PRO-DEX, INC. The following discussion of our financial condition and results of operations should be read in conjunction with our Financial Statements and the Notes thereto contained elsewhere in this report, as well as the Risk Factors included in Item 1A of this report. The following discussion contains forward-looking statements. (See "Cautionary Note Regarding Forward-Looking Statements" included in Part I of this report.) Overview
The following discussion and analysis provides information that management
believes is relevant to an assessment and understanding of our results of
operations and financial condition for the fiscal years ended
We specialize in the design, development, and manufacture of autoclavable, battery-powered and electric, multi-function surgical drivers and shavers used primarily in the orthopedic, thoracic, and CMF markets. Additionally, we provide engineering, quality, and regulatory consulting services to our customers. We also sell rotary air motors. Our products are found in hospitals, medical engineering labs, scientific research facilities, and high-tech manufacturing operations around the world. We are headquartered inIrvine, California . COVID-19 Pandemic We have adjusted certain policies and procedures based on applicable national, state, and local emergency orders and safety guidance that may be issued from time to time, in order to effectively manage our business during the pandemic, including:
· Non-essential employees that are able to work remotely did so during most of
fiscal 2021 and some of fiscal 2022;
· Increased frequency of disinfectant cleanings, especially for high-touch
surfaces;
· Curtailed business travel;
· Multiple, staggered work shifts have been implemented in order to achieve
effective social distancing;
· Provided training, education and appropriate personal protective equipment;
· Implemented quarterly, then monthly, company-wide COVID-19 testing through June
2021; and
· Daily temperature screenings and personal affidavits of wellness.
While we have yet to see any decline in our customer orders, we have received and accepted some customer requests to delay the shipment of their existing orders. We provide our largest customer with a device used primarily in elective surgeries and although this customer has not requested a reduction or delay to their planned shipments, if this pandemic continues to adversely impactthe United States and other markets where our products are sold, coupled with the recommended deferrals of elective procedures by governments and other authorities, we would expect to see a decline in demand from our principal customer. We are focused on the health and safety of all those we serve - our customers, our communities, our employees, and our suppliers. We are supporting our customers according to their priorities and working with them to the degree that we can offer relief in the form of delayed shipments. We are focused on continuity of supply by working with our suppliers, some of whom have delivered our orders late and are quoting longer lead times. 16 While the COVID-19 pandemic did not materially adversely affect our financial results and business during calendar 2021, we began to see some challenges in our supply chain in the form of delayed shipments, longer lead times, and surcharges, much of which our suppliers indicate has been caused by the COVID-19 pandemic. As previously disclosed, during early calendar 2022, we saw these conditions persist and worsen such that we expected them to negatively impact our financial performance in the third quarter and possibly the fourth quarter of fiscal 2022, reflected as a reduction in net sales. However, we did not end up experiencing this anticipated decline in our sales because we were able to largely mitigate our biggest concerns by sourcing replacement chips through alternative suppliers, albeit at much higher prices, for many of our printed circuit board assemblies. In so doing, our cost of sales increased during the third and fourth quarter of fiscal 2022. We continue to implement plans and processes to mitigate these challenges that many manufacturers similarly face. Our long-term prospects remain positive, and we believe these challenges will negatively impact us only in the short-term. Critical Accounting Policies Our financial statements are prepared in accordance withU.S. GAAP. The preparation of our financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures. We base our estimates on historical experience and various other assumptions that are believed 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. Revenue Recognition Under Accounting Standards Update ("ASU") 2014-09, (Topic 606) "Revenue From Contracts with Customers," we recognize revenue from the sales of products and services by applying the following steps: (1) identify the contract with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to each performance obligation in the contract; and (5) recognize revenue when each performance obligation is satisfied. We primarily sell finished products and recognize revenue at point of sale or delivery. However, we also perform services when we are engaged to design a product for a customer and there is more judgment involved in determining the amount and timing of revenue recognition under those types of contracts. In fiscal 2022, the revenue from non-recurring engineering ("NRE") and prototype services represents approximately 2% of total revenue.
Returns of our product for credit are not material; accordingly, we do not establish a reserve for product returns at the time of sale.
