Item 1B.
Unresolved Staff Comments
None.
Our principal executive offices are located in Madison, Wisconsin, where we lease three buildings:
In addition, we lease office space totaling approximately 5,000 square feet in Brussels, Belgium under a lease expiring in 2014, and our wholly-owned subsidiary, Chengdu Twin Peak Accelerator Technology Inc. (Twin Peak), leases approximately 850 square meters of space in a manufacturing facility in Chengdu, China under a lease that expired in October 2010 and is in the process of being renewed until October 2011. CPAC leases space totaling approximately 16,000 square feet in Livermore, California under a lease that expires in January 2013. We believe that our existing facilities are adequate for our current needs and that suitable additional or alternative space will be available on commercially reasonable terms to meet our future needs.
The information set forth in Note H to our consolidated financial statements included in this Annual Report on Form 10-K is incorporated herein by reference. In addition, we are subject to various claims and legal proceedings arising in the ordinary course of our business. We believe that the ultimate resolution of these matters, whether individually or in the aggregate, will not have a material adverse effect on our business, prospects, financial condition and results of operations.
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Market Information
Our common stock is traded on the NASDAQ Global Select Market under the symbol “TOMO.” The high and low sale prices for each full quarterly period within the two most recent fiscal years are as follows:
Holders
As of February 28, 2011, there were 505 registered shareholders of record of our common stock.
Dividends
We have never paid cash dividends to our common shareholders, nor do we have current plans to pay cash dividends to our common shareholders in the foreseeable future. Our Board of Directors intends to reinvest any future earnings in the growth, development and support of our operations.
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2010 with respect to the shares of our common stock that may be issued under our existing equity compensation plans.
Performance Graph
The graph set forth below compares the cumulative total shareholder return on our common stock between May 9, 2007 (our initial trading date) and December 31, 2010, with the cumulative total return of (i) the NASDAQ Composite Index and (ii) the S&P Healthcare Index over the same period. This graph assumes the investment of $100 on May 9, 2007 in our common stock, the NASDAQ Composite Index and the S&P Healthcare Index, and assumes the reinvestment of dividends, if any. The graph assumes the initial value of our common stock on May 9, 2007 was the closing sales price of $22.67 per share.
The comparisons shown in the graph below are based upon historical data. We caution that the stock price performance shown in the graph below is not necessarily indicative of, nor is it intended to forecast, the potential future performance of our common stock.
Recent Sales of Unregistered Securities
(a) From January 1, 2008 through the date of this Annual Report on Form 10-K, we sold the following securities that were not registered under the Securities Act.
1. From January 2008 through April 2008, we issued an aggregate of 4,672 shares of common stock to two investors upon the exercise of our Series D warrants. The exercise price was $1.84 per share, and the aggregate consideration received by us was $8,588.
2. During February 2009, we issued an aggregate of 1,104 shares of common stock to two investors upon the exercise of our Series D warrants. The exercise price was $1.84 per share, and the aggregate consideration received by us was $2,029.
We believe that the offer and sale of the above-referenced securities were exempt from registration under the Securities Act by virtue of Section 4(2) and/or Rule 506 under Regulation D promulgated thereunder as transactions not involving any public offering. All of the purchasers of unregistered securities for which we relied on Section 4(2) and/or Regulation D represented that they were accredited investors as defined under the Securities Act. We claimed such exemption on the basis that (a) the purchasers in each case represented that they intended to acquire the securities for investment only and not with a view to the distribution thereof and that they either received adequate information about us or had access, through employment or other relationships, to such information, (b) appropriate legends were affixed to the warrants and/or stock certificates issued in such transactions, and (c) offers and sales of these securities were made without general solicitation or advertising.
(b) From January 1, 2008 to December 31, 2010, we did not grant any options to purchase shares of unregistered common stock to our directors, employees and consultants nor did we issue any shares of unregistered common stock upon the exercise of such options.
Use of Proceeds from Public Offering of Common Stock
Our initial public offering of 13,504,933 shares of our common stock, par value $0.01 per share, was effected through a Registration Statement on Form S-1 (Reg. No. 333-140600), which was declared effective by the SEC on May 8, 2007. We issued 10,602,960 shares on May 9, 2007 for gross proceeds to the Company of $201.5 million. We paid the underwriters a commission of $14.1 million and incurred additional offering expenses of approximately $2.7 million. After deducting the underwriters’ commission and the offering expenses, we received net proceeds of approximately $184.7 million. The managing underwriter of our initial public offering was Merrill Lynch & Co. In addition, 2,901,973 shares were sold by selling shareholders, 1,761,513 of which were purchased by the underwriters’ exercise of their overallotment option.
No payments of underwriters’ commissions or offering expenses were made directly or indirectly to (i) any of our directors, officers or their associates, (ii) any person(s) owning 10% or more of any class of our equity securities, or (iii) any of our affiliates.
Through December 31, 2010, we used $109.6 million of the net proceeds from our initial public offering, as described in the following table (in millions):
None of the above uses of cash involved payments made directly or indirectly to (i) any of our directors, officers or their associates (other than payments made to our directors or officers in the ordinary course of business out of working capital), (ii) any person(s) owning 10% or more of any class of our equity securities, or (iii) any of our affiliates.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table summarizes repurchases of our common stock during the three months ended December 31, 2010 from employees who are restricted stockholders to satisfy income tax withholding obligations:
(1)
Consists of shares surrendered to us from employees to satisfy income tax withholding obligations that arose upon the vesting of restricted stock awards.
(2)
Pursuant to our 2007 Equity Incentive Plan, as amended (the Plan), we may occasionally repurchase shares of our common stock from recipients of restricted stock awards under the Plan in order to permit such participants to satisfy income tax obligations arising upon the vesting of such restricted stock awards. The amount of such future share repurchases, if any, is unascertainable as of the date of this Annual Report on Form 10-K.
The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The consolidated balance sheet data as of December 31, 2010 and 2009 and the consolidated statements of operations data for the years ended December 31, 2010, 2009 and 2008 are derived from our audited consolidated financial statements included elsewhere herein, which have been prepared in accordance with generally accepted accounting principles in the United States. The consolidated balance sheet data as of December 31, 2008, 2007 and 2006 and the consolidated statements of operations for the years ended December 31, 2007 and 2006 have been derived from our audited consolidated financial statements, which are not included in this Annual Report on Form 10-K.
Consolidated Balance Sheet data (in thousands):
Consolidated Statement of Operations data (in thousands except per share data):
(1)
Represents the impact of the adoption of new accounting guidance on the accounting for freestanding warrants and other similar instruments on shares that are redeemable. Pursuant to the new accounting guidance, we were required to classify our outstanding warrants to purchase preferred stock as a liability on our balance sheet and record adjustments to their fair value in our statements of operations at the end of each reporting period. For the year ended December 31, 2006, the impact of the change in accounting principle was to decrease net income by $3.1 million, consisting of a $2.1. million cumulative effect adjustment for the change in accounting principle as of January 1, 2006, when we adopted the new accounting guidance, and $0.9 million of expense that was recorded in other income (expense), net to reflect the increase in fair value between January 1, 2006 and December 31, 2006. The warrants were subject to revaluation at each balance sheet date and any change in fair value was recognized as a component of other income (expense), net, until the completion of our initial public offering when the preferred warrants converted to common stock warrants.
(2)
Accretion of redeemable convertible preferred stock represents the impact attributable to the increase in the fair market value of shares of our redeemable convertible preferred stock prior to their conversion into shares of our common stock upon the closing of our initial public offering. The holders of Series A, B, C and D preferred stock had the option to sell their stock back to us at the greater of (i) the original purchase price plus accrued dividends, or (ii) the fair market value of the stock. The holders of Series E preferred stock had the option to sell their stock back to us at the original purchase price plus accrued dividends. The put option and the related accretion of the preferred stock terminated upon the completion of our initial public offering when all of our issued and outstanding shares of preferred stock converted to common stock.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read together with our audited consolidated financial statements and the notes to those financial statements, which are included in this report. This report may contain or incorporate by reference forward-looking statements made pursuant to the safe harbor provisions of Section 27A of the Securities Act and Section 21E of the Exchange Act. These statements reflect management’s expectations, estimates and assumptions, based on information available at the time of the statement or, with respect to any document incorporated by reference, available at the time that such document was prepared. Forward-looking statements include, but are not limited to, statements regarding future events, plans, goals, objectives, prospects and expectations. Forward-looking statements are often, but not always, made through the use of words such as “believe,” “anticipate,” “should,” “intend,” “plan,” “will,” “likely,” “expect,” “estimate,” “project” and similar expressions. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties, and other factors, including, but not limited to, those discussed below under “Factors Affecting Our Financial Performance” and those in the section entitled “Risk Factors” under Part I, Item 1A of this Annual Report on Form 10-K, which may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed in or implied by those statements. We undertake no obligation to, and expressly disclaim any such obligation to, update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events or changes to future results over time or otherwise, except as required by law.
Overview
We develop, manufacture, market and sell advanced radiation therapy solutions to treat a wide range of cancer types. We market and sell our products to hospitals and cancer treatment centers in the Americas, Europe, the Middle East and Asia-Pacific and offer customer support services in each region either directly or through distributors.
The treatment systems in our TomoTherapy product offering (collectively, the System or Systems) operate on a ring gantry and combine integrated CT imaging with conformal radiation therapy to deliver sophisticated radiation treatments with speed and precision while reducing radiation exposure to surrounding healthy tissue. Our Systems include: (1) the Hi Art treatment system; (2) the TomoHD treatment system; and (3) the TomoMobile relocatable radiation therapy solution. The Hi Art treatment system is our flagship product and has been used since 2003 to deliver CT-guided, helical intensity-modulated radiation therapy (IMRT) treatment fractions. The TomoHD treatment system was announced in October 2009, was first shipped in the fourth quarter of 2010, and includes both our TomoHelical and TomoDirect treatment modalities to enable cancer centers to treat a broader patient population with a single device. The TomoMobile relocatable radiation therapy solution, first shipped in late 2009, consists of a standard TomoTherapy treatment system housed in a movable coach and is designed to improve the access and availability of state-of-the-art cancer care.
For the years ended December 31, 2010 and 2009, our revenue was $195.4 million and $164.0 million, respectively, an increase of 19%, and our net loss attributable to shareholders was $29.9 million and $37.4 million, respectively, a decrease of 20%. Our results of operations for the year ended December 31, 2010 improved compared to the year ended December 31, 2009 despite the continued impact of the global economic downturn, limited credit availability for our customers and enhanced competitive pressure. Although we experienced a net loss in the year ended December 31, 2010, we had a working capital balance, which is calculated by subtracting our current liabilities from our current assets, of $135.1 million, including $152.1 million of cash, cash equivalents and short-term investments, as of December 31, 2010. Thus, we believe we will be able to fund ongoing operations and invest in future product offerings for at least the next 12 months.
During 2008, we acquired 100% of the outstanding capital stock of Twin Peak, a privately-held company based in Chengdu, China, for consideration of approximately $3.1 million. In December 2009, we installed our first System containing a Twin Peak linear accelerator. We believe Twin Peak will be a lower-cost alternative and secondary source of supply for linear accelerators, a critical component of the System.
Despite continued economic uncertainty during the year ended December 31, 2010, we are encouraged by the improvements in our financial results and we remain confident in the future commercial demand for our technology and product offerings due to planned new products, product enhancements and anticipated growth in global demand for CT image-guided radiation therapy equipment.
Factors Affecting Our Financial Performance
Our financial performance is significantly affected by the following factors:
Incoming orders
Because we sell high-priced capital equipment with a transaction cycle that can take many months between customer order and delivery, an important measure of our future financial performance is the dollar value of incoming orders for equipment. During the year ended December 31, 2010, we experienced a 57% increase in incoming orders as compared to the year ended December 31, 2009, despite the continued impact of the global economic downturn, limited credit availability for our customers and increased competitive pressure. We believe this increase in orders is the result of improvements generated by the transition in sales leadership we implemented during 2009 and 2010, recent product introductions and the successful execution of our global sales and marketing initiatives.
Despite the significant increase in new orders in 2010, we still face a number of risks that could negatively impact our incoming orders in the future. Since the System is a major capital expenditure, our customers may require funding through a credit facility or lease arrangement. In the current economic environment, some customers may have difficulty obtaining the necessary credit or may be subject to increased constraints on their use of available cash. In addition, the current economic environment may cause potential new customers to delay placing capital equipment orders or to purchase equipment that is less costly.
We continued to experience heightened competition in the marketplace during the year ended December 31, 2010. To counter this competitive pressure, we continue our efforts to improve the quality and effectiveness of our sales force, maintain our focus on group purchasing organizations and national accounts, continue our emphasis on regional user meetings and expand our product features. Furthermore, we believe continued innovation and expansion of our clinical capabilities will extend our technology leadership position, increase our prospects for greater market share and generate revenue growth.
