cutr20210331

cutr20210331_10q.htm

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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 March 31, 2021

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

For the transition period from _____ to_____.

Commission File Number: 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)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock ($0.001 par value)	CUTR	The NASDAQ Stock Market, LLC

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 every Interactive Data File required to be submitted 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 such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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 (check one):

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 April 30, 2021, was 17,803,274.

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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 Loss	5
	Condensed Consolidated Statements of Changes in Stockholders’ Equity	6
	Condensed Consolidated Statements of Cash Flows	7
	Notes to Condensed Consolidated Financial Statements	8
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 3	Quantitative and Qualitative Disclosures About Market Risk	30
Item 4	Controls and Procedures	31

PART II	OTHER INFORMATION

Item 1	Legal Proceedings	31
Item 1A	Risk Factors	31
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 3	Defaults Upon Senior Securities	31
Item 4	Mine Safety Disclosures	31
Item 5	Other Information	31
Item 6	Exhibits	32
	Signature	32

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

This report may contain references to its proprietary intellectual property, including among others, trademarks for its systems and ancillary products, Cutera®,AccuTip®, CoolGlide®, CoolGlide excel®, enlighten®, excel HR®, excel V®, excel V+®, LimeLight®, MyQ®, Pearl®, PicoGenesis™,ProWave®, Solera®, Titan®, truSculpt®, truSculpt® flex, Secret PRO®, Secret RF® and xeo®.

These trademarks and trade names are the property of Cutera or the property of its consolidated subsidiaries and are protected under applicable intellectual property laws. Solely for convenience, its 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 the Company will not assert, to the fullest extent under applicable law, its rights to these trademarks and tradenames.

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PART I. FINANCIAL INFORMATION

ITEM 1.

FINANCIAL STATEMENTS (UNAUDITED)

CUTERA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

(unaudited)

	March 31, 2021			December 31, 2020
Assets
Current assets:
Cash and cash equivalents	$	164,932		$	47,047
Accounts receivable, net of allowance for credit losses of $1,611 and $1,598, respectively		24,151			21,962
Inventories		34,578			28,508
Other current assets and prepaid expenses		10,339			8,779
Total current assets		234,000			106,296

Property and equipment, net		2,373			2,299
Deferred tax asset		598			643
Operating lease-right-of-use assets		16,570			17,076
Goodwill		1,339			1,339
Other long-term assets		4,853			5,080
Total assets	$	259,733		$	132,733

Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable	$	5,031		$	6,684
Accrued liabilities		41,329			31,079
Operating lease liabilities		2,351			2,260
PPP loan payable		6,352			3,630
Extended warranty liability		1,039			1,216
Deferred revenue		10,019			9,489
Total current liabilities		66,121			54,358

Deferred revenue, net of current portion		1,718			1,748
Operating lease liabilities, net of current portion		15,394			15,950
PPP loan payable, net of current portion		851			3,555
Convertible notes, net of unamortized debt issuance costs of $4,665		133,585			—
Other long-term liabilities		434			242
Total liabilities		218,103			75,853

Commitments and Contingencies (Notes 12)

Stockholders’ equity:
Common stock, $0.001 par value; authorized: 50,000,000 shares; issued and outstanding: 17,801,926 and 17,679,232 shares at March 31, 2021 and December 31, 2020, respectively		18			18
Additional paid-in capital		102,206			117,097
Accumulated deficit		(60,594	)		(60,235	)
Total stockholders’ equity		41,630			56,880
Total liabilities and stockholders’ equity	$	259,733		$	132,733

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

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CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended
	March 31,
	2021			2020
Net revenue:
Products	$	43,551		$	26,391
Service		6,117			5,848
Total net revenue		49,668			32,239
Cost of revenue:
Products		18,331			14,103
Service		3,627			3,800
Total cost of revenue		21,958			17,903
Gross profit		27,710			14,336

Operating expenses:
Sales and marketing		15,068			14,789
Research and development		4,112			3,870
General and administrative		7,365			7,806
Total operating expenses		26,545			26,465
Income (loss) from operations		1,165			(12,129	)
Interest and other expense, net:
Amortization of debt issuance costs		(52	)		—
Interest on Convertible notes		(191	)		—
Other expense, net		(1,023	)		(207	)
Total interest and other expense, net		(1,266	)		(207	)
Loss before income taxes		(101	)		(12,336	)
Income tax expense		258			78
Net loss	$	(359	)	$	(12,414	)

