Electromed, Inc. - Quarter Report: 2014 March (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-Q


(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2014

o	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		(IRS Employer
incorporation or organization)		Identification No.)


500 Sixth Avenue NW
New Prague, MN 56071
(Address of principal executive offices, including 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 x No o

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 x No o

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 o	Accelerated filer o
	Non-accelerated filer o	Smaller Reporting Company x

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

There were 8,114,252 shares of Electromed, Inc. common stock, par value $0.01, outstanding as of the close of business on May 9, 2014.

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


	PART I. FINANCIAL INFORMATION	Page No.

Item 1	Condensed Consolidated Financial Statements	3

	Condensed Consolidated Balance Sheets as of March 31, 2014 (unaudited) and June 30, 2013	3

	Condensed Consolidated Statements of Operations (unaudited) for the three-month and nine-month periods ended March 31, 2014 and 2013	4

	Condensed Consolidated Statements of Cash Flows (unaudited) for the nine-month periods ended March 31, 2014 and 2013	5

	Notes to (unaudited) Condensed Consolidated Financial Statements	6

Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3	Quantitative and Qualitative Disclosures About Market Risk	18

Item 4	Controls and Procedures	19

	PART II. OTHER INFORMATION

Item 1	Legal Proceedings	20

Item 1A	Risk Factors	20

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	20

Item 3	Defaults Upon Senior Securities	20

Item 4	Mine Safety Disclosures	20

Item 5	Other Information	20

Item 6	Exhibits	20

	Signatures	21

	Exhibit Index	22

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Electromed, Inc. and Subsidiary
Condensed Consolidated Balance Sheets


	March 31, 2014			June 30, 2013
	(Unaudited)
Assets
Current Assets
Cash and cash equivalents	$	772,428		$	503,564
Accounts receivable (net of allowances for doubtful accounts of $45,000)		6,469,927			9,014,043
Inventories		2,550,815			1,379,594
Prepaid expenses and other current assets		448,262			428,843
Income taxes receivable		529,599			538,285
Deferred income taxes, net		—			557,000
Total current assets		10,771,031			12,421,329
Property and equipment, net		3,972,254			3,743,675
Finite-life intangible assets, net		993,807			1,080,734
Other assets		359,504			310,089
Total assets	$	16,096,596		$	17,555,827

Liabilities and Equity
Current Liabilities
Current maturities of long-term debt	$	45,758		$	57,540
Accounts payable		1,004,025			643,681
Accrued compensation		326,846			565,023
Warranty reserve		740,000			680,000
Other accrued liabilities		295,446			247,267
Total current liabilities		2,412,075			2,193,511
Long-term debt, less current maturities		1,262,889			1,332,455
Deferred income taxes, net		—			103,000
Total liabilities		3,674,964			3,628,966

Commitments and Contingencies (Note 7)

Equity
Common stock, $0.01 par value; authorized: 13,000,000; shares issued and outstanding: 8,114,252 shares		81,143			81,143
Additional paid-in capital		13,208,759			13,134,938
(Accumulated deficit) retained earnings		(868,270	)		710,780
Total equity		12,421,632			13,926,861
Total liabilities and equity	$	16,096,596		$	17,555,827

See Notes to Condensed Consolidated Financial Statements.

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Electromed, Inc. and Subsidiary
Condensed Consolidated Statements of Operations (Unaudited)


	For the Three Months Ended March 31,						For the Nine Months Ended March 31,
	2014			2013			2014			2013

Net revenues	$	3,956,335		$	3,198,534		$	10,875,588		$	11,086,190
Cost of revenues		1,436,195			756,693			3,476,570			3,309,148
Gross profit		2,520,140			2,441,841			7,399,018			7,777,042

Operating expenses
Selling, general and administrative		2,634,036			3,034,189			8,097,067			8,850,735
Research and development		103,166			101,460			405,009			311,899
Total operating expenses		2,737,202			3,135,649			8,502,076			9,162,634
Operating loss		(217,062	)		(693,808	)		(1,103,058	)		(1,385,592	)
Interest expense, net of interest income of $392, $618, $11,730, and $15,940 respectively		23,321			29,158			57,992			91,673
Net loss before income taxes		(240,383	)		(722,966	)		(1,161,050	)		(1,477,265	)

Income tax benefit (expense)		(764,000	)		292,000			(418,000	)		564,000
Net loss	$	(1,004,383	)	$	(430,966	)	$	(1,579,050	)	$	(913,265	)

Loss per share:
Basic and diluted	$	(0.12	)	$	(0.05	)	$	(0.19	)	$	(0.11	)

Weighted-average common shares outstanding:
Basic		8,114,252			8,114,252			8,114,252			8,114,252
Diluted		8,114,252			8,114,252			8,114,252			8,114,252

See Notes to Condensed Consolidated Financial Statements.

