What changed in this filing

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Item 2. Management’s Discussion and Analysis

2022-02-03 compared with 2021-11-15 · 311 added, 301 removed, 88 unchanged (87% of the section changed)

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.

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

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(“Company,” “Pro-Dex,”

“we,” “our,” or “us”) for the three-month periods ended September 30, 2021 and 2020.

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

“we,” “our,” or “us”) for the three-month and six-month periods ended December 31, 2021 and 2020.

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.

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and other cautionary language discussed in our Annual Report on Form 10-K for our fiscal year ended June 30, 2021.

specialize in the design, development, and manufacture of powered rotary drive surgical instruments used primarily in the orthopedic,

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.

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 .

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.

our Code of Ethics and other corporate governance documents may be found on our website at the Internet address set forth above.

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.

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

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.

principal headquarters are located at 2361 McGaw Avenue, Irvine, California 92614 and our phone number is (949) 769-3200.

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.

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 results of operation

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, 2022, 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 financial statements are

prepared in accordance with U.S.

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 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, 2022, 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

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

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Management believes that there have been no significant changes during

the three months ended September 30, 2021, 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, 2021.

Business Strategy and

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

the three and six months ended December 31, 2021, 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

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

This building is located approximately four miles from our Irvine, California headquarters and was acquired to provide

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and new products.

Currently, we are completing our build-out of the property and performing necessary validations for both equipment and

processes and have yet to transition any of our employees into the facility.

We expect that we will begin operations in the new facility

during the second quarter.

We substantially completed the build-out of the property in the first quarter

of this fiscal year.

Currently, we are actively engaged in various verification and validation

activities so that we can move certain employees and operations into the new building .

We expect that we will begin certain operations

in the new facility this fiscal year.

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 Pro-Dex branded drivers to leverage our torque-limiting software, expansion of our manufacturing capacity through

the build-out of 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.

Our investments in research and development have increased disproportionately to our growth in revenue and we anticipate this to continue

in the near term.

These expenditures are being made in an effort to release new products and garner new customer relationships.

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.

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.

COVID-19 Pandemic

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and procedures based on applicable national, state, and local emergency orders and safety guidance that may be issued from time to time,

in order to effectively manage our business during the pandemic, including:

in order to effectively manage our business during the COVID-19 pandemic, including:

· Non-essential employees that are able to work remotely are doing so;

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· Curtailed business travel;

· Multiple, staggered work shifts

have been implemented in order to achieve effective social distancing;

· Provided training, education

and appropriate personal protective equipment;

· Implemented quarterly company-wide

COVID-19 testing.

While we have yet to see any

significant decline in our customer orders, we have received and accepted some customer requests to delay the shipment of their existing

We provide our largest customer with a device used primarily in elective surgeries and although this customer has not requested

a reduction or delay to their planned shipments, if this pandemic continues to adversely impact the United States and other markets where

our products are sold, coupled with the potential for recommended deferrals of elective procedures by governments and other authorities,

we would expect to see a decline in demand from certain of our customers, including our principal customer.

are focused on the health and safety of all those we serve – our customers, our communities, our employees, and our suppliers.

are supporting our customers according to their priorities and working with them to the degree that we can offer relief in the form of

delayed shipments.

We are focused on continuity of supply by working with our suppliers, some of whom have delivered our orders late and

are quoting longer lead times.

While the COVID-19 pandemic

has not materially adversely affected our financial results and business operations thus far, we cannot predict the full impact of the

COVID-19 pandemic on our business.

Results of Operations

The following tables set forth

results from continuing operations for the three months ended September 30, 2021 and 2020 (in thousands, except percentages):

Three Months Ended September 30,

Dollars in thousands

% of Net Sales

Cost of sales

Selling expenses

General and administrative expenses

Research and development costs

Operating income

Other income (expense), net

Income before income taxes

Provision for income taxes

· Multiple, staggered work shifts have been implemented

in order to achieve effective social distancing;

· Provided training, education and appropriate

personal protective equipment;

· Monthly company-wide COVID-19 testing.

While we have yet to see any significant

decline in our customer orders, we have received and accepted some customer requests to delay the shipment of their existing orders.

provide our largest customer with a device used primarily in elective surgeries and although this customer has not requested a reduction

or delay to their planned shipments, if this pandemic continues to adversely impact the United States and other markets where our products

are sold, coupled with the recommended deferrals of elective procedures by governments and other authorities, we would expect to see a

decline in demand from certain of our customers, including our principal customer.

focused on the health and safety of all those we serve – our customers, our communities, our employees, and our suppliers.

supporting our customers according to their priorities and working with them to the degree that we can offer relief in the form of delayed

We are focused on continuity of supply by working with our suppliers, some of whom have delivered our orders late and are quoting

longer lead times.

