cutr20180930_10q.htm
 

Table of Contents


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q


(Mark One)

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period _____ to_____.

 

Commission file number: 000-50644

 

 


Cutera, Inc.
(Exact name of registrant as specified in its charter)
 

 


 

Delaware

 

77-0492262

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. employer identification no.)

 

3240 Bayshore Blvd., Brisbane, California 94005

(Address of principal executive offices)

 

(415) 657-5500

(Registrant’s telephone number, including area code)

 

 


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    ☒    No    ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ☒     No    ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ☐

Accelerated filer  ☒

Non-accelerated filer  ☐

Smaller reporting company  ☐

Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes    ☐    No    ☒

 

The number of shares of Registrant’s common stock issued and outstanding as of October 31, 2018 was 13,903,830

 

 

 

CUTERA, INC.

 

FORM 10-Q

 

TABLE OF CONTENTS

 

 

 

 

 

Page

PART I

 

FINANCIAL INFORMATION

 

  

 

 

 

 

  

Item 1

 

Financial Statements (unaudited)

 

3

 

 

Condensed Consolidated Balance Sheets

 

3

 

 

Condensed Consolidated Statements of Operations

 

4

 

 

Condensed Consolidated Statements of Comprehensive Income (Loss)

 

5

 

 

Condensed Consolidated Statements of Cash Flows

 

6

 

 

Notes to Condensed Consolidated Financial Statements

 

7

Item 2

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

22

Item 3

 

Quantitative and Qualitative Disclosures About Market Risk

 

32

Item 4

 

Controls and Procedures

 

33

 

 

 

 

  

PART II

 

OTHER INFORMATION

 

  

 

 

 

 

  

Item 1

 

Legal Proceedings

 

33

Item 1A

 

Risk Factors

 

33

Item 2

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

33

Item 3

 

Defaults Upon Senior Securities

 

33

Item 4

 

Mine Safety Disclosures

 

33

Item 5

 

Other Information

 

33

Item 6

 

Exhibits

 

34

 

 

Signature

 

34

 

                    

                                                      

In this Quarterly Report on Form 10-Q, “Cutera,” “the Company,” “we,” “us” and “our” refer to Cutera, Inc. and its consolidated subsidiaries.

 

This report may contain references to our proprietary intellectual property, including among others, trademarks for our systems and ancillary products, Accutip®, Coolglide®, Coolglide Excel®, enlighten®, Excel HR®, Excel V®, Limelight®, MyQ®, Pearl®, Pico Genesis™, ProWave®, Solera®, Titan®, TruSculpt®, Vantage®, and Xeo®.

 

These trademarks and trade names are the property of Cutera or the property of our consolidated subsidiaries and are protected under applicable intellectual property laws. Solely for convenience, our trademarks and tradenames referred to in this Quarterly Report on Form 10-Q may appear without the ® or ™ symbols, but such references are not intended to indicate in any way that we will not assert, to the fullest extent under applicable law, our rights to these trademarks and tradenames. 

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1.

FINANCIAL STATEMENTS

 

CUTERA, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

 (unaudited)

 

   

September 30,

2018

   

December 31,

2017

 

Assets

               

Current assets:

               

Cash and cash equivalents

  $ 21,866     $ 14,184  

Marketable investments

    5,018       21,728  

Accounts receivable, net

    25,444       20,777  

Inventories

    31,322       28,782  

Other current assets and prepaid expenses

    3,716       2,903  

Total current assets

    87,366       88,374  
                 

Property and equipment, net

    2,784       2,096  

Deferred tax asset

    21,402       19,055  

Goodwill

    1,339       1,339  

Other long-term assets

    6,048       374  

Total assets

  $ 118,939     $ 111,238  
                 

Liabilities and Stockholders' Equity

               

Current liabilities:

               

Accounts payable

  $ 13,321     $ 7,002  

Accrued liabilities

    22,904       26,848  

Deferred revenue

    8,939       9,461  

Total current liabilities

    45,164       43,311  
                 

Deferred revenue, net of current portion

    2,380       2,195  

Income tax liability

    352       379  

Other long-term liabilities

    640       460  

Total liabilities

    48,536       46,345  
                 

Commitments and Contingencies (Note 13)

               
                 

Stockholders’ equity:

               

Common stock, $0.001 par value; authorized: 50,000,000 shares; issued and outstanding: 13,890,590 and 13,477,973 shares at September 30, 2018 and December 31, 2017, respectively

    14       13  

Additional paid-in capital

    68,180       62,025  

Accumulated income

    2,283       2,947  

Accumulated other comprehensive loss

    (74)       (92)  

Total stockholders’ equity

    70,403       64,893  
                 

Total liabilities and stockholders’ equity

  $ 118,939     $ 111,238  


The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

 

 

CUTERA, INC.

 

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 (in thousands, except per share data)

 (unaudited)

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Net revenue:

                               

Products

  $ 35,675     $ 33,486     $ 102,589     $ 89,688  

Service

    4,898       4,687       14,662       14,173  

Total net revenue

    40,573       38,173       117,251       103,861  

Cost of revenue:

                               

Products

    15,909       13,859       46,876       38,843  

Service

    2,779       2,104       8,779       6,241  

Total cost of revenue

    18,688       15,963       55,655       45,084  

Gross profit

    21,885       22,210       61,596       58,777  
                                 

Operating expenses:

                               

Sales and marketing

    14,479       13,148       43,102       36,708  

Research and development

    3,244       3,467       10,895       9,393  

General and administrative

    5,160       3,379       15,501       10,143  

Lease termination income

          (4,000)             (4,000)  

Total operating expenses

    22,883       15,994       69,498       52,244  

Income (loss) from operations

    (998)       6,216       (7,902)       6,533  

Interest and other income (expense), net

    (49)       197       (80)       746  

Income (loss) before income taxes

    (1,047)       6,413       (7,982)       7,279  

Provision (benefit) for income taxes

    (174)       225       (3,505)       166  

Net income (loss)

  $ (873)     $ 6,188     $ (4,477)     $ 7,113  
                                 

Net income (loss) per share:

                               

Basic

  $ (0.06)     $ 0.44     $ (0.33)     $ 0.51  

Diluted

  $ (0.06)     $ 0.42     $ (0.33)     $ 0.48  
                                 

Weighted-average number of shares used in per share calculations:

                               

Basic

    13,851       13,973       13,717       13,917  

Diluted

    13,851       14,767       13,717       14,733  

 

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

 

 

CUTERA, INC.

 

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

 (unaudited)

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Net income (loss)

  $ (873)     $ 6,188     $ (4,477)     $ 7,113  

Other comprehensive income (loss):

                               

Available-for-sale investments

                               

Net change in unrealized gains (losses) on available-for-sale investments

    13       5       9       13  

Less: Reclassification adjustment for gains (losses) on investments recognized during the period

                9       (4

)

Net change in unrealized gain and losses on available-for-sale investments

    13       5       18       9  

Tax provision

                       

Other comprehensive income (loss), net of tax

    13       5       18       9  

Comprehensive income (loss)

  $ (860)     $ 6,193     $ (4,459)     $ 7,122  

 

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

 

 

CUTERA, INC.

 

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 (in thousands)

  (unaudited)

 

   

Nine Months Ended September 30,

 
   

2018

   

2017

 

Cash flows from operating activities:

               

Net income (loss)

  $ (4,477)     $ 7,113  

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

               

Stock-based compensation

    5,524       3,623  

Depreciation of tangible assets

    849       750  

Amortization of contract acquisition costs

    1,304        

Change in deferred tax assets

    (3,507)        

Provision for doubtful accounts receivable

    877       (9)  

Other

    215       (58)  

Changes in assets and liabilities:

               

Accounts receivable

    (5,544)       (3,048)

 

Inventories

    (2,540)       (8,751)

 

Other current assets and prepaid expenses

    (797)       (633)

 

Other long-term assets

    (2,301)       (1)

 

Accounts payable

    6,319       3,207  

Accrued liabilities

    (4,177)       4,757  

Other long-term liabilities

    105        

Deferred revenue

    58       652  

Income tax liability

    (27)       3  

Net cash provided by (used in) in operating activities

    (8,119)       7,605  
                 

Cash flows from investing activities:

               

Acquisition of property, equipment and software

    (1,214)       (443

)

Disposal of property and equipment

    41       53  

Proceeds from sales of marketable investments

    13,044       9,154  

Proceeds from maturities of marketable investments

    8,050       39,612  

Purchase of marketable investments

    (4,390)       (44,156

)

Net cash provided by investing activities

    15,531       4,220  
                 

Cash flows from financing activities:

               

Repurchase of common stock

          (13,776

)

Proceeds from exercise of stock options and employee stock purchase plan

    3,603       4,566  

Taxes paid related to net share settlement of equity awards

    (2,971)       (1,332

)

Payments on capital lease obligations

    (362)       (274

)

Net cash provided by (used) in financing activities

    270       (10,816

)

                 

Net increase in cash and cash equivalents

    7,682       1,009  

Cash and cash equivalents at beginning of period

    14,184       13,775  

Cash and cash equivalents at end of period

  $ 21,866     $ 14,784  
                 

Supplemental disclosure of non-cash items:

               

Assets acquired under capital lease

  $ 610     $ 257  

 

The accompanying notes are an integral part of these unaudited Condensed Consolidated Financial Statements.

