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, 2022 (“fiscal 2022”). 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 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 2022. 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 and are based upon our historical experience, known trends in our industry, terms of existing contracts, other information from outside sources, as appropriate and other factors. Therefore, management discusses the development, selection and disclosures with the audit committee. 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, inventory valuation, share-based compensation and warranty reserve. 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. 12 We believe that the impact of the COVID-19 pandemic on our home care and institutional business will likely continue during the first half of our fiscal year ending June 30, 2023 (“fiscal 2023”). Our home care and institutional revenue for the three months ended September 30, 2022 increased as compared to the three months ended September 30, 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 rates during the second half of fiscal 2022 and into the three months ended September 30, 2022. The changes to our supply chain timelines resulted in a temporary interruption that impacted product availability for certain customers in September 2022. We do not anticipate this will have an effect on our fiscal 2023 revenue. We expect that material and shipping rates will remain elevated during fiscal 2023 relating to supply chain availability and inflationary trends in electronic components and may extend to other components. In certain instances, we have purchased key electronic materials in advance to ensure adequate future supply and mitigate the risk of potential supply chain disruptions. 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 further 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. 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 October 13, 2022. Results of Operations Net Revenues Net revenues for the three months ended September 30, 2022 and 2021 are summarized in the table below. Three Months Ended September 30, 2022 2021 Increase (Decrease) Home Care Revenue $ 9,632,000 $ 9,284,000 $ 348,000 3.7 % Home Care Distributor Revenue 554,000 156,000 398,000 255.1 % Institutional Revenue 391,000 449,000 (58,000 ) (12.9 %) International Revenue 81,000 112,000 (31,000 ) (27.7 %) Total Revenue $ 10,658,000 $ 10,001,000 $ 657,000 6.6 % Home care revenue . Home care revenue increased by $348,000, or 3.7%, for the three months ended September 30, 2022 compared to the same period in fiscal 2022. The increase was primarily due to an increase in referrals and approvals. The increase in referrals was due to an increase in direct sales representatives. The increase was slightly offset by a temporary interruption in supply chain and associated operations in September 2022. The CMS waiver continues to benefit the non-commercial Medicare portion of our home care revenue by increasing the number of referrals and the approval percentage for 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 January 2023. 13 Home care distributor revenue . Home care distributor revenue increased by $398,000, or 255.1%, for the three months ended September 30, 2022 compared to the same period in fiscal 2022. The revenue increase was due to increased demand from one of our primary home care distribution partners. Institutional revenue. Institutional revenue decreased by $58,000, or 12.9%, for the three months ended September 30, 2022 compared to the same period in fiscal 2022. International revenue . International revenue decreased by $31,000, or 27.7%, for the three months ended September 30, 2022 compared to the same period in fiscal 2022. Gross profit Gross profit increased to $8,331,000, or 78.2% of net revenues, for the three months ended September 30, 2022, from $7,701,000, or 77.0% of net revenues, in the same period in fiscal 2022. The increase in gross profit dollars and percentage for the three months ended September 30, 2022 was primarily due to increased revenue and operational efficiencies partially offset by increased direct expenses and patient training related expenses due to increased face-to-face trainings. Operating expenses Selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were $7,989,000 for the three months ended September 30, 2022, representing an increase of $1,202,000 or 17.7%, compared to the same period in the prior year. Payroll and compensation-related expenses increased by $671,000, or 15.9%, to $4,884,000 for the three months ended September 30, 2022, compared to the same period in the prior year. The increase was primarily due salaries and incentive compensation related to the higher average number of sales, sales support and marketing personnel, and reimbursement personnel to process higher patient referrals. 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 53 as of September 30, 2022, 44 of which were direct sales representatives, compared to 51 field sales employees and 41 direct sales representatives as of September 30, 2021. Travel, meals and entertainment expenses increased $253,000, or 39.5%, to $894,000 for the three months ended September 30, 2022, compared to the same period in the prior year. The increase was primarily due to airfare, lodging and inflationary expenses for our annual sales meeting as well a higher average number of direct sales representatives. Total discretionary marketing expenses increased $80,000, or 46.2%, to $253,000 for the three months ended September 30, 2022, compared to the same period in the prior year. The increase was primarily due to an investment in direct-to-consumer and direct-to-physician marketing. Professional fees increased $75,000, or 5.5%, to $1,431,000 for the three months ended September 30, 2022, compared to the same period in the prior year. Professional fees are primarily for