Backlog
As of December 31, 2010, we had a backlog of $133.0 million, the majority of which we believe should convert to revenue within the next 12 months. We define backlog as the total contractual value of all firm orders received for Systems and related options that we believe are likely to ship within 24 months, plus the minimum payments that are contractually obligated under system rental agreements. To be included in backlog, orders must be evidenced by a signed quotation or a purchase order from the customer or distributor. Backlog does not include any revenue from service contracts, which represents a growing portion of our overall revenue.
On a regular basis, we review our open orders to determine if they meet our backlog definition by evaluating various factors including site identification, requested delivery date and customer or distributor history. If they no longer meet our backlog definition, we remove the orders from our backlog.
Revenue
Product revenue
The majority of our product revenue is generated from sales of the Systems. We negotiate the actual purchase price with each customer or distributor and, historically, the purchase price has varied across geographic regions.
We are starting to see modest improvement in the market, most notably in the Americas, which has historically been our largest market, including an increase in new orders for the year ended December 31, 2010 compared to the year ended December 31, 2009. Despite lower backlog, we expect our 2011 revenue to improve in comparison to 2010 revenue due to a higher number of incoming orders being delivered within the year. We continue to be confident in the future commercial demand for our technology and product offerings due to our new products, new features and anticipated growth in demand for CT image-guided radiation therapy equipment.
Our revenue projections can be impacted by a number of factors, including the following:
•
On average, the Systems are shipped to customers within 12 months after we receive the order. However, individual orders may take longer than 12 months to ship. Timing of deliveries can be affected by factors outside of our control, such as construction delays at customer project sites and customer credit issues. For direct and non-certified distributor sales, we recognize revenue upon end customer acceptance of the System, which usually occurs three to four weeks after its delivery. For certified distributor sales, we recognize revenue upon title transfer of the System to the certified distributor, as the Company’s only remaining obligation is its post-installation warranty services to the distributor. Each System installation represents a significant percentage of our revenue for the period in which it occurs.
•
Our geographic mix of customers may impact our average selling prices. We intend to continue to expand our international selling efforts, although we cannot be certain about the impact this will have on pricing. As of December 31, 2010, we did not have a hedging program in place to offset foreign exchange risk and, therefore, cannot be certain of how foreign currency exchange rates will impact our financial results in the future.
•
Our ability to demonstrate the clinical benefits of the Systems compared to competing systems is an important factor in our ability to increase market demand for the Systems. To compete effectively, we may need to offer additional features that could require substantial additional resources to develop.
•
Our focus on sales to group purchasing organizations (GPOs) and multi-center customers may result in our lowering selling prices, as these customers tend to negotiate quantity discounts. Orders from these customers may remain in backlog longer than those from customers who place single unit orders, as units sold to multi-center customers tend to install sequentially over a longer period of time.
•
The Systems are major capital equipment items that represent a significant purchase for most of our customers. While we believe macroeconomic conditions are improving, our customers remain cautious and, as a result, may choose to delay some of their capital spending or may not have or be able to obtain the funds necessary to purchase equipment such as the Systems. These factors may have a material adverse effect on our incoming orders and subsequent revenue recognition.
Also included in our product revenue are sales of optional equipment and software enhancements. Because we plan to further develop the Systems by adding upgraded features, we expect continued revenue growth from sales of optional equipment and software enhancements to new and existing customers.
Service revenue
Our service revenue is generated primarily from post-warranty service contracts and the sale of service spare parts. Our service contracts may be purchased with one- or multiple-year terms and for a variety of service levels, giving our customers the option to contract for the level of support they desire. As of December 31, 2010, our most popular service plan continued to be our Total TLC Service Package (Total TLC). Under Total TLC, we provide customers with full spare parts coverage, including installation service by our field service engineers, full scheduled maintenance and unplanned repair service. We recognize service contract revenue ratably over the term of the contract. We generally recognize revenue from spare parts, which are primarily sold to our distributors, upon delivery. As the number of installed Systems continues to grow, we expect growth in our revenue from post-warranty service contracts.
Our ability to execute our strategies to increase incoming orders, expand backlog with high quality orders, raise sales of optional equipment and software enhancements and grow our service revenue will have a direct impact on our ability to increase overall revenue in the future. If we are unable to execute these strategies successfully, we may generate revenue at levels that are lower than those we have generated in the past.
Cost of revenue
Cost of revenue includes all of our manufacturing and service costs. It consists of material, labor and overhead costs incurred in manufacturing the Systems. It also includes the cost of shipping the Systems to the customer site, installation costs, warranty provisions and royalty payments to Wisconsin Alumni Research Foundation (WARF), one of our shareholders. Finally, cost of revenue includes the customer support expenses required to service and repair the System during both the warranty and service contract periods.
In future periods, we expect to improve our gross margins through the following initiatives:
•
Service and support expenses. We have certain individual service contracts that produce negative gross profit margins for which we have recorded a reserve for the related estimated future losses. We anticipate the number of contracts producing negative margins will decline as we further our efforts to reduce the overall average direct service costs per installed System. We expect to continue to improve service contract margins by leveraging our service infrastructure costs over a larger installed base, implementing remote diagnostic functionalities, outsourcing certain tasks when cost-effective and feasible, introducing component design changes aimed at reducing costs, increasing longevity and improving serviceability of our components, increasing the price for some of our older annual service contracts, and training our personnel to improve their problem-solving capabilities. Additionally, we invested $2.4 million in our “Fast Track” program during 2010. This program targeted selected systems in the field for upgrades of certain technology. While it increased our cost of revenue in 2010, this program is expected to reduce the cost to service the targeted systems in future periods. We believe that achieving success in these initiatives should also lead to reduced warranty costs and improved System performance.
•
Component supply and cost. Our cost of revenue continues to be impacted by high component costs and high replacement rates. We continue efforts to develop alternate components and implement enhancements to increase the performance of components used in the System. We are also seeking to identify lower-priced components of comparable or improved performance and quality, as well as making engineering improvements to the Systems in order to reduce costs. We believe that achieving these goals will result in reduced manufacturing, warranty and service support costs in the long term.
Our ability to execute on these strategies to reduce customer service and support expenses, as well as component costs and failure rates, will have a direct impact on our ability to improve profitability in the future. If we are unable to successfully execute these strategies, we may experience margins that are similar to or lower than our past margins.
Research and development expenses
Research and development expenses consist primarily of salary and benefits for research and development personnel who design and develop future products and product enhancements. Research and development also includes expenses associated with product design and development, the Compact Particle Acceleration Corporation (CPAC) proton therapy research project, customer research collaborations and fees to third parties who furnish services related to these activities.
We expect research and development expenses to increase during 2011 as compared to 2010, as we intend to increase our spending to support our ongoing product development initiatives. Partially offsetting this increase, we expect to capitalize more software development costs related to ongoing product development projects in 2011 as compared to 2010.
Selling, general and administrative expenses
Selling, general and administrative expenses consist of salary and benefits for executive management, sales, marketing and other corporate functions. Also included in these expenses are travel, sales commissions, trade shows and marketing materials and expenses related to accounting, legal, tax and other consulting fees.
We expect 2011 selling, general and administrative expenses to increase as compared to 2010, as we intend to increase our selling and marketing expenses to further promote our products in targeted markets.
Other income (expense)
Because we conduct business in numerous foreign jurisdictions, we are exposed to changes in foreign currency exchange rates. Foreign currency exchange rate fluctuations could materially adversely affect our business, financial condition and results of operations. Our primary exposures are related to foreign currency denominated sales and expenses in Europe. As of December 31, 2010, we did not have a hedging program in place to offset these risks.
Interest income
We expect interest income to decline in 2011 as compared to 2010, due to lower levels of investable cash.
Income tax expense (benefit)
We are subject to taxation in the United States and in numerous foreign jurisdictions. Significant judgments and estimates are required when evaluating our tax positions and determining our worldwide provision for income taxes. As a result, our effective tax rate may fluctuate based on a number of factors including variations in projected taxable income and tax positions taken on tax returns filed in the numerous geographic locations in which we operate, changes in the valuation of our deferred tax assets, tax positions taken on tax returns filed in the geographic locations in which we operate, introduction of new accounting standards and changes in tax liabilities to address potential tax exposures related to business and income tax positions we have taken that could be challenged by taxing authorities.
When deemed necessary, we establish valuation allowances to reduce deferred tax assets to amounts more-likely-than-not to be realized. This requires an assessment of both positive and negative evidence when determining whether it is more-likely-than-not that deferred tax assets will be realized. Evidence considered during 2009, and again in 2010, included the existence of cumulative three-year losses, changes in backlog, current year loss and the negative impact of current economic conditions, which resulted in our continuing to record a valuation allowance to offset net deferred tax assets in domestic and certain foreign taxing jurisdictions.
Noncontrolling interests
Our consolidated financial statements include the accounts of CPAC. Although our ownership in CPAC is less than 50%, we are the primary beneficiary of CPAC and have consolidated CPAC, due to our overall control of CPAC’s activities and our ownership interest in CPAC. Therefore, CPAC’s outside stockholders’ interests are shown in our consolidated financial statements as “Noncontrolling interests.” If CPAC obtains additional third-party funding, we expect our ownership percentage to continue to decline.
Results of Operations
The following table sets forth certain elements from our consolidated statements of operations as a percentage of revenue for the periods indicated:
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Revenue
Revenue by geographic region for the years ended December 31, 2010 and 2009 was as follows (in thousands):
Product revenue increased $20.8 million, or 17%, between periods. This increase was attributable to 16% more Systems installed and accepted during the year ended December 31, 2010 compared to the year ended December 31, 2009. Average System selling prices during the year ended December 31, 2010 decreased 2% from selling prices during the year ended December 31, 2009. This decline includes the impact of selling refurbished systems in 2010, which did not occur in 2009. Refurbished systems have a lower selling price than new systems, which drove the reduction. Additionally, we sold more optional equipment and software enhancements in 2010 as compared to 2009.
Service and other revenue increased $10.6 million, or 24%, between years. This increase was primarily attributable to an increase in service contract revenue, as we had 21% more Systems that were covered under service contracts at December 31, 2010 as compared to December 31, 2009 as well as a slight increase in the average price per contract.
No single customer accounted for more than 10% of our revenue for the year ended December 31, 2010 or 2009.
Cost of revenue
Cost of revenue increased to $148.4 million for the year ended December 31, 2010 from $133.1 million for the year ended December 31, 2009, an increase of $15.3 million, or 12%. The increase in cost of revenue was primarily due to higher product costs related to more Systems being installed and accepted and higher service and other costs to support the increase in our installed base. Our gross profit was 24.0% for the year ended December 31, 2010 compared to 18.9% for the year ended December 31, 2009. The increase in our gross profit percentage for the year ended December 31, 2010 was the result of higher System volume, an increase in higher margin option sales and improved service margin.
Product costs increased by $6.8 million, or 11%, for the year ended December 31, 2010 compared to the year ended December 31, 2009. This increase was primarily due to higher System sales volume. While total product costs increased, margins improved due to an increase in sales of higher margin options and better leverage of fixed costs.
Total service and other costs increased by $8.6 million for the year ended December 31, 2010 compared to the year ended December 31, 2009. The increase was due to a 21% increase in the number of units under service contract at December 31, 2010 as compared to December 31, 2009. The increase also reflected $2.4 million we expended for our “Fast Track” program, which we believe will reduce service costs in the future, and a charge to reduce our estimate of net realizable value of certain inventory items by $2.2 million. Although service costs have increased overall, service margins have improved 15.7% year over year due to reduced employee and other service support costs per service contract.
Warranty expenses increased $1.1 million for the year ended December 31, 2010 compared to the year ended December 31, 2009, due an increase in the weighted average number of systems covered by warranty, partially offset by a reduction in the average warranty cost per system.
Research and development expenses
Research and development expenses by category for the years ended December 31, 2010 and 2009 were as follows (in thousands):
Total research and development expenses increased $5.9 million, or 21%, between years. System research and development activities increased by $5.4 million primarily due to a $3.5 million decrease in capitalized internal software development costs, a $0.9 million increase in employee costs and a $1.7 million increase in consulting expense offset by a decrease in test system amortization of $0.6 million for the year ended December 31, 2010 as compared to the year ended December 31, 2009. The proton therapy research project spending increased $0.5 million for the year ended December 31, 2010 when compared to the year ended December 31, 2009.
Selling, general and administrative expenses
Selling, general and administrative expenses increased to $51.8 million for the year ended December 31, 2010 from $48.2 million for the year ended December 31, 2009, an increase of $3.6 million, or 7%. The increase was primarily due to a $2.8 million increase in employee costs, a $0.9 million increase in trade show expenses, a $0.8 million increase in travel costs and a $0.9 million increase in legal fees. These increases were partially offset by a $1.7 million decrease in sales concessions in the year ended December 31, 2010 compared to the year ended December 31, 2009.
Other income (expense)
We had other income of $1.7 million and $2.1 million for the years ended December 31, 2010 and 2009, respectively. The $0.4 million decrease was primarily due to a $1.1 million decrease in interest income, as our investment balances and interest rates were lower during the year ended December 31, 2010 than during the year ended December 31, 2009, partially offset by the favorable impact of foreign currency exchange rates.
