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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

or

Commission file number 0-18053

LASERSCOPE

3070 ORCHARD DRIVE, SAN JOSE, CALIFORNIA 95134-2011
(Address of Principal Executive Offices)

Registrant’s Telephone Number, Including Area Code: (408) 943-0636

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES o  NO x

The number of shares of Registrant’s common stock issued and outstanding as of October 31, 2003 was 17,840,813.

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TABLE OF CONTENTS

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PART I.	FINANCIAL INFORMATION.

Item 1.	Financial Statements.

Laserscope

See Accompanying Notes to Condensed Consolidated Financial Statements

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Laserscope

See Accompanying Notes to Condensed Consolidated Financial Statements

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Laserscope

See Accompanying Notes to Condensed Consolidated Financial Statements

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Laserscope Notes to Unaudited Condensed Consolidated Financial Statements:

1.

Basis of presentation

The accompanying unaudited condensed consolidated financial statements include Laserscope (the “Company,” “management,” “we,” “us,” “our”) and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated. While the financial information in this report is unaudited, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position and results of operations as of and for the periods indicated have been recorded. We suggest that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2002 included in the Company’s annual report on Form 10-K for the year ended December 31, 2002. The results of operations for the three and nine month periods ended September 30, 2003 are not necessarily indicative of the results expected for the full year.

2.

Accounting for Stock-Based Compensation

The Company has adopted Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and its related interpretations and has elected to follow the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the stock option grant between the fair value of the Company’s stock and the exercise price of the stock option.

Had compensation cost for stock-based employee compensation arrangements been determined based on the fair value at the date of the awards consistent with the provisions of SFAS No. 123, the impact on Laserscope’s net income would be as follows (in thousands, except per share data):

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Laserscope accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

3.

Inventories, net

Inventories were comprised of the following (in thousands):

4.

Warranty and Service Contracts

Warranty

We have a direct field service organization that provides service for our products. We generally provide a twelve month warranty on our laser systems. After the warranty period, maintenance and support is provided on a service contract basis or on an individual call basis. Our warranties and premium service contracts provide for a “99.0% Uptime Guarantee” on our laser systems. Under provisions of this guarantee, we extend the term of the related warranty or service contract if specified system uptime levels are not maintained.

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The Company currently provides for the estimated cost to repair or replace products under warranty at the time of sale. The cost estimate is based on warranty costs experienced in the prior 12 months, and the outstanding warranty liability is revalued on a quarterly basis.

Service Contracts

Deferred service contract revenue is recognized on a pro rata basis over the period of the applicable service contract. Costs are recognized as incurred.

5.

Net income per share

Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by giving effect to all dilutive potential common shares, including options, warrants, and convertible debentures. A reconciliation of the numerator and denominator used in the calculation of historical basic and diluted net income per share follows:

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The following outstanding options (prior to the application of the treasury stock method) and convertible debentures (on an as-converted basis) were excluded from the computation of diluted net income per common share for the periods ended September 30, 2003 and 2002 because including them would have had an antidilutive effect:

6.

Comprehensive income

Total comprehensive income during the periods ended September 30, 2003 and 2002 consisted of (in thousands):

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7.

Contingencies

The Company is at times a party to legal proceedings and claims arising in the ordinary course of its business. While it is not feasible to predict or determine the outcome of the actions brought against the Company, management believes that the ultimate resolution of these claims will not ultimately have a material adverse effect on the Company’s financial position, results of operations, or future cash flows.

8.

Recent accounting pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), ‘Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.’ FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. During October, 2003, the FASB issued FASB Staff Position 46-6 (“FSP 46-6”), ‘Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities’. FSP 46-6 is effective for financial statements issued after October 9, 2003, and provides a broad deferral of the latest date by which all public entities must apply FIN 46 to certain variable interest entities, to the first reporting period ending after December 15, 2003. The Company does not expect the adoption of FIN 46 to have a material impact upon its financial position, cash flows or results of operations.

In April 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying to conform it to language used in FIN No. 45, and amends certain other existing pronouncements. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, provisions of SFAS No. 149 should be applied prospectively. The adoption of SFAS No. 149 did not have a material impact on the Company’s financial statements.

