|
For
the three and six-months ended June 30, 2003 and 2002, potential common shares of
4,407,498 and 5,415,678, respectively, of certain outstanding stock options and stock
warrants were not included in the diluted weighted average shares outstanding as they were
antidilutive.
10. Funded product
development revenue
As
of February 14, 2003, the Company entered into a Development and License Agreement with
the Gillette Company (NYSE: G) (“Gillette”) to complete development and
commercialize a home-use, light-based, hair removal device for women. The device is
protected by multiple patents within Palomar’s patent portfolio. The agreement
provides up to $7 million in initial development support funding to be paid by Gillette to
Palomar over approximately the first 30 months of the agreement, with $2.6 million to be
provided during 2003.
The
Company accounts for funded product development revenue under the Gillette agreement as
received because the funding must be made so long as the Company is not in breach of the
agreement.
8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
We
are a researcher and developer of proprietary light (both lasers and lamp) based systems
for hair removal and other cosmetic treatments; as well as, the first company to obtain
clearance from the FDA using laser systems for “permanent hair reduction.”
Palomar’s light based hair removal systems have been installed in physician practices
worldwide. Through Palomar’s research partnerships with Massachusetts General
Hospital’s Wellman Laboratories (“General”) and other centers, new
indications are being tested to further advance the hair removal market and other cosmetic
light based applications including fat reduction, acne treatment and skin rejuvenation.
Broad
market acceptance of light based hair and tattoo removal and other cosmetic applications
and further acceptance of the Palomar MediLux™ lamp based system, the Palomar
EsteLux™ lamp based system and the Palomar Q-Yag 5™ Q-Switched ND: Yag laser
system are critical to the Company’s success. These three systems, all of which have
FDA clearance, cover a wide spectrum of cosmetic applications. The Palomar MediLux system
is a higher powered system than the Palomar EsteLux system, and also has a higher
repetition rate (treatment rate) and quick connect handpiece connector. Both the Palomar
MediLux and EsteLux systems are fast, compact and efficient lamp based systems for both
temporary and permanent hair reduction and pigmented and vascular lesion removal. In
addition, the Palomar MediLux and EsteLux systems are sold outside the United States for
treatment of acne and Palomar is currently seeking FDA clearance for this application in
the United States. The Palomar Q-Yag 5 is a laser system for tattoo and pigmented lesion
removal. The Company has traditionally spent a significant amount of its resources in
developing new technologies and products and believes that the successful introduction and
marketing of new products is critical to the Company’s long-term success.
On
February 14, 2003, the Company entered into a Development and License Agreement with
Gillette to complete development and commercialize a home-use, light-based hair removal
device for women.
Critical Accounting
Policies
The
discussion and analysis of the Company’s financial condition and results of
operations are based upon the Company’s consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the United
States. The preparation of these financial statements requires the Company to make
estimates and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses, and related disclosure of contingent assets and liabilities. On an on-going
basis, the Company evaluates its estimates, including those related to revenue
recognition, bad debts, inventories, warranty obligations, contingencies, restructurings
and income taxes. The Company bases its estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying value of assets and
liabilities that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. A discussion of the
Company’s critical accounting policies and the related judgments and estimates
affecting the preparation of the Company’s consolidated financial statements is
included in the Annual Report on Form 10-K of the Company for fiscal year 2002.
Results of Operations
Product
revenues. Product revenues increased to $7.7 million from $5.4 million during the
three-month period ended June 30, 2003 in comparison to the same period in 2002. The
leading contributor to this increase of $2.3 million or 44% in product revenues was the
increase in sales of the family of “Lux” product lines which includes the
EsteLux, MediLux and additional handpieces. During the three-month period ended June 30,
2003, the sale of additional Lux handpiece revenue increased substantially as there were
no additional Lux handpieces sold during the same period in 2002.
Product
revenues increased to $13.9 million from $8.8 million during the six-month period ended
June 30, 2003. The leading contributor to this increase of $5.1 million or 58% in product
revenues was the family of “Lux” product lines which includes the
EsteLux, MediLux and additional handpieces. During six-month period ended June 30, 2003,
the sale of additional Lux handpiece revenue increased substantially as there were no
additional Lux handpieces sold during the same period in 2002.
9
Royalty
revenues. Royalty revenues decreased to $233,000 from $977,000 for the three-months
ended June 30, 2003 and 2002, respectively. Royalty revenues decreased to $469,000 from
$1.8 million for the six-months ended June 30, 2003 and 2002, respectively. These
decreases in comparison to the same period in 2002 are attributed to Lumenis Inc.‘s
(Nasdaq: LUME) (“Lumenis”) failure to make its royalty payments starting in
October 2002 (see “Legal Proceedings”).
