Electromed, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited Condensed Financial Statements and related notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, and our audited financial statements and related notes thereto included in Part II, Item 8 of our Annual Report on Form 10-K for the fiscal year ended June 30, 2021 (“fiscal 2021”). Overview Electromed, Inc. (“we,” “our,” “us,” “Electromed” or the “Company”) develops and provides innovative airway clearance products applying High Frequency Chest Wall Oscillation (“HFCWO”) technologies in pulmonary care for patients of all ages. We manufacture, market and sell products that provide HFCWO, including the SmartVest® Airway Clearance System (“SmartVest System”) that includes our newest generation SmartVest SQL® and previous generation SV2100, and related products, to patients with compromised pulmonary function. The SmartVest SQL is smaller, quieter and lighter than our previous product, with enhanced programmability and ease of use. Our products are sold in both the home health care market and the institutional market for use by patients in hospitals, which we refer to as “institutional sales.” The SmartVest SQL has been sold in the domestic home care market since 2014. In 2015, we launched the SmartVest SQL into institutional and certain international markets. In June 2017, we announced the launch of the SmartVest SQL with SmartVest Connect™ wireless technology, which allows data connection between physicians and patients to track therapy performance and collaborate in treatment decisions. SmartVest Connect is currently available to pediatric and cystic fibrosis patients and was made available to certain targeted adult pulmonary clinics starting in November 2017. Since 2000, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis and repeated episodes of pneumonia. Additionally, we offer our products to a patient population that includes neuromuscular disorders such as cerebral palsy, muscular dystrophies, amyotrophic lateral sclerosis (“ALS”), the combination of emphysema and chronic bronchitis commonly known as chronic obstructive pulmonary disease (“COPD”), and patients with post-surgical complications or who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport. 11 The SmartVest System is often eligible for reimbursement from major private insurance providers, health maintenance organizations (“HMOs”), state Medicaid systems and the federal Medicare system, which we believe is an important consideration for patients considering an HFCWO course of therapy. For domestic sales, the SmartVest System may be reimbursed under the Medicare-assigned billing code (E0483) for HFCWO devices if the patient has cystic fibrosis, bronchiectasis (including chronic bronchitis or COPD that has resulted in a diagnosis of bronchiectasis) or any one of certain enumerated neuromuscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Private payers consider a variety of sources, including Medicare, as guidelines in setting their coverage policies and payment amounts. Critical Accounting Policies and Estimates For a description of our critical accounting policies, estimates and assumptions used in the preparation of our financial statements, including the unaudited Condensed Financial Statements in this Quarterly Report on Form 10-Q, see Note 1 to our unaudited Condensed Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q and Part II, Item 7, and Note 1 to our audited financial statements included in Part II, Item 8, of our Annual Report on Form 10-K for fiscal 2021. Some of our accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial statements. Such judgments are subject to an inherent degree of uncertainty. Among other factors, these judgments are based upon our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe the critical accounting policies that require the most significant assumptions and judgments in the preparation of our financial statements, including the unaudited Condensed Financial Statements contained in this Quarterly Report on Form 10-Q, include: revenue recognition and the estimation of variable consideration, allowance for doubtful accounts, inventory obsolescence, share-based compensation and warranty liability. Impacts of COVID-19 on Our Business and Operations In March 2020, the World Health Organization designated COVID-19 as a global pandemic, and the U.S. Department of Health and Human Services designated COVID-19 as a public health emergency. The impact of the COVID-19 pandemic on our business remains uncertain, and its effects on our operational and financial performance will depend in part on future developments, which cannot be reasonably estimated at this time. Such future developments include, but are not limited to, the duration, scope and severity of the COVID-19 pandemic in geographic areas in which we operate or in which our patients live, actions taken to contain or mitigate its impact, the impact on governmental healthcare programs and budgets, the development and distribution of treatments or vaccines, and the resumption of widespread economic activity. Due to the inherent uncertainty of the unprecedented and evolving situation, we are unable to predict with confidence the likely impact of the COVID-19 pandemic on our future operations. During the second quarter of our fiscal year ending June 30, 2022 (“fiscal 2022”), we continued to experience a reduction in the number of clinics allowing face-to-face access by our sales team as the number of infections relating to the Omicron variant of COVID-19 increased throughout most regions of the United States, and hospitals implemented additional safety protocols. Our sales team continued to utilize a hybrid sales process of virtual and face-to-face clinician interaction with strict adherence to specific clinic and healthcare system safety protocols, which we believe allowed them to drive stronger referral growth compared to the prior-year period. We believe that the impact of the COVID-19 pandemic on our home care and institutional business will likely continue during the remainder of fiscal 2022. Our home care and institutional revenue for the three months ended December 2021 has increased as compared to the three months ended December 2020; however, if COVID-19 infection rates increase and federal, state and local restrictions on commerce, stay-at-home orders or other restrictions on businesses are reinstated, then such measures could have a material adverse effect on our business. 