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In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. The adoption of SFAS No. 150 did not have a material impact on the Company’s financial statements.

9.

Debentures

In February of 2000, the Company sold $3 million of 8.00% convertible debentures in a private placement. Under the original terms, the debentures mature in February 2007 and interest and principal is paid in monthly installments. In the first six months of 2003, $400,000 of the debentures were converted to Laserscope common stock. On October of 2003, the debenture agreement was modified. Under the terms of the amended agreement, the Company will not be required to make any principal payments until expiration of the debentures on February 11, 2007, and principal payments will only be made at that time if there is a balance of principal which has not been converted to common stock. However, not withstanding the foregoing, the debenture holders may, at their sole discretion, direct the Company to resume making monthly principal payments at any time prior to expiration and in an amount sufficient to bring payments made plus conversions to the level specified in the original debenture.

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

INTRODUCTORY STATEMENT

Some of the statements in this Quarterly Report on Form 10-Q, including but not limited to “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this document are forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “predict,” “potential” or “continue” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. We refer you to the factors described under the heading “Risk Factors” in this Quarterly Report on Form 10-Q as well as to our Annual Report on Form 10-K for the year ended December 31, 2002 under the heading “Risk Factors.” Readers are cautioned not to place undue reliance on forward-looking statements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of those statements.

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We are under no duty to publicly release any revision to the forward-looking statements after the date of this document.

Laserscope designs, manufactures, sells and services, on a worldwide basis, an advanced line of medical laser systems and related energy devices for the medical office, outpatient surgical center and hospital markets. The Company is a pioneer in the development and commercialization of lasers and advanced fiber-optic devices for a wide variety of applications. Our product portfolio consists of more than 150 products, including KTP/532, Nd:YAG, Er:YAG, and Dye medical laser systems and related energy delivery devices.

Our primary medical markets include dermatology, aesthetic surgery and urology. Our secondary markets include ear, nose and throat surgery, general surgery, gynecology, photo-dynamic therapy and other surgical specialties.

Results of Operations.

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes included in Part I — Item 1 of this Quarterly Report and the audited consolidated financial statements and notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 and the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following table contains selected income statement information, which serves as the basis of the discussion of the Company’s results of operations for the quarter and nine months ended September 30, 2003 (in thousands, except for percentages):

Revenues from the sales of lasers and instrumentation increased during the three month and nine month periods ended September 30, 2003 compared to the same periods in 2002. The three month period increase primarily was driven by a higher volume of GreenLight PV^TM lasers sold.

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The GreenLight PV is a surgical laser used in the treatment of benign prostatic hyperplasia (BPH), a procedure called Photo Vaporization of the Prostate (PVP^TM). In the three month period ended September 30, 2003 we sold 34 GreenLight PV units compared to nine units in the corresponding period in 2002. Due to Manufacturing improvements we were able to decrease some of the backlog in the quarter ended September 30, 2003 that existed in prior quarters. The nine month period increase primarily was driven by a higher sales volume of aesthetic lasers and accompanying instruments. This was in large part due to the increasing success of the distribution arrangement with McKesson Corporation which began in 2001. Also, through the nine month period of 2003 we shipped 60 GreenLight PV laser units for revenue while at the same time building a backlog of 12 units. In the first nine months of 2002, we had sold 24 GreenLight PV lasers. The Company expects that sales of lasers and instrumentation will continue to be a major source of revenue.

We have made significant strides in procuring critical GreenLight PV laser components and we continue to work with our suppliers to resolve these issues. In the quarter ended September 30, 2003, we were able to significantly reduce our backlog due to progress made. Backlog declined to 12 systems at the end of the third quarter, versus 21 systems at the close of the second quarter. We will closely monitor our suppliers’ progress toward the eventual goal of being able to ship within 30 to 60 days after receipt of a customer order.

Revenues from the sales of disposable supplies increased 74% and 73% during the three month and nine month periods ended September 30, 2003 compared to the corresponding periods in 2002. The increase in revenues in both the three and nine month periods is primarily due to higher unit sales of GreenLight PV fibers. In the first nine months of 2003 we sold approximately 7,895 GreenLight PV fibers whereas in the first nine months of 2002 we sold approximately 1,790 GreenLight PV fibers. This was a direct result of an increase in our GreenLight PV installed base as well as a higher number of fibers purchased per laser in the installed base. The Company expects revenues from the sales of disposable supplies to incrementally increase as we ship more GreenLight PV lasers, which require a single-use fiber optic energy delivery device.