Estimated Losses on Product Development Services
Cost and revenue estimates related to the product development service portions of development and supply contracts are reviewed and updated quarterly. An expected loss on development service contracts is recognized immediately in cost of sales. Losses recorded in fiscal 2022 and 2021 related to these services totaled$0 and$71,000 , respectively. Owing to the complexity of many of the contracts we have undertaken, the cost estimation process requires significant judgment. It is based upon the knowledge and experience of our project managers, engineers, and finance professionals. Factors that are considered in estimating the cost of work to be completed and ultimate profitability of the fixed price product development portion of development and supply contracts include the nature and complexity of the work to be performed, availability and productivity of labor, the effect of change orders, the availability of materials, performance of subcontractors, and expected costs for specific regulatory approvals. 17 Warranties
Most of our products are sold with a warranty that provides for repairs or replacement of any defective parts for a period, generally one to two years, after the sale. At the time of the sale, we accrue an estimate of the cost of providing the warranty based on prior experience with such factors as return rates and repair costs, which factors are reviewed quarterly.
Warranty expenses, including changes of estimates, are included in cost of sales in our statements of operations.
Inventories
Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Reductions to estimated net realizable value are recorded, and charged to cost of sales, when indicated based on a formula that compares on-hand quantities to both historical usage and estimated demand over the ensuing 12 months from the measurement date. Accounts Receivable Trade receivables are stated at their original invoice amounts, less an allowance for doubtful portions of such accounts. Management determines the allowance for doubtful accounts based on facts and circumstances related to specific accounts, and on historical experience related to the age of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously reserved are offset against the allowance when received. Deferred Costs
Deferred costs reflect costs incurred related to non-recurring engineering services under the terms of the related development and supply contracts. These costs get recorded to cost of sales in the period that the revenue is recognized.
Investments Investments consist of marketable equity securities of publicly held companies. The investments were made to realize a reasonable return, although there is no assurance that positive returns will be realized. Investments are marked to market at each measurement date, with unrealized gains and losses presented in other income (expense) in our consolidated income statements. Some of our investments include the common stock of public companies that are thinly traded. Certain of these investments are classified as long-term in nature, as we may not be able to liquidate the investments in a timely manner even if we wish to sell them. Thinly traded investments were subject to a valuation analysis as ofJune 30, 2022 and 2021. Long-lived Assets
We review the recoverability of long-lived assets, consisting of building, equipment, and improvements, when events or changes in circumstances occur that indicate carrying values may not be recoverable.
Building, equipment, and improvements are recorded at historical cost and
depreciation is provided using the straight-line method over the following
periods:
Building Thirty years
Equipment Three to ten years
Improvements Shorter of the remaining life of the underlying
building, lease term, or the asset's estimated
useful life
18
Intangibles
Other intangibles consist of legal fees incurred in connection with patent applications. The legal fees will be amortized over the estimated life of the product(s) that will be utilizing the technology or expensed immediately in the event the patent office denies the issuance of the patent. The expense associated with the amortization of the patent costs is recognized in research and development costs. Income Taxes
We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities, along with net operating loss and tax credit carryovers. Deferred tax assets atJune 30, 2022 and 2021 consisted primarily of basis differences related to unrealized gain/loss related to investments, stock-based compensation, fixed assets, accrued expenses and inventories. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. Significant management judgment is required in determining our provision for income taxes and the recoverability of our deferred tax assets. Such determination is based on our historical taxable income, with consideration given to our estimates of future taxable income and the periods over which deferred tax assets will be recoverable. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence, including reversals of deferred tax liabilities, projected future taxable income, and results of recent operations. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying business. In evaluating the objective evidence that historical results provide, we consider three years of cumulative operating income (loss).
