UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

FORM 10-Q

 

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended October 2, 2004.

 

Commission file number 000-14742

 

CANDELA CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:  (508) 358-7400

 

 

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  ý   No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Securities
Exchange Act of 1934).

Yes  ý  No  o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

	Class				Outstanding at November 4, 2004
Common Stock, $.01 par value per share				22,517,832

 

 

CANDELA CORPORATION

Index

 

			Page
Part I.	Financial Information:
	Item 1.	Financial Statements
		Unaudited Consolidated Balance Sheets as of October 2, 2004 and July 3, 2004	3
		Unaudited Consolidated Statements of Operations and Comprehensive Income (Loss) for the three-month periods ended October 2, 2004 and September, 27 2003	4
		Unaudited Consolidated Statements of Cash Flows for the three-month periods ended October 2, 2004 and September 27, 2003	5
		Notes to Unaudited Consolidated Financial Statements	6-12
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12-16
	Item 3.	Quantitative and Qualitative Disclosure about Market Risk	17
	Item 4.	Controls and Procedures	17
Part II.	Other Information:
	Item 1.	Legal proceedings	18
	Item 6.	Exhibits	18
	Signatures		19
	Index to Exhibits		20

 

2

 

Part I.  Financial Information

 

Item 1 - Financial Statements

 

CANDELA CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

 

(in thousands)		October 2, 2004			July 3, 2004
Assets:
Current assets:
Cash and cash equivalents		$	36,611		$	37,139
Restricted cash		260			257
Accounts receivable, net		32,202			34,302
Notes receivable		543			1,151
Inventories, net		14,352			13,571
Other current assets		2,259			2,184
Total current assets		86,227			88,604
Property and equipment, net		3,338			3,406
Deferred tax assets		5,915			5,914
Prepaid licenses		1,010			1,054
Other assets		2,452			1,501
Total assets		$	98,942		$	100,479
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	4,940		$	6,973
Accrued payroll and related expenses		3,188			5,428
Accrued warranty costs		4,468			4,946
Income taxes payable		2,714			1,844
Other accrued liabilities		2,767			3,586
Deferred income (current portion)		3,702			3,421
Current liabilities of discontinued operations		1,288			1,019
Total current liabilities		23,067			27,217
Other long-term liabilities		4,195			3,945
Long-term liabilities of discontinued operations		2,100			2,548
Total liabilities		29,362			33,710
Stockholders’ equity:
Common stock		246			246
Treasury stock, at cost		(12,997		)	(12,997		)
Additional paid-in capital		53,221			53,069
Accumulated earnings		28,869			26,023
Accumulated other comprehensive income		241			428
Total stockholders’ equity		69,580			66,769
Total liabilities and stockholders’ equity		$	98,942		$	100,479

 

The accompanying notes are an integral part of the unaudited consolidated financial statements.

 

3

 

CANDELA CORPORATION
Consolidated Statements of Operations and Comprehensive Income (loss)
(in thousands, except per share data)
(unaudited)

 

		For the three months ended:
		October 2, 2004			September 27, 2003
Revenue
Lasers and other products		$	18,343		$	15,357
Product-related service		4,048			3,329
Total revenue		22,391			18,686
Cost of sales
Lasers and other products		7,553			7,630
Product-related service		2,797			1,743
Total cost of sales		10,350			9,373
Gross profit		12,041			9,313
Operating expenses:
Selling, general and administrative		6,660			5,403
Research and development		1,335			1,076
Total operating expenses		7,995			6,479
Income from operations		4,046			2,834
Other income (expense):
Interest income		96			79
Interest expense		—			(4		)
Other income, net		43			32
Total other income, net		139			107
Income from continuing operations before income taxes		4,185			2,941
Provision for income taxes		1,339			1,152
Income from continuing operations		2,846			1,789
Discontinued operations:
Loss from discontinued Skin Care Center operations of $473, less income tax benefit of $175		—			(298		)
Loss on closure of Skin Care Center, of $3,348 less income tax benefit of $1,253		—			(2,095		)
		—			(2,393		)
Net (loss) income		$	2,846		$	(604	)
Net income (loss) per share of common stock:
Basic:
Income from continuing operations		$	0.13		$	0.08
Loss from discontinued operations		—			(0.11		)
Net (loss) income		$	0.13		$	(0.03	)
Diluted:
Income from continuing operations		$	0.12		$	0.08
Loss from discontinued operations		—			(0.11		)
Net (loss) income		$	0.12		$	(0.03	)
Weighted average shares outstanding		22,326			21,388
Adjusted weighted average shares outstanding		23,031			22,188
Net income (loss)		$	2,846		$	(604	)
Other comprehensive income (loss) net of tax:
Foreign currency translation adjustment		(187		)	(153		)
Total comprehensive income (loss)		$	2,659		$	(757	)

 

The accompanying notes are an integral part of the unaudited consolidated financial statements.

