What changed in this filing

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Item 2. Management’s Discussion and Analysis

2022-11-03 compared with 2022-05-05 · 308 added, 362 removed, 77 unchanged (90% 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 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 and nine-month periods ended March 31, 2022 and 2021.

discussion should be read in conjunction with the condensed financial statements and the notes thereto included elsewhere

“we,” “our,” or “us”) for the three-month periods ended September 30, 2022 and 2021.

This discussion

should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere

in this report.

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of our product development plans, business strategies, strategic opportunities, and market factors

influencing our results, including uncertainties related to the COVID-19 pandemic, 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.

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

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, 2022.

specialize in the design, development, and manufacture of powered rotary drive surgical instruments 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.

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.

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

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 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.

The condensed consolidated results

of operations presented in this report are not audited and those results are not necessarily indicative of the results to be expected

for the entirety of our fiscal year ending June 30, 2023, 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 quarter.

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

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 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 and nine months ended March 31, 2022 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

the three months ended September 30, 2022, 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, 2022.

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

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

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

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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 and we moved certain employees into the new building during the third quarter of this fiscal year.

We completed the build-out of the property during fiscal 2022, we received FDA authorization to commence manufacturing

activities during the first quarter of fiscal 2023, and we are currently performing various verification and validation activities for

both equipment and processes, which includes the validation of our new clean room.

We expect that we will begin operations in the new

facility during the third quarter of 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.

are focused primarily on maintaining our relationships with our current medical device customers, investing in research and development

activities to design unique medical devices as well as Pro-Dex branded drivers to leverage our torque-limiting software, expansion of

our manufacturing capacity through the commencement of operations at the Franklin Property, and promoting active product development proposals

to new and existing customers for both orthopedic shavers and screw drivers for a multitude of surgical applications, while monitoring

closely the progress of all these individual endeavors.

While we expect revenue growth in the future, it may not be a consistent trajectory

but rather periods of incremental growth that current expenditures are helping to create.

However, there can be no assurance that we will

be successful in any of these objectives.

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 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;

· Company-wide COVID-19 testing

on a periodic basis.

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 any recommended deferrals of elective procedures by governments and other authorities, we would expect

in order to effectively manage our business during the pandemic and to keep our employees safe.

These measures have changed over time

and continue to change as our specific circumstances change.

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 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.

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 has been caused

by the COVID-19 pandemic.

As previously disclosed, during early calendar 2022, we saw these conditions persist and worsen such that we

expected 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.

While we did see a decline in our third quarter sales compared to sales during our fiscal first and second

quarter, we were able to largely mitigate our biggest concerns by sourcing replacement chips through alternative suppliers, albeit at

much higher prices, for many of our printed circuit board assemblies.

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

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.

During fiscal 2022, we began to

see some challenges in our supply chain in the form of delayed shipments, longer lead times, higher prices, and surcharges, much of which

our suppliers indicate have been caused by the COVID-19 pandemic.

We have largely been able to mitigate our biggest supply chain concerns

by sourcing replacement chips through alternative suppliers, albeit at much higher prices, for many of our printed circuit board assemblies.

In so doing, our cost of sales increased during the second half of fiscal 2022 and thus far in fiscal 2023.

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.

Results of Operations

The following tables set forth results

from continuing operations for the three months ended September 30, 2022 and 2021 (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, net

Income before income taxes

Provision for income taxes

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

Nine Months Ended

Medical device products

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

Dollars in thousands

% of Net Sales

Medical device

Industrial and scientific

Dental and component

NRE & Proto-type

Repairs and other

NRE & proto-types

Discounts and other

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

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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

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

Three Months Ended

Nine Months Ended

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

Dollars in thousands

% of Med Device Sales

Medical device sales:

of our medical device products decreased $4.1 million, or 39%, and $558,000, or 2%, respectively, for the three and nine months ended

March 31, 2022, respectively, compared to the corresponding periods of the prior fiscal year.

Our medical device revenue to our largest

customer, included in orthopedic sales above, decreased $1.5 million and increased $1.2 million, respectively, for the three and nine

months ended March 31, 2022 compared to the corresponding periods of the prior fiscal year .

In the third quarter of this fiscal

year there was a delay in shipping due to the release of our largest customer’s next generation device, which disruption we do not

expect to recur.