Income tax expense (benefit)
For the year ended December 31, 2010, we recorded an income tax expense of $0.1 million resulting in an effective income tax rate of (0.4)%. The effective tax rate for the year ended December 31, 2010 differed significantly from the statutory tax rate primarily due to recording a valuation allowance for deferred tax assets in domestic and certain foreign taxing jurisdictions that are not “more-likely-than-not” to be realized. For the year ended December 31, 2009, we recorded an income tax benefit of $(0.3) million resulting in an effective income tax rate of 0.7%, which included the aforementioned valuation allowance for deferred tax assets.
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
Revenue
Revenue by geographic region for the years ended December 31, 2009 and 2008 was as follows (in thousands):
Product revenue decreased $54.4 million, or 31%, between years. The decrease was primarily due to a $45.1 million decline in revenue related to a lower number of Systems installed and accepted during 2009 as compared to 2008. Also contributing to the decrease was a $6.0 million reduction in revenue related to a 5% decline in the System’s average selling price during 2009 from 2008, which was primarily caused by a 10% decrease in the System’s average selling price in Europe and the Middle East due largely to a decline in foreign currency exchange rates. In addition, revenue related to our optional software packages decreased by $1.5 million. Finally, we recognized a net reduction to revenue of $1.4 million during 2009 related to our transition of Japanese distributors.
Service and other revenue increased $13.8 million, or 47%, between periods. This increase was primarily attributable to an increase in service contract revenue, as more Systems moved from warranty to service contract coverage. There were 50% more units covered by service contracts at December 31, 2009 as compared to December 31, 2008.
No single customer accounted for more than 10% of our revenue for the year ended December 31, 2009 or 2008.
Cost of revenue
Cost of revenue decreased to $133.1 million for the year ended December 31, 2009 from $155.1 million for the year ended December 31, 2008, a reduction of $22.0 million, or 14%, and, overall, our gross margin was 18.9% for the year ended December 31, 2009 compared to 24.2% for the year ended December 31, 2008. Although manufacturing period expenses increased, the increase was more than offset by decreases in product costs due to the installation and acceptance of fewer Systems in 2009 as compared to 2008, as well as lower total service and support costs and warranty expenses.
Manufacturing period expenses increased by $2.0 million for the year ended December 31, 2009 as compared to the year ended December 31, 2008. This increase was primarily due to our decision to slow manufacturing activity during the first six months of 2009, which led to an increase in unabsorbed costs.
Total service and support costs decreased by $2.6 million for the year ended December 31, 2009 compared to the year ended December 31, 2008. Although there was a $9.4 million increase in our overall service contract costs during 2009 due to the larger number of Systems under service contract at December 31, 2009 as compared to December 31, 2008, such increase was more than offset by several factors, including (a) an $11.1 million decline in service infrastructure costs, as travel and overtime expenses decreased $4.8 million due to a lower number of service repair interventions to our installed base, costs associated with component and software upgrades to the installed base decreased $3.3 million, employee costs decreased $0.7 million, as fewer employees were engaged in customer support activities, and outside services decreased $0.7 million, as we incurred additional expenses during 2008 related to our Japanese distributor transition, and (b) a $1.0 million decrease in our excess and obsolete service inventory provision due to an overall reduction in our spare parts inventory and improved inventory management.
Warranty expenses decreased $7.5 million, or 62%, for the year ended December 31, 2009 compared to the year ended December 31, 2008, as fewer warranty service calls were required due to the improved overall performance of our installed base of Systems. In addition, our average annual cost per direct warranty unit declined 22% from 2008, due mainly to decreases in labor and parts costs, and our base of units under warranty declined 15% from 2008 due to a lower number of Systems installed and accepted during 2009.
During 2009, we continued to make progress related to the financial performance of our service contracts. We charge each service contract with the direct costs associated with performing service at the particular site, including direct labor, overhead, parts and freight. During 2009, we serviced our growing installed base of Systems with a smaller staff of field engineers, invested in training our personnel to improve their diagnostic capabilities and redesigned certain System components. As a result, our average annual cost per direct service contract declined 12% in 2009 as compared to 2008.
Research and development expenses
Research and development expenses by category for the years ended December 31, 2009 and 2008 were as follows (in thousands):
Total research and development expenses decreased $14.9 million, or 35%, between periods. System research and development activities decreased by $10.6 million primarily due to a $4.2 million reduction in project spending, as we focused our spending mainly on high priority projects and a $2.4 million decrease in employee costs, as fewer employees were engaged in research and development activities. We also capitalized internal development costs of $3.6 million during 2009 related to certain software options that were under development as compared to $0.2 million in capitalized internal development costs during 2008. The proton therapy research project spending decreased by approximately $4.3 million during 2009, as CPAC slowed its development activities during the first quarter of 2009 until it received additional third-party capital and reduced consultant fees by $2.1 million during the second half of 2009 due to funding limitations.
Selling, general and administrative expenses
Selling, general and administrative expenses increased to $48.2 million for the year ended December 31, 2009 from $46.3 million for the year ended December 31, 2008, an increase of $1.9 million, or 4%. The increase was primarily due to a $2.1 million expense recorded during 2009 related to our transition of Japanese distributors, a $1.7 million increase in selling costs due to our decision to provide concessions in response to customer requests for product support, a $1.3 million increase in facility, insurance and test system costs and a $1.3 million increase in bonus expense, as we established a discretionary provision during 2009. The increases were largely offset by a $3.2 million reduction in commission expenses due to the lower volume of Systems ordered or accepted during 2009 and a $1.4 million decrease in travel expenses.
Other income (expense)
We had other income of $2.1 million and $5.7 million for the years ended December 31, 2009 and 2008, respectively, a decrease of $3.6 million, or 63%. The decrease was primarily due to a $2.2 million decline in interest income, as our average investment balances and interest rates were lower during 2009 as compared to 2008. In addition, we experienced an unfavorable impact from foreign currency exchange of $1.2 million, as the value of the U.S. dollar decreased during 2009.
Income tax expense (benefit)
We recorded an income tax benefit of $(0.3) million for the year ended December 31, 2009. For the year ended December 31, 2008, we recorded income tax expense of $6.9 million. Although we had a net loss during 2008, we established a $21.1 million valuation allowance against deferred tax assets in domestic and foreign jurisdictions, which resulted in an expense rather than a benefit for the year.
Liquidity and Capital Resources
To date, we have funded our working capital and capital expenditure requirements using cash generated from sales of equity securities and, to a lesser extent, borrowings. From our inception through December 31, 2010, we obtained financing of $260.2 million primarily through public and private placements of equity securities and the exercise of stock options.
Financial Condition
Our cash, cash equivalents and short-term investments were $152.1 million at December 31, 2010, compared to $154.3 million at December 31, 2009, a decrease of $2.2 million, or 1%. Information regarding short-term investments, which totaled $28.2 million at December 31, 2010, is set forth in the following table (in thousands):
Our working capital, which is calculated by subtracting our current liabilities from our current assets, was $135.1 million at December 31, 2010 compared to $161.8 million at December 31, 2009, a decrease of $26.7 million, or 16.5%. Our shareholders’ equity was $162.6 million at December 31, 2010 compared to $183.4 million at December 31, 2009, a decrease of $20.8 million, or 11.3%. The decreases in our working capital and our shareholders’ equity were primarily related to our operating loss during 2010.
In 2009, we instituted a working capital management program that focused on improving cash flow related to current assets and liabilities. This program is a significant driver behind the Company’s ability to minimize the cash use from operations. While this program has been successful, our ability to continue to generate cash from working capital in future periods is uncertain.
Cash Flows
Cash flows from operating activities
Net cash used in operating activities was $1.8 million for the year ended December 31, 2010. This included a net loss of $36.8 million, which was partially offset by the following noncash items: $9.7 million of depreciation and amortization and $7.9 million of share-based compensation. The net use of cash was further reduced by changes in operating assets and liabilities, which resulted in a source of cash of $17.4 million for the year ended December 31, 2010, largely driven by increased accounts payable due to increased manufacturing activity levels, and higher accrued expenses which resulted from a higher bonus liability and distributor-related costs at the end of 2010 as compared to the end of 2009. Additionally, customer deposits increased during 2010, due to the timing of advance System payments received from customers.
Net cash used in operating activities was $1.0 million for the year ended December 31, 2009. This included a net loss of $42.5 million, which was adjusted for the following noncash items: $10.7 million of depreciation and amortization and $6.3 million of share-based compensation. Receivables decreased by $8.8 million due to improved collections and a lower volume of System shipments and acceptances during the latter part of 2009. Inventory decreased by $14.5 million due to fewer finished and semi-finished Systems in stock at December 31, 2009 compared to December 31, 2008 and to lower service spare parts inventory, as we eliminated several of our global inventory depots in 2009. Accrued warranty decreased by $3.3 million, as our average cost to service a unit under warranty declined as a result of improved overall performance of our installed base of Systems and our base of units under warranty decreased due to a decline in Systems installed and accepted during 2009. Deferred revenue increased by $8.6 million due largely to an increase in deferred service contract revenue from our growing installed base and to an increase in the number of Systems that were awaiting customer acceptance as of December 31, 2009 compared to December 31, 2008. Customer deposits decreased by $2.2 million due to a decline in incoming orders received during 2009.
Net cash used in operating activities was $35.7 million for the year ended December 31, 2008. This included a net loss of $40.6 million, which was adjusted for the following noncash items: $8.7 million of depreciation and amortization, $7.3 million of deferred income tax expense and $4.7 million of share-based compensation. Receivables decreased by $1.9 million primarily due to higher collections, as the average number of days our receivables were outstanding improved to 45 days as of December 31, 2008 from 50 days as of December 31, 2007. Inventory increased by $10.3 million due to a larger number of finished Systems awaiting shipment and to an increase in the number of global inventory depots for the stocking of spare parts. Accounts payable decreased by $9.8 million, as our inventory purchasing decreased as a result of our decision to slow manufacturing activity during the fourth quarter of 2008. Accrued expenses decreased by $5.3 million due primarily to the decrease of bonus, commission and warranty accruals. Deferred revenue increased by $12.5 million due largely to an increase in deferred service contract revenue, as more customers entered into service contracts due to growth in the installed base. In addition, two Systems were awaiting customer acceptance as of December 31, 2008 compared to none as of December 31, 2007. Customer deposits decreased by $4.8 million due to a lower number of new orders received during the fourth quarter.
Cash flows from investing activities
Net cash provided by investing activities was $42.1 million for the year ended December 31, 2010. Cash expended for additions of property and equipment was $5.9 million and for other investing activities was $1.0 million. Net cash proceeds from the sales, maturities and purchases of short-term investments were $49.0 million.
Net cash provided by investing activities was $3.7 million for the year ended December 31, 2009, as we received $17.4 million in proceeds from the sales and maturities of short-term investments. These proceeds were partially offset by $7.5 million in purchases of short-term investments, $4.2 million of other investing activities, which included $3.6 million of capitalized internal development costs related to new software products, and $2.0 million in capital expenditures for tools and equipment to support our operations and new computer hardware and software.
Net cash used in investing activities was $100.1 million for the year ended December 31, 2008, as we invested $131.9 million in short-term investments with a third-party investment manager. These investments were partially offset by $44.4 million in proceeds from the sales and maturities of such short-term investments. We also used $7.6 million to purchase capital equipment, which included tools and equipment to support our operations and new computer equipment, $2.8 million to purchase Systems for internal development, training and testing of manufacturing components and $2.2 million for other investing activities, primarily to purchase intangible assets.
Cash flows from financing activities
Net cash provided by financing activities was $8.7 million for the year ended December 31, 2010. Cash provided by financing activities primarily consisted of proceeds from third-party investors related to the issuance of CPAC common stock of $6.6 million, the issuance of CPAC notes payable of $0.5 million, $0.6 million in proceeds from the issuance of our common stock through our Employee Stock Purchase Plan and the exercise of stock options of $1.4 million.
Net cash provided by financing activities was $7.6 million for the year ended December 31, 2009. This included $6.9 million in proceeds from third-party investors related to the issuance of CPAC common stock, $0.6 million in proceeds from the issuance of our common stock through our Employee Stock Purchase Plan and $0.4 million in proceeds from the exercises of stock options and warrants for our common stock.
Net cash provided by financing activities was $11.1 million for the year ended December 31, 2008. This included $9.3 million in proceeds from third-party investors related to the issuance of CPAC common stock, $1.4 million in proceeds from the exercises of stock options and warrants for our common stock and $0.5 million in proceeds from the issuance of our common stock through our Employee Stock Purchase Plan.
The effect of foreign currency exchange rate changes on our cash and cash equivalents resulted in decreases of $1.1 million, $0.1 million and $1.2 million during the years ended December 31, 2010, 2009 and 2008, respectively.