Net loss per share:
Basic and Diluted	$	(0.02	)	$	(0.86	)

Weighted-average number of shares used in per share calculations:
Basic and Diluted		17,768			14,433

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

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CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(Unaudited)

	Three Months Ended
	March 31,
	2021			2020
Net loss	$	(359	)	$	(12,414	)
Other comprehensive loss:
Available-for-sale investments
Reclassification adjustment for losses on investments recognized during the period		-			61
Net change in unrealized loss on available-for-sale investments		-			61
Other comprehensive gain, net of tax		-			61
Comprehensive loss	$	(359	)	$	(12,353	)

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

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CUTERA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(in thousands, except share amounts)

Three Months Ended March 31, 2021 and 2020

	Common Stock				Additional Paid-in			Retained Earnings (Accumulated			Accumulated Other Comprehensive		Total Stockholders’
	Shares		Amount		Capital			Deficit)			Income (loss)		Equity

Balance at December 31, 2020		17,679,232	$	18	$	117,097		$	(60,235	)	$	-	$	56, 880
Exercise of stock options		24,090		-		396			-			-		396
Purchase of capped call		-		-		(16,134	)		-			-		(16,134	)
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes		98,604		-		(999	)		-			-		(999	)
Stock-based compensation expense		-		-		1,846			-			-		1,846
Net loss		-		-		-			(359	)		-		(359	)
Balance at March 31, 2021		17,801,926	$	18	$	102,206		$	(60,594	)	$	-	$	41,630

	Common Stock				Additional Paid-in			Retained Earnings (Accumulated			Accumulated Other Comprehensive			Total Stockholders’
	Shares		Amount		Capital			Deficit)			Income (loss)			Equity

Balance at December 31, 2019		14,315,586	$	14	$	82,346		$	(36,358	)	$	(60	)	$	45,942
Exercise of stock options		22,291				200			-			-			200
Issuance of common stock in settlement of restricted and performance stock units, net of shares withheld for employee taxes		240,269		1		(2,234	)		-			-			(2,233	)
Stock-based compensation expense		-		-		1,980			-			-			1,980
Net loss		-		-		-			(12,414	)		-			(12,414	)
Net change in unrealized loss on available-for-sale investments		-		-		-			-			61			61
Balance at March 31, 2020		14,578,146	$	15	$	82,292		$	(48,772	)	$	1		$	33,536

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

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CUTERA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended March 31,
	2021			2020
Cash flows from operating activities:
Net loss	$	(359	)	$	(12,414	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Stock-based compensation		1,846			1,980
Depreciation and amortization		361			360
Amortization of contract acquisition costs		545			717
Amortization of debt issuance costs		52			-
Impairment of capitalized cloud computing costs		182			-
Change in deferred tax asset		45			15
Provision for credit losses		218			590
Gain on sale of property and equipment		(59	)		-
Change in right-of-use asset		604			645
Other		-			35
Changes in assets and liabilities:
Accounts receivable		(2,407	)		5,306
Inventories		(6,021	)		(3,020	)
Other current assets and prepaid expenses		(1,560	)		807
Other long-term assets		(500	)		(207	)
Accounts payable		(1,653	)		1,919
Accrued liabilities		10,199			(6,567	)
Extended warranty liabilities		(177	)		(234	)
Operating lease liabilities		(563	)		(645	)
Deferred revenue		500			(1,253	)
Net cash provided by (used in) operating activities		1,253			(11,966	)

Cash flows from investing activities:
Acquisition of property, equipment, and software		(101	)		(230	)
Proceeds from disposal of property and equipment		52			-
Proceeds from maturities of marketable investments		-			6,800
Purchase of marketable investments		-			(3,930	)
Net cash provided by (used in) investing activities		(49	)		2,640

Cash flows from financing activities:
Proceeds from exercise of stock options and employee stock purchase plan		396			201
Purchase of capped call		(16,134	)		-
Proceeds from issuance of Convertible notes		138,250			-
Payment of issuance costs of Convertible notes		(4,717	)		-
Taxes paid related to net share settlement of equity awards		(999	)		(2,234	)
Payments on finance lease obligations		(115	)		(183	)
Net cash provided by (used in) financing activities		116,681			(2,216	)

Net increase (decrease) in cash and cash equivalents		117,885			(11,542	)
Cash and cash equivalents at beginning of period		47,047			26,316
Cash and cash equivalents at end of period	$	164,932		$	14,774