 

4

 

CANDELA CORPORATION
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

 

		For the three months ended:
		October 2, 2004			September 27, 2003
Cash flows from operating activities:
Net income (loss)		$	2,846		$	(604	)
Adjustments to reconcile net income (loss) to net cash used for operating activities:
Provision for disposal of discontinued operations		—			2,095
Loss from discontinued operations		—			298
Depreciation and amortization		177			159
Provision for bad debts		(137		)	(28		)
Effect of exchange rate changes on foreign currency denominated assets and liabilities		8			9
Increase (decrease) in cash from working capital:
Accounts receivable		2,237			(21		)
Notes receivable		591			(16		)
Inventories		(817		)	(1,027		)
Other current assets		(1,019		)	(272		)
Other assets		43			62
Accounts payable		(2,571		)	60
Accrued payroll and related expenses		(1,878		)	(1,935		)
Deferred revenue		296			42
Accrued warranty costs		(482		)	392
Income taxes payable		882			(711		)
Long-term portion of deferred revenue		247			(795		)
Other accrued liabilities		(814		)	324
Change in restricted cash		(3		)	—
Net cash used for operating activities		(394		)	(1,968		)
Cash flows from investing activities:
Purchases of property and equipment		(119		)	(17		)
Net cash used for investing activities		(119		)	(17		)
Cash flows from financing activities:
Proceeds from the issuance of common stock		108			531
Net cash provided by financing activities		108			531
Effect of exchange rates on cash and cash equivalents		(123		)	(270		)
Net decrease in cash and cash equivalents		(528		)	(1,724		)
Cash and cash equivalents at beginning of period		37,139			31,870
Cash and cash equivalents at end of period		$	36,611		$	30,146

 

The accompanying notes are an integral part of the unaudited consolidated financial statements.

 

5

 

1.                   Basis of Presentation

 

The accompanying unaudited consolidated financial statements and notes do not include all of the disclosures made in the Annual Report on Form 10-K of Candela Corporation (the “Company”, or “Candela”) for fiscal year 2004, which should be read in conjunction with these financial statements.  The financial information included herein is unaudited, with the exception of the consolidated balance sheet as of July 3, 2004, which was derived from the audited consolidated balance sheet dated July 3, 2004. However, in the opinion of management, the financial statements include all necessary adjustments, consisting of normal recurring accruals, for a fair presentation of the quarterly results and are prepared and presented in a manner consistent with the Company’s Annual Report on Form 10-K. The results for the three-month period ended October 2, 2004 are not necessarily indicative of the results to be expected for the full year.

 

2.                   Discontinued Operations

 

On September 27, 2003 management initiated a plan to close its only remaining skin care center. The closure is accounted for as a discontinued operation in accordance with Statement of Financial Accounting Standards (“SFAS”) 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” and SFAS 146 “Accounting for Costs Associated with Exit or Disposal Activities”. As a result, in the fiscal quarter ended September 27, 2003, the Company recorded a $2,095 charge for the accrual of $3,000 of future occupancy costs, primarily relating to future lease payments for the Boston facility, and $348 of severance obligations and other related costs of closure, net of anticipated tax benefits of $1,253. Approximately 45 positions have been eliminated as a result of this restructuring plan, and 44 employees have been terminated as of October 2, 2004.

 

Prior to fiscal 2002, the Company recorded combined restructuring charges of $3,721 resulting from management’s decision to close the skin care center located in Scottsdale, Arizona. During the three-month period ended December 29, 2001, the Company secured a sublease for the Scottsdale facility.  The sublessee commenced making payments to the landlord on behalf of the Company on April 1, 2002.  As a result of the sublease, the Company revised the estimate of future costs associated with the Scottsdale facility and, in the quarter ended March 30, 2002, reversed $693 of the restructuring reserve which represents primarily the amount of future contractual sublease payments as well as revisions to the net realizable value of certain leasehold improvements.