Loans and Available Borrowings
On November 30, 2010, we entered into an amended revolving credit facility with M&I Marshall & Ilsley Bank under which there were no borrowings as of December 31, 2010. The available amount of the revolving credit facility is based on our maintaining certain tangible net worth and EBITDA. In the event tangible net worth and EBITDA values are not maintained at specified levels as of the end of each calendar quarter, the Bank may make corresponding adjustments in the available amount of the credit facility to a minimum of $20 million. The facility bears interest at the one-month British Bankers Association LIBOR plus an interest margin of 2.25%, adjusted based on monthly changes to such index, and payable monthly. The credit facility expires on November 30, 2011 and is collateralized by our deposit accounts. The facility requires the Company to maintain a minimum tangible net worth, a certain ratio of total liabilities to tangible net worth and a minimum level of cash and short-term investments. The Company may be considered in default upon a material adverse change in the Company’s financial condition, upon a change in ownership of 25% or more of the common stock of the Company or if the Bank believes the prospect of payment or performance of the facility is impaired. The Company was in compliance with these covenants as of December 31, 2010. The available credit as of December 31, 2010 was $30 million.
Contractual Obligations and Commitments
The following table is a summary of our long-term contractual obligations as of December 31, 2010 (in thousands):
(1)
Included in “Minimum purchase agreement” amounts are future purchase obligations underlying a supply agreement for the purchase of xenon gas detectors from Hitachi Medical Corporation on a non-exclusive basis; the agreement expires in June 2012. Refer to our Current Report on Form 8-K, dated September 10, 2010, for more information.
The table of contractual obligations and commitments does not include royalty payments payable to WARF under our license agreement with WARF. Under the license agreement, the amount of royalty payments due to WARF is based on the number of Systems sold and therefore cannot be determined accurately in advance. The license agreement requires a minimum annual payment of $0.3 million, which we have exceeded in recent years, as royalty expenses were $1.0 million in 2010, $0.8 million in 2009 and $1.3 million in 2008.
Unrecognized tax benefits of $5.0 million, excluding interest and penalties, are not included in the table of contractual obligations and commitments, as their resolution cannot be reasonably estimated.
Pending Litigation
Securities Litigation
On May 30, 2008 and June 10, 2008, two separate complaints were filed by certain of our shareholders in the U.S. District Court for the Western District of Wisconsin (the Court) against us and certain of our officers and all of our independent directors during the period in question. The complaints were consolidated on October 23, 2008. In the consolidated action (the 2008 Securities Litigation), the plaintiffs allege that the defendants violated the Securities Act with respect to statements made in connection with the initial and secondary public offerings of our common stock and the Exchange Act by misrepresenting our projected financial outlook during the period May 9, 2007 through April 17, 2008. The named plaintiffs, Michael Schultz, John Scala, et al., seek to represent persons who purchased our securities between those dates and who were damaged as a result of the decline in the price of our stock between those dates, allegedly attributable to the financial misrepresentations, and seek compensatory damages in an unspecified amount.
We moved to dismiss the consolidated complaint on December 8, 2008. On July 9, 2009, the Court ruled on the motion to dismiss the consolidated complaint by dismissing without prejudice all claims under the Exchange Act and all but one claim under the Securities Act for failure to state a claim upon which relief could be granted. On August 3, 2009, the plaintiffs amended the consolidated complaint by filing their Second Amended Consolidated Complaint (the Amended Complaint). We moved to dismiss the Amended Complaint on September 3, 2009, and on December 15, 2009, the Court granted this second motion to dismiss in part and denied it in part. The plaintiffs have moved for class certification.
However, on July 28, 2010, we entered into an agreement to settle the 2008 Securities Litigation. Under the proposed settlement, the claims against us and our officers and directors stated in the Amended Complaint would be dismissed with prejudice and released in exchange for a cash payment of $5.0 million to be funded by our insurance carrier. The proposed settlement remains subject to the satisfaction of various conditions, including negotiation and execution of a final stipulation of settlement and approval by the Court following notice to members of the purported class. On September 20, 2010, the Court preliminarily approved the terms for distribution of the settlement fund, which has been placed in escrow, to purported class members, less fees awarded by the Court to class counsel, and other terms of the settlement. Class members were notified and given until January 18, 2011 to opt out of the class or file claims. Final court approval of the settlement is expected to occur in the first half of 2011.
We continue to believe that we have substantial legal and factual defenses to the allegations contained in the Amended Complaint, and we intend to pursue these defenses vigorously if the proposed settlement is not finalized and approved by the Court. If the settlement is not finalized and the 2008 Securities Litigation instead continues, although we carry insurance for these types of claims and related defense costs, a judgment significantly in excess of our insurance coverage could materially and adversely affect our financial condition, results of operations and cash flows. As of December 31, 2010, we estimated that our potential loss from these claims and related defense costs will not exceed our insurance deductible of $0.5 million, whether or not the proposed settlement is finalized and approved by the Court.
Stockholder Derivative Actions
On May 28, 2010 and July 9, 2010, two separate derivative lawsuits were filed in the Circuit Court of Dane County in Madison, Wisconsin by certain of our shareholders against (a) certain of our officers and all of the persons who have served as our directors since May 9, 2007 (collectively, the Individual Defendants) and (b) us, as nominal defendant. In their respective complaints (together, the Complaints), each of the named plaintiffs, The Dixon Family Living Trust and David Huh, allege that all of the Individual Defendants breached their fiduciary duties and engaged in abuse of control, gross mismanagement and waste of corporate assets, and that certain Individual Defendants were unjustly enriched. The Complaints were consolidated on October 11, 2010. The allegations are substantially similar to those claims made in the 2008 Securities Litigation. The Complaints seek damages, equitable relief, restitution and disgorgement of profits, costs and disbursements of the action, and other relief the court deems proper.
In March 2010, we received two shareholder demand letters from attorneys representing other shareholders (together, the Demand Letters) containing allegations substantially similar to those made in the Complaints. To our knowledge, as of the date of this Annual Report on Form 10-K, no lawsuits have been filed against us or any Individual Defendants in connection with the Demand Letters.
On February 9, 2011, the parties entered into a Memorandum of Understanding (MOU) expressing their intention to seek court approval to settle the derivative lawsuits. Under the proposed settlement as outlined in the MOU, the claims against our officers and directors, and nominally against us asserted in both the Complaints and the Demand Letters would be dismissed with prejudice and released in exchange for an attorneys’ fees payment of $275,000, of which $25,000 would be paid by us and the remaining $250,000 by our insurance carrier, as well as implementation by us of a number of corporate governance changes. The proposed settlement remains subject to the satisfaction of various conditions, including approval by the Court and notice to the public.
We and the Individual Defendants believe that there are substantial legal and factual defenses to the allegations contained in the Complaints. Moreover, we and the Individual Defendants carry insurance for these types of claims and related defense costs. As of December 31, 2010, we estimated that we would not incur any material costs in connection with these claims or the defense thereof, given that we have already paid the applicable $0.5 million insurance deductible in connection with the 2008 Securities Litigation.
Reserve for Contingency
During 2008, we terminated our distribution agreement with Hi-Art Co., Ltd. (Hi-Art), our former distributor in Japan. Effective January 1, 2009, we entered into an agreement with Hitachi Medical Corporation (Hitachi) to serve as our new distributor in Japan.
In connection with the termination, we entered into an agreement with Hi-Art to acquire certain assets, such as inventory and the regulatory license, and to compensate Hi-Art for certain sales prospects, which we expected to close during the first quarter of 2009. While we ultimately were able to transfer some assets to Hitachi in order to support the transition, we incurred additional costs and experienced delays. As a result, the agreement to acquire the identifiable assets remains open and unsettled.
In July 2009, Hi-Art filed a complaint against us in the Tokyo District Court seeking compensation it claims is owed under the asset acquisition agreement. Although we believe that we have substantial legal and factual defenses to Hi-Art’s allegations and intend to pursue these defenses vigorously, there can be no assurance that we will prevail. Accordingly, we maintain a reserve with respect to this matter. We may change the amount of such reserve from time to time in the future due to new developments or changes in strategy related to this matter.
Operating Capital and Capital Expenditure Requirements
Our future capital requirements depend on numerous factors. These factors include, but are not limited to, the following:
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Revenue generated from sales of Systems and service contracts;
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The performance of the Systems operating in the field and corresponding service costs;
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The level of investment required by our service and support organization;
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The level of investment required for research and development activities;
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Costs associated with our manufacturing, sales and marketing and general and administrative activities, CPAC spending; and
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Effects of competing technological and market developments.
The global economy remains volatile and could have potentially negative effects on our near-term liquidity and capital resources, including slower collection of receivables, delays in the delivery of existing orders and postponements of incoming orders. However, we believe that our cash, cash equivalents and short-term investments as of December 31, 2010 will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. As of December 31, 2010, we had $152.1 million of cash, cash equivalents and short-term investments. We do not expect to draw on our line of credit, and we believe our financial position will remain strong through 2011. Moreover, we continue to manage our cash resources and are carefully monitoring our ongoing expenditures.
Off-Balance Sheet Arrangements
As of December 31, 2010, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of our financial condition and results of operations are based upon our 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 financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base these estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
We believe the following accounting policies and estimates are most critical to understanding our financial statements because they inherently involve significant judgments and uncertainties.
Revenue Recognition
In September 2009, the Financial Accounting Standards Board (FASB) amended the accounting guidance on revenue recognition. Under the amended guidance (“new revenue guidance”), consideration in a multiple element arrangement may now be allocated in a manner that more closely reflects the structure of the transaction. Also, under the new revenue guidance, tangible products that contain software components essential to the functionality of the tangible product will no longer be subject to software revenue recognition.
We elected to early adopt this new revenue guidance as of January 1, 2010 on a prospective basis for applicable arrangements originating or materially modified after that date. For 2010, adoption of the new revenue guidance did not have a material impact on our consolidated financial statements and we do not expect the new revenue guidance will have a material impact on our consolidated financial statements in future periods.
We recognize revenue from System sales, including sales to distributors, and related services, when earned. Revenue is recognized when the following criteria are met: persuasive evidence of an arrangement exists, title and risk of loss have been transferred to the customer, the sales price is fixed or determinable and collection is reasonably assured.
Payments received for products prior to shipment are recorded as customer deposits. Once a System has been shipped, the related deposits are transferred to deferred revenue until the criteria for revenue recognition are satisfied.
We recognize revenue in connection with distributor sales of the System based on the distributor’s certification status. If a distributor is certified by us to provide installation, testing, training and post-installation warranty services to end customers, we recognize revenue upon shipment to that certified distributor, at which time our only remaining obligation is our post-installation warranty services to the distributor. We recognize revenue for direct sales and sales through distributors that are not certified upon receipt of the signed acceptance procedure document from the end customer. Distributors do not have any contractual right of return for Systems, and we have not accepted any System returns from any distributor.
We frequently enter into sales arrangements with customers that contain multiple elements or deliverables such as hardware and post-warranty maintenance services. For such arrangements, we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, the new revenue guidance establishes a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). Under previous guidance, in instances when evidence of VSOE of all undelivered elements exists, evidence does not exist for one or more delivered elements and the fair value of all of the undelivered elements is less than the arrangement fee, revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. The residual method of accounting for revenue from multiple element arrangements is no longer permitted for transactions subject to the new revenue guidance. Under the new revenue guidance, revenue allocated to each element is recognized as the element is delivered to the customer.
Payments received for post-warranty maintenance services on Systems are recorded as deferred revenue upon receipt and are recognized as revenue ratably over the term of the contract, which generally ranges from twelve to sixty months.
We sell optional software packages for which the selling price, cost and functionality are incidental to the operation of the System itself. We recognize revenue for these optional software packages when all of the following criteria are met: persuasive evidence of an arrangement exists, the fee is fixed or determinable, collection of the related receivable is reasonably assured and delivery of the product has occurred, provided that all other criteria for revenue recognition have been met. Revenue earned on software arrangements involving multiple elements is allocated to each element using the hierarchy in the new revenue guidance.
We record all revenue net of any governmental taxes.
Inventories
Inventories are valued at the lower of cost or market, determined by the first-in, first-out method. We regularly review our inventory quantities on hand and record a provision for excess or obsolete inventory primarily based on our estimated forecast of product demand and existing product configurations. Our inventories may become obsolete due to the rapid technological change in our industry. As changes to the System are released, a determination must be made to identify any parts that are no longer useful. If a part is determined to be obsolete, a reserve is recorded for the value of the inventory of such on hand. We also forecast usage and compare this with the quantity of parts on hand. Additionally, we periodically reclaim select parts from a system as part of our warranty and service activities. These parts can be refurbished and reused in future warranty and service activities, so we estimate the fair value of these parts and record them as inventory, less an allowance for the estimated costs to refurbish. We regularly review the estimate of fair value of these parts and reduce the carrying value of our inventories for differences between the cost and estimated net realizable value, taking into consideration usage in the preceding twelve months, expected demand, technological obsolescence and other information.