Supplemental disclosure of non-cash items:
Assets acquired under finance lease	$	25		$	-
Assets acquired under operating lease	$	123		$	-
Debt issuance costs accrued	$	452		$	-
Supplemental disclosure of cash flow information:
Income tax paid	$	458		$	75

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

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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”) provides energy-based aesthetic systems for practitioners worldwide. The Company develops, manufactures, distributes, and markets 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: enlighten, excel, Secret PRO, Juliet, Secret RF, truSculpt and xeo. Several of the Company’s systems offer multiple hand pieces and applications, providing customers the flexibility to upgrade their systems. The sales of (i) systems, system upgrades, and hand pieces (collectively “Systems” revenue); (ii) replacement hand pieces, Titan, truSculpt 3D,truSculpt iD and truSculpt flex cycle refills, as well as single use disposable tips applicable to Secret PRO, Juliet and Secret RF (“Consumables” revenue); (iii) the distribution of third party manufactured skincare products (“Skincare” revenue); and (iv) the leasing of equipment through a membership program; 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, truSculpt iD and truSculpt flex and service labor for the repair and maintenance of products that are out of warranty, all of which are collectively classified as “Service” revenue.

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 also maintains regional distribution centers (“RDCs”) in selection locations across the U.S. These RDCs serve as forward warehousing for systems and service parts in various geographies. 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 42 countries. The Condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All inter-company transactions and balances have been eliminated.

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 global financial markets, cybersecurity breaches and other disruptions that could compromise the Company’s information or results, business disruptions that are caused by natural disasters or pandemic events, 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.

In March 2020, the World Health Organization declared the COVID-19 outbreak a pandemic. The COVID-19 outbreak has negatively affected the United States and global economies. The spread of the coronavirus, which caused a broad impact in 2020 globally, including restrictions on travel, shifting work force to work remotely and quarantine policies put into place by businesses and governments, had a material economic effect on the Company’s business during the year ended December 31, 2020. Notably, healthcare facilities in many countries effectively banned elective procedures. Many of the Company’s products are used in aesthetic elective procedures and as such, the bans on elective procedures substantially reduced the Company’s sales and marketing efforts in the early months of the pandemic and led the Company to implement cost control measures. Although the Company’s revenues and profits have improved compared to the first, second, and third quarters of fiscal 2020, which were hard hit during the pandemic, and the overall economic outlook due to the COVID-19 pandemic improves in 2021, the COVID-19 outbreak continues to be fluid and the aftermath of the business and economic disruptions due to the COVID-19 is still uncertain, making it difficult to forecast the final impact it could have on the Company’s future operations, including disruptions in the Company's supply chain and contract manufacturing operations. The Company cannot presently predict the scope and severity of any impacts in future periods from the business shutdowns or disruptions due to the COVID-19 pandemic, but the impact on economic activity such as the possibility of recession or financial market instability could have a material adverse effect on the Company’s business, revenue, operating results, cash flows and financial condition. The Company continues to assess whether any impairment of its goodwill or its long-lived assets has occurred and has determined that no charges other than an impairment loss of $0.2 million on capitalized implementation costs of cloud-based customer relationship management (“CRM”) software during the three months ended March 31, 2021. The Company’s assumptions about future conditions important to its assessment of potential impairment of its long-lived assets, and goodwill, including the impacts of the COVID–19 pandemic and other ongoing impacts to its, are subject to uncertainty, and the Company will continue to monitor these conditions in future periods as new information becomes available, and will update its analyses accordingly.

The Company has experienced a significant increase in sales of skincare products under the exclusive distribution agreement with ZO Skin Health, Inc. (“ZO”), which allows the Company to sell ZO’s skincare products in Japan. The reason for the increase in skincare products sales might have been the result of changes in customers’ spending habits to purchase more aesthetic treatments which could be applied at home due to limitations on in-person aesthetic procedures, social distancing and mask wearing requirements due to the COVID-19 pandemic. Future growth in sales of skincare products depends on the customers’ spending habits, which may revert to original spending habits after the COVID-19 pandemic. Such changes may have a material adverse effect on the Company’s revenue, operating results, and cash flows.

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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 Condensed consolidated statements of financial position as of March 31, 2021 and 2020, and its Condensed consolidated statements of results of operations, comprehensive loss, changes in equity, and cash flows for the three months ended March 31, 2021, and 2020. The December 31, 2020 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. Presentation of certain prior year balances have been updated to conform with current year presentation. 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, 2020 filed with the Securities and Exchange Commission (the “SEC”) on March 23, 2021.