While the COVID-19 pandemic has

not materially adversely affected our financial results and business during calendar 2021, we began to see some challenges in our supply

chain in the form of delayed shipments, longer lead times, and surcharges, much of which our suppliers indicate have been caused by the

COVID-19 pandemic.

During early calendar 2022, we are seeing these conditions persist and worsen such that we expect them to negatively

impact our financial performance in the third quarter and possibly the fourth quarter of fiscal 2022, reflected as a reduction in net

We continue to implement plans and processes to mitigate these challenges that many manufacturers similarly face.

Our long-term

prospects remain positive, and we believe these challenges will negatively impact us only in the short-term.

Description of Business Operations

majority of our revenue is derived from designing, developing and manufacturing surgical

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 2020 To 2021

Dollars in thousands

% of Net Sales

Medical device

devices for the medical device industry.

The proportion of total sales by type is as follows

(in thousands, except percentages):

Three Months Ended

Six Months Ended

Medical device products

Industrial and scientific

Dental and component

NRE & proto-types

NRE & Prototype

Discounts and other

of our medical device products utilize proprietary designs developed by us under exclusive

development and supply agreements.

development and/or supply agreements.

All of our medical device

products utilize proprietary manufacturing methods and know-how, and are manufactured in our Irvine, 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 2020 To 2021

Dollars in thousands

% of Med Device Sales

products utilize proprietary manufacturing methods and know-how, and are manufactured in our Irvine, California facility, as are our industrial

Details of our medical device sales by type is as follows (in thousands, except percentages):

Three Months Ended

Six Months Ended

Medical device sales:

medical device revenue increased $1.5 million, or 23%, in the first quarter of fiscal 2022 compared to the corresponding period of the

prior fiscal year .

Our orthopedic sales include the surgical handpiece that we sell to our largest customer which increased $2.0

million in the current year due to a supply disruption in the first quarter of the prior year that did not recur in the current year.

Sales of our CMF products increased $862,000 in the first quarter of fiscal 2022 compared to the corresponding period of the prior fiscal

year due in part to the launch of a new driver to our existing largest customer during the third quarter of the prior fiscal year.

of our thoracic drivers decreased $1.3 million in the first quarter of fiscal 2022 compared to the corresponding period of the prior fiscal

year due primarily as a result of our customer filling the near-term requirements of its distribution network.

of our compact pneumatic air motors increased $52,000, or 32%, in the first quarter of fiscal

2022 compared to the corresponding period of the prior fiscal year.

The revenue increase relates to a continued interest in these legacy

products but is not due to any substantive marketing efforts .

Sales of our dental products

and components remained flat in the first quarter of fiscal 2022 compared to the corresponding quarter of the prior fiscal year.

continue to experience future declines in this area as we are no longer manufacturing dental products, but rather simply selling remaining

Our non-recurring engineering (“NRE”) and proto-type revenue increased $186,000 in the first quarter of

fiscal 2022 compared to the corresponding period of the prior fiscal year, due to increased billable contracts in the current fiscal first

Our NRE and proto-type revenue is typically a small percentage of our total revenue and can vary significantly from quarter to

revenue decreased by $168,000 in the first quarter of fiscal 2022 compared to the corresponding period of the prior fiscal year, due to

decreased repairs of the orthopedic handpiece we sell to our largest customer.

Typically, upon initial product launch, repair revenue

is minimal as most repairs are typically covered under warranty, but as the products mature in the marketplace and after a certain number

of routine duty cycles in the operating room, repairs generally increase.

and other increased by $216,000 in the first quarter of fiscal 2022 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.

30, 2021, we had a backlog of approximately

$12.8 million, of which $12.6 million is s cheduled for delivery during the remainder of fiscal 2022.

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

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.

of our medical device products increased $2.0 million, or 31%, for the three months ended December 31, 2021, and increased $3.5 million,

or 27%, for the six months ended December 31, 2021, compared to the corresponding periods of the prior fiscal year.

The majority, or $2.9

million, of our increase in medical device sales for the six months ended December 31, 2021, relates to sales of the orthopedic surgical

handpiece that we sell to our largest customer.

Sales of our CMF products increased $2.3 million for the six months ended December 31,

2021, compared to the corresponding period of the prior fiscal year, in part due to the launch of a new driver to our existing

largest customer during the third quarter of the prior fiscal year.