Warranty Obligations
We warrant the Systems for a contractually determined period, typically twelve months, following customer acceptance. Upon revenue recognition of each System sale, we accrue a warranty obligation liability for the expected costs. The accrued warranty obligation costs, which are recorded to cost of revenue, represent our best estimate of the total costs that we expect to incur to repair or replace parts that fail while a System is under warranty. We monitor warranty costs both to update the historical trend data and to determine if the accrued balance is sufficient to meet our outstanding warranty obligations.
Income Taxes
We utilize the liability method of accounting for income taxes. Accordingly, we are required to estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, together with assessing temporary differences resulting from different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Due to the evolving nature and complexity of tax laws combined with the large number of jurisdictions in which we operate, it is possible that our estimates of our tax liability could change in the future, which may result in additional tax liabilities and adversely affect our results of operations, financial condition and cash flows. Under the liability method, a deferred tax asset or liability is determined based on the difference between the financial statement and tax basis of assets and liabilities, as measured by the enacted tax rates.
During 2008, we recorded a 100% valuation allowance reserve against our net deferred tax assets in domestic and certain foreign jurisdictions. We assessed both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. The valuation allowance was established based on our three-year cumulative net loss as of December 31, 2008 and our near-term financial forecasts. As a result, we believe that there is a more likely than not possibility that we will not be able to realize the net deferred tax assets during the foreseeable future. During 2010 and 2009, we maintained a full valuation allowance against net deferred tax assets in domestic and certain foreign jurisdictions primarily based on the substantial book loss incurred during each of those years.
Our practice for accounting for uncertainty in income taxes is to recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not criteria, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. Upon adoption, we applied this policy to all tax positions for which the statute of limitations remained open. The unrecognized tax benefits relate primarily to federal and state research tax credits.
Investment in CPAC
Our consolidated financial statements include the accounts of TomoTherapy Incorporated, its wholly-owned subsidiaries and CPAC. Although our ownership in CPAC is less than 50%, we have consolidated CPAC, as Tomo is the primary beneficiary of CPAC, due to its overall control of CPAC’s activities and Tomo’s ownership interest. Therefore, CPAC’s outside stockholders’ interests are shown in our consolidated financial statements as “Noncontrolling interests.” Intercompany balances and transactions have been eliminated in consolidation.
Share-Based Compensation
Share-based compensation to employees, including grants of employee stock options and stock sold pursuant to employee stock purchase plans, is measured at fair value and expensed in the consolidated statements of operations over the service period of the grant, which is generally the vesting period. We use the Black-Scholes option-pricing model to value stock options. We use the historical stock prices of a peer group of companies as the basis for our volatility assumptions. The assumed risk-free rates are based on U.S. Treasury rates in effect at the time of grant with a term consistent with the expected option lives. We employ the simplified method of estimating the expected term of the options, as we do not have significant historical experience. The forfeiture rate is based on past history of forfeited options. The expected dividend yield is based on our history of not paying dividends. We continue to account for options issued prior to January 1, 2006 under an intrinsic value method.
Capitalized Software Development Costs
Software development costs incurred prior to the establishment of technological feasibility are expensed when incurred and are included in research and development expense. Technological feasibility is evaluated for each software version developed and can occur early or later in the development cycle depending on the nature of the development project. Once the software has reached technological feasibility, all subsequent software development costs are capitalized until that software is released for sale. After the software is released for sale, the capitalized software development cost is amortized over the software’s useful life, and the related expense is charged to cost of revenue. We review our capitalized software development costs for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.
Recent Accounting Pronouncements
In June 2009, the FASB issued revised guidance for the accounting of variable interest entities. This revised guidance replaces the quantitative-based risks and rewards approach with a qualitative approach that focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits from the entity that could be potentially significant to the variable interest entity. The accounting guidance also requires an ongoing reassessment of whether an enterprise is the primary beneficiary and requires additional disclosures about an enterprise’s involvement in variable interest entities. The adoption of this accounting guidance, which became effective for us in 2010, did not have a material impact on our consolidated financial statements.
In January 2010, the FASB amended its guidance for disclosures about fair value measurements by requiring disclosures about transfers of assets in and out of Levels 1 and 2, and activity in Level 3 fair value measurements, within the three-tier fair value hierarchy. The disclosure requirements in the amended guidance are effective for annual reporting periods beginning after December 15, 2010, and should be used for interim and annual reporting periods. These disclosures did not have a material effect on our consolidated financial statements and it is expected that these disclosures will not have a material effect on our consolidated financial statements in future periods.
In July 2010, the FASB amended its guidance on disclosures for financing receivables with the intention of providing additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosure requirements in the amended guidance that are as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this accounting guidance did not have a material effect on end of year reporting disclosures in our consolidated financial statements. It is expected that disclosures about activity will not have a material effect on our consolidated financial statements in future periods.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Market risk relates to changes in market prices of financial instruments that may adversely impact our consolidated financial position, results of operations or cash flows. Such risks include changes in interest rates, foreign currency exchange rates and inflation.
Interest Rate Risk
Our investments consist primarily of money market funds and short-term marketable debt securities. While the instruments we hold are subject to changes in the financial standing of the issuer of such securities, we do not believe that we are subject to any material risks arising from changes in interest rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments primarily due to the short-term nature of our investments. It is our policy not to enter into interest rate derivative financial instruments. We do not currently have any significant interest rate exposure.
The interest rate under our revolving credit facility is subject to change based on the London Interbank Offered Rate. We do not currently have any borrowings under our revolving credit facility.
Foreign Currency Exchange Rate Risk
A significant portion of our sales and expenses historically have been denominated in U.S. dollars. Although the percentage of sales denominated in foreign currencies has risen in 2010 and we anticipate this trend may continue, we have not experienced significant foreign currency exchange gains or losses to date. For the year ended December 31, 2010, approximately 30% of our product revenue was derived from contracts denominated in Euros, Swiss Francs, Canadian Dollars, British Pounds and Swedish Krona. For the year ended December 31, 2009, approximately 20% of our product revenue was derived from contracts denominated in Euros, Swiss Francs, Canadian Dollars, British Pounds and Swedish Krona. We operate and staff an office in Brussels, Belgium and have multiple international subsidiaries, for which we incur foreign currency-denominated expenses that are paid directly from the U.S. These expenses represented approximately 24% of our total operating expenses in 2010. We currently do not hedge our foreign currency exchange rate risk, since the exposure has not been material to our historical operating results. To date, our Euro-denominated sales orders have included significant down payments, limiting the need to hedge the related currency exchange rate risk. Future fluctuations in the value of the U.S. dollar may affect the price competitiveness of the Systems outside the United States. To the extent that we can predict the timing of payments under these contracts, we may engage in hedging transactions to mitigate such risks in the future.
Inflation Risk
Our operations have not been, and we do not expect them to be, materially affected by inflation. Historically, we have been successful in adjusting prices to our customers to reflect changes in our material and labor costs.
Item 8.
Item 8.
Financial Statements and Supplementary Data
TomoTherapy Incorporated and Subsidiaries
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
TomoTherapy Incorporated:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, shareholders’ equity (deficit) and cash flows present fairly, in all material respects, the financial position of TomoTherapy Incorporated and its subsidiaries at December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule of Valuation and Qualifying Accounts as of and for the years ended December 31, 2010 and 2009, presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Chicago, Illinois
March 3, 2011
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
TomoTherapy Incorporated
We have audited the accompanying consolidated statements of operations, shareholders’ equity (deficit), and cash flows of TomoTherapy Incorporated (a Wisconsin corporation) and subsidiaries (the Company) for the year ended December 31, 2008. Our audit of the basic financial statements included the financial statement schedule listed in the index appearing under item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of the Company's operations and cash flows for the year ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
/s/ GRANT THORNTON LLP
Milwaukee, Wisconsin
March 12, 2009 (except for the retrospective adoption of new accounting guidance related to noncontrolling interests described in Note B, as to which the date is March 11, 2010)
TOMOTHERAPY INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
TOMOTHERAPY INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
TOMOTHERAPY INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
TOMOTHERAPY INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)
(In thousands)
The accompanying notes are an integral part of these consolidated statements.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - DESCRIPTION OF BUSINESS
The organization is comprised of TomoTherapy Incorporated, a Wisconsin corporation (Tomo), its wholly-owned subsidiaries and its minority-owned affiliate (collectively, together with Tomo, the Company). Tomo and its wholly-owned subsidiaries (TomoTherapy) develop, manufacture, market and sell advanced radiation therapy solutions to treat a wide range of cancer types. The treatment systems in TomoTherapy’s platform (collectively, the System or Systems) include: (1) the Hi Art treatment system, which delivers CT-guided, helical intensity-modulated radiation therapy (IMRT) treatment fractions, (2) the TomoHD treatment system, which includes both the TomoHelical and TomoDirect treatment modalities, and (3) the TomoMobile treatment system, which is a relocatable radiation therapy solution. TomoTherapy markets and sells its products to hospitals and cancer treatment centers in the Americas, Europe, the Middle East and Asia-Pacific. Compact Particle Acceleration Corporation (CPAC), Tomo’s controlled, minority-owned affiliate, is an enterprise focused on the development of a proton therapy system.
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The Company’s consolidated financial statements include the accounts of CPAC. Although Tomo’s ownership in CPAC is less than 50%, it has consolidated CPAC, as Tomo is the primary beneficiary of CPAC, due to its overall control of CPAC’s activities and Tomo’s ownership interest in CPAC. CPAC’s outside stockholders’ interests are shown in the Company’s condensed consolidated financial statements as “Noncontrolling interests.” Intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the years presented. Actual results could differ from those estimates.
Fair Value of Financial Instruments
The Company’s financial instruments consist primarily of cash and cash equivalents, short-term investments, accounts receivable, accounts payable and long-term debt. The carrying values of cash and cash equivalents, accounts receivable, accounts payable and long-term debt approximate their respective fair values. The fair value of short-term investments is based on quoted prices for similar items in active markets.
Receivables, net
The Company’s receivables, which are mainly due from hospitals and cancer treatment centers, arise from the sale of goods and services, and generally have contractual maturities of one year or less. Credit is extended based on evaluation of a customer’s financial condition, and collateral is not generally required. Accounts receivable are due in accordance with contract terms and are considered past due if not paid within 30 days of contract terms. In addition, the Company frequently enters into sales contracts for the Systems that require advance payments from customers. The Company’s allowance for doubtful accounts reflects its best estimate of probable losses inherent in its accounts receivable balance. The Company determined the allowance based on known troubled accounts, historical experience and other available evidence.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Revenue Recognition
In September 2009, the Financial Accounting Standards Board (FASB) amended the accounting guidance on revenue recognition. Under the amended guidance (“new revenue guidance”), consideration in a multiple element arrangement may now be allocated in a manner that more closely reflects the structure of the transaction. Also, under the new revenue guidance, tangible products that contain software components essential to the functionality of the tangible product will no longer be subject to software revenue recognition.
The Company elected to early adopt this new revenue guidance as of January 1, 2010 on a prospective basis for applicable arrangements originating or materially modified after that date. For 2010, adoption of the new revenue guidance did not have a material impact on its consolidated financial statements, and the Company does not expect the new revenue guidance will have a material impact on its consolidated financial statements in future periods.
The Company recognizes revenue from System sales, including sales to distributors, and related services, when earned. Revenue is recognized when the following criteria are met: persuasive evidence of an arrangement exists, title and risk of loss have been transferred to the customer, the sales price is fixed or determinable and collection is reasonably assured.
Payments received for products prior to shipment are recorded as customer deposits. Once a System has been shipped, the related deposits are transferred to deferred revenue until the criteria for revenue recognition are satisfied.
The Company recognizes revenue in connection with distributor sales of Systems based on the distributor’s certification status. If a distributor is certified by the Company to provide installation, testing, training and post-installation warranty services to end customers, the Company recognizes revenue upon shipment to that certified distributor, at which time the Company’s only remaining obligation is its post-installation warranty services to the distributor. The Company recognizes revenue for direct sales and sales through distributors that are not certified upon receipt of the signed acceptance procedure document from the end customer. Distributors do not have any contractual right of return for Systems, and the Company has not accepted any System returns from any distributor.
The Company frequently enters into sales arrangements with customers that contain multiple elements or deliverables such as hardware and post-warranty maintenance services. For such arrangements, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the new revenue guidance establishes a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). Under previous guidance, in instances when evidence of VSOE of all undelivered elements exists, evidence does not exist for one or more delivered elements and the fair value of all of the undelivered elements is less than the arrangement fee, revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. The residual method of accounting for revenue from multiple element arrangements is no longer permitted for transactions subject to the new revenue guidance. Under the new revenue guidance, revenue allocated to each element is recognized as the element is delivered to the customer.
Payments received for post-warranty maintenance services on the System are recorded as deferred revenue upon receipt and are recognized as revenue ratably over the term of the contract, which generally ranges from twelve to sixty months.
The Company sells optional software packages for which the selling price, cost and functionality are incidental to the operation of the System itself. The Company recognizes revenue for these optional software packages when all of the following criteria are met: persuasive evidence of an arrangement exists, the fee is fixed or determinable, collection of the related receivable is reasonably assured and delivery of the product has occurred, provided that all other criteria for revenue recognition have been met. Revenue earned on software arrangements involving multiple elements is allocated to each element using the hierarchy in the new revenue guidance.
The Company records all revenue net of any governmental taxes.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Shipping and Handling Costs
The Company records costs incurred in connection with shipping and handling products as cost of revenue. Amounts billed to customers in connection with these costs are included in revenue and are not material for any of the periods presented in the accompanying consolidated financial statements.
Capitalized Software Development Costs
Software development costs incurred prior to the establishment of technological feasibility are expensed when incurred and are included in research and development expense. Technological feasibility is evaluated for each software version developed and can occur early or later in the development cycle depending on the nature of the development project. Once the software has reached technological feasibility, all subsequent software development costs are capitalized until that software is released for sale. After the software is released for sale, the capitalized software development cost is amortized over the software’s useful life, and the related expense is charged to cost of revenue. The Company reviews its capitalized software development costs for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.
Share-Based Compensation
Share-based compensation to employees, including grants of employee stock options, restricted stock awards and stock sold pursuant to employee stock purchase plans, is measured at fair value and expensed in the consolidated statements of operations over the service period of the grant, which is generally the vesting period. The Company uses the Black-Scholes option-pricing model to value stock options. The Company uses historical stock prices of a peer group of companies as the basis for its volatility assumptions. The assumed risk-free rates are based on U.S. Treasury rates in effect at the time of grant with a term consistent with the expected option lives. The Company employs the simplified method of estimating the expected term of the options, as the Company does not have significant historical experience. The forfeiture rate is based on past history of forfeited options. The expected dividend yield is based on the Company’s history of not paying dividends. The Company continues to account for options issued prior to January 1, 2006 under an intrinsic value method.
Income Taxes
The Company recognizes deferred tax assets and liabilities for the future tax consequences of temporary differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance if, based upon management’s estimates, it is more likely than not that a portion or all of the net deferred tax assets will not be realized. The factors used to assess the likelihood of realization are primarily the forecast of future taxable income and the remaining time period to utilize any tax operating losses and tax credits.
The Company’s practice for accounting for uncertainty in income taxes is to recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not criteria, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. The unrecognized tax benefits relate primarily to federal and state research tax credits.
Concentration of Credit Risk and Other Risks and Uncertainties
The Company’s cash and cash equivalents are deposited with several major financial institutions. At times, deposits in these institutions exceed the amount of insurance provided on such deposits. The Company has not experienced any losses in such accounts and believes that it is not exposed to any significant risk on these balances.
The Company is subject to risks common to companies in the medical device industry including, but not limited to: new technological innovation, dependence on key personnel, dependence on key suppliers, protection of proprietary technology, compliance with government regulations, uncertainty about widespread market acceptance of products and potential product liability. The Company’s products include components subject to rapid technological change. Certain components used in manufacturing have relatively few alternative sources of supply and establishing additional or replacement suppliers for such components cannot be accomplished quickly. While the Company has ongoing programs to minimize the adverse effect of such uncertainty and considers technological change in estimating its allowances, uncertainty continues to exist.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The products currently under development by the Company may require clearance by the U.S. Food and Drug Administration (FDA) or other international regulatory agencies prior to commercial sales. There can be no assurance that the Company’s products will receive the necessary clearance. Denial or delay of such clearance could have a material adverse impact on the Company.
Recent Accounting Pronouncements
In June 2009, the FASB issued revised guidance for the accounting of variable interest entities. This revised guidance replaces the quantitative-based risks and rewards approach with a qualitative approach that focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits from the entity that could be potentially significant to the variable interest entity. The accounting guidance also requires an ongoing reassessment of whether an enterprise is the primary beneficiary and requires additional disclosures about an enterprise’s involvement in variable interest entities. The adoption of this accounting guidance, which became effective for the Company in 2010, did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB amended its guidance for disclosures about fair value measurements by requiring disclosures about transfers of assets in and out of Levels 1 and 2, and activity in Level 3 fair value measurements, within the three-tier fair value hierarchy. The disclosure requirements in the amended guidance are effective for annual reporting periods beginning after December 15, 2010, and should be used for interim and annual reporting periods. These disclosures did not have a material effect on the Company’s consolidated financial statements and it is expected that these disclosures will not have a material effect on the Company’s consolidated financial statements in future periods.
In July 2010, the FASB amended its guidance on disclosures for financing receivables with the intention of providing additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosure requirements in the amended guidance that are as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of this accounting guidance did not have a material effect on end of year reporting disclosures in the Company’s consolidated financial statements. It is expected that disclosures about activity will not have a material effect on the Company’s consolidated financial statements in future periods.
NOTE C - SUPPLEMENTAL FINANCIAL INFORMATION
Cash and Cash Equivalents
The Company considers all highly liquid interest-earning investments with original maturities of three months or less to be cash equivalents. The balance in the Company’s foreign cash accounts was $6.9 million and $5.9 million at December 31, 2010 and 2009, respectively.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Short-term Investments
Investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term if they are highly liquid, as such securities represent the investment of cash that is available for current operations. All short-term investments are classified as available for sale and are recorded at fair value using the specific identification method. Unrealized changes in fair value, net of tax, are reflected in the consolidated financial statements as “Other comprehensive income (loss).”
Investments consisted of the following (in thousands):
The remaining maturities of investments in debt securities were as follows (in thousands):
The Company determines the fair value of its investments using a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, as follows:
•
Level 1 - Quoted prices in active markets for identical assets or liabilities.
•
Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices 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 assets or liabilities.
•
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
As of December 31, 2010 and 2009, the Company’s financial assets, which consist of its investments, were measured at fair value employing Level 2 inputs.
Sales of short-term investments resulted in immaterial gross gains and losses for the years ended December 31, 2010, 2009 and 2008.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Inventories, net
Components of inventory include raw materials, work-in-process and finished goods. Finished goods include in-transit Systems that have been shipped to the Company’s customers or non-certified distributors, but are not yet installed or accepted by the end customer. All inventories are stated at the lower of cost or market, with cost determined by the first-in, first-out method. The Company reduces the carrying value of its inventories for differences between the cost and estimated net realizable value, taking into consideration usage in the preceding twelve months, expected demand, technological obsolescence and other information.
Costs associated with the procurement and warehousing of inventories, such as inbound freight charges and purchasing and receiving costs, are included in the cost of revenue line item within the statements of operations.
Some inventory is returned to the Company as part of its warranty and service activities, and refurbished. This refurbished inventory, once fully repaired and tested, is functionally equivalent to new production but may have a reduced useful life, and is utilized to satisfy the Company’s requirements under its warranty and service contracts. This inventory is valued at estimated fair value, and an allowance is also made for estimated refurbishment costs. In the fourth quarter of 2010 the Company recorded a charge to cost of revenue of $2.2 million to reduce our estimate of the net realizable value of certain refurbished inventory.
As of December 31, 2010 and 2009, the Company had an inventory allowance of $4.7 million and $5.1 million, respectively, which is primarily related to service spare parts inventory.
Net inventories consisted of the following (in thousands):
Property and Equipment, net
Property and equipment consisted of the following (in thousands):
Property and equipment are recorded at cost and are depreciated using the straight-line method over the following estimated useful lives:
Depreciation expense associated with property and equipment was $5.6 million, $6.1 million and $5.1 million for the years ended December 31, 2010, 2009 and 2008, respectively.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Intangible Assets
Included in other non-current assets are intangible assets which consisted of the following (in thousands):
The Company generated patents of $0.6 million in 2010 and $0.4 million in 2009 and capitalized software of $0.1 million in 2010 and $3.6 million in 2009 to maintain the competitiveness of its products. The purchased intellectual property and the Japanese sales license were acquired in 2008.
Intangible assets are amortized on the straight-line method over the estimated useful lives. Amortization expense for intangible assets was $2.4 million, $1.3 million and $0.2 million for the years ended December 31, 2010, 2009 and 2008.
At December 31, 2010, estimated amortization for each of the succeeding years on intangible assets is as follows:
Long-lived Assets
The Company reviews long-lived assets, including test systems, property and equipment and intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the sum of the expected undiscounted cash flows is less than the carrying value of the related asset or group of assets, a loss is recognized for the difference between the fair value and carrying value of the asset or group of assets. Such analysis necessarily involves significant judgment. No impairment losses were recorded on the Company’s long-lived assets during the years ended December 31, 2010 and 2009.
The Company’s foreign-based long-lived assets were $3.6 million and $2.0 million at December 31, 2010 and 2009, respectively.
Test systems, included with other non-current assets, net, at December 31, 2010 and 2009 had a cost of $15.9 million and $14.7 million, respectively, and accumulated depreciation of $13.2 million and $11.5 million, respectively. Test equipment is depreciated on the straight-line method over three years. Depreciation expense was $1.7 million, $3.3 million and $3.4 million for the years ended December 31, 2010, 2009 and 2008, respectively.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Accrued Expenses
Accrued expenses consisted of the following (in thousands):
Accrued Warranty
The Company’s sales terms include a warranty that generally covers the first year of System operation and is based on terms that are generally accepted in the marketplace. The Company records a current liability for the expected cost of warranty-related claims at the time of sale.
The following table presents changes in the Company’s product warranty liability (in thousands):
Deferred Revenue
Deferred revenue is recorded on a gross basis with the corresponding costs of revenue residing in inventory until such revenue is recognized. Deferred revenue includes amounts primarily related to services and, to a lesser extent, amounts related to product sales, including in-transit Systems that have shipped to the Company’s customers, but are not yet installed and accepted by the customer. The Company ultimately expects to recognize these amounts as revenue upon performance of the services or once the Company’s product has been delivered and accepted by the customer.
The costs of revenue associated with services primarily relate to spare parts inventory along with the direct labor charges corresponding to post-warranty maintenance, which are recognized as incurred over the term of the service contract. The costs of revenue associated with product sales are comprised primarily of finished goods inventory, along with the corresponding installation costs, which are recognized as incurred once the product has been accepted by the customer.
Deferred revenue with expected recognition dates of greater than one year are classified in the consolidated financial statements as “Other non-current liabilities.” As of December 31, 2010 and 2009, the Company’s non-current deferred revenue was $0.8 million and $2.7 million, respectively.
Research and Development Expenses
Research and development expenses consist primarily of salary and benefits for research and development personnel who design and develop future products and product enhancements. Research and development also includes expenses associated with product design and development, customer research collaborations and fees to third parties who furnish services related to these activities. Research and development costs are generally expensed as incurred.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company has entered into research collaboration agreements with selected hospitals, cancer treatment centers, academic institutions and research institutions worldwide. These agreements support the Company’s internal research and development capabilities. Costs related to any of the Company’s research collaboration agreements are recorded as a prepayment and amortized over the duration of such agreement. For years ended December 31, 2010, 2009 and 2008, the Company amortized research collaboration expenses of $0.8 million, $0.9 million and $0.7 million, respectively.
Advertising Expenses
For the years ended December 31, 2010, 2009 and 2008, the Company charged advertising costs of $0.5 million, $0.3 million, and $0.2 million, respectively, to selling, general and administrative expense as incurred.
Foreign Currency
The Company’s international subsidiaries use their local currencies as their functional currencies. For those subsidiaries, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense accounts at weighted-average exchange rates during the year. Resulting translation adjustments are reflected in the consolidated financial statements as “Other comprehensive income (loss).” Foreign currency transaction gains and losses are included as a component of other income and expense. The Company’s foreign currency transaction gains or losses consisted of a gain of $0.2 million, a loss of $0.4 million and a gain of $0.8 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Other Comprehensive Income (Loss)
Other comprehensive income (loss) refers to revenue, expenses, gains and losses that, under U.S. GAAP, are included in other comprehensive income (loss), but are excluded from net income (loss), as these amounts are recorded directly as an adjustment to shareholders’ equity, net of tax, when applicable.
Other comprehensive income (loss) consisted of the following (in thousands):
NOTE D - LOSS PER COMMON SHARE
The Company calculates its loss per common share using the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Under that method, net loss is adjusted by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends that must be paid for the current period. The remaining earnings are allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security are determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. The total earnings allocated to each security are divided by the number of outstanding shares of the security to which the earnings are allocated to determine the earnings per share for the security.
For the years ended December 31, 2010, 2009 and 2008, diluted net loss per share was the same as basic net loss per share since the effects of potentially dilutive securities are anti-dilutive.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Outstanding anti-dilutive securities not included in diluted net loss per share calculation are as follows (in thousands):
NOTE E - SEGMENT INFORMATION
The Company has determined that it operates in only one segment, as it only reports profit and loss information on an aggregate basis to its chief operating decision maker.
The Company categorizes revenue by geographic region. Revenues are attributed to geographic region based on country location of the customer site. The following table summarizes revenue by geographic region (in thousands):
NOTE F - LONG-TERM DEBT AND NOTES PAYABLE
Prior to January 1, 2008, the Company entered into a $0.5 million note agreement with the Wisconsin Department of Commerce. The note payable bears interest at 2% and is payable in monthly installments of $8,647, and the remaining unpaid principal is due on March 1, 2013. The note payable is collateralized by all of the Company’s equipment, fixtures, inventory, general intangibles and contract rights. The outstanding principal balances at December 31, 2010 and 2009 were $0.3 million and $0.3 million, respectively.