 

 

CUTERA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

Note 1. Summary of Significant Accounting Policies

 

Description of Operations and Principles of Consolidation

 

Cutera, Inc. (“Cutera” or the “Company”) is a global provider of laser and energy-based aesthetic systems for practitioners worldwide. The Company designs, develops, manufactures, distributes and markets laser and energy-based product platforms for use by physicians and other qualified practitioners, enabling them to offer safe and effective aesthetic treatments to their customers. The Company currently markets the following system platforms: excel, enlighten, Juliet, Secret RF, truSculpt and xeo. The Company’s systems offer multiple hand pieces and applications, allowing customers to upgrade their systems. The sales of (i) systems, system upgrades and hand pieces (“Systems” revenue); (ii) hand piece refills applicable to Titan, truSculpt 3D and truSculpt iD , as well as single use disposable tips applicable to Juliet, Secret RF (“Consumables” revenue); and (iii) the distribution of third party manufactured skincare products ("Skincare” revenue); are collectively classified as “Products” revenue. In addition to Products revenue, the Company generates revenue from the sale of post-warranty service contracts, parts, detachable hand piece replacements (except for Titan , truSculpt 3D and truSculpt iD ) and service labor for the repair and maintenance of products that are out of warranty, all of which are classified as “Service” revenue.

 

Headquartered in Brisbane, California, the Company has wholly-owned subsidiaries that are currently operational in Australia, Belgium, Canada, France, Germany, Hong Kong, Japan, Spain, Switzerland and the United Kingdom. The Company’s wholly owned subsidiary in Italy is currently dormant. These active subsidiaries market, sell and service the Company’s products outside of the United States. The Condensed Consolidated Financial Statements include the accounts of the Company and its subsidiaries. All inter-company accounts, transactions and balances have been eliminated.

 

Unaudited Interim Financial Information

 

In the opinion of the Company, the accompanying unaudited condensed consolidated financial statements included in this report reflect all adjustments (consisting of only normal recurring adjustments) necessary for a fair statement of its financial position as of September 30, 2018, its results of operations for the three and nine months periods ended September 30, 2018, and 2017, respectively, comprehensive income (loss) for the three and nine months periods ended September 30, 2018 and 2017, respectively, and cash flows for the nine months ended September 30, 2018, and 2017, respectively. The December 31, 2017 condensed consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles in the United States of America (“GAAP”). The results for interim periods are not necessarily indicative of results for the entire year or any other interim period. The accompanying condensed consolidated financial statements should be read in conjunction with the Company’s previously filed audited financial statements and the related notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2017 filed with the Securities and Exchange Commission (the “SEC”) on March 26, 2018.

 

 Use of Estimates

 

The preparation of interim Condensed Consolidated Financial Statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the amounts reported of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial Statements and the accompanying notes, and the reported amounts of revenue and expenses during the reported periods. Actual results could differ materially from those estimates.

 

On an ongoing basis, management evaluates its estimates, including those related to warranty obligations, sales commission, accounts receivable and sales allowances, valuation of inventories, fair values of goodwill, useful lives of property and equipment, assumptions regarding variables used in calculating the fair value of the Company's equity awards, expected achievement of performance based vesting criteria, fair value of investments, the standalone selling price of the Company's products and services, the customer life and period of benefit used to capitalize and amortize contracts acquisition costs, variable consideration, contingent liabilities, recoverability of deferred tax assets, and effective income tax rates, among others. Management bases estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

 

 Risks and Uncertainties

 

The Company's future results of operations involve a number of risks and uncertainties. Factors that could affect the Company's future operating results and cause actual results to vary materially from expectations include, but are not limited to, rapid technological change, continued acceptance of the Company's products, stability of world financial markets, cybersecurity breaches and other disruptions that could compromise the Company’s information or results, management of international activities, competition from substitute products and larger companies, ability to obtain and maintain regulatory approvals, government regulations and oversight, patent and other types of litigation, ability to protect proprietary technology from counterfeit versions of the Company's products, strategic relationships and dependence on key individuals.

 

 

Comparability

 

The Company adopted the new revenue standard effective January 1, 2018, using the modified retrospective method. Prior period financial statements were not retrospectively restated. The consolidated balance sheet as of December 31, 2017 and results of operations for the three and nine months ended September 30, 2017 were prepared using an accounting standard that was different than that in effect for the three and nine months ended September 30, 2018. As a result the consolidated balance sheets as of September 30, 2018 and December 31, 2017 are not directly comparable, nor are the condensed consolidated statement of operations for the three and nine months ended September 30, 2018 and September 30, 2017.

 

Adopted Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers,” amending revenue recognition guidance and requiring more detailed disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The amended guidance, herein referred to as Topic 606, is effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted for public companies effective for annual and interim reporting periods beginning after December 15, 2016. The Company adopted the new revenue standard in the first quarter of fiscal year 2018 using the modified retrospective method. The Company recognized the cumulative effect of applying the new revenue standard as an adjustment to retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for the period presented.

 

See Note 2 - Revenue Recognition, for additional accounting policy and transition disclosures.

 

Other Accounting Pronouncements Not Yet Adopted

 

In June 2018, the FASB issued ASU No. 2018-07, "Compensation -Stock Compensation (Topic 718): Improvement to Nonemployee Share-Based Payment Accounting". The new guidance changes the accounting for nonemployee awards including: (1) Equity-classified share-based payment awards issued to nonemployees will be measured on the grant date, instead of the previous requirement to remeasure the awards through the performance completion date, (2) For performance conditions, compensation cost associated with the award will be recognized when the achievement of the performance condition is probable, rather than upon achievement of the performance condition, and (3) The current requirement to reassess the classification (equity or liability) for nonemployee awards upon vesting will be eliminated, except for awards in the form of convertible instruments. The new guidance also clarifies that any share-based payment awards issued to customers should be evaluated under ASC 606. The amendments in the new guidance are effective for annual and interim reporting periods beginning after December 15, 2018, with early adoption permitted for public companies, but no earlier than an entity’s adoption date of Topic 606. The Company will adopt the new standard effective January 1, 2019. The Company has immaterial non-employee stock based expense, and expects that the impact upon adoption of the new standard will not be material to the financial statements.

 

In February 2016, the FASB issued ASU 2016-02 , "Leases," which will require, among other items, lease accounting to recognize most leases as assets and liabilities on the balance sheet. Qualitative and quantitative disclosures will be enhanced to better understand the amount, timing and uncertainty of cash flows arising from leases. In July 2018, the FASB issued ASU 2018 -11, "Targeted Improvements," which gives the option to apply the transition provisions of ASU 2016-02  at its adoption date instead of at the earliest comparative period presented in its financial statements. In addition, ASU 2018 2018 -11 provides a practical expedient that permits lessors to not separate nonlease components from the associated lease component if certain conditions are met. Also in July 2018, the FASB issued ASU 2018-10 , "Codification Improvements to Topic 842, Leases," which clarifies certain aspects of ASU 2016-02 . The Company will adopt ASU 2016-02  on a modified retrospective basis on its adoption date of January 1, 2019 with practical expedients, instead of at the earliest comparative period presented in the Company’s financial statements. The Company expects the impact to be material.

 

 

Note 2. Revenue recognition

 

The Company adopted ASC Topic 606, "Revenue from Contracts with Customers," on January 1, 2018, applying the modified retrospective method to all contract agreements that were not completed as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported under the accounting standards in effect for the prior period. A cumulative catch up adjustment was recorded to beginning retained earnings to reflect the impact of all existing arrangements under Topic 606.

 

Upon adoption of Topic 606, the Company recorded an increase to retained earnings, net of deferred tax liability, of $3.8 million (Note 12) for contracts still in force as of January 1, 2018 for the following items in the first and second quarters of 2018:

 

$237,000 reduction in deferred revenue balances for the differences in the amount of revenue recognition for the Company’s revenue streams as a result of allocation of revenue based on standalone selling prices to the Company’s various performance obligations.

$151,000 increase in deferred revenue balances, related to the accretion of financing costs for multi-year post-warranty service contracts for customers who pay more than one year in advance of receiving the service. The Company estimated interest expense for such advance payments under the new revenue standard.

$210,000 decrease in accrued liabilities.

$4.7 million for the capitalization of the incremental contract acquisition costs, such as sales commissions paid in connection with system sales. These contract acquisition costs were capitalized and will be amortized over the period of anticipated support renewals. The Company expensed such costs when incurred under the prior guidance.

$1.2 million deferred tax liability related to the direct tax effect of the ASC 606 adoption.

  

The Company’s revenue consists of Products and Service revenue resulting from the sale of systems, training on the systems, extended service contracts, consumables and other accessories. The Company accounts for a contract with a customer when there is a legally enforceable contract between the Company and the customer, the rights of the parties are identified, the contract has commercial substance, and collectability of the contract consideration is probable. Revenues are recognized when control of the promised goods or services are transferred to the Company’s customers, in an amount that reflects the consideration that the Company expects to receive in exchange for those goods or services.

 

The Company's system sale arrangements generally contain multiple products and services. For these bundled sale arrangements, the Company accounts for individual products and services as separate performance obligations if they are distinct. The Company’s products and service are distinct if a customer can benefit from the product or service on its own or with other resources that are readily available to the customer, and if the Company’s promise to transfer the products or service to the customer is separately identifiable from other promises in the contract. The Company’s system sale arrangements include a combination of the following performance obligations: the system and software license (considered as one performance obligation), system accessories (hand pieces), training, other accessories, extended service contracts and marketing services. For the Company’s system sale arrangements that include an extended service contract, the period of service commences at the expiration of the Company’s standard warranty offered at the time of the system sale. The Company considers the extended service contracts terms in the arrangements that are legally enforceable to be performance obligations. Other than extended service contracts and marketing services (which are satisfied over time), the Company generally satisfies all of the performance obligations at a point in time. Systems, system accessories (hand pieces), training, and time and material services are also sold on a stand-alone basis.

