UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)
☑	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934   For the quarterly period ended December 31, 2016
☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934   For the transition period from ________ to ________.

Commission File No.: 001-34839

Electromed, Inc.

(Exact Name of Registrant as Specified in its Charter)

 

Minnesota		41-1732920
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
500 Sixth Avenue NW New Prague, Minnesota		56071
(Address of principal executive offices)		(Zip Code)

 

(952) 758-9299

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑   No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑   No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐ (Do not check if smaller reporting company)	Smaller reporting company ☑

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐   No ☑

 

There were 8,230,167 shares of Electromed, Inc. common stock, par value $0.01, outstanding as of the close of business on February 3, 2017.

 

 

Electromed, Inc.
Index to Quarterly Report on Form 10-Q

 

			Page
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements		1
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		14
Item 4.	Controls and Procedures		14
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings		15
Item 1A.	Risk Factors		15
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		15
Item 3.	Defaults Upon Senior Securities		15
Item 4.	Mine Safety Disclosures		15
Item 5.	Other Information		15
Item 6.	Exhibits		15

 

 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements. 

 

Electromed, Inc.

Condensed Balance Sheets

 

		December 31, 2016				June 30, 2016
		(Unaudited)
Assets
Current Assets
Cash		$	4,821,504			$	5,123,355
Accounts receivable (net of allowances for doubtful accounts of $45,000)			8,284,895				7,611,437
Inventories			2,570,850				2,480,443
Prepaid expenses and other current assets			425,855				419,616
Income tax receivable			2,896				192,685
Total current assets			16,106,000				15,827,536
Property and equipment, net			3,381,803				3,375,189
Finite-life intangible assets, net			776,091				904,033
Other assets			112,058				127,759
Deferred income taxes			330,000				343,000
Total assets		$	20,705,952			$	20,577,517
Liabilities and Shareholders’ Equity
Current Liabilities
Current maturities of long-term debt		$	49,720			$	46,309
Accounts payable			466,863				589,225
Accrued compensation			724,504				1,489,798
Warranty reserve			660,000				660,000
Other accrued liabilities			455,747				287,194
Total current liabilities			2,356,834				3,072,526
Long-term debt, less current maturities and net of debt issuance costs			1,120,856				1,146,395
Total liabilities			3,477,690				4,218,921
Commitments and Contingencies
Shareholders’ Equity
Common stock, $0.01 par value; authorized: 13,000,000 shares; 8,230,167 and
8,187,112 issued and outstanding at December 31, 2016 and June 30, 2016,			82,302				81,871
respectively
Additional paid-in capital			13,783,754				13,549,551
Retained earnings			3,362,206				2,727,174
Total shareholders’ equity			17,228,262				16,358,596
Total liabilities and shareholders’ equity		$	20,705,952			$	20,577,517

 

See Notes to Condensed Financial Statements. 

 

 

Electromed, Inc.

Condensed Statements of Operations (Unaudited)

 

		For the Three Months Ended December 31,								For the Six Months Ended December 31,
		2016				2015				2016				2015
Net revenues		$	6,372,243			$	6,262,106			$	11,917,606			$	11,263,295
Cost of revenues			1,445,786				1,363,509				2,663,522				2,505,268
Gross profit			4,926,457				4,898,597				9,254,084				8,758,027
Operating expenses
Selling, general and administrative			4,096,197				3,591,934				7,784,107				6,824,653
Research and development			100,801				57,090				451,641				98,634
Total operating expenses			4,196,998				3,649,024				8,235,748				6,923,287
Operating income			729,459				1,249,573				1,018,336				1,834,740
Interest expense, net of interest income of $3,603, $2,924, $6,969 and $3,548 respectively			15,598				17,880				32,304				38,086
Net income before income taxes			713,861				1,231,693				986,032				1,796,654
Income tax expense			(270,000	)			(164,000	)			(351,000	)			(388,000	)
Net income		$	443,861			$	1,067,693			$	635,032			$	1,408,654
Income per share:
Basic		$	0.05			$	0.13			$	0.08			$	0.17
Diluted		$	0.05			$	0.13			$	0.08			$	0.17
Weighted-average common shares outstanding:
Basic			8,167,112				8,133,857				8,167,112				8,133,857
Diluted			8,426,996				8,195,389				8,440,698				8,185,196

 

See Notes to Condensed Financial Statements. 

 

 

Electromed, Inc.

Condensed Statements of Cash Flows (Unaudited)

 

		Six Months Ended December 31,
		2016				2015
Cash Flows From Operating Activities
Net income		$	635,032			$	1,408,654
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation			312,075				307,778
Amortization of finite-life intangible assets			60,963				61,272
Amortization of debt issuance costs			9,216				9,327
Share-based compensation expense			234,634				109,164
Deferred taxes			13,000				(288,000	)
Loss on disposal of property and equipment			–				17,117
Loss on disposal of intangible assets			111,497				7,848
Changes in operating assets and liabilities:
Accounts receivable			(673,458	)			(384,562	)
Inventories			(53,894	)			(290,582	)
Prepaid expenses and other assets			196,835				57,843
Accounts payable and accrued liabilities			(807,188	)			151,127
Net cash provided by operating activities			38,712				1,166,986
Cash Flows From Investing Activities
Expenditures for property and equipment			(267,117	)			(181,290	)
Expenditures for finite-life intangible assets			(44,518	)			(17,790	)
Net cash used in investing activities			(311,635	)			(199,080	)
Cash Flows From Financing Activities
Principal payments on long-term debt including capital lease obligations			(24,056	)			(24,046	)
Payment of deferred financing fees			(4,872	)			(13,520	)
Net cash used in financing activities			(28,928	)			(37,566	)
Net increase (decrease) in cash			(301,851	)			930,340
Cash
Beginning of period			5,123,355				3,598,240
End of period		$	4,821,504			$	4,528,580

 

See Notes to Condensed Financial Statements. 

