PRO DEX INC 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our unaudited interim condensed consolidated financial statements and the related notes and other financial information appearing elsewhere in this report. COMPANY OVERVIEW The following discussion and analysis provides information that management believes is relevant to an assessment and understanding of the results of operations and financial condition of Pro-Dex, Inc. (“Company,” “Pro-Dex,” “we,” “our,” or “us”) for the three-month periods ended September 30, 2023 and 2022. This discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this report. This report contains certain forward-looking statements and information. The cautionary statements included herein should be read as being applicable to all related forward-looking statements wherever they may appear. Our actual future results could differ materially from those discussed herein. Except for the historical information contained herein, the matters discussed in this report, including, but not limited to, discussions of our product development plans, business strategies, strategic opportunities, and market factors influencing our results, are forward-looking statements that involve certain risks and uncertainties. Actual results may differ from those anticipated by us as a result of various factors, both foreseen and unforeseen, including, but not limited to, our ability to continue to develop new products and increase sales in markets characterized by rapid technological evolution, the impact of the COVID-19 pandemic on our suppliers, customers and us, consolidation within our target marketplace and among our competitors, competition from larger, better capitalized competitors, and our ability to realize returns on opportunities. Many other economic, competitive, governmental, and technological factors could impact our ability to achieve our goals. You are urged to review the risks, uncertainties, and other cautionary language described in this report, as well as in our other public disclosures and reports filed with the Securities and Exchange Commission (“SEC”) from time to time, including, but not limited to, the risks, uncertainties, and other cautionary language discussed in our Annual Report on Form 10-K for our fiscal year ended June 30, 2023. We specialize in the design, development, and manufacture of powered rotary drive surgical instruments used primarily in the orthopedic, thoracic, and maxocranial facial (“CMF”) markets. Our principal headquarters are located at 2361 McGaw Avenue, Irvine, California 92614 and our phone number is (949) 769-3200. Our Internet address is www.pro-dex.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports, and other SEC filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. In addition, our Code of Ethics and other corporate governance documents may be found on our website at the Internet address set forth above. Our filings with the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov and company specific information at www.sec.gov/edgar/searchedgar/companysearch.html. Basis of Presentation The condensed consolidated results of operations presented in this report are not audited and those results are not necessarily indicative of the results to be expected for the entirety of our fiscal year ending June 30, 2024, or any other interim period during such fiscal year. Our fiscal year ends on June 30 and our fiscal quarters end on September 30, December 31, and March 31. Unless otherwise stated, all dates refer to our fiscal year and those fiscal quarters. 17 Critical Accounting Estimates and Judgments Our financial statements are prepared in accordance with U.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. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. Management believes that there have been no significant changes during the three months ended September 30, 2023, to the items that we disclosed as our critical accounting policies in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for our fiscal year ended June 30, 2023. Business Strategy and Future Plans Our business today is almost entirely driven by sales of our medical devices. Many of our significant customers place purchase orders for specific products that were developed by us under various development and/or supply agreements. Our customers may request that we design and manufacture a custom surgical device or they may hire us as a contract manufacturer to manufacture a product of their own design. In either case, we have extensive experience with autoclavable, battery-powered and electric, multi-function surgical drivers, and shavers. We continue to focus a significant percentage of our time and resources on providing outstanding products and service to our valued principal customers. During the first quarter of fiscal 2021, our largest customer executed an amendment to our existing supply agreement such that we shall continue to supply their surgical handpieces to them through calendar 2025. Simultaneously, we are working to build top-line sales through active proposals of new medical device products with new and existing customers. Our patented adaptive torque-limiting software has been very well received in the CMF and thoracic markets. Additionally, we have other significant engineering projects under way described more fully below under “Results of Operations.” In November 2020, we purchased an approximate 25,000 square foot industrial building in Tustin, California (the “Franklin Property”). This building is located approximately four miles from our Irvine, California headquarters and was acquired to provide us additional capacity for