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, 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. Except for the historical information contained herein, the matters discussed in this report, including, but not limited to, discussions of our product development plans, business strategies, strategic opportunities, and market factors influencing our results, are forward-looking statements that involve certain risks and uncertainties. Actual results may differ from those anticipated by us as a result of various factors, both foreseen and unforeseen, including, but not limited to, our ability to continue to develop new products and increase sales in markets characterized by rapid technological evolution, the impact of the COVID-19 pandemic on our suppliers, customers, and us, consolidation within our target marketplace and among our competitors, competition from larger, better capitalized competitors, and our ability to realize returns on opportunities. Many other economic, competitive, governmental, and technological factors could impact our ability to achieve our goals. You are urged to review the risks, uncertainties, and other cautionary language described in this report, as well as in our other public disclosures and reports filed with the Securities and Exchange Commission (“SEC”) from time to time, including, but not limited to, the risks, uncertainties, and other cautionary language discussed in our Annual Report on Form 10-K for our fiscal year ended June 30, 2021. 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. 18 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, 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 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, 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 30, 2021. 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 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, 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. 19 COVID-19 Pandemic We have adjusted certain policies 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 COVID-19 pandemic, including: · Non-essential employees that are able to work remotely are doing so; · Increased frequency of disinfectant cleanings, especially for high-touch surfaces; · 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; and · 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. 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 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. We are focused on the health and safety of all those we serve – our customers, our communities, our employees, and our suppliers. We 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 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 sales. 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 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, 2021 2020 2021 2020 % of Revenue % of Revenue % of Revenue % of Revenue Net sales: Medical device products $ 8,389 83 % $ 6,391 77 % $ 16,673 83 % $ 13,131 78 % Industrial and scientific 238 2 % 221 2 % 454 2 % 385 2 % Dental and component 82 1 % 11 — 144 1 % 74 — NRE & Prototype 115 1 % 120 2 % 311 1 % 130 1 % Repairs 1,568 15 % 1,523 19 % 3,027 15 % 3,149 19 % Discounts and other (219 ) (2 %) (1 ) — (448 ) (2 %) (14 ) — $ 10,173 100 % $ 8,265 100 % $ 20,161 100 % $ 16,855 100 % 20 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 in our Irvine, 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, 2021 2020 2021 2020 % of Total % of Total % of Total % of Total Medical device sales: Orthopedic $ 5,331 64 % $ 4,413 69 % $ 11,037 66 % $ 8,102 62 % CMF 2,604 31 % 1,117 18 % 4,991 30 % 2,642 20 % Thoracic 454 5 % 861 13 % 645 4 % 2,387 18 % Total $ 8,389 100 % $ 6,391 100 % $ 16,673 100 % $ 13,131 100 % Sales 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. Sales 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. Repair 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. At 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 revenues. 21 Cost of Sales and Gross Margin (in thousands except percentages) Three Months Ended December 31, Six Months Ended December 31, 2021 2020 2021 2020 % of Total % of Total % of Total % of Total Cost of sales: Product cost $ 6,340 94 % $ 5,188 91 % $ 12,972 97 % $ 10,120 94 % Under(over)-absorption of manufacturing costs 248 3 % 275 5 % 102 1 % 352 3 % Inventory and warranty charges 181 3 % 206 4 % 255 2 % 312 3 % Total cost of sales $ 6,769 100 % $ 5,669 100 % $ 13,329 100 % $ 10,784 100 % Three Months Ended December 31, Six Months Ended December 31, Year over Year ppt Change 2021 2020 2021 2020 Three Months Six Months Gross margin 34 % 31 % 34 % 36 % 3 (2 ) Cost 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. Gross 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. Cost 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. Gross 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. 22 Operating Expenses Operating Costs and Expenses (in thousands except % change) Three Months Ended December 31, Six Months Ended December 31, Year over Year % Change 2021 2020 2021 2020 Three Months Six Months % of Net Sales % of Net Sales % of Net Sales % of Net Sales Operating expenses: Selling expenses $ 22 — $ 150 2 % $ 59 — $ 280 2 % (85 %) (79 %) General and administrative expenses 1,165 12 % 936 11 % 2,257 11 % 1,641 12 % 25 % 38 % Research and development costs 615 6 % 989 12 % 1,596 8 % 2,080 10 % (38 %) (23 %) $ 1,802 18 % $ 2,075 25 % $ 3,912 19 % $ 4,001 24 % (13 %) (2 %) 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. 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 position in the first quarter of fiscal 2022. 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 $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. These 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. 23 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 Est Market Launch (1) Est Annual Revenue Total Research & Development costs: $ 615 $ 1,596 $ 989 $ 2,080 Products in development: ENT Shaver 32 263 76 258 Q4 2022 $ 1,000 Vital Ventilator — 108 8 65 Q1 2023 $ 1,500 CMF Driver — — 279 468 (2) $ 1,000 Sustaining & Other 583 1,225 626 1,289 Total $ 615 $ 1,596 $ 989 $ 2,080 (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 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 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. 24 Liquidity and Capital Resources 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 Six Months Ended December 31, 2021 2020 (in thousands) Cash provided by (used in): Operating activities $ 4,219 $ 1,085 Investing activities $ (1,430 ) $ (6,703 ) Financing activities $ (1,258 ) $ 4,720 Cash and Working Capital: Cash and cash equivalents $ 5,252 $ 5,523 Working Capital $ 20,117 $ 17,776 Operating Activities 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 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 fiscal year. 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 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. 25 Financing Facilities & Liquidity Requirements for the Next Twelve Months 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 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 (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 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. Both Mr. 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. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.