Electromed, Inc. 10-K

Item 7. 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 financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. The forward-looking statements include statements that reflect management’s good faith beliefs, plans, objectives, goals, expectations, anticipations and intentions with respect to our future development plans, capital resources and requirements, results of operations, and future business performance. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in the section entitled “Information Regarding Forward-Looking Statements” immediately preceding Part I of this Annual Report on Form 10-K. Overview Electromed develops and provides innovative airway clearance products applying HFCWO technologies in pulmonary care for patients of all ages. We manufacture, market and sell products that provide HFCWO, including the 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, 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, ALS, the combination of emphysema and chronic bronchitis commonly known as COPD, and patients with post-surgical complications or who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport. 14 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. We employ a direct-to-patient and provider model, through which we obtain patient referrals from clinicians, manage insurance claims on behalf of our patients and their clinicians, deliver our solutions to patients and train them on proper use in their homes. This model allows us to directly approach patients and clinicians, whereby we disintermediate the traditional durable medical equipment channel and capture both the manufacturer and distributor margins. We have engaged a limited number of regional durable medical equipment distributors focused on respiratory therapies as an alternate sales channel. Revenue through this channel was 4% of our total revenues in fiscal 2022. Our key growth strategies for fiscal 2023 are to: accelerate our revenue growth by taking market share and expanding the addressable population for the largest and fastest growing segments of the market: adult pulmonology/bronchiectasis. Actions to support accelerating our growth include the following: ● Expand our sales force in targeted geographies with high potential, adding an additional five territories and direct sales reps; ● Increase Electromed brand awareness through direct-to-consumer and physician marketing, and peer to peer education; ● Provide best-in-class customer care and support; ● Develop and promulgate the body of bronchiectasis clinical evidence to increase physician adoption of the SmartVest System for patients; and ● Introduce our innovative next generation device that appeals to patients. Critical Accounting Estimates During the preparation of our financial statements, we are required to make estimates, assumptions and judgment that affect reported amounts. Those estimates and assumptions affect our reported amounts of assets and liabilities, our disclosure of contingent assets and liabilities, and our reported revenues and expenses. We update these estimates, assumptions, and judgment as appropriate. Some of our accounting policies and estimates 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. The following is a summary of our primary critical accounting policies and estimates. See also Note 1 to the Financial Statements, included in Part II, Item 8, of this Annual Report on Form 10-K. 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. 15 During fiscal 2022, we experienced a reduction in the number of clinics allowing face-to-face access by our sales team although not to the extent experienced in fiscal 2021 as the number of infections relating to the Omicron variant and related subvariants 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 fiscal 2021. During the second half of fiscal 2022, we observed an improvement in clinic access and patient flow compared to earlier in the fiscal year, which we believe is likely a result of Omicron-related case reductions throughout most of the United States, contributing to a record high number of monthly referrals for our company. We believe that the impact of the COVID-19 pandemic on our home care and institutional business will continue during at least the beginning of fiscal 2023. Our home care revenue for fiscal 2022 has increased as compared to fiscal 2021; 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, we believe that such measures could have a material adverse effect on our business. We observed increased changes to our supply chain timelines and increased material and shipping costs during the second half of fiscal 2022, but we did not experience any disruptions that materially impacted product availability for our customers. We anticipate that increased material and shipping costs will continue during fiscal 2023 relating to supply chain availability and inflationary trends in electronic components but may extend to other components as well. In certain instances, we have purchased key electronic materials in advance to ensure adequate future supply and mitigate the risk of supply chain disruption. It is possible that 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 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 July 15, 2022. We did not receive any direct financial assistance from any government program during fiscal 2021 or fiscal 2022 in connection with COVID-19 relief measures. Revenue Recognition Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and other factors affecting the transaction price, including consideration paid or payable to customers and significant financing components. Revenue from all customers is recognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer. Individual promised goods and services in a contract are considered a performance obligation and accounted for separately if the individual good or service is distinct (i.e., the customer can benefit from the good or service on its own or with other resources that are readily available to the customer and the good or service is separately identifiable from other promises in the arrangement). If an arrangement includes multiple performance obligations, the consideration is allocated between the performance obligations in proportion to their estimated standalone selling price, unless discounts or variable consideration is attributable to one or more but not all the performance obligations. Costs related to products delivered are recognized in the period incurred, unless criteria for capitalization of costs under Accounting Standards Codification (“ASC”) 340-40, “Other Assets and Deferred Costs,” or the requirements under other applicable accounting guidance are met. 16 The Company includes shipping and handling fees in net revenues. Shipping and handling costs associated with the shipment of the Company’s SmartVest System after control has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenues. We request that customers return previously sold units that are no longer in use to us in order to limit the possibility that such units would be resold by unauthorized parties or used by individuals without a prescription. The customer is under no obligation to return the product; however, we do reclaim the majority of previously sold units upon the discontinuance of patient usage. We are certified to recondition and resell returned SmartVest System units. Returned units are typically reconditioned and resold and continue to be used for demonstration equipment and warranty replacement parts. Inventory Valuation Inventories are stated at the lower of cost (first-in, first-out method) or net realizable value. Work in process and finished goods are carried at standard cost, which approximates actual cost, and includes materials, labor and allocated overhead. The reserve for obsolescence is determined by analyzing the inventory on hand and comparing it to expected future sales. Estimated inventory to be returned is based on how many devices that have shipped that are expected to be returned prior to completion of the insurance reimbursement process. Warranty Reserve The Company provides a lifetime warranty on its products to the prescribed patient for sales within the U.S. and a three-year warranty for all institutional sales and sales to individuals outside the U.S. The Company estimates the costs that may be incurred under its warranty and records a liability in the amount of such costs at the time the product is shipped. Factors that affect the Company’s warranty reserve include the number of units shipped, historical and anticipated rates of warranty claims, the product’s useful life and cost per claim. The Company periodically assesses the adequacy of its recorded warranty reserve and adjusts the amounts as necessary. Share-Based Compensation Share-based payment awards consist of options to purchase shares of our common stock issued to employees. Expense for share-based payment awards consist of options to purchase shares of our common stock issued to employees for services. Expense for options is estimated using the Black-Scholes pricing model at the date of grant and expense for restricted stock is determined by the closing price on the day the grant is made. Expense is recognized on a straight-line basis over the requisite service or vesting period of the award, or at the time services are provided for non-employee awards. In determining the fair value of options, we make various assumptions using the Black-Scholes pricing model, including expected risk-free interest rate, stock price volatility, and life. See Note 8 to the Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K for a description of these assumptions. 17 Results of Operations Fiscal Year Ended June 30, 2022 Compared to Fiscal Year Ended June 30, 2021 Revenues Revenue for the fiscal years ended June 30, 2022 and 2021 are summarized in the table below (dollar amounts in thousands). Fiscal Years Ended June 30, 2022 2021 Increase (Decrease) Home Care Revenue $ 38,004,000 $ 32,986,000 $ 5,018,000 15.2 % Institutional Revenue 1,660,000 1,549,000 111,000 7.2 % Home Care Distributor Revenue 1,474,000 563,000 911,000 161.8 % International Revenue 521,000 658,000 (137,000 ) (20.8 %) Total Revenue $ 41,659,000 $ 35,756,000 $ 5,903,000 16.5 % Home Care Revenue. Home care revenue increased by $5,018,000, or 15.2%, in fiscal 2022 compared to fiscal 2021. The revenue increase compared to fiscal 2021 was primarily due to increases in referrals and approvals. The increase in referrals was primarily due to an increase in direct sales representatives, increased sales representative productivity driven by increased clinic access and patient flow, our sales team refining their selling process and clinic targeting methodology, and benefits of the CMS waiver on the non-commercial Medicare portion of our home care revenue. Additionally, we also benefitted from a Medicare allowable rate increase that took effect on January 1, 2022. Annual Medicare rate increases for our device are linked closely to changes in the Urban Consumer Price Index. 