Accounting Policies

These unaudited Condensed consolidated financial statements are prepared in accordance with the rules and regulations of the SEC applicable to interim financial statements. While these statements reflect all normal recurring adjustments that are, in the opinion of management, necessary for fair presentation of the results of the interim period, they do not include all of the information and footnotes required by GAAP for complete financial statements. These Condensed consolidated financial statements should be read in conjunction with the financial statement disclosures in its annual report on Form 10-K for the year ended December 31, 2020 filed with the SEC on March 23, 2021.

The Company uses the same accounting policies in preparing quarterly and annual financial statements. Unless otherwise noted, amounts presented within the notes to Condensed consolidated financial statements refer to the Company’s continuing operations. Note 13 provides information about the Company’s adoption of the new accounting standard for debt with conversion and other options which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts in an entity’s own equity.

The Company issued $138.3 million of convertible senior notes ("Notes" or "Convertible notes") in a private placement offering on March 5, 2021. The Convertible notes bear interest at a rate of 2.25% per year. In accordance with ASU 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging— Contracts in Entity’s Own Equity (Subtopic 815-40),” the Company recorded the Convertible notes in long-term debt with no separation between the Convertible notes and the conversion option. Each reporting period, the Company will determine whether any criteria is met for the note holders to have the option to redeem the Convertible notes early, which will result in a change in the classification of the Convertible notes to current liabilities.

The costs associated with issuance of the Convertible notes, including underwriters’ fees are presented in the Condensed consolidated balance sheet as a direct deduction from the carrying amount of the Convertible notes. The debt issuance costs are amortized over the life of the Convertible notes as additional non-cash interest expense.

In connection with issuance of the Convertible notes, the Company entered into capped call transactions with certain option counterparties. The capped call transactions are generally designated to reduce the potential dilution of the Company's common stock upon any conversion of the Notes. The capped calls were purchased for $16.1 million and recorded as a reduction to additional paid in capital in the Condensed consolidated balance sheet as of March 31, 2021.

Use of Estimates

The preparation of 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, allowance for credit losses, sales allowances, valuation of inventories, fair value of goodwill, useful lives of property and equipment, impairment testing for long-lived-assets, implicit and incremental borrowing rates related to the Company’s leases, assumptions regarding variables used in calculating the fair value of the Company's equity awards, expected achievement of performance based vesting criteria, management performance bonuses, assumptions used in operating and sales-type lease classification, the standalone selling price of the Company's products and services, the period of benefit used to capitalize and amortize contract acquisition costs, variable consideration, contingent liabilities, recoverability of deferred tax assets, residual value of leased equipment, lease term and effective income tax rates. 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.

Recently Adopted Accounting Pronouncements

In December 2019, the FASB issued ASU No. 2019-12 “Income Taxes (Topic 740)-Simplifying the Accounting for Income Taxes,” to remove certain exceptions and improve consistency of application, including, among other things, requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date. The Company adopted this guidance in the three months ended March 31, 2021. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

In August 2020, the FASB issued ASU No. 2020-06, "Debt – Debt with Conversion and Other Options (Topic 470) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Topic 815)." This amendment simplifies the accounting for convertible debt instruments by removing the beneficial conversion and cash conversion separation models for convertible instruments. Under the amendment, the embedded conversion features are no longer separated from the host contract for convertible instruments with conversion features that are not required to be accounted for as derivatives or that do not result in substantial premiums accounted for as paid-in capital. The update also amends the accounting for certain contracts in an entity’s own equity that are currently accounted for as derivatives because of specific settlement provisions. In addition, the new guidance modifies how particular convertible instruments and certain contracts that may be settled in cash or shares impact the computation of diluted earnings per share. The Company early adopted the guidance on a prospective basis effective January 1, 2021. See Note 13 – Debt.

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Note 2. Cash, Cash Equivalents

The following table summarizes the Company's cash and cash equivalents (in thousands):

(Dollars in thousands)

March 31,

2021

December 31,

2020

Cash and cash equivalents

164,932

47,047

The Company has no marketable securities as of March 31, 2021 and December 31, 2020.

Note 3. Fair Value of Financial Instruments

Fair value is an exit price representing the amount that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy contains three levels of inputs that may be used to measure fair value, in accordance with ASC 820, as follows:

● Level 1: inputs, which include quoted prices in active markets for identical assets or liabilities;

● Level 2: inputs, which include observable inputs other than Level 1 inputs, such as quoted prices for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability. When sufficient quoted pricing for identical securities is not available, the Company uses market pricing and other observable market inputs for similar securities obtained from various third-party data providers. These inputs either represent quoted prices for similar assets in active markets or have been derived from observable market data; and

● Level 3: inputs, which include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the underlying asset or liability. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies, or similar valuation techniques, as well as significant management judgment or estimation.