 

The following table summarizes the effects of adopting Topic 606 on the Company’s condensed consolidated balance sheet as of September 30, 2018:

 

   

As reported under

Topic 606

   

Adjustments

   

Balances under

Prior GAAP

 
   

(In thousands)

 
                         

Other long-term assets

  $ 6,048     $ 5,380     $ 668  

Deferred tax asset

    21,402       (1,160)       22,562  

Accrued liabilities

    22,904       (111)       23,015  

Deferred revenue

    11,319       (315)       11,634  

Retained earnings (deficit)

    2,283       4,645       (2,132)  

 

 

The following table summarizes the effects of adopting Topic 606 on the Company’s condensed consolidated income statement for the three months ended September 30, 2018:

 

   

As reported under

Topic 606

   

Adjustments

   

Balances under

Prior GAAP

 
                         
   

(In thousands)

 

Products revenue

  $ 35,675     $ (56)     $ 35,731  

Service revenue

    4,898       (59)       4,957  

Sales and marketing

    14,479       (55)       14,534  

Interest and other income, net*

    (49)       (55)       6  

 

 

The following table summarizes the effects of adopting Topic 606 on Company’s condensed consolidated income statement for the nine months ended September 30, 2018:

 

 

   

As reported under

Topic 606

   

Adjustments

   

Balances under

Prior GAAP

 
                         
   

(In thousands)

 

Products revenue

  $ 102,589     $ 9     $ 102,580  

Service revenue

    14,662       74       14,588  

Sales and marketing

    43,102       (703)

 

    43,805  

Interest and other income, net*

    (80)

 

    (184)

 

    104  

 

* Included in interest and other income, net, is the estimated interest expense for advance payment related to service contracts under the new revenue standard.

 

Adoption of the standard had no impact on total net cash from or used in operating, investing, or financing activities within the condensed consolidated statements of cash flows.

 

As part of the Company's adoption of ASC 606, the Company elected to use the following practical expedients: (i) not to adjust the promised amount of consideration for the effects of a significant financing component when the Company expects, at contract inception, that the period between the Company's transfer of a promised product or service to a customer and when the customer pays for that product or service will be one year or less; (ii) to expense costs as incurred for costs to obtain a contract when the amortization period would have been one year or less; (iii) not to recast revenue for contracts that begin and end in the same fiscal year; and (iv) not to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer.

 

Note 3. Cash, Cash Equivalent and Marketable Investments

 

The Company invests its cash primarily in money market funds and in highly liquid debt instruments of U.S. federal and municipal governments and their agencies, commercial paper and corporate debt securities. All highly liquid investments with stated maturities of three months or less from date of purchase are classified as cash equivalents; all highly liquid investments with stated maturities of greater than three months are classified as marketable investments. The majority of the Company’s cash and investments are held in U.S. banks and the Company's foreign subsidiaries maintain a limited amount of cash in their local banks to cover their short term operating expenses.

 

The Company determines the appropriate classification of its investments in marketable securities at the time of purchase and re-evaluates such designation at each balance sheet date. The Company’s marketable securities have been classified and accounted for as available-for-sale securities. Investments with remaining maturities of more than one year are viewed by the Company as available to support current operations, and are classified as current assets under the caption marketable investments in the accompanying condensed consolidated balance sheets. Investments in marketable securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity. Any realized gains or losses on the sale of marketable securities are determined on a specific identification method, and such gains and losses are reflected as a component of interest and other income, net.

 

 

The following tables summarize the components, and the unrealized gains and losses position, related to the Company’s cash, cash equivalents and marketable investments (in thousands):

 

September 30, 2018

 

Amortized

Cost

   

Gross

Unrealized

Gains

   

Gross

Unrealized

Losses

   

Fair Market

Value

 

Cash and cash equivalents:

                               

Cash

  $ 13,355     $     $     $ 13,355  

Money market funds

    8,511                   8,511  

Total cash and cash equivalents

    21,866                   21,866  
                                 

Marketable investments:

                               

U.S. government notes

  $ 2,015             (1 )   $ 2,014  

Municipal securities

    202             (1 )     201  

Corporate debt securities

    2,815       1       (13 )     2,803  

Total marketable investments

    5,032       1       (15 )     5,018  
                                 

Total cash, cash equivalents and marketable investments

  $ 26,898     $ 1     $ (15 )   $ 26,884  

 

 

 

 

December 31, 2017

 

Amortized

Cost

   

Gross

Unrealized

Gains

   

Gross

Unrealized

Losses

   

Fair Market

Value

 

Cash and cash equivalents:

                               

Cash

  $ 14,058     $     $     $ 14,058  

Money market funds

    126                   126  

Total cash and cash equivalents

    14,184                   14,184  
                                 

Marketable investments:

                               

U.S. government notes

    11,885             (15)       11,870  

Municipal securities

    201             (1)       200  

Commercial paper

    1,836             (3)       1,833  

Corporate debt securities

    7,838       2       (15)       7,825  

Total marketable investments

    21,760       2       (34)       21,728  
                                 

Total cash, cash equivalents and marketable investments

  $ 35,944     $ 2     $ (34)     $ 35,912  

 

As of September 30, 2018 and December 31, 2017, total gross unrealized losses were $15,000 and $34,000, respectively, and were related to interest rate changes on available-for-sale marketable investments. The Company has concluded that it is more-likely-than-not that the securities will be held until maturity or the recovery of their cost basis. No securities were in an unrealized loss position for more than 12 months.

 

The following table summarizes the contractual maturities of the Company’s available-for-sale securities, classified as marketable investments as of September 30, 2018 (in thousands):

 

   

Amount

 

Due in less than one year

  $ 4,619  

Due in 1 to 3 years

    399  

Total marketable investments

  $ 5,018  

 

 

Note 4. Fair Value of Financial Instruments

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as considers counterparty credit risk in its assessment of fair value. The Company’s financial instruments include cash equivalents, accounts receivable, accounts payable and accrued liabilities. Carrying amounts of the Company's financial instruments, approximate their fair values as of the balance sheet dates given their generally short maturities. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below in accordance with ASC 820:

● Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities.

● Level 2: Directly or indirectly observable inputs as of the reporting date through correlation with market data, including quoted prices for similar assets and liabilities in active markets and quoted prices in markets that are not active. Level 2 also includes assets and liabilities that are valued using models or other pricing methodologies that do not require significant judgment since the input assumptions used in the models, such as interest rates and volatility factors, are corroborated by readily observable data from actively quoted markets for substantially the full term of the financial instrument.

● Level 3: Unobservable inputs that are supported by little or no market activity and reflect the use of significant management judgment. These values are generally determined using pricing models for which the assumptions utilize management’s estimates of market participant assumptions.

 

In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Company also considers counterparty credit risk in its assessment of fair value.

 

As of September 30, 2018, financial assets measured and recognized at fair value on a recurring basis and classified under the appropriate level of the fair value hierarchy as described above were as follows (in thousands):

 

 

September 30, 2018

 

Level 1

   

Level 2

   

Level 3

   

Total

 

Cash equivalents:

                               

Money market funds

  $ 8,511     $     $     $ 8,511  

Marketable investments:

                               

Available-for-sale securities

          5,018             5,018  

Total assets at fair value

  $ 8,511     $ 5,018     $     $ 13,529  

 

As of December 31, 2017, financial assets measured and recognized at fair value on a recurring basis and classified under the appropriate level of the fair value hierarchy as described above were as follows (in thousands):

 

December 31, 2017

 

Level 1

   

Level 2

   

Level 3

   

Total

 

Cash equivalents:

                               

Money market funds

  $ 126     $     $     $ 126  

Marketable investments:

                               

Available-for-sale securities

          21,728             21,728  

Total assets at fair value

  $ 126     $ 21,728     $     $ 21,854  

 

The Company’s Level 1 financial assets are money market funds with fair values that are based on quoted market prices. The Company’s Level 2 investments include U.S. government-backed securities and corporate securities that are valued based upon observable inputs that may include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data including market research publications. The average remaining maturity of the Company’s Level 2 investments as of September 30, 2018 is less than 7 months and all of these investments are rated by S&P and Moody’s at A or better. The Company recognizes transfers between levels of the fair value hierarchy as of the end of the reporting period. There were no transfers within the hierarchy during the quarter and year ended September 30, 2018 and December 31, 2017, respectively. As of September 30, 2018 and December 31, 2017 the Company did not have any Level 3 investments.

 

 

Note 5. Balance Sheet Details

 

Inventories

 

As of September 30, 2018 and December 31, 2017, inventories consist of the following (in thousands):

 

   

September 30,

2018

   

December 31,

2017

 

Raw materials

  $ 18,177     $ 19,160  

Work in progress

    2,079       2,744  

Finished goods

    11,066       6,878  

Total

  $ 31,322     $ 28,782  

 

 Accrued Liabilities

 

As of September 30, 2018 and December 31, 2017, accrued liabilities consist of the following (in thousands):

 

   

September 30,

2018

   

December 31,

2017

 

Accrued payroll and related expenses

  $ 11,098     $ 12,567  

Sales and marketing programs

    2,138       3,710  

Warranty liability

    3,640       3,508  

Sales tax

    2,728       2,920  

Other

    3,300       4,143  

Total

  $ 22,904     $ 26,848  

 

Note 6. Warranty and Extended Service Contracts

 

The Company has a direct field service organization in North America (including Canada). Internationally, the Company provides direct service support in Australia, Belgium, France, Germany, Hong Kong, Japan, and Switzerland, as well as through third-party service providers in Spain and the United Kingdom. In several other countries, where the Company does not have a direct presence, the Company provides service through a network of distributors and third-party service providers.