 

The following table reflects the combined restructuring charges incurred in the three-month period ended October 2, 2004:

 

(in thousands)		Payroll and Severance				Leasehold Improvements and Fixed Assets			Facility Costs			Total
Balance at July 3, 2004		$		0		$	197		$	2,809		$	3,006
Reduction of reserve due to cash payments		—				—			220			220
Non-cash amortization		—				26			—			26
Balance at October 2, 2004		$	0			$	171		$	2,589		$	2,760

 

6

2.                   Discontinued Operations, continued

 

At October 2, 2004, the discontinued segment had a net liability of approximately $3.4 million consisting primarily of the aforementioned reserve of $2.8 million and deferred gift certificate revenue of $0.8 million partially offset by fixed assets of approximately $0.2 million.  Revenues for discontinued operations for the quarter ended September 27, 2003 were approximately $0.4 million. There have been no subsequent revenues.

 

3.      Stock-based Compensation

 

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure” (“FAS 148”). FAS 148 provides alternative methods of transition for a voluntary change to the recognition of the cost of the options in the statement of operations. FAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, FAS 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of FAS 148 were effective for fiscal years ended after December 15, 2002. The interim disclosure requirements of FAS 148 are effective for interim periods beginning after December 15, 2002. The adoption of the provisions of FAS 148 did not have an impact on the Company’s consolidated financial statements; however, the Company has modified its disclosures as provided for in the new standard.

 

The Company follows the provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). The provisions of FAS 123 allow companies to either expense the estimated fair value of stock options or to continue to follow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), but disclose the pro forma effects on net income (loss) had the fair value of the options been expensed. Candela has elected to continue to apply APB 25 in accounting for its stock option incentive plans.

 

In accordance with APB 25 and related interpretations, compensation expense for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees equals or exceeds the fair market value of Candela common stock at the date of grant, thereby resulting in no recognition of compensation expense by Candela. For awards that generate compensation expense as defined under APB 25, the Company calculates the amount of compensation expense and recognizes the expense over the vesting period of the award.

 

7

3.      Stock-based Compensation, continued

 

Had compensation cost for Candela’s stock option plans been determined based on the fair value method set forth in FAS 123, Candela’s net income and basic and diluted net income per common share would have been changed to the pro forma amounts indicated below:

 

(in thousands, except per share data)		For the three months ended:
		October 2, 2004			September 27, 2003
Net income (loss), as reported		$	2,846		$	(604	)
Add: stock-based employee compensation expense included in reported net income, net of related tax effects		—			—
Deduct: total stock-based employee compensation expense, determined under fair value based method for all awards, net of related tax effects		(745		)	(363		)
Pro forma net income (loss)		$	2,101		$	(967	)
Net income (loss) per share of common stock
Basic - as reported		$	0.13		$	(0.03	)
Basic - pro forma		$	0.09		$	(0.04	)
Diluted - as reported		$	0.12		$	(0.03	)
Diluted - pro forma		$	0.09		$	(0.04	)

 

In computing this pro-forma amount, the Company has used the Black-Scholes pricing model using the following assumptions for options granted in fiscal years 2005 and 2004:

 

		2005		2004
Risk-free interest rate		4.25	%	4.25	%
Estimated volatility		79	%	76	%
Expected life for stock options (yrs)		2.88		2.99
Expected life for stock purchase plan (yrs)		0.5		0.5
Expected dividends		—		—

 

4.                   Earnings Per Share

 

Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period and, if there are dilutive securities, diluted earnings per share is computed by including common stock equivalents outstanding for the period in the denominator.

 

8

4.                   Earnings Per Share, continued

 

Common stock equivalents include shares issuable upon the exercise of stock options or warrants, net of shares assumed to have been purchased with the proceeds, using the treasury stock method.

 

(in thousands, except per share data)		For the three months ended:
		October 2, 2004			September 27, 2003
Basic shares used in the calculation of earnings per share		22,326			21,388
Effect of dilutive securities:
Stock options		705			751
Stock warrants		—			49
Diluted shares used in the calculation of earnings per share		23,031			22,188
Per share effect of dilutive securities on income from continuing operations		$	0.01		$	0.00
Per share effect of dilutive securities on net income		$	0.01		$	0.00

 

During the three-month period ended October 2, 2004, options to purchase 639,891 shares of common stock were excluded from the calculation of diluted earnings per share because the exercise price of such options was greater than the average market price of the common stock for the period.  During the three-month period ended September 27, 2003, all options to purchase shares of common stock were included in the calculation of diluted earnings per share.