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Electromed, Inc. and Subsidiary
Condensed Consolidated Statements of Cash Flows (Unaudited)


	For the Nine Months Ended March 31,
	2014			2013
Cash Flows From Operating Activities
Net loss	$	(1,579,050	)	$	(913,265	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation		409,651			344,695
Amortization of finite-life intangible assets		95,082			98,069
Amortization of debt issuance costs		13,078			8,691
Share-based compensation expense		73,821			132,179
Deferred income taxes		454,000			—
Loss on disposal of property and equipment		34,110			43,143
Changes in operating assets and liabilities:
Accounts receivable		2,544,116			1,652,815
Inventories		(1,171,221	)		250,971
Prepaid expenses and other assets		(37,930	)		(632,197	)
Accounts payable and accrued liabilities		184,333			5,086
Net cash provided by operating activities		1,019,990			990,187

Cash Flows From Investing Activities
Expenditures for property and equipment		(626,327	)		(707,140	)
Expenditures for finite-life intangible assets		(8,155	)		(35,642	)
Net cash used in investing activities		(634,482	)		(742,782	)

Cash Flows From Financing Activities
Net payments on revolving line of credit		—			(1,208,128	)
Principal payments on long-term debt including capital lease obligations		(81,348	)		(236,762	)
Payments of deferred financing fees		(35,296	)		—
Net cash used in financing activities		(116,644	)		(1,444,890	)
Net increase (decrease) in cash and cash equivalents		268,864			(1,197,485	)
Cash and cash equivalents
Beginning of period		503,564			1,702,435
End of period	$	772,428		$	504,950

See Notes to Condensed Consolidated Financial Statements.

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


Note 1.	Interim Financial Reporting

Basis of presentation: Electromed, Inc. (the “Company”) develops, manufactures and markets innovative airway clearance products which apply High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages. The Company markets its products in the United States 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 $585,000 and $552,000 for the nine months ended March 31, 2014 and 2013, respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment.

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed consolidated 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, Rule 10-01. 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. generally accepted accounting principles for annual reports. This interim report should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2013.

Principles of consolidation: The accompanying condensed consolidated financial statements include the accounts of Electromed, Inc. and its subsidiary, Electromed Financial, LLC. Operating activities and net assets in Electromed Financial, LLC were insignificant as of and for the three and nine months ended March 31, 2014 and the year ended June 30, 2013.

Liquidity: For the three and nine months ended March 31, 2014, the Company incurred a net loss of approximately $1,004,000 and $1,579,000, respectively. This was primarily as a result of a decrease in domestic home care revenues and the addition of a valuation allowance against the Company’s deferred tax assets. Cash generated in operating activities was approximately $1,020,000, for the nine months ended March 31, 2014. The principal sources of liquidity in the future are expected to be cash flows from operations and availability on our line of credit. In order to operate profitably in the future, the Company must increase its revenue.

The Company’s ability to generate sufficient cash flows over the next year could be negatively impacted by the business challenges in reimbursement from third party payers. There continues to be downward pressure on pricing and added administrative procedures implemented by third party payers in the insurance claims process which has lengthened the approval process compared with the prior year. In fiscal 2013, one of the largest domestic third party payers 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 challenges the Company currently faces could result in future noncompliance with the covenants contained within the Company’s credit facility. 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 the Company’s indebtedness or preventing access to additional funds under the credit facility, or requiring prepayment of outstanding indebtedness under the credit facility. If the maturity of the indebtedness is accelerated, or the Company is unable to renew the line of credit, sufficient cash resources to satisfy the debt obligations may not be available and the Company may not be able to continue operations as planned. The indebtedness under the credit agreement is secured by a security interest in substantially all tangible and intangible assets of the Company. If the Company is unable to repay such indebtedness, the bank could foreclose on these assets.

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The Company was in violation of the tangible net worth covenant during the quarter ended March 31, 2014, and the bank has waived the event of default. On May 6, 2014, the Company entered into an amendment to the credit facility to reduce the requirement to maintain a minimum tangible net worth from $12,000,000 to $10,125,000. The Company believes it will be able to maintain compliance with the future covenants set forth in the amendment and negotiate an extension of the line of credit past its current expiration date of December 31, 2014, or obtain alternative financing.

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

Use of estimates: Management uses estimates and assumptions in preparing the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. 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 consolidated 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 loss per common share: Net loss is presented on a per share basis for both basic and diluted common shares. Basic net loss per common share is computed using the weighted average number of common shares outstanding during the period. The diluted net loss per common share calculation assumes that all stock warrants were exercised and converted into common stock at the beginning of the period, unless their effect would be anti-dilutive. Common stock equivalents of 609,900 and 624,900 were excluded from the calculation of diluted earnings per share for the three and nine months ended March 31, 2014 and 2013, respectively, as their impact was antidilutive.