Additionally, recurring revenue from distributors of CMF drivers increased $27,000 and $2.4 million, respectively, for

the three and nine months ended March 31, 2022, compared to the corresponding periods 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.

thoracic sales revenue decreased $2.8 million and $4.6 million, respectively, for the three and

nine months ended March 31, 2022, respectively, compared to the corresponding periods 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

$113,000, or 54%, and $182,000, or 31%, respectively, for the three and nine months ended March 31, 2022, 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 .

of our dental products and components increased $179,000, or 746%, and $250,000, or 255%, respectively, for the three and nine months

ended March 31, 2022, compared to the corresponding periods of the prior fiscal year.

The increase was primarily related to sales to our

largest customer of component inventory used in their legacy design which we do not expect to recur.

We expect future declines in this

area as we are no longer manufacturing dental products, but rather are simply selling remaining component inventory.

As previously discussed,

in January 2018, we sent notification to our dental product customers that we were discontinuing the manufacture of these products.

cessation of our dental line of products did not have a material impact on our financial position or results of operations and reflected

a conscious decision to increase capacity for our medical device products.

revenue increased $858,000, or 106%, and $284,000, or 7%, for the three and nine months ended March 31, 2022, respectively, compared to

the corresponding periods of the prior fiscal year due to increased repairs of the orthopedic handpiece we sell to our largest customer.

March 31, 2022, we had a backlog of approximately $21.2 million, of which $7.9 million is scheduled to be delivered in the fourth quarter

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.

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.

medical device revenue decreased $0.4 million, or 5%, in the first quarter of fiscal 2023 compared to the corresponding period of the

prior fiscal year .

The declines in medical device sales across all of our product lines seems to reflect a general softening of

of our compact pneumatic air motors increased $8,000, or 4%, in the first quarter of fiscal

2023 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 increased $41,000 in the first quarter of fiscal 2023 compared to the corresponding quarter of the prior fiscal year.

believe this increase is temporary due to sales of components to our board assembly houses due to the recent chip shortages experienced

Our non-recurring engineering (“NRE”) and proto-type revenue increased $711,000 in the first quarter of fiscal

2023 compared to the corresponding period of the prior fiscal year, due to an increase in billable contracts.

Our NRE and proto-type revenue

is typically a small percentage of our total revenue and can vary significantly from quarter to quarter.

revenue increased by $793,000 in the first quarter of fiscal 2023 compared to the corresponding period of the prior fiscal year, due to

an increased number of repairs of the orthopedic handpiece we sell to our largest customer.

This increase was expected as we have been

asked to upgrade handpieces to the next generation, which design was released to manufacture in the third quarter of fiscal 2022.

and other increased by $57,000 in the first quarter of fiscal 2023 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, 2022, we had a backlog of approximately

$26.6 million, of which $18.6 million is s cheduled for delivery during the remainder of fiscal 2023.

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.

Cost of Sales and Gross Margin

(in thousands except percentages)

Three Months Ended

Nine Months Ended

Three Months Ended September 30,

Increase (Decrease) From

Dollars in thousands

% of Net Sales

Cost of sales:

Product costs

Under-(over) absorption of manufacturing costs

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Total cost of sales

Three Months Ended

Nine Months Ended

Year over Year

of sales for the three months ended March 31, 2022, decreased $947,000, or 13%, compared to the corresponding period of the prior fiscal

The decrease in total costs of sales was caused by the 21% decrease in revenue for the same period.

Under-absorption of manufacturing

costs increased by $410,000 for the three months ended March 31, 2022, compared to the corresponding period of the prior fiscal year due

in part to our inability absorb our fixed costs, which were not reduced in the third quarter, in anticipation of future revenue growth.

Costs relating to inventory and warranty charges increased $178,000 for the third quarter ended March 31, 2022 compared to the third quarter

of the prior fiscal year, largely due to sourcing components for our printed circuit board assemblies at prices higher than usual.

previously disclosed, our supply chain has incurred many disruptions that suppliers indicate have been caused by the COVID-19 pandemic.

profit decreased by approximately $1.5 million, or 35%, for the three months ended March 31, 2022, compared to the corresponding period

of the prior fiscal year, consistent with the overall decrease in revenue.