 

 

5.                   Inventories

 

(in thousands)		October 2, 2004			July 3, 2004
Raw materials		$	3,891		$	4,833
Work in process		447			556
Finished goods		10,014			8,182
		$	14,352		$	13,571

 

6.      Segment Information

 

The Company operates principally in one industry segment: the design, manufacture, sale, and service of medical devices and related equipment. The results in this segment have been presented in the Consolidated Statements of Operations for the appropriate periods.

 

9

 

7.      Guarantees

 

The Company’s products generally carry a standard one-year warranty, except for Vbeam products which typically carry a three-year warranty. The Company records a reserve based on anticipated warranty claims at the time product revenue is recognized. In anticipation of actual warranty claims, the Company amortizes the reserve ratably over the life of the warranty, thereby offsetting actual warranty claims incurred. Actual warranty claims incurred and charged to product costs of sales during an interim period may be more or less than the amount of amortized warranty reserve allocated against them. Factors that affect the Company’s product warranty liability include the number of installed units, the anticipated cost of warranty repairs, and historical and anticipated rates of warranty claims.

 

The following table reflects changes in the Company’s accrued warranty account during the three-month period ended October 2, 2004:

 

(in thousands)
Beginning balance July 3, 2004		$	8,257
Plus accruals related to new sales		931
Less amortization of prior period accruals		1,888
Ending balance on October 2, 2004		$	7,300

 

The Company also offers extended service contracts that may be purchased after a standard warranty has expired. Service contracts may be purchased for periods from one to five years. The Company recognizes service contract revenue ratably over the life of the contract. Actual service contract expenses incurred and charged to service costs of sales during an interim period may be more or less than the amount of amortized service contract revenue recognized in that period.

 

The following table reflects changes in the Company’s deferred revenue account during the three-month period ended October 2, 2004:

 

(in thousands)
Beginning balance July 3, 2004		$	4,055
Plus deferral of new service contract sales		2,531
Less recognition of deferred revenue		1,521
Ending balance on October 2, 2004		$	5,065

 

The Company has an agreement (the “Agreement”) with an independent leasing company whereby the Company will purchase delinquent leases (the “UNL Provision”) relating to Company products purchased by customers and financed through the leasing company.  The Company is required to honor the UNL Provision when the leasing company’s aggregate losses reach levels specified in the Agreement.  The UNL Provision of the Agreement was recently eliminated for any lease initiated after December 31, 2002.  Since the inception of the Agreement, the cumulative amounts paid to the leasing company under the UNL Provision have not been significant.

 

8.      Asset Acquisition

 

On January 8, 2003, the Company acquired substantially all of the assets of Applied Optronics, the diode division of Schwartz Electro-Optics, Inc., for approximately $1.2 million in cash. Applied Optronics was a leading manufacturer of high-powered, pulsed lasers, and was a component supplier to the OEM market that serves a variety of industries including the military, medical, industrial, research and robotics fields. Applied Optronics was the lead supplier of the diodes for the Company’s Smoothbeam™ diode laser system. In accordance with SFAS No. 141 “Business Combinations,” the Company records acquisitions under the purchase method of accounting. Accordingly, the purchase price is allocated to the tangible assets and liabilities and intangible assets acquired, based on their estimated fair values.

 

The asset acquisition consisted primarily of fixed assets, including production and office equipment, and inventory located at the division’s facility in New Jersey. The acquisition increased the Company’s net property and equipment by approximately $0.8 million and inventory by approximately $0.4 million. For the three months ended October 2, 2004, the Applied Optronics operation generated approximately $0.4 million in revenue from diode sales to third-party customers.

 

10

 

9.             Stock split

 

On January 28, 2004, the Company announced that its Board of Directors approved a two-for-one stock split of the Company’s common stock effected in the form of a stock dividend paid on March 16, 2004. As a result of this action 13.3 million shares were issued to shareholders of record as of February 16, 2004. Par value of the stock remains at $.01 per share and accordingly, $133 was transferred from additional paid-in capital to common stock. All references to the number of common shares and per common share amounts have been restated to give retroactive effect to the stock split for all periods presented.