Funded
product development revenues. For the three-months and six-months ended June 30, 2003,
funded product development revenue of $700,000 and $1.2 million, respectively, was for
work performed in connection with payments made by Gillette. On February 14, 2003, the
Company entered into a Development and License Agreement with Gillette to complete
development and commercialize a home-use, light-based hair removal device for women.
Cost
of product revenues. Cost of product revenues increased to $3.2 million from $2.6
million for the three-months ended June 30, 2003 in comparison to the same period in 2002.
The increase in cost of product revenues during 2003 as compared to 2002 is solely
attributed to increased product sales volume. As a percentage of product revenues, cost of
product revenues decreased to 42% for the three-months ended June 30, 2003 from 48% for
the same period in 2002. Contributing to this decrease of the cost of product revenue as a
percentage of product revenue is the efficient use of the Company’s fixed overhead
costs with the increased volume associated with the growth in product revenues.
Cost
of product revenues increased to $5.9 million from $4.8 million for the six-months ended
June 30, 2003 in comparison to the same period in 2002. The increase in cost of product
revenues during 2003 as compared to 2002 is primarily attributed to increased product
sales volume. As a percentage of product revenues, cost of product revenues decreased to
42% for the six-months ended June 30, 2003 from 55% for the same period in 2002.
Contributing to this decrease of the cost of product revenue as a percentage of product
revenue is the efficient use of the Company’s fixed overhead costs with the increased
volume associated with the growth in product revenues and the adjustment made to royalty
reserves of approximately $332,000 to reflect royalty rates established with General. A
portion of this decrease as a percentage of product revenues in 2003 was offset by the
Company writing off $250,000 of clinical and demonstration units related to the SLP 1000
product line during the first quarter of 2003.
Cost
of royalty revenues. Cost of royalty revenues decreased in dollars to $93,000
from $391,000 for the three-month period ended June 30, 2003 and as a percentage of
royalty revenues was consistent at 40%. Cost of royalty revenues decreased in dollars to
$188,000 from $733,000 for the six-month period ended June 30, 2003 and as a percentage of
royalty revenues was consistent at 40%. The decrease in royalty revenues is attributed to
Lumenis’ failure to make its royalty payment resulting in a reduced cost of royalty
due to General.
Research
and development expenses. Research and development expenses increased to $1.4 million
(16% of total revenues) from $1.1 million (17% of total revenues) for the three-months
ended June 30, 2003 and 2002, respectively. Research and development expenses increased to
$2.7 million (17% of total revenues) from $2.1 million (20% of total revenues) for the
six-months ended June 30, 2003 and 2002, respectively. This increase in dollars is
attributed to costs associated with the Development and License Agreement with Gillette to
complete development and commercialize a home-use, light-based hair removal device for
women. Research and development costs as a percentage of total revenues decreased during
the three-months and six-months ended June 30, 2003 as compared to the same period in
2002, due to increased total revenues. The spending on research and development reflects
the Company’s commitment to continuing dermatology research for a better
understanding of various cosmetic and medical conditions and to continuing research and
development of devices and delivery systems to better treat those various cosmetic and
medical conditions. The research and development goals in the fields of light based hair
removal and pigmented and vascular lesion removal are to design systems that (1) permit
more rapid treatment of large areas, (2) have high gross margins, and (3) are manufactured
at lower costs, to expand our current markets. Furthermore, the Company is developing
products to address other dermatology and cosmetic conditions, including the fields of fat
reduction, acne treatment and skin rejuvenation.
10
Selling
and marketing expenses. Selling and marketing expenses increased to $2.1 million (25%
of total revenues) from $1.4 million (22% of total revenues) for the three-months ended
June 30, 2003 as compared to 2002. Selling and marketing expenses increased to $3.7
million (24% of total revenues) from $2.2 million (20% of total revenues) for the
six-months ended June 30, 2003 as compared to 2002. This increase in selling and marketing
expenses is due to increased costs associated with the roll-out of the Company’s
product lines and an expanded direct sales force and international commissions.
General
and administrative expenses. General and administrative expenses increased to $1.2
million (14% of total revenues) from $789,000 (12% of total revenues) for the three-months
ended June 30, 2003 as compared to 2002. General and administrative expenses increased to
$2.2 million (14% of total revenues) from $1.4 million (13% of total revenues) for the
six-months ended June 30, 2003 as compared to 2002. The increase in general and
administrative dollars and as a percentage of revenues is primarily related to additional
legal expenses incurred as a result of enforcing the Company’s patent position
against infringers, defending the opposition of a European Patent exclusively licensed
to the Company by General and an increase in the incentive compensation accrual.
