       (62,448 )
      Changes in assets and liabilities:
               
         Accounts receivable
    (641,899 )     (1,973,267 )
         Inventories
    (4,087,659 )     (5,765,014 )
         Other current assets
    (103,238 )     (846,986 )
         Other assets
    (200,000 )     (42,007 )
         Accounts payable
    (531,992 )     960,346  
         Accrued liabilities
    (2,559,731 )     (2,033,611 )
         Accrued income taxes
    47,221       40,709  
         Deferred revenue
    (317,066 )     1,414,664  
            Net cash used in operating activities
    (9,834,286 )     (10,962,184 )
                 
Investing activities
               
   Purchases of property and equipment
    (463,446 )     (702,941 )
   Purchases of short-term investments, marketable securities and other investments
    (14,495,058 )     (6,087,680 )
   Proceeds from sale of short-term investments, marketable securities and other investments
    17,744,880       27,900,000  
            Net cash from investing activities
    2,786,376       21,109,379  
                 
Financing activities
               
   Proceeds from the exercise of stock options and warrants
    15,300       164,608  
   Tax benefit from the exercise of stock options
    15,242       22,524  
            Net cash from financing activities
    30,542       187,132  
                 
Effect of exchange rate changes on cash and cash equivalents
    (10,188 )     82,308  
                 
Net (decrease) increase in cash and cash equivalents
    (7,027,556 )     10,416,635  
Cash and cash equivalents, beginning of the period
    63,077,178       55,099,319  
Cash and cash equivalents, end of the period
  $ 56,049,622     $ 65,515,954  
                 
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
  $ (24,079 )   $ 25,148  
                 
                 
                 
 
See accompanying notes to condensed consolidated financial statements.

 

 

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 position, 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 about 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.
 
In order to be comparable to our 2012 financial statements, financial information for the three and six months ended June 30, 2011 has also been presented for our two reportable operating segments.
 
 
6

 
 
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.
 
   
For the three months ended June 30,
 
(in thousands)
 
2012
   
2011
 
   
Professional
   
Consumer
   
Total
   
Professional
   
Consumer
   
Total
 
                                     
Revenues
  $ 18,770     $ 900     $ 19,670     $ 16,265     $ -     $ 16,265  
Cost of revenues and royalties
    7,310       776       8,086       6,334       14       6,348  
Gross profit (loss)
    11,460       124       11,584       9,931       (14 )     9,917  
Operating expenses
    11,802       1,051       12,853       13,050       928       13,978  
Loss from operations
  $ (342 )   $ (927 )   $ (1,269 )   $ (3,119 )   $ (942 )   $ (4,061 )
                                                 
 
 
   
For the six months ended June 30,
 
(in thousands)
 
2012
   
2011
 
   
Professional
   
Consumer
   
Total
   
Professional
   
Consumer
   
Total
 
                                     
Revenues
  $ 36,791     $ 1,879     $ 38,670     $ 34,421     $ -     $ 34,421  
Cost of revenues and royalties
    14,591       1,611       16,202       13,717       56       13,773  
Gross profit (loss)
    22,200       268       22,468       20,704       (56 )     20,648  
Operating expenses
    24,060       1,998       26,058       25,135       1,552       26,687  
Loss from operations
  $ (1,860 )   $ (1,730 )   $ (3,590 )   $ (4,431 )   $ (1,608 )   $ (6,039 )
                                                 
 
As of June 30, 2012 and December 31, 2011, we had $166.5 million and $171.7 million, respectively, in total assets related to our Professional Product segment.  As of June 30, 2012 and December 31, 2011, we had $5.9 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 tables present total revenues for the three and six months ended June 30, 2012 and 2011 and long-lived assets as of June 30, 2012 and December 31, 2011.
 
