Electromed, Inc. - Quarter Report: 2012 December (Form 10-Q)

Table of Contents

          Operating expenses

          Selling, general and administrative expenses. Selling, general and administrative expenses were approximately $5,817,000 for the six months ended December 31, 2012, representing a decrease of approximately $714,000, or 10.9%, compared to SG&A expenses of approximately $6,531,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $2,794,000 for the six months ended December 31, 2012, representing a decrease of approximately $327,000, or 10.5%, compared to approximately $3,121,000 in the same period the prior year. This decrease was primarily a result of lower incentive compensation for the CAMs which is correlated with revenue levels, as well as a reduction of overall management compensation as compared to the same period in the prior year.

          Travel, meals and entertainment and trade show expenses were approximately $724,000 in the six months ended December 31, 2012, representing a decrease of approximately $214,000, or 22.8%, compared to approximately $938,000 in the same period in the prior year. This decrease was primarily due to the elimination of industry training that was sponsored by Electromed, eliminating costs related to tradeshows that do not fit our growth strategies and reducing travel expenses among the sales force through improved travel planning.

          Advertising and marketing expenses for the six months ended December 31, 2012 were approximately $334,000, a decrease of approximately $327,000, or 49.5%, compared to approximately $661,000 in the same period the prior year. These decreased expenditures related to bringing marketing leadership in-house, thus reducing our external marketing fees, as well as targeting more cost-effective advertising.

          Professional fees for the six months ended December 31, 2012 were approximately $561,000, an increase of approximately $53,000 compared to approximately $508,000 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, one time consulting expenses, 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 annual meeting and the resulting litigation brought by the Company, as well as consulting fees related to upgrading our current information technology infrastructure.

          Research and development expenses. Research and development expenses were approximately $210,000 for the six months ended December 31, 2012, representing a decrease of approximately $257,000, or 55.0%, compared to approximately $467,000 in the same period the prior year. Approximately $180,000 of the decrease was a result of discontinuing the use of a certain outside vendor based on project needs. Research and development expenses for the six months ended December 31, 2012 were 2.7% of revenue, compared to 4.6% of revenue in the same period the prior year. As a percentage of sales, management expects to spend approximately 5.0% of sales on research and development expenses over the long term.

          Interest expense

          Interest expense was approximately $78,000 for the six months ended December 31, 2012, representing a decrease of approximately $13,000, or 14.3%, compared to approximately $91,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding.

          Income tax benefit (expense)

          Income tax benefit is estimated at approximately $272,000 for the six months ended December 31, 2012 compared to income tax expense of approximately $195,000 in the same period in the prior year. The effective tax rates for the six months ended December 31, 2012 and December 31, 2011 were 36.1% and 41.9%, respectively. On a quarterly basis, management estimates what its effective tax rate will be for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the estimate is refined based on the facts and circumstances by each tax jurisdiction. The decrease in effective tax rate is related primarily to permanent differences including certain meals and entertainment expenses that are only 50% deductible for tax purposes as well as the estimate for the Federal Research and Development Tax Credit which was not extended until January 2013, by the U.S. Congress. The effect of the estimated tax credit will be recorded in the quarter ended March 31, 2013.

- 14 -

Table of Contents

          Net income (loss)

          Net loss for the six months ended December 31, 2012 was approximately $482,000 compared to net income of approximately $270,000 for the same period the prior year. The decrease in net income primarily resulted from a decrease in sales volume partially offset by decreases in expenses. Management continues to believe certain investments currently being made are creating the platform for profitable sales growth. During the quarter ended December 31, 2012, management completed a realignment of sales regions. Management is focused on controlling costs more aggressively short term while implementing key strategies for growth which includes full staffing of our U.S. sales regions, updated branding including a new logo, marketing material, and developing more distributors internationally by hiring an international sales manager.

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

          Cash Flows from Operating Activities

          For the six months ended December 31, 2012, net cash provided by operating activities was approximately $1,202,000. Cash flows provided by operations consisted of approximately $482,000 in net loss, adjusted for non-cash expenses of approximately $413,000, offset by decreases in accounts receivable and inventory of $1,126,000 and $493,000, respectively, and increases in prepaid expenses and other assets of $272,000. In addition, accounts payable and accrued liabilities decreased approximately $75,000.