 

 

Electromed, Inc.
Notes to Condensed Financial Statements
(Unaudited)

 

Note 1.          Interim Financial Reporting

 

Basis of presentation: Electromed, Inc. (the “Company”) develops, manufactures and markets innovative airway clearance products that apply High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages. The Company markets its products in the U.S. to the home health care and institutional markets for use by patients in personal residences, hospitals and clinics. The Company also sells internationally both directly and through distributors. International sales were approximately $332,000 and $352,000 for the six months ended December 31, 2016 and 2015, respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment.

 

The accompanying unaudited condensed financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial statements and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments consisting of normal recurring adjustments necessary for a fair presentation of the Company’s financial position and results of operations as required by Regulation S-X. Interim results of operations are not necessarily indicative of the results that may be achieved for the full year. The financial statements and related notes do not include all information and footnotes required by U.S. GAAP for annual reports. This interim report should be read in conjunction with the financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2016 (“fiscal 2016”).

 

A summary of the Company’s significant accounting policies follows:

 

Use of estimates: Management uses estimates and assumptions in preparing the condensed financial statements in accordance with U.S. GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could vary from the estimates that were used. The Company believes the critical accounting policies that require the most significant assumptions and judgments in the preparation of its condensed financial statements include revenue recognition and the related estimation of selling price adjustments, allowance for doubtful accounts, inventory obsolescence, share-based compensation, income taxes and the warranty reserve.

 

Net income per common share: Net income is presented on a per share basis for both basic and diluted common shares. Basic net income per common share is computed using the weighted average number of common shares outstanding during the period, excluding any restricted stock awards which have not vested. The diluted net income per common share calculation includes outstanding restricted stock grants and assumes that all stock options were exercised and converted into common stock at the beginning of the period, unless their effect would be anti-dilutive. Common stock equivalents excluded from the calculation of diluted earnings per share because their impact was anti-dilutive was 196,500 for the three and six months ended December 31, 2016 and 305,800 for the three and six months ended December 31, 2015.

 

New accounting pronouncements: In May 2014, the Financial Accounting Standards Board (“FASB”) issued guidance creating Accounting Standards Codification (“ASC”) Section 606, “Revenue from Contracts with Customers.” The new section will replace ASC Section 605, “Revenue Recognition” and creates modifications to various other revenue accounting standards for specialized transactions and industries. The section is intended to conform revenue accounting principles with a concurrently issued International Financial Reporting Standards with previously differing treatment between U.S. practice and that of much of the rest of the world, as well as to enhance disclosures related to disaggregated revenue information. Entities will have the option to apply the standard retrospectively to all prior periods presented, or to apply it retrospectively only to contracts existing at the effective date, with the cumulative effect of the standard recorded as an adjustment to beginning retained earnings. In August 2015, the FASB issued Accounting Standards Update (“ASU”) 2015-14 which delayed the effective date of the new revenue recognition guidance by one year. The updated guidance will be effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within that year. The Company is evaluating the impact of this standard on its financial statements.

 

In April 2015, FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs.” This standard became effective on July 1, 2016 for the Company and requires that debt issuance costs be presented as a direct deduction from the carrying amount of long-term debt on the balance sheet. The new guidance aligns the presentation of debt issuance costs with debt discounts and premiums. The Company adopted this guidance retrospectively effective as of July 1, 2016. As a result, the Company presented $10,000 of unamortized debt issuance costs that had been included in “Other assets” on its condensed balance sheet as of June 30, 2016 as a direct deduction from the carrying amounts of the related long-term debt liability.

 

 

In July 2015, FASB issued ASU 2015-11, “Inventory (Topic 330) Related to Simplifying the Measurement of Inventory,” which applies to all inventory except that which is measured using last-in, first-out (“LIFO”) or the retail inventory method. Inventory measured using first-in, first-out (“FIFO”) or average cost is within the scope of the new guidance and should be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable cost of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. The amendments will be effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The new guidance should be applied prospectively, and earlier application is permitted as of the beginning of an interim or annual reporting period. The Company is evaluating the impact of the standard on its financial statements.

 

In February 2016, FASB issued ASU 2016-02, “Leases.” This standard requires the recognition of all lease transactions with terms in excess of 12 months on the balance sheet as a lease liability and a right-of-use asset (as defined in the standard). ASU 2016-02 will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted.  Upon adoption, the lessee will apply the new standard retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption. The Company is currently assessing the effect the standard will have on its financial statements.