Gross margin as a percentage of sales decreased by approximately

6 percentage points compared to the corresponding period of the prior fiscal year due primarily to reduced sales, increased under-absorption

of manufacturing costs as a result of decreased sales and the increases in inventory and warranty charges, which relates mostly to component

inventory write-downs to net realizable value as many of these component price increases cannot be passed on to our customers,

many of whom have price protections in place under long-term contracts .

of sales for the nine months ended March 31, 2022 increased by $1.6 million, or 9%, compared to the corresponding period of the prior

fiscal year, consistent with the increased revenue of 3% for the same period, the reasons for which are discussed above.

Additionally,

total cost of sales reflects a $161,000 increase in under-absorbed manufacturing costs due to actual production hours being less than

Inventory and warranty charges increased by approximately $122,000, or 22%, for the nine months ended March 31, 2022, compared

to the corresponding period of the prior fiscal year, due to component inventory write-downs to net realizable value.

profit decreased by $767,000, or 7%, for the nine months ended March 31, 2022, compared to the corresponding period of the prior fiscal

year, primarily as a result of the increase in cost of sales described above.

Gross margin for the nine months ended March 31, 2022, decreased

by 4 percentage points compared to the corresponding period of the prior fiscal year.

Operating Expenses

Gross profit and gross margin

of sales for the three-month period ended September 30, 2022 increased by $1.6 million, or 24%, compared to the corresponding period of

the prior fiscal year.

Although some of the increase in cost of sales is consistent with the 11% increase in revenue for the same period,

approximately $450,000 of the increase relates to the repairs performed to upgrade the orthopedic handpieces we sell our largest customer

to the newest release at no additional cost.

We continue to negotiate in good faith with our customer for additional remuneration for

these refurbished and repaired handpieces.

Product costs increased by $979,000, or 15%, during the three months ended September 30, 2022,

compared to the corresponding period of the prior fiscal year, due to both higher material costs, predominantly related to the repairs

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

During the first quarter of fiscal

2023 we experienced $362,000 of under-absorbed manufacturing costs compared to an over-absorption of $146,000 in the first quarter of

fiscal 2022, primarily due to the growth of indirect costs outpacing actual production hours.

Costs related to inventory and warranty

charges increased $84,000 in the first quarter of fiscal 2023 compared to the corresponding quarter of fiscal 2022, due primarily to upgraded

repairs we perform on orthopedic handpieces we sell to our largest customer that are still under-warranty at no additional cost.

profit decreased by approximately $472,000, or 14%, for the three months ended September 30, 2022 compared to the corresponding period

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

as a result of higher component costs and additional repair costs described above.

Operating Costs and Expenses

(in thousands except % change)

Three Months Ended

Nine Months Ended

Year over Year % Change

% of Net Sales

Three Months Ended September 30,

Increase (Decrease) From

Dollars in thousands

% of Net Sales

4 unchanged sentences

Research and development costs

Selling expenses consist of

salaries and other personnel-related expenses for our business development department, as well as advertising and marketing expenses,

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 and nine

months ended March 31, 2022, decreased $116,000, or 85%, and $336,000, or 81%, respectively, compared to the corresponding periods of

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.

Selling expenses for the three months

ended September 30, 2022 increased $16,000, or 43%, compared to the corresponding year-earlier period.

The increase is primarily due to

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 decreased $135,000 and increased $480,000, respectively, during the three and nine months

ended March 31, 2022, when compared to the corresponding periods of the prior fiscal year.

The decrease in general and administrative

expenses for the three months ended March 31, 2022, compared to the corresponding period of fiscal 2021 relates primarily to reduced non-cash

compensation expense because 62,000 stock options granted in February 2021 vested in June 2021 and therefore compensation expense for

those awards ceased in fiscal 2021.

The increase in general and administrative expenses for the nine months ended March 31, 2022, compared

to the corresponding period of fiscal 2021 relate primarily to higher non-cash stock-based compensation expense related to the remaining

awards granted in the prior and current 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

nine months ended March 31, 2022, decreased $446,000 and $930,000, respectively, compared to the corresponding periods of the prior fiscal

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.

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 36% and 49% of total operating

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

The amount spent

on projects under development is summarized below (in thousands):

and Nine Months Ended

March 31, 2022 Three

and Nine Months Ended

March 31, 2021

Total Research & Devel opment costs:

(“G&A”) consist of salaries and other personnel-related expenses of our accounting, finance, and human resources personnel,

professional fees, directors’ fees, and other costs and expenses attributable to being a public company.

