Our critical accounting policies and estimates are disclosed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 1 to our Audited Consolidated Financial Statements, included in Part II, Item 8, of our Annual Report on Form 10-K for the fiscal year ended June 30, 2013. The critical accounting policies used in the preparation of the financial statements as of September 30, 2013 have remained unchanged from June 30, 2013.
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 its consolidated financial statements include: revenue recognition and the estimation of selling price adjustments, allowance for doubtful accounts, inventory obsolescence, share-based compensation, income taxes, and warranty liability.
Revenue results for the three month periods are summarized in the table below (dollar amounts in thousands).
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Government/Institutional Revenue. Government/institutional revenue was approximately $426,000 for the three months ended September 30, 2013, representing an increase of approximately $78,000, or 22.4%, compared to approximately $348,000 during the same period in 2012. This resulted from a $127,000 increase in Government sales, which increased to approximately $188,000 for the three months ended September 30, 2013, from approximately $61,000 during the same period the prior year. Institutional revenue, which includes sales to distributors, group purchasing organization (GPO) members, and other institutions, decreased by $49,000 compared to the same period the prior year. The overall increase in Institutional and Governmental sales was the result of the continued focused efforts of our sales force.
Gross Profit
Gross profit decreased to approximately $2,356,000, or 68.9% of net revenues, for the three months ended September 30, 2013, from approximately $2,821,000, or 70.0% of net revenues in the same period in 2012. The decrease in gross profit dollars resulted primarily from the decrease in sales volume. The decrease in gross profit percentage was primarily the result of reduced leverage of manufacturing costs on lower revenue levels. We believe that as we grow sales, we will again be able to leverage manufacturing costs more effectively and margins will return to historical levels above 70%. The decrease in gross profit percentage was also the result of lower than average reimbursement from the mix of referrals during the three months ended September 30, 2013. Factors such as diagnoses that are not assured of reimbursement, insurance programs with lower allowable reimbursement amounts (for example, state Medicaid programs), and whether the patient meets prerequisite medical criteria for reimbursement, affect average reimbursement received.
Operating expenses
Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses were approximately $2,724,000 for the three months ended September 30, 2013, representing a decrease of approximately $92,000, or 3.3%, compared to SG&A expenses of approximately $2,816,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $1,388,000 for the three months ended September 30, 2013, representing an increase of approximately $52,000, or 3.9%, compared to approximately $1,336,000 in the same period the prior year. The increase was primarily due to a change in our sales compensation plan which resulted in higher total sales compensation compared to the same period in 2012.
Professional fees for the three months ended September 30, 2013 were approximately $281,000, an increase of approximately $37,000 compared to approximately $244,000 in the same period in the prior year. These fees are for services related to legal costs, reporting requirements, expenses related to information technology security and backup, and expenses for printing and other shareowner services. The increase in fees over the same period last year was primarily due to a shareholder’s proposal at our 2013 Annual Meeting of Shareholders and the resulting litigation, which has now been concluded by settlement of the parties (see Part II, Item 1 for further discussion). We have insurance for professional fees and expenses incurred in connection with the litigation and are working with our insurance carrier on coverage matters. While we believe that a majority of our fees and expenses incurred as a result of the litigation will be covered by insurance, there can be no guarantee of any specific coverage amount.
Advertising and marketing expenses, including tradeshows and event sponsorships for the three months ended September 30, 2013 decreased by approximately $52,000 to approximately $108,000, compared to approximately $160,000 in the same period in the prior year. The decrease was related to bringing marketing leadership in-house, thus reducing our external marketing fees, as well as targeting more cost-effective advertising. Travel, meals and entertainment expenses were approximately $314,000 for the three months ended September 30, 2013, representing a decrease of approximately $55,000, or 14.9%, compared to approximately $369,000 for the same period in the prior year. This decrease was primarily due to the elimination of industry training that was sponsored by Electromed, as well as eliminating costs related to tradeshows that do not fit our growth strategies.
In addition, selling, general and administrative expenses increased approximately $31,000 compared to the same period in the prior year as a result of the medical device excise tax that went into effect January 1, 2013.
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Research and development expenses.Research and development expenses were approximately $209,000 for the three months ended September 30, 2013, representing an increase of approximately $108,000, or 107%, compared to approximately $101,000 in the same period the prior year. Research and development expenses for the three months ended September 30, 2013 were 6.1% of revenue, compared to 2.5% of revenue in the same period the prior year. As a percentage of revenue, management expects to spend up to 5.0% of revenue on research and development expenses over the long term, although the timing of certain projects will cause the expense in any individual quarter to fluctuate.