Results of Operations for the Fiscal Year Ended
The following tables set forth results from operations for the fiscal years
ended
Years Ended June 30,
2022 2021
Dollars in thousands
% of % of
Net Sales Net Sales
Net sales $ 42,041 100 % $ 38,029 100 %
Cost of sales 28,909 69 % 24,454 64 %
Gross profit 13,132 31 % 13,575 36 %
Selling expenses 91 - 590 2 %
General and administrative expenses 4,903 12 % 4,076 11 %
Loss from disposal of equipment 35 - - -
Research and development costs 2,980 7 % 4,384 11 %
8,009 19 % 9,050 24 %
Operating income 5,123 12 % 4,525 12 %
Other income (loss), net (417 ) (1 %) 2,472 6 %
Income before income taxes 4,706 11 % 6,997 18 %
Income tax expense 851 2 % 1,176 3 %
Net income $ 3,855 9 % $ 5,821 15 %
19
Net Sales
The majority of our revenue is derived from designing, developing, and
manufacturing powered surgical instruments for medical device original equipment
manufacturers. We also manufacture and sell rotary air motors to a wide range of
industries. The proportion of total sales by product/service type is as follows:
Increase
(Decrease) From
Years Ended June 30, 2021 To
2022 2021 2022
Dollars in thousands
% of % of
Net Sales Net Sales
Net sales:
Medical devices $ 34,004 81 % $ 32,149 85 % 6 %
Industrial and scientific 919 2 % 854 2 % 8 %
NRE & Prototype services 1,014 2 % 324 1 % 213 %
Dental and component 465 1 % 161 - 189 %
Repairs 6,610 16 % 4,956 13 % 33 %
Discounts & Other (971 ) (2 %) (415 ) (1 %) 134 %
$ 42,041 100 % $ 38,029 100 % 11 %
Net sales in fiscal 2022 increased by
Increase
(Decrease)
Years Ended June 30, From 2021 To
2022 2021 2022
Dollars in thousands
% of % of
Total Total
Medical device sales:
Orthopedic $ 21,877 64 % $ 18,061 56 % 21 %
CMF 10,277 30 % 6,212 19 % 65 %
Thoracic 1,850 6 % 7,876 25 % (77 %)
Total $ 34,004 100 % $ 32,149 100 % 6 %
Sales of our medical device products increased$1.9 million , or 6% during, fiscal 2022 as compared to fiscal 2021. During fiscal 2022, orthopedic sales increased by$3.8 million to$21.9 million , up from$18.1 million in fiscal 2021, due primarily to increased sales to our largest customer. Additionally, recurring revenue from distributors of CMF drivers increased$4.1 million in fiscal 2022 compared to fiscal 2021 in part due to the launch of a new driver to our existing largest customer during the third quarter of fiscal 2021. Our fiscal 2022 thoracic sales revenue decreased$6.0 million compared to the prior fiscal year, due likely as a result of our customer filling the near-term requirements of its distribution network. Currently, the thoracic driver is only sold to one customer, although we are in discussions with other of our existing customers who have expressed an interest in this driver. Sales of our industrial and scientific products, which consist primarily of our compact pneumatic air motors, increased$65,000 , or 8%, for fiscal 2022 compared to fiscal 2021. The revenue increase relates to a continued interest in these legacy products, but is not due to any substantive marketing efforts.
Sales of our NRE & proto-type services increased
20 Sales of our dental products and components in fiscal 2022 increased$304,000 , or 189%, as compared to fiscal 2021. The increase in sales in fiscal 2022 related to component sales of excess inventory directly to our largest customer due to the release of their next generation device. We expect future declines in this area as we are no longer manufacturing dental products, but rather are simply selling remaining component inventory. Our fiscal 2022 repair revenue has increased approximately$1.7 million , or 33%, over fiscal 2021 to$6.6 million , due to increased repairs of the orthopedic handpiece we sell to our largest customer. We expect repair revenue to continue to increase based upon expected refurbishments to upgrade the handpiece to the next generation, which was released in the third quarter of fiscal 2022. While we expect the volume of repairs to increase, we expect the gross margin to deteriorate, at least in the near term, as we are currently upgrading these handpieces at no additional cost while we continue to negotiate a new repair price with our largest customer in good-faith. AtJune 30, 2022 , we had a backlog of$16.5 million compared with a backlog of$9.7 million atJune 30, 2021 . Our backlog represents firm purchase orders received and acknowledged from our customers and does not include all revenue expected to be generated from existing customer contracts. Our entire backlog atJune 30, 2022 , as well as certain purchase orders received subsequent toJune 30, 2022 , are expected to be delivered during fiscal 2023. We have experienced, and may continue to experience, variability in our new order bookings due to, among other reasons, the launch of new products, the timing of customer orders based on end-user demand, and customer inventory levels. We do not typically experience seasonal fluctuations in our shipments and revenues.