 

10.          Commitments and Contingencies

 

The Company has an Amended and Restated License Agreement (the “License”) with The Regents of the University of California (“The Regents”) pursuant to which the Company licenses certain patent rights to its dynamic cooling device (“DCD”) from The Regents.  The Company sells its DCD as a component part of its Smoothbeam ® laser system and as an accessory to its other laser systems.  In April of 2004, The Regents issued a notice of default under the License, asserting, among other things, that the Company is in breach of the License for the alleged failure to make required royalty payments and to make required disclosures.  The Regents’ April notice asserted that the total underpaid royalties, interest and other charges for the period from August of 2000 through September 2003 are $1,128,000.  The Regents issued a subsequent notice of default, dated June 30, 2004, relating to the quarterly periods ended December 27, 2003 and March 27, 2004, for which The Regents asserted that the Company underpaid additional royalties amounting to $1,350,000.  The Company and The Regents differ in their respective interpretations of which products sold by the Company give rise to a royalty-bearing obligation to The Regents.  The Company believes it has made all payments it was required to make.

 

11

10.          Commitments and Contingencies, continued

 

Under the License, disputes are to be settled by binding arbitration through a mutually acceptable single arbitrator.  On June 14, 2004, the Company filed a Demand for Arbitration to adjudicate the differing interpretations of the License Agreement held by the Company and The Regents.  On July 8, 2004, The Regents filed their response and counterclaim for breach of contract and declaratory relief.  Candela deposited approximately $1.0 million in June of 2004, and an additional $1.0 million in August of 2004, into an escrow fund to be paid in whole or in part to the Company or The Regents as determined by the arbitrator.  As a result of the establishment of the escrow fund, The Regents will not terminate or purport to terminate the License Agreement based on any alleged breach by the Company related to any matter now before the arbitrator.  The $2.0 million deposited in the escrow fund has been included in Other Assets on the accompanying balance sheet, and no expense has or will be recorded with respect to the escrow fund or any additional contingent liabilities while the matter is being arbitrated. A final decision of the arbitrator in this matter is presently expected to be delivered during the second or third quarter of fiscal 2005.

 

From time to time, the Company is a party to various legal proceedings incidental to its business.  Except for the pending arbitration proceedings with The Regents, the Company believes that none of the legal proceedings that are presently pending, if adversely decided to the Company, will have a material adverse effect upon its financial position, results of operations, or liquidity.

 

CANDELA CORPORATION

 

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

 

We research, develop, manufacture, market and service lasers used to perform aesthetic and cosmetic procedures. We sell our lasers to physicians and personal care practitioners.  We market our products directly and through a network of distributors to end-users. Our traditional customer base includes plastic and cosmetic surgeons and dermatologists. More recently we have expanded our sales to a broader group of practitioners consisting of general practitioners and certain specialists including obstetricians, gynecologists and general and vascular surgeons.  We derive our revenue from the sales of lasers and other products, and the provision of product-related services.

 

Critical Accounting Policies

 

This discussion and analysis of our financial condition and results of operations is based upon our 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 us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates and judgments on an on-going basis, including those related to revenue recognition, bad debts, inventories, warranty obligations, contingencies, restructurings and income taxes. We base our estimates and judgments on historical experience and on various other assumptions that we believe 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 and judgments under different assumptions or conditions. A discussion of our critical accounting policies and the related estimates and judgments affecting the preparation of our consolidated financial statements is included in our Annual Report on Form 10-K for fiscal year 2004.

 

12

 

Results of Operations

 

Revenue.

 

Revenue source by geographic region is reflected in the following table:

 

(in thousands)		For the three months ended:
		October 2, 2004					September 27, 2003					Change
US revenue		$	9,424		42	%	$	7,852		42		$	1,572		20	%
Foreign revenue		12,967			58	%	10,834			58	%	2,133			20	%
Total revenue		$	22,391		100	%	$	18,686		100	%	$	3,705		20	%

 

Consolidated Overview

 

Consolidated revenue increased $3.7 million, to $22.4 million for the three months ended October 2, 2004, from $18.7 million for the three months ended September 27, 2003.  The increase was due primarily to uniform increase in demand for our products and related service on a worldwide basis, coupled with our emerging ability to reach into new markets.