 

After the original warranty period, maintenance and support are offered on a extended service contract basis or on a time and materials basis. The Company provides for the estimated cost to repair or replace products under warranty at the time of sale. The following table provides the changes in the product warranty accrual for the three and nine months ended September 30, 2018 and 2017 (in thousands):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Beginning Balance

  $ 3,561     $ 2,877     $ 3,508     $ 2,461  

Add: Accruals for warranties issued during the period

    1,589       959       6,164       5,038  

Less: Warranty related expenses during the period

    (1,510)       (896)

 

    (6,032)       (4,559)

 

Ending Balance

  $ 3,640     $ 2,940     $ 3,640     $ 2,940  

 

Note 7. Revenue

 

Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for promised goods or services. The Company’s performance obligations are satisfied either over time or at a point in time. Revenue from performance obligations that are transferred to customers over time accounted for approximately 9% of the Company’s total revenue for the nine months ended September 30, 2018.

 

The Company's system sale arrangements generally contain multiple products and services. For these bundled sale arrangements, the Company accounts for individual products and services as separate performance obligations if they are distinct. The Company’s products and service are distinct if a customer can benefit from the product or service on its own or with other resources that are readily available to the customer, and if the Company’s promise to transfer the products or service to the customer is separately identifiable from other promises in the contract. The Company’s system sale arrangements include a combination of the following performance obligations: the system and software license (considered as one performance obligation), system accessories (hand pieces), training, other accessories, extended service contracts and marketing services.

 

 

For the Company’s system sale arrangements that include an extended service contract, the period of service commences at the expiration of the Company’s standard warranty offered at the time of the system sale. The Company considers the extended service contracts terms in the arrangements that are legally enforceable to be performance obligations. Other than extended service contracts and marketing services (which are satisfied over time), the Company generally satisfies all of the performance obligations at a point in time. Systems, system accessories (hand pieces), training, time and materials services are also sold on a stand-alone basis, and related performance obligations are satisfied at a point in time. For contracts with multiple performance obligations, the Company allocates the transaction price of the contract to each performance obligation on a relative standalone selling price basis.

 

Nature of Products and Services

 

Systems

 

System revenue represents the sale of a system or an upgrade of an existing system. A system consists of a console that incorporates a universal graphic user interface, a laser or other energy based module, control system software and high voltage electronics, as well as one or more hand pieces. However, depending on the application, the laser or other energy based module is sometimes contained in the hand piece such as with the Company’s Pearl and Pearl Fractional applications instead of within the console.

 

The Company offers customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications to their system as their practice grows. This provides customers the flexibility to upgrade their systems whenever they choose and provides the Company with a source of additional Systems revenue.

 

The Company concludes that the system or upgrade and the right to use the embedded software represent a single performance obligation as the software license is integral to the functionality of the system or upgrade.

 

The Company does not identify calibration and installation services for systems other than enlighten as performance obligations because such services are immaterial in the context of the contract.  The related costs to complete calibration and installation for systems other than enlighten are immaterial. Calibration and installation services for enlighten systems are identified as separate performance obligations.

 

For systems sold directly to end-customers that are credit approved, revenue is recognized when the Company transfers control to the end-customer, which occurs when the product is shipped to the customer or when the customer receives the product, depending on the nature of the arrangement. The Company recognizes revenue on a cash basis for system sales to international direct end-customer sales that have not been credit approved, as the performance obligations in the contract are satisfied. For systems sold through credit approved distributors, revenue is recognized at the time of shipment. The Company’s system arrangements generally do not provide a right of return. The Company provides a standard one-year warranty coverage for all systems sold to end-customers to cover parts and service, and extended service plans that vary by the type of product and the level of service desired.

 

The Company typically receives payment for its system consoles and other accessories within 30 days of shipment. Certain international distributor arrangements allow for longer payment terms.

 

Skincare products

 

The Company sells third-party manufactured skincare products in Japan. The third-party skincare products are purchased from the third-party manufacturers and sold to licensed physicians. The Company acts as the principal in this arrangement, as it determines the price to charge customers for the skincare products, and controls the products before they are transferred to the customer. Skincare products are typically sold in contracts in which the skincare products represent the sole performance obligations. The Company recognizes revenue for skincare products at a point in time, generally upon shipment.

 

Consumables (Other accessories)

 

The Company treats its customers' purchases of replacement Titan, truSculpt 3D and truSculpt iD hand pieces as Consumable revenue, which provides the Company with a source of recurring revenue from existing customers. The Company’s recently launched Juliet and Secret RF products have single use disposable tips which must be replaced after every treatment. Sales of these consumable tips further enhance the Company’s recurring revenue. Hand piece refills of the Company’s legacy truSculpt product are accounted for in accordance with the Company’s standard warranty and service contract policies.

 

 

Extended contract services

 

The Company offers post-warranty services to its customers through extended service contracts that cover preventive maintenance and (or) replacement parts and labor for a term of one, two, or three years. The Company also offers services on a time-and-materials basis for detachable hand piece replacements, parts and labor. These post-warranty services serve as additional sources of recurring revenue from the Company’s installed product base. Service revenue is recognized over time, using a time based measure of progress, as the customers benefit from the service throughout the service period. Revenue related to services performed on a time-and-materials basis is recognized when performed.

 

Training

 

Sales of system to customers include training on the system to be provided within 90 days of purchase. The Company considers training as a separate performance obligation as customers can immediately benefit from the training due to the fact that the customer already has the system. Training is also sold separately from systems. The Company recognizes revenue for training when the training is provided. Training is not required for customers to use the systems.

 

Customer Marketing Support

 

In North America, the Company offers marketing and consulting phone support to its customers who purchase its truSculpt 3D and truSculpt iD systems. These customer marketing support services include a practice development model and marketing training, performed remotely with ongoing phone consultations for six months from date of purchase. The Company considers customer marketing support a separate performance obligation, and recognizes revenue over the six-month term of the contracts. The Company estimates the standalone selling price of customer marketing support by using the cost plus a margin approach.

 

Significant Judgments

 

More judgments and estimates are required under Topic 606 than were required under the previous revenue recognition guidance, Topic 605. Revenue recognition under Topic 606 for the Company’s arrangements may be dependent on contract-specific terms.

 

The enlighten system includes the related software license as one performance obligation and the calibration/installation services are accounted for as separate performance obligations. The calibration/installation is a separate performance obligation for the enlighten system because a knowledgeable third-party could perform this service.

 

The Company has however concluded that set-up or installation for all other systems (excluding the enlighten system) is perfunctory as the set-up or installation for systems other than enlighten takes only a short time and the related costs to complete set-up or installation are immaterial.

 

Judgment is required to determine the standalone selling price ("SSP") for each distinct performance obligation. The Company estimates SSPs for each performance obligation as follows:

 

Systems: The SSPs for systems are based on directly observable sales in similar circumstances to similar customers.  When SSP is not directly observable, the Company estimates SSP using the expected cost plus margin approach.

 

Training: SSP is based on observable price when sold on a standalone basis.

 

Extended warranty: SSP is based on observable price when sold on a standalone basis (by customer type).

 

Customer Marketing Support: SSP is estimated based on cost plus a margin.

 

The Company will combine two or more contracts entered into at or near the same time with the same customer (or related parties of the customer) and account for the contracts as a single contract. If a group of agreements are so closely related that they are, in effect, part of a single arrangement, such agreements are deemed to be one arrangement for revenue recognition purposes. The Company exercises significant judgment to evaluate the relevant facts and circumstances in determining whether the separate agreements should be accounted for separately or as, in substance, a single arrangement. The Company’s judgments about whether a group of contracts comprise a single arrangement can affect the allocation of consideration to the distinct performance obligations, which could have an effect on results of operations for the periods involved.

 

The Company is required to estimate the total consideration expected to be received from contracts with customers. In limited circumstances, the consideration expected to be received is variable based on the specific terms of the contract or based on the Company’s expectations of the term of the contract. Generally, the Company has not experienced significant returns or refunds to customers. These estimates require significant judgment and the change in these estimates could have an effect on its results of operations during the periods involved.

 

 

Deferred Sales Commissions

 

Incremental costs of obtaining a contract, including sales commissions, are capitalized and amortized on a straight-line basis over the expected customer relationship period if the Company expects to recover those costs. The Company uses the portfolio method to recognize the amortization expense related to these capitalized costs related to initial contracts and such expense is recognized over a period associated with the revenue of the related portfolio, which is generally two to three years for the Company’s product and service arrangements.

 

Total capitalized costs as of September 30, 2018 were $5.4 million and are included in other long-term assets in the Company’s condensed consolidated balance sheet. Amortization of this asset was $0.5 million and $1.3 million, respectively, during the three and nine months ended September 30, 2018 and is included in sales and marketing expense in the Company’s condensed consolidated statements of operations.

 

Note 8. Contract Balances

 

The Company records deferred revenue when revenue is recognized subsequent to invoicing.  For extended service contracts, the Company generally invoices customers at the beginning of the extended service contract term.  The Company’s extended service contracts typically have one, two or three year terms.  Deferred revenue also includes payments for installation, training and extended marketing support service.  Approximately 79% of the Company’s deferred revenue balance of $11.3 million as of September 30, 2018 will be recognized over the next 12 months.

 

The following table provides changes in the deferred contract revenue balance for the three and nine months ended September 30, 2018 and 2017 (in thousands):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Beginning Balance

  $ 11,807     $ 10,013     $ 11,656     $ 9,431  

Add: Payments received

    3,609       3,178       12,025       10,290  

Less: Revenue recognized

    (4,097)       (3,233)

 

    (12,362)       (9,763)  

Ending Balance

  $ 11,319     $ 9,958     $ 11,319     $ 9,958  

 

Costs for extended service contracts for the three and nine months ended September 30, 2018, were $1.7 million and $5.7 million, respectively.