Note 2.	Inventories

The components of inventory were approximately as follows:


	March 31, 2014			June 30, 2013
Parts inventory	$	1,821,000		$	951,000
Work in process		146,000			196,000
Finished goods		614,000			263,000
Less: Reserve for obsolescence		(30,000	)		(30,000	)
Total	$	2,551,000		$	1,380,000


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. Accumulated amortization was approximately $574,000 and $479,000 at March 31, 2014 and June 30, 2013, respectively.

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


	Nine Months Ended March 31, 2014			Year Ended June 30, 2013
Balance, beginning	$	1,081,000		$	1,174,000
Additions		8,000			37,000
Amortization expense		(95,000	)		(130,000	)
Balance, ending	$	994,000		$	1,081,000


Note 4.	Warranty Liability

The Company provides a lifetime warranty on its products to the prescribed patient for sales within the United States and a three-year warranty for all institutional sales and sales to individuals outside the United States. 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, 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:


	Nine Months Ended March 31, 2014			Year Ended June 30, 2013
Beginning warranty reserve	$	680,000		$	610,000
Accrual for products sold		192,000			232,000
Expenditures and costs incurred for warranty claims		(132,000	)		(162,000	)
Ending warranty reserve	$	740,000		$	680,000


Note 5.	Income Taxes

On a quarterly basis, the Company 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 Company refines its estimate based on the facts and circumstances by each tax jurisdiction. The effective tax rate for the nine months ended March 31, 2014 and 2013 was negative 36.0% and 38.2%, respectively. For the nine months ended March 31, 2014, the Company recorded an income tax expense of $418,000. This amount includes a current tax benefit of $36,000 and a discrete tax expense of $454,000 due primarily to the Company’s recording of a full valuation allowance against all of its net US federal and state deferred tax assets at March 31, 2014. For the three months ended March 31, 2014, tax expense also included $346,000 of tax expense due to the reversal of the current tax benefit recorded during the first two quarters of the fiscal year.

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The Company assessed whether a valuation allowance should be established against its deferred tax assets based on consideration of all available evidence, using a “more likely than not” standard. In assessing the need for a valuation allowance, the Company considered both positive and negative evidence related to the likelihood of realization of deferred tax assets. In making such assessments, more weight was given to evidence that could be objectively verified. The Company’s current and previous losses were given more weight than its future outlook. Under this approach, the recent cumulative losses and the loss recorded this quarter became a piece of significant negative evidence. This factor impaired the Company’s ability to rely on future taxable income projections in determining whether a valuation allowance is appropriate. Future sources of taxable income considered in determining the amount of recorded valuation allowance included:


	•	Taxable income in prior carryback years, if carryback is permitted under the tax law;

	•	Future reversals of existing taxable temporary differences, excluding those related to indefinite-lived intangible assets;

	•	Tax planning strategies; and

	•	Future taxable income exclusive of reversing temporary differences and carryforwards.

Based on the evaluation of these factors, in the quarter ended March 31, 2014, the Company determined that a full valuation allowance was appropriate. In future periods, the Company will continue to assess the likelihood that its deferred taxes will be realizable, and its valuation allowance will be adjusted accordingly, which could materially impact its financial position and results of operations.


Note 6.	Financing Arrangements and Subsequent Events

On December 18, 2013, the Company entered into a new credit facility with Venture Bank, which replaced its facility with U.S. Bank. The new credit facility provides for a $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of March 31, 2014. Interest on the line of credit accrues at the prime rate plus 1.50%, with a floor of 4.50% (4.75% at March 31, 2014) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.75% of eligible accounts receivable and the line of credit expires on December 18, 2014, if not renewed. The line of credit is secured by a security interest in substantially all of the tangible and intangible assets of the Company.

As a part of the new credit facility, the Company also refinanced its outstanding U.S. Bank term loan which had an outstanding principal balance of approximately $1,341,000 and bore interest at 5.79%. It was repaid in full and replaced by a $1,300,000 term loan from Venture Bank that bears interest at 5.00%, with monthly payments of principal and interest of approximately $8,600 and a final payment of principal and interest of approximately $1,095,000 due on the maturity date of December 18, 2018. The term loan is secured by a mortgage on the Company’s real property.

The Company’s new credit facility contains certain financial and nonfinancial covenants which include a minimum tangible net worth covenant of not less than $12,000,000 and restrictions on the Company’s ability to incur certain additional indebtedness or pay dividends. As a result of paying off its outstanding loan and terminating its credit facility with U.S. Bank, the Company incurred approximately $3,000 in prepayment penalties.