Interest
income. Interest income increased to $20,000 from $15,000 for the three-months ended
June 30, 2003 and 2002, respectively. Interest income remained constant at $35,000 for the
six-months ended June 30, 2003 and 2002 as the higher levels of excess cash was offset by
lower interest rates.
Interest
expense. Interest expense decreased to $1,000 from $27,000 for the three-months ended
June 30, 2003 as compared to 2002. Interest expense decreased to $25,000 from $57,000 for
the six-months ended June 30, 2003 as compared to 2002. This decrease is attributable to
the reduction of debt, on March 14, 2003, as a result of a director surrendering a $1
million Promissory Note and was issued 293,255 shares of the Company’s Common
Stock with no registration rights at a price of $3.41 per share. The price was calculated
at 110% of the Company’s Common Stock trailing ten-day average closing price of $3.10
per share
Other
income. Other income for the three-months ended June 30, 2002 was $110,000. Other
income decreased to $58,000 from $168,000 for the six-months ended June 30, 2003 as
compared to 2002. Other income is attributable to payments received from a previously
written-off equity investment and a partial payment of a note receivable that was written
off in a prior year.
Income
Taxes. The benefit from income taxes for the three-months and six-months ended June
30, 2003 was $430,000 and reflects the Company’s filing of refund claims to carryback
operating losses to recover taxes paid in prior years pursuant to the Economic Stimulus
package of 2002. Offsetting the refund claims, the company is providing a 4% effective tax
rate for both the three-months and six-months ended June 30, 2003 for the anticipated
alternative minimum taxes and minimum state taxes due for 2003.
Liquidity and Capital
Resources
As
of June 30, 2003, the Company had $7.4 million in cash and cash equivalents. The
continued, successful sales of the Company’s current products and future products
will be critical to the Company’s future liquidity.
The
Company believes that cash balances will be sufficient to meet anticipated cash
requirements for the next twelve months. The Company cannot be sure that it will not
require additional capital beyond the amounts currently forecasted by the Company or that
any such required additional capital will be available on reasonable terms, if at all,
when such capital is required.
The
Consolidated Statements of Cash Flows reflect events in the first six-months of 2003 and
2002 as they affect the Company’s liquidity. A net use of cash from operating
activities was $854,000 in the 2003 period as compared to $1.2 million in 2002. Positively
affecting cash flows for the 2003 period were net income, depreciation and amortization,
inventory write-off and deferred revenue. Negatively impacting operating cash flows in
2003 were increases in accounts receivable, inventories, other current assets and
decreases in accounts payable and accrued liabilities. Positively affecting cash flows for
the 2002 period were depreciation and amortization, decreases in inventories, other
current assets and an increase in accrued liabilities and deferred revenue. Negatively
impacting operating cash flows in 2002 were the net loss, increase in accounts receivable
and decreases in accounts payable.
11
Net
cash from investing activities used cash of $151,000 in the 2003 period as compared to
$89,000 in 2002 primarily the result of purchases of property and equipment.
Net
cash from financing activities provided cash of $3.9 million in 2003 and used cash of
$407,000 in 2002. Positively affecting cash flows from financing activities for 2003 were
the proceeds from the sales of common stock, the exercise of stock options and employee
stock purchase plan and proceeds from the sale of common stock. Positively affecting cash
flows from financing activities for 2002 were the proceeds from the exercise of stock
options and employee stock purchase plan. Negatively affecting cash flows from financing
activities for the 2003 and 2002 were costs incurred related to the issuance of common
stock. In addition, negatively affecting cash flows in 2002 were payments made on a
convertible debenture.
The
Company anticipates that capital expenditures for the remainder of 2003 will total
approximately $100,000, consisting primarily of machinery, equipment, computers and
peripherals. The Company expects to finance these expenditures with cash on hand.