Offsetting this increase, thoracic

revenue decreased approximately $1.7 million for the six months ended December 31, 2021, compared to the corresponding period of

the prior fiscal year, due primarily as a result of our customer filling the near-term requirements of its distribution network.

of our compact pneumatic air motors, reported as Industrial and scientific sales above, increased

$17,000, or 8%, and $69,000, or 18%, for the three and six months ended December 31, 2021, respectively, compared to the corresponding

periods of the prior fiscal year.

The revenue increase relates to a continued interest in these legacy products but is not due to any

substantive marketing efforts.

revenue remained relatively flat for the three and six months ended December 31, 2021, compared to the corresponding periods of the prior

fiscal year and are primarily comprised of repairs of handpieces for our largest customer.

December 2021, we had a backlog of approximately $6.0 million, of which $5.7 million is scheduled to be delivered in the third and fourth

quarters of fiscal 2022 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.

As an example, currently our largest customer

is delaying issuance of purchase orders to us because they are releasing a next generation of their handpiece, but we expect to receive

orders for the balance of the fiscal year shortly.

However, we do not typically experience seasonal fluctuations in our shipments and

Cost of Sales and Gross Margin

Three Months Ended September 30,

Increase (Decrease) From 2020 To 2021

Dollars in thousands

% of Net Sales

(in thousands except percentages)

Three Months Ended

Six Months Ended

Cost of sales:

Product costs

Under(over)-absorption of manufacturing costs

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Total cost of sales

Gross profit and gross margin

Cost of sales for the three-month

period ended September 30, 2021 increased by $1.4 million, or 28%, compared to the corresponding period of the prior fiscal year.

some of the increase in cost of sales is consistent with the 16% increase in revenue for the same period, some of the increase relates

to the change in product mix from the first quarter of fiscal 2021 to 2022.

Product costs increased by 35% during the three months ended

September 30, 2021, compared to the corresponding period of the prior fiscal year, due to both higher material costs and higher direct

costs in our machine shop, materials, assembly and quality departments.

During the first quarter of fiscal 2022 we experienced $146,000

of over-absorbed manufacturing costs compared to an under-absorption of $94,000 in the first quarter of fiscal 2021, primarily due to

actual production hours exceeding the corresponding period of the prior fiscal year.

Costs related to inventory and warranty charges decreased

$32,000 in the first quarter of fiscal 2022 compared to the corresponding quarter of fiscal 2021, due primarily to a prior year accrual

for the replacement cost of batteries owed to one of our customers.

No similar costs were incurred in the first quarter of fiscal 2022.

profit decreased by approximately $47,000, or 1%, for the three months ended September 30, 2021 compared to the corresponding period of

the prior fiscal year, and gross margin as a percentage of sales decreased by approximately six percentage points between such periods,

primarily as a result of product mix.

Three Months Ended

Six Months Ended

Year over Year

of sales for the three months ended December 31, 2021, increased $1.1 million, or 19%, compared to the corresponding period of the prior

fiscal year, due primarily to the 23% increase in sales for the same period and reduced COVID-19 compensated absences in the three months

ended December 31, 2021, compared to the corresponding period of the prior fiscal year.

profit increased by $808,000, or 31%, for the three months ended December 31, 2021, compared to the corresponding period of the prior

fiscal year, primarily as a result of the increase in revenue for the same period.

Gross margin as a percentage of sales increased by

approximately three percentage points compared to the corresponding period of the prior fiscal year due primarily to the increased sales,

described above.

of sales for the six months ended December 31, 2021, increased by $2.5 million, or 24%, compared to the corresponding period of the prior

fiscal year, consistent with the increased revenue of 20% for the same period, the reasons for which are discussed above.

Additionally,

during the six months ended December 31, 2020, we had higher compensated absences related to COVID-19 than the corresponding period of

the current fiscal year.

profit increased by $761,000, or 13%, for the six months ended December 31, 2021, compared to the corresponding period of the prior fiscal

year, primarily as a result of increased sales to our largest customer.

Gross margin for the six months ended December 31, 2021, decreased

to 34% compared to 36% for the corresponding period of the prior fiscal year, due to price concessions to our largest customer.

Operating Expenses

Operating Costs and Expenses

Three Months Ended September 30,

Increase (Decrease) From 2019 To 2020

Dollars in thousands

(in thousands except % change)

Three Months Ended

Six Months Ended

Year over Year % Change

% of Net Sales

Operating expenses:

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Research and development costs

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, 2021 decreased $93,000, or 72%, compared to the corresponding year-earlier period.

