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 and six-month periods ended December 31, 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, our ability to optimize our operations at our Franklin facility, 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 autoclavable, battery-powered and electric, multi-function surgical drivers and shavers used primarily in the orthopedic, thoracic, and maxocranial facial (“CMF”) markets. We have patented adaptive torque-limiting software and proprietary sealing solutions which appeal to our customers, primarily medical device distributors. We also manufacture and sell rotary air motors to a wide range of industries. 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. 19 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 the 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. Critical Accounting Estimates and Judgments Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. 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 and six months ended December 31, 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 the 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 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. 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. 20 Description of Business Operations Revenue The majority of our revenue is derived from designing, developing and manufacturing surgical devices for the medical device industry. The proportion of total sales by type is as follows (in thousands, except percentages): Three Months Ended December 31, Six Months Ended December 31, 2023 2022 2023 2022 % of Revenue % of Revenue % of Revenue % of Revenue Net sales: Medical device products 8,945 71 % 8,754 78 % 16,754 68 % 16,641 74 % Industrial and scientific 239 2 % 208 2 % 380 2 % 431 2 % Dental and component 45 — 36 — 84 — 139 1 % NRE & Prototype 338 3 % 483 4 % 528 2 % 1,391 6 % Repairs 3,294 26 % 2,089 19 % 7,316 30 % 4,341 19 % Discounts and other (273 ) (2 %) (288 ) (3 %) (536 ) (2 %) (574 ) (2 %) 12,588 100 % 11,282 100 % 24,526 100 % 22,369 100 % Certain of our medical device products utilize proprietary designs developed by us under exclusive development and/or supply agreements. All of our medical device products utilize proprietary manufacturing methods and know-how, and are manufactured or machined in our Irvine, California facility, and assembled in our Tustin, California facility, as are our industrial products. Details of our medical device sales by type is as follows (in thousands, except percentages): Three Months Ended December 31, Six Months Ended December 31, 2023 2022 2023 2022 % of Total % of Total % of Total % of Total Medical device sales: Orthopedic 5,533 62 % 5,770 66 % 10,371 62 % 11,405 69 % CMF 2,759 31 % 2,239 26 % 4,393 26 % 4,322 26 % Thoracic 653 7 % 745 8 % 1,990 12 % 914 5 % Total 8,945 100 % 8,754 100 % 16,754 100 % 16,641 100 % Sales of our medical device products increased $0.2 million, or 2%, for the three months ended December 31, 2023, and increased slightly by $113,000, or 1%, for the six months ended December 31, 2023, compared to the corresponding periods of the prior fiscal year. Sales of our compact pneumatic air motors, reported as Industrial and scientific sales above, increased $31,000, or 15%, and decreased $51,000, or 12%, respectively, for the three and six months ended December 31, 2023, compared to the corresponding periods of the prior fiscal year. These are legacy products with no substantive marketing efforts. Our non-recurring (“NRE”) and proto-type revenue decreased $145,000, or 30%, and $863,000, or 62%, for the three and six months ended December 31, 2023, compared to the corresponding periods of the prior fiscal year, due to a decrease in billable contracts for various NRE projects undertaken for our customers. Repair revenue increased $1.2 million, or 58%, and $3.0 million, or 68%, respectively, for the three and six months ended December 31, 2023, compared to the corresponding periods of the prior fiscal year, primarily due to upgrades of handpieces for our largest customer. This increase was expected, as we have been asked to upgrade handpieces for this customer to its next generation, as well as include the advance replacement of certain components, beginning in December 2022. We expect to see continued heightened repair revenue from these upgrades for at least the remainder of this fiscal year. At December 31, 2023, we had a backlog of approximately $29.1 million, of which $18.9 million is scheduled to be delivered in fiscal 2024 and the balance is scheduled to be delivered next fiscal year. 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. Cost of Sales and Gross Margin (in thousands except percentages) Three Months Ended December 31, Six Months Ended December 31, 2023 2022 2023 2022 % of Total % of Total % of Total % of Total Cost of sales: Product cost 9,798 100 % 7,864 91 % 18,341 102 % 15,557 93 % Under(over)-absorption of manufacturing costs (31 ) (1 %) 696 8 % (316 ) (2 %) 977 6 % Inventory and warranty charges 19 1 % 99 1 % 41 — 257 1 % Total cost of sales 9,786 100 % 8,659 100 % 18,066 100 % 16,791 100 % Three Months Ended December 31, Six Months Ended December 31, Year over Year ppt Change 2023 2021 2023 2022 Three Months Six Months Gross margin 22 % 23 % 26 % 25 % (1 ) 1 Cost of sales for the three and six months ended December 31, 2023, increased $1.1 million, or 13%, and $1.3 million, or 8%, respectively, compared to the corresponding periods