Interest expense
Interest expense was approximately $23,000 for the three months ended September 30, 2013, representing a decrease of approximately $18,000, or 43.9%, compared to approximately $41,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding due to payments on term loans.
Income taxbenefit
Income tax benefit is estimated at approximately $257,000 for the three months ended September 30, 2013, compared to income tax benefit of $62,000 in the same period in the prior year. The effective tax rates for the three months ended September 30, 2013 and September 30, 2012 were 43.4% and 46.6%, respectively.
Netloss
Net loss for the three months ended September 30, 2013 was approximately $335,000 compared to net loss of approximately $71,000 for the same period the prior year. The net loss was primarily the result of a decrease in domestic home care revenue caused by lower average selling price with continued downward pricing pressure and a decrease in referral counts, year over year. There also continues to be added administrative procedures implemented by third party payers in the insurance claims process which has lengthened the approval process compared to the prior year. In fiscal 2013, one of the largest domestic third party payers, Blue Cross and Blue Shield, decentralized its contracting process. As a result, the decentralization has required significantly more administrative efforts on the part of the Company to complete the necessary contracts to maintain our national coverage with that payer. Certain contracts were resolved during fiscal 2013, although the final completion of this process has extended into fiscal year 2014. The net loss was also impacted by reduced leverage of manufacturing costs on lower revenue levels which decreased our gross margin percentage, as well as by the increase in legal expenses primarily due to a shareholder’s proposal at our 2013 Annual Meeting of Shareholders and the resulting litigation, which has now been concluded by settlement of the parties (see Part II, Item 1 for further discussion).
Liquidity and Capital Resources
Cash Flows and Sources of Liquidity
Cash Flows from Operating Activities
For the three months ended September 30, 2013, net cash provided by operating activities was approximately $742,000. Cash flows provided by operations consisted of approximately $335,000 in net loss, offset by non-cash expenses of approximately $214,000, decreases in accounts receivable of $1,025,000, and an increase in accounts payable and accrued liabilities of approximately $161,000. In addition, inventory, prepaid expenses and other assets increased by approximately $323,000.
For the three months ended September 30, 2012, net cash provided by operating activities was approximately $114,000. Cash flows provided by operations consisted of approximately $71,000 in net loss, adjusted for non-cash expenses of approximately $198,000, offset by decreases in accounts receivable and inventory of $435,000 and $87,000, respectively, and increases in prepaid expenses and other assets of $188,000. In addition, accounts payable and accrued liabilities decreased by approximately $347,000.
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Management believes that the net cash provided by operating activities during the three months ended September 30, 2013 was attributable, in part, to the reduction of expenses and better accounts receivable collection as demonstrated by the decrease in accounts receivable of approximately $1,025,000 for the three months ended September 30, 2013, as compared to a decrease of approximately $435,000 for the three months ended September 30, 2012.
Cash Flows from Investing Activities
For the three months ended September 30, 2013, cash used in investing activities was approximately $149,000 for purchases of property and equipment.
For the three months ended September 30, 2012, cash used in investing activities was approximately $224,000. During this period we paid approximately $197,000 for purchases of property and equipment. We also paid approximately $27,000 for patent related costs.
Cash Flows from Financing Activities
For the three months ended September 30, 2013, cash used in financing activities was approximately $19,000, which consisted entirely of principal payments on long-term debt.
For the three months ended September 30, 2012, cash used in financing activities was approximately $110,000, which consisted entirely of principal payments on long-term debt.
Adequacy of Capital Resources
Based on our current operational performance, we believe our working capital of approximately $10 million and available borrowings under the existing credit facility will provide adequate liquidity for the next year. Our current line of credit expires on December 31, 2013. Based on our ability to service our debt we believe that we will be able to renew our line of credit prior to December 31, 2013 or obtain alternative financing. However, we cannot guarantee that we will be able to procure additional financing upon favorable terms, if at all. The Company’s credit facility contains certain financial and nonfinancial covenants and restricts the payment of dividends. The agreement also contains financial covenants that require maintaining minimum liquidity, a minimum EBITDA and maintenance of certain fixed charge and balance sheet leverage ratios.
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 or preventing access to additional funds under the credit facility, or requiring prepayment of outstanding indebtedness under the credit facility, or the inability 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 credit agreement is secured by a security interest in substantially all of our tangible and intangible assets of the Company. If we are unable to repay such indebtedness, the bank could foreclose on these assets.