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.

See Note 13 for the carrying amount and estimated fair value of the Company’s Convertible notes due 2026.

Note 4. Balance Sheet Details

Inventories

As of March 31, 2021 and December 31, 2020, inventories consist of the following (in thousands):

	March 31, 2021		December 31, 2020
Raw materials	$	15,335	$	14,874
Work in process		1,359		1,030
Finished goods		17,884		12,604
Total	$	34,578	$	28,508

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Accrued Liabilities

As of March 31, 2021 and December 31, 2020, accrued liabilities consist of the following (in thousands):

	March 31, 2021		December 31, 2020
Accrued payroll and related expenses	$	12,558	$	12,197
Sales and marketing accruals		3,134		2,352
Accrued inventory in transit		7,501		2,476
Product warranty		3,351		2,908
Accrued sales tax		6,935		5,343
Other accrued liabilities		7,850		5,803
Total	$	41,329	$	31,079

Product Remediation Liability

During the fourth quarter of 2018, the Company recognized a liability for a product remediation plan related to one of its legacy systems. This was related to a voluntary action initiated by the Company to replace a component in one of the Company’s legacy products. The remediation plan consists primarily of replacement of a component in the system. The accrued liability consisted of the estimated cost of materials and labor to replace the component in all units that were under the Company's standard warranty or were covered under the existing extended warranty contracts. The Company recorded a liability of approximately $5.0 million in 2018.

As of March 31, 2021 and December 31 2020, approximately $0.4 million of the total product remediation liability balance was recorded as a component of the Company’s product warranty and included in accrued liabilities, and $1.0 million and $1.2 million, respectively, was separately recorded as extended warranty liability. Total costs incurred related to product warranty and extended warranty liability during the three months ended March 31, 2021 were $0 and $0.2 million, respectively. Total costs incurred related to product warranty and extended warranty liability during the three months ended March 31, 2020 were Nil and $0.2 million, respectively.

Note 5. Warranty and Extended Service Contract

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 an extended service contract basis or on a time and materials basis. The Company provides for the estimated cost to repair or replace products under standard warranty at the time of sale. Costs incurred in connection with extended service contracts are recognized at the time when costs are incurred, except the one-time extended service contracts charge of $3.2 million recorded in the year ended December 31, 2018 related to the cost to replace a component in one of the Company's legacy products.

The following table provides the changes in the product warranty accrual for the three months ended March 31, 2021 and 2020 (in thousands):

	Three Months Ended
	March 31,
	2021			2020 (1)
Beginning Balance	$	2,908		$	4,401
Add: Accruals for warranties issued during the period		1,525			860
Less: Settlements made during the period		(1,082	)		(1,863	)
Ending Balance	$	3,351		$	3,398

(1)

The ending product warranty accrual balance excludes $1.0 million and $1.8 million as of March 31, 2021 and 2020, respectively, related to one-time extended service contracts costs to replace components in one of the Company’s legacy products.

The $1.1 million and $1.9 million of settlements made in the three months ended March 31, 2021 and 2020, respectively, exclude costs related to extended service contract cost of $0.2 million in each of the respective periods to replace a component in one of the Company's legacy products.

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Note 6. Deferred Revenue

The Company records deferred revenue when revenue is to be 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 training and extended marketing support service. Approximately 85% of the Company’s deferred revenue balance of $11.7 million as of March 31, 2021 will be recognized over the next 12 months.

The following table provides changes in the deferred revenue balance for the three months ended March 31, 2021 and 2020 (in thousands):

	Three Months Ended
	March 31,
	2021			2020
Balance at beginning of quarter	$	11,237		$	14,222
Add: Payments received		4,929			3,571
Less: Revenue		(445	)		(592	)
Less: Revenue included in the beginning balance and recognized as revenue in the current quarter		(3,984	)		(4,232	)
Balance at end of quarter	$	11,737		$	12,969

Costs for extended service contracts were $2.0 million and $2.2 million for the three months ended March 31, 2021 and 2020, respectively.

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 12% and 18% respectively, of the Company’s total revenue for the three months ended March 31, 2021 and 2020.