 

In March 2016, FASB issued ASU 2016-09, “Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting,” which reduces complexity in accounting standards related to share-based payment transactions, including, among others, (1) accounting for income taxes, (2) classification of excess tax benefits on the statement of cash flow, (3) forfeitures, and (4) statutory tax withholding requirements.  The ASU will be effective for annual reporting periods beginning on or after December 15, 2016, and interim periods within those annual periods, with earlier application permitted.  The Company is evaluating the impact of the standard on its financial statements.

 

Reclassifications: Certain items in the Company’s financial statements for fiscal 2016 have been reclassified to be consistent with the classifications adopted for the Company’s fiscal quarter ended December 31, 2016. The fiscal 2016 reclassifications are specific to the adoption of ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs” and had no impact on previously reported net income or equity.

 

Note 2.          Inventories

 

The components of inventory were approximately as follows:

 

		December 31, 2016				June 30, 2016
Parts inventory		$	1,877,000			$	1,615,000
Work in process			149,000				165,000
Finished goods			705,000				850,000
Less: Reserve for obsolescence			(160,000	)			(150,000	)
Total		$	2,571,000			$	2,480,000

 

Note 3.          Finite-life Intangible Assets

 

The carrying value of patents and trademarks includes the original cost of obtaining the patents, periodic renewal fees, and other costs associated with maintaining and defending patent and trademark rights. Patents and trademarks are amortized over their estimated useful lives, generally 15 and 12 years, respectively. During the six months ended December 31, 2016 and the year ended June 30, 2016, the Company abandoned certain domestic and foreign patents with net values of approximately $111,000 and $18,000, respectively, which was included as an expense in selling, general and administrative expense on the statements of operations. The majority of the pending patents, that were abandoned, related to the initial development of our SQL SmartVest technology and during a review of the Company’s patent portfolio it was determined that certain patents proved redundant to a subsequent SQL patent filing and were therefore abandoned. A smaller portion of expense was related to patents that covered technology that management considered outdated, and was no longer in use. Accumulated amortization was $789,000 and $820,000 at December 31, 2016 and June 30, 2016, respectively.

 

 

The activity and balances of finite-life intangible assets were approximately as follows:

 

		December 31, 2016				June 30, 2016
Balance, beginning		$	904,000			$	1,000,000
Additions			45,000				45,000
Abandonments			(112,000	)			(18,000	)
Amortization expense			(61,000	)			(123,000	)
Balance, ending		$	776,000			$	904,000

 

Note 4.          Warranty Liability

 

The Company provides a lifetime warranty on its products to the prescribed patient for sales within the U.S. and a three-year warranty for all institutional sales and sales to individuals outside the U.S. The Company estimates the costs that may be incurred under its warranty and records a liability in the amount of such costs at the time the product is shipped. Factors that affect the Company’s warranty liability include the number of units shipped, historical and anticipated rates of warranty claims, the product’s useful life and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary.

 

Changes in the Company’s warranty liability were approximately as follows:

 

			Six Months Ended				Fiscal Year Ended
			December 31, 2016				June 30, 2016
Beginning warranty reserve		$	660,000			$	660,000
Accrual for products sold			70,000				152,000
Expenditures and costs incurred for warranty claims			(70,000	)			(152,000	)
Ending warranty reserve		$	660,000			$	660,000

 

Note 5.          Income Taxes

 

On a quarterly basis, the Company estimates its effective tax rate for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the Company refines its estimate based on the facts and circumstances by each tax jurisdiction. Income tax expense was estimated at approximately $351,000 and the effective tax rate was 35.6% for the six months ended December 31, 2016. Estimated income tax expense for the six months ended December 31, 2016 includes a recognized tax benefit of approximately $22,000 as a result of the lapse of the statute of limitation on uncertain tax positions, which reduced the effective tax rate by 2.2% for that period.

 

Income tax expense was estimated at approximately $388,000 and the effective tax rate was 21.6% for the six months ended December 31, 2015. Estimated income tax expense during the six months ended December 31, 2015 includes a current tax expense of $682,000 and a discrete tax benefit of $294,000 due primarily to the Company’s release of the full valuation allowance against all of its net U.S. federal and state deferred tax assets. 

 

Note 6.          Financing Arrangements

 

The Company has a credit facility that provides for a revolving line of credit and a term loan.  Effective December 18, 2016, the Company renewed its $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of December 31, 2016 or June 30, 2016. Interest on borrowings under the line of credit, if any, would accrue at the prime rate (3.75% at December 31, 2016) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable and the line of credit expires on December 18, 2017, if not renewed. At December 31, 2016, the maximum $2,500,000 was eligible for borrowing. The line of credit is secured by a security interest in substantially all of the tangible and intangible assets of the Company.

 

In connection with the credit facility, the Company also has a term loan, which had an outstanding principal balance of approximately $1,178,000 at December 31, 2016 and $1,200,000 as of June 30, 2016. The term loan was refinanced effective December 18, 2016, reducing the interest rate from 5.00% to 3.88%. The unamortized debt issuance cost associated with this debt was approximately $8,000 and $10,000 as of December 31, 2016 and June 30, 2016, respectively. The term loan bears interest at 3.88%, with monthly payments of principal and interest of approximately $7,900 and a final payment of principal and interest of approximately $1,085,000 due on the maturity date of December 18, 2018. Payment obligations under the term loan are secured by a mortgage on the Company’s real property. 