our expected continued future growth, including anticipated expanded capacity for the manufacture of batteries and new products. We began operations in the new facility during the fourth quarter of fiscal 2023 and believe that the additional capacity will allow for our continued expected growth. In summary, our current objectives are focused primarily on maintaining our relationships with our current medical device customers, investing in research and development activities to design unique medical devices as well as Pro-Dex branded drivers to leverage our torque-limiting software, expansion of our manufacturing capacity through the commencement of operations at the Franklin Property, and promoting active product development proposals to new and existing customers for both orthopedic shavers and screw drivers for a multitude of surgical applications, while monitoring closely the progress of all these individual endeavors. While we expect revenue growth in the future, it may not be a consistent trajectory but rather periods of incremental growth that current expenditures are helping to create. However, there can be no assurance that we will be successful in any of these objectives. 18 Results of Operations The following tables set forth results from continuing operations for the three months ended September 30, 2023, and 2022 (in thousands, except percentages): Three Months Ended September 30, 2023 2022 (as restated) Dollars in thousands % of Net Sales % of Net Sales Net sales $ 11,938 100 % $ 11,087 100 % Cost of sales 8,280 69 % 8,131 73 % Gross profit 3,658 31 % 2,956 27 % Selling expenses 25 — 53 — General and administrative expenses 995 8 % 1,024 9 % Research and development costs 805 7 % 929 8 % 1,825 15 % 2,006 18 % Operating income 1,833 15 % 950 9 % Other income (loss), net (2,662 ) (22 %) 519 5 % Income before income taxes (829 ) (7 %) 1,469 13 % Provision for income taxes (214 ) (2 %) 266 2 % Net income (loss) $ (615 ) (5 %) $ 1,203 11 % Revenue The majority of our revenue is derived from designing, developing, and manufacturing surgical devices. We continue to sell our rotary air motors for industrial and scientific applications, but our focus remains in medical devices. The proportion of total sales by type is as follows (in thousands, except percentages): Three Months Ended September 30, Increase (Decrease) From 2022 To 2023 2022 2023 Dollars in thousands % of Net Sales % of Net Sales Net sales: Medical device $ 7,808 65 % $ 7,887 71 % (1 %) Industrial and scientific 141 1 % 224 2 % (37 %) Dental and component 39 — 103 1 % (62 %) NRE & proto-types 190 2 % 907 8 % (79 %) Repairs 4,023 34 % 2,252 20 % 79 % Discounts and other (263 ) (2 %) (286 ) (2 %) (8 %) $ 11,938 100 % $ 11,087 100 % 8 % 19 Certain of our medical device products utilize proprietary designs developed by us under exclusive development and supply agreements. All of our medical device products utilize proprietary manufacturing methods and know-how, and are manufactured in our Irvine, California facility and assembled in our Tustin, California facility. Details of our medical device sales by type is as follows (in thousands, except percentages): Three Months Ended September 30, Increase (Decrease) From 2022 To 2023 2022 2023 Dollars in thousands % of Med Device Sales % of Med Device Sales Medical device sales: Orthopedic $ 4,838 62 % $ 5,635 72 % (14 %) CMF 1,634 21 % 2,083 26 % (22 %) Thoracic 1,336 17 % 169 2 % 691 % $ 7,808 100 % $ 7,887 100 % (1 %) Our medical device revenue decreased $79,000, or 1%, in the first quarter of fiscal 2024 compared to the corresponding period of the prior fiscal year . Our orthopedic sales decreased $797,000 in the first quarter of fiscal 2024 compared to the first quarter of fiscal 2023, due in part, to our largest customer shifting priorities to an enhanced repair program (described under the discussion of repair revenue below). Recurring revenue from distributors of CMF drivers decreased $449,000 in fiscal 2024 compared to fiscal 2023. While we do not have much visibility into our customers’ distribution networks, we do know that one of our distributors is selling some legacy products in their inventory which has caused a reduction in demand for the CMF driver they procure from us. We anticipate higher purchase volumes from this customer in the future. Our thoracic sales increased by $1.2 million for the three months ended September 30, 2023 compared to the corresponding period of the prior fiscal year because of the launch of a new product in the first quarter of this fiscal year. Sales of our compact pneumatic air motors decreased $83,000, or 37%, in the first quarter of fiscal 2024 compared to the corresponding period of the prior fiscal year. The revenue decrease is consistent with our lack of substantive marketing efforts . Sales of our dental products and components decreased $64,000 in the first quarter of fiscal 2024 compared to the corresponding quarter of the prior fiscal year, which is expected given our prior disclosures that we are no longer pursuing this line of business. Our non-recurring engineering (“NRE”) and proto-type revenue decreased $717,000 in the first quarter of fiscal 2024 compared to the corresponding period of the prior fiscal year, due to a decline in billable contracts. Our NRE and proto-type revenue is typically a small percentage of our total revenue and can vary significantly from quarter to quarter. Repair revenue increased by $1.8 million in the first quarter of fiscal 2024 compared to the corresponding period of the prior fiscal year, due to an increased number of repairs of the orthopedic handpiece we sell to our largest customer. This increase relates to the continuation of the previously disclosed enhanced repair program that we began last fiscal year. Discounts and other decreased by $23,000 in the first quarter of fiscal 2024 compared to the corresponding period of the prior fiscal year, due to volume rebates related to the orthopedic handpiece we sell to our largest customer, which they negotiated in conjunction with our contract extension through 2025. At September 30, 2023, we had a backlog of approximately $35.7 million, of which $25.4 million is s cheduled for delivery during the remainder of fiscal 2024. 