 

Note 9. Stockholders’ Equity and Stock-based Compensation Expense

 

In 1998, the Company adopted the 1998 Stock Plan, under which 4,650,000 shares of the Company’s common stock were reserved for issuance to employees, directors and consultants. On January 12, 2004, the Board of Directors adopted the 2004 Equity Incentive Plan. A total of 1,750,000 shares of common stock were originally reserved for issuance pursuant to the 2004 Equity Incentive Plan. In addition, the shares reserved for issuance under the 2004 Equity Incentive Plan included shares reserved but un-issued under the 1998 Stock Plan and shares returned to the 1998 Stock Plan as the result of termination of options or the repurchase of shares. In 2012 the Company's stockholders approved a “fungible share” provision whereby each full-value award issued under the 2004 Equity Incentive Plan results in a requirement to subtract 2.12 shares from the shares reserved under the plan.

 

 

Activity under the Company’s Amended and Restated 2004 Equity Incentive Plan, as amended, is summarized as follows:

 

           

Options Outstanding

 
   

Shares

Available

for Grant

   

Number of

Stock Options

Outstanding

   

Weighted-

Average Exercise

Price

 

Balance as of December 31, 2017

    1,494,865       839,919     $ 16.46  
                         

Options granted

                                (21,010)                                        21,010                                         50.65  

Stock awards granted(1)

                              (530,876)                                           

Options exercised

                                    —                                    (241,021)                                         10.16  

Options canceled

                                  46,333                                      (46,333)                                         22.14  

Stock awards canceled(1)

                                  95,775                                          —                                           —  

Balance, as of September 30, 2018

                             1,085,088                                     573,575      $                                  19.90  

 

(1)

The Company has a “fungible share” provision in its Amended and Restated 2004 Equity Incentive Plan whereby for each full-value award (RSU/PSU) issued or canceled under the plan requires the subtraction or add back of 2.12 shares from or to the Shares Available for Grant, respectively.

 

Under the Amended and Restated 2004 Equity Incentive Plan, the Company issued 412,617 shares of common stock during the nine months ended September 30, 2018, in conjunction with stock options exercised and the vesting of restricted stock units ("RSUs") and Performance stock units ("PSUs").

 

As of September 30, 2018, there was approximately $14.5 million of unrecognized compensation expense, net of projected forfeitures, for stock options and stock awards. The expense is expected to be recognized over the remaining weighted-average period of 2.53 years. The actual expense recorded in the future may be higher or lower based on a number of factors, including actual forfeitures experienced and the degree of achievement of the performance goals related to PSUs granted.

 

Non-Employee Stock-Based Compensation

 

The Company granted 3,384 RSUs and 3,384 PSUs to non-employees during the nine months ended September 30, 2018, and 7,745 stock options and 2,478 RSUs during the year ended December 31, 2017. Stock options typically vest over 4 years at 25% on the first anniversary of the grant date and 1/48th each month thereafter. The RSUs vest over 4 years at 25% on each anniversary of the grant date, while vesting of the PSUs is subject to the recipient's continued service and achievement of pre-established metrics. The RSUs, PSUs and stock options were granted in exchange for consulting services to be rendered. The Company recognizes stock-based compensation expense for the stock options and stock awards granted to non-employees in an amount equal to the equity instruments fair value when the equity instrument vests.

 

Stock-based Compensation Expense

 

Stock-based compensation expense by department recognized during the three and nine months ended September 30, 2018 and 2017 were as follows (in thousands):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Cost of revenue

  $ 196     $ 101     $ 576     $ 377  

Sales and marketing

                               

Employee

    572       394       1,684       1,215  

Non-Employee

    (32)             60        

Research and development

    164       157       617       633  

General and administrative

    731       345       2,587       1,398  

Total stock-based compensation expense

  $ 1,631     $ 997     $ 5,524     $ 3,623  

 

 

Note 10. Net Loss Per Share

 

Basic net income (loss) per share is computed using the weighted-average number of shares outstanding during the period. In periods of net income, diluted shares outstanding include the dilutive effect of in-the-money equity awards (stock options, restricted stock units, performance stock units and employee stock purchase plan contributions), which is calculated based on the average share price for each fiscal period using the treasury stock method. In accordance with ASC 260, the assumed proceeds under the treasury stock method include the average unrecognized compensation expense of in-the money stock options and restricted stock units. This results in the assumed buyback of additional shares, thereby reducing the dilutive impact of equity awards.

 

Diluted earnings per share is the same as basic earnings per share for the periods in which the Company had a net loss because the inclusion of outstanding common stock equivalents would be anti-dilutive.

 

The following table sets forth the computation of basic and diluted net income (loss) and the weighted average number of shares used in computing basic and diluted net income (loss) per share (in thousands, except per share data):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Numerator

                               

Net income (loss)

  $ (873)     $ 6,188     $ (4,477)     $ 7,113  

Denominator

                               

Weighted average shares of common stock outstanding used in computing net income (loss) per share, basic

    13,851       13,973       13,717       13,917  

Dilutive effect of incremental shares and share equivalents

          794             816  

Weighted average shares of common stock outstanding used in computing net income (loss) per share, diluted

    13,851       14,767       13,717       14,733  

Net income (loss) per share:

                               

Net income (loss) per share, basic

  $ (0.06)     $ 0.44     $ (0.33)     $ 0.51  

Net income (loss) per share, diluted

  $ (0.06)     $ 0.42     $ (0.33)     $ 0.48  

 

The following numbers of shares outstanding, prior to the application of the treasury stock method, were excluded from the computation of diluted net income (loss) per common share for the period presented because including them would have had an anti-dilutive effect (in thousands):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 

Options to purchase common stock

    607       42       707       31  

Restricted stock units

    411             419       6  

Performance stock units

    24             19        

Employee stock purchase plan shares

    47             82        

Total

    1,089       42       1,227       37  

 

Note 11. Income Taxes

 

The Company calculates the provision for income taxes during interim reporting periods by applying an estimate of the annual effective tax rate for the full year to "ordinary" income or loss (pretax income or loss excluding unusual or infrequently occurring discrete items) for the reporting period. When applicable, the year-to-date tax provision reflects adjustments from discrete tax items. The income tax benefits for the three and nine months ended September 30, 2018 reflect a projected income tax benefit for U.S. and non-U.S. operations resulting in an annual effective tax rate applied to the year-to-date ordinary loss. This tax benefit is increased by excess tax benefits generated by stock deductions exercised or vested in the three and nine months ended September 30, 2018.

 

 

For the three and nine months ended September 30, 2018, the Company's income tax benefit was $174,000 and $3,505,000 respectively, compared to income tax expense of $225,000 and $166,000 for the same periods in 2017. The income tax benefits for the three and nine months ended September 30, 2018 include a tax benefit for excess tax deductions of approximately $0.3 million and $2.8 million, respectively, recorded discretely in the reporting period.

  

The Company utilizes the asset and liability method of accounting for income taxes, under which deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. As of December 31, 2017, the Company released its valuation allowance against U.S. federal and all other domestic state net deferred tax assets except for California and Massachusetts. The Company maintained this valuation allowance position through September 30, 2018. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferred tax assets, the Company considered all available positive and negative evidence. The Company also considered, commensurate with its objective verifiability, the forecast of future taxable income including the reversal of temporary differences, the implementation of feasible and prudent tax planning strategies and the impact of the Tax Cuts and Jobs Act of 2017.

 

Note 12. Correction of Prior Period Immaterial Error

 

During the three months ended June 30, 2018, management discovered that the Company had not recorded the tax effect of the adoption of ASC 606 in the balance sheet of the unaudited condensed consolidated financial statements as of March 31, 2018. Upon adoption of Topic 606, the Company recorded an increase to retained earnings of $5.0 million for contracts still in force as of January 1, 2018. The tax effect of the 606 adoption was $1.2 million.

 

The Company evaluated the impact of the error on prior period and determined that the effect was not material to the financial statements as of and for the three months ended March 31, 2018 and six months ended June 30, 2018. The Company corrected the error in the unaudited condensed consolidated financial statements as of and for the six months ended June 30, 2018. The correction of the error increased the Company's deferred tax liability by $1.2 million and decreased retained earnings by $1.2 million (Note 2) as of January 1, 2018.

 

The Company’s condensed consolidated statements of operations, comprehensive income (loss) and cash flows for the three months ended March 31, 2018, the three and six months ended June 30, 2018, and the three and nine months ended September 30, 2018 were not affected by this correction of the error. Accordingly, the Company's loss per share for the three months ended March 31, 2018, the three and six months ended June 30, 2018, and the three and nine months ended September 30, 2018 remains unchanged.

 

Note 13. Commitments and Contingencies

 

Operating Leases

  

The Company leases space for operations in United States, Japan and France. Future minimum lease commitments under the Company’s facility operating leases as of September 30, 2018 were as follows (in thousands):

 

Year Ending December 31,

 

Amount

 

2018

  $ 745  

2019

                                      2,981  

2020

                                      2,922  

2021

                                      2,544  

2022

                                      2,496  

2023 and beyond

                                         214  

Total future minimum lease payments

  $ 11,902  

 

In addition to the above facility leases, the Company also routinely leases automobiles for certain sales and field service employees under capital leases. The remaining committed lease payments as of September 30, 2018 was $1.15 million.

 

Contingencies

 

The Company is named from time to time as a party to other legal proceedings, product liability, commercial disputes, employee disputes, and contractual lawsuits in the ordinary course of business. These matters are subject to many uncertainties and outcomes that are not predictable and that may not be known for extended periods of time. A liability and related charge are recorded to earnings in the Company’s consolidated financial statements for legal contingencies when the loss is considered probable and the amount can be reasonably estimated. The assessment is re-evaluated each accounting period and is based on all available information, including discussion with outside legal counsel. If a reasonable estimate of a known or probable loss cannot be made, but a range of probable losses can be estimated, the low-end of the range of losses is recognized if no amount within the range is a better estimate than any other. If a material loss is reasonably possible, but not probable and can be reasonably estimated, the estimated loss or range of loss is disclosed in the notes to the consolidated financial statements. The Company expenses legal fees as incurred.