The Company was in violation of the tangible net worth covenants during the quarter ended March 31, 2014, and bank has waived the events of default. On May 6, 2014, the Company entered into an amendment to the credit facility to reduce the requirement to maintain a minimum tangible net worth from $12,000,000 to $10,125,000.


Note 7.	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.

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Note 8.	Related Parties

The Company uses a parts supplier whose founder and president is a director of the Company. For the nine months ended March 31, 2014 and 2013, the Company made payments to the supplier of approximately $163,000 and $288,000, respectively.

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

Some of the statements in this report may contain forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 that reflect our current view on future events, future business, industry and other conditions, our future performance, and our plans and expectations for future operations and actions. In some cases, you can identify forward-looking statements by the following words: anticipate, believe, continue, could, estimate, expect, intend, may, ongoing, plan, potential, predict, project, should, will, would, or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. Our forward-looking statements in this report primarily relate to the following: our expectations regarding international markets and their impact on our sales; our beliefs regarding the effect of new products on our revenues; our expectations regarding contract renewal and negotiation; our expectations regarding long-term margins; our expectations regarding research and development expenses; our expectations regarding sales growth, future efficiencies and profitability with the increase in our sales force; our expectations regarding capital expenditures; our expectations regarding insurance coverage for incurred litigation expenses; our beliefs regarding the benefits of our products; our beliefs regarding realization of deferred tax assets and the associated valuation allowance; our beliefs regarding the sufficiency of working capital; and our ability and intention with regard to future financing and compliance with financial covenants in our current credit facility. These statements involve known and unknown risks, uncertainties and other factors that may cause our results or our industry’s actual results, levels of activity, performance or achievements to be materially different from the information expressed or implied by these forward-looking statements. Forward-looking statements are only predictions and are not guarantees of performance. These statements are based on our management’s beliefs and assumptions, which in turn are based on currently available information.

You should read this report thoroughly with the understanding that our actual results and actions may differ materially from those set forth in the forward-looking statements for many reasons, including the reasons described in this report. These factors include, but are not limited to: the competitive nature of our market; the risks associated with expansion into international markets; 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; our ability to recruit, train and retain an effective sales force, reimbursement staff, and patient services staff; our ability to protect our intellectual property; the effect of litigation, including legal expenses, which may arise with respect to our intellectual property in the ordinary course of business or otherwise; the impact of tight credit markets on our ability to continue to obtain financing on reasonable terms; and general economic and business conditions.

Overview

Electromed, Inc. (“we,” “us,” “our,” the “Company” or “Electromed”) was incorporated in 1992. We are engaged in the business of providing innovative airway clearance products applying High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages.

We manufacture, market and sell products that provide HFCWO, including the Electromed, Inc. SmartVest® Airway Clearance System (“SmartVest System”) and related products, to patients with compromised pulmonary function. The products are sold for both the home health care market and the institutional market for use by patients in hospitals, which are referred to as “institutional sales.” For approximately twelve years, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis (including chronic bronchitis or chronic obstructive pulmonary disease (COPD) that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuro-muscular diseases. Reimbursement often requires the patients with these conditions to demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Additionally, we offer such products, upon physician prescription to a patient population that includes post-surgical and intensive care patients, patients with end-stage neuromuscular disease, and ventilator-dependent patients. Our goal is to be a consistent innovator with unmatched customer service in providing HFCWO to patients with impaired pulmonary function.

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On December 30, 2013, we announced that we had received clearance from the FDA to market the SmartVest^® SQL™ (“SQL”), our newest product in the SmartVest family. SQL offers significant improvements in terms of lighter weight, quieter operation and an overall smaller footprint while utilizing the same wearable garment as previous Electromed products. Additionally, new features include programmable ramping, an enhanced pause feature and more user-friendly graphics. These are improvements that have been long requested by both patients who use and medical practitioners who prescribe HFCWO therapy devices. We believe these improvements will increase the likelihood that patients will adhere to their prescribed therapy regimen, resulting in better outcomes and lower treatment costs in the long term as therapy adherence reduces the potential for adverse events such as respiratory infections and pneumonia. We believe the features and benefits of the SQL make it an attractive option within the HFCWO market. We commenced selling the SQL into the domestic homecare market in January 2014. Due to the length of the reimbursement process for HFCWO as discussed in the Revenue section below, we believe the SQL will have minimal impact on revenue over the short term.

Critical Accounting Policies and Estimates

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 March 31, 2014 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 amounts contained in the 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 reserve.

Results of Operations

Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013

Revenues

Revenue results for the three month periods are summarized in the table below (dollar amounts in thousands).


