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 nine-month periods ended March 31, 2024 and 2023. 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, 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. 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. 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. 20 Critical Accounting Estimates and Judgments Our condensed 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 nine months ended March 31, 2024 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. 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, expanding our manufacturing capacity with the addition of the Franklin Property, investing in research and development activities to design Pro-Dex branded drivers to leverage our torque-limiting software, and promoting active product development proposals to new and existing customers for orthopedic shavers, screw drivers for a multitude of surgical applications, and other medical devices, while monitoring closely the progress of all these individual endeavors. Our investments in research and development have historically increased disproportionately to our growth in revenue and we anticipate this may continue in future periods. These expenditures are being made in an effort to release new products and garner new customer relationships. 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. 21 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 March 31, Nine Months Ended March 31, 2024 2023 2024 2023 % of Revenue % of Revenue % of Revenue % of Revenue Net Sales: Medical device products $ 9,782 68 % $ 6,990 54 % $ 26,536 68 % $ 23,631 67 % Industrial and scientific 211 1 % 260 2 % 591 2 % 691 2 % Dental and component 62 1 % 43 — 146 — 182 — NRE & Proto-type 234 2 % 970 7 % 762 2 % 2,361 7 % Repairs 4,433 31 % 5,068 39 % 11,749 30 % 9,410 26 % Discounts and other (429 ) (3 %) (252 ) (2 %) (965 ) (2 %) (827 ) (2 %) $ 14,293 100 % $ 13,079 100 % $ 38,819 100 % $ 35,448 100 % 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, along with our industrial products. Details of our medical device sales by type is as follows (in thousands, except percentages): Three Months Ended March 31, Nine Months Ended March 31, 2024 2023 2024 2023 % of Total % of Total % of Total % of Total Medical device sales: Orthopedic $ 6,765 69 % $ 3,866 55 % $ 17,136 65 % $ 15,271 65 % CMF 2,247 23 % 2,886 41 % 6,641 25 % 7,208 30 % Thoracic 770 8 % 238 4 % 2,759 10 % 1,152 5 % Total $ 9,782 100 % $ 6,990 100 % $ 26,536 100 % $ 23,631 100 % Sales of our medical device products increased $2.8 million, or 40%, and $2.9 million, or 12%, respectively, for the three and nine months ended March 31, 2024, compared to the corresponding periods of the prior fiscal year. Our medical device revenue to our largest customer, included in orthopedic sales above, increased $2.9 million and $1.9 million, respectively, for the three and nine months ended March 31, 2024 compared to the corresponding periods of the prior fiscal year . Additionally, recurring revenue from distributors of thoracic drivers increased $532,000 and $1.6 million, respectively, for the three and nine months ended March 31, 2024, compared to the corresponding periods of the prior fiscal year in part due to the launch of a new driver to one of our customers in the first quarter of this fiscal year. Our CMF sales revenue decreased $639,000 and $567,000, for the three and nine months ended March 31, 2024, respectively, compared to the corresponding periods of the prior fiscal year. 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. Sales of our compact pneumatic air motors, reported as industrial and scientific sales above, decreased $49,000, or 19%, and $100,000, or 14%, respectively, for the three and nine months ended March 31, 2024, compared to the corresponding periods of the prior fiscal year. These are legacy products with no substantive marketing efforts . Our NRE and proto-type revenue decreased $736,000, or 76%, and $1.6 million, or 68%, for the three and nine months ended March 31, 2024, 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. Sales of our dental products and components increased $19,000, or 44%, and decreased $36,000, or 20%, respectively, for the three and nine months ended March 31, 2024, compared to the corresponding periods of the prior fiscal year. In the prior fiscal year we sold component inventory to our largest customer used in their legacy design which did not recur in the current fiscal year. We expect future declines in this area as we are no longer manufacturing dental products, but rather are simply selling remaining component inventory. Repair revenue decreased $635,000 or 13%, and increased $2.3 million, or 25%, for the three and nine months ended March 31, 2024, respectively, compared to the corresponding periods of the prior fiscal year due to repairs of the orthopedic handpiece we sell to our largest customer. The year-to-date increase was expected as we have been upgrading handpieces to the next generation, which design was released to manufacture in the third quarter of fiscal 2022. The repair revenue recorded during the three months ended March 31, 2023, included an additional $520,000 in compensation, for handpieces upgraded between July 2022 and December 2022. There was no similar adjustment in the current fiscal year. 22 At March 31, 2024, we had a backlog of approximately $25.2 million, of which $9.9 million is scheduled to be delivered in the fourth quarter of 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 March 31, Nine Months Ended March 31, 2024 2023 2024 