The Company has certain system sale arrangements that 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 services 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 sale arrangements. The Company’s system sale arrangements can include all or 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, marketing services, and time and materials 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 performance obligations at a point in time. Systems, system accessories (hand pieces), service contracts, training, and time and materials services are also sold on a stand-alone basis, and these 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

Systems revenue is generated from the sale of systems and from the sale of upgrades to existing systems. 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. In certain applications, the laser or other energy-based module is contained in the hand piece, such as with the Company’s Pearl and Pearl Fractional applications, rather than 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 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.

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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. When collectability is not established in advance of receipt of payment from the customer, revenue is recognized upon the later of the receipt of payment or the satisfaction of the performance obligation. For systems sold through credit approved distributors, revenue is recognized at the time of shipment to the distributor.

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 skincare products are purchased from a third-party manufacturer and sold to medical offices and licensed physicians. The Company warrants that the skincare products are free of significant defects in workmanship and materials for 90 days from shipment. These are typically sold in a separate contract as the only performance obligations. The Company acts as the principal in this arrangement, as the Company determines the price to charge customers for the skincare products and controls the products before they are transferred to the customer. The Company recognizes revenue for skincare products at a point in time upon shipment.

Consumables and other accessories

The Company classifies its customers' purchases of replacement cycles for truSculpt iD and truSculpt flex, as well as replacement hand pieces, Titan and truSculpt 3D hand pieces, and single use disposable tips applicable to Secret PRO, Juliet, and Secret RF, as Consumable revenue, which provides the Company with a source of recurring revenue from existing customers. The Juliet and Secret RF products' single use disposable tips must be replaced after every treatment. Sales of these consumable tips further enhance the Company’s recurring revenue. The Company’s systems offer multiple hand pieces and applications, which allow customers to upgrade their systems.

Equipment leasing

The Company leases equipment to customers through membership programs and receives a fixed monthly fee over the term of the arrangement. The Company classifies its lease income as product revenue. The Company recognizes lease income over the term of the lease if the lease is classified as an operating lease. For agreements that grant customers the right to purchase the leased system, the Company typically classifies the lease as a sales-type lease as the Company has determined it is reasonably certain that the customer will exercise the purchase option. On the commencement of sales-type leases, the Company recognizes revenue upfront in product revenue and the corresponding receivables recorded in other current assets and prepaid expenses on the Condensed consolidated balance sheets (See Note 11). There was no revenue recognized for sales-type leases for the three months ended March 31, 2021. Revenue from equipment leases, which was accounted for as operating leases, was not material for the three months ended March 31, 2021.

Extended contract services

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

Training

Sales of systems to customers include training on the use of the system to be provided within 180 days of purchase. The Company considers training a separate performance obligation as customers can immediately benefit from the training together with the customer’s 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.

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The Company classifies as product revenue the sales of systems, system upgrades, hand pieces, hand piece refills (applicable to Titan® and truSculpt), equipment leasing and the distribution of third-party manufactured skincare products.

Customer Marketing Support

In North America, the Company offers marketing and consulting phone support to its customers across all system platforms. 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.

Significant Judgments

The determination of whether two or more contracts entered into at or near the same time with the same customer should be combined and accounted for as one contract may require the use of significant judgment. In making this determination, the Company considers whether the contracts are negotiated as a package with a single commercial objective, have price interdependencies, or promise goods or services that represent a single performance obligation.

While the Company’s purchase agreements do not provide customers with a contractual right of return, the Company maintains a sales allowance to account for potential returns or refunds as a reduction in transaction price at the time of sale. The Company estimates sales returns and other variable consideration based on historical experience.

The Company determines standalone selling price ("SSP") for each performance obligation as follows:

●	Systems: The SSPs for systems are based on directly observable sales in similar circumstances to similar customers.

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

Loyalty Program

The Company has a customer loyalty program for qualified customers located in the U.S. and Canada. Under the loyalty program, customers accumulate points based on their purchasing levels which can be redeemed for such rewards as the right to attend the Company’s advanced training event for truSculpt, or a ticket for the Company’s annual forum. A customer’s account must be in good standing to receive the benefits of the rewards program. Rewards are earned on a quarterly basis and must be used in the following quarter. All unused rewards are forfeited. The fair value of the reward earned by loyalty program members is included in accrued liabilities and recorded as a reduction. of net revenue at the time the reward is earned. As of March 31, 2021 and December 31, 2020, the liability for the loyalty program included in accrued liabilities was $0.4 million and $0.3 million, respectively.