	Three Months Ended March 31,				Increase (Decrease)
	2014		2013

Total Revenue	$	3,956	$	3,199	$	757	23.7	%

Home Care Revenue	$	3,227	$	2,611	$	616	23.6	%

International Revenue	$	289	$	215	$	74	34.4	%

Government/Institutional Revenue	$	440	$	373	$	67	18.0	%

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Home Care Revenue. Home care revenue was approximately $3,227,000 for the three months ended March 31, 2014, representing an increase of approximately $616,000, or 23.6%, compared to the same period in 2013. The increase in revenue was caused by an increase in approvals and a higher average selling price based on the mix of referrals, as compared with the same period in the prior year. There 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. The decentralization has required significantly more administrative efforts on our part to complete the necessary contracts to maintain our national coverage with that payer. We have completed the majority of the contracts with the Blue Cross and Blue Shield affiliates that had a large historical referral base, and we will continue to work with the remaining affiliates to become in-network providers.

International Revenue. International revenue was approximately $289,000 for the three months ended March 31, 2014, representing an increase of approximately $74,000, or 34.4%, compared to the same period in 2013. International sales can be affected by the timing of distributor purchases and cause fluctuation on a quarterly basis.

Government/Institutional Revenue. Government/institutional revenue was approximately $440,000 for the three months ended March 31, 2014, representing an increase of approximately $67,000, or 18.0%, compared to approximately $373,000 during the same period in the prior year. This resulted from a $6,000 increase in government sales, which increased to approximately $75,000 for the three months ended March 31, 2014. Institutional revenue, which includes sales to distributors, group purchasing organization (GPO) members, and other institutions, also increased by $61,000 compared to the same period the prior year. The overall increase in institutional and government sales was the result of the continued focused efforts of our sales force.

Gross profit

Gross profit increased to approximately $2,520,000, or 63.7% of net revenues, for the three months ended March 31, 2014, from approximately $2,442,000, or 76.3% of net revenues, in the same period in the prior year. The decrease in gross profit percentage was primarily the result of the mix of referrals which included a lower percentage of approvals on an increase in the number of units shipped, and, as is often the case with new products, we have not yet reached full efficiency in sourcing and manufacturing the SQL and this directly impacted our gross margin in the quarter. We believe that as we grow sales, we will be able to continue to leverage manufacturing costs and gross margins, over the long-term, will return to approximately 70%.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses were approximately $2,634,000 for the three months ended March 31, 2014, representing a decrease of approximately $400,000, or 13.2%, compared to SG&A expenses of approximately $3,034,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $1,449,000 for the three months ended March 31, 2014, representing a decrease of approximately $137,000, or 8.6%, compared to approximately $1,586,000 in the same period the prior year. This decrease was due to a 2.9% reduction in full time equivalent employees including certain higher compensated employees.

Professional fees for the three months ended March 31, 2014 were approximately $126,000, a decrease of approximately $194,000 compared to approximately $320,000 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 decrease in fees over the same period last year was primarily due to one-time consulting fees related to upgrading our information technology infrastructure that occurred in the prior year, as well as a shareholder’s proposal at our 2013 Annual Meeting of Shareholders and the resulting litigation, which was concluded by settlement of the parties in the first quarter of fiscal year 2014. We have insurance for professional fees and expenses incurred in connection with the litigation and are working with our insurance carrier on coverage matters. During April 2014 we received approximately $100,000 of reimbursement from insurance and we believe there is a possibility of receiving additional reimbursement, however, there can be no guarantee of any specific additional coverage amount.

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Advertising and marketing expenses, including tradeshows and event sponsorships, for the three months ended March 31, 2014 decreased by approximately $56,000 to approximately $100,000, compared to approximately $156,000 in the same period in the prior year due to onetime costs associated with our website redesign in the prior year. Travel, meals and entertainment expenses were approximately $281,000 for the three months ended March 31, 2014, representing a decrease of approximately $32,000, or 10.2%, compared to expenses of approximately $313,000 for the same period in the prior year. This decrease was primarily due to eliminating the Company’s winter sales event.

In addition, selling, general and administrative expenses increased approximately $14,000 compared to the same period in the prior year as a result of the medical device excise tax, which increased due to increased revenue.

Research and development expenses. Research and development expenses were approximately $103,000 for the three months ended March 31, 2014, representing an increase of approximately $2,000, or 2.0%, compared to approximately $101,000 in the same period the prior year. Research and development expenses for the three months ended March 31, 2014 were 2.6% of revenue, compared to 3.2% of revenue in the same period the prior year. As a percentage of revenue, we expect to spend approximately 3.0% to 5.0% of revenue on research and development expenses over the long term.

