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 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. 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, 2022. We specialize in the design, development, and manufacture of powered rotary drive surgical instruments used primarily in the orthopedic, thoracic, and maxocranial facial (“CMF”) markets. Our principal headquarters are located at 2361 McGaw Avenue, Irvine, California 92614 and our phone number is (949) 769-3200. Our Internet address is www.pro-dex.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports, and other SEC filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. In addition, our Code of Ethics and other corporate governance documents may be found on our website at the Internet address set forth above. Our filings with the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov and company specific information at www.sec.gov/edgar/searchedgar/companysearch.html. Basis of Presentation The condensed consolidated results of operations presented in this report are not audited and those results are not necessarily indicative of the results to be expected for the entirety of 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. 15 Critical Accounting Estimates and Judgments Our financial statements are prepared in accordance with U.S. GAAP. 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 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 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 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 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, 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. 16 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 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. 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. 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. 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, 2022 2021 Dollars in thousands % of Net Sales % of Net Sales Net sales $ 11,087 100 % $ 9,988 100 % Cost of sales 8,131 73 % 6,560 66 % Gross profit 2,956 27 % 3,428 34 % Selling expenses 53 — 37 — General and administrative expenses 1,024 9 % 1,093 11 % Research and development costs 929 8 % 980 10 % 2,006 18 % 2,110 21 % Operating income 950 9 % 1,318 13 % Other income, net 344 3 % 53 1 % Income before income taxes 1,294 12 % 1,371 14 % Provision for income taxes 218 2 % 307 3 % Net income $ 1,076 10 % $ 1,064 11 % 17 Revenue The majority of our revenue is derived from designing, developing, and manufacturing surgical devices. 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 2022 2021 2021 To 2022 Dollars in thousands % of Net Sales % of Net Sales Net sales: Medical device $ 7,887 71 % $ 8,284 83 % (5 %) Industrial and scientific 224 2 % 216 2 % 4 % Dental and component 103 1 % 62 1 % 66 % NRE & proto-types 907 8 % 196 2 % 363 % Repairs 2,252 20 % 1,459 14 % 54 % Discounts and other (286 ) (2 %) (229 ) (2 %) 25 % $ 11,087 100 % $ 9,988 100 % 11 % Certain of our medical device products utilize proprietary designs developed by us under exclusive development and supply agreements. All of our medical device products utilize proprietary manufacturing methods and know-how, and are manufactured in our Irvine, California facility. Details of our medical device sales by type is as follows (in thousands, except percentages): Three Months Ended September 30, Increase (Decrease) From 2022 2021 2021 To 2022 Dollars in thousands % of Med Device Sales % of Med Device Sales Medical device sales: Orthopedic $ 5,635 72 % $ 5,706 69 % (1 %) CMF 2,083 26 % 2,387 29 % (13 %) Thoracic 169 2 % 191 2 % (12 %) $ 7,887 100 % $ 8,284 100 % (5 %) Our 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 the markets. Sales 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. We believe this increase is temporary due to sales of components to our board assembly houses due to the recent chip shortages experienced globally. 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. Repair 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. 18 Discounts 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. At September 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 contracts. We may experience variability in our new order bookings due to various reasons, including, but not limited to, the timing of major new product launches and customer planned inventory builds. However, we do not typically experience seasonal fluctuations in our shipments and revenues. Cost of Sales and Gross Margin Three Months Ended September 30, Increase (Decrease) From 2022 2021 2021 To 2022 Dollars in thousands % of Net Sales % of Net Sales Cost of sales: Product costs $ 7,611 69 % $ 6,632 66 % 15 % Under-(over) absorption of manufacturing costs 362 3 % (146 ) (1 %) 348 % Inventory and warranty charges 158 1 % 74 1 % 114 % Total cost of sales $ 8,131 73 % $ 6,560 66 % 24 % Gross profit and gross margin $ 2,956 27 % $ 3,428 34 % (14 %) Cost 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. Gross 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. 19 Operating Costs and Expenses Three Months Ended September 30, Increase (Decrease) From 2022 2021 2021 To 2022 Dollars in thousands % of Net Sales % of Net Sales Operating expenses: Selling expenses $ 53 1 % $ 37 — 43 % General and administrative expenses 1,024 9 % 1,093 11 % (6 %) Research and development costs 929 8 % 980 10 % (5 %) $ 2,006 18 % $ 2,110 21 % (5 %) 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, 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 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. The decrease 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 year period. 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. 20 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, Market Est. Annual 2022 2021 Launch (1) Revenue (2) Total Research & Development costs: $ 929 $ 980 Products in development: ENT Shaver $ 43 $ 232 Q4 2023 $ 1,000 Sustaining & Other 886 748 Total. $ 929 $ 980 (1) Represents the calendar quarter of expected market launch. (2) The products in development include risks that they could be abandoned in the future prior to completion, they could fail to become commercialized, or the actual annual revenue realized may be less than the amount estimated. As we introduce new products into the market, we expect to see an increase in sustaining and other engineering expenses. Typical examples of sustaining engineering activities include, but are not limited to, end-of- life component replacement, especially in electronic components found in our printed circuit board assemblies, analysis of customer complaint data to improve process and design, replacement and enhancement of tooling and fixtures used in 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 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. 21 Income Tax Expense 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 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, 2022 2021 (in thousands) Cash provided by (used in): Operating activities $ 2,892 $ 2,701 Investing activities $ (90 ) $ (874 ) Financing activities $ (853 ) $ (371 ) Cash and working capital: Cash and cash equivalents $ 2,798 $ 5,177 Working capital $ 20,162 $ 19,806 Operating Activities 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. 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. Investing Activities Net cash used in investing activities 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 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. 22 Financing Activities Net cash used in financing activities 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 Months 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 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 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 sell additional shares of our common stock under our previously disclosed ATM Agreement, which is currently suspended. 23 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable.