(a) Why is the MD&A section of the annual report useful to the financial analyst? What types of information can be found in this section?

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(b) Using the excerpts from the MD&A of the Biolase, Inc. 2013 Form 10-K, discuss whether each of the items that should be discussed in an MD&A is, in fact, presented in this section. Give examples to support your answer.

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(c) Evaluate the overall quality of the information presented by Biolase Inc. in the MD&A.

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(d) Based on this section only, what is your assessment of the prospects for this company?

Overview

We are a biomedical company that develops, manufactures, and markets lasers in dentistry and medicine and also markets and distributes dental imaging equipment, including cone beam digital x-rays and CAD/CAM intra-oral scanners, and in-office, chair-side milling machines, and three-dimensional (“3-D”) printers; products that are focused on technologies that advance the practice of dentistry and medicine. Our proprietary dental laser systems allow dentists, periodontists, endodontists, oral surgeons, and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures with less pain and faster recovery times than are generally achieved with drills, scalpels, and other instruments. We have clearance from the FDA to sell our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union, and various other international markets. Our licensed dental imaging equipment and other related products are designed to improve diagnoses, applications, and procedures in dentistry and medicine.

We offer two categories of laser system products: WaterLase systems and Diode systems. Our flagship product category, the WaterLase system, uses a patented combination of water and laser energy to perform most procedures currently performed using dental drills, scalpels, and other traditional dental instruments for cutting soft and hard tissue. We also offer our Diode laser systems to perform soft tissue, pain therapy, and cosmetic procedures, including teeth whitening. We currently have approximately 180 issued and 120 pending U.S. and international patents, the majority of which are related to our core WaterLase technology and dental and medical lasers. From 1998 through December 31, 2013, we have sold over 10,200 WaterLase systems, including more than 6,200 WaterLase MD and iPlus systems, and more than 24,800 laser systems in over 70 countries around the world.

We have suffered recurring losses from operations and have not generated cash from operations for the three years ended December 31, 2013. Our inability to generate cash from operations, the potential need for additional capital, and the uncertainties surrounding our ability to raise additional capital, raises substantial doubt about our ability to continue as a going concern. Accordingly, the accompanying financial statements have been prepared to assume that we will continue as a going concern, which contemplates that we will continue in operation for the next twelve months and will be able to realize our assets and discharge our liabilities and commitments in the normal course of business. The financial statements do not include any adjustments to reflect the possible future effects of recoverability and classifications of assets or the amounts and classifications of liabilities that may result from our inability to continue as a going concern.

The available borrowing capacity on our lines of credit with Comerica Bank and the net proceeds from the below-mentioned equity transactions have been principal sources of liquidity during the year ended December 31, 2013. On September 6, 2013, and November 8, 2013, we amended our lines of credit with Comerica Bank. These amendments waived non-compliance with certain financial covenants and established future covenants, restrictions, and potential penalties for noncompliance. The amendment on November 8, 2013, included liquidity ratio and liquid asset covenants, and an equity raise requirement. We met the equity raise requirement on February 10, 2014. We received waivers for non-compliance with financial covenants as of January 31, 2014, December 31, 2013, and November 30, 2013. In connection with the waiver for January 2014 and December, 2013 Comerica Bank reduced the total aggregate available borrowings on the lines of credit to $5 million. The waiver for November 2013 reset covenants for the remaining term of the agreements. These credit facilities expire May 1, 2014, and we are considering alternative solutions, including potentially issuing alternative debt securities, to mitigate any future liquidity constraints these covenants, restrictions, and maturities may impose on us. Further discussion of the amendments is included in Note 5 to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K, which is incorporated herein by reference.

On December 19, 2013, we entered into a subscription agreement (the “December 2013 Subscription Agreement”) with Oracle Ten Fund Master, L.P. under which we offered an aggregate of 340,000 unregistered shares of common stock in a private placement at a price of $1.80 per share. Gross proceeds from the sale totaled $612,000, and net proceeds, after offering expenses of approximately $34,000, totaled approximately $578,000. We used the proceeds for working capital and general corporate purposes.

On July 26, 2013, we filed a registration statement on Form S-3, File No. 333-190158 (the “2013 Registration Statement”) with the SEC to register an indeterminate number of shares of common stock, preferred stock, and warrants with a total offering price not to exceed $5 million. The 2013 Registration Statement was declared effective by the SEC on September 19, 2013. On September 23, 2013, we entered into an agreement with Northland Securities, Inc. (“Northland”), pursuant to which Northland acted as placement agent in connection with the sale of 2,688,172 shares of our common stock to Camber Capital Management, LLC, at a price of $1.86 per share. Gross proceeds from the sale totaled $5 million, and net proceeds, after offering expenses of $408,000 which included Northland’s fee, totaled approximately $4.6 million.