Deferred Sales Commissions

Incremental costs of obtaining a contract, which consist primarily of commissions and related payroll taxes, are capitalized and amortized on a straight-line basis over the expected period of benefit, except for costs that are recognized when product is sold. 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.

Total capitalized costs as of March 31, 2021 and December 31, 2020 were $3.4 million, respectively, and are included in other long-term assets in the Company’s Condensed consolidated balance sheet. Amortization expense for these assets was $0.5 million and $0.7 million, respectively, during the three months ended March 31, 2021 and 2020 and is included in Sales and marketing expense in the Company’s Condensed consolidated statement of operations.

Note 8. Stockholders’ Equity and Stock-based Compensation Expense

The Company’s equity incentive plans are broad-based, long-term programs intended to attract and retain talented employees and align stockholder and employee interests. In June 2019, stockholders approved an amendment and restatement of the Amended and Restated 2004 Equity Incentive Plan as the 2019 Equity Incentive Plan (the “2019 Plan”) and approved an additional 700,000 shares, available for future grants (in addition to the 9,701,192 shares provided under the Prior Plan). In June 2020, stockholders approved additional 600,000 shares for future grants. The 2019 Plan provides for the grant of incentive stock options, non-statutory stock options, RSAs restricted stock units (“RSUs”), stock appreciation rights, performance stock units, performance shares, and other stock or cash awards.

The Company’s Board of Directors granted its executive officers and senior management 88,588 performance stock units (“PSUs”) during the three months ended March 31, 2021. The PSUs granted in the three months ended March 31, 2021 vest subject to the recipients continued service and to the Company’s achievement of certain operational goals for the Company’s 2021 fiscal year related to product milestones, sales and commercial structure improvement and certain cost reduction targets.

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The Company’s Board of Directors also granted its executive officers and senior management 56,597 RSUs and 68,673 non-qualified stock options (“NQs”) during the three months ended March 31, 2021. The RSUs and NQs vest over four years with one-fourth vesting on the first anniversary of the vesting commencement date of January 1, 2021 and 1/36 of the underlying shares vest each month thereafter.

During the quarter ended September 30, 2019 the Company's Board awarded its new CEO, David H. Mowry, 67,897 shares, which are scheduled to vest over 4 years from 2019 through 2022 (the 2019 tranche is 15% of the award, or 10,185 PSUs; the 2020 tranche is 25% of the award, or 16,974 PSUs; the 2021 tranche is 30% of the award, or 20,369 PSUs; 2020 tranche is 30% of the award, or 20,369 PSUs). These PSUs are subject to certain performance-based criteria related to achieving financial metrics in the Board approved annual budgets for the years 2019 through 2022. As of March 31, 2021, the Company concluded that the 2019, 2020 and 2021 tranches met the criteria for measurement and recognition. 8,657 shares of the 2019 tranche vested during the three months ended March 31, 2020. None of the shares for the 2020 tranche vested. The 2022 tranches do not meet the criteria for measurement and recognition as of March 31, 2020 and will meet the criteria for measurement and commencement of recognition when the Company’s Board of Directors establishes the financial metrics for 2022. On April 28, 2021, notwithstanding the prior sentence, the Company’s Board of Directors approved the vesting of Mr. Mowry’s 2020 tranche. Upon the approval, 16,974 shares vested. The Company will account for it as a modification of the performance award in the second quarter ending June 30, 2021.

On August 2, 2020, the Board awarded its new CFO, Rohan Seth, an option grant for 60,000 shares, which vests over 5 years, and a PSU award covering a target of 22,423 shares, which vests over 2.5 years and is subject to performance-based criteria relating to the achievement of certain goals with 40% based on achievement of Finance department goals and 60% based on the Company’s achievement of financial performance goals. All of the Finance department goals were met and 8,971 shares, or 40%, of the award vested and was released upon the Board’s approval on April 28, 2021.

Under the 2019 Plan, the Company issued 122,694 shares of common stock during the three months ended March 31, 2021, in conjunction with stock options exercised and the vesting of RSUs and PSUs, net of shares withheld for employee taxes.

As of March 31, 2021, the unrecognized compensation cost, net of expected forfeitures, was $1.6 million for stock options, which will be recognized over an estimated weighted-average remaining amortization period of 3.9 years. The unrecognized compensation cost, net of expected forfeitures, for stock awards, including performance-based awards, was $13.9 million, which will be recognized over an estimated weighted-average remaining amortization period of 2.1 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 the PSUs granted.