Interest expense

Interest expense was approximately $24,000 for the three months ended March 31, 2014, representing a decrease of approximately $6,000, or 20.0%, compared to approximately $30,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding and a lower interest rate on the debt refinanced on December 18, 2013.

Income tax benefit

Income tax expense was estimated at approximately $764,000 for the three months ended March 31, 2014, compared to income tax benefit of $292,000 in the same period in the prior year. The income tax expense for the three months ended March 31, 2014 includes a current tax expense of $310,000 and a discrete tax expense of $454,000 due primarily to our decision to record a full valuation allowance against all of our net US federal and state deferred tax assets at March 31, 2014. The effective tax rates excluding the adjustment for the valuation allowance for the three months ended March 31, 2014 and 2013 were 32.9% and 40.4%, respectively.

Net loss

Net loss for the three months ended March 31, 2014 was approximately $1,004,000 compared to net loss of approximately $431,000 for the same period the prior year. The net loss was primarily the result of our decision to record a full valuation allowance against our net US federal and state deferred tax assets at March 31, 2014. Excluding the adjustments for the valuation allowance included in tax expense our adjusted net loss for the three months ended March 31, 2014 was approximately $161,000, a decrease of approximately $270,000 from the same period the prior fiscal year. The smaller adjusted net loss was due to an increase in revenues and a decrease in certain selling, general and administrative expenses offset by higher cost of revenues. We believe this non-GAAP measure of adjusted net loss is useful because it excludes the significant one-time expense related to the recording of the valuation allowance expense that is considered to be non-operational and of a non-cash nature. This non-GAAP measure thereby allows us to evaluate our current performance and make comparisons to past performance on a consistent basis.

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Nine Months Ended March 31, 2014 Compared to Nine Months Ended March 31, 2013

Revenues

Revenue results for the nine month periods are summarized in the table below (dollar amounts in thousands).


	Nine Months Ended March 31,				Increase (Decrease)
	2014		2013

Total Revenue	$	10,876	$	11,086	$	(210	)	(1.9	)%

Home Care Revenue	$	8,987	$	9,492	$	(505	)	(5.3	)%

International Revenue	$	585	$	552	$	33		6.0	%

Government/Institutional Revenue	$	1,304	$	1,042	$	262		25.1	%

Home Care Revenue. Home care revenue was approximately $8,987,000 for the nine months ended March 31, 2014, representing a decrease of approximately $505,000, or 5.3%, compared to the same period in 2013. The decrease in revenue was caused by a lower average selling price from continued downward pricing pressure and a decrease in referral counts as compared with the same period in the prior 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 year 2013, one of the largest domestic third party payers, Blue Cross and Blue Shield, decentralized its contracting process. The decentralization has required significantly more administrative efforts on our part to complete the necessary contracts to maintain our national coverage with that payer. We have completed the majority of the contracts with the Blue Cross and Blue Shield affiliates that had a large historical referral base, and we will continue to work with the remaining affiliates to become in-network providers.

International Revenue. International revenue was approximately $585,000 for the nine months ended March 31, 2014, representing an increase of approximately $33,000, or 6.0%, compared to the same period in 2013. This increase resulted from an increase in sales to Europe.

Government/Institutional Revenue. Government/institutional revenue was approximately $1,304,000 for the nine months ended March 31, 2014, representing an increase of approximately $262,000, or 25.1%, compared to approximately $1,042,000 during the same period in the prior year. This resulted from a $163,000 increase in government sales, which increased to approximately $357,000 for the nine months ended March 31, 2014. Institutional revenue, which includes sales to distributors, group purchasing organization (GPO) members, and other institutions, also increased by $98,000 compared to the same period the prior year. The overall increase in institutional and government sales was the result of the continued focused efforts of our sales force.

Gross profit

Gross profit decreased to approximately $7,399,000, or 68.0% of net revenues, for the nine months ended March 31, 2014, from approximately $7,777,000, or 70.2% of net revenues, in the same period in the prior year. The decrease in gross profit percentage was primarily the result of lower average selling price, and, as is often the case with new products, we have not yet reached full efficiency in sourcing and manufacturing the SQL and this directly impacted our gross margin in the quarter. We believe that as we grow sales, we will be able to continue to leverage manufacturing costs and gross margins, over the long-term, will return to approximately 70%.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative (SG&A) expenses were approximately $8,097,000 for the nine months ended March 31, 2014, representing a decrease of approximately $754,000, or 8.5%, compared to SG&A expenses of approximately $8,851,000 for the same period the prior year. Payroll and compensation-related expenses were approximately $4,286,000 for the nine months ended March 31, 2014, representing a decrease of approximately $94,000, or 2.1%, compared to approximately $4,380,000 in the same period the prior year. This decrease was due to a 2.9% reduction in full time equivalent employees.