Cost of Sales and Gross Margin
Increase
(Decrease)
Years Ended June 30, From 2021 To
2022 2021 2022
Dollars in thousands
% of % of
Net Sales Net Sales
Cost of sales:
Product costs $ 26,296 63 % $ 23,093 60 % 14 %
NRE and Prototype services
costs 774 2 % 395 1 % 96 %
Under (over)-absorption of
manufacturing overhead 877 2 % 370 1 % 137 %
Inventory and warranty
charges 962 2 % 596 2 % 61 %
Total cost of sales $ 28,909 69 % $ 24,454 64 % 18 %
Cost of sales in fiscal 2022 increased $4.5 million , or 18%, from fiscal 2021,
primarily due to the increase in product costs, consistent with the 11% increase
in net sales, coupled with higher material and labor costs. During fiscal 2021,
we incurred costs of $395,000 to generate $324,000 in revenue related to NRE and
Prototype services, netting losses in the amount of $71,000 compared to netting
profit of $240,000 in fiscal 2022. During fiscal 2022, we experienced $877,000
under-absorption of manufacturing costs compared to a $370,000 in fiscal 2021,
due primarily to actual production hours being less than planned. Costs related
to inventory and warranty charges increased $366,000 in fiscal 2022 compared to
fiscal 2021, primarily due to sourcing components for our printed circuit board
assemblies at prices higher than usual.
21
Operating Expenses
Increase
(Decrease)
Years Ended June 30, From 2021 To
2022 2021 2022
(Dollars in thousands)
% of % of
Net Sales Net Sales
Operating expenses:
Selling expenses $ 91 - $ 590 2 % (85 %)
General and administrative
expenses 4,903 12 % 4,076 11 % 20 %
Research and development
costs 2,980 7 % 4,384 11 % (32 %)
$ 7,974 19 % $ 9,050 24 % (12 %)
Selling expenses consist of salaries and other personnel-related expenses
related to our business development department, as well as trade show
attendance, advertising and marketing expenses, and travel and related costs
incurred in generating and maintaining customer relationships. Selling expenses
decreased $499,000 , or 85%, compared to fiscal 2021, primarily due to decreased
personnel and related expenses due to combining our Director of Business
Development position with our Director of Engineering position in the first
quarter of fiscal 2022.
General and administrative expenses ("G&A") consist of salaries and other
personnel-related expenses for corporate, accounting, finance, and human
resource personnel, as well as costs for outsourced information technology
services, professional fees, directors' fees, and costs associated with being a
public company. The $827,000 increase in G&A expenses from fiscal 2021 to 2022
is due primarily to $374,000 in increased stock compensation expense related to
awards granted in fiscal 2022 and 2021. We also incurred $261,000 in expenses in
fiscal 2022 related to defending a patent infringement case brought against one
of our customers. We incurred no similar expenses during the prior fiscal year.
Finally, we incurred an increase in professional service fees in fiscal 2022 as
compared to fiscal 2021 related to the costs associated with being a public
company of approximately $142,000 .
Research and development costs generally consist of salaries, employer-paid
benefits, and other personnel- related costs of our engineering and support
personnel, as well as allocated facility and information technology costs,
professional and consulting fees, patent-related fees, lab costs, materials, and
travel and related costs incurred in the development and support of our
products. Research and development costs decreased $1.4 million from fiscal 2021
to 2022 due to decreased spending on internal product development projects. In
fiscal 2022, our engineering department has been engaged in more billable
customer projects and therefore costs get shifted to cost of sales instead
of
research and development.