G&A decreased by $69,000,

or 6%, for the three months ended September 30, 2022, when compared to the corresponding period of the prior fiscal year.

in total G&A was primarily related to reduced 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 products.

Research and development costs decreased $51,000, or 5%, for the quarter ended September 30, 2022, compared to the corresponding prior

The decrease is due primarily to an increase in the amount of $108,000 in salaries and personnel costs offset by $179,000

in reduced internal engineering project spending.

Although the majority of our research

and development costs relate to sustaining activities related to products we currently manufacture and sell, we have created a product

roadmap to develop future products.

Many of our product development efforts are undertaken only upon completion of an analysis of the

size of the market, our ability to differentiate our product from our competitors’, as well as an analysis of our specific sales

prospects with new and/or existing customers.

Research and development costs represent 46% of total operating expenses for all periods

presented and are expected to remain relatively flat the remainder of this fiscal year as we continue to work on customer funded NRE projects.

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,

Total Research & Development costs:

Products in development:

Vital Ventilator

Sustaining & Other

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they could fail to become commercialized, or the actual annual revenue realized may be less than the amount estimated.

(3) 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 nine months ended March 31, 2022 and 2021, includes interest and dividends from our money market accounts and investment portfolio.

As we introduce new products into

the market, we expect to see an increase in sustaining and other engineering expenses.

Typical examples of sustaining engineering activities

include, but are not limited to, end-of- life component replacement, especially in electronic components found in our printed circuit

board assemblies, analysis of customer complaint data to improve process and design, replacement and enhancement of tooling and fixtures

used in the machine shop, assembly operations, and inspection areas to improve efficiency and through-put.

Additionally, these costs include

development projects that may be in their infancy and may or may not result in a full-fledged product development effort or projects that

are later abandoned.

For instance, in prior filings we included expenses related to the VITAL ventilator product, which we have removed

from the table above because we did not spend any resources on this project in the first quarter of fiscal 2023 and we do not expect to

in the foreseeable future.

Other Income (Expense), net

Interest and dividend income

The interest and dividend income

recorded during the quarters ended September 30, 2022 and 2021, consists primarily of interest and dividends from our investments and

money market accounts.

One of the investments in our portfolio paid a $204,000 cash dividend in the first quarter of fiscal 2023, and

no such dividend was paid during the prior fiscal year.

Unrealized gain on marketable equity investments

The unrealized gain on marketable

securities for the quarters ended September 30, 2022 and 2021, relates to our portfolio of investments described more fully in Note 4

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

Interest expense

Interest expense consists primarily

of interest expense related to the notes payable described more fully in Note 11 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 5 to the condensed consolidated financial

statements contained elsewhere in this report.

Gain on Sale of Investments

During the quarter ended March

31, 2021, we sold several of the stocks in our portfolio of equity investments receiving proceeds of $2.9 million and recording a gain

on the sale in the amount of $783,000.

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.

The interest expense recorded during

the quarters ended September 30, 2022 and 2021, relates to our Minnesota Bank and Trust (“MBT”) loans described more fully

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

Income Tax Expense

The effective tax rate for the

three and nine months ended March 31, 2022, 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 nine months ended March 31, 2021, is less

than our combined expected federal and applicable state corporate income tax rates due to 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 9 to the condensed consolidated financial statements contained elsewhere in this

report, as well as unrealized gains on our marketable equity investments.

The effective tax rate for the three

months ended September 30, 2022 and 2021, is 17% and 22%, respectively.

The current year effective tax rate is less than the prior year

rate due primarily to a tax benefit recognized as a result of the common stock awarded to our employees described more fully in Note 8

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

Liquidity and Capital Resources

Cash and cash equivalents at

March 31, 2022, increased $1.0 million to $4.8 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 Nine Months Ended March 31,

Cash and cash equivalents at September

30, 2022 increased $1.9 million to $2.8 million as compared to $0.9 million at June 30, 2022.

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,

(in thousands)

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Operating Activities

Net cash provided by operating

activities was $4.4 million for the nine months ended March 31, 2022, primarily due to net income of $2.4 million and non-cash depreciation

and amortization of $546,000, share-based compensation of $932,000 and unrealized losses on marketable securities in the amount of $427,000

as well as an increase in accounts payable and accrued expenses of $673,000, deferred revenue of $746,000 and a decrease in accounts receivable

in the amount of $2.3 million.