We have an amended and restated credit facility with U.S. Bank, National Association (“U.S. Bank”), which was most recently amended on July 8, 2013, that provides for a revolving line of credit of $2,250,000, and $2,520,000 in term debt. The term debt consists of a $1,520,000 term loan (“Term Loan A”) that bears interest at 5.79% and a $1,000,000 term loan (“Term Loan B”) that bore interest at 4.28% and was paid in full during October 2012.
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Interest on the operating line of credit accrues at LIBOR plus 3.50% (3.75% at September 30, 2013) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to 60% of eligible accounts receivable. The line of credit will expire on December 31, 2013, if not earlier renewed. Term Loan A requires monthly payments of principal and interest of approximately $10,700 and has a maturity date of December 9, 2014. As of September 30, 2013, we had no outstanding borrowings on the operating line of credit and approximately $1,318,000 outstanding on Term Loan A for a total amount outstanding under the U.S. Bank credit facility of approximately $1,318,000. As of September 30, 2013, we had net unused availability of $2,250,000 under the line of credit. We are required to pay a fee of 0.125% per annum on unused portions of the revolving line of credit.
For the first three months of fiscal years 2013 and 2012, we spent approximately $148,000 and $197,000 on property and equipment, respectively. We currently expect to finance 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.
In May 2012, we entered into a separation agreement and release with our former Chairman and Chief Executive Officer, which called for a payment equal to one year’s base salary of $209,000 payable on December 1, 2012. In July 2012, he also received earned and unpaid bonus for the period through May 11, 2012 of approximately $96,000. The Company agreed to make payments of all COBRA health insurance premiums for a period of 18 months following the effective date of retirement, estimated at $16,500. In connection with the litigation relating to our 2013 Annual Meeting of Shareholders, which included a claim relating to alleged breaches of the separation agreement, we withheld payment of the $209,000 pending resolution of the litigation. On September 6, 2013, we settled the litigation with our former Chief Executive Officer and entered into an agreement with him that requires a payment by us of $150,000 in exchange for an extended standstill agreement preventing him from taking certain actions relating to the control of the company for a period of three years from September 6, 2013, restrictions on his ability to vote his shares of Electromed for 18 months from September 6, 2013 and certain other agreements. We paid the $150,000 due to the former Chief Executive Officer during the three months ended September 30, 2013.
Certain Information Concerning Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Item 3. Quantitative and Qualitative Disclosure 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 Securities Exchange Act of 1934 (the “Exchange Act”), as of the end of the period subject to this Report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective.
Changes to Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the first three months of fiscal 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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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.
On December 7, 2012, we instituted a lawsuit in the District Court for Scott County, Minnesota against Eileen Manning, the proponent of a shareholder proposal at the Company’s 2013 Annual Meeting of Shareholders (the “Annual Meeting”) seeking to elect two individuals to the Company’s board of directors, and Robert D. Hansen, the Company’s former Chairman and Chief Executive Officer. The Company asserted that Ms. Manning, the owner of an entity that formerly provided marketing services to the Company, violated the proxy solicitation rules in connection with the nomination and election of directors at the Annual Meeting. Ms. Manning asserted a counterclaim alleging that the Company has violated her rights as a shareholder by failing to count and certify the results of the election. The Company also asserted that Mr. Hansen violated his Separation Agreement and Release in connection with his actions relating to Ms. Manning’s proposal prior to and at the Annual Meeting and sought declaratory relief and damages. Mr. Hansen asserted a counterclaim alleging that the Company breached the Separation Agreement and Release by failing to make a payment of $209,000 to him under the agreement, as well as that the Company has violated his rights as a shareholder by failing to make the payment under the agreement. On September 6, 2013, we settled the litigation with Mr. Hansen and entered into an agreement with him that required a payment by us of $150,000 in exchange for an extended standstill agreement preventing him from taking certain actions relating to the control of the Company for a period of three years from September 6, 2013, restrictions on his ability to vote his shares of Electromed for 18 months from September 6, 2013, and certain other agreements. We paid the $150,000 due to the former Chief Executive Officer during the three months ended September 30, 2013. On September 23, 2013, the Company settled the litigation with Ms. Manning and entered into an agreement with her whereby Ms. Manning agreed to dismiss her claims with prejudice, to refrain from taking certain actions relating to the control of the Company for a period of three years from September 23, 2013, and to withdraw her nomination of two individuals for election to the Company’s board of directors, in addition to certain other agreements.
We have insurance for professional fees and expenses incurred in connection with the litigation described in the immediately preceding paragraph and are working with our insurance carrier on coverage matters. While we believe that a majority of our fees and expenses incurred as a result of the litigation will be covered by insurance, there can be no guarantee of any specific coverage amount.