The decrease is primarily

due to decreased personnel and related expenses due to combining our Director of Business Development position with our Director of Engineering

in the first quarter of fiscal 2022.

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, 2021, decreased $128,000, or 85%, and $221,000, or 79%, compared to the corresponding periods of fiscal 2021.

is primarily due to decreased personnel and related expenses due to combining our Director of Business Development position with our Director

of Engineering position in the first quarter of fiscal 2022.

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 increased by $388,000,

or 55%, for the three months ended September 30, 2021, when compared to the corresponding period of the prior fiscal year.

in total G&A expenses was primarily related to non-cash compensation expense related to the non-qualified stock options granted in

the prior fiscal year.

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

Research and development costs decreased $111,000, or 10%, for the quarter ended September 30, 2021, compared to the corresponding

prior year period.

The decrease is due primarily to a decrease in the amount of $51,000 in engineering projects for new product development

as well as an increase of $58,000 relating to billable non-recurring engineering, which amount has been reclassified to cost of sales

in the condensed consolidated statement of income.

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.

Research and development costs represent between 46% and 57% of total operating expenses

for all periods presented and are expected to increase in the future as we continue to invest in product development.

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,

(“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 $229,000 and $616,000, respectively, during the three and six months ended December

31, 2021, when compared to the corresponding periods of the prior fiscal year.

The increases relate primarily to non-cash compensation

expense related to the non-qualified stock options granted in the prior fiscal year.

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, 2021, decreased $374,000 and $484,000, respectively, compared to the corresponding periods of the prior fiscal year.

decreases are primarily due to increased 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.

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 34% and 52% 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, 2021

Three and Six Months Ended December 31, 2020

Market Launch (1)

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(1) Represents the calendar quarter of expected market launch.

The internal projects currently under development

have been delayed because we have been engaged by our customers to complete several billable non-recurring engineering projects.

(2) The CMF Driver was completed in the third quarter of fiscal 2021 and began shipping to our existing largest

customer under a distribution agreement we executed in the first quarter of fiscal 2021.

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.

Other Income (Expense), net

The interest expense recorded

during the quarters ended September 30, 2021 and 2020 relates to our Minnesota Bank and Trust (“MBT”) loan described more

fully in Note 10 to the condensed consolidated financial statements contained elsewhere in this report.

The unrealized gain (loss) on

marketable securities for the quarters ended September 30, 2021 and 2020 relates to our portfolio of investments described more fully

in Note 4 to the condensed consolidated financial statements contained elsewhere in this report.

The interest and miscellaneous income

recorded during the quarters ended September 30, 2021 and 2020, consists primarily of interest and dividends from our investments and

money market accounts as well as $12,000 of realized gains from the sale of marketable securities during the quarter ended September 30,

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

six months ended December 31, 2021 and 2020, 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.

Gain on Sale of Investments

During the quarter ended September

30, 2020, we liquidated two of the stocks in our portfolio of equity investments, receiving proceeds of $115,000 and recording a gain

on the sale in the amount of $12,000.

Income Tax Expense

The effective tax rate for

the three months ended September 30, 2021 and 2020 is 22% and 20%, 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.

The effective tax rate for the three

and six months ended December 31, 2021, is slightly less than our combined expected federal and applicable state corporate income tax

rates due to federal and state research credits.

The effective tax rate for the three and six months ended December 31, 2020, is significantly

less than our combined expected federal and applicable state corporate income tax rates due to significant unrealized gains on our marketable

equity investments, federal and state research credits, as well as a tax benefit recognized as a result of common stock awarded to employees

under previously granted performance awards in the first quarter of fiscal 2021 as described more fully in Note 7 to the condensed consolidated

financial statements contained elsewhere in this report.

Liquidity and Capital Resources

Cash and cash equivalents at September 30, 2021

Cash and cash equivalents at December

31, 2021, increased $1.5 million to $5.2 million as compared to $3.7 million at June 30, 2021.

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,

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,

(in thousands)

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Operating Activities

Net cash provided by operating

activities during the three months ended September 30, 2021 totaled $2.7 million.

The primary sources of cash arose from (a) our net income

for the quarter of $1.1 million, as well as non-cash share-based compensation and depreciation and amortization of $300,000 and $184,000,

respectively, (b) a decrease of $834,000 in accounts receivable due to more timely collection of receivables from our largest customer,

and (c) a decrease in prepaid expenses and other current assets of $284,000.