Laserscope’s service revenues increased 16% and 8% during the three and nine month periods ended September 30, 2003 compared to the same periods in 2002. Increased service revenues are a result of a larger contract installed base in the domestic region, as well as increased service activity internationally. The Company believes that increases in future revenues depend on increases to the installed base of lasers as well as the purchase of its service contracts by its customers.

Gross margin as a percentage of revenues decreased two percentage points and one percentage point, respectively, during the three and nine month periods ended September 30, 2003 relative to the corresponding periods of 2002. The decrease in gross margin percentage is due primarily to both lower aesthetic laser average selling prices and to GreenLight PV component related manufacturing issues. The Company expects gross margin as a percentage of 2003 revenues to be in the range of 51% to 52%.

Research and development expenses are the result of activities related to the development of new laser, instrumentation and disposable products and the modification and enhancement of Laserscope’s existing products. These expenses increased marginally as a percentage of revenue during the three month period ended September 30, 2003 compared to the same periods in 2002, but decreased 1% for the nine month period ended September 30, 2003 compared to the same period in 2002. The Company expects research and development expenses during 2003 to be approximately 8% of net revenues.

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Selling, general and administrative expenses, as a percentage of revenues, decreased three percentage points in the quarter ended September 30, 2003 and decreased marginally in the nine month period ended September 30, 2003. However, selling, general and administrative expenses increased 29% in absolute terms in both periods. The increase is due primarily to higher variable selling expenses resulting from higher revenues in the three and nine month periods ended September 30, 2003 relative to the same periods last year and to higher marketing expenses for aesthetic and GreenLight PV products. We expect amounts spent in selling, general and administrative expenses to be marginally lower, as a percentage of revenues, in the fourth quarter, but remain relatively high in absolute terms in conjunction with continuing investment in educational and training support and marketing programs for the PVP products.

Liquidity and Capital Resources.

The following table contains selected balance sheet information that serves as the basis of the discussion of the Company’s liquidity and capital resources at September 30, 2003 and for the nine months then ended (in thousands):

The increase in cash and cash equivalents was due primarily to cash provided by financing and operating activities, partially offset by cash used by investing activities.

During the nine months ended September 30, 2003, cash provided by financing activities consisted of the sale of common stock under stock plans — $1.1 million; and was partially offset by payments on obligations under capital leases of $0.1 million.

During the nine months ended September 30, 2003, cash provided by operating activities totaled $0.8 million. This was the combined result of the following sources: depreciation and amortization — $0.9 million; an increase in other current liabilities- $1.2 million, partly due to higher warranty provision, legal accruals, sales tax liability and travel expenses; an increase in accounts payable- $0.7 million; an increase in deferred revenue- $0.5 million; and an increase in accrued compensation-$0.3 million; and a net income of $1 million. These sources were offset by: an increase in inventory- $1.7 million, due to higher material purchases, an increase in accounts receivable- $1.7 million, a result of higher revenue and an increase in other current assets-$0.2 million.

During the nine months ended September 30, 2003, cash used in investing activities consisted of capital expenditures of $0.6 million. The increase in capital expenditures is due to higher purchases of manufacturing machinery and equipment, office equipment and capitalization of laser systems.

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In February of 2000, the Company sold $3 million of 8.00% convertible debentures in a private placement. Under the original terms, the debentures mature in February 2007 and interest and principal is paid in monthly installments. In the first six months of 2003, $400,000 of the debentures were converted to Laserscope common stock. On October of 2003, the debenture agreement was modified. Under the terms of the amended agreement, the Company will not be required to make any principal payments until expiration of the debentures on February 11, 2007, and principal payments will only be made at that time if there is a balance of principal which has not been converted to common stock. However, not withstanding the foregoing, the debenture holders may, at their sole discretion, direct the Company to resume making monthly principal payments at any time prior to expiration and in an amount sufficient to bring payments made plus conversions to the level specified in the original debenture.