22
Although the majority of our research and development costs relate to sustaining
activities related to products we currently manufacture and sell, we have
created a product roadmap to develop future products. Many of our product
development efforts are undertaken only upon completion of an analysis of the
size of the market, our ability to differentiate our product from our
competitors', as well as an analysis of our specific sales prospects with new
and/or existing customers. Research and development costs represent between 37%
and 48% of total operating expenses during fiscal 2021 and 2022 and are expected
to increase in the future as we continue to invest in product development. The
amount spent on projects under development is summarized below (in thousands):
Expected Estimated
Market Annual
Years Ended June 30, Launch(1) Revenue(2)
2022 2021
Dollars in thousandsProducts in development: ENT Shaver 282 829 Q4 2022$ 1,000 CMF Driver - 826 (3)$ 1,000 Vital Ventilator 115 191 Q1 2023$ 1,500 Sustaining & Other 2,583 2,538 Total$ 2,980 $ 4,384
(1) Represents the calendar quarter of expected market launch.
(2) The products in development include risks that they could be abandoned in the
future prior to completion, they could fail to become commercialized, or the
actual annual revenue realized may be less than the amount estimated.
(3) The CMF Driver was completed in the third quarter of fiscal 2021 and began
shipping to our existing largest customer under a distribution agreement we
executed in the first quarter of fiscal 2021. We generated revenue of
million related to this product in fiscal 2022.
As we introduce new products into the market, we expect to see an increase in sustaining and other engineering expenses. Typical examples of sustaining engineering activities include, but are not limited to, end-of- life component replacement, especially in electronic components found in our printed circuit board assemblies, analysis of customer complaint data to improve process and design, replacement and enhancement of tooling and fixtures used in the machine shop, assembly operations, and inspection areas to improve efficiency and through-put. Additionally, these costs include development projects that may be in their infancy and may or may not result in a full-fledged product development effort. Other Income (Expense) Interest and Dividend Income Our interest and dividend income earned in fiscal 2022 and 2021 includes income earned from our interest-bearing money market accounts and portfolio of equity investments.
Unrealized gain (loss) on marketable equity investments
The unrealized gain (loss) on marketable equity investments relates to our investment portfolio more fully described in Note 5 to the consolidated financial statements contained elsewhere in this report.
Gain on Sale of Investments
During fiscal 2022, we liquidated some of the investments in our portfolio of equity investments receiving proceeds of$770,000 and recording a gain of$28,000 . During fiscal 2021, we liquidated some of the investments in our portfolio of equity investments receiving proceeds of$4.6 million and recording a gain of$1.3 million . 23 Interest Expense Interest expense incurred in fiscal 2022 and 2021 consists primarily of interest expense related to our debt withMinnesota Bank & Trust ("MBT") described more fully in Note 8 to the consolidated financial statements contained elsewhere in this report. Income Taxes The effective tax rate for the fiscal years endedJune 30, 2022 and 2021, was 18% and 17%, respectively, slightly less than our combined expected federal and applicable state corporate income tax rates due primarily to federal and state research credits.
Liquidity and Capital Resources
The following table is a summary of our Statements of Cash Flows andCash and Working Capital as of and for the fiscal years endedJune 30, 2022 and 2021: As of and for the Years Ended June 30, 2022 2021 (In thousands) Cash provided by (used in): Operating activities$ (847 ) $ (2,078 ) Investing activities$ (1,235 ) $ (3,710 ) Financing activities$ (790 ) $ 3,088 Cash, cash equivalents and working capital: Cash and cash equivalents$ 849 $ 3,721 Working capital$ 19,812 $ 18,744
Cash Flows from Operating Activities
Cash used in operating activities totaled$847,000 during fiscal 2022. Our net income was$3.9 million and included non-cash stock compensation expense and depreciation and amortization expense in the amount of$1.3 million and$726,000 , respectively. Additionally, our accounts payable and accrued expenses increased by$2.0 million . Offsetting these inflows of cash, our accounts receivable and inventory balances grew by$4.4 million and$4.2 million , respectively. Cash used in operating activities during fiscal 2021 totaled$2.1 million . Our net income was$5.8 million and included$1.3 million of gains on the sales of certain equity investments,$1.4 million in unrealized gains on marketable equity investments, as well as$901,000 of non-cash stock compensation. Offsetting this net inflow of cash, our accounts receivable balance increased by$5.8 million primarily because our largest customer changed their payment terms from net 30 to net 90 in conjunction with a contract extension executed in fiscal 2021.