 

 

As of September 30, 2018 and December 31, 2017, the Company had accrued $67,000 and $91,000, respectively related to various pending commercial and product liability lawsuits. The Company does not believe that a material loss in excess of accrued amounts is reasonably possible.

 

Note 14. Segment reporting

 

Segment reporting is based on the “management approach,” following the method that management organizes the company’s reportable segments for which separate financial information is made available to, and evaluated regularly by, the chief operating decision maker in allocating resources and in assessing performance. The Company’s chief operating decision maker ("CODM") is its Chief Executive Officer ("CEO"), who makes decision on allocating resources and in assessing performance. The CEO reviews the Company's consolidated results as one operating segment. In making operating decisions, the CEO primarily considers consolidated financial information, accompanied by disaggregated information about revenues by geography and product. All of the Company’s principal operations and decision-making functions are located in the U.S. The Company’s CEO views its operations, manages its business, and uses one measurement of profitability for the one operating segment - which sells aesthetic medical equipment and services, and distributes skincare products, to qualified medical practitioners. Substantially all of the Company’s long-lived assets are located in the U.S.

 

The following table presents a summary of revenue by geography for the three months ended September 30, 2018 and 2017 (in thousands):

 

   

Three Months Ended

September 30,

 
   

2018

   

2017

 

Revenue mix by geography:

               

United States

  $ 24,329     $ 23,275  

Japan

    5,021       4,686  

Asia, excluding Japan

    4,348       3,488  

Europe

    2,356       2,024  

Rest of the world

    4,519       4,700  

Total consolidated revenue

  $ 40,573     $ 38,173  

Revenue mix by product category:

               

Systems

  $ 33,197     $ 31,861  

Consumables

    1,055       596  

Skincare

    1,423       1,029  

Total product revenue

  $ 35,675     $ 33,486  

Service

    4,898       4,687  

Total consolidated revenue

  $ 40,573     $ 38,173  

 

The following table presents a summary of revenue by geography for the nine months ended September 30, 2018 and 2017 (in thousands):

 

   

Nine Months Ended

September 30,

 
   

2018

   

2017

 

Revenue mix by geography:

               

United States

  $ 73,597     $ 64,058  

Japan

    12,522       12,276  

Asia, excluding Japan

    11,422       9,501  

Europe

    6,729       5,469  

Rest of the world

    12,981       12,557  

Total consolidated revenue

  $ 117,251     $ 103,861  

Revenue mix by product category:

               

Systems

  $ 95,727     $ 84,969  

Consumables

    2,881       1,743  

Skincare

    3,981       2,976  

Total product revenue

  $ 102,589     $ 89,688  

Service

    14,662       14,173  

Total consolidated revenue

  $ 117,251     $ 103,861  

 

 

Note 15. Debt

 

Loan and Security Agreement

 

On May 30, 2018, the Company and Wells Fargo Bank, N.A. (“Wells Fargo”) entered into a Loan and Security Agreement (the “Original Revolving Line of Credit”) in the original principal amount of $25 million. The Original Revolving Line of Credit terminates on May 30, 2021. As of September 30, 2018, there were no borrowings under the Revolving Line of Credit.

 

Covenants 

 

The Original Revolving Line of Credit contained financial and other covenants as well as the maintenance of a leverage ratio not to exceed 2.5 to 1.0 and a TTM adjusted EBITDA of not less than $10 million. A violation of any of the covenants could result in a default under the Original Revolving Line of Credit that would permit the lenders to restrict the Company’s ability to further access the revolving line of credit for loans and letters of credit and require the immediate repayment of any outstanding loans under the Loan and Security Agreement.

 

During the third quarter of 2018, the Company determined that the Company was in violation of certain financial covenants in the Original Revolving Line of Credit. Upon receipt of this notice, we entered into discussions with Wells Fargo to amend and revise certain terms of the Original Revolving Line of Credit.  Following the end of our third quarter, on or about November 2, 2018, we entered into a First Amendment and Waiver to the Loan and Security Agreement with Wells Fargo (the “Revised Revolving Line of Credit”).  

 

The Revised Revolving Line of Credit provides for an original principal amount of $15 million, with the ability to request an additional $10 million and a waiver of any existing defaults under the Original Revolving Line of Credit as long as the Company is in compliance with the terms of the Revised Revolving Line of Credit.

 

Similar to the Original Revolving Line of Credit, the Revised Revolving Line of Credit contains revised financial and other covenants as well as the maintenance of a leverage ratio not to exceed 2.0 to 1.0 and a graduated scale of TTM adjusted EBITDA of not less than $1 million as of the last day of the 2018 third fiscal quarter; $2.5 million as of the last day of the 2018 fourth fiscal quarter; $4 million as of the last day of the 2019 first and second fiscal quarters; $6.5 million as of the last day of the 2019 third fiscal quarter; and $10 million as of the last day of each fiscal quarter thereafter.

 

The Company must maintain a minimum cash balance of unrestricted cash equal to at least $15 million, $13 million of which shall be maintained at Wells Fargo. As of the last day of each calendar quarter, the Company must maintain a balance of unrestricted cash equal to at least $20 million. This minimum cash balance requirement shall not apply if and when the Company achieves $15 million of TTM Adjusted EBITDA.

 

A violation of any of the covenants could result in a default under the Revised Revolving Line of Credit that would permit the lenders to restrict the Company’s ability to further access the revolving line of credit for loans and letters of credit and require the immediate repayment of any outstanding loans under the Revised Revolving Line of Credit.

 

As of the date of this filing, there were no borrowings under either the Revised Revolving Line of Credit, or the Original Revolving Line of Credit, and the Company is in compliance with all financial covenants of the Revised Revolving Line of Credit.

 

 

ITEM 2.         MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

You should read the following management’s discussion and analysis of the Company’s financial condition and results of operations in conjunction with the Company’s unaudited condensed consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with the audited financial statements and notes thereto for the year ended December 31, 2017, included in the annual report on Form 10-K filed on March 26, 2018 with the U.S. Securities and Exchange Commission (SEC).

 

Special note regarding forward-looking statements

 

This report contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those discussed in the forward-looking statements. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, ("the Exchange Act"). Forward-looking statements are often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “strategy,” “target,” “will,” “would” and similar expressions or variations intended to identify forward- looking statements. These statements are based on the beliefs and assumptions of the Company’s management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included under Part II, Item 1A below.

 

Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements. The statements are subject to change based on various factors, including but not limited to the risks and uncertainties summarized below:

 

changes in the Company’s common stock price;

the inability to meet the Company's debt repayment obligations under the Loan and Security Agreement with Wells Fargo Bank, N.A. (the “Revised Revolving Line of Credit”) due to insufficient cash;

the ability of the Company’s sales force to effectively market and promote the Company’s products, and the extent to which those products gain market acceptance;

the possibility that cybersecurity breaches, data breaches, and other disruptions could compromise our information or result in the unauthorized disclosure of confidential information;

the existence and timing of any product approvals or changes;

the rate and size of expenditures incurred on the Company’s clinical, manufacturing, sales, marketing and product development efforts;

the Company’s ability to obtain and retain personnel;

the availability of key components, materials and contract services, which depends on the Company’s ability to forecast sales, among other things;

investigations of the Company’s business and business-related activities by regulatory or other governmental authorities;

variations in timing and quantity of product orders;

temporary manufacturing interruptions or disruptions;

the timing and success of new product and new market introductions, as well as delays in obtaining domestic or foreign regulatory approvals for such introductions;

increased competition, patent expirations or new technologies or treatments;

impact of the FDA communication letter regarding “vaginal rejuvenation” procedures using energy-based devices on sales of the Company's products;

product recalls or safety alerts;

litigation, including product liability, patent, employment, securities class action, stockholder derivative, general commercial and other lawsuits;

continued volatility in the global market and worldwide economic conditions, including, but not limited to, the impact of events such as Brexit;

changes in tax laws, including the new U.S. tax reform, and changes due to Brexit, or exposure to additional income tax liabilities;

the impact of the new European Union privacy regulations (the General Data Protection Regulation) on the Company’s resources - the failure to comply could result in fines;

The impact of tariffs on sales of the Company's products and purchases from suppliers.

the financial health of the Company’s customers and their ability to purchase the Company’s products in the current economic environment; and

other unusual or non-operating expenses, such as expenses related to mergers or acquisitions, may cause operating result variations.

 

 

Introduction

 

The Management’s Discussion and Analysis, or MD&A, is organized as follows:

 

Executive Summary. This section provides a general description and history of the Company’s business, a brief discussion of the Company’s product lines and the opportunities, trends, challenges and risks we focus on in the operation of the Company’s business.

Critical Accounting Policies and Estimates. This section describes the key accounting policies that are affected by critical accounting estimates.

Results of Operations. This section provides the Company’s analysis and outlook for the significant line items on the Company’s Condensed Consolidated Statements of Operations.

Liquidity and Capital Resources. This section provides an analysis of the Company’s liquidity and cash flows, as well as a discussion of the Company’s commitments that existed as of September 30, 2018.

