Summary of TOMOTHERAPY INC

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 of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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 be materially different from any future results, performance, or achievements expressed 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.
Restatement
We determined that our financial statements as of December 31, 2008 and for the year then ended required restatement to correct errors in the accounting for income taxes. The errors were the result of establishing a tax valuation allowance for unrecognized tax benefits which had already been reserved for and a failure to consider all future sources of taxable income, such as items in Other Comprehensive Income, in the evaluation of the valuation allowance. We have also netted the liability for unrecognized tax benefits as of December 31, 2008 against the carrying amount of related deferred tax asset credit carryforwards, reclassified certain current and noncurrent deferred tax assets and liabilities and adjusted accrued expenses related to our acquisition due to reclassifying estimated deferred tax assets recorded at the time of the acquisition. See Note C to our consolidated financial statements for further information relating to the restatement. The corrections have been incorporated into Management's Discussion and Analysis of Financial Condition and Results of Operations below.
Overview
We developed, market and sell the Hi Art system, an advanced and versatile radiation therapy system for the treatment of a wide variety of cancers. The Hi Art system combines integrated CT imaging with radiation therapy to deliver radiation treatment with speed and precision while reducing radiation exposure to surrounding healthy tissue which, we believe, can lead to improved patient outcomes. We market and sell the system to hospitals and cancer treatment centers in North America, Europe, the Middle East and Asia-Pacific and offer customer support services in each region either directly or through distributors.
For the years ended December 31, 2008 and 2007, our revenue was $204.6 million and $232.8 million, respectively, a decrease of 12%. We believe that a combination of the current global economic downturn, the ongoing credit crisis, our transition in sales leadership and enhanced competitive pressure resulted in fewer Hi Art systems being installed and accepted in 2008 versus 2007. Our net loss for the year ended December 31, 2008 was $33.5 million, and our net income for the year ended December 31, 2007 was $10.7 million. The decreased profitability in 2008 was primarily caused by the sale of 18% fewer systems, continued investments in our service operations and a charge of $17.8 million related to the establishment of a valuation allowance against our deferred tax assets. Although our revenue decreased from the prior year and we experienced a net loss, we remain in a strong capital position with $155 million of cash and short-term investments as of December 31, 2008. Thus, we are readily able to fund ongoing operations and to invest in future product offerings. Our total assets decreased to $296.4 million at December 31, 2008 from $325.1 million at December 31, 2007, a decrease of $28.7 million or 9%, which is primarily attributable to reduced cash balances and the establishment of the aforementioned deferred tax asset valuation allowance. In an effort to conserve our cash resources, we are carefully monitoring our ongoing expenditures, as was evidenced by a 16% decrease in operating expenses during the fourth quarter 2008 versus 2007 and by our December 2008 reduction in staff.
During 2008, we acquired 100% of the outstanding capital stock of Chengdu Twin Peak Accelerator Technology Inc. (Twin Peak), a privately held company based in Chengdu, China, for consideration of approximately $3.1 million. We believe that Twin Peak could be a lower-cost alternative and secondary source of supply for linear accelerators, a critical component of the Hi Art system.
Because of the current volatile state of the global economy, especially as it is related to capital equipment manufacturers, and because of continued market competition, we expect our 2009 financial performance to be somewhat similar to 2008. Like 2008, we expect the year to be somewhat back-end loaded with only 30% to 40% of our 2009 revenue expected to be generated during the first