   
For the three months
   
For the six months
 
   
ended June 30,
   
ended June 30,
 
(in thousands)
 
2012
   
2011
   
2012
   
2011
 
                         
United States
  $ 10,341     $ 8,865     $ 20,886     $ 19,816  
Europe
    3,043       1,994       6,225       4,410  
Middle East
    1,819       1,077       2,642       1,992  
Canada
    1,231       1,452       2,988       2,303  
Australia
    1,231       731       1,576       1,537  
Asia / Pacific Rim
    759       794       1,113       1,510  
Japan
    745       526       1,606       1,078  
South and Central America
    501       826       1,634       1,775  
Total Revenues
  $ 19,670     $ 16,265     $ 38,670     $ 34,421  
                                 
 
 
7

 
 
   
June 30,
   
December 31,
 
(in thousands)
 
2012
   
2011
 
             
United States
  $ 36,310     $ 36,550  
Europe
    95       107  
Japan
    54       57  
Total Long-Lived Assets
  $ 36,459     $ 36,714  
                 
 
 
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 three and six months ended June 30, 2012, we recognized $0.9 million and $1.9 million, respectively, of consumer product revenues.  At June 30, 2012 and December 31, 2011, we had no deferred revenue related to the PaloVia laser.  Included in our consolidated inventory balances at June 30, 2012 and December 31, 2011 is approximately $5.1 million and $5.3 million, respectively, of consumer product inventory.  At June 30, 2012 and December 31, 2011, we had $0.6 million and $0.8 million, respectively, of inventory on consignment in finished goods.
 
Note 3 – Stock-based compensation
 
Stock-based compensation expense recorded was $0.7 million and $0.9 million for the three months ended June 30, 2012 and June 30, 2011, respectively and $1.4 million and $2.1 million for the six months ended June 30, 2012 and June 30, 2011, respectively.  As of June 30, 2012, there was $5.6 million of unrecognized compensation expense related to non-vested share awards.  The expense is expected to be recognized over a weighted-average period of 2.8 years.

During the six months ended June 30, 2012, we granted 16,000 restricted stock awards.  No grants were made during the three months ended June 30, 2012.
 
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 June 30, 2012 and December 31, 2011, inventories consisted of the following:
 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
Raw materials
  $ 10,091,767     $ 10,068,589  
Work in process
    2,440,035       1,217,968  
Finished goods
    12,709,730       9,889,197  
   Total
  $ 25,241,532     $ 21,175,754  
                 

Included in our finished goods inventory at June 30, 2012 and December 31, 2011, are $2.6 million and $2.7 million, respectively, of demonstration products that are used by our sales organization.
 
At June 30, 2012 and December 31, 2011, we had $0.6 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
 
At June 30, 2012 and December 31, 2011, property and equipment consisted of the following:

   
June 30,
   
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
    3,359,974       3,231,920  
3-7 years
Furniture and fixtures
    6,168,194       5,836,744  
7 years
Leasehold improvements
    96,621       99,243  
Shorter of estimated useful life or term of lease
    $ 44,810,363     $ 44,353,481    
Accumulated depreciation
    (8,351,571 )     (7,639,903 )  
   Total
  $ 36,458,792     $ 36,713,578    
                   
                   
                   

Note 6 – Warranty costs

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 June 30, 2012 and 2011:

   
For the three months ended
   
For the six months ended
 
    June 30,    
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Warranty accrual, beginning of period
  $ 892,920     $ 580,451     $ 785,412     $ 529,374  
Charges to cost and expenses relating to new sales
    486,509       193,950       884,690       472,575  
Costs of product warranty claims/change of estimate
    (354,392 )     (258,697 )     (645,065 )     (486,245 )
Warranty accrual, end of period
  $ 1,025,037     $ 515,704     $ 1,025,037     $ 515,704  
                                 
 
Note 7 – Fair Value of Financial Instruments

 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 June 30, 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.
 
 
 
9

 
·  
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 June 30, 2012 and December 31, 2011.