12 We have observed increased changes to our supply chain timelines and increased raw material and shipping costs during the most recent quarter, but we have not experienced any disruptions that impacted product availability for our customers. We anticipate that raw material costs will increase in future quarters primarily relating to electronic components but may extend to other components. It is possible the COVID-19 pandemic could have a greater adverse impact on our supply chain in the future, including impacts associated with preventative and precautionary measures taken by other businesses and applicable governments. A reduction or interruption in any of our manufacturing processes could have a material adverse effect on our business. Any significant increases to our raw material or shipping costs could reduce our gross margins. We have also taken measures to ensure the safety of our employees and to comply with applicable governmental orders. We consider our business to be essential under applicable governmental orders, primarily due to our role in manufacturing and supplying needed medical devices to patients with respiratory-related issues and have therefore continued to operate during the government restrictions put in place in response to the pandemic. In response to the COVID-19 pandemic and the U.S. federal government’s declaration of a public health emergency, the Centers for Medicare & Medicaid Services (“CMS”) implemented a number of temporary rule changes and waivers to allow prescribers to best treat patients during the period of the public health emergency. These waivers became effective on March 1, 2020. Clinical indications and documentation typically required will not be enforced for respiratory-related products including the SmartVest System (solely with respect to Medicare patients). The minimum documentation now requires a valid order and documentation of a respiratory-related diagnosis. Face-to-face and in-person requirements for respiratory devices are being waived while the waiver is in place. The CMS waiver was recently extended in conjunction with the extension of the federal public health emergency for an additional 90-day period beginning January 16, 2022. The Company continues to evaluate the scope and application of existing, pending and potential COVID-19 vaccination mandates and their potential impacts on our future financial condition and results of operations. In September 2021, President Joe Biden signed an executive order directing executive departments and agencies to include a clause in all covered federal contracts to comply with guidance issued by the Safer Federal Workforce Task Force, which requires, among other things, covered federal contractor employees, including employees working remotely related to federal contracts, to be fully vaccinated by December 8, 2021, unless the employee is entitled to an accommodation. As a federal contractor to the U.S. Department of Veterans Affairs Federal Supply Schedule (“Veterans Administration”), we are subject to this regulation. In fiscal 2021, $557,000, or 1.6% of our total revenues, were attributable to the Veterans Administration, and we intend to leverage that business as a future growth opportunity; approximately 19 million U.S. veterans were served by the Veterans Administration healthcare system in calendar year 2020. During the three-month period ended December 2021, we conducted a review process to ensure that we fully comply with the Safer Federal Workforce Task Force regulations. Through a concerted effort to increase vaccination rates among our workforce, we were able to achieve compliance with such regulations with minimal disruption. Results of Operations Net Revenues Net revenues for the three and six months ended December 31, 2021 and 2020 are summarized in the table below. Three Months Ended December 31, Six Months Ended December 31, 2021 2020 Increase (Decrease) 2021 2020 Increase Home care $ 9,404,000 $ 8,903,000 $ 501,000 5.6 % $ 18,688,000 $ 16,366,000 $ 2,322,000 14.2 % Institutional 333,000 309,000 24,000 7.8 % 782,000 587,000 195,000 33.2 % Home care distributor 387,000 149,000 238,000 159.7 % 543,000 326,000 217,000 66.6 % International 124,000 135,000 (11,000 ) (8.1 %) 236,000 221,000 15,000 6.8 % Total $ 10,248,000 $ 9,496,000 $ 752,000 7.9 % $ 20,249,000 $ 17,500,000 $ 2,749,000 15.7 % 13 Home care revenue . Home care revenue for the three months ended December 31, 2021 was $9,404,000, representing an increase of $501,000, or 5.6%, compared to the same period in fiscal 2021. For the six months ended December 31, 2021, home care revenue was $18,688,000, representing an increase of $2,322,000, or 14.2%, compared to the same period in fiscal 2021. The revenue increases compared to the prior-year periods were primarily due to increases in referrals and approvals. The increases in referrals compared to the prior-year periods were due to the sales team adapting to a hybrid virtual and face-to-face selling model implemented to address clinic