services related to legal costs, shareowner services and reporting requirements, information technology technical support and consulting fees. The increase was primarily due to nonrecurring legal compliance fees of approximately $400,000 incurred for a reimbursement-related project offset by a reduction in expenses related to shareholder activism incurred during the three months ended September 30, 2021, which concluded with a cooperation agreement that became effective in September 2021. Research and development expenses. Research and development (“R&D”) expenses decreased $78,000, or 20.7%, to $298,000 for the three months ended September 30, 2022 compared to the same period in the prior year. The decrease was primarily due to reduced professional services costs associated with our next generation platform development. R&D expenses for the three months ended September 30, 2022 were 2.8% of revenue compared to 3.8% of revenue for the same period in the prior year. Interest income, net Net interest income decreased $5,000, or 55.6%, to $4,000 for the three months ended September 30, 2022, compared to the same period in the prior year. 14 Income tax expense Income tax benefit was estimated at $33,000 for the three months ended September 30, 2022 and the income tax expense was estimated at $108,000 for the three months ended September 30, 2021. The effective tax rate was (68.8%) and 19.7% for the three months ended September 30, 2022 and 2021, respectively. Estimated income tax benefit for the three months ended September 30, 2022 included a $44,000 discrete tax benefit related to the exercise of stock options. The net impact of this discrete event created an income tax benefit. The income tax expense for the three months ended September 30, 2021 included a discrete tax benefit of $20,000 related to the exercise of stock options. Net income Net income for the three months ended September 30, 2022 was $81,000 compared to $439,000 for the same period in the prior year. The decrease in net income was primarily due to increased S&GA expenses related to our sales and reimbursement related investments in revenue growth partially offset by increased gross profit. Liquidity and Capital Resources Cash Flows and Sources of Liquidity Cash Flows from Operating Activities For the three months ended September 30, 2022, net cash used in operating activities was $1,694,000. Cash flows provided by operating activities consisted of net income of $81,000, an increase in non-cash expenses of $255,000, and a decrease in accounts receivable of $95,000. These cash flows from operating activities were offset by a decrease in accrued compensation of $1,132,000, a decrease in accounts payable and other accrued liabilities of $26,000, an increase in inventory of $500,000, an increase in contract assets of $167,000, an increase in prepaid expenses and other assets of $125,000, and an increase in income tax receivable of $175,000. The decrease in accrued compensation was primarily due to the payment of annual incentives. Cash Flows from Investing Activities For the three months ended September 30, 2022, cash used in investing activities was $256,000. Cash used in investing activities consisted of $241,000 primarily related to our enterprise resource planning infrastructure investments and $15,000 in expenditures for intangible asset costs. Cash Flows from Financing Activities For the three months ended September 30, 2022, cash used in financing activities was $205,000, which consisted of $145,000 used for our share repurchase program and $60,000 for taxes paid on net share settlement 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 $27,267,000 and available borrowings under our existing credit facility will provide adequate liquidity during fiscal 2023. Our credit facility provides us with a revolving line of credit. Interest on borrowings on the line of credit accrues at the prime rate (6.25% at September 30, 2022) less 1.00% and is payable monthly. There was no outstanding principal balance on the line of credit as of September 30, 2022 or June 30, 2022. 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. As of September 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. 15 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 three months ended September 30, 2022 and 2021, we spent $241,000 and $225,000, 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 and the foreseeable future. We will continue to evaluate our projected expenditures relative to our available cash and evaluate financing alternatives in order to satisfy our working capital and other cash requirements. Information 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,” “goal,” “target,” “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; ● ability to obtain reimbursement from Medicare, Medicaid, or private insurance payers for our products including potential adverse impact with an expiration of the CMS waiver for certain respiratory diseases; ● component or raw material shortages, changes to lead times or significant price increases; ● adverse changes to state and federal health care regulations; ● our ability to develop new sales channels for our products such as the home care distributor channel; ● our ability to maintain regulatory compliance and to gain future regulatory approvals and clearances; 16 ● entry of new competitors including new drug or pharmaceutical discoveries; ● adverse economic and business conditions or intense competition; ● wage and component price inflation; ● technical problems with our research and products; ● changes affecting the medical device industry; ● adverse international health care regulation impacting current international business; ● 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 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 2022. 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. 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.