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. We may experience variability in our new order bookings due to various reasons, including, but not limited to, the timing of major new product launches and customer planned inventory builds. However, we do not typically experience seasonal fluctuations in our shipments and revenues. 20 Cost of Sales and Gross Margin Three Months Ended September 30, Increase (Decrease) From 2022 To 2023 2022 2023 Dollars in thousands Cost of sales: % of Net Sales % of Net Sales Product costs $ 8,543 71 % $ 7,611 69 % 12 % Under-(over) absorption of manufacturing costs (285 ) (2 %) 362 3 % (179 %) Inventory and warranty charges 22 — 158 1 % (86 %) Total cost of sales $ 8,280 69 % $ 8,131 73 % 2 % Gross profit and gross margin $ 3,658 31 % $ 2,956 27 % 24 % Cost of sales for the three-month period ended September 30, 2023 increased by $149,000, or 2%, compared to the corresponding period of the prior fiscal year. Although some of the increase in cost of sales is consistent with the 8% increase in revenue for the same period, approximately $450,000 of the prior year product costs included the repairs we performed to upgrade the orthopedic handpieces we sell our largest customer to the newest release at no additional cost. Product costs increased by $932,000, or 12%, during the three months ended September 30, 2023, compared to the corresponding period of the prior fiscal year, due to higher material costs, predominantly related to the repairs discussed above. During the first quarter of fiscal 2024 we experienced $285,000 of over-absorbed manufacturing costs compared to an under-absorption of $362,000 in the first quarter of fiscal 2023, primarily due to increases in our standard labor and overhead rates which are made in an attempt to minimize our over-under absorption. Costs related to inventory and warranty charges decreased $136,000 in the first quarter of fiscal 2024 compared to the corresponding quarter of fiscal 2023, due primarily to a reduction in warranty expenses due to the shift to enhanced repairs we perform on orthopedic handpieces we sell to our largest customer. Gross profit increased by approximately $702,000, or 24%, for the three months ended September 30, 2023 compared to the corresponding period of the prior fiscal year, and gross margin as a percentage of sales increased by four percentage points between such periods, primarily as a result of a more favorable product mix of sales during the three months ended September 30, 2023 compared to the corresponding period of the prior fiscal year, coupled with reduced inventory and warranty charges. Operating Costs and Expenses Three Months Ended September 30, Increase (Decrease) From 2022 To 2023 2022 2023 Dollars in thousands % of Net Sales % of Net Sales Operating expenses: Selling expenses $ 25 — $ 53 1 % (53 %) General and administrative expenses 995 8 % 1,024 9 % (3 %) Research and development costs 805 7 % 929 8 % (13 %) $ 1,825 15 % $ 2,006 18 % (9 %) Selling expenses consist of salaries and other personnel-related expenses in support of business development, as well as trade show attendance, advertising and marketing expenses, and travel and related costs incurred in generating and maintaining our customer relationships. Selling expenses for the three months ended September 30, 2023 decreased $28,000, or 53%, compared to the corresponding year-earlier period. The decrease relates to a reduction in sales commissions and tradeshow expenses, which was partially offset by higher payroll expenses. 21 General and administrative expenses (“G&A”) consist of salaries and other personnel-related expenses of our accounting, finance, and human resources personnel, professional fees, directors’ fees, and other costs and expenses attributable to being a public company. G&A decreased by $29,000, or 3%, for the three months ended September 30, 2023, when compared to the corresponding period of the prior fiscal year. The decrease in total G&A was a result of non-cash compensation expense related to the non-qualified stock options granted in the prior fiscal year and reduced professional fees, partially offset by higher payroll and personnel expenses. Research and development costs generally consist of compensation and other personnel-related costs of our engineering and support personnel, related 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 $124,000, or 13%, for the quarter ended September 30, 2023, compared to the corresponding prior year period. The decrease is due primarily to a $242,000 reduction in internal engineering project spending, partially offset by a reduction in billable offsets reclassed to costs of sales of approximately $87,000 and an increase in legal expense related to IP matters of $25,000. 