Lumenis
has failed to make the royalty payments due since October 30, 2002 for sales of their
Lightsheer diode laser system On February 14, 2003, the Company terminated its license
agreement with Lumenis (see part II, item 1, Legal Proceedings for more details). During
the second quarter of 2003, Carl Zeiss Meditec AG, parent company to Asclepion-Meditec AG,
notified the Company that it had sold Asclepion to EL.EN and Quanta System and,
consequently, terminated the sub-license agreement between Asclepion and the Company
effective July 31, 2003. To date, Asclepion has only paid the Company a minimum royalty
payment of fifty thousand dollars ($50,000) per year, prorated in the first and last
years. These reductions and any other loss or reduction in the Company’s royalty
revenues could have a material adverse effect on the business and financial condition,
affect future liquidity and prevent the Company from maintaining profitability. The
Company faces risks associated with pending litigation and there can be no assurance that
these royalty amounts from other third parties will not decrease or that the Company will
be able to collect all licensing royalties owed by current licensees or increase royalties
by sub-licensing additional third parties.
On
February 14, 2003, the Company entered into a Development and License Agreement with
Gillette to complete development and commercialize a home-use, light-based, hair removal
device for women. The agreement provides up to $7 million in initial development support
funding to be paid by Gillette to Palomar over approximately the first 30 months of the
agreement, with $2.6 million to be provided during 2003.
On
March 14, 2003, a director surrendered the $1 million principal balance of a Promissory
Note and was issued 293,255 shares of the Company’s common stock with no
registration rights at a price of $3.41 per share. The price was calculated at 110% of the
Company’s common stock trailing ten-day average closing price of $3.10 per share.
On
March 14, 2003, the Company completed a private placement with Craig Drill Capital, a
private investment firm based in New York City, for the purchase of 1 million shares of
the Company’s common stock with no registration rights at a price of $3.41 per share
for an aggregate subscription price of $3.4 million. The price was calculated at 110% of
the Company’s common stock trailing ten-day average closing price of $3.10 per share.
Statement Under the
Private Securities Litigation Reform Act
In
addition to the other information in this Form 10-Q, the following cautionary statements
should be considered carefully in evaluating the Company and its business. Statements
contained in this Form 10-Q that are not historical facts may contain certain
forward-looking information, as defined by (i) the Private Securities Litigation Reform
Act of 1995 (the “Reform Act”) and (ii) releases by the SEC including but not
limited to statements relating to new markets, development and introduction of new
products, and financial projections that involve risk and uncertainties that may
individually or mutually impact the matters herein, and cause actual results, events and
performance to differ materially from such forward-looking statements. Our actual results
could differ materially from those suggested in such forward-looking statements due to the
cautionary statements identified below and other factors including, without limitation,
risks concerning the timing of new product introductions, financing of future operations,
manufacturing risks, variations in our quarterly results, the occurrence of unanticipated
events and circumstances and general economic conditions, including stock market
volatility, results
12
of future operations, technological
difficulties in developing or introducing new products, the results of future research,
lack of product demand and market acceptance for current and future products, challenges
in managing joint ventures and research with third-parties, the impact of competitive
products and pricing, governmental regulations with respect to medical devices, including
whether FDA clearance will be obtained for future products, the results of litigation,
difficulties in collecting royalties, potential infringement of third-party intellectual
property rights, and/or other factors, which are detailed from time to time in the
Company’s SEC reports, including the report on Form 10-K for the year ended December
31, 2002 and the Company’s quarterly reports on Form 10-Q. Readers are cautioned not
to place undue reliance on these forward-looking statements, which speak only as of the
date hereof. The Company undertakes no obligation to release publicly the results of any
revisions to these forward-looking statements that may be made to reflect events or
circumstances after the date hereof or to reflect the occurrence of unanticipated events.
The cautionary statements below are being made pursuant to the provisions of the Reform
Act and with the intention of obtaining the benefits of safe harbor provisions of the
Reform Act. Forward looking statements include statements regarding our expectations,
beliefs, intentions or strategies regarding the future and can be identified by
forward-looking words such as “anticipate,” “believe,”
“could,” “estimate,” “expect,” “intend,”
“may,” “should,” “will,”, “would” and
“potential” or similar words.
Cautionary Statements
Our future revenue depends on our
successfully developing and marketing new products.
Light
based technology is rapidly changing and improving. In order to be successful, we must
continue to make significant investments in research and development in order to develop
in a timely and cost-effective manner new products that meet changing market demands,
enhance existing products, and achieve market acceptance for such products. We have in the
past experienced delays in developing and marketing new products and enhancing existing
products. Furthermore, some of our new products under development are based on unproven
technology and/or technology with which the Company has no previous experience. In
addition, the market for professional hair removal light based devices may already be
saturated. At present, broader market acceptance of light based hair removal is critical
to our success and we intend to continue our goals of bringing light based hair removal
devices to the mass consumer market. We also intend to continue to diversify our product
line by developing cosmetic light based products for uses other than hair and tattoo
removal and treatment of pigmented and vascular lesions. There can be no assurance that we
will be able to successfully implement such strategy in a timely fashion or at all.