 

 

The documents governing the line of credit and term loan contain certain financial and nonfinancial covenants that include a minimum tangible net worth covenant of not less than $10,125,000 and restrictions on the Company’s ability to incur certain additional indebtedness or pay dividends.

 

Note 7.          Stock-Based Compensation

 

The Company recorded approximately $235,000 and $109,000 of compensation expense related to current and past grants of stock options and restricted stock for the six months ended December 31, 2016 and 2015, respectively. This expense is included in selling, general and administrative expense. As of December 31, 2016, approximately $537,000 of total unrecognized compensation expense related to non-vested equity awards is expected to be recognized over a weighted average period of approximately 1.2 years.

 

The Company recognizes compensation expense related to share-based payment transactions in the financial statements based on the estimated fair value of the award issued. The fair value of each option is estimated using the Black-Scholes pricing model at the time of award grant. The Company estimates the expected life of options based on the expected holding period by the option holder. The risk-free interest rate is based upon observed U.S. Treasury interest rates for the expected term of the options. The Company makes assumptions with respect to expected stock price volatility based upon the volatility of its stock price. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from initial estimates. Forfeitures are estimated based on the percentage of awards expected to vest, taking into consideration the seniority level of the award recipient.

 

The following assumptions were used to estimate the fair value of options granted:

 

	Six Months Ended December 31, 2016		Fiscal Year Ended June 30, 2016
Risk-free interest rate	1.14% - 1.27%		1.40% - 1.92%
Expected term (years)	6		6
Expected volatility	100.5% - 105.8%		89.3% - 93.1%

 

Stock Options

 

The Company issued 176,500 stock options pursuant to its 2014 Stock Compensation Plan during the six months ended December 31, 2016. Stock option transactions during the six months ended December 31, 2016 are summarized as follows:

						Weighted Average
		Number of Shares				Exercise Price per Share
Outstanding at June 30, 2016			599,800				$2.62
Granted			176,500				$3.91
Exercised			–				–
Cancelled or Forfeited			–				–
Outstanding at December 31, 2016			776,300				$2.92

 

The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price. At December 31, 2016, the weighted average remaining contractual term for all outstanding stock options was 5.93 years and their aggregate intrinsic value was approximately $763,000. Outstanding at December 31, 2016 were 776,300 stock options issued to employees, of which approximately 467,000 were exercisable and had an aggregate intrinsic value of approximately $508,000.

 

Restricted Stock

 

The Company’s 2014 Stock Compensation Plan permits the grant of other stock-based awards. Historically, the Company makes restricted stock grants to key employees and non-employee directors that vest over six months to three years.

 

 

During the six months ended December 31, 2016, the Company issued restricted stock awards to employees totaling 30,000 shares of common stock, with a vesting term of one to three years and a fair value of $3.82 per share and to directors totaling 13,055 shares of common stock, with a vesting term of six months and a fair value of $3.83 per share. The restricted stock’s fair value per share represents the closing price of its common stock on the date of the grant. Restricted stock transactions during the six months ended December 31, 2016 are summarized as follows:

 

			Number of Shares				Weighted Average Grant Date Fair Value per Share
Unvested shares at June 30, 2016			19,999				$1.80
Granted			43,055				$3.82
Vested			–				–
Forfeited			–				–
Unvested at December 31, 2016			63,054				$3.18

 

Note 8.          Commitments and Contingencies

 

The Company is occasionally involved in claims and disputes arising in the ordinary course of business. The Company insures its business risks where possible to mitigate the financial impact of individual claims, and establishes reserves for an estimate of any probable cost of settlement or other disposition.

 

 

Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed financial statements and related notes thereto included in Item 1 of Part I of this Quarterly Report on Form 10-Q and the audited financial statements, related notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2016, or “fiscal 2016.”

 

Overview

 

Electromed, Inc. (“we,” “our,” “us,” or the “Company”) develops and provides innovative airway clearance products applying High Frequency Chest Wall Oscillation (“HFCWO”) technologies in pulmonary care for patients of all ages.

 

We manufacture, market and sell products that provide HFCWO, including the SmartVest^® Airway Clearance System (“SmartVest System”) that includes our newest generation SmartVest SQL^® and previous generation SV2100, and related products, to patients with compromised pulmonary function. The SmartVest SQL is smaller, quieter and lighter than our previous product, with enhanced programmability and ease of use. Our products are sold in both the home health care market and the institutional market for use by patients in hospitals, which we refer to as “institutional sales.” The SmartVest SQL has been sold in the domestic home care market since the quarter ended March 31, 2014. In the fourth quarter of fiscal 2015, we launched the SmartVest SQL into the institutional and certain international markets. Since 2000, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis and repeated episodes of pneumonia. Additionally, we offer our products to a patient population that includes neuromuscular disorders such as cerebral palsy, muscular dystrophies, amyotrophic lateral sclerosis (“ALS”), the combination of emphysema and chronic bronchitis commonly known as chronic obstructive pulmonary disease (“COPD”), and patients with post-surgical complications or who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport.