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.
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Item 5. Other Information
On September 23, 2013, the Company entered into a settlement agreement with Eileen Manning. Previously, on September 6, 2013, the Company entered into a settlement agreement with Robert D. Hansen, the Company’s former Chairman and Chief Executive Officer. Pursuant to these settlement agreements, the Company resolved a lawsuit filed by the Company against Ms. Manning and Mr. Hansen in December 2012.
On December 7, 2012, the Company instituted a lawsuit in the District Court for Scott County, Minnesota against Ms. Manning, the proponent of a shareholder proposal at the Company’s 2013 Annual Meeting of Shareholders (the “Annual Meeting”) seeking to elect two individuals to the Company’s board of directors, and Mr. Hansen, the Company’s former Chairman and Chief Executive Officer. The Company asserted that Ms. Manning, the owner of an entity that formerly provided marketing services to the Company, violated the proxy solicitation rules in connection with the nomination and election of directors at the Annual Meeting. Ms. Manning asserted a counterclaim alleging that the Company has violated her rights as a shareholder by failing to count and certify the results of the election. The Company also asserted that Mr. Hansen violated his Separation Agreement and Release in connection with his actions relating to Ms. Manning’s proposal prior to and at the Annual Meeting and sought declaratory relief and damages. Mr. Hansen asserted a counterclaim alleging that the Company breached the Separation Agreement and Release by failing to make a payment of $209,000 to him under the agreement, as well as that the Company has violated his rights as a shareholder by failing to make the payment under the agreement.
On September 6, 2013, the Company settled the litigation with Mr. Hansen and entered into an agreement with him that required a payment by us of $150,000 in exchange for an extended standstill agreement preventing him from taking certain actions relating to the control of the Company for a period of three years from September 6, 2013, restrictions on his ability to vote his shares of Electromed for 18 months from September 6, 2013 and certain other agreements. We paid the $150,000 due to the former Chief Executive Officer during the three months ended September 30, 2013.
On September 23, 2013, the Company settled the litigation with Ms. Manning and entered into an agreement with her whereby Ms. Manning agreed to dismiss her claims with prejudice, to refrain from taking certain actions relating to the control of the Company for a period of three years from September 23, 2013 and to withdraw her nomination of two individuals for election to the Company’s board of directors, in addition to certain other agreements.
The foregoing summaries of the settlement agreements do not purport to be complete and are qualified in their entirety by reference to the settlement agreements, which are attached hereto as Exhibits 10.3 and 10.4, and are incorporated herein by reference.
Item 6. Exhibits
See attached exhibit index.
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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: November 13, 2013 | | /s/ Kathleen S. Skarvan |
| | Kathleen S. Skarvan, Chief Executive Officer |
| | (Principal Executive Officer) |
| | |
| | /s/ Jeremy T. Brock |
| | Jeremy T. Brock, Chief Financial Officer |
| | (Principal Financial Officer and Principal Accounting Officer) |
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EXHIBIT INDEX
ELECTROMED, INC.
FORM 10-Q
| | |
Exhibit
Number | | Description |
| | |
10.1 | | Sixth Amendment to Credit Agreement, dated as of July 8, 2013, by and between Electromed, Inc. and U.S. Bank, National Association, incorporated herein by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on July 10, 2013. |
| | |
10.2 | | Amendment to Employment Agreement between Electromed, Inc. and Kathleen Skarvan, effective July 1, 2013, incorporated herein by reference to Exhibit 10.44 to the Registrants Annual Report on Form 10-K for the fiscal year ended June 30, 2013. |
| | |
10.3 | | Mediated Settlement Agreement, dated September 6, 2013, between Electromed, Inc. and Robert D. Hansen, incorporated herein by reference to Exhibit 10.46 to the Registrants Annual Report on Form 10-K for the fiscal year ended June 30, 2013 . |
| | |
10.4 | | Settlement Agreement and Release, dated September 23, 2013, between Electromed, Inc. and Eileen M. Manning, incorporated herein by reference to Exhibit 10.47 to the Registrants Annual Report on Form 10-K for the fiscal year ended June 30, 2013. |
| | |
31.1 | | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | |
31.2 | | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| | |
32.1 | | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | |
32.2 | | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | |
101 | | Financial statements from the quarterly report on Form 10-Q of the Company for the quarter ended September 30, 2013 formatted in XBRL: (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the Condensed Consolidated Statements of Cash Flows, and (iv) the Notes to Condensed Consolidated Financial Statements. |
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