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 effective until October 2022. Institutional Revenue. Institutional revenue increased by $111,000, or 7.2%, in fiscal 2022 compared to fiscal 2021. Institutional revenue includes sales to group purchasing organizations, rental companies and other institutions. The revenue increase was due to increased capital purchases and stronger consumable volumes compared to fiscal 2021, as hospitals resumed utilization of HFCWO protocols after reducing utilization early in the COVID-19 pandemic. Home Care Distributor Revenue. Home care distributor revenue increased by $911,000, or 161.8%, in fiscal 2022 compared to fiscal 2021. The revenue increase in fiscal 2022 was due to increased demand from one of our primary home care distribution partners. 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 decreased by $137,000, or 20.8%, in fiscal 2022 compared to fiscal 2021. International revenue growth is not currently a primary focus for us, and our corporate resources are focused on supporting and maintaining our current distributors. 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 $31,442,000 in fiscal 2022, or 75.5% of net revenues, from $27,305,000, or 76.4% of net revenues, in fiscal 2021. The increase in gross profit was primarily related to increases in domestic home care revenue including the Medicare allowable rate increase that took effect in January 2022. The decrease in gross profit as a percentage of net revenue was driven by higher raw material and shipping costs as well as patient training related expenses due to increase in face-to-face trainings. 18 We believe as we continue to grow revenue, we will be able to leverage manufacturing costs, although there may be fluctuations on a short-term basis related to increased material and shipping costs as well as average reimbursement based on the mix of referrals during any given period. Factors such as diagnoses that are not assured of reimbursement, insurance programs with lower allowable reimbursement amounts (for example, state Medicaid programs), whether an individual patient meets prerequisite medical criteria for reimbursement, and continuation of the Medicare waiver currently in place may have an effect on average reimbursement received on a short-term basis. We have a goal of improving our gross margin percentage over time due to lower product costs associated with our next generation product, supplier optimization, and gaining operating leverage on higher volumes. Operating Expenses Selling, General and Administrative Expenses. Selling, general and administrative (“SG&A”) expenses were $27,114,000 in fiscal 2022, representing an increase of $4,671,000 or 20.8% from $22,443,000 in fiscal 2021. SG&A payroll and compensation-related expenses increased by $2,206,000, or 15.3%, to $16,640,000 in fiscal 2022, compared to $14,434,000 in fiscal 2021. The increase in the current year was primarily due to a higher average number of sales, sales support 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. We have also continued to provide regular merit-based increases for our employees and are regularly benchmarking our compensation ranges for new and existing employees to ensure we can hire and retain the talent needed to drive growth in our business. Field sales employees totaled 52, of which 43 were direct sales, as of June 30, 2022, compared to 46 as of June 30, 2021, of which 37 were direct sales. Professional and legal fees increased by $875,000, or 36.0%, to $3,308,000 in fiscal 2022, compared to $2,433,000 in fiscal 2021. Professional fees include services related to legal costs, shareowner services and reporting requirements, information technology technical support and consulting fees. The increase in the current year was primarily due to a shareholder activism matter, increased investment in our system infrastructure and increased clinical study costs. Our shareholder activism matter concluded with a cooperation agreement in September 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 optimizing 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. We also expect to continue investing in our on-going clinical studies in order to continue building the body of evidence around positive outcomes from bronchiectasis patients using HFCWO and SmartVest therapy. Total discretionary marketing expenses decreased by $238,000, or 22.4% to $824,000 in fiscal 2022, compared to $1,062,000 in fiscal 2021. The decrease in the current year was primarily due to a shift to more cost-effective direct-to-consumer marketing investments. Travel, meals and entertainment expenses increased $734,000, or 41.2%, to $2,514,000 for fiscal 2022 compared to $1,780,000 in fiscal 2021. The increase in the current year period was primarily due to our sales team resuming closer-to-normal levels of travel compared to the COVID-19 driven travel restrictions in the prior year and an increase in regional sales meetings that were cancelled in the prior year due to COVID-19. The Company also held an in-person national sales meeting in August 2021 whereas the national sales meeting was held virtually in fiscal 2021 due to COVID-19. Recruiting fees increased by $362,000 or 134.6% to $631,000 for fiscal 2022 compared to $269,000 in fiscal 2021. The increase in recruiting fees is primarily due to increased recruiting for senior leadership and direct sales representative positions. Insurance expenses increased by $229,000 or 20.6% to $1,339,000 for fiscal 2022 compared to $1,110,000 in fiscal 2021. The increase in the current year is primarily due to higher health insurance, director and officer insurance costs and cyber insurance costs. 