Uses of cash arose primarily from an increase in inventory

of $470,000 primarily related to timing of various components and advance procurement of long-lead time items.

Net cash used by operating activities

during the three months ended September 30, 2020 totaled $888,000.

The primary sources of cash arose from our net income for the quarter

of $1,158,000, as well as non-cash depreciation and amortization of $150,000, offset by an increase in accounts receivable of $986,000

due to extended payment terms from our largest customers, a decrease in accounts payable and accrued expenses of $767,000, as well as

payments for income taxes in the amount of $747,000.

Net cash provided by operating activities

was $4.2 million for the six months ended December 31, 2021, primarily due to net income of $2.0 million and non-cash stock-based compensation

and depreciation and amortization of $575,000 and $366,000, respectively.

Although we experienced an influx of cash in the amount of $2.1

million in collections from receivables during the six months ended December 31, 2021, our inventory increased by $848,000.

Net cash provided by operating activities

was $1.1 million for the six months ended December 31, 2020, primarily due to net income of $2.9 million and non-cash depreciation and

amortization of $320,000 offset by unrealized gains on marketable securities in the amount of $1.3 million and an increase in inventory

of $913,000, reflecting purchases for existing demand as well as long-lead time parts for products in development.

Investing Activities

Net cash used in investing activities

for the three months ended September 30, 2021 was $874,000 and related primarily to the purchase of manufacturing equipment and improvements

at the Franklin Property in the amount of $847,000.

Net cash provided by investing activities for

the three months ended September 30, 2020 was $25,000 and related primarily to the sale of marketable equity securities in the amount

of $115,000 offset by the purchase of capitalized equipment and software in the amount of $89,000.

for the six months ended December 31, 2021, was $1.4 million and related to an investment in marketable securities of $334,000 and equipment

and improvements primarily for the Franklin Property of $1.1 million.

During the second quarter ended

December 31, 2020, we closed on our acquisition of the Franklin Property.

We substantially completed the build-out of the property in

the first quarter of this fiscal year.

Currently, we are actively engaged in various verification and validation activities so that we

can move certain employees and operations into the new building.

We expect that we will begin certain operations in the new facility this

In addition to our acquisition of the Franklin Property, we also invested $316,000 in machinery and equipment during the

six months ended December 31, 2020.

Financing Activities

Net cash used in financing activities

for the three months ended September 30, 2021 included the repurchase of $95,000 of common stock pursuant to our share repurchase program,

as well as payments of $306,000 on our loans from 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 three months ended September 30, 2020 included payments of $161,000 on our existing term loan from MBT as well as $259,000 of

employee payroll taxes related to the award of 40,000 shares of common stock to employees under previously granted performance awards.

Financing Facilities

& Liquidity Requirements for the Next Twelve Months

As of September 30, 2021, our

working capital was $19.8 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 may also borrow against our $2.0 million Revolving Loan with MBT, which we have recently renewed.

Notes 10 and 14 to condensed consolidated financial statements contained elsewhere in this report.)

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.

for the six months ended December 31, 2021, totaled $1.3 million and related primarily to the $672,000 repurchase of 27,952 shares of

our common stock pursuant to our share repurchase program as well as $616,000 of principal payments on our loans from MBT.

Net cash provided by financing activities

for the six months ended December 31, 2020, included proceeds of $5.2 million from a Property Loan with MBT, offset by $261,000 of principal

payments on our term loan with MBT more fully described in Note 10 to the condensed consolidated financial statements contained elsewhere

in this report, as well as payment of $259,000 of employee payroll taxes related to the award of 40,000 shares of common stock to employees

under previously granted performance awards.

Financing Facilities & Liquidity Requirements for the Next Twelve

As of December 31, 2021, our working

capital was $20.1 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

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 borrow against our $2.0 million Revolving Loan with MBT (See Note 10 to condensed consolidated financial

statements contained elsewhere in this report).

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 revolving loan with MBT, or sell additional shares of our common stock under our previously disclosed ATM Agreement,

which is currently suspended.

We believe that if we need to raise additional capital to fund our operations

we can do so by selling additional shares of our common stock under the ATM Agreement.

(See Note 11 to 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 Cabillot and Nicholas Swenson, who chairs the committee.

Cabillot and Mr.

Swenson 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 Messrs.

Swenson or Cabillot 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 $3.2 million of

marketable public equity securities that we held at December 31, 2021.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET

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Item 2. Management’s Discussion and Analysis