During the year ended December 31, 2013 (“Fiscal 2013”), we received FDA clearance for both the Diolase 10S and Epic 10S for over 80 different procedures in 19 additional medical markets, including general surgery, ophthalmology, dermatology, plastic surgery, ENT, oral surgery, arthroscopy, gastroenterology, podiatry, GI/GU, gynecology, neurosurgery, pulmonary surgery, cardiac surgery, thoracic surgery, urology, aesthetics, and vascular surgery. We continue to invest in our intellectual property and were granted several new patents covering the use of laser technologies for treating various conditions of the eye, including presbyopia, glaucoma, retinal disorders, and cataracts, several new patents for our laser delivery system configurations, and a new patent for our non-contact handpiece for cutting both hard and soft tissue with our WaterLase all tissue lasers. The FDA also cleared the WaterLase iPlus all-tissue laser for use as a surgical instrument for soft-tissue procedures in orthopedic and podiatric surgery.

We have taken steps during Fiscal 2013, which we believe will improve our financial condition and ultimately improve our financial results, including increasing our product offerings with the launch of the new Epic 10S and Epic V-Series diode laser systems. The Epic 10S platform has launched us into the medical field serving otolaryngologists (also known as “Ear, Nose, and Throat” or “ENT” doctors). We also have a strategic agreement with Valam, Inc. (“Valam”) to develop, market, and sell office-based laser systems to otolaryngologists (the “Valam Agreement”). The Valam Agreement provides us with an exclusive worldwide license to Valam’s ENT related patents and patent applications which complement our patent portfolio. We believe our Epic V-Series platform will be a leading technology in the evolution of dental and medical treatments available in the veterinary market. We expanded our line of digital imaging equipment with the NewTom Biolase VG3.

Our recently launched OCC ULASE website is also a marketing platform for our ophthalmology technologies for which we continue to seek strategic partnerships to assist in our entry into the ophthalmology laser market. We continue to reshape and expand our direct sales force and certain distributor relationships. During this period we also restructured our sales and marketing department and its priorities, which we expect will lead to improved resource allocation within the largest share of our operating expenses.

Comparison of Results of Operations

Year Ended December 31, 2013, Compared With Year Ended December 31, 2012

Net Revenue. Net revenue for Fiscal 2013 was $56.4 million, a decrease of $926,000, or 2%, as compared with net revenue of $57.4 million for the year ended December 31, 2012 (“Fiscal 2012”). Domestic revenues were $35.6 million, or 63% of net revenue, for Fiscal 2013 compared to $40.6 million, or 71% of net revenue, for Fiscal 2012. International revenues for Fiscal 2013 were $20.8 million, or 37% of net revenue compared to $16.8 million, or 29% of net revenue for Fiscal 2012. The decrease in period over- period net revenue resulted from decreases in domestic laser system revenue, offset by increases in imaging systems, consumables and other, services, and license fees, and royalty revenue. We believe that these results were primarily due to our transition from primarily selling WaterLase dental lasers to selling a wide range of hard- and soft-tissue dental and medical lasers and other high-tech solutions for dentists, including digital radiography and CAD/CAM intra-oral scanners. In order to more effectively deploy our resources and improve overall revenue as well as our margins we recently changed our sales and marketing leadership. Subsequent to our leadership change we have hired 15 additional sales personnel of which 12 will be primarily focused on selling our core laser products.

Laser system net revenues, as a result of the aforementioned reasons, decreased by approximately $3.6 million, or 9%, in Fiscal 2013 compared to Fiscal 2012. As expected, we experienced an improvement in sales of our core laser systems during the quarter ending December 31, 2013 as compared with the quarter ending September 30, 2013. Historically, revenue in the fourth quarter has typically been stronger than average due to the buying patterns of dental professionals. We believe that a significant number of dentists purchase capital equipment during the fourth quarter in order to maximize their practice earnings and minimize their taxes through the utilization of certain tax incentives, such as accelerated depreciation methods for purchased capital equipment, as part of their year-end tax planning.