of the prior fiscal year. The increase in cost of sales is consistent with the 12% and 10% increase in revenue for the three and six months ended December 31, 2023, compared to the corresponding periods of the prior fiscal year. Additionally, under(over)-absorption for the three and six months ended December 31, 2023, decreased $727,000, and $1.3 million, respectively, compared to the corresponding periods of the prior fiscal year, based upon increasing our labor and overhead rates to better absorb our indirect costs. Gross profit increased by $179,000, or 7%, and $882,000, or 16%, for the three and six months ended December 31, 2023, respectively, compared to the corresponding periods of the prior fiscal year, primarily as a result of the increase in repair revenue for the same periods as described above. Gross margin as a percentage of sales for the three and six months ended December 31, 2023 remained relatively comparable (within one percentage point) compared to the corresponding periods of the prior fiscal year. 21 Operating Expenses Operating Costs and Expenses (in thousands except % change) Three Months Ended December 31, Six Months Ended December 31, Year over Year % Change 2023 2022 2023 2022 Three Months Six Months % of Net Sales % of Net Sales % of Net Sales % of Net Sales Operating expenses: Selling expenses 37 — 68 1 % 63 — 122 1 % (46 %) (48 %) General and administrative expenses 1,200 10 % 951 8 % 2,195 9 % 1,975 9 % 26 % 11 % Research and development costs 788 6 % 467 4 % 1,593 7 % 1,395 6 % 69 % 14 % 2,025 16 % 1,486 13 % 3,851 16 % 3,492 16 % 36 % 10 % Selling expenses consist of salaries and other personnel-related expenses for our business development department, as well as advertising and marketing expenses, and travel and related costs incurred in generating and maintaining our customer relationships. Selling expenses for the three and six months ended December 31, 2023 decreased $31,000 and $59,000, respectively, compared to the corresponding periods of fiscal 2023. The decrease in both periods is primarily due to decreased sales commissions. General and administrative expenses (“G&A”) consists of salaries and other personnel-related expenses of our accounting, finance and human resource personnel, as well as costs for outsourced information technology services, professional fees, directors’ fees, and other costs and expenses attributable to being a public company. G&A increased $249,000 and $220,000, respectively, during the three and six months ended December 31, 2023, when compared to the corresponding periods of the prior fiscal year. The increases relate primarily to increased professional fees (consisting primarily of audit and valuation fees, related to the restatement of our financial statements as referenced in Note 1 to the condensed consolidated financial statements contained elsewhere in this report) and increased personnel costs, offset by decreased legal fees related to intellectual property matters. Research and development costs generally consist of salaries, employer paid benefits, and other personnel- related costs of our engineering and support personnel, as well as allocated facility and information technology costs, professional and consulting fees, patent-related fees, lab costs, materials, and travel and related costs incurred in the development and support of our products. Research and development costs for the three and six months ended December 31, 2023, increased $321,000 and $198,000, respectively, compared to the corresponding periods of the prior fiscal year. These increases are primarily due to a reduction of billable customer projects in the current fiscal year compared to the prior year. When our engineers are engaged in billable projects as opposed to internal projects, costs get shifted to cost of sales instead of research and development. 22 Although the majority of our research and development costs relate to sustaining activities related to products we currently manufacture and sell, we have created a product roadmap to develop future products. The research and development costs represent between 31% and 41% of total operating expenses for all periods presented and are expected to increase in the future as we continue to invest in our business. The amount spent on internal projects under development is summarized below (in thousands): Three and Six Months Ended December 31, 2023 Three and Six Months Ended December 31, 2022 Est Market Launch Est Annual Revenue Total Research & Development costs: $ 788 $ 1,593 $ 467 $ 1,395 Products in development: ENT Shaver. 2 2 1 44 Q4 2024 $ 1,000 Sustaining & Other 786 1,591 466 1,351 Total $ 788 $ 1,593 $ 467 $ 1,395 (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 our 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 that later may ultimately be abandoned. Interest & Other Income Interest income for the three and six months ended December 31, 2023, and 2022 includes interest and dividends from our money market accounts and investment portfolio. Unrealized Gain (Loss) on Investments The unrealized gain (loss) on investments consists of our investment portfolio described more fully in Note 4 to the condensed consolidated financial statements contained elsewhere in this report. All of these investments are recorded at estimated fair value and as of December 31, 2023, all of these investments relate to common stock of publicly traded companies whose stock price is subject to significant