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 44% and 46% of total operating expenses for all periods presented and are expected to remain relatively flat the remainder of this fiscal year. The amount spent on projects under development, along with the current estimated commercial launch date and estimated recurring annual revenue, is summarized below (in thousands): For the Three Months Ended September 30, 2023 2022 Market Launch (1) Est. Annual Revenue (2) Total Research & Development costs: $ 805 $ 929 Products in development: ENT Shaver $ 19 $ 43 Q4 2024 $ 1,000 Sustaining & Other 786 886 Total. $ 805 $ 929 (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. 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 or projects that are later abandoned. 22 Other Income (Expense), net Interest and Dividend Income The interest and dividend income recorded during the quarters ended September 30, 2023 and 2022, consists primarily of interest and dividends from our investments and money market accounts. One of the investments in our portfolio paid a $204,000 cash dividend in the first quarter of fiscal 2023, and no such dividend was paid during the current fiscal year. Unrealized Gain (Loss) on Investments The unrealized gain or (loss) on marketable securities for the quarters ended September 30, 2023 and 2022, relates to our portfolio of investments described more fully in Note 4 to the condensed consolidated financial statements contained elsewhere in this report. Interest Expense The interest expense recorded during the quarters ended September 30, 2023 and 2022, relates to our Minnesota Bank and Trust (“MBT”) loans described more fully in Note 10 to the condensed consolidated financial statements contained elsewhere in this report. Income Tax Expense The effective tax rate for the three months ended September 30, 2023 and 2022, is 26% and 18%, respectively. The prior year effective tax rate is less than the current year rate due primarily to a tax benefit recognized as a result of the common stock awarded to our employees described more fully in Note 8 to the condensed consolidated financial statements contained elsewhere in this report. Liquidity and Capital Resources Cash and cash equivalents at September 30, 2023 decreased $1.0 million to $1.9 million as compared to $2.9 million at June 30, 2023. The following table includes a summary of our condensed statements of cash flows contained elsewhere in this report. As of and For the Three Months Ended September 30, 2023 2022 (in thousands) Cash provided by (used in): Operating activities $ 392 $ 2,892 Investing activities $ (126 ) $ (90 ) Financing activities $ (1,298 ) $ (853 ) Cash and working capital: Cash and cash equivalents $ 1,904 $ 2,798 Working capital $ 23,143 $ 20,162 Operating Activities Net cash provided by operating activities during the three months ended September 30, 2023 totaled $392,000. This is primarily because our net loss of $615,000 for the three months ended September 30, 2023 included non-cash unrealized loss on investments, share-based compensation and depreciation and amortization of $2.6 million, $188,000 and $283,000, respectively. Uses of cash arose primarily from an increase in accounts receivable of $1.1 million related to increased sales and our increase in income tax assets of $874,000. 23 Net cash provided by operating activities during the three months ended September 30, 2022 totaled $2.9 million. The primary sources of cash arose from (a) our net income for the quarter of $1.2 million, as well as non-cash share-based compensation and depreciation and amortization of $207,000 and $193,000, respectively, (b) a decrease of $4.3 million in accounts receivable due to more timely collection of receivables from our largest customer, and (c) an increase in accounts payable and accrued expenses of $273,000. Uses of cash arose primarily from an increase in inventory of $3.0 million primarily related to building up inventory in anticipation of our transfer of assembly and repairs to the Franklin Property. Investing Activities Net cash used in investing activities for the three months ended September 30, 2023 was $126,000 and related to the purchase of equipment and improvements. Net cash used in investing activities for the three months ended September 30, 2022 was $90,000 and related primarily to the purchase of equipment and improvements at the Franklin Property in the amount of $178,000, partially offset by the sale of marketable securities in the amount of $88,000. Financing Activities Net cash used in financing activities for the three months ended September 30, 2023 included principal payments of $1.3 million on our loans from MBT, which included a $1 million payment against our revolving loan. Net cash used in financing activities for the three months ended September 30, 2022 included net principal payments of $318,000 on our existing loans from MBT more fully described in Note 10 to the condensed consolidated financial statements contained elsewhere in this report, the repurchase of $354,000 of common stock pursuant to our share repurchase program, as well as $223,000 of employee payroll taxes related to the award of 37,500 shares of common stock to employees under previously granted performance awards. Financing Facilities & Liquidity Requirements for the Next Twelve Months As of September 30, 2023, our working capital was $23.1 million. We currently believe that our existing cash and cash equivalent balances together with our account receivable balances will provide us sufficient funds to satisfy our cash requirements as our business is currently conducted for at least the next 12 months. In addition to our cash and cash equivalent balances, we expect to derive a portion of our liquidity from our cash flows from operations. 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 on 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 MBT revolver. 24 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.