access limitations due to the COVID-19 pandemic, benefits of the CMS waiver on the non-commercial Medicare portion of our home care revenue and an increase in direct sales representatives. The CMS waiver benefited the non-commercial Medicare portion of our home care revenue by increasing the number of referrals and the approval percentage for previously non-covered diagnoses. We believe that our ongoing sales team execution, along with the expected return to pre-COVID-19 levels of patient face-to-face engagement with physicians and clinic access for our sales team, has the potential to mitigate the impact of a CMS waiver expiration, which is currently set to expire in April 2022. Institutional revenue. Institutional revenue for the three months ended December 31, 2021 was $333,000, representing an increase of $24,000, or 7.8%, compared to the same period in fiscal 2021. For the six months ended December 31, 2021, institutional revenue was $782,000, an increase of $195,000, or 33.2%, compared to the same period in fiscal 2021. The revenue increase in the current-year periods was due to increased capital purchases and stronger disposable volumes compared to the corresponding prior-year periods, as hospitals resumed utilization of HFCWO protocols after reducing utilization early in the COVID-19 pandemic. Home care distributor revenue . Home care distributor revenue for the three months ended December 31, 2021 was $387,000, representing an increase of $238,000, or 159.7%, compared to the same period in fiscal 2021. For the six months ended December 31, 2021, home care distributor revenue was $543,000, an increase of $217,000, or 66.6%, compared to the same period in fiscal 2021. The revenue increase in the current-year periods was due to an increase in orders by one home care distribution partner. We began selling to a limited number of home medical equipment distributors during our fiscal year ended June 30, 2020, who in turn sell our SmartVest System in the U.S. home care market. International revenue . International revenue for the three months ended December 31, 2021 was $124,000, representing a decrease of $11,000, or 8.1%, compared to the same period in fiscal 2021. For the six months ended December 31, 2021, international revenue was $236,000, an increase of $15,000, or 6.8%, compared to the same period in fiscal 2021. International sales are affected by the timing of international distributor purchases that can cause significant fluctuations in reported revenue on a quarterly basis. Gross profit Gross profit increased to $7,880,000, or 76.9% of net revenues, for the three months ended December 31, 2021, from $7,525,000, or 79.2% of net revenues, in the same period in fiscal 2021. Gross profit increased to $15,581,000, or 76.9% of net revenues, for the six months ended December 31, 2021, from $13,673,000, or 78.1% of net revenues, in the same period in fiscal 2021. The decrease in gross profit as a percentage of net revenues compared to the prior-year periods was primarily due to higher raw material and shipping costs. Operating expenses Selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were $6,475,000 and $13,262,000 for the three and six months ended December 31, 2021, respectively, representing increases of $1,040,000 and $2,823,000, or 19.1% and 27.0%, respectively, compared to the same periods in the prior year. Payroll and compensation-related expenses were $4,025,000 and $8,040,000 for the three and six months ended December 31, 2021, respectively, representing increases of $593,000 and $1,308,000, or 17.3% and 19.4%, respectively, compared to the same periods in the prior year. The increase in the current-year periods was primarily due to a higher average number of sales and marketing personnel, increased reimbursement personnel to process higher patient referrals, increased temporary resources to assist with systems infrastructure investments and increased incentive payments on higher home care revenue . Field sales employees totaled 48, of which 39 were direct sales, as of December 31, 2021, compared to 45 as of December 31, 2020, of which 38 were direct sales. 14 Travel, meals and entertainment expenses were $590,000 and $1,231,000 for the three and six months ended December 31, 2021, respectively, representing increases of $124,000 and $401,000, or 26.6% and 48.3%, respectively, compared to the same periods in the prior year. The increase in the current-year periods was primarily due to our sales representatives resuming closer-to-normal levels of travel compared to the COVID-19 driven travel restrictions in the prior-year periods and a national sales meeting that was held in August 2021 but was not held in the prior fiscal year due to COVID-19. Total discretionary marketing expenses were $211,000 and $365,000 for the three and six months ended December 31, 2021, respectively, representing decreases of $106,000 and $141,000, or 33.4% and 27.9%, respectively, compared to the same periods in the prior year. The decrease in the current-year periods was primarily due to a shift to more cost-effective direct-to-consumer marketing investments. Professional fees were $624,000 and $1,735,000 for the three and six months ended December 31, 2021, respectively, representing increases of $91,000 and $748,000, or 17.1% and 75.8%, respectively, compared to the same periods in the prior year. Professional fees include services related to legal costs, shareowner services and reporting requirements, information technology technical support and consulting fees. The increase in professional fees compared to prior periods was primarily due an increase in system infrastructure investments and costs related to a shareholder activism matter, which concluded with a cooperation