Offsetting these sources of cash, our inventory increased by $3.4 million primarily due to replenishment

of sub-assemblies and long-lead time parts.

Net cash used in operating activities

was $2.8 million for the nine months ended March 31, 2021, primarily due to net income of $5.0 million and non-cash depreciation and amortization

of $502,000 and share-based compensation of $508,000 offset by an unrealized gain on marketable securities in the amount of $1.4 million

and an increase in accounts receivable in the amount of $6.8 million due to our largest customer changing their payment terms from net

30 to net 90 in conjunction with a contract extension.

Additionally, our net income included $795,000 of realized gains from the sales

of stock in our marketable securities portfolio.

Net cash provided by operating activities

during the three months ended September 30, 2022 totaled $2.9 million.

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

quarter of $1.1 million, as well as non-cash share-based compensation and depreciation and amortization of $207,000 and $193,000, respectively,

(b) a decrease of $4.3 million in accounts receivable due to more timely collection of receivables from our largest customer, and (c)

an increase in accounts payable and accrued expenses of $273,000.

Uses of cash arose primarily from an increase in inventory of $3.0 million

primarily related to building up inventory in anticipation of our transfer of assembly and repairs to the Franklin Property.

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

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.

Investing Activities

Net cash used in investing activities

for the nine months ended March 31, 2022, was $1.6 million and related to purchases of equipment and improvements primarily for the Franklin

Property in the amount of $1.3 million and investments in marketable equity securities of publicly traded companies in the amount of $334,000.

for the three months ended September 30, 2022 was $90,000 and related primarily to the purchase of equipment and improvements at the Franklin

Property in the amount of $178,000 offset by the sale of marketable securities in the amount of $88,000.

Net cash used in investing activities

for the nine months ended March 31, 2021, was $4.4 million and related primarily to the purchase of the Franklin Property acquired during

the second quarter of fiscal 2021 for a purchase price of $6.5 million as well as expenditures related to machinery and equipment totaling

Offsetting these uses of cash, we sold some of our marketable securities during the nine months ended March 31, 2021 for $3.0

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

improvements at the Franklin Property.

Financing Activities

Net cash used in financing activities

for the nine months ended March 31, 2022, totaled $1.8 million and related primarily to the $1.3 million repurchase of 52,718 shares of

our common stock pursuant to our share repurchase program as well as $561,000 of principal payments on our term loan from Minnesota Bank

and Trust (“MBT”) more fully described in Note 11 to the condensed consolidated financial statements contained elsewhere in

Net cash provided by financing

activities for the nine months ended March 31, 2021, totaled $4.6 million and included $9.1 million in various loans from MBT more fully

described in Note 11 to the condensed consolidated financial statements contained elsewhere in this report, offset by $4.0 million related

to the repurchase of 161,291 shares of our common stock pursuant to our share repurchase program, $307,000 of principal payments on our

loans with MBT, 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 months

As of March 31, 2022, our working

for the three months ended September 30, 2022 included net principal payments of $318,000 on our existing loans from MBT more fully described

in Note 10 to the condensed consolidated financial statements contained elsewhere in this report, the repurchase of $354,000 of common

stock pursuant to our share repurchase program, as well as $223,000 of employee payroll taxes related to the award of 37,500 shares of

common stock to employees under previously granted performance awards.

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 principal payments of $306,000 on our loans from MBT.

Financing Facilities & Liquidity Requirements for the Next Twelve

As of September 30, 2022, our working

capital was $20.2 million.

We currently believe that our existing cash and cash equivalent balances together with our accounts receivable

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

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from operations.

We may also liquidate some or all of our investment portfolio or borrow against our $2.0 million Revolving Loan with

MBT (see Note 11 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.

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.

Investment Strategy

We invest surplus cash from

time to time through our Investment Committee, which is comprised of one management director, Mr.

Van Kirk, and two non-management directors,

Cabillot and Mr.

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 $2.9 million of marketable public equity

securities held at March 31, 2022.

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

sell additional shares of our common stock under our previously disclosed ATM Agreement, which is currently suspended.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET

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What changed 10-Q

Item 2. Management’s Discussion and Analysis