 

The SmartVest System is often eligible for reimbursement from major private insurance providers, health maintenance organizations, or “HMOs”, state Medicaid systems, and the federal Medicare system, which is an important consideration for patients considering an HFCWO course of therapy. For domestic sales, the SmartVest System may be reimbursed under the Medicare-assigned billing code for HFCWO devices if the patient has cystic fibrosis, bronchiectasis (including chronic bronchitis or COPD that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuro-muscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Private payers consider a variety of sources, including Medicare, as guidelines in setting their coverage policies and payment amounts.

 

Critical Accounting Policies and Estimates

 

For a description of our critical accounting policies, estimates and assumptions used in the preparation of our financial statements, including the condensed financial statements in this report, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 1 to our audited financial statements, included in Part II, Item 8, of our Annual Report on Form 10-K for fiscal 2016.

 

Some of our accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial statements. Such judgments are subject to an inherent degree of uncertainty. These judgments are based upon our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe the critical accounting policies that require the most significant assumptions and judgments in the preparation of our financial statements, including the condensed financial statements in this report, include: revenue recognition and the estimation of selling price adjustments, allowance for doubtful accounts, inventory obsolescence, share-based compensation, income taxes and warranty liability.

 

 

Results of Operations

 

Revenues

 

Revenue for the three and six-month periods ended December 31, 2016 and 2015 are summarized in the table below (dollar amounts in thousands).

 

		Three Months Ended																Six Months Ended
		December 31,								Increase								December 31,								Increase (Decrease)
		2016				2015												2016				2015
Total Revenue		$	6,372			$	6,262			$	110				1.8	%		$	11,918			$	11,263			$	655				5.8	%
Home Care Revenue			5,502				5,501				1				0.0	%			10,635				9,987				648				6.5	%
Institutional Revenue			605				529				76				14.4	%			951				924				27				2.9	%
International Revenue			265				232				33				14.2	%			332				352				(20	)			(5.7	%)

 

Home Care Revenue. Home care revenue for the three months ended December 31, 2016 was approximately $5,502,000, an increase of approximately $1,000 compared to the same period in fiscal 2015. For the six months ended December 31, 2016, home care revenue was approximately $10,635,000, an increase of approximately $648,000, or 6.5%, compared to the same periods in fiscal 2015. During the three months ended December 31, 2016, home care revenue was negatively impacted by the retroactive repayment of previously collected and recognized revenue to a state Medicaid program totaling approximately $212,000. The repayment resulted from the state Medicaid program’s reinterpretation of its reimbursement process and a reduction in its allowable payments. We believe that the repayment is a one-time event and is not reflective of other state Medicaid reimbursement processes. During the three months ended December 31, 2015, home care revenue benefited by approximately $250,000 from processing a backlog of referrals from the prior fiscal year in a certain state. The backlog accumulated while we reapplied for a state home medical equipment license until we met a newly imposed requirement to have an approved in-state presence. The license was reinstated in October 2015.

 

After taking into consideration the negative impact of the retroactive repayment during the three months ended December 31, 2016, and the favorable impact of the processing of backlogged referrals during the three months ended December 31, 2015, home care revenue for the three months ended December 31, 2016 increased primarily due to increases in both approvals and referrals. The increase in referrals was predominately due to growth in the number of field sales employees and a higher referral per field sales employee as compared to the comparable prior year period. The increase in home care revenue for the six months ended December 31, 2016 was primarily due to an increase in the average rate of reimbursement per approval and increases in approvals and referrals. The increase in referrals was primarily due to growth in the number of field sales employees as compared to the comparable prior year period.

 

Institutional Revenue. Institutional revenue for the three and six months ended December 31, 2016 was approximately $605,000 and $951,000, respectively, representing an increase of approximately $76,000 and $27,000, or 14.4% and 2.9%, compared to the same periods in fiscal 2015. The increase in revenue for the three months ended December 31, 2016 was primarily due a higher average selling price for devices sold compared to the same period in the prior year. The increase in revenue for the six months ended December 31, 2016 was due to an increase in sales of single patient use garments, partially offset by a decrease in the number of units sold compared to the same period in the prior year. Institutional revenue includes sales to distributors, group purchasing organization (“GPO”) members and other institutions.

 

International Revenue. International revenue for the three months ended December 31, 2016 was approximately $265,000, representing an increase of approximately $33,000, or 14.2%, compared to the same period in fiscal 2015. For the six months ended December 31, 2016, international revenue was approximately $332,000, a decrease of approximately $20,000, or 5.7%, from the same period in fiscal 2015. International sales are affected by the timing of distributor purchases that can cause significant fluctuations in reported revenue on a quarterly basis.

 

Gross profit

 

Gross profit increased to approximately $4,926,000, or 77.3% of net revenues, for the three months ended December 31, 2016, from approximately $4,899,000, or 78.2% of net revenues, in the same period in fiscal 2015. Gross profit increased to approximately $9,254,000, or 77.7% of net revenues, for the six months ended December 31, 2016, from approximately $8,758,000, or 77.8% of net revenues, in the same period in fiscal 2015. The increase in gross profit dollars resulted from increases in domestic home care revenues and a decrease in our manufacturing costs of the SmartVest SQL as compared to the prior fiscal year. The increases in gross profit were partially offset by a charge recognized during the three and six months ended December 31, 2016 related to the retroactive repayment of previously collected and recognized revenue to a state Medicaid program totaling approximately $212,000.