19 Research and Development Expenses R&D expenses decreased by $366,000, or 21.3%, to $1,356,000 in fiscal 2022 compared to $1,722,000 in fiscal 2021. The decrease in the current year was primarily due to reduced professional consulting costs associated with our next generation platform development activities. R&D expenses were 3.3% of revenue in fiscal 2022 compared to 4.8% of revenue in fiscal 2021. We expect R&D spending to be between 2.0% and 3.0% of revenue during fiscal 2023, as we look to finalize our development and product testing work in preparation for an anticipated fiscal year 2023 next generation product launch. Interest Income, net Net interest income was approximately $25,000 in fiscal 2022 compared to net interest income of $39,000 in fiscal 2021. The decrease in the current year was primarily due to lower rates earned on our cash deposits and lower cash deposits in the bank compared to prior fiscal periods. Income Tax Expense Income tax expense in fiscal 2022 was 692,000, which includes a current tax expense of $1,181,000 and a deferred benefit of $489,000. Estimated income tax expenses include a discrete current tax benefit of approximately $37,000 related to exercised fully vested stock options and a discrete current benefit of approximately $21,000 related to the excess tax benefit of non-qualified stock options that were exercised during the period. Income tax expense in fiscal 2021 was $805,000, which included a current tax expense of $1,099,000 and a deferred benefit of $294,000. Estimated income tax expense included a discrete deferred tax expense of approximately $81,000 related to unexercised fully vested stock options that expired and a discrete current tax benefit of approximately $33,000 related to the excess tax benefit of non-qualified stock options that were exercised during the period. The effective tax rates were 23.1% and 25.4% for fiscal 2022 and 2021, respectively. The effective tax rates differ from the statutory federal rate due to the effect of state income taxes, R&D tax credits, and other permanent items that are non-deductible for tax purposes relative to the amount of taxable income. Net Income Net income for fiscal 2022 was $2,305,000, compared to net income of $2,362,000 in fiscal 2021. The decrease in current year net income was primarily due to increased strategic investments in SG&A, shareholder activism costs and higher product costs partially offset by stronger home care and distributor revenue growth. Liquidity and Capital Resources Cash Flows and Sources of Liquidity Cash Flows from Operating Activities Net cash used in operating activities in fiscal 2022 was $686,000. Cash flows from operating activities consisted of net income of $2,305,000, non-cash expenses of approximately $1,115,000, a $2,170,000 increase in accounts payable and accrued liabilities and a decrease in contract assets of $107,000. These cash flows from operating activities were offset by a $4,020,000 increase in accounts receivable, an increase in inventory of $1,072,000, and a $1,322,000 increase in prepaid expenses. The increase in accounts receivable was primarily due to an increase in the Medicare portion of our home care business, which has a 13-month payment cycle. Three distinct items have negatively impacted our operating cash flow in fiscal 2022, including tax payments on higher-than-expected fiscal 2021 net income, increased payments to secure adequate supply of key raw material components, and a one-time payout of accrued vacation balances as part of an enhancement to our paid time off policy. Our cash receipt collection remains strong, with the three months ended June 30, 2022 period having the highest cash receipt collections in our company's history, building upon the prior record that was set in the previous quarter. 20 Cash Flows from Investing Activities Net cash used in investing activities in fiscal 2022 was approximately $1,525,000. Cash used in investing activities consisted of approximately $1,425,000 in expenditures for property and equipment, approximately $943,000 for software and $482,000 for equipment, and $100,000 in payments for patent and trademark costs. Cash Flows from Financing Activities Net cash used in financing activities in fiscal 2022 was approximately $1,525,000, consisting of $1,448,000 used for our share repurchase program and $77,000 for 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 infrastructure investments, 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 approximately $27,389,000 and available borrowings under our existing credit facility will provide adequate liquidity for fiscal 2023. 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 (4.75% as of June 30, 2022) less 1.0% and is payable monthly. There was no outstanding principal balance on the line of credit as of June 30, 2022 or June 30, 2021. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.0% of eligible accounts receivable, and the line of credit expires on December 18, 2023, if not renewed. As of June 30, 2022, 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. During fiscal 2022 and 2021, we spent approximately $1,425,000 and $287,000, respectively, on property and equipment. We currently expect to finance planned equipment purchases with 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. While the impact of the COVID-19 pandemic and other factors such as inflation are difficult to predict, we believe our cash, cash equivalents and cash flows from operations will be sufficient to meet our working capital, capital expenditure, operational cash requirements for fiscal 2023. Accounting Standards Recently Issued But Not Yet Adopted by the Company See Note 1 of the Notes to our Financial Statements in this Annual Report on Form 10-K for information on new accounting standards adopted in fiscal 2022 or pending adoption. 21 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. As a smaller reporting company, we are not required to provide disclosure pursuant to this item. 22