Assets
  Fair Value as of June 30, 2012  
(in thousands)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
   Cash and cash equivalents
  $ 56,050     $ -     $ -     $ 56,050  
   Short-term investments*
    30,143       -       -       30,143  
   Other investments*
    11,521       -       -       11,521  
   Auction-rate municipal securities
    -       -       963       963  
   Total
  $ 97,714     $ -     $ 963     $ 98,677  
                                 
 
* The amortized cost of these investments approximates fair market value.

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 June 30, 2012, we held $30.1 million of short-term investments classified as held-to-maturity, which included $14.0 million in commercial paper, $9.1 million in corporate bonds, and $7.0 million in U.S agency bonds.  As of June 30, 2012, the remaining maturity dates for commercial paper, corporate bonds, and U.S agency bonds range from 0.1 to 0.4 years, 0.1 to 0.8 years, and 0.2 to 1.0 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 June 30, 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 June 30, 2012, we had $11.5 million of other investments classified as held-to-maturity securities, which included $5.0 million in U.S. agency bonds, $3.5 million in U.S. Treasury Notes, and $3.0 million in corporate bonds.  These other investments are recorded at amortized cost.  As of June 30, 2012, the maturity dates for the agency bonds, U.S. Treasury Notes, and corporate bonds range from 1.1 to 1.9 years, 1.1 to 1.8 years, and 1.1 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. Treasury Notes.  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. Treasury Notes 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.
 
 
10

 
 
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 six months ended June 30, 2012.

   
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
    (35 )     (35 )
Balance at June 30, 2012
  $ 963     $ 963  
                 
                 
 
All of the above ARS have been in a continuous unrealized loss position for 12 months or longer.  We continue to receive regular interest payments 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 June 30, 2012 and December 31, 2011.
 
The estimated fair value of our holdings of ARS at June 30, 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 and six months ended June 30, 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 June 30, 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 June 30, 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.
 
 
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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.

A reconciliation of basic and diluted shares for the three and six months ended June 30, 2012 and 2011 is as follows:
 
    Three Months Ended    
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Basic weighted average number of shares outstanding
    18,821,644       18,699,608       18,835,623       18,688,202  
Potential common shares pursuant to stock options, SARs, and restricted stock awards
    -       -       -       -  
Diluted weighted average number of shares outstanding
    18,821,644       18,699,608       18,835,623       18,688,202  
                                 
 
For the three months ended June 30, 2012 and 2011, 2.7 million and 2.5 million, respectively, and for the six months ended June 30, 2012 and 2011, 2.8 million and 1.2 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 six months ended June 30, 2012 and 2011, our effective tax rate was 2.5% and 1.7%, respectively.  In 2012, the company is generating taxable profits before the excess tax benefit of stock option deductions and our rate consists primarily of federal tax and minimum state taxes.  In 2011, our effective tax rate consisted primarily of minimum state taxes as the company generated operating losses during the period ending June 30, 2011.
 
In 2012 and 2011, we have maintained a valuation allowance against our U.S. and foreign 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.
 
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 June 30, 2012, we have $3.1 million of unrecognized tax benefits, including related accrued interest.
 
We recognize interest and penalties related to uncertain tax positions in income tax expense. As of both June 30, 2002 and June 30, 2011, we had approximately $0.2 million of accrued interest and penalties related to uncertain tax positions.
 
 
 
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The tax years 2008 through 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 – License Agreement with The Procter & Gamble Company (and its wholly owned subsidiary The Gillette Company)
 