We face intense competition from
companies with superior financial, marketing and other resources.
The
light based hair removal industry is highly competitive and companies frequently introduce
new products. We compete in the development, manufacture, marketing, sales and servicing
of light based hair removal devices with numerous other companies, some of which have
substantially greater financial, marketing and other resources than the Company. Our
products also face competition from medical products and cosmetic procedures, such as
electrolysis and waxing, among others. We may not be able to differentiate our products
from the products of our competitors, and customers may not consider our products to be
superior to competing products or procedures, especially if competitive products and
procedures are offered at lower prices. Our competitors may develop products or new
technologies that make our products obsolete or less competitive.
We may need to secure
additional financing.
Although
the Company has generated a profit in recent quarters, the Company has a history of
losses. We may have to secure additional financing to complete our research and
development activities, commercialize our current and proposed light based products, and
fund ongoing operations. However, there can be no assurance that such financing will be
obtained. We may also determine, depending upon the opportunities available, to seek
additional debt or equity financing to fund the costs of operations or expansion.
Additionally, if we incur indebtedness to fund increased levels of accounts receivable,
finance the acquisition of capital equipment, or if we issue debt securities in connection
with any acquisition we will be subject to risks associated with incurring substantial
additional indebtedness. Our quarterly operating results are and may continue to be
volatile, and that may hurt the price of our common stock. If our operating results fall
below the expectations of investors or public market analysts, the price of our common
stock could decline.
13
We depend on a number of vendors
for critical components in our current and future products.
We
develop light based systems that incorporate third-party components. Some of these items
are custom made or otherwise not readily available on the market. We purchase some of
these components from small, specialized vendors that are not well capitalized. A
disruption in the delivery of these key components could have an adverse effect on our
business. We depend on an acceptable level of reliability for purchased components.
Reliability below expectations for key components could have an adverse affect on
inventory and inventory reserves.
Our products are subject to
numerous medical device regulations. Compliance is expensive and time-consuming. Our new
products may not be able to obtain the necessary clearances in order to sell them.
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. We have modified some of our products under
letters to file. The FDA could retroactively decide that the modification require 510(k)
or PMA clearance and may force us to cease marketing and/or recall the modified products.
Our products may also be subject to state regulations, which are, in many instances, in
flux. Changes in state regulations may enhance or impede sales. Our products are subject
to similar regulations in our major 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, and we may not be able to obtain such clearances
in a timely fashion or at all. 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.
Federal
regulation allows our products to be sold to and used by licensed practitioners as
determined on a state-by-state basis. As a result, in some states non-physicians may
operate our product. However, a state could disagree with our decision to sell to a
particular type of end user or change regulations allowing sales to particular types of
end users. Similar risks apply to our international markets. The purchase and use of our
products by non-physicians may result in their misuse, which could harm our reputation and
expose us to costly product liability litigation.
We are dependent on
third-party researchers.
We
are substantially dependent upon third-party researchers over whom we do not have absolute
control to satisfactorily conduct and complete research on our behalf. We are also
substantially dependent upon third-party researchers to grant us licensing terms, which
may or may not be favorable for products and technology, which they may develop. At
present, our principal research partner is the Wellman Laboratories of Photomedicine at
Massachusetts General Hospital. We provide research funding, light technology and optics
know-how in return for licensing rights with respect to specific medical applications and
patents. In return for certain exclusive license rights, the Company is subject to due
diligence obligations in order to maintain such exclusivity. Our success will be highly
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 the
Company’s 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.
Our common stock could be further
diluted as the result of outstanding options and warrants.
In
the past, we have issued and still have outstanding convertible securities in the form of
warrants in order to raise money and for payment of certain consulting agreements. We have
and may continue to issue options and warrants as compensation for services and incentive
compensation for our employees and directors. 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.
14
Our proprietary
technology has only limited protections.
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, license and confidentiality agreements to protect our
proprietary rights. We generally enter into non-disclosure 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. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to copy or
otherwise obtain and use our technology. 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 technology, our ability to compete effectively could be harmed. 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. Our competitors also may independently develop technologies that are
substantially equivalent or superior to our technology and which do not infringe our
patents.
We could become subject to claims
by third parties regarding intellectual property rights.
In
recent years, there has been significant litigation in the United States involving patents
and other intellectual property rights. The light based hair removal industry in
particular is characterized by the large number of patents and frequent claims and related
litigation regarding patent 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. 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 products. This could have a material adverse effect on our business,
results of operations and financial condition.