We have in place an asset-based line of credit, which was renewed on September 25, 2003, that provides for borrowing up to $5.0 million and expires in September 2004. The line of credit bears annual interest at a rate equal to the prime rate plus 2.0%. Credit is extended and collateralized based on eligible accounts receivable and inventory. At September 30, 2003, we had approximately $3.6 million in borrowing capacity available and $1.2 million in letter of credit reserve requirements. As of September 30, 2003, we had no outstanding borrowings under the line and were in compliance with all covenants associated with the line of credit and our convertible debentures. We anticipate that future changes in cash and working capital will be dependent on a number of factors including:

•

our ability to effectively manage inventory and accounts receivable;

•

our ability to anticipate and adapt to the changes in our industry such as new and alternative medical procedures;

•

our level of profitability;

•

our determination to acquire or invest in products and businesses complementary to ours; and

•

the market price for our common stock as it affects the exercise of stock options and sale of common stock under stock plans.

We have historically financed acquisitions using our existing cash resources. While we believe our existing cash resources, including our bank line of credit, will be sufficient to fund our operating needs for the next twelve months, additional financing may be required for our currently envisioned long-term needs.

There can be no assurance that any additional financing will be available on terms acceptable to us, or at all. In addition, future equity financings could result in dilution to our shareholders, and future debt financings could result in certain financial and operational restrictions.

Recent accounting pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), ‘Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.’

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FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. During October 2003, the FASB issued FASB Staff Position 46-6 (“FSP 46-6”), ‘Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities’. FSP 46-6 is effective for financial statements issued after October 9, 2003, and provides a broad deferral of the latest date by which all public entities must apply FIN 46 to certain variable interest entities, to the first reporting period ending after December 15, 2003. The Company does not expect the adoption of FIN 46 to have a material impact upon its financial position, cash flows or results of operations.

In April 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly. In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying to conform it to language used in FIN No. 45, and amends certain other existing pronouncements. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, provisions of SFAS No. 149 should be applied prospectively. The adoption of SFAS No. 149 did not have a material impact on the Company’s financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. The adoption of SFAS No. 150 did not have a material impact on the Company’s financial statements.

Risk Factors.

Our business, financial condition and results of operations have been, and in the future may be, affected by a variety of factors, including those set forth below and elsewhere in this report.

Limited Working Capital; Potential Need to Raise Additional Capital.

Current and anticipated demand for our products as well as procurement and production affect our need for capital. Changes in these or other factors could have a material impact on capital requirements and may require us to raise additional capital.

History of Losses; Uncertain Future Profitability.

There can be no assurance that we can achieve or maintain profitability on a quarterly basis or at all.

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Government Regulation; Uncertainty of Obtaining Regulatory Approval.

Government regulation in the United States and other countries is a significant factor in the development, manufacturing and marketing of many of our products.

Laserscope and its products are regulated in the United States by the Food and Drug Administration (FDA) under the Federal Food, Drug and Cosmetic Act (the “FDC Act”) and the Radiation Control for Health and Safety Act. There can be no assurance that the FDA will grant marketing clearance for our future products on a timely basis, or at all. Delays in receiving such clearances could have a significant adverse impact on our ability to compete in our industry. The FDA may also require post-market testing and surveillance programs to monitor certain products.

Certain other countries require medical device manufacturers to obtain clearances for products prior to marketing the products in those countries. The requirements vary widely from country to country and are subject to change.

We are also required to register with the FDA and state agencies, such as the Food and Drug Branch of the California Department of Health Services (CDHS), as a medical device manufacturer. We are inspected routinely by these agencies to determine our compliance with the FDA’s current “Good Manufacturing Practice” regulations. Those regulations impose certain procedural and documentation requirements upon medical device manufacturers concerning manufacturing, testing and quality control activities. If these inspections determine violations of applicable regulations, the continued marketing of any products manufactured by us may be adversely affected.

In addition, our laser products are covered by a performance standard for laser products set forth in FDA regulations. The laser performance standard imposes certain specific record-keeping, reporting, product testing, and product labeling requirements on laser manufacturers. These requirements also include affixing warning labels to laser systems, as well as incorporating certain safety features in the design of laser products.