Table of Contents

half of the year. Furthermore, because of our planned cash conservation efforts, we expect to use only a marginal amount of cash during 2009, thus maintaining our sound financial position.
Despite near-term economic challenges, we remain optimistic about our long-term financial performance. This is based on continued growth in market demand for image-guided radiation therapy equipment, our new senior sales management, our expected release of product enhancements in the future and our revenue backlog of $176 million as of December 31, 2008. Factors Affecting Our Financial Performance Our financial performance is significantly affected by the following factors:
Incoming Orders
Since we sell high-priced capital equipment with a long sales cycle and an approximate 12-month window between customer order and delivery, an important measure of our future financial performance is the dollar value of incoming orders for equipment. During 2008, we experienced a decline in incoming orders as compared to 2007. We believe that this decline resulted from a combination of the current global economic downturn, the ongoing credit crisis, our transition in sales leadership and increased competitive pressure.
Since the Hi Art system is a major capital expenditure, our customers may require funding through a credit facility or lease arrangement, and they may have increased difficulty obtaining the necessary credit in the current economic environment. 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. In the last few months, some United States orders we expected to close have not been placed, which we believe might be the result of concerns about economic conditions.
We experienced increased competition in the marketplace during 2008, which we believe has created some market confusion. We intend to improve our sales competitiveness by selectively increasing sales force coverage and by expanding product features, as evidenced by our recently announced plans to launch TomoDirect software, in order to open more market opportunities. Furthermore, we believe continued innovation and expansion of our clinical capabilities will extend our technology leadership position and increase our prospects for greater market share and continued growth.
During 2008, we terminated the distribution agreement with our former Japanese distributor, resulting in a stoppage of incoming orders from Japan. Effective January 1, 2009, we entered into a distributorship agreement with Hitachi Medical Corporation (Hitachi) to distribute the Hi Art system in Japan. Japan is the second largest market in the world for radiation therapy equipment. We believe that Hitachi will help revitalize the Japanese market for us and create growth in market share.
During the second half of 2008, we restructured our global sales management to enhance our sales execution capabilities. With our new sales management team, we believe that we have strengthened our ability to drive sales performance and increase market share.
Backlog
As of December 31, 2008, we had a backlog of $176 million, the majority of which should convert to revenue within the next 12 months. We define backlog as the total contractual value of all firm orders received for the Hi Art system and related options that have installation sites identified and that we believe are likely to ship within 24 months. To be included in backlog, such orders must be evidenced by a signed quotation or purchase order from the customer.
On a regular basis, we review our open orders to determine if they meet our backlog definition. As a result of this process, we removed a significant number of orders from our backlog during the year ended December 31, 2008. Reasons for these removals included uncertainty regarding customer project sites, customer shipment schedules, customer economic issues, the timing of shipments to our Japanese distributor and competitive losses of two customers. As a result of our new process for tracking orders that we implemented in the second quarter of 2008, we believe that we have improved accuracy in determining backlog and predicting the timing of shipments.

Table of Contents

Revenue
The majority of our revenue is generated from sales of the Hi Art system. We negotiate the actual purchase price with each customer, and, historically, the purchase price has varied significantly across geographic regions.
Because of the current unstable global economy and increased competition, we expect our 2009 revenue to be similar to our 2008 revenue. However, based on continued growth in market demand for image-guided radiation therapy equipment, our new senior sales management, our growing number of service contracts, our revenue backlog as of December 31, 2008 and our expected release of product enhancements in the future, we are optimistic about our revenue growth beyond 2009.
Our revenue projections can be impacted by a number of factors, including the following:
• Shipments of the Hi Art system generally occur 9 to 12 months after the order is received. Timing of deliveries can be affected by factors out of our control such as construction delays at customer project sites and customer credit issues. We generally recognize revenue from a system sale upon customer acceptance, which usually occurs three to four weeks after delivery. Each installation represents a significant percentage of our revenue for a particular quarter.

• Our geographic mix of customers may impact our average selling prices. Increased sales of the Hi Art system outside of North America have tended to favorably impact our gross margins due to higher average selling prices in these markets. We intend to continue to expand our international selling efforts, although we cannot be certain that favorable pricing trends will continue nor can we 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 Hi Art system compared to competing systems is a factor in our ability to influence the market demand for the Hi Art system. To compete effectively, we may need to offer additional features that could require substantial internal resources to develop.

• Our focus on sales to for-profit, multi-center customers in the United States may require us to lower selling prices, as these customers tend to be more price-conscious. In addition, we have a limited history of working with these for-profit, multi-center customers. 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 Hi Art system is a major capital equipment item that represents a significant purchase for most of our customers. If the global economy continues its downward trend, our customers may choose to delay some of their capital spending, and, as a result, our incoming orders and subsequent revenue recognition may be materially adversely affected.