 

 

Operating expenses

 

Selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were approximately $4,096,000 and $7,784,000 for the three and six months ended December 31, 2016, respectively, representing an increase of approximately $504,000 and $959,000, or 14.0% and 14.1%, respectively, compared to the same periods in the prior year.

 

Payroll and compensation-related expenses were approximately $2,350,000 and $4,387,000 for the three and six months ended December 31, 2016, respectively, representing an increase of approximately $247,000 and $530,000, or 11.7% and 13.7%, respectively, compared to the same periods in the prior year. The increases in the current year periods were due to additional employees in sales and administration, additional sales incentives on higher revenue, higher share-based equity compensation expense, annual salary increases and the replacement of certain employees at increased salaries in our sales department, which were partially offset by lower management bonus accruals.

 

Professional fees for the three and six months ended December 31, 2016 were approximately $325,000 and $672,000, respectively, an increase of approximately $48,000 and $120,000, or 17.3% and 21.7%, respectively, compared to the same periods in the prior year. These fees are primarily for services related to legal costs, shareowner services and reporting requirements, information technology (“IT”) security and backup, and consulting fees for sales training. The increase in professional fees was primarily due to increases in consulting fees associated with sales training and investor relations costs.

 

Recruiting fees for the three and six months ended December 31, 2016 were approximately $87,000 and $158,000, respectively, an increase of approximately $35,000 and $72,000, or 67.3% and 83.7%, respectively, compared to the same period in the prior year. The increase in recruiting fees was due primarily to adding more employees in sales and administrative roles as compared to the prior year.

 

Travel, meals and entertainment expenses were approximately $398,000 and $817,000 for the three and six months ended December 31, 2016, respectively, representing an increase of approximately $63,000 and $125,000, or 18.8% and 18.1%, respectively, compared to the same periods in the prior year. The increase was due primarily to additional sales personnel.

 

SG&A expenses included a loss on the abandonment of certain domestic and foreign patents with net values of approximately $111,000 during both the three and six months ended December 31, 2016 as compared to zero and $8,000 recognized during the three and six months ended December 31, 2015, respectively.

 

In addition, SG&A expenses did not include medical device excise tax for the three and six months ended December 31, 2016, representing a decrease of approximately $66,000 and $132,000, respectively, compared to the same periods in the prior year. Beginning with the third quarter of fiscal 2016, we realized a positive impact to operating profit with the Federal Consolidated Appropriations Act, 2016, which included a two-year moratorium on the U.S. Federal medical device excise tax effective as of January 1, 2016.

 

Research and development expenses. Research and development (“R&D”) expenses were approximately $101,000 and $452,000 for the three and six months ended December 31, 2016, respectively, representing an increase of approximately $44,000 and $353,000 compared to the same periods in the prior year. R&D expenses for the three and six months ended December 31, 2016 were 1.6% and 3.8% of revenue, respectively, compared to 0.9% of revenue for both periods in the prior year. During Fiscal 2016, we began developing a new wireless connectivity feature for our HFCWO device that will allow data connection between physicians and patients. We believe this innovation will strengthen our patient and clinician partnerships, leading to greater therapy adherence and improved quality of life for individuals with compromised pulmonary function. We expect to launch the new feature by end of fiscal 2017. We believe that R&D expense over the next few quarters will decrease as we have concluded the majority of work on our wireless data connectivity project but would expect expenses to increase in future quarters as we initiate new projects. During the quarter ended December 31, 2016, we capitalized an additional $190,000 related to software development in conjunction with this project.

 

 

Interest expense

 

Interest expense, net, was approximately $16,000 and $32,000 for the three and six months ended December 31, 2016, respectively, compared to $18,000 and $38,000 in the same periods in the prior year due to lower levels of long-term debt and increased interest income.

 

Income tax expense

 

Income tax expense was estimated at approximately $270,000 and $351,000 and the effective tax rates were 37.8% and 35.6%, respectively, for the three and six months ended December 31, 2016. Estimated income tax expense for the six months ended December 31, 2016 includes a recognized tax benefit of approximately $22,000 as a result of the lapse of the statute of limitation on uncertain tax positions, which reduced the effective tax rate by 2.2% for that period.

 

Income tax expense was estimated at approximately $164,000 and $388,000 and the effective tax rates were 13.3% and 21.6%, respectively, for the three and six months ended December 31, 2015. Income tax expense during the three and six months ended December 31, 2015 includes a current tax expense of $458,000 and $682,000, respectively, and a discrete tax benefit of $294,000 due primarily to the Company’s release of the full valuation allowance against all of its net U.S. federal and state deferred tax assets. The discrete tax benefit reduced the effective tax rate by 23.9% and 16.4% during the three and six months ended December 31, 2015, respectively.

 

Net income

 

Net income for the three and six months ended December 31, 2016 was approximately $444,000 and $635,000, respectively, compared to net income of approximately $1,068,000 and $1,409,000 for the same periods in the prior year. The year-over-year decrease in net income was driven primarily by increased payroll and compensation expenses in sales and administrative positions and increased research and development costs, which were partially offset by increased in gross profit driven by higher revenue. Additionally, the prior year benefited by a discrete tax benefit of $294,000 during the three and six months ended December 31, 2015.