On December 9, 2010, we announced an amendment to the License Agreement with Procter & Gamble (“P&G”) and Gillette. The amendment provided additional funding from each company to meet the common goal of a successful product launch. The amendment did not change the scope of P&G’s non-exclusive license to Palomar’s broad patent portfolio as well as its non-exclusive license to the extensive technology developed by Palomar prior to February 28, 2008 for home-use, light-based hair removal devices for women.  Under the amended License Agreement, the parties agreed to reduce pre-commercial launch quarterly technology transfer payments (“TTP Quarterly Payments” as defined in the License Agreement) from $1.25 million to $1.0 million for the calendar quarter ending December 31, 2010 and thereafter the TTP Quarterly Payments would be $2.0 million per year for an agreed period, after which the payments would return to $1.25 million per calendar quarter if no product has been launched. P&G was to apply the savings, together with agreed minimum overall program funding, to accelerating product readiness and commercialization while Palomar will be paid an increased percentage of sales after commercial launch.   The TTP Quarterly Payments under the amended license agreement were being recognized ratably through the expected launch term.
 
During the three months ended June 30, 2012, P&G launched a light-based hair removal product and paid us an Additional TTP Quarterly Payment (as defined in the License Agreement) of $1.0 million.  This Additional TTP Quarterly Payment resulted in $0.7 million in other revenues during the second quarter of 2012 after being netted with the receivable from P&G as payments under the amended License Agreement were being recognized ratably through the expected launch term.  During the six months ended June 30, 2012, other revenues consists of $0.6 million related to TTP Quarterly Payments received under the amended License Agreement which were being recognized ratably through the expected launch term plus the $0.7 million previously mentioned.  For the three and six months ended June 30, 2011, other revenues consisted of the recognition of $0.6 million and $1.1 million, respectively, related to TTP Quarterly Payments received under the amended License Agreement.  The TTP Quarterly Payments under the amended License Agreement were being recognized ratably through the expected launch term.
 
Going forward, P&G will make technology transfer payments (“TTPs”) based on a percentage of net sales of its light-based hair removal product.
 
 
Note 11 – 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.
 
 
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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 12 – Contingencies

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

In addition, although monetary and injunctive relief is typically sought, remedies and restitution are generally not determined until the conclusion of the trial court proceedings and can be modified on appeal. Accordingly, the outcomes of individual cases are difficult to time, predict or quantify.

We are not insured with respect to intellectual property infringement and maintain an insurance policy providing limited coverage against securities claims and product liability claims. The absence of significant third-party insurance coverage increases our potential exposure to unanticipated claims or adverse decisions.

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

 
 14

 

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 June 30, 2012.
 
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.
 
 
15

 
 
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 which encompasses over 70 countries.
 
Results of operations

Revenues for the quarter ended June 30, 2012 were $19.7 million, a 21 percent increase over the $16.3 million reported in the second quarter of 2011.  Professional product revenues for the quarter ended June 30, 2012 were $13.0 million, an increase of 30 percent over the second quarter of 2011.  Professional product gross margins were 61% in both the second quarter of 2012 and 2011.  Consumer product revenues were $0.9 million for the quarter ended June 30, 2012.  No consumer revenues were recognized in the second quarter last year.  Consumer product revenues gross margin was 14% in the second quarter of 2012.  Loss before taxes for the quarter ended June 30, 2012 was $1.5 million.  Loss before taxes for the quarter ended June 30, 2011 was $3.9 million.  Net loss for the quarter ended June 30, 2012 was $1.5 million, or $0.08 per share, as compared to a net loss for the quarter ended June 30, 2011 of $4.0 million, or $0.21 per share.  As of June 30, 2012, the balance sheet continues to be strong with $98.7 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 and six months ended June 30, 2012 and 2011, respectively (in thousands, except for percentages):

   
Three Months Ended June 30,
         
   
2012
   
2011
           
         
As a % of
     
As a % of
           
         
Total
         
Total
   
Change
 
   
Amount
   
Revenue
   
Amount
   
Revenue
     $     %
Revenues
                                   
   Professional product revenues
  $ 13,030       66 %   $ 10,054       62 %   $ 2,976     30 %
   Consumer product revenues
    900       5 %     -       - %     900     N/ A
   Service revenues
    3,546       18 %     3,907       24 %     (361 )   (9 %)
   Royalty revenues
    1,527       8 %     1,749       11 %     (222 )   (13 %)
   Other revenues
    667       3 %     556       3 %     111     20 %
   Total revenues
    19,670       100 %     16,266       100 %     3,404     21 %
                                               