2023 % of Total % of Total % of Total % of Total Cost of sales: Product cost $ 9,815 95 % $ 8,510 92 % $ 28,156 99 % $ 24,066 92 % Under(over)-absorption of manufacturing costs 170 2 % 729 8 % (146 ) — 1,705 7 % Inventory and warranty charges 306 3 % 29 — 347 1 % 287 1 % Total cost of sales $ 10,291 100 % $ 9,268 100 % $ 28,357 100 % $ 26,058 100 % Three Months Ended March 31, Nine Months Ended March 31, Year over Year ppt Change 2024 2023 2024 2023 Three Months Nine Months Gross margin 28 % 29 % 27 %% 26 % (1 ) 1 Cost of sales for the three months ended March 31, 2024, increased $1.0 million, or 11%, compared to the corresponding period of the prior fiscal year. The increase in total costs of sales is consistent with the 9% increase in revenue for the same period. Under-absorption of manufacturing costs decreased by $559,000 for the three months ended March 31, 2024, compared to the corresponding period of the prior fiscal year due to increases in our standard labor and overhead rates. Costs relating to inventory and warranty charges increased $277,000 for the three months ended March 31, 2024 compared to the corresponding period of the prior fiscal year, due to an increase in both inventory reserves and warranty accruals. Gross profit increased by approximately $191,000, or 5%, for the three months ended March 31, 2024, compared to the corresponding period of the prior fiscal year, consistent with the overall increase in revenue. Gross margin as a percentage of sales decreased by approximately 1 percentage point compared to the corresponding period of the prior fiscal year due primarily to our increased inventory and warranty charges compared to the corresponding period of the prior fiscal year. Cost of sales for the nine months ended March 31, 2024, increased by $2.3 million, or 9%, compared to the corresponding period of the prior fiscal year. Although some of the increase in cost of sales is consistent with the 4% increase in revenue for the same period, for the reasons discussed above, the majority of the increase relates to increased labor and overhead rates in the current fiscal year, compared to the corresponding period of the prior fiscal year. Inventory and warranty charges increased by approximately $60,000, or 21%, for the nine months ended March 31, 2024, compared to the corresponding period of the prior fiscal year, due to an increase in both inventory reserves and warranty accruals. Some of the inventory charges relate to our in-house packaging of batteries. This fiscal year we have begun the process of packaging our batteries, which we had previously out-sourced, and we are continuing to make improvements to our assembly procedures and processes to reduce our costs. 23 Gross profit increased by $1.1 million, or 11%, for the nine months ended March 31, 2024, compared to the corresponding period of the prior fiscal year, representing an increase of 1 percentage point compared to the corresponding period of the prior fiscal year. Operating Expenses Operating Costs and Expenses (in thousands except percentages) Three Months Ended March 31, Nine Months Ended March 31, Year over Year % Change 2024 2023 2024 2023 Three Months Nine Months % of Net Sales % of Net Sales % of Net Sales % of Net Sales Operating expenses: Selling expenses $ 17 — $ 24 — $ 79 — $ 146 — (29 %) (46 %) General and administrative expenses 1,012 7 % 1,009 8 % 3,208 9 % 2,983 9 % — 8 % Research and development costs 760 5 % 713 5 % 2,353 6 % 2,109 6 % 7 % 12 % $ 1,789 12 % $ 1,746 13 % $ 5,640 15 % $ 5,238 15 % 2 % 8 % 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 nine months ended March 31, 2024, decreased $7,000, or 29%, and $67,000, or 46%, 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”) consist 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 $3,000 and $225,000, respectively, during the three and nine months ended March 31, 2024, 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 nine months ended March 31, 2024, increased $47,000, or 7%, and $244,000, or 12%, compared to the corresponding periods of the prior fiscal year. This relates to a decrease in personnel-related costs as well as a decrease in spending on billable development projects. When our engineers are engaged in a billable project as opposed to an internal project, costs get shifted to cost of sales instead of research and development. 24 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. The research and development costs represent between 40% and 42% of total operating expenses for all periods presented and are expected to increase in the future as we continue to invest in product development efforts. The amount spent on internal projects under development is summarized below (in thousands): Three and Nine Months Ended March 31, 2024 Three and Nine Months Ended March 31, 2023 Market Launch (1) Est Annual Revenue (2) Total Research & Development costs: $ 760 $ 2,353 $ 713 $ 2,109 Products in development: ENT Shaver. $ — $ 2 $ 6 $ 50 n/a n/a CMF Driver. 3 3 10 17 Q1 2025 $ 500 Sustaining & Other 757 2,348 697 2,042 Total. $ 760 $ 2,353 $ 713 $ 2,109 (1) Represents the calendar quarter of expected market launch. The ENT Shaver project has been suspended. At this time, we do not know when or whether we will continue with this product development effort. (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. Interest & Other Income Interest income for the three and nine months ended March 31, 2024 and 2023, includes interest and dividends from our money market accounts and investment portfolio. Interest Expense Interest expense consists primarily of interest expense related to the notes payable described more fully in Note 10 to the condensed consolidated financial statements contained elsewhere in this report. Unrealized Gain (Loss) on Marketable Equity Investments The unrealized gain (loss) on marketable equity investments relates to our investment portfolio more fully described 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 March 31, 2024, all of these investments relate to common stock of publicly traded companies whose stock price is subject to significant volatility. 