 

Foreign revenue increased 20% to $13.0 million for the three-month period ended October 2, 2004, as compared to the three-month period ended September 27, 2003. Foreign revenue increased across all countries with South America and Europe showing the most strength. Revenues in South America increased over 400 percent, accounting for approximately $0.6 million or 29% of this comparative increase while European revenues increased approximately $1.2 million accounting for 57% of this comparative increase. Increases in Japan were more modest, totaling approximately $0.3 million for the quarter or approximately 14% of the quarter over quarter increase.

 

US revenue increased 20% to $9.4 million for the three-month period ended October 2, 2004, as compared to the three-month period ended September 27 2003.  The revenue increase in the US was uniform across all regions denoting solid demand for our products and related services.

 

Revenue source by type is reflected in the following table:

 

		For the three months ended:
(in thousands)		October 2, 2004					September 27, 2003					Change
Revenue
Lasers and other products		$	18,343		82	%	$	15,357		82		$	2,986		19	%
Product-related service		4,048			18	%	3,329			18	%	719			22	%
Total revenue		$	22,391		100	%	$	18,686		100	%	$	3,705		20	%

 

The increase in revenue from lasers and other products for the three months ended October 2, 2004, compared to the three-month period ended September 27, 2003 resulted primarily from an increase in the sales volume of our new GentleYag™ product. The increase in revenue from product-related service for the three months ended October 2, 2004 compared to the three months ended September 27, 2003 resulted primarily from an increase in the number of service related contracts sold in addition to an increase in the number of consumables and accessories sold to support our installed base.

 

13

 

Cost of Sales.  Cost of sales increased 10% to $10.4 million for the three months ended October 2, 2004 as compared to cost of sales of $9.4 million for the three months ended September 27, 2003.  As a percentage of revenue, cost of sales decreased almost 4% on a comparative basis, quarter over quarter.

 

Gross Profit.  Gross profit was approximately $12.0 million or 54% of revenues for the three-month period ended October 2, 2004, compared to gross profit of approximately $9.3 million or 50% for the same period one year earlier. This increase in gross profit results principally from the increase in sales volume of our GentleYag™ product line.

 

Selling, General and Administrative Expense.  Selling, general and administrative expenses increased 23%, to approximately $6.7 million for the three-month period ended October 2, 2004 from approximately $5.4 million for the three-month period ended September 27, 2003. As a percentage of revenue, selling, general and administrative expenses increased to 30% from 29% of revenues for the same respective periods. This increase was due primarily to commission and employee related expense of approximately $0.5 million in the US and $0.5 million internationally, coupled with increased administrative costs in Spain as a result of our expansion effort into Portugal.

 

Research and Development Expense.  Research and development spending increased to $1.3 million for the three-month period ended October 2, 2004 from $1.1 million for the three-month period ended September 27, 2003 due primarily to an increase in project related expenses.

 

Other Income/Expense.  Net other income for the current period remained relatively unchanged as compared to the three months ended September 27, 2003.

 

Income Taxes.  The provision for income taxes results from a combination of activities of both the domestic operations and foreign subsidiaries of the Company.  We recorded a 32% effective tax rate for the three-month period ended October 2, 2004.  This compares to the three-month period ended September 27, 2003, in which we recorded a 31.5% effective tax rate.  The provision for income taxes for the three months ended October 2, 2004 differs from the U.S. statutory rate as a result of tax provisions calculated for income generated by foreign subsidiaries at a rate that differs from the U.S. statutory rate.

 

Discontinued Operations

 

On September 27, 2003, we permanently closed our only remaining skin care center, which was located in Boston. The closure of the Boston skin care center, together with the earlier closing of our Scottsdale, Arizona spa, and the associated cessation of this line of business, is accounted for as discontinued operations. As a result of the closure of the Boston skin care center, in the fiscal quarter ended September 27, 2003, we recorded a $2.1 million charge for the accrual of $3.0 million of future occupancy costs and $0.3 million of severance obligations and other related costs of closure, net of anticipated tax benefits of $1.3 million. In addition, both the financial statements for the three months ended October 2, 2004 and all prior financial statements have been restated to reflect skin care center operations as discontinued.  The Company believes that the size of the accrual that it has established is sufficient to cover all future leasehold expenses for the remainder of the lease term. Leasehold expenses could potentially be mitigated through the sublease of the property. The landlord has notified the Company that it has re-let the premises. The Company has elected not to reverse any portion of the accrual at this time because the potential economic benefits are not yet known.