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Advertising and marketing expenses, including tradeshows and event sponsorships, were approximately $363,000 in the nine months ended March 31, 2014, representing a decrease of approximately $95,000, or 20.7%, compared to approximately $458,000 in the same period in the prior year. This decrease was primarily due to the elimination of industry training that was sponsored by Electromed as well as targeting more cost-effective advertising.

Professional fees for the nine months ended March 31, 2014 were approximately $571,000, a decrease of approximately $376,000 compared to approximately $947,000 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 decrease in fees over the same period last year was primarily due to one-time consulting fees related to upgrading our information technology infrastructure that occurred in the prior year, as well as a shareholder’s proposal at our 2013 Annual Meeting of Shareholders and the resulting litigation, which was concluded by settlement of the parties during the first quarter of fiscal year 2014. We have insurance for professional fees and expenses incurred in connection with the litigation and are working with our insurance carrier on coverage matters. During April 2014 we received approximately $100,000 of reimbursement from insurance and we believe there is a possibility of receiving additional reimbursement, however, there can be no guarantee of any specific additional coverage amount.

Research and development expenses. Research and development expenses were approximately $405,000 for the nine months ended March 31, 2014, representing an increase of approximately $93,000, or 29.8%, compared to approximately $312,000 in the same period the prior year. The increase was due to finalizing the development and testing of the new SmartVest SQL. Research and development expenses for the nine months ended March 31, 2014 were 3.7% of revenue, compared to 2.8% of revenue in the same period the prior year. As a percentage of revenue, management expects to spend approximately 3.0% to 5.0% of revenue on research and development expenses over the long term.

Interest expense

Interest expense was approximately $70,000 for the nine months ended March 31, 2014, representing a decrease of approximately $38,000, or 35.2%, compared to approximately $108,000 for the same period the prior year. The decrease resulted from a decrease in average debt outstanding and a lower interest rate on the debt refinanced on December 18, 2013.

Income tax benefit

Income tax expense was estimated at approximately $418,000 for the nine months ended March 31, 2014, compared to income tax benefit of $564,000 in the same period in the prior year. The income tax expense for the nine months ended March 31, 2014 includes a current tax benefit of $36,000 and a discrete tax expense of $454,000 due primarily to our decision to record a full valuation allowance against all of our net US federal and state deferred tax assets at March 31, 2014. The effective tax rates excluding the adjustment for the valuation allowance for the nine months ended March 31, 2014 and 2013 were 36.0% and 38.2%, respectively.

Net loss

Net loss for the nine months ended March 31, 2014 was approximately $1,579,000 compared to net loss of approximately $913,000 for the same period the prior year. The net loss was primarily the result of our decision to record a full valuation allowance against all of our net US federal and state deferred tax assets at March 31, 2014. Excluding the adjustments for the valuation allowance included in tax expense our adjusted net loss for the nine months ended March 31, 2014, was approximately $736,000, a decrease of approximately $177,000 from the same period the prior fiscal year. The smaller adjusted net loss was due to a decrease in certain selling, general and administrative expenses offset by lower revenues and a higher cost of revenues. We believe this non-GAAP measure of net loss is useful because it excludes the significant one-time expense related to the recording of the valuation allowance that is considered to be non-operational and of a non-cash nature. This non-GAAP measure thereby allows us to evaluate our current performance and make comparisons to past performance on a consistent basis.

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Our focus remains on controlling costs in an environment of downward reimbursement pressure while implementing key growth strategies. These include marketing and selling our recently FDA-cleared SQL to the domestic homecare market, and strengthening our focus on the institutional market which includes the recent addition of a senior sales position better leverage our current contracts and adding new contracts.

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

Cash Flows from Operating Activities

For the nine months ended March 31, 2014, net cash provided by operating activities was approximately $1,020,000. Cash flows provided by operations consisted of approximately $1,579,000 in net loss, adjusted for non-cash expenses of approximately $1,080,000, offset by a decrease in accounts receivable and an increase in accounts payable and accrued liabilities of $2,544,000 and $184,000, respectively. In addition, inventories and prepaid expenses and other assets increased approximately $1,171,000 and 38,000, respectively.

For the nine months ended March 31, 2013, net cash provided by operating activities was approximately $990,000. Cash flows provided by operations consisted of approximately $913,000 in net loss, adjusted for non-cash expenses of approximately $627,000, offset by decreases in accounts receivable, inventories, and trade payables and accrued liabilities of $1,653,000, $251,000, and $5,000, respectively. In addition, prepaid expenses and other assets increased by approximately $632,000.

Cash Flows from Investing Activities

For the nine months ended March 31, 2014, cash used in investing activities was approximately $634,000. During this period we paid approximately $626,000 for purchases of property and equipment. We also paid approximately $8,000 for patent related costs.