 

Executive Summary

 

Company Description

 

We are a leading medical device company specializing in the research, development, manufacture, marketing and servicing of laser and energy based aesthetics systems for practitioners worldwide. In addition to internal development of products, we distribute third party sourced products under the Company’s own brand names. We offer easy-to-use products which enable physicians and other qualified practitioners to perform safe and effective aesthetic procedures, including treatment for body contouring, skin resurfacing and rejuvenation, tattoo removal, removal of benign pigmented lesions, vascular conditions, hair removal, toenail fungus and vaginal health. The Company’s platforms are designed to be easily upgraded to add additional applications and hand pieces, which provide flexibility for the Company’s customers as they expand their practices. In addition to systems and upgrade revenue, we generate revenue from the sale of post warranty service contracts, providing services for products that are out of warranty, the sale of hand piece refills, and distributing third-party manufactured skincare products.

 

The Company’s ongoing research and development activities primarily focus on developing new products, as well as improving and enhancing the Company’s portfolio of existing products. The Company also explores ways to expand the Company’s product offerings through alternative arrangements with other companies, such as distribution arrangements. The Company introduced Juliet, a product for women’s health, in December 2017, Secret RF, a fractional RF microneedling device for skin rejuvenation, in January 2018, enlighten SR in April 2018, and truSculpt iD in July 2018.

 

The Company’s corporate headquarters and U.S. operations are located in Brisbane, California, where the Company conducts manufacturing, warehousing, research and development, regulatory, sales and marketing, service, and administrative activities. The Company markets, sells and services the Company’s products through direct sales and service employees in North America (including Canada), Australia, Austria, Belgium, France, Germany, Hong Kong, Japan, Spain, Switzerland and the United Kingdom. Sales and Services outside of these direct markets are made through a worldwide distributor network in over 40 countries.

 

Products and Services

 

The Company derives revenue from the sale of Products and Services. Product revenue includes revenue from the sale of systems, hand pieces and upgrade of systems (collectively “Systems” revenue), replacement hand pieces, truSculpt iD cycle refills, as well as single use disposable tips applicable to Juliet, Secret RF (“Consumables” revenue), and the sale of skincare products (“Skincare” revenue). A system consists of a console that incorporates a universal graphic user interface, a laser and (or) other energy based module, control system software and high voltage electronics, as well as one or more hand pieces. However, depending on the application, the laser or other energy based module is sometimes contained in the hand piece such as with the Company’s Pearl and Pearl Fractional applications instead of within the console.

 

The Company offers customers the ability to select the system that best fits their practice at the time of purchase and then to cost-effectively add applications to their system as their practice grows. This provides customers the flexibility to upgrade their systems whenever they choose and provides us with a source of additional Systems revenue.

 

Skincare revenue relates to the distribution of ZO’s skincare products in Japan.

 

The Company’s primary system platforms include: excel, enlighten, Juliet, Secret RF, truSculpt and xeo.

 

 

Service includes prepaid service contracts, training services, enlighten installation, direct billings for detachable hand piece replacements and revenue for parts, customer marketing support and labor on out-of-warranty products.

 

Significant Business Trends

 

The Company believes that the ability to grow revenue will be primarily dependent on the following:

 

continuing to expand the Company’s product offerings, both through internal development and sourcing from other vendors;

ongoing investment in the Company’s global sales and marketing infrastructure;

use of clinical results to support new aesthetic products and applications;

enhanced luminary development and reference selling efforts (to develop a location where Company’s products can be displayed and used to assist in selling efforts);

customer demand for the Company’s products;

weakening against the U.S. dollar of key international currencies in which we transact (e.g. Australian Dollar, Japanese Yen, Euro, Swiss Franc and British Pound);

consumer demand for the application of the Company’s products;

marketing to physicians in the core dermatology and plastic surgeon specialties, as well as outside those specialties; and

generating recurring revenue from the Company’s growing installed base of customers through the sale of system upgrades, services, hand piece refills, skincare products and replacement tips for Juliet and Secret RF products.

 

For a detailed discussion of the significant business trends impacting the Company’s business, please see the section titled “Results of Operations” below.

 

Factors that May Impact Future Performance

 

The Company’s industry is impacted by numerous competitive, regulatory and other significant factors. The Company’s industry is highly competitive and the Company’s future performance depends on the Company’s ability to compete successfully. Additionally, the Company’s future performance is dependent upon the ability to continue to expand the Company’s product offerings with innovative technologies, obtain regulatory clearances for the Company’s products, protect the proprietary technology of the products and manufacturing processes, manufacture the products cost-effectively, and successfully market and distribute the products in a profitable manner. If the Company fails to execute on the aforementioned initiatives, the Company’s business would be adversely affected.

 

On July 30, 2018, the FDA issued a public statement and sent letters to a number of companies in the medical aesthetics industry expressing concerns regarding “vaginal rejuvenation” procedures using energy-based devices.  The Company was not named in the announcement, and the Company has not received a letter from the agency, however the Company’s Juliet device is promoted and used by physicians in procedures that are the subject of the FDA’s public warning. The Company is not aware of any adverse events resulting from the use of Juliet anywhere in the world, and is confident in Juliet’s development and promotion based on science and clinical evidence.

 

Notwithstanding, the Company saw a significant slowdown in the sales of Juliet in the third quarter of 2018, particularly in the last month of the quarter, when the Company does the bulk of its sales. The Company believes this relates to the safety letter, given the timing.

 

The Company supports any action that helps ensure patient safety going forward. The Company has a robust, multi-functional process that reviews its promotional claims and materials to ensure they are truthful, not misleading, fair and balanced, and supported by sound scientific evidence.

 

A detailed discussion of these and other factors that could impact the Company’s future performance are provided in (1) Part I, Item 1A “Risk Factors” and elsewhere in this Form 10-Q, (2) the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, (3) the Company’s reports and registration statements filed and furnished from time to time with the SEC, and (4) other announcements the Company makes from time to time.

  

Critical accounting policies, significant judgments and use of estimates

 

The Company's management discussion and analysis of financial condition and results of operations are based upon the Company’s unaudited condensed consolidated financial statements. For the three and nine months ended September 30, 2018, the Company’s income tax benefit was $174,000 and $3,505,000, respectively, compared to income tax expense of $225,000 and $166,000, respectively, for the same periods in 2017. In the nine months ended September 30, 2018, the Company calculated the provision for income taxes for interim reporting periods by applying an estimate of the "annual effective tax rate" for the full year to ordinary income or loss for the reporting period. The Company’s income tax benefit for the nine months ended September 30, 2018 reflects a projected income tax benefit for U.S. and non-U.S. operations resulting in an annual effective tax rate applied to the year-to-date ordinary loss. The income tax benefit includes excess tax benefits generated by stock deductions exercised or vested in the nine months ended September 30, 2018.

 

For the Company’s income tax provision in the nine months ended September 30, 2017, the tax benefit was primarily related to projected U.S. alternative minimum taxes and income taxes from non-U.S. operations. The income tax benefit resulted from applying the annual effective tax rate by the year-to-date ordinary loss. The projected income tax reflected utilization of net operating loss carryforwards. However, the tax effect of such utilization was offset by a change in valuation allowance for the nine months ended September 30, 2017 condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, (“U.S. GAAP”). The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate the Company’s critical accounting policies and estimates. The Company based the estimates on historical experience and on various other assumptions that the Company believes to be reasonable in the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. The Company’s significant accounting policies are more fully described in Note 1 of the accompanying unaudited condensed consolidated financial statements and in Note 2 to the Company’s audited consolidated financial statements contained in the Annual Report on Form 10-K filed on March 26, 2018 with the SEC. With the exception of the change in revenue recognition as a result of the adoption of ASC Topic 606, (see Notes 2 and 7) there have been no new or material changes to the critical accounting policies and estimates discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017, that are of significance, or potential significance to the Company.

 

 

Results of Operations

The following table sets forth selected consolidated financial data for the periods indicated, expressed as a percentage of total revenue, net. Percentages in this table and throughout the Company’s discussion and analysis of financial condition and results of operations may reflect rounding adjustments.

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2018

   

2017

   

2018

   

2017

 
                                 

Net revenue

    100%       100%

 

    100%       100%

 

Cost of revenue

    46%       42%

 

    47%       43%

 

Gross margin

    54%       58%

 

    53%       57%

 

                                 

Operating expenses:

                               

Sales and marketing

    36%       34%

 

    37%       35%

 

Research and development

    8%       9%

 

    9%       9%

 

General and administrative

    13%       9%

 

    13%       10%

 

    Lease termination income     0%       (10)%       0%       (4)%  

Total operating expenses

    57%       42%

 

    59%       50%

 

                                 

Income (loss) from operations

    (3)%       16%

 

    (7)%       6%

 

Interest and other income (expense), net

          1%

 

          1%

 

Income (loss) before income taxes

    (3)%       17%

 

    (7)%       7%

 

                                 

Provision (benefit) for income taxes

          1%

 

    (3)%      

 

Net income (loss)

    (3)%       16%

 

    (4)%       7%  

  

Revenue

 

The timing of the Company’s revenue is significantly affected by the mix of system products, installation, training, consumables and extended contract services. The revenue generated in any given period is also impacted by whether the revenue is recognized over time or at a point in time, upon completion of delivery. For an additional description on revenue, see Note 2 in the notes to consolidated financial statements on the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017 and Notes 2 and 7 in the accompanying unaudited condensed consolidated financial statements.

 

As of September 30, 2018, approximately 9% of the Company’s revenue is recognized over time, and the remainder of the revenue is recognized upon completion of delivery. Revenue recognized over time relates to revenue from the Company’s extended service contracts and customer marketing support. Revenue recognized upon delivery is primarily generated by the sales of systems, consumables and skincare.