Activity under the 2019 Plans are summarized as follows:

				Options Outstanding
	Shares Available for Grant			Number of Stock Options Outstanding			Weighted- Average Exercise Price
Balance, December 31, 2020		1,085,170			217,007		$	22.35
Stock awards granted		(234,227	)		68,673			32.87
Options exercised		-			(24,090	)		16.41
Options canceled		2,500			(2,500	)		39.30
Stock awards canceled		58,232			-			-
Balance, March 31, 2021		911,675			259,090		$	25.53

Stock-based Compensation Expense

Stock-based compensation expense by department recognized during the three months ended March 31, 2021 and 2020 were as follows (in thousands):

	Three Months Ended
	March 31,
	2021		2020
Cost of revenue	$	144	$	290
Sales and marketing		721		719
Research and development		301		321
General and administrative		680		650
Total stock-based compensation expense	$	1,846	$	1,980

Note 9. Net Loss Per Share

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method or the if-converted method. Dilutive potential common shares include outstanding stock options, stock awards, shared performance stock awards, and conversion shares under the Convertible notes.

As of March 31, 2021, the Company’s Convertible notes were convertible into 4,167,232 shares of common stock. The Company receives shares or cash, at its option, under the capped call transactions which will always be anti-dilutive to EPS. For the three months ended March 31, 2021 and 2020, basic loss per common share and diluted loss per common share are the same as inclusion of any potentially issuable shares would be anti-dilutive.

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

	Three Months Ended March 31, 2021			Three Months Ended March 31, 2020
Numerator:
Net loss	$	(359	)	$	(12,414	)
Denominator:
Weighted average shares of common stock outstanding used in computing net loss per share, basic		17,768			14,433
Dilutive effect of incremental shares and share equivalents		-			-
Weighted average shares of common stock outstanding used in computing net loss per share, diluted		17,768			14,433
Net loss per share:
Net loss per share, basic and diluted	$	(0.02	)	$	(0.86	)

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

	Three Months Ended
	March 31,
	2021		2020
Convertible notes(1)(2)		4,167		-
Options to purchase common stock		245		276
Restricted stock units		585		669
Performance stock units		92		216
Employee stock purchase plan shares		30		71
Total		5,119		1,232

(1)

Anti-dilutive convertible notes were calculated under the if-converted method for the three months ended March 31, 2021.

(2)

The Company entered into capped call transactions with certain financial institutions, which are generally designated to reduce common stock dilution upon conversion of the Convertible notes. The capped call transactions are excluded from the computation of diluted net loss per common share as their effect would be anti-dilutive.

Note 10. Income Taxes

For the three months ended March 31, 2021, the Company's income tax expense was $258,000, compared to the tax expense of $78,000 for the three months ended March 31, 2020.

The Company's income tax expense for the three months ended March 31, 2021 is due primarily to income taxes in foreign jurisdictions. The Company continues to maintain a full valuation allowance on its U.S. deferred tax assets.

Note 11. Leases

The Company is a party to certain operating and finance leases for vehicles, office space and storages facilities. The Company’s operating leases consist of office space, as well as storage facilities and finance leases consist of automobiles. The Company’s leases generally have remaining terms of 1 to 10 years, some of which include options to renew the leases for up to 5 years. The Company leases space for operations in the United States, Japan, Belgium, France and Spain. In addition to the above facility leases, the Company also routinely leases automobiles for certain sales and field service employees under finance leases.

The Company determines if a contract contains a lease at inception. Operating lease assets and liabilities are recognized at the lease commencement date. Operating lease liabilities represent the present value of lease payments not yet paid. Operating lease assets represent the right to use an underlying asset and are based upon the operating lease liabilities adjusted for prepayments or accrued lease payments, initial direct costs, lease incentives, and impairment of operating lease assets. To determine the present value of lease payments not yet paid, the Company estimates the incremental secured borrowing rates corresponding to the maturities of the leases. The Company based the rate estimates on prevailing financial market conditions, credit analysis, and management judgment.

The Company recognizes expense for these leases on a straight-line basis over the lease term. Additionally, tenant incentives used to fund leasehold improvements are recognized when earned and reduce the Company’s right-of-use (“ROU”) asset related to the lease. These are amortized through the ROU asset as reductions of expense over the lease term.

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Supplemental balance sheet information related to leases was as follows (in thousands):

Leases	Classification	March 31, 2021	December 31, 2020
Assets
Right-of-use assets	Operating lease assets	$

SEC Form 10-Q filed by Cutera, Inc.