Prior to January 1, 2008, the Company also entered into a $0.4 million note agreement with Madison Development Corporation. The note payable bore interest at 4% and was payable in monthly installments of $4,050, with the last installment due on March 1, 2011. The note payable was collateralized by all of the Company’s equipment, fixtures, inventory, general intangibles and contract rights. The outstanding principal balances at December 31, 2010 and 2009 were $0.2 million and $0.3 million, respectively.
In the fourth quarter of 2010, CPAC issued $0.5 million of convertible notes to certain of its shareholders. See note N for further discussion.
The annual principal payments for all loans are as follows (in thousands):
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On November 30, 2010, the Company entered into an amended revolving credit facility with M&I Marshall & Ilsley Bank under which there were no borrowings as of December 31, 2010. The available amount of the revolving credit facility is based on the Company maintaining certain tangible net worth and EBITDA. In the event tangible net worth and EBITDA values are not maintained at specified levels, at the end of each calendar quarter the Bank may make corresponding adjustments in the available amount of the credit facility to a minimum of $20 million. The facility bears interest at the one-month British Bankers Association LIBOR plus an interest margin of 2.25%, adjusted based on monthly changes to such index, and payable monthly. The credit facility expires on November 30, 2011 and is collateralized by the Company’s deposit accounts. The facility requires the Company to maintain a minimum tangible net worth, a certain ratio of total liabilities to tangible net worth, and a minimum level of cash and short-term investments. The Company may be considered in default upon a material adverse change in the Company’s financial condition, upon a change in ownership of 25% or more of the common stock of the Company, or if the Bank believes the prospect of payment or performance of the facility is impaired. The Company was in compliance with these covenants at December 31, 2010. The available credit as of December 31, 2010 was $30 million.
NOTE G - INCOME TAXES
The provision for income taxes is as follows (in thousands):
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The significant components of deferred tax assets and liabilities are as follows (in thousands):
At December 31, 2010 and 2009, the Company recorded valuation allowances of $46.3 million and $34.4 million, respectively. The valuation allowance was determined through an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable. During the year ended December 31, 2008, the Company established a valuation allowance to offset net deferred tax assets in domestic and certain foreign taxing jurisdictions. The valuation allowance was established based on the Company’s three-year cumulative net taxable loss as of December 31, 2008, a decrease in backlog and projected taxable losses. As a result, at December 31, 2008, the Company believed that it was more likely than not that the Company would not be able to realize its net deferred tax assets during the foreseeable future. Through December 31, 2010, the Company continued to record a valuation allowance to offset net deferred tax assets in domestic and certain foreign taxing jurisdictions, which was based primarily on the Company’s substantial book losses. The valuation allowance increased $11.8 million, $11.8 million and $21.1 million in 2010, 2009, and 2008, respectively, primarily because of the Company’s inability to utilize its net operating losses.
At December 31, 2010 and 2009, the Company had approximately $96.3 million and $65.1 million of U.S. federal net operating loss carryforwards, respectively, and $5.9 million and $5.0 million of U.S. federal research tax credit carryforwards, respectively, which will expire beginning in 2021. In the event of a change in ownership greater than 50% in a three-year period, utilization of the net operating losses may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. At December 31, 2010 and 2009, the Company had $66.5 million and $51.5 million of state net operating loss carryforwards, respectively, and $3.8 million and $3.2 million of state research tax credit carryforwards, respectively, which will expire beginning in 2013.
As of December 31, 2010 and 2009, the Company had excess tax benefit stock option deductions of $2.5 million and $2.2 million, respectively, and had an additional potential tax benefit related to research tax credits of $1.7 million, which had not been utilized due to the excess stock option deductions. These benefits will be credited to additional paid in capital when realized. For the years ended December 31, 2010 and 2009, the Company credited additional paid in capital for the realization of $0.05 million and $0.6 million in tax benefits, respectively.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2010 and 2009, there were no undistributed earnings from the Company’s foreign subsidiaries due to substantial foreign losses incurred during the current year. The Company has not recognized a deferred tax liability for the undistributed earnings of its foreign subsidiaries, as the Company currently does not expect to remit earnings in the foreseeable future. Determination of the amount of unrecognized deferred tax liability related to undistributed earnings of foreign subsidiaries is not practicable, as such liability, if any, is dependent on circumstances existing if and when remittance occurs.
The Company’s practice for accounting for uncertainty in income taxes is to recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not criteria, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. Upon adoption, this policy was applied to all tax positions for which the statute of limitations remained open. As of December 31, 2010 and 2009, the amount of unrecognized tax benefits, which primarily relate to federal and state research tax credits, was $5.0 million and $4.3 million, respectively. If ultimately recognized, these tax benefits will reduce the Company’s annual effective tax rate. The Company does not anticipate that there will be a significant change in the total amount of unrecognized tax benefits in the next twelve months. A reconciliation of unrecognized tax benefits is as follows (in thousands):
The Company’s practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company had no accruals for interest and penalties on the Company’s balance sheets at December 31, 2010 or 2009, and did not recognize any interest or penalties in its statement of operations for the years ended December 31, 2010, 2009 or 2008. The Company is subject to taxation in the U.S. federal and various state and foreign jurisdictions. All of the Company’s tax years are currently open to examination by the U.S. federal, state and foreign tax authorities due to the carryforward of unutilized net operating losses and research and development credits.
NOTE H - COMMITMENTS AND CONTINGENCIES
On occasion, the Company is subject to proceedings, lawsuits and other claims related to patents, products and other matters. The Company assesses the likelihood of any adverse judgments or outcomes with respect to these matters and determines loss contingency assessments on a gross basis after assessing the probability of incurrence of a loss and whether a loss is reasonably estimable. In addition, the Company considers other relevant factors that could impact its ability to reasonably estimate a loss. A determination of the amount of reserves required, if any, for these contingencies is made after analyzing each matter. The Company’s reserves may change in the future due to new developments or changes in strategy in handling these matters.
Pending Litigation
Securities Litigation
On May 30, 2008 and June 10, 2008, two separate complaints were filed by certain of our shareholders in the U.S. District Court for the Western District of Wisconsin (the Court) against us and certain of our officers and all of our independent directors during the period in question. The complaints were consolidated on October 23, 2008. In the consolidated action (the 2008 Securities Litigation), the plaintiffs allege that the defendants violated the Securities Act with respect to statements made in connection with the initial and secondary public offerings of our common stock and the Exchange Act by misrepresenting our projected financial outlook during the period May 9, 2007 through April 17, 2008. The named plaintiffs, Michael Schultz, John Scala, et al., seek to represent persons who purchased our securities between those dates and who were damaged as a result of the decline in the price of our stock between those dates, allegedly attributable to the financial misrepresentations, and seek compensatory damages in an unspecified amount.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
We moved to dismiss the consolidated complaint on December 8, 2008. On July 9, 2009, the Court ruled on the motion to dismiss the consolidated complaint by dismissing without prejudice all claims under the Exchange Act and all but one claim under the Securities Act for failure to state a claim upon which relief could be granted. On August 3, 2009, the plaintiffs amended the consolidated complaint by filing their Second Amended Consolidated Complaint (the Amended Complaint). We moved to dismiss the Amended Complaint on September 3, 2009, and on December 15, 2009, the Court granted this second motion to dismiss in part and denied it in part. The plaintiffs have moved for class certification.
However, on July 28, 2010, we entered into an agreement to settle the 2008 Securities Litigation. Under the proposed settlement, the claims against us and our officers and directors stated in the Amended Complaint would be dismissed with prejudice and released in exchange for a cash payment of $5.0 million to be funded by our insurance carrier. The proposed settlement remains subject to the satisfaction of various conditions, including negotiation and execution of a final stipulation of settlement and approval by the Court following notice to members of the purported class. On September 20, 2010, the Court preliminarily approved the terms for distribution of the settlement fund, which has been placed in escrow, to purported class members, less fees awarded by the Court to class counsel, and other terms of the settlement. Class members were notified and given until January 18, 2011 to opt out of the class or file claims. Final court approval of the settlement is expected to occur in the first half of 2011.
We continue to believe that we have substantial legal and factual defenses to the allegations contained in the Amended Complaint, and we intend to pursue these defenses vigorously if the proposed settlement is not finalized and approved by the Court. If the settlement is not finalized and the 2008 Securities Litigation instead continues, although we carry insurance for these types of claims and related defense costs, a judgment significantly in excess of our insurance coverage could materially and adversely affect our financial condition, results of operations and cash flows. As of December 31, 2010, we estimated that our potential loss from these claims and related defense costs will not exceed our insurance deductible of $0.5 million, whether or not the proposed settlement is finalized and approved by the Court.
Stockholder Derivative Actions
On May 28, 2010 and July 9, 2010, two separate derivative lawsuits were filed in the Circuit Court of Dane County in Madison, Wisconsin by of our certain shareholders against (a) certain of our officers and all of the persons who have served as our directors since May 9, 2007 (collectively, the Individual Defendants) and (b) us, as nominal defendant. In their respective complaints (together, the Complaints), each of the named plaintiffs, The Dixon Family Living Trust and David Huh, allege that all of the Individual Defendants breached their fiduciary duties and engaged in abuse of control, gross mismanagement and waste of corporate assets, and that certain Individual Defendants were unjustly enriched. The Complaints were consolidated on October 11, 2010. The allegations are substantially similar to those claims made in the 2008 Securities Litigation. The Complaints seek damages, equitable relief, restitution and disgorgement of profits, costs and disbursements of the action, and other relief the court deems proper.
In March 2010, we received two shareholder demand letters from attorneys representing other shareholders (together, the Demand Letters) containing allegations substantially similar to those made in the Complaints. To our knowledge, as of the date of this Annual Report on Form 10-K, no lawsuits have been filed against us or any Individual Defendants in connection with the Demand Letters.
On February 9, 2011, the parties entered into a Memorandum of Understanding (MOU) expressing their intention to seek court approval to settle the derivative lawsuits. Under the proposed settlement as outlined in the MOU, the claims against our officers and directors, and nominally against us asserted in both the Complaints and the Demand Letters would be dismissed with prejudice and released in exchange for an attorneys’ fees payment of $275,000, of which $25,000 would be paid by us and the remaining $250,000 by our insurance carrier, as well as implementation by us of a number of corporate governance changes. The proposed settlement remains subject to the satisfaction of various conditions, including approval by the Court and notice to the public.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
We and the Individual Defendants believe that there are substantial legal and factual defenses to the allegations contained in the Complaints. Moreover, we and the Individual Defendants carry insurance for these types of claims and related defense costs. As of December 31, 2010, we estimated that we would not incur any material costs in connection with these claims or the defense thereof, given that we have already paid the applicable $0.5 million insurance deductible in connection with the 2008 Securities Litigation.
Reserve for Contingency
During 2008, the Company terminated its distribution agreement with Hi-Art Co., Ltd. (Hi-Art), its former distributor in Japan. Effective January 1, 2009, the Company entered into an agreement with Hitachi Medical Corporation (Hitachi) to serve as its new distributor in Japan.
In connection with the termination, the Company entered into an agreement with Hi-Art to acquire certain assets, such as inventory and the regulatory license, and to compensate Hi-Art for certain sales prospects, which it expected to close during the first quarter of 2009. While the Company ultimately was able to transfer some assets to Hitachi in order to support the transition, it incurred additional costs and experienced delays. As a result, the agreement to acquire the identifiable assets remains open and unsettled.
In July 2009, Hi-Art filed a complaint against the Company in the Tokyo District Court seeking compensation Hi-Art claims is owed under the asset acquisition agreement. Although the Company believes that it has substantial legal and factual defenses to Hi-Art’s allegations and intends to pursue these defenses vigorously, there can be no assurance it will prevail. Accordingly, the Company maintains a reserve with respect to this matter. The Company may change the amount of such reserve from time to time in the future due to new developments or changes in strategy related to this matter.
Purchase Commitment
The Company entered into a supply agreement with Hitachi Medical Corporation (Hitachi) for the purchase of xenon gas detectors on a non-exclusive basis. At December 31, 2010, the agreement with Hitachi requires the Company to purchase $4.9 million of xenon gas detectors through June 2012.
Operating Leases
The Company leases six facilities under separate operating leases with various expiration dates through 2018. The Company also leases automobiles under separate operating leases with various expiration dates through 2014.
Rent expense during the years ended December 31, 2010, 2009 and 2008 was $4.7 million, $4.8 million and $4.2 million, respectively.