Complying with applicable governmental regulations and obtaining necessary clearances or approvals can be time consuming and expensive. There can be no assurance that regulatory review will not involve delays or other actions adversely affecting the marketing and sale of our products. We also cannot predict the extent or impact of future legislation or regulations.

We are also subject to regulation under federal and state laws regarding, among other things, occupational safety, the use and handling of hazardous materials and protection of the environment.

Insurance Reimbursement.

Demand for certain of our products depends on government and private insurance reimbursement of hospitals and physicians for health care costs, including, but not limited to, reimbursement of capital equipment costs. Reductions or delays in such insurance coverage or reimbursement may negatively impact hospitals’ and physicians’ decisions to purchase our products, adversely affecting our future sales.

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Substantial portions of our laser sales are for aesthetic procedures that are generally not subject to reimbursement by government or private health insurance. The general absence of insurance coverage for these cosmetic procedures may restrict the development of this market.

In November 2002, the Centers for Medicare and Medicaid Services (CMS) announced its final rule with respect to Ambulatory Payment Classification (APC) reimbursement codes to be implemented in January 2003. One of the APC codes that was affected is currently being used by hospitals to bill Medicare for the Photo Vaporization of the Prostate (“PVP”) procedures. In February 2003, CMS issued a technical correction to this APC code which represents the reimbursement under this code for 2003. The reimbursement level to the hospital for this code was reduced approximately 19% for the hospital site of service for Medicare patients compared to the reimbursement during 2002. In August 2003, the Centers for Medicare and Medicaid Services (CMS) announced adjusted reimbursement rates for various BPH treatment alternatives. These rates are due to become effective in January 2004. The national average reimbursement rates for the PVP procedure in 2004 are now projected to be slightly higher in outpatient hospital facilities. In November 2003, CMS notified Laserscope that its application for assignment of PVP to treat BPH to a new technology Ambulatory Payment Classification (APC) has been accepted. CMS has determined that PVP meets the new technology APC qualification criteria and will be assigned a new APC code effective April 1, 2004. Until that time, PVP will continue to be reimbursed under current designated codes. Details regarding the specific coding information and the new associated reimbursement rates will be forthcoming prior to the reassignment. Over the next few months, we will continue to work closely with CMS and the American Urological Association to ensure that the hospital outpatient and physician reimbursement rates for furnishing PVP reflect the appropriate costs of performing the procedure.

If reimbursement rates are not increased soon, it will likely have a short-term adverse effect on the adoption and sales growth of the PVP procedure in the United States as some hospital-based customers who would normally consider adopting the PVP procedure delay their purchases or adoption until the reimbursement climate becomes more attractive.

Uncertainty of Technological Change; Uncertainty of New Product Development and Acceptance.

We operate in an industry that is subject to rapid technological change. Our ability to remain competitive and future operating results will depend upon, among other things, our ability to anticipate and respond rapidly to such change by developing, manufacturing and marketing technologically innovative products in sufficient quantities at acceptable costs to meet such demand. As we introduce new products this may cause some of our existing products to become obsolete, which may result in the write-off of inventory. However, without new products and enhancements, our existing products will likely become obsolete due to technological advances by other companies, which could result in the write-off of inventory as well as diminished revenues. Therefore, we intend to continue to invest significant amounts in research and development.

We anticipate that our ability to compete will require significant research and development expenditures with a continuing flow of innovative, high-quality products. We cannot assure that we will be successful in designing, manufacturing or selling enhanced or new products in a timely manner. Nor can we assure that a competitor could not introduce a new or enhanced product or technology that could have an adverse effect on our competitive position.

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Our current research and development programs are directed toward the development of new laser systems and delivery devices. We cannot assure that these markets will develop as anticipated or that our product development efforts will prove successful. Nor can we assure that such new products, if developed and introduced, will be accepted by the market.

Dependence on Single-Source Suppliers and Certain Third Parties.

Certain of the components used in our laser products, including certain optical components, are purchased from single sources. While we believe that most of these components are available from alternate sources, an interruption of these or other supplies could adversely affect our ability to manufacture lasers.