          For the six months ended December 31, 2011, net cash used in operating activities was approximately $1,533,000. Cash flows used by operations consisted of approximately $270,000 in net income, adjusted for non-cash expenses of approximately $332,000, offset by increases in accounts receivable, inventory, and prepaid expenses and other assets of $1,112,000, $542,000, and $139,000, respectively. In addition, accounts payable and accrued liabilities decreased approximately $343,000.

          Cash Flows from Investing Activities

          For the six months ended December 31, 2012, cash used in investing activities was approximately $510,000. During this period we paid approximately $482,000 for purchases of property and equipment. We also paid approximately $28,000 for patent related costs.

          For the six months ended December 31, 2011, cash used in investing activities was approximately $642,000. During this period we paid approximately $619,000 for purchases of property and equipment, including $414,000 for converting approximately 10,000 square feet of a newly leased building to office space. We also paid approximately $23,000 for patent related costs.

          Cash Flows from Financing Activities

          For the six months ended December 31, 2012, cash used in financing activities was approximately $1,389,000, which consisted of principal payments on long-term debt of $221,000, and payments on our revolving line of credit of $1,168,000.

- 15 -

---

Table of Contents

          For the six months ended December 31, 2011, cash used in financing activities was approximately $172,000. We received approximately $28,000 from warrant exercises and receipts on subscription notes receivable, offset by principal payments on long-term debt of approximately $189,000 and payments of deferred financing fees of approximately $11,000.

Adequacy of Capital Resources

          Based on our current operational performance, we believe our cash and available borrowings under the existing credit facility will provide adequate liquidity for the next year. However, we cannot guarantee that we will be able to procure additional financing upon favorable terms, if at all.

          Our primary capital requirements relate to adding employees in our sales force and supporting functions; continuing research and development efforts; and for general corporate purposes, including to finance equipment purchases and other capital expenditures in the ordinary course of business and to satisfy working capital needs.

          For the first six months of fiscal years 2013 and 2012, we spent approximately $482,000 and $619,000 on property and equipment, respectively. We currently expect to finance equipment purchases with borrowings under our credit facility and cash flows from operations. We may need to incur additional debt or equity financing if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows.

          On November 8, 2011 we entered into an amended and restated credit facility with U.S. Bank, National Association (U.S. Bank), which was amended on December 30, 2011, May 14, 2012, September 21, 2012, and February 13, 2013, that provides for a revolving line of credit of $2,500,000, and $2,520,000 in term debt. A $1,520,000 Term Loan bears interest at 5.79% (Term Loan A). The remaining $1,000,000 term loan bore interest at 4.28% (Term Loan B) and was paid in full during October 2012. Interest on the operating line of credit accrues at LIBOR plus 3.50% (3.75% at February 13, 2013, the date of the most recent amendment) 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 December 31, 2012, we had $600,000 outstanding on the operating line of credit and approximately $1,385,000 outstanding on Term Loan A for a total amount outstanding under the U.S. Bank credit facility of $1,985,000. As of the most recent amendment date of February 13, 2013, we had $600,000 outstanding on the operating line of credit and net unused availability of $1,900,000. We are required to pay a fee of 0.125% per annum on unused portions of the revolving line of credit.

          Our credit facility contains certain financial and nonfinancial covenants, which, among others, required the Company to maintain a certain fixed charge coverage ratio and a maximum cash flow leverage ratio, and restricts the payment of dividends. We were in violation of certain financial and nonfinancial covenants during the period ended December 31, 2012. On February 13, 2013, we entered into a Waiver and Fourth Amendment to our Credit Agreement with U.S. Bank (the “Waiver Agreement”). See Part II, Item 5 to this quarterly report for a description of the material terms of such Waiver Agreement.

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.

- 16 -

---

Table of Contents

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 three months ended December 31, 2012 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.

          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 2012 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 asserts 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 has 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 asserts 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 seeks declaratory relief and damages. Mr. Hansen has asserted a counterclaim alleging that the Company breached the Separation Agreement and Release by failing to make a payment under the agreement.

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.