Costs and expenses
                                             
   Cost of professional product revenues
    5,045       26 %     3,970       24 %     1,075     27 %
   Cost of consumer product revenues
    776       4 %     14       - %     762     N/ A
   Cost of service revenues
    1,654       8 %     1,664       10 %     (10 )   (1 %)
   Cost of royalty revenues
    611       3 %     700       4 %     (89 )   (13 %)
   Research and development
    2,836       14 %     3,880       24 %     (1,044 )   (27 %)
   Selling and marketing
    7,075       36 %     6,316       39 %     759     12 %
   General and administrative
    2,942       15 %     3,782       23 %     (840 )   (22 %)
   Total costs and expenses
    20,939       106 %     20,326       125 %     613     3 %
                                               
   Loss from operations
    (1,269 )     (6 %)     (4,060 )     (25 %)     2,791     (69 %)
                                               
   Interest income
    86       - %     89       1 %     (3 )   (3 %)
   Other (loss) income
    (271 )     (1 %)     29       - %     (300 )   (1034 %)
                                               
Loss before income taxes
    (1,454 )     (7 %)     (3,942 )     (24 %)     2,488     (63 %)
                                               
Provision for income taxes
    18       - %     57       - %     (39 )   (68 %)
                                               
Net loss
  $ (1,472 )     (7 %)   $ (3,999 )     (25 %)   $ 2,527     (63 %)
                                               
                                               
                                               
 
 
 
17

 

   
Six Months Ended June 30,
         
   
2012
   
2011
         
          As a % of        
As a % of
           
         
Total
         
Total
   
Change
 
   
Amount
   
Revenue
   
Amount
   
Revenue
     $     %
Revenues
                                   
   Professional product revenues
  $ 24,927       64 %   $ 20,601       60 %   $ 4,326     21 %
   Consumer product revenues
    1,879       5 %     -       - %     1,879     N/ A
   Service revenues
    7,316       19 %     7,742       22 %     (426 )   (6 %)
   Royalty revenues
    3,325       9 %     4,967       14 %     (1,642 )   (33 %)
   Other revenues
    1,222       3 %     1,111       3 %     111     10 %
   Total revenues
    38,669       100 %     34,421       100 %     4,248     12 %
                                               
Costs and expenses
                                             
   Cost of professional product revenues
    9,946       26 %     8,274       24 %     1,672     20 %
   Cost of consumer product revenues
    1,611       4 %     56       - %     1,555     2777 %
   Cost of service revenues
    3,314       9 %     3,456       10 %     (142 )   (4 %)
   Cost of royalty revenues
    1,330       3 %     1,987       6 %     (657 )   (33 %)
   Research and development
    6,208       16 %     7,528       22 %     (1,320 )   (18 %)
   Selling and marketing
    13,756       36 %     11,891       35 %     1,865     16 %
   General and administrative
    6,093       16 %     7,268       21 %     (1,175 )   (16 %)
   Total costs and expenses
    42,258       109 %     40,460       118 %     1,798     4 %
                                               
   Loss from operations
    (3,589 )     (9 %)     (6,039 )     (18 %)     2,450     (41 %)
                                               
   Interest income
    175       - %     202       1 %     (27 )   (13 %)
   Other (loss) income
    (259 )     (1 %)     39       - %     (298 )   (764 %)
                                               
Loss before income taxes
    (3,673 )     (9 %)     (5,798 )     (17 %)     2,125     (37 %)
                                               
Provision for income taxes
    90       - %     95       - %     (5 )   (5 %)
                                               
Net loss
  $ (3,763 )     (10 %)   $ (5,893 )     (17 %)   $ 2,130     (36 %)
                                               