Cash Flows from Investing Activities
Net cash used in investing activities in fiscal 2022 was
Net cash used in investing activities in fiscal 2021 was$3.7 million . During the 2021 fiscal year, we generated$4.6 million in proceeds from sales of marketable equity securities under the direction of the Investment Committee of our Board, purchased the Franklin Property for$6.5 million and made capital expenditures in the amount of$1.8 million primarily for the Franklin Property. 24
Cash Flows from Financing Activities
Net cash used in financing activities for fiscal 2022 totaled$790,000 and related primarily to the$1.6 million repurchase of 75,250 shares of our common stock pursuant to our share repurchase program, as well as$1.2 million of principal payments primarily related to our various loans from MBT offset by the$2.0 million in new borrowings from MBT more fully described in Note 8 to the consolidated financial statements contained elsewhere in this report. Net cash provided by financing activities for fiscal 2021, totaled$3.1 million and included$9.1 million in various loans from MBT more fully described in Note 8 to the consolidated financial statements contained elsewhere in this report, offset by$5.5 million related to the repurchase of 216,171 shares of our common stock pursuant to our share repurchase program,$351,000 of principal payments on our loans with MBT, as well as payment of$259,000 of employee payroll taxes related to the award of 40,000 shares of common stock to employees under previously granted performance awards.
Liquidity Requirements for the Next 12 Months
As ofJune 30, 2022 , our working capital was$19.8 million . We currently believe that our existing cash and cash equivalent balances, together with our account receivable balances, and anticipated cash flows from operations will provide us sufficient funds to satisfy our cash requirements as our business is currently conducted for at least the next 12 months. We are focused on preserving our cash balances by monitoring expenses, identifying cost savings, and investing only in those development programs and products that we believe will most likely contribute to our profitability. As we execute our current strategy, however, we may require debt and/or equity capital to fund our working capital needs and requirements for capital equipment to support our manufacturing and inspection processes. In particular, we have experienced negative operating cash flow in the past, especially as we procure long-lead time materials to satisfy our backlog, which can be subject to extensive variability. We believe that if we need additional capital to fund our operations, we can borrow against our revolving loan with MBT, or sell additional shares of our common stock under our ATM Agreement, which is currently suspended, but which we believe we could reinstate if needed.
Surplus Capital Investment Policy
During fiscal 2013, our Board approved a Surplus Capital Investment Policy (the "Policy") that provides, among other items, for the following:
(a) Determination by our Board of Directorsof (i) our surplus capital balance and
(ii) the portion of such surplus capital balance to be invested according to
the Policy;
(b) Selection of an Investment Committee responsible for implementing the Policy;
and
(c) Objectives and criteria under which investments may be made.
The Investment Committee is comprised of Messrs.
The Investment Committee approved each of the investments comprising the$2.5 million of marketable public equity securities held atJune 30, 2022 , which amount includes unrealized holding losses in the amount of$262,000 at June
30, 2022. InDecember 2019 , our Board approved a new share repurchase program authorizing us to repurchase up to one million shares of our common stock, as the prior repurchase plan, authorized by our Board in 2013, authorizing the repurchase of 750,000 shares of common stock was nearing completion. In accordance with, and as part of, these share repurchase programs, our Board has approved the adoption of several prearranged share repurchase plans intended to qualify for the safe harbor Rule 10b5-1 under the Securities Exchange Act of 1934, as amended ("10b5-1 Plan" or "Plan"). 25
During the fiscal year endedJune 30, 2022 , we repurchased 75,250 shares at an aggregate cost, inclusive of fees under the Plan, of$1.6 million . During the fiscal year endedJune 30, 2021 , we repurchased 216,171 shares at an aggregate cost, inclusive of fees under the Plan, of$5.5 million . On a cumulative basis, we have repurchased a total of 1,110,746 shares under the share repurchase programs at an aggregate cost, inclusive of fess under the Plan, of$15.7 million . All repurchases under the 10b5-1 Plans were administered through an independent broker.
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