Manufacturing.

We manufacture in the United States the laser resonators, system chassis and certain accessories including disposable products and re-usable hand pieces used in our laser systems. Our laser manufacturing operations concentrate on the assembly and test of components and subassemblies manufactured to our designs and specifications by outside vendors. We believe that we have sufficient manufacturing capacity in our present facilities to support current operations at least through the end of 2003.

A challenge we have been recently experiencing relates to some of our component suppliers. Our commitment to delivering a quality product for the GreenLight PV procedure has stretched some of our vendors to the point where we were unable to fulfill our GreenLight PV laser backlog during the first three quarters of 2003 due to a shortage of some critical components. We have made progress and we are continuing to work with these suppliers to resolve these issues. In the quarter ended September 30, 2003, we were able to significantly reduce our backlog due to progress made. We will closely monitor our suppliers’ progress toward the eventual goal of being able to ship within 30 to 60 days after receipt of a customer order.

Competition.

We compete in the non-ophthalmic surgical segment of the worldwide medical laser market. In this market, lasers are used in hospital operating rooms, outpatient surgery centers and individual physician offices for a wide variety of procedures. This market is highly competitive. Our competitors are numerous and include some of the world’s largest organizations as well as smaller, highly specialized firms. Our ability to compete effectively depends on such factors as:

•

market acceptance of our products;

•

product performance;

•

price;

•

customer support;

•

the success and timing of new product development; and

•

continued development of successful distribution channels.

Some of our current and prospective competitors have or may have significantly greater financial, technical, research and development, manufacturing and marketing resources than we have. To compete effectively, we will need to continue to expand our product offerings, periodically enhance our existing products and continue to enhance our distribution.

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Certain surgical laser manufacturers have targeted their efforts on narrow segments of the market, such as angioplasty and lithotripsy. Their products may compete for the same capital equipment funds as our products, and accordingly, these manufacturers may be considered our competitors. Generally, surgical laser manufacturers such as Laserscope compete with standard surgical methods and other medical technologies and treatment modalities. We cannot assure that we can compete effectively against such competitors. In addition, we cannot assure that these or other companies will not succeed in developing technologies, products or treatments that are more effective than ours or that would render our technology or products obsolete or non-competitive.

Reliance on Patents and Licenses.

We hold several patents issued in the United States, generally covering surgical laser systems, delivery devices, calibration inserts and the laser resonator. We have also licensed certain technologies from others.

We cannot assure that any patents or licenses that we hold or that may be issued as a result of our patent applications will provide any competitive advantages for our products. Nor can we assure that any of the patents that we now hold or may hold in the future will not be successfully challenged, invalidated or circumvented in the future. In addition, we cannot assure that competitors, many of which have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with our ability to make, issue, use and sell our products.

Intellectual Property Infringement Claims.

From time to time we receive notices from others claiming we are infringing their patent or other intellectual property rights. Responding to any infringement claim, regardless of its validity, could:

•

be time-consuming to defend;

•

result in costly litigation;

•

divert management’s time and attention from developing our business;

•

require us to enter into royalty and licensing agreements that we would not normally find acceptable;

•

require us to stop selling or to redesign our products; and

•

require us to pay money as damages or to satisfy indemnification obligations that we have with our customers.

If a successful claim is made against us and we fail to develop or license a substitute technology, our business, results of operations, financial condition or cash flows could be materially adversely affected.

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Failure to Attract or Retain Key Personnel Can Adversely Affect Results.

We depend upon the efforts and abilities of a number of current key personnel. If we are unable to attract and retain key employees it would have a material adverse effect on our business, financial condition and results of operations.

Reliance on Key Customers.

In December 2000, Laserscope and McKesson Corporation (“McKesson”) entered into a five year agreement whereby McKesson would obtain exclusive distribution rights for the Company’s aesthetic product lines to doctors’ offices in the United States. If we are unable to maintain a favorable relationship with McKesson or if McKesson encounters financial difficulties, it would have a material adverse effect on our business, financial condition, results of operations, and future cashflows.

Fluctuations in Quarterly Operating Results.