Professional product revenues.  During the three and six months ended June 30, 2012, our professional product revenues increased 30% and 21%, respectively, as compared to the corresponding periods in the prior year, primarily due to the Icon Aesthetic System, our new flagship platform, which we launched during the second half of 2011.  Almost 50% of our professional product revenues in the three and six months ended June 30, 2012 were from Icon System sales.  We are still in the regulatory registration process for many countries and will continue to sell the StarLux 500® system until we have registrations in all areas around the world.  In the first three and six months of 2012, as compared to the corresponding periods in 2011, professional product revenues were favorably impacted by the Icon System as well as the introduction of the Emerge™ Fractional Laser and Vectus system in the first quarter of 2012. 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 System.
 
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 and six months ended June 30, 2012, we recognized $0.9 million and $1.9 million, respectively, 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 professional products. During the three and six months ended June 30, 2012, service revenues decreased 9% and 6%, respectively, as compared to the corresponding periods in the prior year.  The decrease in the three and six months ended June 30, 2012 was primarily due to lower sales from ongoing service contracts and billable services.
 
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
 
Six Months Ended
   
June 30,
 
June 30,
   
2012
 
2011
 
2012
 
2011
North America
    51 %     57 %     55 %     57 %
Europe
    18 %     14 %     19 %     16 %
Middle East
    11 %     8 %     8 %     7 %
Australia
    7 %     5 %     5 %     5 %
Asia/Pacific Rim
    5 %     6 %     3 %     5 %
Japan
    5 %     4 %     5 %     4 %
South and Central America
    3 %     6 %     5 %     6 %
                                 
Total
    100 %     100 %     100 %     100 %
                                 

In the first three and six month periods of 2012, 100% and 92%, respectively, of our Consumer Product segment revenues were derived from sales in the United States and 0% and 8%, respectively, were from Europe.

Royalty revenues.  Royalty revenues decreased for the three and six months ended June 30, 2012 by 13% and 33%, respectively, as compared to the corresponding periods in the prior year.  The decrease is 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 and six months ended June 30, 2012, other revenues increased 20% and 10%, respectively, as compared to the corresponding periods in the prior year.  Other revenues were generated from the amendment to our license agreement (“License Agreement”) with P&G which was signed in the fourth quarter of 2010.  In accordance with the License Agreement, during the second quarter of 2012, P&G paid us an Additional TTP Quarterly Payment (as defined in the License Agreement) of $1.0 million.  This Additional TTP Quarterly Payment resulted in $0.7 million in other revenues during the second quarter of 2012 after being netted with the receivable from P&G as payments under the amended License Agreement were being recognized ratably through the expected launch term. During the six months ended June 30, 2012, other revenues consists of $0.6 million related to TTP Quarterly Payments received under the amended License Agreement which were being recognized ratably through the expected launch term plus the $0.7 million previously mentioned.  For the three and six months ended June 30, 2011, other revenues consisted of the recognition of $0.6 million and $1.1 million, respectively, related to TTP Quarterly Payments received under the amended License Agreement.  The TTP Quarterly Payments under the amended License Agreement were being recognized ratably through the expected launch term.

Going forward, P&G will make technology transfer payments (“TTPs”) based on a percentage of net sales of its light-based hair removal product.  We will recognize these TTPs as other revenues.

 Cost of professional product revenues. For the three months ended June 30, 2012 and 2011, the cost of professional product revenues increased in absolute dollars, but remained consistent as a percentage of professional product revenues at 39% in both 2012 and 2011. For the six months ended June 30, 2012 and 2011, the cost of professional product revenues increased in absolute dollars, but remained consistent as a percentage of professional product revenues at 40% 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.

 
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Cost of consumer product revenues. The cost of consumer product revenues relates to the PaloVia® Skin Renewing Laser®.  For the three and six months ended June 30, 2012, cost of consumer product revenues was $0.8 million and $1.6 million, respectively or 86% of consumer product revenues for both periods.  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 and the related expenses.
 