Imaging system net revenue increased by approximately $1.3 million, or 38%, in Fiscal 2013 compared to Fiscal 2012. The increase was driven by increased offerings at various value propositions, including the recently introduced NewTom VG3. We expect continued improvement in sales of our imaging systems during the year ended December 31, 2014, as we gain more experience with these products, as a result of the recent changes we have made to our sales and marketing leadership, and as we continue to increase in the number of sales professionals that will be primarily focused on selling our imaging products.

Consumables and other net revenue, which includes consumable products such as disposable tips and shipping revenue, increased approximately $504,000, or 8%, for Fiscal 2013, as compared to Fiscal 2012. This increase in consumables and other net revenue was primarily a result of auxiliary sales to our growing laser customer base.

Services net revenue, which consists of extended warranty service contracts, advanced training programs, and other services, increased by approximately $836,000, or 15%, for Fiscal 2013, as compared to Fiscal 2012. The increased revenue was due largely to increased follow-on sales related to our growing laser customer base and increased sales and marketing efforts in this part of our business.

License fees and royalty revenue increased approximately $79,000 to approximately $244,000 in Fiscal 2013 compared to $165,000 in Fiscal 2012. These license fees and royalty revenue were attributable to intellectual property related to our laser technologies. We also have a non-exclusive license agreement with P&G, granting them non-exclusive license rights to certain of our patents. Although the term of the arrangement continues until the underlying patents expire unless terminated earlier by either party, we have not generated revenue under the arrangement since 2011 and we are exploring alternative product development opportunities.

Cost of Revenue. Cost of revenue in Fiscal 2013 increased by $4.0 million, or 13%, to $34.9 million, or 62% of net revenue, compared with the cost of revenue of $30.9 million, or 54% of net revenue, in Fiscal 2012. The increased cost as a percentage of revenue is a result of lower laser system sales and increased imaging and international sales. Our laser systems generally have significantly higher margins than our licensed imaging systems and our domestic sales generally have higher margins than our international sales. We also recorded a provision of $1.0 million for excess and obsolete inventory during the quarter ended September 30, 2013, related to negative market trends for certain products and the decreased velocity of certain elements of our inventory at that time.

Gross Profit. Gross profit for Fiscal 2013 was $21.5 million, or 38% of net revenue, a decrease of approximately $5.0 million, as compared with gross profit of $26.5 million, or 46% of net revenue, for Fiscal 2012. The decrease was primarily due to higher sales of licensed imaging systems, which generally carry lower margins than our laser products, increased international laser sales, which generally carry a lower margin than our domestic laser sales, and the increased provision for excess and obsolete inventory.

Operating Expenses. Operating expenses for Fiscal 2013 were $32.5 million, or 58% of net revenue, an increase of approximately $3.5 million as compared with $29.0 million, or 51% of net revenue, for Fiscal 2012. We expect that operating expenses as a percentage of net revenue will decrease for the year ending December 31, 2014, as a result of cost-saving measures we began implementing in February 2014, including streamlining operations and reducing payroll and payroll-related expenses by approximately $1.3 million, net (unaudited), on an annualized basis, and reducing and rationalizing certain marketing and advertising activities. We expect that we will begin to realize the impact of these cost-saving measures in the quarter ending June 30, 2014. The year over- year increase in expense is explained in the following expense categories:

Sales and Marketing Expense. Sales and marketing expenses for Fiscal 2013 increased by $2.4 million, or 15%, to $18.7 million, or 33% of net revenue, as compared with $16.3 million, or 28% of net revenue, for Fiscal 2012. The increase was primarily a result of increased payroll and consulting related expenses of $1.4 million, increased convention costs of $579,000, and increased media and advertising expenses of $471,000, offset by decreased commission expenses of $482,000 related to lower sales. The increased costs were related to the launch and integration of our Cefla NewTom and Biolase DaVinci 3-D Imaging product lines and our 3Shape Trios intraoral scanners, the launch of our Epic V-Series and Epic 10S diode lasers in veterinary and otolaryngology, respectively, and the introduction of our Galaxy BioMill CAD/CAM chairside milling system. We expect our efficiencies with these new products to improve as we continue their integration and from the recent changes, we have made to our sales and marketing leadership.

General and Administrative Expense. General and administrative expenses for Fiscal 2013 increased by $1.3 million, or 16%, to $9.4 million, or 17% of net revenue, as compared with $8.1 million, or 14% of net revenue, for Fiscal 2012. We experienced increased legal expenses of $615,000, of which $250,000 related to the defense of class action lawsuits (refer to “Part I, Item 3. Legal Proceedings”), increased payroll and consulting related expenses of $536,000, and increased investor relations expenses of $220,000.