Our charter documents and Delaware
law may discourage potential takeover attempts.
Our
Second Restated Certificate of Incorporation and our 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 the Secretary of the
Company 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
affirmative vote of a majority of the Board of Directors. These provisions could delay any stockholder actions
that are favored by the holders of a majority of the outstanding stock of the Company
until the next stockholders’ meeting. In addition, the Board of Directors is
authorized to issue shares of 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 the
Company.
15
The
Company is also subject to the anti-takeover provisions of Section 203 of the Delaware
General Corporation Law, which prohibits the Company 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, 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
management of the Company, including transactions in which stockholders might otherwise
receive a premium for their shares over the then current market price.
As with any new products, there is
substantial risk that the marketplace may not accept or be receptive to the potential
benefits of our products.
Market
acceptance of our current and proposed products will depend, in large part, upon our or
any marketing partner’s ability to demonstrate to the marketplace the advantages of
our products over other types of products. There can be no assurance that the marketplace
will accept applications or uses for our current and proposed products or that any of our
current or proposed products will be able to compete effectively.
We may not be able to
successfully collect licensing royalties.
In
past years, material portions of our revenues consisted of royalties from sub-licensing
patents licensed to us on an exclusive basis by General.
Lumenis
failed to make the royalty payments due since October 30, 2002 for sales of their
Lightsheer diode laser system. On February 14, 2003, the Company terminated its license
agreement with Lumenis (see part II, item 1, Legal Proceedings for more details). This
reduction and any other loss or reduction in the Company’s royalty revenues could
have a material adverse effect on the business and financial condition, affect future
liquidity and prevent the Company from maintaining profitability. The Company faces risks
associated with pending litigation and there can be no assurance that these royalty
amounts from other third parties will not decrease or that the Company will be able to
collect all licensing royalties owed by current licensees or increase royalties by
sub-licensing additional third parties.
We
are involved in disputes with other third parties, including Altus Medical Inc.
(“Altus”) (see part II, item 1, Legal Proceedings). Such disputes have resulted
in litigation with such parties. We have incurred, and likely will continue to incur,
legal expenses in connection with such matters. There can be no assurance that such
litigation will result in favorable outcomes for us. Any adverse result in litigation
could have a material adverse effect on our business, financial condition and results of
operations.
We may not be able to retain our
key executives and research and development personnel.
As
a small company with less than 125 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.
We face a risk of financial
exposure to product liability claims in the event that the use of our products results in
personal injury.
Our
products are and will continue to be designed and manufactured with numerous safety
features, but it is possible that consumers could be adversely affected by use of one of
our products. 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.
Although we have not experienced any material losses due to product liability claims to
date, there can be no assurance that we will not experience such losses in the future. We
maintain general liability insurance in the amount of $1 million per occurrence and $2
million in the aggregate and maintain umbrella coverage in the aggregate amount of $25
million; however, there can be no assurance that such coverage will continue to be
available on terms acceptable to us or that such coverage will be adequate for liabilities
actually incurred. In the event we are found liable for damages in excess of the limits of
our insurance coverage or if any claim or product recall results in significant adverse
publicity against us, our business, financial condition and results of operations could be
materially and adversely affected. In addition, although our products have been and will
continue to be designed to operate in a safe manner, and although we attempt to educate
customers with respect to the proper use of our products, misuse of our products by
personnel over whom we cannot exert control may result in the filing of product liability
claims or significant adverse publicity against us.
16
We face risks of obsolete
inventory as a result of rapid changes in technology.
We
operate in an industry that is subject to rapid changes in technology and intense
competition, which could make our light based systems obsolete. If forecasted demand
decreases, we could have excess inventories, which could obsolete certain product lines
and result in a write-off of some or all of our inventory.
We face risks associated
with revenues.
There
can be no certainty as to the severity or duration of the current economic downturn and
its impact on our future revenues.
We face risks associated
with product warranties.
We
could incur substantial costs as a result of product failures for which the Company is
responsible under warranty obligations.
We face risks associated
with liquidity and capital resources.
There
can be no assurance that we will not require additional financing to fund our operations
or that such additional funding, if needed, will be available on terms acceptable to us or
at all. We may be unable to generate sufficient revenues to achieve profitability.
There
can be no assurance that our revenues will increase or that we will generate sufficient
revenues to achieve or sustain profitability. While we strive to minimize the
Company’s business expenses, we will continue to have large fixed expenses and we
expect to continue to incur significant sales and marketing, product development, customer
support and service, administrative, legal and other expenses. As a result, we need to
generate a significant amount of revenue to achieve and maintain profitability.