 

Liquidity and Capital Resources

 

Cash Flows and Sources of Liquidity

 

Cash Flows from Operating Activities

 

For the six months ended December 31, 2016, net cash provided by operating activities was approximately $39,000. Cash flows provided by operating activities consisted of approximately $635,000 of net income, non-cash expenses of $741,000 and a decrease in prepaid expenses and other assets of $197,000. These cash flows from operating activities were offset by a decrease of approximately $807,000 in accounts payable and accrued liabilities, an increase in accounts receivable of $673,000 and an increase in inventory of $54,000.

 

For the six months ended December 31, 2015, net cash provided by operating activities was approximately $1,167,000. Cash flows provided by operating activities consisted of approximately $1,409,000 in net income, non-cash expenses of approximately $225,000, a decrease in prepaid expenses and other assets of approximately $58,000, and an increase in accounts payable and accrued liabilities of approximately $151,000. This was offset by an increase in accounts receivable and inventories of approximately $385,000 and $291,000, respectively.

 

Cash Flows from Investing Activities

 

For the six months ended December 31, 2016, cash used in investing activities was approximately $312,000. Cash used in investing activities consisted of approximately $267,000 in expenditures for property and equipment and $45,000 in payments for patent costs. The expenditures for property and equipment consisted primarily of costs associated with the development of software associated with the new wireless connectivity feature for our HFCWO device.

 

For the six months ended December 31, 2015, cash used in investing activities was approximately $199,000. Cash used in investing activities consisted of approximately $181,000 in expenditures for property and equipment and $18,000 in payments for patent costs.

 

 

Cash Flows from Financing Activities

 

For the six months ended December 31, 2016, cash used in financing activities was approximately $29,000, which consisted of principal payments on long-term debt of $24,000, and payments of deferred financing fees of $5,000.

 

For the six months ended December 31, 2015, cash used in financing activities was approximately $38,000, which consisted of principal payments on long-term debt of $24,000, and payments of deferred financing fees of $14,000.

 

Adequacy of Capital Resources

 

Our primary working capital requirements relate to adding employees to our sales force and support functions, continuing research and development efforts, and supporting general corporate needs, including financing equipment purchases and other capital expenditures incurred in the ordinary course of business. Based on our recent operational performance, we believe our working capital of approximately $13,749,000 as of December 31, 2016 and available borrowings under our existing credit facility will provide adequate liquidity for the next year.

 

Effective December 18, 2016, we renewed our credit facility, which provides us with a revolving line of credit and a term loan. Interest on borrowings on the line of credit accrues at the prime rate and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable, and the line of credit expires on December 18, 2017, if not renewed. At December 31, 2016, the maximum $2,500,000 was available under the line of credit and the applicable interest rate (the prime rate) was 3.75%. Payment obligations under the line of credit are secured by a security interest in substantially all of our tangible and intangible assets.

 

In connection with the credit facility, the Company also has a term loan, which had an outstanding principal balance of approximately $1,178,000 at December 31, 2016 and $1,200,000 as of June 30, 2016. The term loan was refinanced effective December 18, 2016, reducing the interest rate from 5.00% to 3.88%. The unamortized debt issuance cost associated with this debt was approximately $8,000 and $10,000 as of December 31, 2016 and June 30, 2016, respectively. The term loan bears interest at 3.88%, with monthly payments of principal and interest of approximately $7,900 and a final payment of principal and interest of approximately $1,085,000 due on the maturity date of December 18, 2018. Payment obligations under the term loan are secured by a mortgage on the Company’s real property.

 

The documents governing our line of credit and term loan contain certain financial and nonfinancial covenants that include a minimum tangible net worth of not less than $10,125,000 and restrictions on our ability to incur certain additional indebtedness or pay dividends. We were in compliance with these covenants as of December 31, 2016.

 

Any failure to comply with these covenants in the future may result in an event of default, which if not cured or waived, could result in the lender accelerating the maturity of our indebtedness, preventing access to additional funds under the line of credit and/or term loan, requiring prepayment of outstanding indebtedness under either arrangement, or refusing to renew the line of credit. If the maturity of the indebtedness is accelerated or the line of credit is not renewed, sufficient cash resources to satisfy the debt obligations may not be available and we may not be able to continue operations as planned. The indebtedness under the line of credit and term loan are secured by a security interest in substantially all of our tangible and intangible assets and a mortgage on our real property, respectively. If we are unable to repay such indebtedness, the lender could foreclose on these assets.

 

For the six months ended December 31, 2016 and 2015, we spent approximately $267,000 and $181,000, respectively, on property and equipment. We currently expect to finance planned equipment purchases with cash flows from operations or borrowings under our credit facility. We may need to incur additional debt if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2016, we had no off-balance sheet arrangements.