 

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Liquidity and Capital Resources

 

Cash used in operating activities was $0.4 million for the three months ended October 2, 2004, in comparison to cash used in operating activities of $2.0 million for the same period in the prior year. This decrease in cash used by operating activities primarily reflects stronger overall operating results combined with the replenishment of cash due to the collection of accounts receivable. This was partially offset by an increase in accruals and accounts payable due to the timing of our current quarter end as compared to the prior year.  In addition, the Company deposited $1.0 million during the current quarter into an escrow account which is being carried as an other asset at the current balance sheet date. Cash used by investing activities remained relatively flat for the three months ended October 2, 2004, as the Company continued its conservative policy towards capital outlays for property, plant and equipment.

 

Our outstanding contractual obligations as of October 2, 2004, are reflected in the following table:

 

(in thousands)		Total		Maturity Less than 1 year		Maturity 1-3 years		Maturity 4-5 years		Maturity in excess of 5 years
Operating leases		2,152		742		981		350		79

 

We also maintain a renewable $10,000,000 revolving credit agreement with a major bank with interest at the bank’s base rate, or LIBOR plus 2.25%.  Any borrowings outstanding under the line of credit are due on demand or according to a payment schedule established at the time funds are borrowed.  The line of credit is unsecured.  The agreement contains restrictive covenants limiting the establishment of new liens, and the purchase of margin stock.  No amounts were outstanding under the line of credit as of October 2, 2004.

 

We believe that our current cash balances will be sufficient to meet anticipated cash requirements for the next twelve months.  However, we cannot be sure that we will not require additional capital beyond the amounts currently forecasted by us, or that any such required additional capital will be available on reasonable terms, if at all, when such capital becomes required.

 

Cautionary Statements

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are not promises or guarantees and are subject to risks and uncertainties that could cause our actual results to differ materially from those anticipated.  Such statements may relate to, among other things, the future of the industry, product development, business strategy (including the possibility of future acquisitions), anticipated operational and capital expenditure levels, continued acceptance and growth of our products, and dependence on significant customers and suppliers.  Forward-looking statements may also include, without limitation, any statement relating to future events, conditions or circumstances or using words such as or similar to:  anticipate; believe; continue; could; estimate; expect; intend; plan; predict; project; may; or will.  The risks and uncertainties that may affect forward-looking statements and/or our business include, among others, those discussed in “Cautionary Statements” in our Annual Report filed on Form 10-K for the fiscal year ended July 3, 2004, as well as other risks and uncertainties referenced in this Quarterly Report.  These risks and uncertainties include, but are not limited to, the following:

 

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Cautionary Statements, continued

 

•                  Our principal source of liquidity is our current cash and equivalents. Our ability to generate cash from operations is dependant upon our ability to generate revenue from selling our lasers and other products and providing product-related services. A decrease in demand for our products and related services or increases in operating costs would likely have an adverse effect on our liquidity.

 

•                  Because we typically derive more than half of our revenue from international sales, we are susceptible to currency fluctuations, negative economic changes taking place in foreign marketplaces, and other risks associated with conducting business overseas.

 

•                  The failure to obtain alexandrite rods for certain laser systems from our sole supplier would impair our ability to manufacture and sell these laser systems, which has accounted for a substantial portion of our revenue in certain recent periods.

 

•                  An adverse result in the arbitration proceeding pending against The Regents of the University of California would result in additional expenditures and would negatively impact our operating results.

 

•                  Our failure to respond to rapid changes in technology and intense competition in the laser industry could make our lasers obsolete.

 

•                  Like other companies in our industry, we are subject to a regulatory review process and our failure to receive necessary government clearances or approvals could affect our ability to sell our products and remain competitive.

 

•                  Achieving complete compliance with FDA regulations is difficult, and if we fail to comply, we could be subject to FDA enforcement action.

 

•                  Claims by others that our products infringe their patents or other intellectual property rights, or that the patents which we own or have licensed rights to are invalid, could prevent us from manufacturing and selling some of our products or require us to incur substantial costs from litigation or development of non-infringing technology.

 

•                  We could incur substantial costs as a result of product liability claims.

 

•                  We may be unable to attract and retain management and other personnel we need to succeed.