Initial terms for facility leases are up to 13 years, with renewal options at various intervals, and may include rent escalation clauses. The total amount of the minimum rent is expensed on a straight-line basis over the initial term of the lease unless external economic factors exist such that renewals are reasonably assured, in which case the Company would include the renewal period in its amortization period. Most of the leases provide that the Company pay taxes, maintenance, insurance and certain other expenses applicable to the leased premises. The Company expects that in the normal course of business leases that expire will be renewed or replaced by other leases.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2010, future payments under operating leases (including rent escalation clauses) were as follows (in thousands):
NOTE I - WARRANTS
Prior to January 1, 2008, there were 158,566 warrants outstanding for the purchase of shares of Tomo’s Series D preferred stock at a price per share of $1.84, which became options to purchase shares of common stock at an exercise price of $1.84 per share. The warrants expired on February 18, 2009. As a result, Tomo had no warrants outstanding at December 31, 2010 and 2009.
NOTE J - STOCK INCENTIVE PLANS
The Company sponsors three stock incentive plans (the Plans), which allow for the grant of incentive stock options, nonqualified stock options and restricted stock. Each option grant entitles the holder to purchase a specified number of shares of Tomo common stock at a specified price that may not be less than the fair market value on the grant date. Although the option grants under the Plans have a maximum life of ten years, the majority of the grants made to date have lives of six years and vest at various intervals. Each restricted stock grant entitles the holder to receive a specified number of Tomo shares of common stock and vests at various intervals. Vesting schedules are determined at the grant date by the Compensation Committee of Tomo’s Board of Directors.
Under the 2007 Equity Incentive Plan (as amended in March 2009 and December 2010), Tomo’s Board of Directors is authorized to grant stock-based awards to employees, directors, and consultants for up to 7,335,822 shares in aggregate. As of December 31, 2010, two other plans remained in effect along with the 2007 Plan; however, equity-based awards may only be granted under the 2007 Plan.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the activity under the Plans (in thousands, except for weighted-average exercise price and weighted-average fair value at grant date):
The following table summarizes the nonvested shares under the Plans (in thousands, except for weighted-average fair value at grant date):
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2010, the range of exercise prices on outstanding stock options was as follows (in thousands, except for exercise price and remaining contractual life):
The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying stock options and the fair value of the Company’s common stock at December 31, 2010, which was $3.61 per share.
At December 31, 2010, the Company’s weighted-average remaining contractual term was 2.6 years for all outstanding stock options, 2.5 years for outstanding vested stock options and 2.1 years for restricted stock.
As of December 31, 2010, the Company had $9.3 million of total unrecognized compensation expense that it expects to recognize over a weighted-average period of 2.0 years for nonvested awards granted under the Company’s stock based plans.
The fair values of each option grant were estimated at the date of grant using the Black-Scholes option-pricing model based on the assumptions in the following table (no options were granted in 2010):
The following table summarizes the net effect of the Company’s share-based compensation expense (in thousands):
NOTE K - RETIREMENT PLANS
The Company has a 401(k) plan covering all qualified employees based in the United States. Employer contributions are at the discretion of Tomo’s Board of Directors, and the policy is to fund the 401(k) plan contributions as they accrue. Additionally, the Company funds retirement plans for certain employees based in foreign countries. The Company contributed $1.5 million, $1.6 million and $1.8 million to these plans during the years ended December 31, 2010, 2009 and 2008, respectively.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTE L - EMPLOYEE STOCK PURCHASE PLAN
The Company has an Employee Stock Purchase Plan (as amended, ESPP) for all qualified employees, which was adopted in 2007 and amended in 2009. The participants’ purchase price under the ESPP is 85% of the lesser of (1) the fair market value of the Company’s common stock as of the beginning of an applicable offering period or (2) the fair market value of the Company’s common stock as of an applicable purchase date. Offering periods generally occur once every twelve months. Under the ESPP, the Company issued 209,229 shares for $0.6 million, 261,766 shares for $0.6 million, and 269,872 shares for $0.5 million during the years ended December 31, 2010, 2009 and 2008, respectively. During the years ended December 31, 2010, 2009 and 2008, the Company recorded share-based compensation expense related to these ESPP shares of $0.3 million, $0.2 million and $0.2 million, respectively. A total of 1,050,000 shares of the Company’s common stock were reserved for issuance under the ESPP. As of December 31, 2010, 254,475 of such shares were available for issuance.
As of December 31, 2010, there was approximately $0.3 million of unrecognized compensation cost related to the ESPP, which is expected to be recognized over a period of approximately 11 months. The fair value of ESPP shares was $1.17 per share.
NOTE M - RELATED PARTY TRANSACTIONS
The Company has an exclusive license agreement with the Wisconsin Alumni Research Foundation (WARF), a shareholder of the Company, to make, use, sell and otherwise distribute products under certain of WARF’s patents anywhere in the world. The Company is required to pay WARF a royalty for each product sold. The Company has recorded to cost of revenue WARF royalties of $1.0 million, $0.8 million and $1.3 million during the years ended December 31, 2010, 2009 and 2008, respectively. The license agreement expires upon expiration of the patents and may be terminated earlier if the Company so elects. The Company may also grant sublicenses to third parties but must pay WARF 50% of all fees, royalties and other payments received. WARF has the right to terminate the license agreement if the Company does not meet the minimum royalty obligations, which are $0.3 million per year, or if the Company commits any breach of the license agreement’s covenants. If the Company were to lose this license, it would be unable to produce or sell the Systems. The Company had WARF royalty payable balances of $0.3 million as of December 31, 2010 and 2009.
NOTE N - INVESTMENT IN COMPACT PARTICLE ACCELERATION CORPORATION
During April 2008, TomoTherapy established a new affiliate, CPAC, to develop a compact proton therapy system for the treatment of cancer. CPAC’s investors include TomoTherapy, private investors and potential customers.
Tomo contributed intellectual property with a fair market value of approximately $1.9 million as its investment in CPAC. CPAC raised additional capital of $6.6 million and $6.9 million during 2010 and 2009, respectively. As of December 31, 2010 and 2009, Tomo’s ownership interest in CPAC was 5.3% and 7.3%, respectively.
In the fourth quarter of 2010, Tomo and certain other CPAC investors purchased convertible promissory notes from CPAC. Under the terms of the notes, Tomo paid for 50% of the notes it purchased prior to December 31, 2010 and received 693,491 of CPAC’s warrants, with the remainder expected to be paid in the first quarter of 2011. Total consideration for the notes Tomo purchased is $0.8 million. Outside investors purchased $0.6 million of the convertible promissory notes payable together with 978,666 of its warrants. The notes payable are due on June 3, 2011 at 12% and convertible into CPAC’s common stock at the per share conversion price as defined in the notes. The CPAC warrants are exercisable through November 2020 at a $0.57 per CPAC common share. At December 31, 2010, no notes payable had been converted and no warrants had been exercised.
Tomo also has a contractual agreement to provide certain support and management services to CPAC. Tomo may provide additional financial support to CPAC in the future. Settlements of CPAC’s obligations are restricted to the assets of CPAC. The creditors and beneficial interest holders of CPAC have no recourse to TomoTherapy.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTE O - ACQUISITION
On October 31, 2008, the Company acquired 100% of the outstanding capital stock of Chengdu Twin Peak Accelerator Technology Inc. (Twin Peak), a privately held company based in Chengdu, China. The Company expects Twin Peak to be an alternative and secondary source of supply for linear accelerators, a critical component of the System. Total consideration for the acquisition was approximately $3.1 million payable over four installments. The first installment of $0.9 million was paid on closing, and the second installment of $0.2 million was paid on December 16, 2009. The third installment of $0.5 million was paid on September 29, 2010. The fourth installment of $1.4 million is due on October 31, 2011. As of December 31, 2010, the Company had paid $2.0 million in acquisition payments and ancillary closing costs.
Twin Peak was consolidated into the Company’s financial statements for the years ended December 31, 2010, 2009 and 2008. This transaction was accounted for as a purchase business combination, and the purchase consideration was allocated based on the fair values of identifiable tangible and intangible assets and liabilities as follows (in thousands):
The business combination did not have a material impact on the Company’s results of operations for the year ended December 31, 2008 and would not have materially impacted the Company’s results of operations for the 2008 interim periods had the business combination occurred on January 1, 2008.
NOTE P - RESTRUCTURING
In early October 2009, Tomo’s management approved a restructuring program to downsize certain customer service and administrative functions. On October 14, 2009, Tomo announced the organizational restructuring internally. The purpose of this program was to realign resources with the Company’s current business outlook, to streamline its service organization and to integrate certain business functions in order to eliminate redundant tasks.
As a result of the restructuring program, the Company recognized a total restructuring charge of approximately $1.9 million in the fourth quarter of 2009. For non-executive employees, this charge included termination benefits provided to employees based upon each employee’s current position, salary and length of service with the Company, along with outplacement assistance and other transition costs. One executive employee was included, and his termination benefits were based on the terms of his employment agreement. Any discount arising from determining the present value of the payouts is deemed immaterial due to the relatively short period between the communication date and the termination of employment. The Company’s liability for restructuring charges was $1.0 million at December 31, 2009. As of December 31, 2010, no further obligations under the restructuring program remained.
TOMOTHERAPY INCORPORATED AND SUBSIDIAIRES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTE Q - QUARTERLY FINANCIAL DATA (unaudited)
(In thousands, except per share amounts)
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We have established disclosure controls and procedures to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to our management, with the participation of our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures. Based on their evaluation as of December 31, 2010, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of assets that could have a material effect on the financial statements.
Internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements prepared for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, under the framework in Internal Control - Integrated Framework, management concluded that our internal control over financial reporting was effective as of December 31, 2010.
The effectiveness of our internal control over financial reporting as of December 31, 2010 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein.
Changes in Internal Control over Financial Reporting
There were no changes in internal control over financial reporting during the quarter ended December 31, 2010 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
None
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information required by this item with respect to our executive officers is set forth in Part I, Item 1 of this Annual Report on Form 10-K under the caption “Executive Officers of the Registrant” and is incorporated herein by reference. The information required by this item with respect to our directors, our Audit Committee and its members and Audit Committee financial expert is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the captions “Proposal One - Election of Directors - Nominees for Election for a One-Year Term Ending with the 2012 Annual Meeting,” “Corporate Governance and Board Matters” and “Audit Committee Report.” The information required by this item with respect to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the caption “Stock Ownership - Section 16(a) Beneficial Ownership Reporting Compliance.”
We have adopted a Comprehensive Compliance Program that applies to all of our executive officers and directors. The Comprehensive Compliance Program is posted on our website. The Internet address for our website is http://www.tomotherapy.com and the Comprehensive Compliance Program may be found as follows:
1. From our main web page, first click on “Investor Relations.”
2. Next, click on “Corporate Governance” in the top navigation bar.
3. Finally, click on “Comprehensive Compliance Program” under “Governance Documents.”
Copies of our Comprehensive Compliance Program may also be obtained without charge by sending a written request to our Corporate Secretary at our executive offices.
The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the caption “Executive Compensation.”
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters
Equity Compensation Plan Information
The following table provides information as of December 31, 2010 with respect to the shares of our common stock that may be issued under our existing equity compensation plans.
The information required by this item with respect to the security ownership of certain beneficial owners and the security ownership of management is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the caption “Stock Ownership - Beneficial Ownership of Certain Shareholders, Directors and Executive Officers.”
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this item with respect to certain relationships and related transactions is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the caption “Certain Relationships and Related Transactions.” The information required by this item with respect to director independence is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the caption “Corporate Governance and Board of Directors Matters - The Board and Committees of the Board.”
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders under the captions “Proposal Two - Ratification of the Company’s Independent Registered Public Accounting Firm - Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Public Accounting Firm” and “Proposal Two - Ratification of the Company’s Independent Public Accounting Firm - Principal Accountant Fees and Services.”
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
1. Financial Statements
The financial statements of TomoTherapy Incorporated and its subsidiaries are set forth in Item 8 of this Report.
2. Financial Statement Schedule (in thousands)
All other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.
3. Exhibits
EXHIBIT INDEX
*
Filed herewith

Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from the corresponding filing and submitted separately to the SEC.
+
Executive compensation plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
TomoTherapy Incorporated
By: /s/ Frederick A. Robertson
Frederick A. Robertson, M.D.
Chief Executive Officer and President
Dated: March 3, 2011
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Brenda S. Furlow his or her true and lawful attorney-in-fact, with full power of substitution and resubstitution for him or her and in his or her name, place and stead, in any and all capacities to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact or her substitute, each acting alone, may lawfully do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 3, 2011 by the following persons on behalf of the registrant and in the capacities indicated.
Name
Position
/s/ Frederick A. Robertson
Frederick A. Robertson, M.D.
Chief Executive Officer, President and Director (principal executive officer)
/s/ Thomas E. Powell
Thomas E. Powell
Chief Financial Officer and Treasurer (principal financial and accounting officer)
/s/ T. Rockwell Mackie
T. Rockwell Mackie, Ph.D.
Chairman of the Board, Director
/s/ Lance C. Balk
Director
Lance C. Balk
EXHIBIT INDEX
*
Filed herewith

Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from the corresponding filing and submitted separately to the SEC.
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Executive compensation plan or arrangement.