25 Gain on Sale of Investments During the first quarter ended September 30, 2022, we sold some of the stocks in our portfolio of equity investments receiving proceeds of $89,000 and recording a gain on the sale in the amount of $7,000. Income Tax Expense The effective tax rate for the three months ended March 31, 2024 and 2023 was 28% and 25%, respectively. These tax rates are consistent with our combined expected federal and applicable state corporate income tax rates. The effective tax rate for the nine months ended March 31, 2024 and 2023 was 23% and 24%, respectively, and is less than our combined expected federal and applicable state corporate income tax rates due to the release of a valuation allowance related to previously recognized unrealized losses on investments in the current fiscal year and a tax benefit recognized as a result of common stock awarded to employees under previously granted performance awards in the first quarter of fiscal 2023 as described more fully in Note 8 to the condensed consolidated financial statements contained elsewhere in this report, as well as unrealized gains on our marketable equity investments. Liquidity and Capital Resources Cash and cash equivalents at March 31, 2024, increased $283,000 to $3.2 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 Nine Months Ended March 31, 2024 2023 (in thousands) Cash provided by (used in): Operating activities $ 5,179 $ 4,835 Investing activities $ (2,126 ) $ (733 ) Financing activities $ (2,770 ) $ (2,863 ) Cash and Working Capital: Cash and cash equivalents $ 3,219 $ 2,088 Working capital $ 25,538 $ 21,001 Operating Activities Net cash provided by operating activities was $5.2 million for the nine months ended March 31, 2024, primarily due to net income of $540,000, non-cash unrealized losses on marketable equity investments of $3.8 million, depreciation and amortization of $854,000, share-based compensation of $588,000 as well as a decrease in inventory of $1.9 million. Offsetting these sources of cash, our accounts receivable increased by $2.6 million consistent with our increase in revenue. Net cash provided by operating activities was $4.8 million for the nine months ended March 31, 2023, primarily due to net income of $5.6 million, non-cash depreciation and amortization of $594,000, share-based compensation of $584,000, and collections of accounts receivable in the amount of $4.8 million offset by non-cash unrealized gains on marketable equity investments of $3.4 million, a decrease in accounts payable and accrued expenses of $1.0 million, a decrease in deferred revenue of $956,000, and an increase in inventory in the amount of $2.5 million. Investing Activities Net cash used in investing activities for the nine months ended March 31, 2024, was $2.1 million and related to the exercise of the 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 $876,000. Net cash used in investing activities for the nine months ended March 31, 2023, was $733,000 and related primarily to the purchases of equipment and improvements primarily for the Franklin Property totaling $822,000. Offsetting this use of cash, we sold some of our marketable securities during the nine months ended March 31, 2023 for $89,000. 26 Financing Activities Net cash used in financing activities for the nine months ended March 31, 2024, totaled $2.8 million and related primarily to the $1.8 million repurchase of 96,890 shares of our common stock pursuant to our share repurchase program as well as $990,000 of net principal payments on our loans from Minnesota Bank and Trust (“MBT”) more fully described in Note 10 to the condensed consolidated financial statements contained elsewhere in this report. Net cash used in financing activities for the nine months ended March 31, 2023, totaled $2.9 million and related primarily to the $1.5 million repurchase of 86,422 shares of our common stock pursuant to our share repurchase program, $4.8 million of payments to MBT as well as payment of $223,000 of employee payroll taxes related to the award of 37,500 shares of common stock to employees under previously granted performance awards. Offsetting these uses of cash we also borrowed $3.6 million from MBT under our amended revolving loan, and collected $78,000 and $11,000, respectively, related to employee contributions to the ESPP plan and exercises of stock options. Financing Facilities & Liquidity Requirements for the next twelve months As of March 31, 2024, our working capital was $25.5 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 or all of our investment portfolio or borrow further against our $7.0 million Amended Revolving Loan with MBT (see Note 10 to condensed consolidated financial statements contained elsewhere in this report), under which we had availability of $4.5 million as of March 31, 2024. 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. 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 $6.1 million of marketable public equity securities held at March 31, 2024. 27 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.