We face risks associated with
selling more than half of our products and services internationally.
We
sell more than half of our products and services outside of the United States and expect
that these 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. In particular, longer payment cycles common in foreign markets,
credit risk and delays in obtaining necessary import or foreign regulating approvals for
products may occur.
We face risks associated with
managing a joint development and license agreement.
On
February 14, 2003, we entered into a Development and License Agreement with Gillette to
complete development and commercialize a home-use, light-based hair removal device for
women. We believe that this represents a unique opportunity to bring light based devices
to the mass market. Under the agreement, significant resources and the attention of key
technical personnel and management will be directed to the development of such a device
even though such device will not likely be commercialized for several years, if ever. In
addition, we cannot be sure that Gillette will agree with our interpretation of the terms
of the 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. After the expiration of 12 months and at several points thereafter, Gillette
has the ability to choose not to continue and may terminate the agreement. In such cases,
we will not receive certain payments but may proceed to develop and commercialize the
device on our own or with a third party. There can be no assurance that we will be able to
successfully implement such a strategy. In addition, after commercialization of such
device, Gillette is to pay us a percentage of net sales of such device. Certain of these
percentages of net sales are only owed if the device is covered by valid patents. There
can be no assurance that valid patents will cover the device in any or all countries in
which the device will be manufactured, used or sold. This could have a material adverse
effect on our business, results of operations and financial condition.
17
We face risks associated with
Section 11 (a)(4) Securities Act of 1933.
Prior
to June 28, 2002, Arthur Andersen LLP served as the Company’s independent auditors.
On March 14, 2002, Arthur Andersen was indicted on federal obstruction of justice charges
arising from the government’s investigation of Enron Corporation and on June 15,
2002, Arthur Andersen was found guilty. Arthur Andersen informed the SEC that it would
cease practicing before the SEC by August 31, 2002, unless the SEC determined that another
date was appropriate. On June 28, 2002, the Company dismissed Arthur Andersen and retained
Ernst & Young LLP as its independent auditors for its fiscal year ended December 31,
2002. SEC rules require the Company to present historical audited financial statements in
various SEC filings, such as registration statements, along with Arthur Andersen’s
consent to the Company’s inclusion of Arthur Andersen’s audit report in those
filings. Since the Company’s former engagement partner and audit manager have left
Arthur Andersen and in light of the announced cessation of Arthur Andersen’s SEC
practice, the Company will not be able to obtain the consent of Arthur Andersen to the
inclusion of Arthur Andersen’s audit report in the Company’s relevant current
and future filings. The SEC recently has provided regulatory relief designed to allow
companies that file reports with the SEC to dispense with the requirement to file a
consent of Arthur Andersen in certain circumstances, but purchasers of securities sold
under the Company’s registration statements, which were not filed with the consent of
Arthur Andersen to the inclusion of Arthur Andersen’s audit report will not be able
to sue Arthur Andersen pursuant to Section 11(a)(4) of the Securities Act of 1933 and
therefore the purchasers’ right of recovery under that section may be limited as a
result of the lack of the Company’s ability to obtain Arthur Andersen’s consent.
Terrorist acts and acts of war may
seriously harm our business and revenues, costs and expenses and financial condition.
Terrorist
acts or acts of war (wherever located around the world) may cause damage or disruption to
the Company, our employees, facilities, partners, suppliers, distributors, resellers, or
customers, which could significantly impact our revenues, costs and expenses and financial
condition. The terrorist attacks that took place in the United States on September 11,
2001 were unprecedented events that have created many economic and political
uncertainties, some of which may materially harm our business and results of operations.
The potential for future terrorist attacks, the national and international responses to
terrorist attacks, and other acts of war or hostility have created many economic and
political uncertainties, which could adversely affect our business and results of
operations in ways that cannot presently be predicted.
Item 3. Quantitative and
Qualitative Disclosures About Market Risk.
Derivative Financial
Instruments, Other Financial Instruments, and Derivative Commodity Instruments.
SFAS
No. 107 requires disclosure about fair value of financial instruments. Financial
instruments consist of cash equivalents, accounts receivable, accounts payable and
short-term debt obligations. The fair value of these financial instruments approximates
their carrying amount as of June 30, 2003 due to their short-term nature. All of the
Company’s investments are considered cash equivalent money market accounts and debt
securities which are carried at cost, which approximates market value. The Company has no
quantitative information concerning the market risk of participating in such investments.