volatility. Interest Expense Interest expense consists primarily of interest expense related 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 December 31, 2023, and 2022 is 19% and 26%, respectively. The decrease in the current year effective tax rate is due primarily to the release of a $60,000 valuation allowance related to previously recognized unrealized losses on investments. The effective tax rate for the six months ended December 31, 2023, and 2022 is 45% and 24%, respectively. The increase in the current year effective tax rate is similarly due to the release of the valuation allowance recorded in the second quarter of fiscal 2024 and is a tax benefit since we have a year-to-date pre-tax loss. 23 Liquidity and Capital Resources Cash and cash equivalents at December 31, 2023 decreased $1.6 million to $1.3 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 Six Months Ended December 31, 2023 2022 (in thousands) Cash provided by (used in): Operating activities $ 1,102 $ 2,497 Investing activities $ (2,009 ) $ (598 ) Financing activities $ (740 ) $ (2,366 ) Cash and Working Capital: Cash and cash equivalents $ 1,289 $ 382 Working Capital $ 26,610 $ 19,722 Operating Activities Net cash provided by operating activities was $1.1 million for the six months ended December 31, 2023, primarily due to our net loss of $115,000 offset by non-cash stock-based compensation, depreciation and amortization, and unrealized losses on marketable equity investments of $386,000, $568,000, and $2.6 million, respectively. Although we experienced an influx of cash in the amount of $1.1 million due to a reduction in our inventory balance during the six months ended December 31, 2023, our accounts receivable balance increased by $3.2 million due to timing of customer payments. Net cash provided by operating activities was $2.5 million for the six months ended December 31, 2022, primarily due to net income of $4.0 million and non-cash depreciation and amortization of $384,000 offset by unrealized gains on marketable securities in the amount of $3.2 million. Accounts receivable net collections amounted to $3.2 million for the six months ended December 31, 2022, offset by expenditures of $2.5 million for inventory, based primarily upon a forecast received from our largest customer, which later was reduced. Although current inventory levels exceed immediate requirements for this customer, they do not exceed the amounts that will ultimately be required to fulfill our customers’ contractual requirements. Investing Activities Net cash used in investing activities for the six months ended December 31, 2023, was $2.0 million and related to the exercise of our Monogram Warrant for cash in the amount of $1,250,000 (See Note 4 to the condensed consolidated financial statements contained elsewhere in this report) as well as equipment and improvements purchases in the amount of $759,000. Net cash used in investing activities for the six months ended December 31, 2022, was $598,000 and related mostly to improvements and equipment primarily for the Franklin Property. Financing Activities Net cash used in financing activities for the six months ended December 31, 2023, totaled $740,000 and related primarily to the net principal payments of $665,000 on our loans from MBT more fully described in Note 10 to the condensed consolidated financial statements contained elsewhere in this report, as well as repurchase of 6,285 shares of our common stock pursuant to our share repurchase program in the amount of $107,000. Net cash used in financing activities for the six months ended December 31, 2022, included net principal payments of $839,000 on our existing loans from MBT, the repurchase of $1.3 million of our 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. 24 Financing Facilities & Liquidity Requirements for the Next Twelve Months As of December 31, 2023, our working capital was $26.6 million. We currently believe that our existing cash and cash equivalent balances together with our accounts 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 may also liquidate some of our marketable equity investments, which had an estimated fair market value of $7.3 million as of December 31, 2023. 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 to raise additional capital to fund our operations, we can do so by borrowing against our $7.0 million Amended Revolving Loan with MBT (See Note 10 to the condensed consolidated financial statements contained elsewhere in this report). Investment Strategy We invest surplus cash from time to time through our Investment Committee, which is comprised of one management director, Richard Van Kirk, and two non-management directors, Raymond (“Ray”) Cabillot and Nicholas (“Nick”) Swenson, who chairs the committee. Both Nick and Ray are active investors with extensive portfolio management expertise. We leverage the experience of these committee members to make investment decisions for the investment of our surplus operating capital or borrowed funds. Additionally, many of our securities holdings include stocks of public companies that either Nick or Ray or both may own from time to time either individually or through the investment funds that they manage, or other companies whose boards they sit on. The Investment Committee approved each of the investments comprising the $7.3 million of marketable public equity securities that we held on December 31, 2023. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.