A number of factors affect our quarterly financial results including the timing of shipments and orders. Our laser products are relatively expensive pieces of medical capital equipment and the precise shipment date of specific units can have a marked effect on our results of operations on a quarterly basis. Any delay in product shipments near the end of a quarter could cause our quarterly results to fall short of anticipated levels. Furthermore, to the extent we receive orders near the end of a quarter, we may not be able to fulfill the order during the balance of that same quarter. Moreover, we typically receive a disproportionate percentage of orders toward the end of each quarter. To the extent that we do not receive anticipated orders or orders are delayed beyond the end of the applicable quarter, our results may be adversely affected and may be unpredictable from quarter to quarter. In addition, because a significant portion of our revenues in each quarter result from orders received in that quarter, we base our production, inventory and operating expenditure levels on anticipated revenue levels. Thus, if sales do not occur when expected, expenditure levels could be disproportionately high and operating results for that quarter and potentially future quarters, would be adversely affected. We cannot assure that Laserscope will accomplish revenue growth or profitability on a quarterly or annual basis. Nor can we assure that revenue growth or profitability will not fluctuate significantly from quarter to quarter.

Potential of Product Defects.

Laser systems are inherently complex in design and require ongoing regular maintenance. The manufacture of our lasers, laser products and systems involves a highly complex and precise process. As a result of the technical complexity of our products, changes in our or our suppliers’ manufacturing processes or the inadvertent use of defective materials by us or our suppliers could result in a material adverse effect on our ability to achieve acceptable manufacturing yields and product reliability. To the extent that we do not achieve such yields or product reliability, our business, operating results, financial condition and customer relationships would be adversely affected.

Our customers may discover defects in our products after the products have been fully deployed and operated under peak stress conditions. In addition some of our products are combined with products from other vendors, which may contain defects. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things:

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loss of customers;

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increased costs of product, returns and warranty expenses;

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damage to our brand reputation;

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failure to attract new customers or achieve market acceptance;

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diversion of development and engineering resources; and

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legal actions by our customers.

The occurrence of any one or more of the foregoing factors could seriously harm our business, financial condition and results of operations.

Product Liability Risk; Limited Insurance Coverage.

Our business has significant risks of product liability claims. We have experienced product liability claims from time to time, which we believe are ordinary for our business. While we cannot predict or determine the outcome of the actions brought against us, we believe that these actions will not ultimately have a material adverse impact on Laserscope’s financial position, results of operations or future cash flows.

At present, we maintain product liability insurance on a “claims made” basis with coverage of $10.0 million in the aggregate with a deductible of $0.1 million per occurrence and an annual maximum aggregate deductible of $0.5 million. We cannot assure that such insurance coverage will be available to us in the future at a reasonable cost, if at all. Nor can we assure that other claims will not be brought against us in excess of our insurance coverage.

Natural Catastrophic Events; Terrorism and Other Manmade Problems.

Our corporate headquarters, including our research and development operations, our manufacturing facilities, and our principal sales, marketing and service offices, are located in the Silicon Valley area of Northern California, a region known for seismic activity. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results, and financial condition. In addition, despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. Any such event could have a material adverse effect on our business, operating results, and financial condition. In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operating results, and financial condition. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 disrupted commerce throughout the world and intensified the uncertainty of the U.S. and other economies. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or the manufacture or shipment of our products, our business, operating results and financial condition could be materially and adversely affected.

Factors Affecting Financial Results and Stock Price.

A number of factors affect our financial results and stock price including, but not limited to:

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product mix;

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competitive pricing pressures;

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material costs;

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revenue and expenses related to new products and enhancements to existing products;

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delays in customer purchases in anticipation of new products or product enhancements by Laserscope or its competitors; and

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the risk of loss or interruption to our operations or increased costs due to earthquakes, the availability of power and energy supplies and other events beyond our control.

The market price of our common stock may be subject to significant fluctuations. These fluctuations may be due to factors specific to Laserscope, such as:

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quarterly fluctuations in our financial results;

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changes in analysts’ estimates of future results;

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changes in investors’ perceptions of our products;

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announcement of new or enhanced products by us or our competitors;

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announcements relating to acquisitions and strategic transactions by us

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or our competitors;

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general conditions in the medical equipment industry; and