 

•                  Our failure to manage acquisitions and joint ventures effectively may divert management attention from our core business and cause us to incur additional debt, liabilities or costs.

 

We caution readers not to place undue reliance upon any forward-looking statements, which speak only as of the date made.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any such statements to reflect any change in our expectations or any change in events, conditions or circumstances on which any such statement is based.

 

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Item 3 - Quantitative and Qualitative Disclosures About Market Risk

 

We have foreign subsidiaries in Japan, Spain, France and Germany.  Approximately 58% of our revenues for the three months ended October 2, 2004 were from operations outside the United States.  These subsidiaries transact business in both local and foreign currency.  Therefore, we are exposed to foreign currency exchange risks and fluctuations in foreign currencies, which could adversely impact our results and financial condition.  However, sales from the United States made directly to customers or distributors in foreign countries are invoiced in U.S. dollars and are not exposed to foreign currency risk.

From time to time, we may enter into foreign currency exchange and option contracts to reduce our exposure to foreign currency risk and variability in operating results due to fluctuation in exchange rates underlying the value of current transactions and anticipated transactions denominated in foreign currencies.  These contracts obligate us to exchange predetermined amounts of specified foreign currencies at specified exchange rates on specified dates.  These contracts are denominated in the same currency in which the

underlying transactions are denominated and bear a contract value and maturity date that approximate the value and expected settlement date, respectively, of the underlying transactions. We do not engage in foreign currency speculation.

 

We have cash equivalents that primarily consist of commercial paper, overnight repurchase agreements and money market accounts.  We believe that any near term changes in interest rates will be immaterial to any potential losses in future earnings, cash flow and fair values.

 

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-15(e)) as of October 2, 2004 (the “Evaluation Date”).  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 to internal controls.  There were no changes in our internal controls over financial reporting during the fiscal quarter ended October 2, 2004 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

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CANDELA CORPORATION

 

Part II.  Other Information

 

Item 1.  Legal Proceedings.

 

The Company has an Amended and Restated License Agreement (the “License”) with The Regents of the University of California (“The Regents”) pursuant to which the Company licenses certain patent rights to its dynamic cooling device (“DCD”) from The Regents.  The Company sells its DCD as a component part of its Smoothbeam ® laser system and as an accessory to its other laser systems.  In April of 2004, The Regents issued a notice of default under the License, asserting, among other things, that the Company is in breach of the License for the alleged failure to make required royalty payments and to make required disclosures.  The Regents’ April notice asserted that the total underpaid royalties, interest and other charges for the period from August of 2000 through September 2003 are $1,128,000.  The Regents issued a subsequent notice of default, dated June 30, 2004, relating to the quarterly periods ended December 27, 2003 and March 27, 2004, for which The Regents asserted that the Company underpaid additional royalties amounting to $1,350,000.  The Company and The Regents differ in their respective interpretations of which products sold by the Company give rise to a royalty-bearing obligation to The Regents.  The Company believes it has made all payments it was required to make.

 

Under the License, disputes are to be settled by binding arbitration through a mutually acceptable single arbitrator.  On June 14, 2004, the Company filed a Demand for Arbitration to adjudicate the differing interpretations of the License Agreement held by the Company and The Regents.  On July 8, 2004, The Regents filed their response and counterclaim for breach of contract and declaratory relief.  Candela deposited approximately $1.0 million in June of 2004, and an additional $1.0 million in August of 2004, into an escrow fund to be paid in whole or in part to the Company or The Regents as determined by the arbitrator.  As a result of the establishment of the escrow fund, The Regents will not terminate or purport to terminate the License Agreement based on any alleged breach by the Company related to any matter now before the arbitrator.  A final decision of the arbitrator in this matter is presently expected to be delivered during the second or third quarter of fiscal 2005.

 

From time to time, we are a party to various legal proceedings incidental to our business.  Except for the pending arbitration proceedings with The Regents, we believe that none of the legal proceedings that are presently pending, if adversely decided to the Company, will have a material adverse effect upon our financial position, results of operations, or liquidity.

 

Item 6.  Exhibits

 

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

				CANDELA CORPORATION
Date:	November 5, 2004			/s/ F. Paul Broyer
				F. Paul Broyer
				Senior Vice President, Finance and Administration
				and Chief Financial Officer

 

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Candela Corporation

 

INDEX TO EXHIBITS

 

 

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