 Cost of service revenues.  For the three months ended June 30, 2012 and 2011, the cost of service revenues decreased in absolute dollars, but increased as a percentage of service revenues to 47% in 2012 from 43% in 2011. The increase as a percentage is due higher material costs, partially offset by a decrease in shipping expenses. For the six months ended June 30, 2012 and 2011, the cost of service revenues decreased in absolute dollars, but remained constant as a percentage of service revenues at 45% for both years.

Cost of royalty revenues.  Cost of royalty revenues decreased for the three and six months ended June 30, 2012 by 13% and 33%, respectively, as compared to the corresponding periods in the prior year.  The decrease is 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. As a percentage of royalty revenues, the cost of royalty revenues for the three and six months ended June 30, 2012 and 2011 were 40%.

Research and development expense. Research and development expense decreased by $1.0 million, or 27%, for the three months ended June 30, 2012 over the corresponding period in 2011.  Research and development expense decreased by $1.3 million, or 18%, for the six months ended June 30, 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 28% and 19%, respectively, for the three and six months ended June 30, 2012, as compared to the corresponding periods 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 remained constant for the three and six months ended June 30, 2012, as compared to the corresponding periods in 2011.
 
 For the three months ended June 30, 2012 and 2011, research and development expense included $0.3 million and $0.4 million, respectively, of stock-based compensation expense.  For the six months ended June 30, 2012 and 2011, research and development expense included $0.5 million and $0.9 million, respectively, of stock-based compensation expense.

Selling and marketing expense.  Selling and marketing expense increased by $0.8 million, or 12%, for the three months ended June 30, 2012 over the corresponding period in 2011.  Selling and marketing expense increased by $1.9 million, or 16%, for the six months ended June 30, 2012 over the corresponding period in 2011.  Selling and marketing expenses relating to our Professional Product segment increased by 10% and 13%, respectively, in the three and six months ended June 30, 2012 as compared to corresponding periods in 2011.   The increase for the three months ended June 30, 2012 was primarily driven by an increase of $0.5 million in commission expense.  The increase for the six months ended June 30, 2012 was primarily driven by an increase of $0.8 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 30% and 45%, respectively, in the three and six months ended June 30, 2012 as compared to corresponding periods in 2011.  The increase for the three and six months ended June 30, 2012 was primarily driven by increases of $0.2 million and $0.4 million, respectively in direct marketing expenses.
 
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For the three months ended June 30, 2012 and 2011, selling and marketing expense included $0.2 million and $0.3 million, respectively, of stock-based compensation expense.  For the six months ended June 30, 2012 and 2011, selling and marketing expense included $0.4 million and $0.6 million, respectively, of stock-based compensation expense.

General and administrative expense.  General and administrative expense decreased by $0.8 million, or 22%, for the three months ended June 30, 2012 over the corresponding period in 2011.  General and administrative expense decreased by $1.2 million, or 16%, for the six months ended June 30, 2012 over the corresponding period in 2011.  The decrease in general and administrative expense for the three months ended June 30, 2012 was driven by lower legal expenses partially offset by higher incentive compensation. The decrease in general and administrative expense for the six months ended June 30, 2012 was driven by lower legal expenses and stock-based compensation expense, partially offset by higher incentive compensation.

For both the three months ended June 30, 2012 and 2011, general and administrative expense included $0.2 million of stock-based compensation expense.  For the six months ended June 30, 2012 and 2011, general and administrative expense included $0.3 million and $0.4 million, respectively, of stock-based compensation expense.

Interest income. Interest income for the three and six months ended June 30, 2012 decreased by 3% and 13%, respectively, as compared to the corresponding periods in 2011 primarily due to lower interest rates, partially offset by a higher average cash and cash equivalents, short-term investments, and marketable securities and other investments balance during the first half of 2012 as compared to the corresponding periods in 2011.
 