Also included in our revenue are sales of optional equipment and software enhancements purchased by our end customers. Because we plan to further develop the Hi Art system by adding upgraded features, we expect to experience continued revenue growth from optional equipment and software enhancements.
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-year or multiple-year terms, giving our customers the option to contract for the level of support they desire. Currently, our most popular service plan is our Total TLC Service Package, or Total TLC. Under Total TLC, we provide customers with full spare parts coverage, including installation service by our field service engineers, and full planned maintenance. We recognize service contract revenue ratably over the term of the contract. We recognize revenue from spare parts, primarily sold to our distributors, upon shipment.
As the number of installed systems continues to grow, we expect to experience growth in our revenue from post-warranty service contracts. Also, we intend to offer various levels of service, which we believe will ultimately enhance our revenue and profitability.
Our ability to execute these strategies to increase incoming orders, to increase backlog with high quality orders, to increase sales of optional equipment and software enhancements and to 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, we may generate revenue at levels that are similar to or lower than those we have generated in the past.

Table of Contents

Cost of revenue
Cost of revenue includes all our manufacturing and service costs. It consists of material, labor and overhead costs incurred in the manufacture of the Hi Art system. It also includes the cost of shipping the system to the customer site, installation costs, warranty provision and royalty payments to Wisconsin Alumni Research Foundation (WARF), a related party. Finally, cost of revenue includes the customer support and service infrastructures required to service and repair the equipment during the warranty and service contract periods.
In future periods, we expect to improve our gross margins through the following initiatives:
Component supply and cost. Our cost of revenue has been impacted by high component costs and higher replacement rates than we originally anticipated, resulting in increased warranty expense and negative profit margins on various service contracts. We are developing alternate components and implementing enhancements to increase the performance of components used in the Hi Art 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 Hi Art system in order to reduce costs. We believe that achieving these goals should result in reduced manufacturing and service support costs in the long term.
Service and support expenses. We continue to have a number of individual service contracts that produce negative gross profit margins, and we have recorded a reserve for the related estimated future losses. However, our average direct service costs per site are beginning to decrease. We expect to continue to improve service contract margins by leveraging our fixed service infrastructure costs over a larger installed base, increasing the price for some of our older annual service contracts, training our personnel to improve their diagnostic capabilities and introducing component design changes, all of which should improve system performance and reduce overall service costs.
Warranty. Our standard sales contract includes a warranty covering replacement components and service for a one-year period. We record a reserve to cost of revenue at the time of revenue recognition for the expected cost of warranty claims based on our historical experience. We believe that our warranty provision can be reduced in the future if our initiatives to reduce service and support costs succeed.
Our ability to execute on these strategies to reduce customer support and service 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 execute these strategies, we may experience margins that are similar to or lower than our past performance.
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.
We expect research and development expenses to decrease during 2009, both in dollars and as a percentage of total revenue, because we have decreased the total number of employees performing research and development activities. We plan to be more selective with our ongoing project spending by focusing on the highest priority projects.
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 selling, general and administrative expenses to remain relatively level during 2009, both in dollars and as a percentage of total revenue. We also expect these expenses to decrease as a percentage of total revenue as our overall business grows in future years.

Table of Contents

Nonoperating expenses
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. We do not currently have a hedging program in place to offset these risks.
Interest income
Since the completion of our initial public offering, we have invested our cash balances in a short-term investment portfolio. Until recently, this has led to growing interest income. We expect interest income to decline in 2009 due both to lower levels of investable cash and to a reduction in interest rates. Income tax expense (benefit)
Multiple taxing jurisdictions and projected financial earnings or losses. We are subject to taxes on earnings in the United States and in numerous foreign jurisdictions. Significant judgments and estimates are required when evaluating our tax positions and determining our provision for taxes on earnings. As a result, our worldwide effective tax rate may fluctuate based on a number of factors including variations in projected taxable income 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
Deferred tax asset valuation allowance. During the fourth quarter of 2008, in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes(SFAS No. 109), we recorded a 100% valuation allowance against our net deferred tax assets in domestic and certain foreign jurisdictions. SFAS No. 109 requires an assessment of 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 primarily due to our three-year cumulative net taxable loss as of December 31, 2008, our projected taxable loss in 2009, our decreased backlog and the challenging near-term economic conditions. As of September 30, 2008, we believed that there was a more likely than not possibility that our deferred assets would be recovered. As a result of the valuation allowance, there will be no net federal tax benefit recorded against the losses that we expect to incur during 2009. Noncontrolling interests
Our consolidated financial statements include the accounts of Compact Particle Acceleration Corporation (CPAC), our controlled, minority-owned affiliate. Because we hold a call option on the medical technology from CPAC and maintain overall control of its board of directors, for accounting purposes we are deemed to have a controlling interest in the entity. Since our ownership interest is less than 50%, the outside stockholders' interests are shown in our consolidated financial statements as "Noncontrolling interests." If we obtain the third-party funding we are seeking for CPAC, we expect our ownership percentage to decline.