Engineering and Development Expense. Engineering and development expenses for Fiscal 2013 decreased by $655,000, or 14%, to $4.0 million, or 7% of net revenue, as compared with $4.7 million, or 8% of net revenue, for Fiscal 2012. The decrease was primarily related to decreased payroll and consulting related expenses of $295,000 and decreased supplies expenses of $463,000. We expect to increase our investment in engineering and development as we continue our efforts in new product development in the future.

Excise Tax Expense. Beginning January 1, 2013, the Patient Protection and Affordable Care Act imposed a 2.3% medical device excise tax on certain product sales to customers located in the U.S. We incurred excise tax expenses of $438,000, or 1% of net revenue, for Fiscal 2013.

Non-Operating Income (Loss)

(Loss) Gain on Foreign Currency Transactions. We recognized a $50,000 loss on foreign currency transactions for Fiscal 2013 compared to a $175,000 loss for Fiscal 2012 due to exchange rate fluctuations between the U.S. dollar and other currencies.

Interest Expense, Net. Interest expense consists primarily of interest on our revolving credit facilities, amortization of debt issuance costs and debt discount, and the financing of our business insurance premiums. Interest expense totaled approximately $600,000 and $239,000 for Fiscal 2013 and 2012, respectively.

Provision (benefit) for Income Taxes. Our provision for income taxes was a benefit of $164,000 for Fiscal 2013, compared to a provision of $111,000 in Fiscal 2012. During Fiscal 2013, we reversed certain tax liabilities associated with unrecognized tax benefits related to international operations due to expiring statutes and recognized tax benefits of $138,000. In addition, we recognized deferred tax assets related to certain indefinite-lived assets (federal alternative minimum tax credits and California R &D credits) that were used to offset deferred tax liabilities related to indefinite-lived intangible assets. This resulted in additional tax benefits of $107,000. We also recorded an income tax expense of $81,000 for the current year's tax provision.

Net Loss. For the reasons stated above, our net loss was $11.5 million for Fiscal 2013 compared to a net loss of $3.1 million for Fiscal 2012.

Liquidity and Capital Resources

On December 31, 2013, we had approximately $1.4 million in cash and cash equivalents. Management defines cash and cash equivalents as highly liquid deposits with original maturities of 90 days or less when purchased. The decrease in our cash and cash equivalents by $1.1 million was primarily due to net cash used in operating and investing activities of $9.3 million and $685,000, respectively, offset by cash provided by financing activities of $8.8 million.

On December 31, 2013, we had approximately $3.9 million in working capital. Our principal sources of liquidity at December 31, 2013, consisted of approximately $1.4 million in cash and cash equivalents, $11.1 million of net accounts receivable, and available borrowings under two revolving credit facility agreements totaling approximately $3.4 million at December 31, 2013.

We have suffered recurring losses from operations and have not generated cash from operations for the three years ended December 31, 2013. Our level of cash from operations, the potential need for additional capital, and the uncertainties surrounding our ability to raise additional capital raises substantial doubt about our ability to continue as a going concern. Accordingly, the accompanying financial statements have been prepared to assume that we will continue as a going concern, which contemplates that we will continue in operation for the next twelve months and will be able to realize our assets and discharge our liabilities and commitments in the normal course of business. The financial statements do not include any adjustments to reflect the possible future effects of recoverability and classifications of assets or the amounts and classifications of liabilities that may result from our inability to continue as a going concern.

The available borrowing capacity on our lines of credit with Comerica Bank, as amended, and the net proceeds from the aforementioned equity transactions have been principal sources of liquidity during the year ended December 31, 2013. These credit facilities expire May 1, 2014, and we are considering alternative solutions, including potentially issuing alternative debt securities, to mitigate any future liquidity constraints these covenants, restrictions, and maturities may impose on us.

Further discussion of our lines of credit is included in Note 5 to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K, which is incorporated herein by reference.

On February 10, 2014, we entered into the February 2014 Subscription Agreement with Oracle Partners L.P., Oracle Institutional Partners, L.P., and Oracle Ten Fund Master L.P. under which we offered an aggregate of 1,945,525 unregistered shares of common stock in a private placement at a price of $2.57 per share. Gross proceeds from the sale totaled $5 million, and net proceeds, after offering expenses of approximately $208,000, totaled approximately $4.8 million.