Other (loss) income.  Other (loss) income for the six months ended June 30, 2012 and 2011 includes the foreign exchange (loss) gain resulting from transactions in currencies other than the U.S. dollar.

Provision for income taxes.  Our effective tax rate for the six months ended June 30, 2012 and 2011 was 2.5% and 1.7%, respectively.  In 2012, the company is generating taxable profits before the excess tax benefit of stock option deductions, and our rate consists primarily of federal tax and minimum state taxes.  In 2011, our effective tax rate consisted primarily of minimum state taxes as the company generated operating losses during the period ending June 30, 2011.  We continue to maintain a full valuation allowance in all jurisdictions and have available net operating losses in foreign jurisdictions to offset future income in those jurisdictions.

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):
 
   
Six months ended
 
Six months ended
         
   
June 30,
 
June 30,
 
Change
   
2012
 
2011
   $   %
Cash flows used in operating activities
  $ (9,834 )   $ (10,962 )     (1,128 )   (10 %)
Cash flows from investing activities
    2,786       21,109       (18,323 )   (87 %)
Cash flows from financing activities
    31       187       (156 )   (83 %)
Capital expenditures
    463       703       (240 )   (34 %)
                               
 
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).
 
 
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June 30,
   
December 31,
Change
   
2012
   
2011
     $   %
Cash and cash equivalents
  $ 56,050     $ 63,077       (7,027 )   (11 %)
Short-term investments
    30,143       24,740       5,403     22 %
Accounts receivable, net
    10,479       9,854       625     6 %
Inventories
    25,242       21,176       4,066     19 %
Marketable securities and other investments
    12,484       21,269       (8,785 )   (41 %)
Working capital
    106,215       99,509       6,706     7 %
                               
 
           As of June 30, 2012, we had $98.7 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 June 30, 2012, we had no debt outstanding.

At June 30, 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 June 30, 2012 and 2011. During the six months ended June 30, 2012 and 2011, we sold $0 and $0.4 million of our ARS at par, respectively.
 
We have determined that the fair value of our ARS was temporarily impaired as of June 30, 2012 and 2011.  For the three months ended June 30, 2012 and 2011, we marked to market our ARS and recorded an unrealized gain of $1,000 and $4,000, respectively, net of taxes in accumulated other comprehensive (loss) income in stockholder’s equity to reflect the temporary impairment of our ARS. For the six months ended June 30, 2012 and 2011, we marked to market our ARS and recorded an unrealized loss of $24,000 and unrealized gain of $25,000, 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 June 30, 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 decreased for the period ended June 30, 2012 as compared to the corresponding period in 2011. This decrease primarily reflects the effects of a smaller net loss, offset by lower stock-based compensation expense and amortization expense. Cash from investing activities increased during the period ended June 30, 2012 as compared to the corresponding period in 2011. These amounts primarily reflect less cash used for purchases of property and equipment and purchases of and proceeds from the sale of short-term investments and marketable securities. Cash from financing activities decreased for period ended June 30, 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.
 
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 June 30, 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 June 30, 2012, we did not purchase any of our common stock through the stock repurchase program.

 
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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 June 30, 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 and six months ended June 30, 2012, totaled approximately $0.6 million and $1.3 million, respectively. For more information, please see the Amended and Restated License Agreement (MGH Case Nos. 783, 912, 2100), the License Agreement (MGH Case No. 2057) and the License Agreement (MGH Case No. 1316) filed as Exhibits 10.1, 10.2, and 10.3 to our Current Report on Form 8-K filed on March 20, 2008.
 
We have obligations related to 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 June 30, 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
  $ 439     $ 278     $ 161     $ -     $ -  
Purchase commitments
    10,814       10,814       -       -       -  
Total contractual cash obligations
  $ 11,253     $ 11,092     $ 161     $ -     $ -  
                                         

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 th