Table of Contents

Results of Operations
The following table sets forth our statements of operations as a percentage of revenue for the periods indicated:

                                                                    Years ended December 31,
                                                             2008              2007             2006
                                                          (Restated)
Revenue                                                       100.0 %          100.0 %          100.0 %
Cost of revenue                                                75.8             62.8             65.8

Gross profit                                                   24.2             37.2             34.2

Operating expenses:
Research and development                                       20.8             14.7             13.7
Selling, general and administrative                            22.7             18.2             14.8

Total operating expenses                                       43.5             32.9             28.5

Income (loss) from operations                                 (19.3 )            4.3              5.7
Other income (expense)                                          2.8              2.8             (0.7 )

Income (loss) before income tax, noncontrolling
interests and cumulative effect of change in
accounting principle                                          (16.5 )            7.1              5.0
Income tax expense (benefit)                                    3.4              2.5             (4.6 )

Income (loss) before noncontrolling interests and
cumulative effect of change in accounting principle           (19.9 )            4.6              9.6
Noncontrolling interests                                        3.5              0.0              0.0

Income (loss) before cumulative effect of change in
accounting principle                                          (16.4 )            4.6              9.6
Cumulative effect of change in accounting principle             0.0              0.0             (1.4 )

Net income (loss)                                             (16.4 )%           4.6 %            8.2 %

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Revenue
   Revenue by major type for the years ended December 31, 2008 and 2007 was as
follows (in thousands):

                                                 Years ended December 31,
                                               2008                    2007
           Product revenue             $ 174,929        86 %   $ 213,900        92 %
           Service and other revenue      29,660        14        18,910         8

                                       $ 204,589       100 %   $ 232,810       100 %

Revenue by geographic region for the years ended December 31, 2008 and 2007 was as follows (in thousands):

                                           Years ended December 31,
                                         2008                    2007
                 North America   $ 135,977        67 %   $ 129,493        56 %
                 Europe             49,588        24        61,337        26
                 Asia-Pacific       19,024         9        41,980        18

                                 $ 204,589       100 %   $ 232,810       100 %

Product revenue decreased $39.0 million or 18% between years. This decrease was attributable to 18% fewer Hi Art systems installed and accepted during the year ended December 31, 2008 versus the year ended December 31, 2007. Also, during the year ended December 31, 2007, 44% of our revenue was from international customers, and these sales generally carried higher average selling prices due to favorable exchange rates. During the year ended December 31, 2008, only 33% of our revenue was generated outside North America. Overall, average selling prices during 2008 decreased 3% from those of 2007.
Service and other revenue increased $10.8 million or 57% between years. This increase was primarily attributable to an $11.3 million increase in service contract revenue, as more systems moved from warranty to service contract coverage. There were 51%

Table of Contents

more units covered by service contracts at December 31, 2008 as compared to December 31, 2007. The increase was also attributable to a $1.1 million increase in turnkey revenue related to construction services managed for customers and was partially offset by a $1.9 million decrease in spare parts and other service revenue.
No single customer accounted for more than 10% of our revenue for the years ended December 31, 2008 or 2007.
Cost of revenue
Cost of revenue increased to $155.0 million for the year ended December 31, 2008 from $146.1 million for the year ended December 31, 2007, an increase of $8.9 million or 6%. Overall, our gross margin was 24.2% for the year ended December 31, 2008 compared to 37.2% for the year ended December 31, 2007. The reduction in gross margin was primarily due to lower product revenue and higher service-related expenses. . . .