For the nine months ended March 31, 2013, cash used in investing activities was approximately $743,000. During this period we paid approximately $707,000 for purchases of property and equipment. We also paid approximately $36,000 for patent and trademark related costs.

Cash Flows from Financing Activities

For the nine months ended March 31, 2014, cash used in financing activities was approximately $117,000, which consisted of principal payments on long-term debt of $81,000, and payments of deferred financing fees of $35,000.

For the nine months ended March 31, 2013, net cash used in financing activities was approximately $1,445,000, which consisted of principal payments on long-term debt of $237,000, and payments on our revolving line of credit of $1,208,000.

Adequacy of Capital Resources

Based on our current operational performance, we believe our working capital of approximately $8 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 18, 2014. Based on our ability to service our debt we believe that we will be able to renew our line of credit prior to December 18, 2014 or obtain alternative financing. However, we cannot guarantee that we will be able to procure additional financing upon favorable terms, if at all. Our credit facility contains certain financial and nonfinancial covenants and restricts us from incurring certain additional indebtedness and the payment of dividends. The credit facility also contains financial covenants which require maintaining a minimum tangible net worth. We were in violation of the tangible net worth covenant during the quarter ended March 31, 2014, and the bank has waived the event of default. As discussed below, we entered into an amendment to the credit facility to reduce the minimum tangible net worth requirement going forward.

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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. If we are unable to repay such indebtedness, the bank could foreclose on these assets.

On December 18, 2013, we entered into a new credit facility with Venture Bank, which replaced our facility with U.S. Bank. The new credit facility provides for a $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of December 31, 2013. Interest on the line of credit accrues at the prime rate plus 1.50%, with a floor of 4.50% (4.75% at March 31, 2014) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.75% of eligible accounts receivable and the line of credit expires on December 18, 2014, if not renewed. The line of credit is secured by a security interest in substantially all of the tangible and intangible assets of the Company.

As a part of the new credit facility, we also refinanced our outstanding U.S. Bank term loan which had an outstanding principal balance of approximately $1,341,000 and bore interest at 5.79%. It was repaid in full and replaced by a $1,300,000 term loan from Venture Bank that bears interest at 5.00%, with monthly payments of principal and interest of approximately $8,600 and a final payment of principal and interest of approximately $1,095,000 due on the maturity date of December 18, 2018. The term loan is secured by a mortgage on our real property.

Our new credit facility contains certain financial and nonfinancial covenants which include a minimum tangible net worth covenant of not less than $12,000,000 and restrictions on our ability to incur certain additional indebtedness or pay dividends. On May 6, 2014, we entered into an amendment to our credit facility to reduce the requirement to maintain a minimum tangible net worth from $12,000,000 to $10,125,000. As a result of paying off our outstanding loan and terminating the credit facility with U.S. Bank, we incurred approximately $3,000 in prepayment penalties. As of March 31, 2014, we had net unused availability of $2,500,000 under the line of credit.

For the first nine months of fiscal years 2014 and 2013, we spent approximately $626,000 and $707,000 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.

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.

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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 March 31, 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.

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

On May 6, 2014, the Company entered into an amendment to its credit facility with Venture Bank, which reduced the requirement to maintain a minimum tangible net worth from $12,000,000 to $10,125,000. All other material terms of the credit facility remain unchanged.

The foregoing description of the amendment is qualified in its entirety by reference to the complete text of Business Loan Agreement, dated May 6, 2014; the Rider to Business Loan Agreement and Related Documents, dated May 6, 2014; the Change in Terms Agreement, dated May 6, 2014; the Business Loan Agreement, dated May 6, 2014; the Rider to Business Loan Agreement (Asset Based), dated May 6, 2014; and the Change in Terms Agreement, dated May 6, 2014, copies of which are filed herewith as Exhibits 10.1, 10.2, 10.3, 10.4, 10.5, and 10.6, respectively, and incorporated herein by reference.

Item 6. Exhibits

See attached exhibit index.

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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: May 14, 2014	/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		Business Loan Agreement between the Company and Venture Bank, dated May 6, 2014.

10.2		Rider to Business Loan Agreement and Related Documents between the Company and Venture Bank, dated May 6, 2014.

10.3		Change in Terms Agreement between the Company and Venture Bank, dated May 6, 2014.

10.4		Business Loan Agreement (Asset Based) between the Company and Venture Bank, dated May 6, 2014.

10.5		Rider to Business Loan Agreement (Asset Based) and Related Documents between the Company and Venture Bank, dated May 6, 2014.

10.6		Change in Terms Agreement between the Company and Venture Bank, dated May 6, 2014.

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 March 31, 2014, 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.