 

During the three and nine months ended September 30, 2018 the Company recognized revenue based on the ASU No.2014-09, “Revenue from Contracts with Customers (Topic 606),” but revenue for the three and nine months ended September 30, 2017 was recognized based on Topic 605. Therefore, the periods are not directly comparable. For additional information on the impact of the new accounting standard on the Company’s revenue, see Notes 2 and 7 in the accompanying unaudited condensed consolidated financial statements.

 

 

Total Net Revenue

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

Revenue mix by geography:

                                               

United States

  $ 24,329       5%     $ 23,275     $ 73,597       15%     $ 64,058  

International

    16,244       9%       14,898       43,654       10%       39,803  

Consolidated total revenue

  $ 40,573       6%     $ 38,173     $ 117,251       13%     $ 103,861  
                                                 

United States as a percentage of total revenue

    60 %             61%

 

    63%               62%

 

International as a percentage of total revenue

    40 %             39%

 

    37%               38%

 

                                                 
Revenue mix by product category:                                                

Systems

                                               

- North America

  $ 22,628       3%     $ 21,869     $ 67,458       14%     $ 58,955  

- Rest of World

    10,569       6%       9,993       28,269       9%       26,014  

Total Systems

    33,197       4%       31,862       95,727       13%       84,969  

Consumables

    1,055       77%       595       2,881       65%       1,743  

Skincare

    1,423       38%       1,029       3,981       34%       2,976  

Total Products

    35,675       7%       33,486       102,589       14%       89,688  

Service

    4,898       5%       4,687       14,662       3%       14,173  

Total Net Revenue

  $ 40,573       6%     $ 38,173     $ 117,251       13%     $ 103,861  

 

Total Net Revenue

 

The Company’s revenue increased by 6% and 13% respectively, for the three and nine months periods ended September 30, 2018, compared to the same periods in 2017, due primarily to increased system revenues.

 

Revenue by Geography

 

The Company’s U.S. revenue increased by $1.0 million, or 5%, and $9.5 million, or 15%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. This increase was due primarily to the introduction of Secret RF and Juliet during January 2018, and truSculpt iD in July 2018.

  

The Company’s international revenue increased $1.3 million, or 9%, and $3.9 million, or 10%, for the three and nine months ended September 30, 2018, compared to the same periods in 2017. The increase was due to growth in the Company’s business in Europe, the Middle East and Asia including Japan.

 

Revenue by Product Type

 

Systems Revenue

 

Systems revenue in North America increased by $0.8 million, or 3%, and $8.5 million, or 14%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017, due to sales in the U.S. and the introduction of Secret RF and Juliet during January 2018, and truSculpt iD in July 2018. The Rest of the World systems revenue increased by $0.6 million or 6%, and $2.3 million, or 9%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The increase in Rest of the World revenue was primarily a result of an increase in the Company’s direct business in Asia, including Japan, as well as increases in the Company’s distributor business in the Middle East and Europe, partially offset by decreases in the Company’s direct business in Australia and Europe.

 

 

Consumables Revenue

 

Consumables revenue increased by $0.5 million, or 77%, and $1.1 million, or 65% for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. The increase in consumables revenue was due to the introduction of Secret RF and Juliet during January 2018, and truSculpt iD in July 2018, each of which have consumable elements.

 

Skincare Revenue

 

The Company’s revenue from Skincare products in Japan increased by $0.4 million, or 38%, and $1.0 million, or 34%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. This increase was due primarily to increased marketing and promotional activities.

 

Service Revenue

 

The Company’s Service revenue increased by $211,000, or 5%, and $489,000, or 3%, for the three and nine months ended September 30, 2018, respectively, compared to the same periods in 2017. This increase was due primarily to increased sales of system parts to the Company's network of international distributors.

 

Gross Profit

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

Gross profit

  $ 21,885       (2)%     $ 22,210     $ 61,596       5%     $ 58,777  

As a percentage of total net revenue

    54%               58%

 

            53%       57%

 

 

The Company’s cost of revenue consists primarily of material, personnel expenses, product warranty costs, and manufacturing overhead expenses. The Company also continues to make investments in its international direct service support, as well as operational improvement activities.

 

Gross margins in the three and nine months ended September 30, 2018 declined 4 percentage points, compared to the same period in 2017. The reduced gross margins during the three and the nine months ended September 30, 2018 were due primarily to:

 

Slightly lower average system pricing across the legacy portfolio. The Company experienced continued pricing pressure on the average selling price of the Company’s enlighten system due to ongoing sales programs;

Product revenue generated from distributors, which increased by 10% and 11% respectively for the three and nine months ended September 30, 2018, compared to the same period in 2017; offset by

Consumables revenue, which is generated by procedural activity from the Company’s Secret RF, Juliet systems and truSculpt systems increased 65%, compared to the same period in 2017; and

Higher margins generated from the Company’s truSculpt iD system which was launched in North America in July 2018 and in EMEA in September 2018.

 

Sales and Marketing

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

Sales and marketing

  $ 14,479       10%     $ 13,148     $ 43,102       17%     $ 36,708  

As a percentage of total net revenue

    36%               34%

 

    37%               35%

 

 

Sales and marketing expenses consist primarily of personnel expenses, expenses associated with customer-attended workshops and trade shows, post-marketing studies, advertising and training.

 

 

The $1.3 million increase in sales and marketing expenses during the three months ended September 30, 2018 compared to the same period in 2017 was due primarily to:

 

$0.2 million increase in stock based compensation, due to headcount increase

$0.5 million of higher promotional and product demonstration expenses, primarily in North America;

$0.3 million of higher travel related expenses in North America resulting from increased headcount;

$0.2 million of consulting expenses;

$0.1 million of higher facility expenses due to the increase in our Brisbane headquarters rental cost.

 

The $6.4 million increase in sales and marketing expenses during the nine months ended September 30, 2018 compared to the same period in 2017 was due primarily to:

 

$1.9 million net increase in personnel related expenses and $0.5 million net increase in stock based compensation, driven primarily by higher headcount and commissions in North America ;

$1.9 million increase promotional and clinical training expenses; 

$1.3 million of higher travel related expenses in North America, resulting from increased headcount;

$0.3 million of higher facility expenses due to increase in the Company's Brisbane headquarters rental cost;

$0.3 million of consulting expenses; and

$0.2 million increase in other administrative expense.

 

Research and Development (“R&D”)

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

Research and development

  $ 3,244       (6)%     $ 3,467     $ 10,895       16%

 

  $ 9,393  

As a percentage of total net revenue

    8%               9%

 

    9%               9%

 

 

R&D expenses consist primarily of personnel expenses, clinical research, regulatory and material costs. R&D expenses decreased by $223,000 or 6%, and represented 8% of total net revenue, in the three months ended September 30, 2018, compared to 9% of total net revenue for the same period in 2017. This decrease in expense was due primarily to decrease in material cost related to ongoing research and development efforts.

 

R&D expenses increased by $1.5 million or 16%, and represented 9% of total net revenue, in the nine months ended September 30, 2018, compared to 9% of total net revenue for the same period in 2017. This increase in expense was due primarily to $0.6 million increase in professional fees and consulting expenses, $0.4 million in rental expenses, and $0.5 million of increased personnel costs related to headcount increases.

 

General and Administrative (“G&A”)

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

General and administrative

  $ 5,160       53%     $ 3,379     $ 15,501       53%     $ 10,143  

As a percentage of total net revenue

    13%               9%

 

    13%               10%

 

 

 

G&A expenses consist primarily of personnel expenses, legal, accounting, audit and tax consulting fees, as well as other general and administrative expenses. G&A expenses increased by $1.8 million, or 53%, and represented 13% of total net revenue in the three months ended September 30, 2018, compared to 9% of total net revenue in the same period in 2017, due primarily to:

 

$0.8 million of increased fees related to professional fees and consulting services, primarily related to accounting, legal and tax;

$0.6 million of increased personnel related expenses, including $0.4 million in stock compensation, driven by increased headcount; and

$0.4 million of increased other administrative expense.

 

G&A expenses increased by $5.3 million, or 53%, and represented 13% of total net revenue in the nine months ended September 30, 2018, compared to 10% of total net revenue in the same period in 2017, due primarily to:

 

$1.8 million of increased personnel related expense and $1.2 million of increased stock based compensation due to higher headcount; 

$1.1 million of increased  fees related to professional and consulting services, primarily related to accounting and tax;

  $0.5 million of higher facility expenses due to increase in the Company's Brisbane headquarters rental cost;

$0.4 million of increased legal fees;and

$0.3 million increased credit card fees as a result of increased North America system revenue.

 

Lease Termination Income

 

In July 2017, the Company agreed to terminate the building lease for a new facility in Fremont, California, which was entered into in May 2017. In conjunction with this lease termination, the Company received a lump sum termination payment of $4.0 million from the landlord.

 

Interest and Other Income (expense), Net

 

Interest and other income, net, consists of the following:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

 

% Change

 

2017

   

2018

 

% Change

 

2017

 

Total interest and other income (expense), net

  $ (49 )                        (125)%   $ 197     $ (80 )                      (111)%   $ 746  

As a percentage of total net revenue

    0 %       1 %     0 %       1 %

 

Interest and other income, net, decreased $246,000 or (125)% and $826,000 or (111)%, respectively, in the three and nine months ended September 30, 2018, compared to the same period in 2017. This decrease was due primarily to interest expense for multi-year post-warranty service contracts for customers who make payment more than one year in advance of receiving the service under the new revenue standard, which is new in 2018,

an increase in net foreign exchange losses as well as a decrease in interest income from the Company’s marketable investments resulting from a decrease in the investment balance.

 

Provision for Income Taxes

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 

(Dollars in thousands)

 

2018

   

% Change

   

2017

   

2018

   

% Change

   

2017

 

Income (loss) before income taxes

  $ (1,047)       (116)%     $ 6,413     $ (7,982)    </