Under
its current policies, the Company does not use derivative financial instruments,
derivative commodity instruments or other financial instruments to manage its exposure to
changes in interest rates, foreign currency exchange rates, commodity prices or equity
prices.
Primary Market Risk
Exposures
The
Company’s primary market risk exposures are in the areas of interest rate risk. The
Company’s investment portfolio of cash equivalents is subject to interest rate
fluctuations, but the Company believes this risk is immaterial because of the short-term
nature of these investments. The Company’s currency exchange rate fluctuations have
been and are expected to continue to be modest since the Company sells its products in
United States currency.
18
Item 4. Controls and
Procedures
(a) Evaluation of disclosure controls and procedures.
An
evaluation was performed under the supervision and with the participation of members of
our management, including our Chief Executive Officer and our Chief Financial Officer, of
the effectiveness of the design and operation of our “disclosure controls and
procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and
15d-14(c)) as of a date (the “Evaluation Date”) within 90 days before the filing
date of this quarterly report. Based on that evaluation, members of our management,
including our Chief Executive Officer and our Chief Financial Officer, have concluded that
as of the Evaluation Date, our disclosure controls and procedures were effective in
enabling us to record, process, summarize and report the information required to be
included in this quarterly report within the required time period.
(b) Changes in internal controls.
There
have been no significant changes in our internal controls or, to our knowledge, in other
factors that could significantly affect our disclosure controls and procedures subsequent
to the Evaluation Date.
PART II – Other
Information
Item 1. Legal Proceedings
The
Company is a party to various legal proceedings incident to its business. Except as noted
below, there are no legal proceedings pending or threatened against the Company that
management believes are likely to have a material adverse effect on the Company’s
consolidated financial position.
The
Company is the exclusive licensee of U.S. Patent Nos. 5,595,568 and 5,735,844 (“the
‘568 and ‘844 patents”) from The General Hospital Corporation
(“General”). Pursuant to a Patent License Agreement dated December 7, 1998,
Lumenis paid the Company a 7.5% royalty on net sales of the LightSheer diode laser system.
As of the quarter ended September 30, 2002, the Company received approximately $3.6
million dollars in royalties from Lumenis for sales of the LightSheer system. On October
24, 2002, Lumenis told the Company that it would no longer pay royalties for sales of the
LightSheer system and filed a complaint in the United States District Court for the
Northern District of California seeking a declaratory judgment that the ‘568 and
‘844 patents are invalid and/or unenforceable and not infringed by any Lumenis
products. The Company believes that Lumenis’ claims are without merit, and on October
29, 2002, the Company filed a complaint in the Middlesex County Superior Court in
Massachusetts against Lumenis for breach of contract, breach of the implied covenant of
good faith and fair dealing, and violation of Massachusetts General Laws Chapter 93A.
The Company has also answered Lumenis’ Federal Court compliant in California with
similar counter claims. On February 14, 2003, the Company terminated the Patent License
Agreement. The parties are in negotiations in an attempt to settle the matter as an
alternative to litigation.
On
February 15, 2002, the Company commenced an action for patent infringement in the United
States District Court for the District of Massachusetts against Altus seeking both
monetary damages and injunctive relief. The complaint alleges Altus’ CoolGlide and
CoolGlide Excel laser systems willfully infringe U.S. patent No. 5,735,844 (“the
‘844 patent”), which is exclusively licensed to the Company by General. General
has been added as a plaintiff in this lawsuit. Altus answered the complaint denying that
its products infringe the asserted patent and filed a counterclaim seeking a declaratory
judgment that the asserted patent is invalid and not infringed. The Company and General
filed a reply denying the material allegations of the counterclaims. The Company and
General have further alleged that Altus’ CoolGlide Vantage and CoolGlide XEO laser
systems also willfully infringe the asserted patent. On June 4, 2003, Altus amended their
answer and asserted a counter claim alleging that the ‘844 patent is unenforceable
due to inequitable conduct. The Company and General believe that this claim is without
merit and filed a reply denying the material allegations of this counterclaim. A Markman
hearing on claim construction was held June 12, 2003. The Judge has not yet issued a
ruling. A trial date has not yet been set.
19
Item 2. Changes in
Securities
Not
applicable.
Item 3. Defaults upon
Senior Securities
Not
applicable.
Item 4. Submission of Matters to a Vote of Security Holders
The
following table sets forth a brief description of each matter voted upon and the number of
votes cast for or against, as well as the number of abstentions, as to each such matter,
at the Company’s Annual Meeting of Stockholders held on May 15, 2003.
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