 

 

Cautionary Note Regarding Forward-Looking Statements

 

Statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact should be considered forward-looking statements within the meaning of the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements include, but are not limited to, statements regarding the following: our business strategy, including our intended level of investment in research and development and marketing activities; our expectations with respect to earnings, gross margins and sales growth, industry relationships, marketing strategies and international sales; our business strengths and competitive advantages; our plans and expectations with respect to international sales growth; our intent to retain any earnings for use in operations rather than paying dividends; our expectation that our products will continue to qualify for reimbursement and payment under government and private insurance programs; our intellectual property plans and practices; the expected impact of applicable regulations on our business; our beliefs about our manufacturing processes; our expectations and beliefs with respect to our employees and our relationships with them; our belief that our current facilities are adequate to support our growth plans; our expectations with respect to ongoing compliance with the terms of our credit facility; our expectations regarding the ongoing availability of credit and our ability to renew our line of credit; and our anticipated revenues, expenses, capital requirements and liquidity. Words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “goal,” “intend,” “may,” “ongoing,” “plan,” “potential,” “project,” “should,” “target,” “will,” “would,” and similar expressions, including the negative of these terms, are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Although we believe these forward-looking statements are reasonable, they involve risks and uncertainties that may cause actual results to differ materially from those projected by such statements. Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results or our industry’s actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by the forward-looking statements.

 

Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

 

●

the competitive nature of our market;

 

●

changes to Medicare, Medicaid, or private insurance reimbursement policies;

 

●

changes to health care laws;

 

●

changes affecting the medical device industry;

 

●

our need to maintain regulatory compliance and to gain future regulatory approvals and clearances;

 

●

new drug or pharmaceutical discoveries;

 

●

general economic and business conditions;

 

●

our ability to renew our line of credit or obtain additional credit as necessary;

 

●

our ability to protect and expand our intellectual property portfolio; and

 

●

the risks associated with expansion into international markets.

 

This list of factors is not exhaustive, however, and these or other factors, many of which are outside of our control, could have a material adverse effect on us and our results of operations. Therefore, you should consider these risk factors with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which the statements are made, and we undertake no obligation to update any forward-looking statement for any reason, even if new information becomes available or other events occur in the future. You should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K and subsequent reports we file with the SEC. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth herein.

 

Item 3.          Quantitative and Qualitative Disclosures About Market Risk.

 

As a smaller reporting company, we are not required to provide disclosure pursuant to this Item.

 

Item 4.          Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures

 

Our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Exchange Act, as of the end of the period subject to this Quarterly Report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the date of such evaluation to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms.

 

 

Changes to Internal Control Over Financial Reporting

 

There were no changes in our internal control over financial reporting that occurred during the three months ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II – OTHER INFORMATION

 

Item 1.          Legal Proceedings.

 

Occasionally, we may be party to legal actions, proceedings, or claims in the ordinary course of business, including claims based on assertions of patent and trademark infringement. Corresponding costs are accrued when it is probable that loss will be incurred and the amount can be precisely or reasonably estimated. We are not aware of any undisclosed actual or threatened litigation that would have a material adverse effect on our financial condition or results of operations.

 

Item 1A.          Risk Factors.

 

As a smaller reporting company, we are not required to provide disclosure pursuant to this Item.

 

Item 2.          Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

Item 3.          Defaults Upon Senior Securities.

 

None.

 

Item 4.          Mine Safety Disclosures.

 

None.

 

Item 5.          Other Information.

 

None.

 

Item 6.          Exhibits.

 

The Exhibit Index following the signature page to this report is incorporated herein by reference.

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

		ELECTROMED, INC.
Date:          February 7, 2017		/s/ Kathleen S. Skarvan
		Kathleen S. Skarvan, President and Chief Executive Officer (duly authorized officer)
Date:          February 7, 2017		/s/ Jeremy T. Brock
		Jeremy T. Brock, Chief Financial Officer
		(principal financial officer and principal accounting officer)

  

 

 

EXHIBIT INDEX

 

Electromed, Inc. 

Form 10-Q

 

Unless otherwise indicated, all documents incorporated into this Quarterly Report on Form 10-Q by reference to a document filed with the SEC pursuant to the Exchange Act are located under SEC file number 001-34839.

 

Exhibit Number		Description		Method of Filing
3.1		Composite Articles of Incorporation, as amended through November 8, 2010 (incorporated by reference to Exhibit 3.1 to Annual Report on Form 10-K for the fiscal year ended June 30, 2015)		Incorporated by Reference
3.2		Composite Bylaws, as amended through June 30, 2012 (incorporated by reference to Exhibit 3.2 to Annual Report on Form 10-K for the fiscal year ended June 30, 2015)		Incorporated by Reference
10.1		Business Loan Agreement (Asset Based) with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
10.2		Rider to Business Loan Agreement (Asset Based) with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
10.3		Change in Terms Agreement with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.3 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
10.4		Business Loan Agreement with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.4 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
10.5		Rider to Business Loan Agreement with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.5 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
10.6		Change in Terms Agreement with Venture Bank, dated December 18, 2016 (incorporated by reference to Exhibit 10.6 to Current Report on Form 8-K filed December 16, 2016)		Incorporated by Reference
31.1		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed Electronically
31.2		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed Electronically
32.1		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		Filed Electronically
32.2		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		Filed Electronically
101		Financial statements from the Quarterly Report on Form 10-Q for the period ended December 31, 2016, formatted in XBRL: (i) Condensed Balance Sheets, (ii) Condensed Statements of Income, (iii) Condensed Statements of Cash Flows, and (iv) Notes to Condensed Financial Statements		Filed Electronically