agreement in September 2021. We did not incur any shareholder activism costs during the three months ended December 31, 2021. We continue to make key investments in systems infrastructure including implementing a new enterprise resource planning (“ERP”) system, enhancing our customer relationship management system and further optimization of the revenue cycle management system that was implemented in June 2021. We expect these system infrastructure investments will result in more efficient and scalable operational processes and provide enhanced analytics to drive business performance. Research and development expenses. Research and development (“R&D”) expenses were $329,000 and $705,000 for the three and six months ended December 31, 2021, respectively, representing decreases of $178,000 and $284,000, or 35.1% and 28.7%, respectively, compared to the same periods in the prior year. The decrease in the current-year periods was primarily due to reduced professional services costs associated with our next generation platform development. R&D expenses were 3.2% and 3.5% of revenue for the three and six months ended December 31, 2021, respectively. Interest income, net Net interest income for the three and six months ended December 31, 2021 was $6,000 and $15,000, respectively, compared to $10,000 and $19,000, respectively, in the comparable prior-year periods. The decrease in the current-year periods was primarily due to lower rates earned on our cash deposits. Income tax expense Income tax expense was estimated at $244,000 and $352,000 and the effective tax rate was 22.6% and 21.6% for the three and six months ended December 31, 2021, respectively. Estimated income tax expense for the three and six months ended December 31, 2021 each include a discrete tax benefit of $1,000 and $21,000, respectively, related to the exercise of stock options. Income tax expense was estimated at $389,000 and $526,000 and the effective tax rate was 24.4% and 23.2% for the three and six months ended December 31, 2020, respectively. Estimated income tax expense for the three and six months ended December 31, 2020 each include a discrete tax expense of $7,000 and a discrete tax benefit of $32,000, respectively, related to the exercise of stock options. Net income Net income for the three and six months ended December 31, 2021 was $838,000 and $1,277,000, respectively, compared to $1,204,000 and $1,738,000 for the same periods in the prior year. The decrease in the current-year periods was driven by increased strategic investments in SG&A and higher shareholder activism costs in the three months ended September 30, 2021 partially offset by stronger home care and distributor revenue. 15 Liquidity and Capital Resources Cash Flows and Sources of Liquidity Cash Flows from Operating Activities For the six months ended December 31, 2021, net cash used by operating activities was $106,000. Cash flows provided by operating activities consisted of net income of $1,277,000, non-cash expenses of $863,000, a decrease in inventory of $334,000, a decrease in contract assets of $111,000, and an increase in accounts payable and accrued liabilities of $22,000. These cash flows from operating activities were offset by an increase in accounts receivable of $2,082,000, an increase in prepaid expenses and other assets of $265,000, and an increase in income tax receivable of $366,000. The increase in accounts receivable was primarily due to continued growth in the Medicare portion of our home care business, which has a 13-month payment cycle. Cash Flows from Investing Activities For the six months ended December 31, 2021, cash used in investing activities was $580,000. Cash used in investing activities consisted of $511,000 in expenditures for property and equipment and $69,000 in expenditures for patent costs. The investment in property and equipment primarily relates to our system infrastructure investments in an ERP system, customer relationship management system and revenue cycle management system, as well as tooling equipment for our next generation product. Cash Flows from Financing Activities For the six months ended December 31, 2021, cash used in financing activities was $733,000, which consisted of $663,000 used to repurchase shares of common stock, and $70,000 of taxes paid on net share settlements of stock option exercises. Adequacy of Capital Resources Our primary working capital requirements relate to adding employees to our sales force and support functions, continuing R&D efforts, IT infrastructure projects, and supporting general corporate needs, including financing equipment purchases and other capital expenditures incurred in the ordinary course of business. Based on our current operational performance, we believe our working capital of $27,780,000 and available borrowings under our existing credit facility will provide adequate liquidity during fiscal 2022. Effective December 17, 2021, we renewed our credit facility, which provides us with a revolving line of credit. Interest on borrowings on the line of credit accrues at the prime rate (3.25% at December 31, 2021) less 1.00% and is payable monthly. There was no outstanding principal balance on the line of credit as of December 31, 2021 or June 30, 2021. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable, and the line of credit expires on December 18, 2023, if not renewed. At December 31, 2021, the maximum $2,500,000 was available under the line of credit. Payment obligations under the line of credit are secured by a security interest in substantially all of our tangible and intangible assets. The documents governing our line of credit contain certain financial and nonfinancial covenants that include a minimum tangible net worth of not less than $10,125,000 and restrictions on our ability to incur certain additional indebtedness or pay dividends. Any failure to comply with these covenants in the future may result in an event of default, which if not cured or waived, could result in the lender accelerating the maturity of our indebtedness, preventing access to additional funds under the line of credit, requiring prepayment of outstanding indebtedness, or refusing to renew the line of credit. If the maturity of the indebtedness is accelerated or the line of credit is not renewed, sufficient cash resources to satisfy the debt obligations may not be available and we may not be able to continue operations as planned. If we are unable to repay such indebtedness, the lender could foreclose on these assets. For the six months ended December 31, 2021 and 2020, we spent $511,000 and $54,000, respectively, on property and equipment. We currently expect to finance planned equipment purchases with available working capital, cash flows from operations or borrowings under our credit facility. We may need to incur additional debt if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows. 16 Off-Balance Sheet Arrangements As of December 31, 2021, we had no off-balance sheet arrangements. Cautionary Note Regarding Forward-Looking Statements Statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact should be considered forward-looking statements within the meaning of 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 (the “Exchange Act”). Forward-looking statements include, but are not limited to, statements regarding: the expected impact of the COVID-19 pandemic on our business; our business strategy, including our intended level of investment in R&D and marketing activities; our expectations with respect to earnings, gross margins and sales growth, industry relationships, marketing strategies and international sales; estimated sizes of markets into which our products are or may be sold; our business strengths and competitive advantages; our ability to grow additional sales distribution channels; our intent to retain any earnings for use in operations rather than paying dividends; our expectation that our products will continue to qualify for reimbursement and payment under government and private insurance programs; our intellectual property plans and practices; the expected impact of applicable regulations on our business; our beliefs about our manufacturing processes; our expectations and beliefs with respect to our employees and our relationships with them; our belief that our current facilities are adequate to support our growth plans; our expectations with respect to ongoing compliance with the terms of our credit facility; our expectations regarding the ongoing availability of credit and our ability to renew our line of credit; enhancements to our products and services; expected excise tax exemption for the SmartVest System; and our anticipated revenues, expenses, capital requirements and liquidity. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “ongoing,” “plan,” “potential,” “project,” “should,” “will,” “would,” and similar expressions, including the negative of these terms, are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Although we believe these forward-looking statements are reasonable, they involve risks and uncertainties that may cause actual results to differ materially from those projected by such statements. Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results or our industry’s actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by the forward-looking statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, the following: ● the duration, extent and severity of the COVID-19 pandemic, including its effects on our business, operations and employees as well as its impact on our customers and distribution channels and on economies and markets more generally; ● the competitive nature of our market; ● changes to Medicare, Medicaid, or private insurance reimbursement policies; ● supply chain disruptions that limit our ability to produce and deliver our products to patients; ● changes to state and federal health care laws; ● changes affecting the medical device industry; ● our ability to develop new sales channels for our products such as the home care distributor channel; ● our need to maintain regulatory compliance and to gain future regulatory approvals and clearances; ● new drug or pharmaceutical discoveries; ● general economic and business conditions; ● our ability to renew our line of credit or obtain additional credit as necessary; ● our ability to protect and expand our intellectual property portfolio; ● the risks associated with expansion into international markets; ● the risks associated with cyberattacks, data breaches, computer viruses and other similar security threats; and ● the risks associated with our planned sales force expansion. This list of factors is not exhaustive, however, and these or other factors, many of which are outside of our control, could have a material adverse effect on us and our results of operations. Therefore, you should consider these risk factors with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which the statements are made, and we undertake no obligation, and expressly disclaim any such obligation, to update any forward-looking statement for any reason other than as required by law, even if new information becomes available or other events occur in the future. You should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K for fiscal 2021. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth herein. 17 Item 3. Quantitative and Qualitative Disclosures About Market Risk. As a smaller reporting company, we are not required to provide disclosure pursuant to this Item.