On January 17, 2014, we filed the January 2014 Registration Statement with the SEC to register an indeterminate number of shares of common stock, preferred stock, and warrants with a total offering price not to exceed $12.5 million. The January 2014 Registration Statement was declared effective by the SEC on January 29, 2014.

In order for us to continue operations beyond the next twelve months and be able to discharge our liabilities and commitments in the normal course of business, we must sell our products directly to end-users and through distributors, establish profitable operations through increased sales, decrease expenses, and generate cash from operations or obtain additional funds when needed. We intend to improve our financial condition and ultimately improve our financial results by increasing revenues through the expansion of our product offerings, continuing to expand and develop our direct sales force and distributor relationships both domestically and internationally, forming strategic arrangements within the dental and medical industries, educating dental and medical patients as to the benefits of our advanced medical technologies, and reducing expenses.

In February 2014, we completed the first phase of our planned cost-saving measures by streamlining operations and reducing payroll and payroll-related expenses by approximately $1.3 million, net (unaudited), on an annualized basis. For the second phase, we have begun to reallocate and rationalize certain marketing and advertising activities. We expect that we will begin to realize the impact of these cost-saving measures in the quarter ending June 30, 2014.

Additional capital requirements may depend on many factors, including, among other things, the rate at which our business grows, demands for working capital, manufacturing capacity, and any acquisitions that we may pursue. From time to time, we could be required, or may otherwise attempt, to raise capital through either equity or debt offerings. We cannot provide assurance that we will enter into any such equity or debt financings in the future or that the required capital would be available on acceptable terms, if at all, or that any such financing activity would not be dilutive to our stockholders.

Our Board has authorized us to seek the services of an investment bank to explore possible merger and acquisition transactions with the goal of maximizing shareholder value. We have engaged the services of Piper Jaffray&Co. (“Piper Jaffray”) and continue to explore opportunities, through either acquisitions or strategic alliances.

We may not be able to increase sales, reduce expenses, or obtain additional funds when needed or guarantee that such funds, if available, will be obtainable on terms satisfactory to us. If we are unable to increase sales, reduce expenses, or raise sufficient additional capital, we may be unable to continue to fund our operations, develop our products, or realize value from our assets and discharge our liabilities in the normal course of business. These uncertainties raise substantial doubt about our ability to continue as a going concern. As a result, the opinion we have received from our independent registered public accounting firm on our consolidated financial statements contains an explanatory paragraph stating that there is substantial doubt regarding our ability to continue as a going concern.

The accompanying financial statements have been prepared on a going concern basis that contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The financial statements do not include adjustments relating to the recoverability of recorded asset amounts or the amounts or classification of liabilities that might be necessary should we be unable to continue as a going concern.

Consolidated Cash Flows

The following table summarizes our statements of cash flows for Fiscal 2013, Fiscal 2012, and Fiscal 2011 (in thousands):

	Years Ended December 31,
	2013	2012	2011
Net cash provided by (used in):
Operating activities	$ (9,296)	$ (1,664)	$ (13,320)
Investing activities	(685)	(698)	(428)
Financing activities	8,847	1,559	15,387
Effect of exchange rates on cash	31	39	(26)
The net change in cash and cash equivalents	$ (1,103)	$ (764)	$ 1,613

Fiscal 2013 Compared to Fiscal 2012

The $7.6 million increase in net cash used in operating activities for Fiscal 2013 compared to Fiscal 2012 was primarily due to our increased net loss, which was primarily caused by our transition from primarily selling WaterLase dental lasers to selling a wide range of hard- and soft-tissue dental and medical lasers and other technological solutions for dentists, including digital radiography and CA D/CAM intra-oral scanners. Net cash used in operating activities consists of our net loss, adjusted for our non-cash charges, plus or minus working capital changes. Cash used in operating activities for Fiscal 2013 totaled $9.3 million and was primarily comprised of non-cash adjusted net loss, excluding changes in operating assets and liabilities, of $7.1 million-plus increases in inventory of $1.4 million.

Net cash used in investing activities remained relatively flat for Fiscal 2013 compared with Fiscal 2012 due to slightly higher capital asset expenditures in Fiscal 2012 offset by proceeds from the sale of long-lived real estate assets in Germany. For fiscal 2014, we expect capital expenditures to total approximately $750,000, and we expect depreciation and amortization to total approximately $650,000.

The $7.3 million increase in net cash provided by financing activities for Fiscal 2013 compared to Fiscal 2012 was primarily due to net proceeds from equity offerings in late 2013 of $5.2 million-plus increased net borrowing under lines of credit of $1.4 million.