- 17 -

---

Table of Contents

Item 5. Other Information

          On February 13, 2013, the Company entered into a Waiver and Fourth Amendment to Credit Agreement (the “Waiver Agreement”) with U.S. Bank National Association (the “Bank”), pursuant to which the Bank waived certain covenant violations by the Company under its Amended and Restated Credit Agreement with the Bank, dated as of November 7, 2011, as amended (the “Credit Agreement”). Amongst other things, the Credit Agreement, as amended prior to the Waiver Agreement, forbid the Company from (1) permitting its fixed charge coverage ratio as of the last day of any fiscal quarter for the four consecutive fiscal quarters ending on such date to be less than 1.2 to 1.0 and (2) permitting its total cash flow leverage ratio as of the last day of any fiscal quarter for the four consecutive fiscal quarters ending on such date to be more than 3.5 to 1.0. In addition, the Credit Agreement requires that the Company’s chief executive officer position may not change without the Bank’s consent. The Company was in violation of the aforementioned financial covenants as of December 31, 2012 and the covenant regarding the chief executive officer position as of December 1, 2012.

          Pursuant to the Waiver Agreement, the Bank agreed to waive the specific covenant violations provided above as events of default under the Credit Agreement. In addition, the Waiver Agreement: (1) revised the definition of Applicable Margin from 3.08% to 3.50%; (2) revised the definition of Fixed Charge Coverage Ratio to remove from the numerator references to certain severance expenses made, and related tax expenses accrued, by the Company during the fiscal quarters ended December 31, 2011 and June 30, 2012; (3) revised the definition of Revolving Commitment Amount from $6,000,000 to $2,500,000; (4) amended the Company’s financial reporting covenant to provide unaudited financial statements on a monthly basis instead of a quarterly basis and to require the Company to provide summaries of referrals and product shipments each month; (5) revised the definition of permitted indebtedness to exclude certain subordinated debt that was previously permitted; (6) revised the definition of fixed charge coverage ratio to decrease the ratio from 1.2 to 1.0 (measured on a quarterly basis using the four consecutive quarters ending on such date) to 1.15 to 1.0 for the quarter ending September 30, 2013 (measured only on such date and only for such quarter); (7) amended the total cash flow leverage ratio covenant to replace the ratio entirely with a minimum EBITDA covenant that forbids the Company from having EBITDA of less than negative $275,000 for the quarter ending March 31, 2013 and $425,000 for the quarter ending June 30, 2013; (8) eliminated the key man life insurance policy covenant; and (9) amended the form of compliance certificate set forth in the Credit Agreement to conform it with the aforementioned changes. The Company also released claims against the Bank, reasserted its representations and warranties under the Credit Agreement, and reaffirmed the Credit Agreement and related loan and security documents.

          The foregoing summary does not purport to be complete and is qualified in its entirety by reference to the full text of the Waiver Agreement, which is filed as Exhibit 10.3 to this quarterly report on Form 10-Q.

Item 6. Exhibits

          See attached exhibit index.

- 18 -

---

Table of Contents

SIGNATURES

          Pursuant to the requirements of Section 13 or 15(d) 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 14, 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)

- 19 -

---

Table of Contents

EXHIBIT INDEX
ELECTROMED, INC.
FORM 10-Q

Exhibit Number		Description
10.1		Waiver Agreement by and between the Company and U.S. Bank, National Association, dated November 13, 2012.
10.2*		Amended and Restated Employment Agreement by and between the Company and Jeremy T. Brock, dated November 15, 2012.
10.3		Waiver and Fourth Amendment to Credit Agreement by and between the Company and U.S. Bank, National Association, dated February 13, 2013.
10.4*		Employment Agreement dated effective December 1, 2012, by and between the Company and Kathleen Skarvan (incorporated by reference to the Company’s current report on Form 8-K filed December 3, 2012).
10.5*		Non-Competition, Non-Solicitation and Confidentiality Agreement dated effective December 1, 2012, by and between the Company and Kathleen Skarvan (incorporated by reference to the Company’s current report on Form 8-K filed December 3, 2012).
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 December 31, 2012, 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.

* Management compensatory plan or agreement.

- 20 -

---